In many ways, the Gazprom-CNPC deal is reminiscent of the Soviet Union’s first gas deal with Europe back in the 1970s. And we all know how that turned out.

Russia's President Vladimir Putin (left) and his Chinese counterpart Xi Jinping talk before the opening ceremony of the fourth Conference on Interaction and Confidence Building Measures in Asia (CICA) summit in Shanghai. Photo: Reuters

On May 21, Gazprom and China National Petrolium Corporation (CNPC) signed a contract that has already been characterized as the largest gas contract in Russia’s gas export history. Yet, the meaning of the contract is widely contested. The main question that is asked is whether it corresponds to the main goals of Russia’s development.

Here’s what we know about the deal: The contract implies export of 38 billion cubic meters (bcm) of natural gas to China annually over a period of 30 years. The contract includes a ‘take-or-pay’ condition and a price formula, which indexes the price of natural gas to the price of oil and oil products. All of these elements are characteristic of a traditional long-term contract that was used for decades in the European gas market and that allowed Russia to become a major supplier to the European gas market.

Those who criticize the deal argue that revenue for the Russian budget will be minimal due to the fact that the price is allegedly too low to assure the profitability of the projects – both exploration and production (E&P) and pipeline construction. Moreover, some argue that the associated fiscal policy is not favorable for Russian society, which allows companies to receive income without paying sufficient amounts in tax to the state budget.

Of course, these concerns are justified. It is important to have some strategic goals in mind, however. The essential goals to keep in mind include: the importance of entry to the Asian market, which in terms of gas pricing is the premium market currently, featuring the highest import prices in the world; and an export strategy is an important means of fuelling the development of Russia’s eastern regions.

The deal can be compared with the entrance of Soviet gas to the European market.

Soviet gas exports to Europe started after contracts with Austria, Germany, France and Italy had been signed in the first half of the 1970s, and the infrastructure had been put in place by 1973-74. According to the very first contract with Germany, the USSR was going to supply 3 bcm annually. The arrangement included a ‘gas for pipes’ deal. In this type of deal, gas supplies from the USSR to Europe were based on export pipelines, with the pipes for these pipelines supplied by Western companies. The construction was financed by credits from Western banks, while supplies were secured through a set of supply contracts with Western gas companies.

Thus, the backbone of the developments was the long-term contract (LTC). The traditional long-term contract was developed throughout the 1960s in order to supply gas from the Netherlands to neighboring countries. The typical LTC, used in the 1970s for Soviet gas exports as well as for today’s long-term contracts, includes the following elements:

- Long-term supply obligation;

- A price formula (meant to account for the replacement value of the gas, ensuring competitiveness of gas with other fuels but at the same time maximizing profitability);

- Possibility to review the price set-up at regular intervals;

- Destination clauses (initially to ensure the highest possible profit for a supplier in any given market; the concept has been challenged, as it may undermine the principles of market competition);

-  Take-or-pay clause (which ensures a high load factor in order to ensure a certain utilization rate of the respective infrastructure).

The format that has been chosen by Gazprom to enter the Chinese gas market seems to be the only possible format. Of course, the situation in the Chinese market is different from the current situation in the European market, but the traditional mechanism of a long-term contract with a price formula indexed to a basket of global commodities is definitely relevant.

Moreover, not signing the contract under these or any other conditions was not an option for Gazprom due to the following reasons. Firstly, there is increasing competition from independent gas producers inside Russia, who already have long-term contracts for liquefied natural gas (LNG) exports. These exports were made possible by the December 2013 decree, which allows limited exports from offshore fields under long-term contracts.

If Gazprom did not prove its ability to keep pipeline exports (and, in particular, pipeline exports to a strategically important region) under control, it would only be logical that the liberalization of exports would go further than LNG. Additionally, the fact that the draft of the Energy Strategy until 2035 hinted at the possibility of splitting Gazprom into several entities, this would have significant implications for future contracts.

Secondly, Gazprom has an LNG strategy that suggests building a new plant in Vladivostok. This plant cannot use gas from the Sakhalin fields  since it is committed to other projects. There is a possibility to use the Eastern Siberian gas for this project, but considering significant costs of infrastructure that is at this stage non-existent, the project was very unlikely to kick-off in the absence of an accompanying long-term contract for pipeline gas exports.

Last but not least, an ambitious project such as the gasification of the Eastern regions of Russia is also not viable in case there is no export plan and thus, no justification for the high cost of infrastructure development. Therefore, it is possible to conclude that the situation for Gazprom had created a strong motivation to pursue the contract with CNPC.

The major conclusion is that the contract between Gazprom and CNPC marks the beginning of a new era. This deal signals the strategic turn of Russia to the East, and in the situation of the changing geography of world energy trade, a presence in the fastest-growing market is essential for a producer that wishes to remain an important player in the international energy markets. The long-term contract secures demand for the development of the pipeline - it is no use to build a pipeline if demand for gas transported through it is not secured.

And finally, consider the volumes for the deal, which were described as ‘not so high’ - 38 bcm versus total exports to Europe estimated at 130 bcm (as reported by BP for the year 2012). That is one comparison, but a more relevant comparison seems to be with the anual size of the initial contract with Germany, which was ‘only’ 3 bcm.

The deal in this respect is of ultimate significance. It is a hugely expensive project, but in the long run it gives Russia the opportunity to win a position in the Asian gas market – which, just for reference, currently is the largest in terms of gas demand, and the gas price there is the highest amongst all regional gas markets.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.