"Energy Only" – der ewi-Blog

The Nord Stream 2 project is discussed controversially with regards to its geopolitical, strategic, economic and environmental implications. A deep-dive analysis on the political and economic drivers of the Nord Stream 2 project has been provided in the report “Options for Gas Supply Diversification for the EU and Germany in the next Two Decades, a joint work by the European Centre for Energy and Resource Security (EUCERS) and ewi ER&S. Based on the study’s main economic and game theoretic findings, this blog article analyses the strategic and economic implications of a build-up of Nord Stream 2, respectively its rejection. The analyses is based on a scenario simulation with ewi’s global gas market equilibrium model COLUMBUS.

The new disequilibrium of Ukraine/Russia gas relations

Five years ago, gas relations between Russia and Gazprom were somewhat in a strategic equilibrium. The entirety of Ukrainian gas imports came from Russia, thereby making up for the major part of Ukrainian gas needs. Russia in turn was dependent from Ukraine as its major gas export routes crossed the country’s territory.

In 2016, there is no such equilibrium anymore. Ukraine has halved gas consumption since 2007 and has not imported any gas from Russia since the end of 2015 as it can be supplied via new interconnection capacities from the EU, foremost Slovakia. Whereas Ukraine has become more or less independent from Russia regarding gas supplies, Russia in turn remains dependent from Ukraine concerning its gas exports to Europe.

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Figure 1: Origin of Ukrainian gas imports

Russian gas export capacity to the EU (excluding the Baltics and Finland and assuming a full use of OPAL capacities) is more than sufficient to satisfy the EU’s import needs today and in 2035. However, excluding Ukraine from that calculation makes obvious that Russia highly depends on Ukrainian gas transit capacities. Given the expiration of the current long-term shipping contract between Russia and Ukraine end of 2019, Gazprom is in a strategic disadvantage regarding the negotiation of a new shipping contract.

The new disequilibrium of Russia/Ukraine gas relations has to be seen in the context of Russia’s position in the EU gas market until 2035.

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Figure 2: Today’s Russian gas export options and EU import demand from Russia in 2035
*Pipeline capacities without routes to the Baltics, Finland and Turkey
**Without the Baltics and Finland

Russia’s position in the EU gas market until 2035

The EU gas supply mix is about to change substantially over the course of next 20 years, with the pricing strategy of big upstream exports such as Gazprom being one of its crucial drivers.

Assuming a competitive pricing strategy of Gazprom and other suppliers, Russia strengthens its position as the EU’s number one gas supply country as gas production in the EU and Norway is projected to decline. Our simulation suggests that in the EU gas supply mix of 2035, assuming a rather constant development of gas demand, EU and Norwegian gas production makes up for only 32% compared to 57% in 2014 whereas Russia increases its market share from 27% in 2014 to 33% in 2035. We expect a strong competition from global LNG markets which are projected to reach 120 bcm in 2035.

Assuming an oligopolistic pricing strategy by the major suppliers, including Russia, Russian gas faces stiff competition from the Southern gas corridor and LNG. Russia remains the most important supply country of the EU, but contributes only 103 bcm to the EU gas supply mix in 2035. In order to make an oligopoly strategy work, Russia would need to withhold large volumes for securing relatively high gas prices. At the same time, higher prices attract LNG imports amounting to 160 bcm. These volumes can reach the European end consumer because of large LNG import capacities as well as cross-border pipeline capacities and liquid trading markets.

The pricing strategy of Russia and hence gas export volumes to the EU affect the profitability of the Nord Stream 2 project.
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Figure 3: EU gas supply mix between 2013 and 2035 for different pricing strategies

Nord Stream 2 is economical for Gazprom, but only when opting for a competitive pricing strategy

If Gazprom opts for a competitive pricing strategy, a full expansion of Nord Stream 2 up to 55 bcm is economical. Based on the assumption to keeping transit fees through Ukraine according to their 2016 level, the scenario simulation indicates that investment in Nord Stream 2 to circumvent Ukraine is economically rational from a Russian perspective.

If assuming Russia’s oligopolistic pricing strategy, the simulation suggests that at a projected capacity need of 13 bcm/a even one string of Nord Stream 2 capacity may not be fully utilised, which makes the construction of the pipeline at its projected capacity not economic.

Transits through Ukraine would decline significantly in both cases given that this analysis assumes constant Ukrainian transit tariffs based on their 2016 level. Namely, Ukraine’s tariffs relative to gas transportation costs through Nord Stream 2 remain high — somewhat at the level of 2016 in real terms. Thus, Russia has an incentive to circumvent Ukraine via new infrastructure in order to be more competitive in the EU gas market.

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Figure 4: Utilization of Russian export routes under competitive (left) and oligopolistic (right) pricing strategy

Lower transit tariffs of Ukraine could erode the profitability of Nord Stream

The profitability of Nord Stream 2 is highly dependent on Ukrainian transit fees. By lowering its transit tariffs compared to 2016 levels, Ukraine could decrease the profitability of Nord Stream 2, and attract more transit volumes. If, in 2035, Ukraine charged the same transit tariffs as in 2016 (in real terms), Ukrainian transits would almost vanish, triggering substantial flows on Nord Stream 2. By decreasing its tariffs, e.g. by 60%, Nord Stream 2 would not be needed anymore from an economic perspective and Ukraine would transit more than 70 bcm to the EU.

However, it is to stress the fact that this analysis only points to the economic drivers. Even if Ukraine decreased its transit fees to zero, it would not be certain that Russia would not prefer building and using Nord Stream 2 for strategic and political reasons, thereby again circumventing Ukraine.
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Figure 5: Utilization of Russian transit routes with respect to different Ukrainian transit fees in 2035

Prohibiting Nord Stream 2 would make Ukraine remain an important transit country
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Figure 6: Pipeline utilization with Nord Stream 2 (left) and without Nord Stream 2 (right)

Without an expansion of Nord Stream 2, Ukraine benefits from higher transit volumes. To underscore the potential implications of Ukraine’s transit tariff policy, we simulate the possibility when the Nord Stream 2 pipeline is not built (as well as any new pipeline under the Black Sea), hence Russia has to transit its gas through Ukraine. Under such a scenario, and if Ukraine maintains today’s transit fees, it still secures the transit of 56 bcm of gas in 2035 (vs. 63 bcm in 2015), which is substantially higher compared to a case when Nord Stream 2 is built.

Banning Nord Stream 2 enables Ukraine to raise its transit tariffs at the disadvantage of Russia

In 2025, Ukraine could increase its transit revenues by increasing the transit fees. Russia remains an important supplier of gas for the EU also in 2025, with large amounts of long-term supply contracts still in place, especially when accounting for decreasing European gas production. However, besides Ukraine, Yamal and Nord Stream 1, there exists no meaningful alternative for gas supplies to Europe, given that the Nord Stream 2 expansion is banned and no further Black Sea pipeline is realized. Hence, dependence from Ukraine is quite high. Therefore, taking only into account the results from this ceteris paribus analysis, Ukraine could exploit the situation and skim high margins. European prices would increase slightly, implying that in 2025, most of the Ukrainian transit revenues would be borne by Russia/Gazprom.

The situation in 2035 is different. The figure implies that Russia reduces its volumes when Ukraine raises its transit fees, but Ukraine could achieve similar transit revenues as in the current situation up to an increase of fees by 40 percent. From an increase of fees by 60 percent onwards revenues are remarkably reduced. This may mean that Russia diminishes quantities to such an extent that higher transit costs cannot level out the drop in revenues. Prices in Europe react very sensibly to a rise or drop of Ukrainian transit fees.

This result can be explained as follows: In 2035, Russia, playing a competitive strategy has to be competitive in terms of prices with competing gas supply sources such as LNG or the Southern Gas Corridor. The higher Ukrainian transit fees are, the more expensive will the marginal unit of Russian gas be, due to the lack of alternative gas transport options, given that Nord Stream 2 expansion is prohibited. Hence Russia loses market share, when Ukrainian transit fees become too high.

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Figure 7: Transit revenues of Ukraine and German wholesale prices in 2025 (left) and 2035 (right) for different levels of Ukrainian transit fees

Gazprom has a higher incentive for oligopolistic pricing when Nord Stream 2 is dismissed

Last, the analysis wants to evaluate whether the expansion of the Nord Stream 2 pipeline influences the pricing strategy played by Russia. For that purpose, we assess the average loss of Russian profit margin (defined as prices minus production and transport costs) as well as the average revenues between 2020 and 2035 in the case that Russia pursues a competitive instead of an oligopoly pricing strategy.

Following a competitive pricing strategy, Russia forfeits annual profits of 2.4 billion Euro compared to an oligopoly strategy, in the case Nord Stream 2 is built. If Nord Stream is not expanded, Russia forfeits annual profits of 3.9 billion Euro. In the latter case, Russia is forced to take the higher priced Ukrainian transport route, making Russian gas more expensive in a competitive pricing strategy. Under an oligopoly strategy, this effect is less important, since Russia ships less gas through Ukraine.

In terms of revenues, we see a similar picture: Russian revenues are 9.6 billion Euro higher under a competitive strategy, if Nord Stream 2 is built. If Nord Stream 2 is not built the additional revenues of enforcing a competitive pricing strategy instead of an oligopoly one are 1.5 billion Euros lower and amount to only 8.1 billion Euro.

Hence, the Nord Stream 2 expansion makes a Russian competitive pricing strategy more likely in terms of profits and revenues.

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Figure 8: Average annual delta (2020-35) of Russian profit margin and revenues from pursuing competitive instead of oligopoly pricing with and without Nord Stream 2

Summing up, analysing the economic fundamentals, Nord Stream 2 is indeed Gazprom’s answer to the current strategic disadvantage with regards to transits via Ukraine and, hence, an option to make its gas more competitive in the European market.

For more details, see the full report “Options for Gas Supply Diversification for the EU and Germany in the next Two Decades” by EUCERS and ewi ER&S.