Here's How the U.S. Will Play the Russia-China Oil Deal

Dr. Kent Moors

Pundits have been quick to label last week's mammoth gas deal between Russia and China as "historic."

That may be true. But the fact is there are a number of important elements in the $400 billion agreement that have yet to be decided.

For one, Moscow and Beijing have a fundamentally different view of what the delivery pipeline should look like. China wants two pipelines, while Russia is interested in a single line that China would have to share with South Korea and Japan.

The issue, as with everything else that is still up in the air, revolves around cost and revenues.

The pipeline is going to cost at least $22 billion to build. But if Gazprom has to run two satellite lines just for China, it will cut into already strained profit margins.

Meanwhile, if additional contracts with Korea and Japan require separate pipelines, another set of major capital expenditures would emerge.

Even if the pipelines are funded with pre-payments on deliveries (which amounts to an advanced credit), that would simply lock Gazprom into specifying a fixed price up front for the initial multi-year consignments.

This is a big problem, especially where the price has yet to be finalized...

The Problems with the Pact

This "historic" pact may talk about providing 38 billion cubic meters annually over 30 years at a price tag of some $400 billion. But the actual price is a closely guarded secret (the norm in such deals) and remains a matter of some dispute.

In fact, the Russians must match the price of gas exports to Europe, running at about $309 per 1,000 cubic meters, with an additional increase pending. That's because the cost of the gas is adjusted based on the price of a basket of crude oil and oil products. This basket is becoming more expensive, bringing the price of gas up right along with it.

And if the Russians provide the kind of discount China wants, Gazprom will open itself up to arbitration suits from existing contracts servicing a number of European end users.

And in this case, Beijing has an ace in the hole.

Put simply, China does not need, nor can it absorb, the volume called for in this deal. At present, gas accounts for no more than 30% of China's energy needs.

What's more, that total is already completely met for at least the next six years, with a combination of domestic production (which is going to increase - China has the largest extractable shale gas reserves in the world) and ongoing import accords with Turkmenistan and Myanmar.

Also, the infrastructure doesn't even exist to use what Russia expects to sell. It might in a decade, but Gazprom needs the revenue now.

And that brings us to the counter-reaction that is already underway. China is also opening its market to liquefied natural gas (LNG) deliveries, reflecting moves that are already well underway elsewhere in Asia.

That sets the stage for a direct confrontation with the as-yet unresolved Russian agreement.

In fact, the announcement has already introduced some rather rapid moves to obstruct Russian control over access to the Asian market.

Dr. Kent Moors

About the Author

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Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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