alternative pipeline routes to korea

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Northeast Asias Kovykta Conundrum:A Decade o Promise and Peril

Se Hyun Ahn & Michael . Jones

research note

http://asiapolicy.nbr.org

keywords: northeast asia; natural resources; natural gas; oil;

pipelines; energy policy; russia; kovykta

se hyun ahn is Assistant Professor at the Government and InternationalRelations Programme in the Division of Humanities and Social Science in theUnited International College, Zhuhai, China. He was previously a research

fellow at the Asia Research Centre at the London School of Economics andPolitical Science. He can be reached at .

michael t. jones is a project manager at Te National Bureau of AsianResearch. He has a degree in Chinese language and literature from the Universityof Washington. His primary areas of research include energy security, politics ofeconomic development, and Asias relations with the developing world. He canbe reached at .

note u Te authors would like to thank Mikkal Herberg and twoanonymous reviewers for helpful insights.

asia pol icy,number 5 (january 2008), 10540


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Tis article seeks to explain whydespite the potential or gas rom Siberia

and the Russian Far East to provide greater energy security or NortheastAsiaa decade o negotiations has still not resulted in an agreement to

construct the Kovykta pipeline.

main argument

Gas rom Russias Kovykta field has the potential not only to drastically

reduce Northeast Asias energy shortage but also to help diversiy Northeast

Asias traditional sources o energy away rom the Middle East.

Te potential or Kovykta gas to reach any Northeast Asian country, however,

has been delayed or over ten years due to the ollowing actors:

Te politics of route determinationu Tough routing the pipeline viaNorth Korea and Mongolia would be cheaper, government and privatesector sensitivities have resulted in proposed routes that circumvent thetwo countries and thus drive up the costs o any such pipeline.

Inherent complexities of gas investmentsu

Natural gas is intrinsically more

difficult to trade than oil, and gas deals require much more confidence,guarantees, and money rom investors and governments.

Demand security u Chinas market is important to Kovyktas success.Despite plans or urther gas market development, however, Chinasreliance on cheap coal has created a sof market or higher-priced gas.

Russias resource nationalism u Rising oil prices have given Moscowimpetus to renationalize Russias energy sector, thereby both complicating

negotiations and causing investors to be wary o a Russia that could useenergy as a political weapon.

policy implications

Tough a more centralized role or Russia in the Kovykta project could speed

the decisionmaking process, striking a price that suits both China and Russia

will be the key determinant in the ate o the pipeline. Gazprom is currently

ocused on other projects, however, and Kovykta will possibly remain

idle or several years to come. Not allowing Russias giant gas field to havesignificant market outlets in Asia will keep gas prices higher than they would

be otherwise, potentially diminish available supplies to the U.S. West Coast,

and keep incentives in place or Asia to increase ties to rogue gas-supplier

states such as Iran and Myanmar.


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E nergy security is gradually replacing the previous ideologicalconrontation that was characteristic o the Cold War to orm a newsecurity paradigm in the Asia-Pacific. Maintaining strong relations with

Russia is extremely advantageous to regional states given that the import

o oil and gas rom Russias Far East has the potential to enhance Northeast

Asias energy security interests by reducing domestic energy shortages and

diversiying energy imports. Since the end o the Cold War, Russia has ofen

been portrayed in Asia as a waning political and economic orce. Since the

dissolution o the Soviet Union, however, Russia has sought to become a

pivotal regional player in Asia. Russian president Vladimir Putin clearly

hopes to upgrade Russias prestige and influence in the region by promoting

his countrys role both as an objective mediator and as a reliable energysupplier. In the last several years in particular Russia has demonstrated power

and influence in the new geopolitical environment o high energy prices.

With enormous oil and gas reserves in Siberia and the Far East, Russia has an

economic interest in expanding the countrys energy markets into the Asia-

Pacific region.

Despite this great potential, the reality is that Russian energy projects

have not emerged as a substantial unctioning unit o economic activity thus

ar. Te many efforts in the last ten years by Northeast Asian statesnotablyChina, South Korea, and Japanto exploit opportunities in Russias Far East

have had only marginal success. Gazprom is now in the midst o taking over

controlling stakes in Russias remaining oreign-owned energy projects. In

mid-June o 2007 Gazprom took a majority share o the Kovykta gas field

project by orcing NK-BP out o the consortium. For ten years this gas

field, located in Russias Irkutsk region, has promised to be a keystone or

physically connecting the nations o Northeast Asia in a way that no other

energy project could. Tough governments o China, Mongolia, South Korea,

North Korea, and Japan have actively discussed Kovyktas development

over the last decade, the development o gas pipelines rom Russia has been

extremely slow. Several actors have impeded progress, including Chinas

underdeveloped and unpredictable gas market, issues related to regional

distrust, political and commercial risks regarding pipeline routing options,

the Asian financial crisis in the late 1990s, and Russias renationalization o the

energy sector. Gazproms ocus on westward exports and lack o technologicalexpertise could seriously impair Russias prospects or a greater share o Asian

gas exports. As such, many consumer countries in Northeast Asia have held

off on dealing with Russia and are beginning to turn elsewhere to ulfill uture


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gas needs. With little development having ensued since Gazproms takeover o

the Kovykta project, the ate o this venture is uncertain.

Tis article uses the case study o the Kovykta gas pipelines proposed in

the region to illustrate both the potential or and the major obstacles to Russia

becoming a major provider o energy security or Northeast Asia.

Tis article is divided into five sections:

u pp. 10814 examine both the current state o natural gas development inSouth Korea and China and the overall benefits o potential Kovykta gasexports to the two countries

u pp. 11421 outline Kovyktas changing development and export plansover the last ten years

u

pp. 12129 analyze the major economic obstacles to the developmentand export o Kovykta gas to Northeast Asia

u pp. 12937 examine Russias resource renationalization and otherdomestic actors that have impinged on the export o Kovykta gas toNortheast Asia

u pp. 13740 consider the uture outlook or Kovykta gas introductioninto Northeast Asia and the geopolitical and economic implications orAsia and the United States

Russias Untapped Potential

Russia has been described as the worlds treasure trove o gas. Around

twenty new giant gas fields have been discovered in the last couple o decades,

each containing over 500 billion cubic meters (bcm). Tese twenty fields

comprise close to three-quarters o Russias total gas reserves. Capable o

producing as much as 130 bcm o natural gas by 2020equivalent to the

current level o Russias gas exports to Europethe Russian Far East can play

a very important role in shaping cooperative energy schemes in Northeast

Asia.1In the last ten years Northeast Asian governments and companies have

made several attempts to capitalize on a number o major energy projects in

the Russian Far East.

1 See Stephen White, Is Russia a Country in the Globalization Era? (presentation preparedor conerence on the Regional Cooperation o Northeast Asia and Russias Globalizationor the 21st Century, Seoul, South Korea, June 2224, 2003); and Eugene M. Khartukov,Russia, in Rethinking Energy Security in East Asia , ed. Paul B. Stares (okyo: Japan Center orInternational Exchange, 2000), 141.


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One o Russias largest gas fields is the Kovyktinskoye (Kovykta) gas

condensate field. Discovered in 1987, this field contains an estimated two

trillion cubic meters o natural gas and condensate.2 Put into perspective,

Kovykta contains more gas than the entire nation o Canada, the major

supplier o gas to the United States. Due to the sheer size and location o the

field, Kovyktas development represents a timely and important opportunity

or China and South Korea. Development o this field as last proposed by

the consortiumwith 20 bcm per year going to China and 10 bcm per year

going to South Koreacould hold many benefits or Russia. Development

at this level could acilitate diversification o Russias Europe-centric export

market, increase government revenues, spur economic development in the

desolate regions o the Russian Far East and Siberia, and promote regionalenergy integration.

With Gazproms recent takeover o the project (discussed in detail below),

pipeline development into Northeast Asia couldi planned careully

represent a significant opportunity or Russia. Te projected $1.21.4 billion

per year in annual tax revenues rom the export o Kovykta gas by 2020 would

benefit both the ederal and local governments.3In 2006 gas rents accounted

or approximately hal o Russias total energy rents. Furthermore, Gazprom

currently exports all o Russias gas to Europe and Eurasia; a major pipelineto Northeast Asia could thereore diversiy the companys export portolio.

In 2006 Gazprom produced 556 bcm o gas and exported around 260

bcmapproximately hal the totalto Europe, the Baltic States, and Central

Asia.4Tus, potential Kovykta gas exports o around 30 bcm per year would

represent over 10% o Gazproms current exports.

As o early 2007, however, domestic consumption o gas supplied rom

the Kovykta field amounted to only 2 bcm. Te main consumers o this initial

production have been the sparse populations o Angarsk, Sayansk, Irkutsk,

and Usolye-Sibirsk.5Tese populations will never consume as much gas as this

field could potentially produce. For the benefit o both the project consortium

and the Russian state, Kovykta gas must reach Asian markets.

2 Kovykta Project, NK-BPu http://www.tnk-bp.com/operations/exploration-production/projects/kovykta/.

3 Ibid.

4 Gazprom Annual Report 2006, OAO Gazprom, 2006 u http://www.gazprom.com/documents/Report_Eng.pd.

5 Ibid.


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South Koreas Looming LNG Supply Gap

In the last ew decades, South Korea has been one o Asias astest-growing

and most dynamic economies. Vast amounts o natural resources will be

needed to maintain this economic growth. Due to the expansion o energy-intensive industries and to increases both in income and in the number o

motor vehicles, total primary energy demand in South Korea has skyrocketed

to 226 million tons o oil equivalent (mtoe) in 2005, approximately 78 mtoe

higher than in 1995.6Having very limited domestic sources o energy, South

Korea relies almost completely on imports. Energy imports as a percentage o

total demand rose rom 73.5% in 1980 to 96.8% in 2005. Te worlds ourth

largest oil consumer, South Korea presently relies solely on imports to meet oil

needs and uses oil as the primary uel source; demand or oil as a percentage

o total energy demand is, however, projected to all rom 53% in 2003 to 39%

by 2030.7

In the mid-1980s Seoul introduced tax incentives to promote widespread

use o natural gas. With the rapid expansion o the countrys natural gas

industry rom 1987 to 2002 and establishment o a nationwide trunk pipeline

network, South Korea has become one o the worlds most dynamic gas

markets. Natural gas continues to be the astest-growing energy resource in

South Korea due both to the convenience and to the environmental riendliness

o natural gas relative to oil. As such, orecasts are that South Koreas demand

or gas will increase by 150% (rom 20 bcm in 2000 to 53 bcm) by 2020.8In

short, natural gas has been and will remain the astest-growing energy source

in South Korea.

South Korea is currently the second-largest importer o liquefied natural

gas (LNG) and home to the worlds largest LNG importer, Korean Gas

Corporation (KOGAS). KOGAS has a de acto monopoly on South Korean gasimports, which thus ar have been exclusively in the orm o LNG.9KOGASs

imports have traditionally come rom Southeast Asia; many o these long-

term KOGAS contracts are ending in 200708, however, and their renewal

6 BP Statistical Review o World Energy 2006, BP p.l.c., June 2006.

7 Ministry o Commerce, Energy, and Industry o the Republic o Korea (MOCIE)uhttp://www.mocie.go.kr.

8 Ibid.

9 Due to privatization efforts that began in 1999, the South Korean government allowed POSCO(a large steel maker) to make a rare spot purchase o 500,000 tones o LNG in 2006. POSCOand K-Power also signed a long-term LNG contract in 2004 or 550,000 and 600,000 million tonsrespectively o LNG rom Indonesias angguh project that will be delivered by the end o 2008.


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is not always certain.10Tereore a growing proportion o South Koreas LNG

is coming rom the Middle East. South Korea began importing LNG rom

Oman and Qatar in 1999 and has secured a contract or large shipments rom

Yemen beginning in 2008. By 2020 nearly 80% o South Koreas LNG imports

will come rom the Middle East (see Figure 1). Imports o LNG to South

Korea will increasingly need to traverse long distances through vulnerable

chokepoints such as the Hormuz and Malacca straits. Furthermore, the

Middle East is acing a shortage in liqueaction capacity, traditional LNG

suppliers (Yemen, Oman, and the United Arab Emirates) all have virtually run

out o new supplies, and approximately 80% o the potential LNG supplies o

Qatarjust emerging as one o the worlds largest LNG exportersare already

committed.11

For South Korea, these phenomena make neighboring Russia anextremely attractive source o gas.

Since KOGAS is the main LNG importer, South Koreas economy is

dependent on winning new long-term LNG contracts. Although KOGASs

contracted supplies roughly matched total gas demand in 2001, the supply-

demand gap has recently noticeably widened due to South Koreas seasonal

demand fluctuations (see Figure 2). South Korea consumes around eleven

times as much LNG in the winter as in the summer. Given that traditionally

strict LNG contracts orbid customers to sell excessive supplies to third parties,South Korea has in effect been orced to buy contracted gas below demand

and to make up the difference with spot-market cargoes.12South Koreas 2005

spot-market purchases came to around 8 mtoe o gasor approximately 9

bcman amount the equivalent to about one-third o the countrys total

gas consumption(seeFigure 2). Reliance on the spot market to make up or

gas shortalls is a major problem or Korea. Although purchases on the spot

market have become increasingly commonplace in the Asia-Pacific, spot

market LNG is vastly more expensive than gas obtained through long-term

10 Indonesia is one such example. Although much o South Koreas LNG in the 1990s came romIndonesia, the uture o Indonesias LNG industry is uncertain. Due to a lack o both avorableinvestment policies and general resource nationalism, this OPEC country became a net importero oil in 2004, with plans to urther develop the countrys LNG or export currently in limbo.An overall push to develop a domestic gas market is emerging to make up or this energy gap.Indonesia already has to import LNG rom other countries in order to meet existing long-term

supply contracts.11 Fereidun Fesharaki, Energy Issues in Iran: It Helps to Know a Few Facts Beore ReachingConclusions! (presentation given at the 27th Annual Oil & Money Conerence, London,September 1819, 2006).

12 Spot markets allow producers o surplus gas to instantly locate available buyers, negotiate prices,and deliver actual commodities to the customer in real time and are either privately operated orcontrolled by industry organizations or government agencies. Spot markets requently attractspeculators because spot market prices are known to the public instantaneously.


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contracts, including pipeline gas.13Kovykta could be a source o both stable

and predictably priced gas or South Korea.

As mentioned above, South Korea is solely reliant on LNG. Te proposed

Kovykta pipeline would thereore allow Seoul to diversiy not only the sources

o gas but also the modes o gas transportation available to South Korea.

For Seoul, the Kovykta pipeline is extremely attractive as such a line could

disperse risk among the multiple parties involved (both government and

private)rather than bilaterally as is the case with LNG dealsand balance

South Koreas reliance on tanker gas coming rom the Middle East.

Chinas Promise as a Gas Market

Natural gas currently comprises only 3% o Chinas total energy

consumption mix, a percentage that is significantly less than the world

13 Te growth o the spot market in Asia is in part due to South Koreas seasonal gas demand swings, anuclear plant shutdown in Japan, and gas supply interruptions in Indonesia.

FIGURE 1

Share of South Koreas LNG Imports by Source, 19902020

Percentage

Year

Source: KOGAS 2005 Annual Report, Korea Gas Corporation, 2006 uwww.kogas.or.kr.

Southeast Asia Middle East Other

1990 1995 2000 2005 2010 2015 2020

0

10

20

30

40

50

60

70

80

90

100


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average o approximately 23%.14 Te lack o gas demand is predominately

due to Chinas reliance on coal or electricity. Accounting or 70% o total

energy consumption in China, coal is slated to remain king in Chinas

energy mix or the next several decades. Beijing is, however, beginning to

realize the limitations o coal or providing a stable supply o electricity inChina. Rampant electricity demand has placed serious stress on Chinas rail

transportation system and has created major transportation bottlenecks that

triggered a rise in coal spot prices and caused severe power outages in many

parts o the country. Faced with these coal shortages, many manuacturers

have resorted to using gas- and diesel-powered generators to meet actory

electricity needs, a substitution that in turn raises Chinas overall oil demand.

Te grave environmental and health implications o Chinas coal use

have received extensive media coverage. Te International Energy Agency

(IEA) predicts that China will overtake the United States in carbon dioxide

14 BP Statistical Review o World Energy 2006.

1990 1995 2000 2005 2010 2015 2020

0

5

10

15

20

25

30

35

40

45

50

FIGURE 2

South Koreas Growing Gas Supply-Demand Gap

Milliontonsofoilequivalent

Year

Source: Outlook or Energy Consumption in 2010, MOCIE uwww.mocie.go.kr; BP Statistical Review o

World Energy 2007, BP p.l.c., 2007; and KOGAS 2005 Annual Report.Note:Data or 2010, 2015, and 2020 is projected.

DemandSupply gap

Supply contracts


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emissions in 2008.15Additionally, the coal industry in China sorely lacks saety

standards. In 2005 nearly 6,000 deaths in coalmine accidents were reported

in China. According to Zhao iechui, chie o China's State Administration o

Coal Mine Saety, China closed a total o 8,984 small coalmines in the first hal

2007 and will close another 2,811 small coalmines by the end o the year.16

Chinas coal industry will require around $100 billion in urther

investments to meet projected demand in 2025.17Rather than making these

needed investments in the coal industry, China could direct investment toward

establishment o an integrated gas system. With 70% o Chinas economy

relying on the coal industry, prospects or diversified gas introduction will

remain a top priority or Beijing. Investments in efficient and clean gas-fired

power stations would play a critical role in alleviating many o Chinas coal-related environmental and health problems.

Domestic gas production has risen dramatically, up 17% between 2005

and 2006. Despite this change, China must increasingly look abroad or

supplemental gas supplies. Until recently China was completely sel-reliant

on domestically produced gas. Because Chinas national gas network is not

even remotely comparable to that o South Korea or Japan, the countrys

domestically produced gas is consumed in close proximity to the production

fields. No consensus has emerged among analysts over the shape Chinesegas demand will take in the next twenty years(seeFigure 3). As economic

development and manuacturing urther stretch into Chinas hinterland,

Beijing will need to build gas pipeline networks and effectively implement

policies or promoting pipeline use. As the majority o Chinas gas consumption

and pipelines (though sparse) are in the countrys northeastern region, Russia

is an extremely attractive gas supplierand Kovykta gas is optimally located

or transport to China.

In 1989 Chung Ju-Yung, chairman o the Hyundai Group, proposed

running a gas pipeline rom Yakutsk to South Korea via North Korea. He

hoped that this project could both enhance South Koreas energy security

15 Richard McGregor, Rampant Growth Spurs Emissions, Financial imes, April 19, 2007.

16 China to Stay Coal Net Exporter through 2007, Energy Economist, no. 310 (August 2007): 38.

17 James P. Dorian, Global Implications o Rising Chinese Energy Demand (paper presented atannual energy security conerence o Te National Bureau o Asian Research, Washington, D.C.,September 2526, 2005).


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and advance the idea o a unified Korea.18 In 1994 the presidents o South

Korea and Russia agreed to jointly develop natural gas rom a field in Yakutia

(Republic o Sakha) in eastern Siberia to supply gas through a pipeline to

Seoul. South Korean president Kim Yong-sam stated that this pipeline would

promot[e] the economies o the two countries[and] contribute to orming

a basis or unification o the two Koreas.19In late 1995 Moscow and Seoul

completed a preliminary study o the technical and economic easibility o

Sakha gas development. Under the agreement a 6,600 km (4,125 mile) natural

gas pipeline would extend rom Sakha through Khabarovski and Primorski

krais. Expectations were that the annual output o gas would total 30 to 45

18Keun-wook Paik, Gas and Oil in Northeast Asia: Policies, Projects, and Prospects(London: TeRoyal Institute o International Affairs, 1995).

19 Russia and South Korea Agree to Develop a Gas Field and Construct a Pipeline, BBC MonitoringService: Asia Pacific, June 3, 1994.

FIGURE 3

Projections of Chinas Gas Demand

Billioncubicmeters

Year

Source: BP Statistical Review o World Energy 2007; 2006 Energy Demand and Supply Outlook, Asia-

Pacific Energy Research Center (APERC), 2006; 2004 World Energy Outlook, International Energy Agency(IEA), 2004; and 2006 International Energy Outlook, Energy Inormation Administration (EIA), 2006.National Development and Reorm Commission (NDRC) figure cited in Akira Miyamoto and ChikakoIshiguro, Pricing and Demand or LNG in China: Consistency between LNG and Pipeline Gas in a FastGrowing Market, Oxord Institute or Energy Studies, NG-9, January 2006.

Note:Actual figure in 2006 is 56 bcm.

2006 2020

0

50

100

150

200

250

300

APERC (153)

EIA (134)

IEA (107)

NDRC (250)


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bcm, 15 to 28 bcm o which would be exported to the Korean Peninsula and

that the project would be shared between Russia (70%) and oreign investors

(30%). Pyongyang approved the transit o the gas pipeline through North

Korean territory because the project would be economically beneficial to the

country. Estimates or the total cost o the project were between $17 and $23

billion, with supplies expected to last fify years.20Te regional pipeline idea

was abandoned, however, because the fields in Sakha Republic were deemed

unprofitable due not only to the huge costs associated with a pipeline o

this length and the harsh climate and geological conditions but also to the

uncertainty o uture South Korean demand or gas. International ocus thus

quickly turned to the Kovykta gas field in Irkutsk.

he Five-Country Feasibility Study (19962000)

Following the discovery o the gas field in 1987 and several short-lived

attempts by Western oil companies to take part in Kovyktas development,

Russias prime minister ordered that Sidancoa newly ormed regional oil

company owned jointly by Russia Petroleum (RP) and the Export-Import Bank

o Russiashould become the major Russian stakeholder in the project. In

1996 a subsidiary o South Koreas Hanbo Group, the East Asia Gas Company(EAGC), took the initiative o purchasing 27.5% o the equity shares in the

project or $25 million and promoting early development o East Siberias

oil and gas reserves.21As a result the Hanbo group (with 46.1% ownership)

became the largest shareholder o the project. Having invested $40 million

in the field development, the consortium began looking or supplemental

oreign investment by 1997. Tat year Russias Ministry o Fuel and Energy

and China National Petroleum Corporation (CNPC) signed an agreement to

bring Kovykta gas to northeast China via Mongolia. At that time total projectcosts were expected to amount to $57 billion.22

South Koreas stake in the project was short-lived; in 1997 a bankrupted

Hanbo Group was orced to sell off a majority o its equity shares. British

Petroleums $571 million purchase o the bulk o Hanbo shares lef EAGC with

just a 7.5% share. Sidanko and BP established a strategic alliance to develop

the project.23Projections at this time or the proposed pipeline put delivery

20 Ekonomicheskii Soyuz Supplement, Rossiskaya gazeta, March 30, 1996.

21 Unless noted otherwise, all monetary values are in U.S. dollars.

22 Russia and China to Build Gas Pipeline to Yellow Sea, BBC Monitoring Service: Former SovietUnion, July 18, 1997.

23 Jeanne Whalen, BP and Uneximbank Close Sidanko Deal,Moscow imes, November 19, 1997.


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o Kovykta gas to China at 20 bcm per year, with the possibility o extending

pipelines to service Korean and Japanese markets. In 1998 Russia, Japan,

China, South Korea, and Mongolia signed a memorandum o understanding

to execute a easibility study.24During this phase o negotiations the pipeline

route deemed most economical was one running rom Irkutsk to Beijing via

Ulaanbaatar, Mongoliaa total distance o 3,364 km.Te planned 1,420 mm-

diameter pipeline would require capital investments o nearly $7 billion.25

Several issues began suracing at this time. Although the proposed route

was the most economical, China was staunchly opposed to Mongolia as a

transit country. Additionally, although China was the main market or the gas

a large portion o the investments would need to come rom South Korea and

Japan. Under these prerequisites, companies rom the two countries wouldneed to be rewarded with larger stakes in the pipeline development. Project

plans collapsed at a December 1998 meeting. In 1999 the development o the

pipeline was revived by a cooperation agreement signed in February 1999

between the prime ministers o Russia and China, Yevgeniy Primakov and

Zhu Rongji.26By the end o 1999 China and Russia had invited South Korea

to join in another easibility study that began in early 2000. Te remainder o

that year was defined by BP taking urther control o RP with the acquisition

o EAGCs remaining shares.

he hree-Country Feasibility Study (200003)

During a November 2000 meeting in Beijing, the BP-controlled RP

signed a new tripartite agreement with CNPC and KOGAS or a easibility

study.27 Shortly afer the agreement, South Korea proposed that the study

include the potential or North Korean participation in the project. South

Korean energy experts and politicians emphasized that by giving NortheastAsia a truly integrated pipeline system the North Korean routing option

would both minimize the unstable political situation in the Korean peninsula

and promote mutual economic prosperity or each participating state.

In 2002, beore the easibility findings were even announced, yumen

Oil Company (NK)a significant shareholder (26%) o RPproposed the

24 E. Siberia Gas Feasibility Study to Be Agreed, Reuters, September 23, 2006.

25 Keun-Wook Paik and Jae-Yong Choi, Pipeline Gas rade between Asian Russia, Northeast AsiaGets Fresh Look, Oil and Gas Journal95, no. 33 (August 18, 1997): 4145.

26 Russian Agency Details Sino-Russian Energy Cooperation Projects, BBC Monitoring: Asia-Pacific, February 24, 1999.

27 Russia, Platts Oilgram News 78, no. 215, November 7, 2000.


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idea o completely bypassing China by directing the pipeline to Nakhodka

or LNG exportation.28A year o shuttle diplomacy and wrangling between

stakeholders, local and ederal governments, and Russian gas giant Gazprom

ensued, due in large part to Moscows 2002 appointment o Gazpromnot

even a stakeholderas the main coordinator or all gas exploration and

production (E&P) and export projects in east Siberia. Moscow specifically

asked Gazprom to coordinate all o Russias gas sales to the Asian markets,

as the company does with European exports.29In February 2003 Gazprom

chie Alexei Miller visited Seoul to discuss KOGASs proposal to build

the Kovykta pipeline into China through North Korea, finally reaching

Pyongtaek in South Korea. NK and BP (which had merged in 2003 giving

the new company NK-BP a 62.5% stake in RP) strongly opposed the routethrough North Korea, however, because o the increased costs and potential

political risks. South Korea eventually abandoned the idea and returned to

the original plan to lay the pipeline on the bottom o the sea between China

and South Korea (see Figure 4).

Te three-country easibility study was eventually conducted and finalized

in the summer o 2003. Te study ound that the project was commercially

sound and projected that the total production volume o gas rom the Kovykta

field would reach 3035 bcm per year, o which China would receive 20 bcmper year and South Korea would receive 10 bcm per year. Te proposed gas

pipeline would have a total length o 4,887 km, starting rom Irkutsk, wrapping

around the southern tip o Lake Baikal, running parallel with the Mongolian

boarder, and crossing the Russia-China boarder at Manzhouli (Manchuria).

In China the pipeline would run through Qiqihaer, Harbin, Changchun, and

Shenyang. From Shenyang the pipeline would splitone line going to Beijing

and the other line going to Dalian. From Dalian a pipeline would run 536 km

under the Yellow Sea to the Korean city o Pyongtaek.30Te study also ound

that the pipeline would take five to six years to build and could ultimately

supply South Korea with gas beginning in 200910. Te study projected that

the project costs would reach $17 billion. According to KOGAS, the price

28 Russian NK Urges OK or Kovykta-Nakhodka Gas Pipeline, Dow Jones International News,March 15, 2002.

29 Gas Pipeline to China and Korea, APS Downstream Review rends, September 4, 2006.

30 Jiqiang Ma, Substantial Result Achieved or Russia-China-ROK Gas Cooperation Project, ChinaOil and Gas, no. 4 (2003): 4245.


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o Kovykta pipeline gas would have been 20% to 30% lower than Koreas

established LNG prices.31

Gazproms Strong-arm (2004Present)

Beore the three parties were able to sign an intergovernmental

agreement, however, Gazprom declared that it would support neither the

proposal nor the export o Kovykta gas to international markets, arguing that

the gas should be sold on Russias domestic market.32During a January 2004

meeting with NK Chairman Viktor Vekselberg, Gazprom Chairman Alexei

Miller declared that Gazprom would not permit the field to be developed

outside Gazproms control and insisted that the priority should be Russias

31 Chang Duckjoon, Northeast Asia Energy Cooperation and the Russia Far East, Korea Focus,MayJune 2004u http://www.koreaocus.or.kr/essays/view.asp?volume_id=34&content_id=8&category=G.

32 Gazprom Says Kovykta Project Unattractive in Current Version, Prime-ASS Energy Service,January 29, 2004.

FIGURE 4

Kovyktas Proposed Pipelines

Source: K. Kanekio, Northeast Asia Natural Gas rade Study: Developing Stable Supply o Cleaner Energy

or Sustainable Development (presented at the World Bank workshop, Beijing, June 24, 2004).

Nakhodka

Khabarovsk

Skovorodino

Dalian

Changchun

Harbin

Daqing

Manzhouli

Irkutsk

Kovykta Gas Field

ChayandinskoyeGas-Oil Field

Beijing

Ulaanbaatar

Pyongtaek


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[ ]

domestic market, noting that supplying gas to Russian consumers must be

a priority in development o East Siberia. Tis principle is not reflected in the

easibility study. Nor are the costs o gasiying regions around the field taken

into account or the potential or developing petrochemical projects using

resources rom Irkutsk fields.33wo months later, Gazprom even suggested

that Kovykta gas be linked to the unified system o gas supply to be diverted

toward European markets.34 Alexander Medvedev, deputy chairman o

Gazprom stated: we told [NK-BP] that we could consider Kovykta as a part

o the export base, but in no way we would discuss supplies rom Kovykta to

China. Tat makes no economic sense.35

Gazprom clearly desired an equity stake in the project, larger than the

11% share that Irkutsk State Property Committee had offered. As holder othe largest stake in the project, NK-BP quickly became Gazproms target.

Although realizing early on the need to effectively work with Gazprom, NK-

BP sought to bring Gazprom in only i on air commercial grounds.

Working through the Ministry o Natural Resources, Gazprom

soon brought to the limelight some o the details in NK-BPs license

agreement and the possible consequences or NK-BP o not meeting the

contract terms. Under this agreement, NK-BP was required to produce

a minimum o 9 bcm per year rom the Kovykta field by 2006 or risklosing the project. In a last-minute effort NK-BP built a small pipeline

rom the Kovykta field to Zhigalovo, a logging village with only 5,000

residents. NK-BP sold the gas or $30 per thousand cubic meters, well

below market prices; Gazprom sells gas to Europe at an average price o

$250 per thousand cubic meters.36

When NK-BPs deadline closed in June 2007, Gazprom agreed to

make a nominal payment o $700900 million to NK-BP and promised

shares in other projects in Russia in return or NK-BPs 62% stake in

Kovykta. Although not yet having made public its official export plans,

Gazprom officially stated that China and South Korea are regrouping on

gas talks.

Although some analysts believe that takeover o the project by Gazprom

could actually expedite the development o an export route (whether

33 Gazprom Outlines Disagreements with NK-BP over Kovykta Project, Platts Commodity News,January 29, 2004.

34 Nodari Simonia, Russian Energy Policy in East Siberia and the Far East, James A. Baker IIIInstitute or Public Policy, Rice University, October 2004, 11.

35 Gazprom: Gas Deal with China to Be Finalized by First Hal o 2006, Caijing Magazine, September26, 2005u http://www.caijing.com.cn/newcn/English/Industry/2005-10-03/13870.shtml.

36 Te Russian Oil and Gas Producers, APS Review Downstream rends, August 21, 2006.


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[ ]

through China and South Korea or to Nakhodka or LNG shipment) such

an outcome is doubtul or several reasons. Most recent reports suggest

that Kovykta gas will not be completely developed until 2017, ten years

later than originally planned. Te next section analyzes both past and

current obstacles or successul development and export o Kovyktas gas

into Northeast Asia.

Since discovery o the Kovykta oil fields, companies and governments

rom Europe and Asia have been vying or a stake in their development.

Most o the European companies, however, quickly abandoned their interests

deeming the project uneconomic. Since these companies backed out, efforts

on the part o both Russia and Asia have notably shifed largely to rom

company level to that o the state. Te companies have merely been appointed

as negotiators on behal o the states involved. As such, state enthusiasm has

been trumped by several economic realities. Tis next section overviews

several o the prevailing economic obstacles to Kovyktas development.

ransit Country Problems

From 1995 to 2007 the Kovykta project has had five major ownership

changeseach bringing a change in routing options. Although proven reserves

o the field have increased by 1 trillion cubic meters, the cost o the proposed

pipeline has increased by $10 billion (see Table 1). Te periodic inclusion

o Mongolia and North Korea has indeed hindered plans or development

o the Kovykta pipeline and has highlighted the complexities involved when

companies and governments are orced to balance the economic validity o

the project with regional politics and international security.

Te South Korean government has ofen discussed energy cooperation

between the two Koreas, apparently with the primary goal o constructing

an integrated pipeline and electricity network across the Korean Peninsula.

Both China and South Korea are clearly aligned in desiring a stable and

benign North Koreaand resolving North Koreas energy insecuritiescould undoubtedly help achieve this goal. Tough the political costs and

risks associated with North Korea are well known, the extension o Russian

pipelines to South Korean (and Northeast Asian) markets via North Korea

has economic as well as political merit. A Northeast Asian pipeline system


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[ ]

ABLE 1

Historical Changes in Routes, Ownership, Costs,

and Reserves of Kovykta

Year(s)Proposed

pipeline routeDistance

(km)Shareholders

Projectedcosts (b)

Estimatedreserves(bcm)

199596 Russia

Yellow Sea

Sidanco, 50%

Russias Export-Import Bank, 50%

$57

199697 Kovykta

Irkutsk

MongoliaBeijing

Dalian

Yellow Sea

South Korea

3,819 km Sidanco, 38%

EAGC, 28%

Irkutsk regional

administration,19%

Irkutskerergo,14%

$10 ~1,000

2002 Kovykta

Irkutsk

Manzhouli

Harbin

Shenyang

Dalian

North Korea

South Korea

4,065 km BP, 33%

TNK, 29%

Interros, 26%

Irkutsk regional

administration,11%

~$12 ~1,900

2003 Kovykta

Irkutsk

Manzhouli

Harbin

Shenyang

Dalian

Yellow Sea

South Korea

4,249 km TNK-BP, 62%

Interros, 26%

Irkutsk regionaladministration,11%

$17 ~2,000

2007 Kovykta

Nakhodka?

Gazprom, 62%

Interros, 26%

Irkutsk regionaladministration,

11%

~2,000

Source: Keun-Wook Paik, Pipeline Gas Introduction to the Korean Peninsula, Chatham House, January2005; and various news reports.

Note:Dash indicates no data is available.


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[ ]

that is unable to traverse North Korea might inevitably leave both suppliers

and consumers alike worse off. Without competitive market outlets or

Russian gas, LNG supplies rom the Middle East and Australia could take

over the gas markets in Asiaa situation that would leave less market share

or Russia and higher energy costs or Northeast Asian and U.S. consumers.37

Chinas recent LNG deals with Australia highlight this growing trend. North

Korea lies directly between Northeast Asias major buyers and sellers. Leaving

North Korea out o Northeast Asias energy corridor would have world-wide

commercial and political implications.

Te inclusion o North Korea in the route, however, temporarily

increased both commercial and political costs to the pipeline. Te additional

246 km o pipeline needed or the North Korea route increased costs by $2billion. Moreover, routing the pipeline through North Korea could have

allowed Pyongyang to easily control the flow o gas to South Korea or

strategic purposes. Although some sectors o the South Korean government

and some in various international organizations agreed in principle to this

route, the 2003 easibility studyled by NK-BPruled out this option on

both commercial and political grounds.38Te six-party talks, however, are

becoming more sanguine. Given that pipeline projects are extremely slow to

develop, the possibility or North Korea to take part in a regional pipelinescheme in the uture is not completely out o the question.

Mongolia also figured in the pipeline scheme in 1997. Although the

most economic and cost-effective way to transport gas rom Kovykta into

China, this possibility o routing the pipeline through Mongolia was quickly

abandoned by China due to domestic concerns. China eared both that the

autonomous region o Inner Mongolia might demand to be a beneactor o

transit ees along with Mongolia and that social unrest might occur i Chinas

ethnic Mongolians elt that they were receiving the short end o the stick.39

China worried that Mongolia could easily become an eastern Ukraine that

would siphon off gas supplies en route to China. More recently China has had

concerns that Mongolia has become too subject to U.S. influence, especially

given Mongolias support or the war on terrorism afer September 11, 2001.

37

Peter Hartley, Amy Myers Jaffe, and Kenneth Medlock, Economic Issues o Natural Gas rade inNortheast Asia: Political Bridges and Economic Advantages, in New Paradigms or ranspacificCollaboration, Korea Economic Institute, Academic Study Series, 2006 uhttp://www.keia.org/2-Publications/2-3-Monograph/Monograph2006/04Jaffe.pd.

38 Pyongyang Could Be Lef Out o Russian Gas Pipeline to Korean Peninsula, Agence FrancePresse, November 12, 2003.

39 Kaoru Yamaguchi and Keii Cho, Natural Gas in China, the Institute o Energy Economics, Japan,August 2003.


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[ ]

Te inclusion o both North Korea and Mongolia in the Kovykta routing

options would have been both economically and politically beneficial. Te

Mongolian route was the cheapest option or all parties involved. Bypassing

Mongolia by instead routing the pipeline through the permarost lands

in Siberia would have significantly increased project costs. Although

more expensive than the Mongolian route, the North Korean option was

considerably cheaper than the most current route consisting o an underwater

pipeline rom Dalian to Pyongtaek. Te higher construction costs o the

diversions will increase the end-user gas price; Russia will have little room lef

to negotiate gas pricing with China, and South Korea will continue to rely on

imported LNG as a more attractive option.

Complexities of Gas Investments

Not ofen reported in the media is the act that natural gas is intrinsically

more difficult to trade than oil and requires greater confidence, many more

guarantees, and much more money rom investors and governments. Te

Kovykta pipeline deal is no exception. Pipelines are rather inflexiblethey

require substantial reserves at one end to sustain and fill the pipeline and

a significant market at the other end to justiy the investment. Once built,pipelines cannot be moved and thus lock the seller and buyer into a long-

term relationship. Whether by LNG or pipeline, the natural gas market is

vastly different than the oil market. Tere is in act no world gas marketthe

majority o the worlds gas is both produced and consumed domestically and

hence lacks a standardized benchmark price. Furthermore, striking natural

gas deals between two parties (let alone three or more parties) involves a

highly sophisticated set o plans and calculations. Te huge amounts o ront-

end investments and the difficulties and expense o storage and transportationorce parties to make long-term all-or-nothing deals. Gas trade has been

traditionally characterized by extremely inflexible contracts arranged between

one concrete buyer and one concrete seller. On average, gas supply contracts

commit two parties to a business relationship or twenty years under tough

take-or-pay and destination clauses that essentially prohibit buyers rom

either decreasing supplies or selling surplus supplies to third parties. Oil, on

the other hand, is a widely traded commodity that has matured to a stage


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[ ]

where uniorm benchmark prices are firmly in place.40In the world oil market,

as long as consumers have spare refinery capacity, engaging in a short-term,

low-risk, low-investment contract with a producer is airly easy. Likewise,

having surplus oil allows producers to find a willing buyer with relative ease.

Te combination o the benchmark pricing system and the fluidity at which

physical commodities can be bought and sold with little risk and investment

makes oil deals much less cumbersome and much less strategic than is the

case with gas.41

Tough Kovykta has been proposed as a cross-border pipeline project,

Gazprom has recently avored having the Kovykta pipeline ollow the

proposed East Siberian-Pacific Ocean (ESPO) oil pipeline route. Tis route

would not cross international boundaries but would run rom Irkutsk toNakhodkaa pipeline over 4,000 km in length. A LNG terminal would be

built at Nakhodka so that LNG could be shipped to several Northeast Asian

states without relying on only one or two markets. Tis proposal, however,

poses several technical and commercial challenges or Gazprom. First,

although extremely capable in pipeline construction, the company has no

experience with LNG. Gazprom would need a major international partner

to provide the technology and experience required not only to build and

operate the terminal but also to manage the LNG supply chain. Second, thisproposal makes little economic sense. LNG is a capital-intensive business

and requires up-ront investments in a acilities chain (upstream production

rigs, liqueaction acilities, LNG tankers, regasification acilities, and local

distribution pipelines). Such a chain could cost as much as $5 billion.42For

LNG to be a profitable business, the gas deposits need to be relatively close

to the terminal; most LNG gas thereore has come rom fields just offshore.

Furthermore, LNG acilities are usually upgraded beore new terminals

are built. Te cost o an upgrade, however, is astronomical in comparison

to an equal capacity upgrade or a pipeline. Roughly speaking, pipelines

can double capacity or only an additional 1020% o original investment;

LNG, however, would require an additional 5060% or the same capacity

40 Te marker crude system was introduced in the mid-1980s. Te spot trade o three main typeso crude (West exas Intermediate, Brent Lend, and Dubai) acts as a barometer o the overall

market level. Using this pricing system, different grades o oil are priced on negotiable differentialsto the marker grade. Te rationale is that the spot price represents the balancing point o supplyand demand. Even though the volumes o oil that trade daily on a term-contract basis betweencompanies or governments are much larger than those that traded on a spot basis, price isdetermined at the margin in the spot market.

41 Te authors would like to thank Mikkal Herberg or bringing these points to their attention.

42 Linda Cook, Te Role o LNG in a Global Gas Market (presentation at the 27th Annual Oil &Money Conerence, London, September 1819, 2006).


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[ ]

upgrade.43Afer decades o technological advances that have slowly reduced

construction costs o LNG plants, costs are now again on the rise. In 2005

LNG plant construction was below $200 per ton per year o production

capacity. Due to rising raw materials and equipment costs and a growing

shortage o experienced engineers, today these costs are around $500 per

ton per year, with some projects even approaching $1000 per ton per year.

Tese cost hikes have caused delays o up to three years or several new LNG

projects.

In sum, whether by pipeline or LNG, gas investments are extremely

complex and risky. Gas projects not only need reliable, long-term commitments

rom consuming countries but also require financial commitments and

technological expertise to sustain a profitable gas business. Kovykta hasbeen and will remain subject to these problems, which are inherent in gas

investment and export.

Demand Security and Pricing

During the ten-plus years o negotiating over the price and timing o the

Kovykta pipeline, gas markets have gone through three distinct phases. During

the first phase (19962000) gas contracts were extremely rigid and prices werehigh. During this period South Korea and Japan, the only importers o natural

gas in the region, had government policies and inrastructure that avored the

use o gas. Te second phase (200005) was a buyers market; this phase was

defined by lower oil price linkages, lower gas prices, and more flexible contract

terms. Te third (and current) phasea sellers marketis characterized both

by prices that link closer to oil and by stricter contract terms. Since the price

o gas and contract terms determine the pace and time o the development o

the gas pipeline as well as the will o oreign investors, the characteristics oeach phase have had distinct implications or the development o the Kovykta

gas pipeline. Furthermore, each party involved in the Kovykta pipeline

negotiations has had different alternatives or gas useand thus has employed

a different set o calculations when ormulating the price o Kovykta gas. For

South Korea the main alternative to pipeline gas is LNG, and or China the

main alternative is coal.

First phaseuDuring the first phase, rom 1996 through 1999, Chinas

domestic gas production o 17.9 bcm per year could clearly cover the countrys

domestic consumption o 17.4 bcm per year. Gas in China was (and today

43 Al roner, Natural Gas: A Natural Choice? CLSA Quarterly1, no. 4 (February 2007): 76.


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[ ]

largely still is) used to produce ertilizer, rather than in gas-fired power plants.

Gas pipeline grids were sparse, and industrial gas use was concentrated in

Chinas northeastern coastal cities. Tus during this phase high costs and

inflexible contract terms made gas a less competitive option compared to

Chinas domestic coal supplies. Tough indeed having much potential, China

simply did not have a gas market. South Korea thereore was brought in to act

as a stable anchor or the projecta new actor that could make the Kovykta

pipeline easible.

In the wake o the Asian financial crisis, however, gas development plans

in all o Asia slowed to a snails pace. South Koreas gas demand decreased by

800,000 Mt (or 1 bcm).44KOGASs LNG storage was at ull capacity, and rom

1997 to 2002 South Korea abandoned a total o 76 energy projects.45

As oneexample, the Hanbo Group lost most o its stake in the Kovykta project afer

going bankrupt in 1997. China, less deeply affected by the financial crisis,

became the silver lining in the project.

Tere is no consensus as to just how Chinese gas demand will take

shape in the next twenty years. Projections o Chinas energy demand made

by various energy agencies differ by as much as 143 bcm (see Figure 3).

Tis projection gap is roughly equivalent to the average capacity o 47 LNG

terminals or around five Kovykta fields. At a March 2005 seminar the NationalDevelopment and Reorm Commission (NDRC), Chinas main economic

and energy policymaking apparatus, projected that Chinas energy demand

could reach 250 bcm per year by 2020representing a 200% increase over

todays figures.46Even with an optimistic domestic gas production outlook

o 150 bcm per year China would still be required to import approximately

100 bcm per year. Beijings plans to build ourteen more LNG terminals by

2020 calls into question the need or Kovykta gas, given that the capacity o

these proposed LNG terminals is roughly equivalent to 48 bcm per year. I

Russian, Eurasian, and Southeast Asian pipeline gas is introduced, supply

would be approximately 36 bcm per year above projected demand.47Although

44 Asia-Pacific Gas Projects Hit the Wall amid Regional Economic Slump, Oil and Gas Journal97,no. 6 (February 8, 1999): 2327.

45 Keun-Wook Paik, Valerie Marcel, Glada Lahn, John V. Mitchell, and Erkin Adyiov, rends in

Asian NOC Investments Abroad, Chatham House, Working Background Paper, March 2007.46 See Akira Miyamoto and Chikako Ishiguro, Pricing and Demand or LNG in China: Consistencybetween LNG and Pipeline Gas in a Fast Growing Market, Oxord Institute or Energy Studies,NG-9, January 2006.

47 Tese figures include high projections o proposed pipelines rom Kazakhstan, urkmenistan,Myanmar, as well as Kovykta and Sakhalin in Russia. See Price, Russia Weaken Case or ChinaLNG, Petroleum Intelligence Weekly44, no. 44 (October 31, 2005); and Miyamoto and Ishiguro,Pricing and Demand or LNG in China.


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[ ]

development o several o these pipelines is highly speculative, building the

Kovykta pipeline to China presents a potentially nightmarish investment

decision. I anticipated sales all through because China is unable to pay or

the gas, investors will have no way to recover sunk costs.

Few experts doubt that in the near uture Chinas gas consumption

will undergo extraordinary growth; yet how China will rapidly develop the

countrys gas market is unclear. o what extent will gas account or Chinas

power generation? How much investment will China make in municipal

gas distribution systems? Developments related to these questions could

ultimately affect the uture o the Kovykta pipeline.

Second phaseuDuring the second phase in natural gas markets,

negotiations over the pipeline were promising but slow-going. With rigorousdiplomatic support, China aggressively pursued development o an LNG

industry. In 2003 North West Shel Australia LNG won a tender to supply

Chinas Guangdong LNG terminal with 3 bcm per year or twenty years at

approximately $3.20 per million British thermal unit (Btu). At that time the

cost o coal in China was approximately $2 per million Btu and the average

cost o Chinas domestic natural gasspecifically rom the arim Basin

was close to $4 per million Btu. Te anticipated price o natural gas rom

the Guangdong LNG terminal, however, is $2.80 per million Btu (includingreight) plus $0.40 per million Btu or regasification.48 At a price o $3.20

per million Btu, coal lost some o its competitive edge, making gas a more

attractive option.

Tird phaseuSince 2006 the global gas market has experienced a third

phasea sellers market. Russia has recently demanded higher prices or

nearly all o the countrys exported gas, including gas rom Kovykta, insisting

on the need to be competitive with LNG rom the Middle East. China is in no

rush, however, to commit to such a high price. In early 2007 Russia offered gas

to China or $300 per 1,000 cubic meters ($8.24 per million Btu), yet China

claims that the country can afford to pay only $180 per 1,000 cubic meters

($4.90 per million Btu).49In the industry $3.34 per million Btu is a significant

price gap to overcome; that China and Russia are arguing over dollars rather

than cents suggests that the issues will not be quickly resolved.

Recent developments, however, indicate that China might be ready

to accept higher prices or gas imports. In September 2007, afer years o

48 2006 World Energy Outlook, U.S. Department o Energy, Energy Inormation Administration,2006, 4546u http://www.eia.doe.gov/oia/ieo/pd/0484(2006).pd.

49 Chinas Foreign Plans Have a Long Way to Go, International Gas Report, no. 568, February26, 2007.


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[ ]

hesitation, China secured a long-term LNG supply contract with Australias

Woodside Petroleum worth $45 billion. Russia was quick to express

satisaction, as a China that is prepared to pay market prices to Australia might

likewise be willing to pay what Russia wants. Tis optimism, however, ignores

two possibilities: that China may be demonstrating a preerence or LNG over

pipeline gas, and that Australia is associated with much less political risk than

is Russia.

As outlined above, many impediments to development o the Kovykta

project have been economic in nature. In the context o Gazproms recent

takeover o the Kovykta project, however, understanding how the changing

economic environment has affected the political and legal landscape in

Russias energy sector is particularly important.

As the result o postSoviet era economic reorms, Russias energy

industry had become increasingly competitive and privatized by the

mid-1990s. Within ten years o the Soviet Unions demise the coal and

oil industries were nearly completely privatized and product prices were

deregulated. According to some calculations, government ownership o

oil and coal companies was below 10% by 2004.50 Russias gas industry,

however, has not seen similar reorms or several reasons. First, gas has been

a more stable contributor to Russias economy than oil, providing the ederal

government with a steady revenue stream throughout the periods o steep

decline in oil prices and production. In 2006 gas alone accounted or around

50%or $200 billiono Russias total oil and gas rents.51Second, although

having the largest proven gas reserves in the world, Russiawhich consumesapproximately 70% o the countrys total gas productionranks second in the

world in natural gas consumption (see Figure 5). Domestic oil consumption,

on the contrary, constitutes only 30% o total production. Although rising,

Russias domestic gas prices are fixed well below market price, especially or

residential users. Tese price distortions have kept domestic demand high,

tightly linking the gas sector to economic development and social stability.

50 Vladimir Milov, Leonard L. Colburn, and Igor Danchenko, Russias Energy Policy: 19922005,Eurasian Geography and Economics47, no. 3 (2006): 286.

51 Clifford Gaddy and Fiona Hill, Te Russian Federation, Brookings Institution, Energy SecuritySeries, October 2006, 10.


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[ ]

During the presidency o Boris Yeltsin (199199) world oil prices

averaged around $14 per barrel, dropping as low as $8 per barrel in the late

1990s (see Figure 6). Under these conditions, Russia became more open to

oreign investments and began to allow oreign ownership o energy resources.

Since Vladimir Putins rise to the presidency in 2000, however, skyrocketing

oil prices have brought the average world crude price over the past seven years

to approximately $34 per barrel.52In the last two years crude oil prices have

hovered around $70 per barrel and even topped $100 per barrel. By some

estimates ederal earnings rom oil and gas under Putin are ten times greater

than under Yeltsin.53

As oil and gas have become central to Russias economy, Putin has

taken great strides toward gaining control o the energy industry. In 2001

Putin appointed three high-level executives at Gazprom, all o whom were

either riends o Putin or ormer Putin administration officials.54 As aptly

52 Based on authors own calculations using Crude Oil Price Summary, Energy InormationAdministration, 2007uwww.eia.doe.gov.

53 Gaddy and Hill, Te Russian Federation, 7.

54 Tese appointees are Dmitry Medvedev (chairman), Aleksei Miller (president), and Igor Yusuov(board o directors). See Michael Fredholm, Te Russian Energy Strategy and Energy Policy:Pipeline Diplomacy or Mutual Dependence? Conflict Studies Research Centre, September 2005.

FIGURE 5

Distribution of Russias Oil and Gas Production, 19912006

Source: BP Statistical Review o World Energy 2007.

Consumption Exports

Billioncubicmeters

Year

1991

1993

1995

1997

1999

2001

2003

2005

0

100

200

300

400

500

600

700Gas

Millionbarrelsperday

Year

1991

1993

1995

1997

1999

2001

2003

2005

0

1

2

3

4

5

6

7

8

9

10Oil


27/36

[ ]

characterized in a Swedish deense analysis, Putin is creating a culture o

a politically correct market economy.55With the oligarchs that run Russias

energy companies voluntarily and naturally placing state interests on par with

commercial ones, direct state intervention no longer seems necessary.

In the mid-1990s when Asian companies entered into the Kovykta

pipeline negotiations, energy prices were low and the Kremlin was weak. Te

autonomous rights o regional authorities (such as those in Sakha and Irkutsk)

were also at a peak, enabling these locales to have greater influence and

independent decisionmaking regarding resource planning and management.

Irkutsks remoteness rom Moscow contributed to this autonomy as well.

Known as the two key system, Russias Subsoil Law o 1992 gave both the

regional (oblast) and ederal governments authority over subsoil use. With

the assignment o Gazprom as chie negotiator o Kovykta and a series o

amendments to the law, however, regional authority over subsoil use was

55 Robert Larson, Russias Energy Policies: Security Dimensions and Russias Reliability as an EnergySupplier, Swedish Deence Research Agency, Deence Analysis, March 2006uhttp://www2.oi.se/rapp/oir1934.pd.

FIGURE 6

Crude Oil Price per Barrel, 19702006

Price($)

Year

Source: BP Statistical Review o World Energy 2007.

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

0

10

20

30

40

50

60

70

80

90

100


28/36

[ ]

stripped and all rights over the issuing or revoking o subsoil licenses were

solely retained by the Kremlin.56Apart rom a role as a small shareholder, the

Irkutsk regional government was removed as the central negotiating authority

in the Kovykta pipeline.

In response to these power shifs, China, South Korea, and NK-BP

became heavily involved in a type o shuttle diplomacy, with representatives

travelling between Irkutsk and Moscow in attempts to figure out who was

in charge. Both China and South Korea were ofen conused as to with

whom or what companythe projects main shareholder and operator

(NK-BP), Russias export monopoly (Gazprom), or the ederal government

(the Kremlin)negotiations ought to be conducted. On the sidelines o

recent Kovykta negotiations South Korea and China uncharacteristicallypublicized rustration regarding Russias ambiguities. Discussing the state o

Sino-Russian energy cooperation and the proposed pipeline, in an interview

in 2006 Zhangguo Bao, ormer vice-director o Chinas NDRC made the

ollowing statement:

Currently, the Sino-Russia pipeline question is one step orward,two steps back. oday is cloudy with a chance o rain whiletomorrow is sunny with a chance or clouds, just like a weatherorecast. One minute Russia has said they have made a decision,

the next saying that no decision has been maderuthully,weve been in contact with Russia or such a long time, but westill dont understand Russia, I eel. We dont know who canmake a decision, or who to seek outWeve talked to Putin anddepartment heads. Weve talked to everyone in the government.Tey say they cant make a decision, and that we should talk to theprivate sector. Weve meet with every company. Tey say they cantsign an agreement and we should talk to the government.57

Te lack o transparency in Russias energy policy has clearly lef all

negotiating parties in limbo.

Balancing Russias Domestic and European Demand

Gazproms entire gas production (apart rom that which is consumed

domestically) is exported directly to European and Eurasian markets;

Germany, Italy, and urkey are Gazproms largest and most important

customers. Nine out o Russias top fifeen importers rely on the company

56 Jennier Joseson, Policy Challenges: A Russian Perspective, in Energy Futures, ed. Ral Boscheck(New York: Palgrave MacMillin, 2007), 98107.

57 China Energy Report Weekly, Interax Inormation Services, March 410, 2006, 2728.


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[ ]

or over 50% o their gas needs.58Some European counties, although hoping

to diversiy gas imports, are locked in to dependence on Russian imports

by decades-old pipelines. Because Russia keeps domestic prices well below

international market prices Gazprom is completely reliant on Europe or

revenues. Geopolitically, Gazprom is currently attempting to create a European

monopoly by undermining efforts by Iran, urkmenistan, and Kazakhstan to

export gas to the European market. Because the majority o Russias pipelines

are aimed toward Europe, Gazprom has ocused on Europe and placed Asia

on the backburner.

Russian domestic demand is another actor behind the politicization o

Russias gas industry. Although Russia currently ranks second in the world

in gas use (behind the United States), the Russian economy is only one-twentieth the size o the U.S. economy. Low-priced gas uels much o Russias

industrial sector, and fixed prices allow household energy bills to remain

low. Although Gazprom is lobbying hard or a sharp increase in domestic

prices the Kremlin remains reluctant to raise prices or ear o provoking

economic and social stresses.

Te political aspects o the recent price debacle with Ukraine received

much attention, yet the move to shut off the gas spigot clearly was an indication

o Russias ear o overstretching Gazproms other export commitments.59Anovercommitment to European consumers would require Russia (Gazprom)

to decrease supplies (i.e., raise prices) to domestic users. Either choice packs a

political punch that neither Gazprom nor the Kremlin wants to eel.

In a worst-case scenario, Russia could also connect Kovykta with the

countrys existing unified gas supply system or domestic consumption in

order to relieve other gas fields that could supply exports to Europe. I Russia

continues to ocus on Europe without increasing production, raising domestic

gas prices, and curbing domestic demand, how can Gazprom justifiably export

Kovykta gas to a China that reuses to pay market prices?

Russias New Subsoil Law

As mentioned above, Russias subsoil law, implemented in 1992, gave

considerable power to regional authorities over subsoil exploitation. Te law

58 Country Analysis Brie: Russia, U.S. Department o Energy, Energy Inormation Administration,April 2007u http://www.eia.doe.gov/emeu/cabs/Russia/Background.html.

59 Due to disagreements over natural gas prices, Gazprom shut off gas supplies to Ukraine on January1, 2006, a move that also affected gas supplies to other parts o Europe. According to the U.S.Department o Energy, this was the first time that a supply disruption rom Russia affected flows toEurope.


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has, however, been amended several times since then. In 2005 the Kremlin

submitted to the Duma a new subsoil lawthe Draf Lawthat merely legally

enorces what has already been in practice or several years. Te major issue

that concerns international oil companies (NK-BP in this case) is the clause

on oreign ownership and strategic resources. According to the new law, no

oreign entity can have controlling stakes (over 50% plus one share) in any o

Russias strategic resources. Te Draf Law defines as strategic (1) various

rare resources such as diamonds, uranium, or quartz; (2) deposits rom any

oil field containing over one billion barrels or any gas field containing over one

trillion cubic meters o gas; and (3) any reserve in close proximity to a military

base.60With two trillion cubic meters o gas, Kovykta is deemed a strategic

resource. As stipulated in the law, neither Gazprom nor the government couldstrip any oreign owners o their assets i a license or production-sharing

agreement (PSA) was conducted beore the amendments to the law came into

effect. Aware that NK-BP was not living up to its production requirements,

Gazprom waited to legally take over the project.

Kovyktas Periphery

For years Gazprom has considered several pipeline options to Chinaand East Asia and even the construction o an integrated oil and gas supply,

storage, and transition system that would tie together all o the countrys

major fields or export to Asia and beyond. In an energy strategy document

the Russian Ministry o Energy outlines the countrys ar-reaching goals to

take over 25% o Northeast Asias gas market beore 2020.61 Russia has no

pipelines in the region, however, and until recently Gazprom has had no

major stakes in any o the key fields in East Siberia and the Russian Far East.

As such, Gazprom has begun to orce its way into all o the major oil and gasfields in the region; using environmental NGOs and the Ministry o Natural

Resources to sofen up the international oil companies (IOC), Gazprom has

managed to get in on avorable terms. Gazprom is in essence expropriating

these fields with a nominal financial recompense.62Tis use o strong-arm

tactics by Gazprom shows that Russia is bent only on controlling these last

strategic resources on the countrys rontier, not on controlling the actual

60Joseson, Policy Challenges, 1045.

61 Te Summary o the Energy Strategy o Russia or the Period o up to 2020, Ministry o Energyo the Russian Federation, (Moscow 2003), 12 uhttp://ec.europa.eu/energy/russia/events/doc/2003_strategy_2020_en.pd.

62 KovyktaWhy Not Call It Expropriation, Energy Economist, no. 309 (July 2007): 3.


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means o gas transportation and export. Because Gazprom lacks an open and

coherent strategy and Russias PSA laws are deteriorating, both international

oil companies and East Asian consumer countries have come to seriously

question Russias reliability as an energy partner. Both the IOCs and Russia

have been competing to gain entry into Asian markets, peripheral export

options that have also undermined Kovyktas positioning.

Altaiu Gazproms most recent gas export proposal to China has not

been Kovykta but Altai. Gazprom has proposed building a pipeline to China

that crosses the western most point o the Russia-China border over the Altai

(or Altay) mountain range. According to Russia, the Altai pipeline is to be the

first o two potential pipelines to China. Altai gas would come rom fields in

Western Siberia and connect with Chinas West-East pipeline, which carriesgas rom fields in Xinjiang to markets in Shanghai.

Notable, however, is that the Altai pipeline proposal was set orth shortly

afer the Ukrainian gas price debaclewhich temporarily halted gas exports

to many European countrieswhen European policymakers began discussing

diversiying gas sources. Viewed by analysts more as a political rebuttal

than as a sound commercial pursuit, this proposal seems designed to show

that Russia can easily divert gas away rom Europe to other markets should

Moscow choose to do so. Moreover, political leaders in the Republic o Altaihave expressed ears that Chinese labor could expand Chinas influence and

presence in the region.63

ChayandauWith gas reserves o 1.2 trillion cubic meters, the

Chayandinskoye (Chayanda) field in Yakutia (like Kovykta) was officially

deemed strategic in 2005. Although Chayanda contains only approximately

hal as much gas as Kovykta and is ar behind Kovykta in the development

process, Russia seems determined to develop this field beore Kovykta. Te

Sakha government has held several meetings with representatives rom China

and South Korea over uture exports. In an effort to undermine Kovykta,

the Republic o Sakha ormed a strategic alliance with Gazprom in 2002 and

began promoting the development and export o Chayanda gas. For Gazprom,

the Chayanda field represented a timely and strategic potential investment.

Chayanda was in act one o the only major fields in Russias eastern rontier

that was not operated by international oil companies. Gazprom could thus

63 Altai Community Approves Gas Pipeline Construction to China Following Harsh Argument,Republic o Altaiu http://eng.altai-republic.ru/modules.php?op=modload&name=News&file=article&sid=597.


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use the threat o Chayanda exports to bypass NK-BPs export plan.64Tere

have even been reports o Russia offering China 10% o Sakha reserves ree o

charge i China were to commit to early development o the field.65

In 2003 the Kremlin held a cabinet meeting to discuss the concept o

a unified pipeline system in Eastern Siberia and the Far East. Tis concept

envisioned a pipeline network connecting all the major eastern gas fields

omsk (which would link up to Russias western gas supply system), Chayanda,

Khabarovsk (where the pipeline would connect to a pipeline that routed the

off-shore Sakhalin gas), and Vladivostok (where it would terminate).Expected

to extend more than 6,000 kilometers, this pipeline did not, however, include

Kovykta in the first set o plans. Since Kovykta was at that time majority owned

by NK-BP, Gazprom viewed Kovykta exports as endangering not only themerit o the other fields in the region but also the potential company and state

revenues that could be gained rom Chayanda.66

Since gaining control o Kovykta, however, Gazproms tone has changed.

Kovykta will be included in this proposed pipeline system, though the time

line is or Chayanda to be online by 2016 and Kovykta by 2017. Large-scale

exploration is not yet underway and may not even begin until Gazprom

has an exploration permit. Gazprom has been aggressively negotiating with

the Ministry o Natural Resources to receive a production license or theChayandinskoye field without having to compete with other companies in

an open auction. Looking at Gazproms record, it will be surprising i the

company ails to take over this project.

Sakhalinuo date Sakhalin has been the most successul o the oil and

gas fields in eastern Russia. Sakhalins success is largely due to act that or the

most part oreign oil companies have undergone the exploration, production,

and development o these fields, which are protected under a PSA.67Because

the three largest gas marketsJapan, the United States, and South Korea

are in such close proximity to the projects, Gazprom has grown convinced

that the company would miss out on a huge commercial opportunity i not

involved. Sakhalin also represents a good opportunity or Gazprom to begin

64 Jonathan Stern, Te Future of Russian Gas and Gazprom(Oxord: Oxord Institute or EnergyStudies, 2005), 1556.

65 Xu Yihe, South Korea May Lose Out on Russia Gas, Dow Jones Newswire, March 7, 2001.

66 Keun-Wook Paik, Pipeline Gas Introduction to the Korea Peninsula, Chatham House, January 2005.

67 For in-depth analyses o the tax structures and PSA arrangements o the Sakhalin projects, seeJudith Tornton, Sakhalin Energy, Comparative Economic Studies43, no. 4 (Winter 2001): 932.For a good comparative overview o energy fiscal regimes, see David Johnston, Petroleum FiscalSystems: Royalty/ax Systems, Production Sharing Contracts and Service Agreements Compared,in Boscheck, Energy Futures, 2771.


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learning the LNG business. For Russia, LNG exports are both commercially

and geopolitically saer than cross-border pipelines, given that LNG can more

easily avoid being trapped in a monopsony.

O the six Sakhalin projects Sakhalin-1 and -2 have the greatest

production potential and have moved along the astest. Tough not yet

exporting LNG, Sakhalin-2 has already committed all o the projects uture

LNG exports.68Afer months o complaining about environmental concerns

and increasing costs associated with Sakhalin-2, Gazprom managed to obtain

Shells position as majority shareholderacquiring a 50% (plus one share)

stake in the project or $7.45 billion in December 2006. Not surprisingly

Gazprom ceased accusations over the projects negative environmental

impacts afer the takeover.Exxon operates Sakhalin-1 and or years has had plans to build a pipeline

to China. In 2006 Exxon signed an agreement with CNPC to supply China

with 8 bcm o gas. Sakhalin-1 is currently the only PSA project outside

Gazproms control, and Exxons unilateral export o this gas could potentially

undermine Gazproms price negotiations with China over gas supply rom

any field. Gazprom has thereore severely criticized Exxons plan, claiming

that the company will buy all uture gas production rom the consortium to

supply the domestic market in the Khabarovsk and Primorye regions.

Gazproms consolidation o gas projects in Siberia and the Far East has

allowed Russia to present several export options to Northeast Asia. Including

Kovykta, Russia has proposed nearly 60 bcm o gas to both China and South

Korea. As a result o Gazproms aggressive behavior in eastern Russia andthreats to target proposed gas or domestic use, Northeast Asian countries

have been turning elsewhere or gas supplies. China in particular is hedging

its bets by looking to urkmenistan and Myanmar or pipeline gas and to

Australia or LNG. urkmenistan is vitally important to Russia, which is

dependent on urkmen gas imports to meet European export obligations.

Tat China has approached urkmenistan could set a negative tone or any

Russian-Chinese gas discussions.69China has also been courting Myanmar,

68 O the total supplies 2% are being retained or operational flexibility. See Michael Bradshaw,Sakhalin-2 in the Firing Line: Environmental Protection or Administrative Leverage, PacificRussia Oil & Gas Report, Winter 2006, 118.

69 Rachel Graham, What Gazprom Wants Gazprom Gets, Energy Economist, no. 309 (July, 2007): 27.


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and the junta recently awarded CNPC with a supply contract o 16 bcm per

year. Te deal is geopolitically strategic in nature or China; not only does

negotiating with Myanmar place China in a stronger position to negotiate

with Russia and Iran over gas supply contracts, but a pipeline rom Myanmar

to Kunming would also establish the groundwork or building additional oil

pipelines that would allow Chinas imports to bypass the Malacca Strait.

Although Gazproms takeover o the project in the summer o 2007 could

in theory expedite the development o Kovykta, other considerations suggest

that the pace may not increase. Gazprom has now assumed controlling stakes

in the largest gas projects in Eastern Siberia and the Russian Far East and is

able to coordinate all gas exports to China, South Korea, and Japan. Gazproms

controlling stakes give the company the upper hand in price negotiations withNortheast Asia, as countries rom the region can no longer negotiate with

the international oil companies to get a lower price. Te uture o Kovykta,

thereore, now depends both on the resolution o price negotiations between

Russia and China and on Gazproms ability to successully finance and operate

several new projects simultaneously in eastern Russia.

Even i China and Russia should reach a price agreement will Gazprom

be able to competently finance, operate, and manage all o these new projects?

Gazprom is among the worlds least efficient energy companies; the companyuses export earnings to subsidize loss-incurring domestic sales at only

approximately 20% o world market prices. Although Gazprom has access to

oreign lending to und its capital expenditure, the companys investment plans

are affected by high levels o debt and continued uncertainty about gas market

reorm. Te government hopes that by removing the ring-encelimiting

oreign share ownership in the companyGazprom will be better positioned

to raise much-needed investment capital. Foreign banks have, however, been

slow to come orward with unding or Gazprom lately. Te European Bank

or Reconstruction and Development, or instance, pulled out o negotiations

on providing $600 million worth o unding Sakhalin-2 afer Gazprom took

control o the project.

When Gazprom controls all the major fields in Eastern Siberia and the

Russian Far East, the company will have to reevaluate its relationships with the

IOCs. Although in some regards Gazprom has an advantage in that the IOCs

have ewer places to turn or new investments, Gazprom will neverthelessneed to rely on the technology and management skills o these IOCs to


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effectively develop and export Eastern Siberian and Russian Far Eastern

gas. As a notable observer o the Russian Far East has observed, only the

IOCs have the experience to delimit the reserves and deliver a commercially

viable development strategy.70 Judging rom the act that Gazprom revises

its investment program several times per year, Gazprom evidently has ew

strategies or plans to deliver such skills. Political expediency has thus ar

dictated Gazproms export policy. Although some oreign investors remain

in Russia, the IOCs will likely reassess political and commercial risk at some

point, which may have consequences or any uture investment.

With Gazproms attention on Sakhalin and urther European expansion,

or the oreseeable uture Kovykta will likely either sit idly or be used to supply

the domestic market. Tough neither option may be the most attractive orGazprom, the company can afford to allow either to happen in this high-price

environment. Both o these scenarios present ormidable implications or

Northeast Asia and the United States. Japan, South Korea, and the United

States are the worlds largest natural gas consumers, and China will join the

ranks. I Russias giant gas fields are not permitted significant market outlets in

Asia, global supply will all, thus effectively keeping gas prices higher than they

would be otherwise. he ate o Kovykta thereore has direct energy security

implications or the United States. As seen through its recent Australian deal,China is turning toward LNG rather than waiting or the Kovykta pipeline

issue to be resolved. Increasingly China, South Korea, and Japan will look

urther west o the Malacca Strait or LNG supplies as well, putting those

countries in direct competition with the United States and potentially reducing

LNG supplies to the U.S. West Coast. Increased competition or new supplies

may also give urther impetus to perceptions o energy insecurity among the

consumers. Although competition

alternative pipeline routes to korea

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