Over the years, Russia has reduced its reliance on the Ukraine as a transport corridor. In the past 80% of Europe’s natural gas imports from Russia traveled through the Ukraine, but that has fallen to 50% following the completion of the construction of the Nord Stream gas pipeline in 2012. 7Gazprom plans to continue the process of securing its gas shipments to its largest customer and bypassing countries it doesn’t want to deal with by building the South Stream Natural Gas Pipeline. The proposed route goes under the Black Sea to Bulgaria and then on to the rest of Europe. Prior to the annexing of Crimea, the proposed route took the South Stream Pipeline around Ukrainian waters.
This is where the plot thickens. A motivating factor behind the swift annexation of Crimea may lie project costs. Estimates are that Gazprom could save $10 billion in construction costs and greatly reduce the complexity of construction by moving into shallower waters. 8 In looking at the Black Sea it becomes visually apparent that running a pipeline through the Crimean peninsula (the peninsula off of Ukraine the extends well into the Black Sea) and along the shelf would be a much simpler, dramatically cheaper and easier to maintain initiative than going through the middle of the Black Sea where depths can reach more than 7,000 feet. 9
(Chart: http://en.wikipedia.org/wiki/File:Black_Sea_map.png)
(Chart: http://geostrategy.org.ua/en)
In recognition of this, the E.U. is talking tough about South Stream while looking for ways to reduce its reliance on gas from Russia. As it progresses down this path it could look to countries like Iran who have significant offshore reserves. However, the fact remains, Russia has the ability to trump most foreign producers on a cost basis (no liquefaction or regasification process required and much of the infrastructure is already in place).
In summary, Russia is a resource-based economy. Oil and gas revenues account for more than 50% of the country’s federal budget revenues. 10Crimea’s annexation was to a large degree an opportunistic move for Russia that it knew it could get away with. In doing so, Moscow was able to add to its gas reserves, improve its naval position in the Black Sea and probably save some rubles as it improves its pipeline infrastructure to its number one customer.
A significant percentage of the world’s oil and gas reserves are located in regions that are becoming increasingly challenging (to say the least) to do business in. When one blends the uncertainty that energy geopolitics like this or those that can be found in resource rich regions of the Middle East, Africa or Latin America into a world that is becoming increasingly dependent on higher cost unconventional production, it becomes clear in the long run that the prices of oil and gas are seemingly destined to go higher. We believe that finding investments in long-lived production at or below the marginal cost of a barrel of production in countries with minimal geopolitical risk is key to securing returns in the long run.
1Pirani, Simon, Katja Yafimava, Howard Rogers, Anouk Honore, and James Henderson. “What the Ukrainian crisis means for gas markets.” The Oxford Institute for Energy Studies. March 10, 2014.
2“Crimea a blow to Ukraine energy security and investors,” Monitor Global Outlook, March 10, 2014, http://monitorglobaloutlook.com/.
3“Crimea a blow to Ukraine energy security and investors,” Monitor Global Outlook, March 10, 2014, http://monitorglobaloutlook.com/.
4Source: U.S. Energy Information Administration (“Russia, Country Analysis Brief Overview” November 2013).
5“Ukraine: ExxonMobil Let Consortium Wins Skifska Bid,” Natural Gas Europe, April 15, 2012, www.naturalgaseurope.com.
6Exxon Mobil Corporation 2014 Analyst Meeting, March 5, 2014.
7Pirani, Simon, Katja Yafimava, Howard Rogers, Anouk Honore, and James Henderson. “What the Ukrainian crisis means for gas markets.” The Oxford Institute for Energy Studies. March 10, 2014.
8“Crimea a blow to Ukraine energy security and investors,” Monitor Global Outlook, March 10, 2014, http://monitorglobaloutlook.com/.
9“Black Sea,” Wikipedia, http://en.wikipedia.org/wiki/Black_Sea.
10Source: U.S. Energy Information Administration (“Russia,” March 2014).
This article was written by Doug Holt, Energy Analyist for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD)