Europe’s Russian Revolution: Natural gas spot markets, oil-­indexed contracts, and the future of Russian-­EU energy relations

Abstract

This thesis examines the significant changes that have been occurring in natural gas markets between Russia and the European Union over the past few years. For the past two decades, European gas companies signed long-term oil-­ indexed natural gas contracts with Gazprom, the Russian state-­owned energy giant. Gazprom posted strong profits from these contracts and gas sales because major gas importers in the EU like Germany and Italy were content with a relatively stable source of natural gas. The existing system began to collapse in 2008-09 as the global financial crisis drastically reduced Europe’s demand for gas. At the same time, the shale gas revolution in the U.S. caused liquefied natural gas (LNG) shipments from the Middle East and Africa to be diverted away from America and toward Europe. Suddenly, an abundant source of cheap natural gas became available in EU markets. The response was staggering: When gas purchasers in the EU realized they could purchase gas at lower prices than Gazprom’s oil-­indexed contracts, they began purchasing the cheaper gas on spot markets and reducing their intake of contracted Russian gas. As a result, over the past few years, Gazprom has been forced to concede to the demands of its European customers. The Russian gas giant has renegotiated contracts, losing billions of dollars in the process. The influx of cheap LNG on European spot markets has raised the possibility of hub development in the EU. Although natural gas spot markets and hubs are currently underdeveloped and underutilized in much of the EU, the recent “gas glut” highlighted the crucial role they can play in the future of gas supply and pricing on the continent. As Gazprom’s position in Europe weakens and hubs gain traction in the short-­term future, a dual system of spot markets and long-­term contracts will develop on the continent. Northwest Europe will lean toward spot-­market pricing while Central, Eastern, and Southern Europe will continue to rely on oil-­indexed contracts. This dual system of spot markets and oil-indexed contacts in the EU will have implications for Gazprom’s business in the EU and for Russian-­EU energy relations in general. Gazprom will struggle to maintain its market share in Europe as shorter-­ term gas contracts become increasingly popular options for gas purchasers. Gazprom will also have trouble selling its gas in other markets like the Far East due to outdated infrastructure and competition with rivals. Thus, the Russian energy giant will have to undergo major reforms to stay relevant in European and global gas markets. Likewise, Russian-EU energy relations will become more strained as Gazprom tries to arrest its declining business in Europe. Ultimately, this dual market system will benefit the EU, allowing member states to liberalize gas markets and receive the fairest gas prices.