The "Countering America's Adversaries Through Sanctions Act" became public law on Aug. 2, 2017. According to this statute, the U.S. president, in coordination with U.S. allies, may impose sanctions with respect to investments in Russia, or supplies for maintenance, expansion, and construction of energy export pipelines from Russia. The act also makes it more complicated for the U.S. to withdraw any sanctions against Russia in the future. The big question is how it will affect Gazprom, one of Europe's biggest gas suppliers, as well as other players in the European gas market.
Europe Relies On Russia's Competitively Priced Gas
Russia is one of Europe's main sources of natural gas (see chart 1), and its gas exports to Europe have been quite reliable since the cold war days, with only a few short-term interruptions related to renegotiation of transit terms through Ukraine. Ukraine remains a key gas transit corridor (see chart 2), funneling 44% of Russia's gas exports in 2016, down from about 80% a decade ago. The Ukraine transit route faces ongoing operational risks, political controversies, and litigation. We therefore believe an important objective for new pipelines from Russia would be to avoid crossing Ukraine. We consider that Gazprom is strongly interested in continuing gas supplies to Europe, since Europe and Turkey are its main source of earnings.
The current transit contract between Gazprom and Ukraine's Naftogas expires in late 2019, and we believe renegotiation may not be easy. Meanwhile, the Ukrainian gas transportation system is widely believed to be underinvested and increasingly subject to operation risks. As a result, Gazprom is investing heavily in several projects that would enable it to channel exports away from Ukraine. The biggest gas export pipelines Gazprom is currently building include:
- Nord Stream 2, running through the Baltic sea to Germany, with a planned capacity of 55 billion cubic meters (bcm), which is expected to go on line by the end of 2019. Gazprom is the sole shareholder after several large European companies (Shell, Uniper, OMV, Engie, and Wintershall) pulled out, although they have committed to providing financing for the project;
- Turkish Stream, which crosses the Black sea to supply Turkey, with planned capacity of 16bcm (including an option to expand to 32bcm) with commissioning scheduled for 2019; and
- Power of Siberia, a 38bcm pipeline from new gas fields in Eastern Siberia to China, with the first stage to be commissioned in December 2019.
We understand that several onward pipelines under construction will link Nord Stream 2 to European hubs (for example, Eugal). In addition, we believe a feasibility study is underway for an additional pipeline, Poseidon, that would take gas from Turkish Stream to southern Europe, but no investment decision has yet been taken.
If constructed, Nord Stream 2 and Turkish Stream would replace most of the Ukrainian transit capacity. Power of Siberia is intended to diversify Gazprom's supplies into Asian markets, using gas from new fields in eastern Siberia, thousands of kilometers away from the western Siberian fields that form the resource base for Russia's European exports. Power of Siberia will transport considerably smaller volumes compared with Gazprom's exports to Europe.
The New Sanctions Act Adds To The Uncertainty
It is still unclear how the sanctions might be put in place. For example, the sanctions can focus on financing only, or include supplies of goods, services, and technology. They could also apply to pipelines under construction as well as to maintenance of existing pipelines, including those across Ukraine.
In our view, the main reasons for the uncertainty are that:
- The Countering America's Adversaries Through Sanctions Act does not introduce the sanctions directly and implies substantial discretion regarding how they will be applied: The act states that the U.S. president, in coordination with U.S. allies, may (rather than "shall") impose sanctions on Russian energy pipelines, ranging from restrictions on export-import bank financing to a ban on property and foreign exchange transactions.
- Germany and Austria, key markets for Nord Stream gas, have publicly criticized the sanctions package. The final language of the sanctions act (unlike in the June 2017 draft) explicitly mentions coordination with U.S. allies.
- Apprehension about Gazprom's market share in Europe and pipeline usage prevails, quite apart from the sanctions act. In March 2017, Gazprom presented its proposals to address the European Commission's competition concerns by lifting restrictions on gas resales and changing the price benchmarks for certain Central and Eastern European countries, but we understand the Commission has not yet made its final decision.
In our base case, we do not assume any material implications for the functioning and development of the gas pipeline system in Europe, because this would go against the interests of many important European market players.
Access To Funding Should Not Be An Issue
The threat of sanctions may dampen investors' appetite for Russian issuers' debt or equity, even though at the moment there is no direct ban on investments in such instruments. Compared with sanctions the U.S. and EU imposed in 2014, the new act introduces only limited changes. Yet a new wave of sanctions could cause a delay in investment decisions or restrict access to technical resources needed to complete the construction of Nord Stream 2 and Turkish Stream. We understand that almost all the pipes have been procured, and Russia has large domestic pipe manufacturing capacity and expertise in building onshore pipes. But without crucial technology and expertise in constructing undersea pipelines, there may be delays or additional costs to find alternative solutions, potentially reducing the promised returns from those projects.
We believe European companies are committed to Nord Stream 2 and would provide their share of funding as agreed, unless prohibited from doing so. But even if Gazprom needs to fund Nord Stream 2 on its own, we believe it can absorb the financial impact without affecting the current stand-alone credit profile or rating. Gazprom is a massive company that generated $25 billion of EBITDA in 2016 alongside $24 billion of capital expenditure and a ratio of debt to EBITDA of 1.4x, with good access to funding from Russian state-owned banks. We understand that Gazprom has already fully consolidated Nord Stream 2 into its accounts, and has received €1 billion of funding from the European partners. We believe Nord Stream 2 and Turkish Stream are strategically important for Russia, and that the remaining funding for these projects can be covered by Russian government-related banks if needed. In addition, we have already factored into our ratings on Gazprom an increase in capital spending and potentially negative free operating cash flow in 2017-2019. Overall, given the company's relatively solid financials, and assuming no further pressures on Russia's gas exports, the sovereign rating remains the key driver of our ratings on Gazprom.
What If New Pipelines Can't Be Built?
If the new gas pipelines cannot be completed as scheduled by 2019, gas supplies from Russia to Europe would depend on successful renegotiation of the contract for gas transit through Ukraine, which may not be straightforward. At this stage, we cannot rule out a temporary halt to Russian gas flows during the contract negotiations, as was the case a decade ago, and we believe sanctions may not only affect new pipeline projects. Operational issues on existing pipelines could accumulate without adequate maintenance, due to sanctions or otherwise. However, we consider that this situation is unlikely to develop because, in our view, continuing the flow of gas from Russia to Europe would benefit all the parties concerned.
For Gazprom, our base-case scenario does not include any significant disruptions in exports to Europe, where the company generates much of its cash flow. We believe that existing underground storage capacity and availability of alternative routes would provide some flexibility. But if such a scenario were to materialize, it would likely affect the rating.
We understand that, compared with a decade ago, Europe's underutilized underground capacity and the number of liquefied natural gas (LNG) terminals have increased. Therefore, we do not anticipate any massive supply disruption. For example, the Dunkirk LNG terminal in France, one of the largest in Europe, was commissioned in early 2017, while other European LNG regasification capacities are far from being fully utilized.
We believe that alternative gas pipeline projects could receive a boost from higher prices in case of a disruption, but there aren't many. The most advanced one is the Shah-Deniz-2 project in Azerbaijan with designed capacity of 16bcm. But a large part of this potential output is destined for Turkey, and the project's relatively small scale means that volumes would be insufficient to replace Russian gas supplies. In addition, Shah-Deniz-2 focuses on Southern Europe only, and gas sales in Europe are scheduled to start only after 2019.
LNG Suppliers Could Benefit From A Disruption Of Russian Gas Exports
From an economic standpoint, Russian pipeline gas is cheaper than LNG imports, and Nord Stream 2 is a shorter, more reliable route than the current one through Ukraine. Following ongoing contract renegotiation in recent years, the price of Russian gas has largely converged with the main European benchmark prices (see chart 3), and over one-third of exports on average are already linked to gas benchmarks rather than to oil products, as was the case historically. We expect such convergence will continue.
U.S. energy companies' interest in the European gas markets is widely known, but the amount of LNG Europe currently buys from the U.S. is very small. We generally expect significant overcapacity in the LNG market until 2021, with half of the incremental capacity coming from the U.S. As a result of committed gas off-take and the tolling model of many U.S. liquefaction projects, U.S. LNG volumes will need to find alternative buyers. Latin America cannot accommodate all of the excess, so U.S. LNG companies have been targeting Asian and European markets. For some time, Asian markets have offered a premium compared with the price paid in the EU, but the gap has narrowed in recent months. Given the shorter shipping distance from the Gulf Coast to Europe than to Asia, the European market offers an attractive and reliable LNG export opportunity for U.S. players.
In our view, the main problem for U.S. LNG exporters is that European hub prices are currently well below those that would be attractive. We estimate that gas prices would need to increase by about 30% from the current level (of about $5.0-$5.5 per million British thermal unit) to make exports profitable for U.S. LNG suppliers. A reduction or interruption of Russian gas supplies to Europe might act as a catalyst to lift gas prices in Europe, to the benefit of U.S. players. Currently, LNG accounts for just below 10% of European gas imports and the share from the U.S. is tiny (see chart 4). But this could change if European gas prices were to rise.
Should LNG imports increase as a consequence of lower Russian gas volumes, we believe this could help companies like Qatar Petroleum, Shell, Exxon Mobil, Engie, and Gas Natural, which have global LNG operations as well as access to export capacity from the U.S. It will also be advantageous for other suppliers of pipeline gas to the EU, notably Statoil. This is not our base-case scenario, however.