Monday, March 16, 2015

Europe’s Nyet to Russian Gas Could Boost US Exports

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Even as the crisis in Ukraine hits a lull with the election of Petro Poroshenko, a pro-Western politician who may declare martial law in the country's eastern provinces to restore stability, Europeans clearly aren't ready to declare more than an uneasy truce with Moscow. The rhetoric has cooled and the Russian military appears to be pulling back from the Ukrainian border, but the European Union (EU) and its allies haven't begun rescinding sanctions. In fact, they seem to be stepping them up.

Europe has long depended on Russia for its energy needs; nearly a third of the EU's natural gas comes from Russia. Half of that is piped in through Ukraine, and since 2009 the EU has been working to diversify those distribution channels. The goal was originally to find ways around Ukraine to avoid its occasional flow-disrupting spates with Russia. To that end, in late 2012 building the South Stream pipeline began.

The 620-mile pipe would allow gas to flow beneath the Black Sea from Russia, then transit through Bulgaria and on to Greece, Italy and Austria. At a cost of about $24 billion, the project would essentially bypass the Russian-Ukrainian equation and allow Moscow a freer hand in dealing with what it views as an unruly satellite state. While the Ukrainians weren't happy about that diversion of gas, the new pipeline was seen as a key element in stabilizing Russian-European relations.

Unfortunately for the Russians, who were emboldened by their successful land grab during the 2008 Russo-Georgian war, they overstepped the bounds of European tolerance by seizing Ukraine's Crimea region.

While Europe relies on Russia for about a third of its natural gas supply, half of Russian federal revenues come from the sale of oil and gas. If Europe is willing to take the pain, it can put a serious dent in Russian revenues by moving away from Russian gas. And it appears that Europe might be willing to do just! that, issuing what amounts to a stop-work order on the South Stream project.

This week the EU demanded that Bulgaria halt construction of the pipeline, saying it suspected violations in regulations on how construction contracts were awarded. Since Bulgaria joined the EU in 2007, it is bound to follow those regulations and has a month to respond to the complaint.

The EU had already frozen high level diplomatic talks with Russia over approval concerns, which focused primarily on Bulgarian legislation that essentially allowed the Russian natural gas giant Gazprom (OTC: OGZPY) to circumvent the bloc's rules on competitive bidding processes. But the bid issues are really a red herring. This is simply a wake-up call to check Russian aggression.

Despite the stop-work order, I suspect this is just slow-pedaling. The European commission responsible for the project is headed by short-timers unlikely to scuttle the deal. In fact, the timing of the stop-work order essentially guarantees that the next round of commissioners will be the primary decision makers. The next commissioners will likely find a way to continue construction of the pipeline.

Energy policy is a key way for Europe to constrain Russia's expansionist impulses, at least for now. In the meantime though, Europe will be looking to diversify its supply and Russia will be looking for new customers. In fact, Russia has already signed a deal to send 38 billion cubic meters of gas to China annually, beginning in 2018, and a second pipeline deal with the Chinese is already in the works.

This bodes well for the future of American natural gas. US policy makers will be keen to support our European allies by moving ahead with liquefied natural gas export terminals. While that wouldn't totally wean Europe from Russian natural gas, our exports would make a dent. That would be a boon for American producers such as Cimerax Energy (NYSE: XEC). It will also provide a boost for companies such as Cheniere Energy (NYSE: LNG), whose Sa! bine Pass! liquefied natural gas terminal is already being converted to accommodate bi-directional flows. Its Gulf Coast location also provides relatively easy access to European markets.

While the current spat between Russia and the Europe doesn't mark a sudden about-face in any nation's energy policy, it could ultimately create a big market for our glut of natural gas.

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