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Nabucco versus Southstream: an economic competition behind a geopolitical confrontation

March 1st, 2010 by Dominique Finon, CNRS Paris

The Nabucco consortium strongly supported by the European Commission in the name of EU energy security interests is going ahead. It decided on February 2010 to order the steel to forge the 3000 km future pipe. Such a strong determination is striking because there is only room for one transit pipe-line and the rival project lead by Gazprom, namely South Stream, has much better chances to win the competitive battle because there will be gas to fill it and money to finance it, which is not the case of Nabucco.

The issue of gas corridor diversification has become increasingly important in the late 2000s setting up many projects driven by political aspirations to reduce dependence on Russian gas. By helping diversification of gas import sources, the European Union has developed a determined foreign policy which is supposed to help European markets to reach Caspian gas and Middle East gas through pipes-lines. Since 2006 it intensively promotes the Nabucco project to help reaching gas resources of Azerbaidjan, Kazkhstan, Turkmenistan, and possibly Iran, Iraq and Egypt. “Nabucco was the first attempt at forging a common energy policy to reduce its dependence on Russian gas. The basis of Nabucco is to bring gas to Europe from new suppliers”, underlined the EU energy Commissioner A. Pielbags in 2007

Foundations of this project are indeed mainly political, because it aims to overcome the Russian gas import monopoly on the Central and Eastern European markets, the risk of which being rapidly compared to transit risk, clearly shown through the successive 2006 and 2009 Ukrainian-Russian gas crises.

Russia has been able to respond to this challenge in two ways, downstream by launching the competing project South Stream which could ship Caspian and Russian gas to the same markets and also to other ones in Southern Europe (Serbia, Slovenia and Italy); and upstream by contracting directly with Turkmenistan to remove all the available gas of the Western Turkmen fields.

Competition theory can be used to throw light on the probable outcome of the competition between the Nabucco project and the SouthStream project. Indeed, it can be viewed as a competition between two firms to buy inputs from the same sources, to transform them in a same product and to sell this product on the same set of geographic markets. The peculiarity of the competition is that these two firms have to decide an investment in a large-scale and indivisible equipment and they also have the option to ex-ante contract with input producers before building it. There are two levels of competition between the two firms, upstream for accessing to Caspian sources or other sources, and downstream for accessing to markets in Central and Southern Europe. That means that competitors will have to anticipate what they will lose if they install their equipment or do not install it, while the situation upstream or downstream could change in their disfavor.

As any imperfect competition game with entry, the dominant player has the possibility to deter entry in three ways: first overinvesting (in a pure economic competition, in fact the “SouthStream firm” assimilated to Russia does not need this costly undersea pipeline to export its gas towards Europe given the existing pipes, but, as being the incumbent, it could decide to invest in order to deter the “Nabucco firm” to invest), second obliging entrant to overinvest and increase its costs (Nabucco would need to link its entry with an investment in the €8-billion TCP to be connected to the main source in East Caspian) and third taking control of the main input source (here by buying all the available Turkmen gas). In this strategic game, the two players have to anticipate their gains and their losses in relation to the likely strategies planned by the other player. We consider the different advantages of the two projects in the point of view of accessing to markets downstream first and second of accessing to sources and finally linking competition downstream and upstream.

Downstream Nabucco has some few advantages on South Stream. Namely its shareholders (onthe long distance, the Turkish section) are the historic companies in Bulgaria, Romania, Hungary and Austria (which would use half of Nabucco capacity for transporting gas to their own markets), the remaining capacity would be for gas trade on the Baugmarten hub at the Austrian frontier with German market. This could be considered as an advantage on South Stream which has not a so clear position on the downstream markets for accessing to national markets. Local gas companies and their governments accept to finance half of the cost of the national sections on the Northern part in Bulgaria and Hungary, but they are not investors on the main part of South Stream under the Black Sea. It is partly compensated by positive development on the downstream branch of South Stream in Serbia and Slovenia. New outlets could be found on the Italian market, in particular with the entry of EDF which controls the third of Italian gas supplier. The main game seems in fact to set upstream. For the access to gas sources, as said above in the storyline, the likely sources available to fill up Nabucco pipe on an horizon compatible with the investment cost recovery period are Azerbadjian and Turkmenistan. It has quickly appeared that Azerbadjian will not have enough gas in the next fifteen years to contract quantities with European buyers that will fill Nabucco at least up to 20 Bcm/y, the level necessary for the fixed cost recovery. Turkmen gas became the only solution for filling Nabucco and making it profitable.

Second upstream resources must not be preempted by an agreement with Russia, and indirectly by the SouthStream project. This Nabucco competitor benefits from the Gazprom ability to control multiple sources of supply, as well as in the Russia’s “Near Foreign”. For gaining agreement with Turkmenistan, Gazprom accepts to change its trade relations withand to pay to Turkmen gas company at the European price. Present attempts from the “Nabucco coalition” to create alternatives to initially hoped-for Turkmen gas quantity in the framework of the so-called Caspian Development Corporation (CDC) is not a credible enterprise on the time scale of the cost recovery period of the project, all the more so that even if new Turkmen gas fields should be developed by the CDC, the gas to be transported to European markets would need the TransCaspian Pipeline (TCP) installation beside Nabucco realization; Finally we consider the game between the two competitors in its vertical dimension including upstream gas access and investment decision in the large upfront cost equipment in relation to their respective competitor anticipated strategy. For the Nabucco coalition it will cost a great amount if it is built without contractual gas, because no quantity will be available during the 2010s at the exception of some Azeri gas. This situation will be the same even if South Stream is not built because all the Turkmen gas which is accessible in the next 15 to 20 years for the European markets is contractualized with Gazprom. It is not because Nabucco will be installed that the advantage of gas source diversification as well as the gas transit risk reduction will be gained for the partners, through lack of gas to fill it in the near and long term. Symmetrically for the South Stream coalition led by Russia/ Gazprom, there would be no cost in relation to the commitment to buy Turkmen gas for controlling the sales of Eastern Caspian gas to Europe, if the pipeline is not built. Indeed Turkmen gas sold to Gazprom could find other outlets and other corridors to reach the European markets, in particular South Stream if it is realised.

If we come back to geopolitics and give up strict economics paradigm, the non realization of South Stream should have an opportunity cost for Russia which would then loose an opportunity to reduce the Ukrainian transit risk, as well as for the buyers of gas transported by South Stream. If the latter will be costly to build, in particular for Russia and Gazprom which are heavily constrained by the financial crisis and sales reduction on the European market in 2009-2010, the economic value of transit risk reduction could be seen as justifying the investment. Alliances with large European “deep pocket” companies (ENI, EDF) should then help to overcome the financial obstacle.

Dominique Finon, CNRS senior researcher, CIRED and Gis LARSEN

For further developments on this issue, see “The limits of the EU direct foreign gas policy. Autopsy of the (soon) stillborn Southern corridor Nabucco”.

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2 Responses to “Nabucco versus Southstream: an economic competition behind a geopolitical confrontation”

  1. Halil Karatas Says:

    First of all, these two projects in question in this article, South Steam and Nabucco, seem to be too much politicized, however this politicization hides an economic competition between these two projects. On the one hand, the Nabucco gas pipeline project appears as a strategic initiative because it represents an opportunity for the European Union to diversify its gas supply options and lessen its reliance on Russian gas imports. But on the other hand, I agree with the author that South Stream has much better chances to win the competitive battle since South Stream project has more financial support than its competitor and without the involvement of Turkmenistan, the Nabucco project would be curtailed. So, the decision of the European Union to order the steel to forge the 3000 km future pipe seems to be risky at first sight.

    The competition theory mentioned by the author is the appropriate approach to analyze this competition in which South Stream is the dominant player. The Russian gas import monopoly Gazprom does not really need to invest in South Stream as Russia already concluded with Germany the Nord Stream project which is a gas pipeline from Russia to Germany under the Baltic Sea and which will start operating in 2011, whereas the construction of South Stream has not begun yet. So, why does Russia insist on investing in South Stream? The capacity of Nord Stream is not sufficient to provide gas for the whole European market and consequently, a part of the transported gas will continue to pass through Ukraine. However, Ukraine may give negative reaction and increase gas transit tariffs as Nord Stream will bypass this country. So, this is the reason why Russia decided to invest in South Stream as well. In other terms, energy policy looks like a chess game, Russia made its calculations a long time ago because Nord Stream and South Stream combined would give the exact same capacity that is currently delivered by the Ukrainian pipelines (118 billion cubic meter/year).

    Moreover, the Trans-Caspian Pipeline (TCP) project, which Turkmenistan plans to use to deliver its gas to Azerbaijan, is at the initial consideration stage. Considering the growing gas demand in Azerbaijan, Georgia and Turkey, I agree with the author that Azerbaijan will not have enough gas in the next fifteen years to contract quantities with European buyers. Furthermore, Turkmenistan’s gas output is contracted to Russia up until 2028 and the possibility of Iranian gas is far from realistic due to its nuclear program. Consequently, the Nabucco pipeline could be empty.

    Likewise, there is also a question about Turkey concerning the future of Nabucco because this country inaugurated with Russia the Blue Stream pipeline that carries natural gas from Russia into Turkey. Indeed, Russia is diversifying its gas supply routes so as not to depend on one transport hub but this creates another political problem: Turkey has already secured its gas supplies because the part of Nabucco which links Azerbaijan to Turkey is already built and consequently, Turkey uses the Nabucco project to put pressure on the European Union about its candidature for membership of the EU.

    Concerning the competition for upstream resources, the European Union is not the only great power which is seeking energy security; Turkmenistan is at the center of a number of pipeline proposals. The European Union, Russia, China and India as well pursue energy security with an eye toward Turkmenistan’s gas deposits and this is why the Turkmenistan-China pipeline’s construction has already begun since 2008. As the author says, the main competition game seems in fact to set upstream. Even if a Chinese-Turkmen deal is concluded, this will not make Russia lose its monopoly on the Central and Eastern European markets. Russia will only be threatened if Turkmenistan increases dramatically its gas production, which is not likely to happen.

    Besides, the European states such as Greece, Italy, Bulgaria as well as Austria are partners in both pipeline projects and the French firm EDF signed on to join South Stream Project. However, this shows that the European Union members disagree with each other, indeed each country has its own energy policy when it comes to energy security and there is not a common European energy policy. As a result, this disagreement is another obstacle for Nabucco.

    Recently, the Italian energy firm ENI suggested that the competing Nabucco and South Stream pipelines would benefit by merging for at least part of their route because this merger could permit to reduce operating costs and increase efficiency. Gazprom immediately refused this merger, this illustrates the will of Russia to keep its monopoly on the Central and Eastern European markets.

    In these circumstances, I share the author’s opinion and I consider that South Stream has much better chances to win the competitive battle. Nevertheless, considering the forecast demand for gas in southeastern Europe, I think that Nabucco will be implemented even if South Stream will become operational.

  2. Eduardo Pinto de Sousa Says:

    Now that race between Russia and EU is more thrilling than ever, new questions often arise adding more complexity to the chess board. After Russian 2006 tapping gas to Ukraine, Europe has felt that it was the right moment to act trying to escape from the net Russia’s gas net. “Nabucco was the first attempt at forging a common energy policy to reduce its dependence on Russian gas. The basis of Nabucco is to bring gas to Europe from new suppliers”, claimed EU Energy Commissioner A.Pielbags in 2007. Since 2006, EU promotes Nabucco project to help reaching gas resources of Azerbaijan, Kazhkstan, Turkmenistan and possibly Iran, Iraq and Egypt.

    Having feared transit risks in Ukraine, judging the country unstable enough to rely on as a “bypass” of Russian gas, EU has launched the massive Nabucco pipeline project. Surprisingly, Ukrainian dolphin of Mr. Vladimir Putin has won the elections setting aside Mrs. Timoshenko, considered to inspire European leaders. So, what changes can we expect in the gas policies from both sides ?

    It has been confirmed that Azerbaijan gas can only meet 5 bmc/year of Nabucco input in the next fifteen years. So, in order to fulfill the minimum of 20 bcm/year to make the Nabucco’s investment profitable, all the attentions will be drawn to Turkmenistan gas. Knowing Turkmenistan is on the sphere of influence of Moscow, what consequences may arise from a possible extension of the pipeline to countries like Iran, Iraq and Egypt ?

    Recently discovered, a new technique that tapped previously inaccessible supplies of natural gas in the United States is spreading to the rest of the world, raising hopes of a huge expansion in global reserves of the cleanest fossil fuel. “It’s a breakout pay that is going to identify gigantic resources around the world”, said Amy Myers Jaffe, an energy expert at Rice University. “That will change the geopolitics of natural gas”. One recent study by Cambridge Energy Research Associate has calculated that this new shale gas outside of North America could turn out to be equivalent to 211 years worth of natural gas consumption in the US. The question is inevitable : Will this wonderful breakthrough in technology ice the gas war of the Nabucco and his concurrent SouthStream ?

    Reinhard Mitschek, managing director of Nabucco Gas Pipeline announced in February that Gazprom would take part in the project, confessing that Russian gas will flow in Nabucco’s pipes. Although knowing that Nabucco needs gas to be economically viable, would it feasible of Russian resources to power up BlueStream, NorthStream, SouthStream and even Nabucco ? Will they have enough gas to meet the demand ?

    At one point, the article refers to the need for contractual gas, with Turkmenistan stating that Gazprom grabbed a deal for the next 15 or 20 years to come. Despite the recent problems within EU, is she in conditions to seal the same deal as Gasprom did ?

    Times are changing and new axis and complexities are coming to play important roles within the subject. Come what may, Russian a true monopoly in its hands and SouthStream will definitively constrain the success of the Nabucco pipeline. As for the rest of the world, we will wait impatiently for new outcomes.

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