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Fracking weakens Russian utility’s hold on gas prices

It's tough being a monopolistic enterprise when the ground is moving under your feet. For Gazprom, the earth is not just shifting but fracturing. Even as the Russian state gas utility last week presented the Ukrainian government with a $7-billion bill for taking less gas than agreed under a long-term supply contract, its troublesome customer was signing a deal with Shell to explore Ukraine's supposedly vast reserves of shale gas.

The bumptious Ukrainians are thumbing their noses at an overbearing neighbour but for Gazprom, the worry is not that Ukraine might have a vast unexploited energy resource. The problem is that a liquid market is beginning to develop in natural gas and Gazprom's business model is ill-equipped to deal with it.

Two months ago, on the other side of the world, an alarm bell was ringing loudly. In years past, the seaborne liquefied natural gas (LNG) trade was invented in the last century to supply Japanese utilities and in the absence of a proper gas spot market, prices were set in relation to an oil index. Now, for the first time, Japan is importing natural gas at prices linked to Henry Hub, the American gas benchmark, which is cheaper than any oil index.

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What has changed is that the LNG trade has hugely expanded worldwide to the extent that cargoes are occasionally diverted to satisfy shifts in supply and demand, as in the oil market. Meanwhile, the shale gas revolution in the U.S. created a gas glut, rendering the link to high oil prices obsolete. BP's contract to sell gas to Kansai, a Japanese utility, means that oil indexation is an idea whose time is over in the Asian market, just as it is dying for Gazprom in Europe. This will have two consequences for Gazprom; with Russia's export volumes to Europe declining, Gazprom is becoming a price taker and the pressure is downwards.

Even worse is the long-term impact of market-based pricing on Gazprom's business. The utility's vast network of pipelines was built and its new Arctic resources were developed with financing that depends on long-term export contracts with Western European utilities linked to oil prices. Without the certainty of those huge and oil-index-inflated cash flows, Gazprom will struggle to continue investing in the future at the rate it has done in the past.

Gazprom has yet to find a new strategy. Hence, the $7-billion bill to Ukraine, a sum based on the terms of a 10-year "take-or-pay" contract under which Ukraine promised to pay the index price whether it took the gas or not. It is these sort of contracts which are probably doomed. Gazprom ought to box more clever; instead of fighting markets, it needs to find a way to exploit them, to develop an LNG capability that will enable Russia to act more nimbly amid the rising and falling gas bubbles. But for that to happen, Russia needs to open up its own gas market to investment and competition. For President Putin, that's a step too far.

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