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How a Russia-China gas deal undercuts Canadian LNG

Canada has been a stern critic of Russia throughout the recent political turmoil in Eastern Europe thanks to Prime Minister Stephen Harper's frequent chastising of President Vladimir Putin for his "cold war state of mind." Mr. Harper's uncompromising stance will have been welcomed in Washington and among some communities in Canada, but for the export economies of Alberta and British Columbia, it could be a shot in the foot.

This week the Russian president is flying to Beijing in the hope of sealing a huge gas pipeline deal with his Chinese counterpart. After decades of argument, suspicion and prevarication, it could be the start of Russia's great assault on the energy markets of the Pacific. For centuries, Russians have looked west for trade, cultural and diplomatic links. Much of the political stand-off in Ukraine can be linked back to a historic Russian interest in an ice-free port which gives access to the Mediterranean; in other words, a link to Western Europe.

For Muscovites, the world to the East was hostile and frightening, a view reinforced by memories of invasion by Mongol hordes. Europe was the only market that mattered – as if to prove that, Siberia's gas and oil pipelines flow from East to West. Huge gas fields were discovered in Eastern Siberia but their riches were left underground, being too remote for export to Europe. The obvious solution, when it was considered, was rejected; a pipeline facing east was a step too far for a Kremlin fearful of arming its Chinese rival with oil, gas and minerals.

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If Russia ever hoped that it could starve China of energy by ignoring it, the strategy failed and China has leapfrogged Russia in economic and political significance. Meanwhile, Mr. Putin's efforts to arm-twist his snooty European neighbours into diplomatic concessions have also failed. OAO Gazprom, Russia's greatest asset and diplomatic weapon, is being threatened with antitrust proceedings while Brussels issues bullying edicts about opening up Russian pipelines to competition. So, the Russian president finds himself looking once again at the long, hard road east across Siberia.

The 30-year take-or-pay contract is largely agreed upon, save the price formula. Unfortunately for Gazprom and Mr. Putin, the price dynamics are likely to have worsened. Since they last talked gas with Beijing, China has sealed a pipeline gas deal with Turkmenistan on favourable terms, so the Russians are unlikely to benefit much from the inflated benchmark set by liquefied natural gas (LNG) imports into Japan. Prices are lower in Europe too, where the expanding trade in European spot gas is forcing Gazprom to delink its prices from oil indexation to the real trade in spot gas – at discounts of 15 to 20 per cent.

This is unfortunate news for Canada's plans to ship cargoes of super-chilled Albertan gas into the Pacific basin. The market is becoming more complex and more competitive than it was 10 years agowhen spare LNG cargo ships could simply dock in Tokyo Bay and sell at five times the Henry Hub benchmark price of gas. The Chinese opening gambit with Gazprom was a price linked to Chinese coal and then to Henry Hub. But the Russians have little choice other than to tempt China with enormous volumes – and those volumes will, inevitably, represent fuel that won't be Canadian.

For Russia, there is no turning back. As if to underline the point, Gazprom revealed plans last week to list its shares on the Singapore stock market. The Asian city state has big plans to develop an exchange for trading LNG, establishing a global benchmark for the commodity. It could be a breakthrough moment when Russia finally turns its gaze permanently to the East. It's not entirely clear yet which way Canada is facing.

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