The myth of cheap Russian gas in Europe

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the author is Chief Global Natural Gas Strategist, S&P Global Commodity Insights

Will Europe return to Russian gas? The EU has vowed to give up its addiction to Russian gas once and for all, but will it? Some believe Europe will be forced to turn to Russia because it needs “cheap” Russian gas to revive its economy and avoid deindustrialization. But this is a myth, both seductive and dangerous. It is based on a fundamental misunderstanding of how the European gas market works. In short, Russian gas has never been cheap.

Russia's natural gas sales to Europe are currently down, but not completely over yet. EU pipeline imports in 2023 are down 84% from pre-invasion 2021, exceeding many expectations. Europe is emerging from its second winter of natural gas crises, with storage levels at seasonal highs. Benchmark prices fell back into familiar ranges. Italy is still buying Russian pipeline gas in 2023 and has announced that it will finally “kick the habit” in 2024 as more Algerian pipeline gas and global LNG become available.

Two years after Russia launched a full-scale invasion of Ukraine, the European Commission remains committed to its original firm response: zero emissions from Russian natural gas by 2027. This means eliminating remaining pipeline flows into Central Europe and halting LNG imports.

But it’s not the committee that decides; This is each individual country. There is a lot of skepticism outside Europe. The question that keeps coming up is: will Europe surely be lured back to cheap Russian gas? “Germany, the European industrial powerhouse, depends on this,” someone said. “Without it, Europe is not competitive.” The “temporary suspension” of new U.S. LNG export authorizations announced in January only reinforces the view that Europe cannot afford to abandon its relationship with Russia for the sake of a potentially “unreliable” U.S. relationship – no matter how troubled the marriage is.

These views fail to recognize the strong sentiment against the Russian regime that prevails in much of Europe. Given that the idea of ​​cheap Russian gas in Europe has always been a myth, basing policy on it would be a serious mistake.

To be sure, Russia has abundant low-cost natural gas that could theoretically be delivered cheaply to Europe. But it has never sold gas at cost — just as Middle Eastern oil has never been sold at cost. Russia sells natural gas competitively, but it is not cheap.

From the 1970s to the 2000s, the Soviet Union and Russia priced natural gas to replace its competitor, industrial fuel oil and heating oil for home heating. Therefore, prices are set as a percentage of the price of these petroleum products. If the price is high, gas prices will rise and Moscow will get a windfall. If oil prices are lower, prices will fall to preserve gas, but sales may still be well above cost. Other supplies sold in Europe – whether in Algeria, the Netherlands or Norway – use the same mechanism.

It's hardly a giveaway, but it's not a bad deal for Europe either. By pricing slightly lower than competitive fuels, Europeans have the confidence to invest in natural gas infrastructure; natural gas is able to penetrate deeply, taking over most residential heating and much of industrial energy supply. Oil (but not cheaper coal) has also been marginalized in power generation.

In the late 1990s, things began to change. Europe wants a market for natural gas. This means moving away from artificial ties to oil and instead setting market prices for gas at hubs and exchanges. The hope is that this will decouple prices from oil and lead to lower prices. At first, the Russians were staunchly opposed. But under pressure from European competition rules, contracts have gradually been adjusted to incorporate reported price benchmarks. This does not mean that Russian gas is sold cheaply; it is sold on a similar basis to all other gas.

China offers another model. Russia responded to the loss of its traditional markets in the West by seeking to expand pipeline sales to the East. Russia and China are in bilateral talks over a giant pipeline that would connect Russia's low-cost natural gas fields in western Siberia to demand centers around Beijing.

The problem is the price. This is a big gain. The Chinese insist on lower prices. Given that China has multiple alternatives and Russia has none of similar size, Beijing appears to have the upper hand in the negotiations. In this way, Russia will eventually pay the price for losing the European market. Because when we talk about cheap Russian gas, it is China that will benefit in the future. This is not the Europe of the past.