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Northeast Asias Kovykta Conundrum:A Decade o Promise and Peril
Se Hyun Ahn & Michael . Jones
research note
http://asiapolicy.nbr.org
keywords: northeast asia; natural resources; natural gas; oil;
pipelines; energy policy; russia; kovykta
se hyun ahn is Assistant Professor at the Government and InternationalRelations Programme in the Division of Humanities and Social Science in theUnited International College, Zhuhai, China. He was previously a research
fellow at the Asia Research Centre at the London School of Economics andPolitical Science. He can be reached at .
michael t. jones is a project manager at Te National Bureau of AsianResearch. He has a degree in Chinese language and literature from the Universityof Washington. His primary areas of research include energy security, politics ofeconomic development, and Asias relations with the developing world. He canbe reached at .
note u Te authors would like to thank Mikkal Herberg and twoanonymous reviewers for helpful insights.
asia pol icy,number 5 (january 2008), 10540
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Tis article seeks to explain whydespite the potential or gas rom Siberia
and the Russian Far East to provide greater energy security or NortheastAsiaa decade o negotiations has still not resulted in an agreement to
construct the Kovykta pipeline.
main argument
Gas rom Russias Kovykta field has the potential not only to drastically
reduce Northeast Asias energy shortage but also to help diversiy Northeast
Asias traditional sources o energy away rom the Middle East.
Te potential or Kovykta gas to reach any Northeast Asian country, however,
has been delayed or over ten years due to the ollowing actors:
Te politics of route determinationu Tough routing the pipeline viaNorth Korea and Mongolia would be cheaper, government and privatesector sensitivities have resulted in proposed routes that circumvent thetwo countries and thus drive up the costs o any such pipeline.
Inherent complexities of gas investmentsu
Natural gas is intrinsically more
difficult to trade than oil, and gas deals require much more confidence,guarantees, and money rom investors and governments.
Demand security u Chinas market is important to Kovyktas success.Despite plans or urther gas market development, however, Chinasreliance on cheap coal has created a sof market or higher-priced gas.
Russias resource nationalism u Rising oil prices have given Moscowimpetus to renationalize Russias energy sector, thereby both complicating
negotiations and causing investors to be wary o a Russia that could useenergy as a political weapon.
policy implications
Tough a more centralized role or Russia in the Kovykta project could speed
the decisionmaking process, striking a price that suits both China and Russia
will be the key determinant in the ate o the pipeline. Gazprom is currently
ocused on other projects, however, and Kovykta will possibly remain
idle or several years to come. Not allowing Russias giant gas field to havesignificant market outlets in Asia will keep gas prices higher than they would
be otherwise, potentially diminish available supplies to the U.S. West Coast,
and keep incentives in place or Asia to increase ties to rogue gas-supplier
states such as Iran and Myanmar.
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E nergy security is gradually replacing the previous ideologicalconrontation that was characteristic o the Cold War to orm a newsecurity paradigm in the Asia-Pacific. Maintaining strong relations with
Russia is extremely advantageous to regional states given that the import
o oil and gas rom Russias Far East has the potential to enhance Northeast
Asias energy security interests by reducing domestic energy shortages and
diversiying energy imports. Since the end o the Cold War, Russia has ofen
been portrayed in Asia as a waning political and economic orce. Since the
dissolution o the Soviet Union, however, Russia has sought to become a
pivotal regional player in Asia. Russian president Vladimir Putin clearly
hopes to upgrade Russias prestige and influence in the region by promoting
his countrys role both as an objective mediator and as a reliable energysupplier. In the last several years in particular Russia has demonstrated power
and influence in the new geopolitical environment o high energy prices.
With enormous oil and gas reserves in Siberia and the Far East, Russia has an
economic interest in expanding the countrys energy markets into the Asia-
Pacific region.
Despite this great potential, the reality is that Russian energy projects
have not emerged as a substantial unctioning unit o economic activity thus
ar. Te many efforts in the last ten years by Northeast Asian statesnotablyChina, South Korea, and Japanto exploit opportunities in Russias Far East
have had only marginal success. Gazprom is now in the midst o taking over
controlling stakes in Russias remaining oreign-owned energy projects. In
mid-June o 2007 Gazprom took a majority share o the Kovykta gas field
project by orcing NK-BP out o the consortium. For ten years this gas
field, located in Russias Irkutsk region, has promised to be a keystone or
physically connecting the nations o Northeast Asia in a way that no other
energy project could. Tough governments o China, Mongolia, South Korea,
North Korea, and Japan have actively discussed Kovyktas development
over the last decade, the development o gas pipelines rom Russia has been
extremely slow. Several actors have impeded progress, including Chinas
underdeveloped and unpredictable gas market, issues related to regional
distrust, political and commercial risks regarding pipeline routing options,
the Asian financial crisis in the late 1990s, and Russias renationalization o the
energy sector. Gazproms ocus on westward exports and lack o technologicalexpertise could seriously impair Russias prospects or a greater share o Asian
gas exports. As such, many consumer countries in Northeast Asia have held
off on dealing with Russia and are beginning to turn elsewhere to ulfill uture
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gas needs. With little development having ensued since Gazproms takeover o
the Kovykta project, the ate o this venture is uncertain.
Tis article uses the case study o the Kovykta gas pipelines proposed in
the region to illustrate both the potential or and the major obstacles to Russia
becoming a major provider o energy security or Northeast Asia.
Tis article is divided into five sections:
u pp. 10814 examine both the current state o natural gas development inSouth Korea and China and the overall benefits o potential Kovykta gasexports to the two countries
u pp. 11421 outline Kovyktas changing development and export plansover the last ten years
u
pp. 12129 analyze the major economic obstacles to the developmentand export o Kovykta gas to Northeast Asia
u pp. 12937 examine Russias resource renationalization and otherdomestic actors that have impinged on the export o Kovykta gas toNortheast Asia
u pp. 13740 consider the uture outlook or Kovykta gas introductioninto Northeast Asia and the geopolitical and economic implications orAsia and the United States
Russias Untapped Potential
Russia has been described as the worlds treasure trove o gas. Around
twenty new giant gas fields have been discovered in the last couple o decades,
each containing over 500 billion cubic meters (bcm). Tese twenty fields
comprise close to three-quarters o Russias total gas reserves. Capable o
producing as much as 130 bcm o natural gas by 2020equivalent to the
current level o Russias gas exports to Europethe Russian Far East can play
a very important role in shaping cooperative energy schemes in Northeast
Asia.1In the last ten years Northeast Asian governments and companies have
made several attempts to capitalize on a number o major energy projects in
the Russian Far East.
1 See Stephen White, Is Russia a Country in the Globalization Era? (presentation preparedor conerence on the Regional Cooperation o Northeast Asia and Russias Globalizationor the 21st Century, Seoul, South Korea, June 2224, 2003); and Eugene M. Khartukov,Russia, in Rethinking Energy Security in East Asia , ed. Paul B. Stares (okyo: Japan Center orInternational Exchange, 2000), 141.
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One o Russias largest gas fields is the Kovyktinskoye (Kovykta) gas
condensate field. Discovered in 1987, this field contains an estimated two
trillion cubic meters o natural gas and condensate.2 Put into perspective,
Kovykta contains more gas than the entire nation o Canada, the major
supplier o gas to the United States. Due to the sheer size and location o the
field, Kovyktas development represents a timely and important opportunity
or China and South Korea. Development o this field as last proposed by
the consortiumwith 20 bcm per year going to China and 10 bcm per year
going to South Koreacould hold many benefits or Russia. Development
at this level could acilitate diversification o Russias Europe-centric export
market, increase government revenues, spur economic development in the
desolate regions o the Russian Far East and Siberia, and promote regionalenergy integration.
With Gazproms recent takeover o the project (discussed in detail below),
pipeline development into Northeast Asia couldi planned careully
represent a significant opportunity or Russia. Te projected $1.21.4 billion
per year in annual tax revenues rom the export o Kovykta gas by 2020 would
benefit both the ederal and local governments.3In 2006 gas rents accounted
or approximately hal o Russias total energy rents. Furthermore, Gazprom
currently exports all o Russias gas to Europe and Eurasia; a major pipelineto Northeast Asia could thereore diversiy the companys export portolio.
In 2006 Gazprom produced 556 bcm o gas and exported around 260
bcmapproximately hal the totalto Europe, the Baltic States, and Central
Asia.4Tus, potential Kovykta gas exports o around 30 bcm per year would
represent over 10% o Gazproms current exports.
As o early 2007, however, domestic consumption o gas supplied rom
the Kovykta field amounted to only 2 bcm. Te main consumers o this initial
production have been the sparse populations o Angarsk, Sayansk, Irkutsk,
and Usolye-Sibirsk.5Tese populations will never consume as much gas as this
field could potentially produce. For the benefit o both the project consortium
and the Russian state, Kovykta gas must reach Asian markets.
2 Kovykta Project, NK-BPu http://www.tnk-bp.com/operations/exploration-production/projects/kovykta/.
3 Ibid.
4 Gazprom Annual Report 2006, OAO Gazprom, 2006 u http://www.gazprom.com/documents/Report_Eng.pd.
5 Ibid.
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South Koreas Looming LNG Supply Gap
In the last ew decades, South Korea has been one o Asias astest-growing
and most dynamic economies. Vast amounts o natural resources will be
needed to maintain this economic growth. Due to the expansion o energy-intensive industries and to increases both in income and in the number o
motor vehicles, total primary energy demand in South Korea has skyrocketed
to 226 million tons o oil equivalent (mtoe) in 2005, approximately 78 mtoe
higher than in 1995.6Having very limited domestic sources o energy, South
Korea relies almost completely on imports. Energy imports as a percentage o
total demand rose rom 73.5% in 1980 to 96.8% in 2005. Te worlds ourth
largest oil consumer, South Korea presently relies solely on imports to meet oil
needs and uses oil as the primary uel source; demand or oil as a percentage
o total energy demand is, however, projected to all rom 53% in 2003 to 39%
by 2030.7
In the mid-1980s Seoul introduced tax incentives to promote widespread
use o natural gas. With the rapid expansion o the countrys natural gas
industry rom 1987 to 2002 and establishment o a nationwide trunk pipeline
network, South Korea has become one o the worlds most dynamic gas
markets. Natural gas continues to be the astest-growing energy resource in
South Korea due both to the convenience and to the environmental riendliness
o natural gas relative to oil. As such, orecasts are that South Koreas demand
or gas will increase by 150% (rom 20 bcm in 2000 to 53 bcm) by 2020.8In
short, natural gas has been and will remain the astest-growing energy source
in South Korea.
South Korea is currently the second-largest importer o liquefied natural
gas (LNG) and home to the worlds largest LNG importer, Korean Gas
Corporation (KOGAS). KOGAS has a de acto monopoly on South Korean gasimports, which thus ar have been exclusively in the orm o LNG.9KOGASs
imports have traditionally come rom Southeast Asia; many o these long-
term KOGAS contracts are ending in 200708, however, and their renewal
6 BP Statistical Review o World Energy 2006, BP p.l.c., June 2006.
7 Ministry o Commerce, Energy, and Industry o the Republic o Korea (MOCIE)uhttp://www.mocie.go.kr.
8 Ibid.
9 Due to privatization efforts that began in 1999, the South Korean government allowed POSCO(a large steel maker) to make a rare spot purchase o 500,000 tones o LNG in 2006. POSCOand K-Power also signed a long-term LNG contract in 2004 or 550,000 and 600,000 million tonsrespectively o LNG rom Indonesias angguh project that will be delivered by the end o 2008.
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is not always certain.10Tereore a growing proportion o South Koreas LNG
is coming rom the Middle East. South Korea began importing LNG rom
Oman and Qatar in 1999 and has secured a contract or large shipments rom
Yemen beginning in 2008. By 2020 nearly 80% o South Koreas LNG imports
will come rom the Middle East (see Figure 1). Imports o LNG to South
Korea will increasingly need to traverse long distances through vulnerable
chokepoints such as the Hormuz and Malacca straits. Furthermore, the
Middle East is acing a shortage in liqueaction capacity, traditional LNG
suppliers (Yemen, Oman, and the United Arab Emirates) all have virtually run
out o new supplies, and approximately 80% o the potential LNG supplies o
Qatarjust emerging as one o the worlds largest LNG exportersare already
committed.11
For South Korea, these phenomena make neighboring Russia anextremely attractive source o gas.
Since KOGAS is the main LNG importer, South Koreas economy is
dependent on winning new long-term LNG contracts. Although KOGASs
contracted supplies roughly matched total gas demand in 2001, the supply-
demand gap has recently noticeably widened due to South Koreas seasonal
demand fluctuations (see Figure 2). South Korea consumes around eleven
times as much LNG in the winter as in the summer. Given that traditionally
strict LNG contracts orbid customers to sell excessive supplies to third parties,South Korea has in effect been orced to buy contracted gas below demand
and to make up the difference with spot-market cargoes.12South Koreas 2005
spot-market purchases came to around 8 mtoe o gasor approximately 9
bcman amount the equivalent to about one-third o the countrys total
gas consumption(seeFigure 2). Reliance on the spot market to make up or
gas shortalls is a major problem or Korea. Although purchases on the spot
market have become increasingly commonplace in the Asia-Pacific, spot
market LNG is vastly more expensive than gas obtained through long-term
10 Indonesia is one such example. Although much o South Koreas LNG in the 1990s came romIndonesia, the uture o Indonesias LNG industry is uncertain. Due to a lack o both avorableinvestment policies and general resource nationalism, this OPEC country became a net importero oil in 2004, with plans to urther develop the countrys LNG or export currently in limbo.An overall push to develop a domestic gas market is emerging to make up or this energy gap.Indonesia already has to import LNG rom other countries in order to meet existing long-term
supply contracts.11 Fereidun Fesharaki, Energy Issues in Iran: It Helps to Know a Few Facts Beore ReachingConclusions! (presentation given at the 27th Annual Oil & Money Conerence, London,September 1819, 2006).
12 Spot markets allow producers o surplus gas to instantly locate available buyers, negotiate prices,and deliver actual commodities to the customer in real time and are either privately operated orcontrolled by industry organizations or government agencies. Spot markets requently attractspeculators because spot market prices are known to the public instantaneously.
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contracts, including pipeline gas.13Kovykta could be a source o both stable
and predictably priced gas or South Korea.
As mentioned above, South Korea is solely reliant on LNG. Te proposed
Kovykta pipeline would thereore allow Seoul to diversiy not only the sources
o gas but also the modes o gas transportation available to South Korea.
For Seoul, the Kovykta pipeline is extremely attractive as such a line could
disperse risk among the multiple parties involved (both government and
private)rather than bilaterally as is the case with LNG dealsand balance
South Koreas reliance on tanker gas coming rom the Middle East.
Chinas Promise as a Gas Market
Natural gas currently comprises only 3% o Chinas total energy
consumption mix, a percentage that is significantly less than the world
13 Te growth o the spot market in Asia is in part due to South Koreas seasonal gas demand swings, anuclear plant shutdown in Japan, and gas supply interruptions in Indonesia.
FIGURE 1
Share of South Koreas LNG Imports by Source, 19902020
Percentage
Year
Source: KOGAS 2005 Annual Report, Korea Gas Corporation, 2006 uwww.kogas.or.kr.
Southeast Asia Middle East Other
1990 1995 2000 2005 2010 2015 2020
0
10
20
30
40
50
60
70
80
90
100
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average o approximately 23%.14 Te lack o gas demand is predominately
due to Chinas reliance on coal or electricity. Accounting or 70% o total
energy consumption in China, coal is slated to remain king in Chinas
energy mix or the next several decades. Beijing is, however, beginning to
realize the limitations o coal or providing a stable supply o electricity inChina. Rampant electricity demand has placed serious stress on Chinas rail
transportation system and has created major transportation bottlenecks that
triggered a rise in coal spot prices and caused severe power outages in many
parts o the country. Faced with these coal shortages, many manuacturers
have resorted to using gas- and diesel-powered generators to meet actory
electricity needs, a substitution that in turn raises Chinas overall oil demand.
Te grave environmental and health implications o Chinas coal use
have received extensive media coverage. Te International Energy Agency
(IEA) predicts that China will overtake the United States in carbon dioxide
14 BP Statistical Review o World Energy 2006.
1990 1995 2000 2005 2010 2015 2020
0
5
10
15
20
25
30
35
40
45
50
FIGURE 2
South Koreas Growing Gas Supply-Demand Gap
Milliontonsofoilequivalent
Year
Source: Outlook or Energy Consumption in 2010, MOCIE uwww.mocie.go.kr; BP Statistical Review o
World Energy 2007, BP p.l.c., 2007; and KOGAS 2005 Annual Report.Note:Data or 2010, 2015, and 2020 is projected.
DemandSupply gap
Supply contracts
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emissions in 2008.15Additionally, the coal industry in China sorely lacks saety
standards. In 2005 nearly 6,000 deaths in coalmine accidents were reported
in China. According to Zhao iechui, chie o China's State Administration o
Coal Mine Saety, China closed a total o 8,984 small coalmines in the first hal
2007 and will close another 2,811 small coalmines by the end o the year.16
Chinas coal industry will require around $100 billion in urther
investments to meet projected demand in 2025.17Rather than making these
needed investments in the coal industry, China could direct investment toward
establishment o an integrated gas system. With 70% o Chinas economy
relying on the coal industry, prospects or diversified gas introduction will
remain a top priority or Beijing. Investments in efficient and clean gas-fired
power stations would play a critical role in alleviating many o Chinas coal-related environmental and health problems.
Domestic gas production has risen dramatically, up 17% between 2005
and 2006. Despite this change, China must increasingly look abroad or
supplemental gas supplies. Until recently China was completely sel-reliant
on domestically produced gas. Because Chinas national gas network is not
even remotely comparable to that o South Korea or Japan, the countrys
domestically produced gas is consumed in close proximity to the production
fields. No consensus has emerged among analysts over the shape Chinesegas demand will take in the next twenty years(seeFigure 3). As economic
development and manuacturing urther stretch into Chinas hinterland,
Beijing will need to build gas pipeline networks and effectively implement
policies or promoting pipeline use. As the majority o Chinas gas consumption
and pipelines (though sparse) are in the countrys northeastern region, Russia
is an extremely attractive gas supplierand Kovykta gas is optimally located
or transport to China.
In 1989 Chung Ju-Yung, chairman o the Hyundai Group, proposed
running a gas pipeline rom Yakutsk to South Korea via North Korea. He
hoped that this project could both enhance South Koreas energy security
15 Richard McGregor, Rampant Growth Spurs Emissions, Financial imes, April 19, 2007.
16 China to Stay Coal Net Exporter through 2007, Energy Economist, no. 310 (August 2007): 38.
17 James P. Dorian, Global Implications o Rising Chinese Energy Demand (paper presented atannual energy security conerence o Te National Bureau o Asian Research, Washington, D.C.,September 2526, 2005).
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and advance the idea o a unified Korea.18 In 1994 the presidents o South
Korea and Russia agreed to jointly develop natural gas rom a field in Yakutia
(Republic o Sakha) in eastern Siberia to supply gas through a pipeline to
Seoul. South Korean president Kim Yong-sam stated that this pipeline would
promot[e] the economies o the two countries[and] contribute to orming
a basis or unification o the two Koreas.19In late 1995 Moscow and Seoul
completed a preliminary study o the technical and economic easibility o
Sakha gas development. Under the agreement a 6,600 km (4,125 mile) natural
gas pipeline would extend rom Sakha through Khabarovski and Primorski
krais. Expectations were that the annual output o gas would total 30 to 45
18Keun-wook Paik, Gas and Oil in Northeast Asia: Policies, Projects, and Prospects(London: TeRoyal Institute o International Affairs, 1995).
19 Russia and South Korea Agree to Develop a Gas Field and Construct a Pipeline, BBC MonitoringService: Asia Pacific, June 3, 1994.
FIGURE 3
Projections of Chinas Gas Demand
Billioncubicmeters
Year
Source: BP Statistical Review o World Energy 2007; 2006 Energy Demand and Supply Outlook, Asia-
Pacific Energy Research Center (APERC), 2006; 2004 World Energy Outlook, International Energy Agency(IEA), 2004; and 2006 International Energy Outlook, Energy Inormation Administration (EIA), 2006.National Development and Reorm Commission (NDRC) figure cited in Akira Miyamoto and ChikakoIshiguro, Pricing and Demand or LNG in China: Consistency between LNG and Pipeline Gas in a FastGrowing Market, Oxord Institute or Energy Studies, NG-9, January 2006.
Note:Actual figure in 2006 is 56 bcm.
2006 2020
0
50
100
150
200
250
300
APERC (153)
EIA (134)
IEA (107)
NDRC (250)
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bcm, 15 to 28 bcm o which would be exported to the Korean Peninsula and
that the project would be shared between Russia (70%) and oreign investors
(30%). Pyongyang approved the transit o the gas pipeline through North
Korean territory because the project would be economically beneficial to the
country. Estimates or the total cost o the project were between $17 and $23
billion, with supplies expected to last fify years.20Te regional pipeline idea
was abandoned, however, because the fields in Sakha Republic were deemed
unprofitable due not only to the huge costs associated with a pipeline o
this length and the harsh climate and geological conditions but also to the
uncertainty o uture South Korean demand or gas. International ocus thus
quickly turned to the Kovykta gas field in Irkutsk.
he Five-Country Feasibility Study (19962000)
Following the discovery o the gas field in 1987 and several short-lived
attempts by Western oil companies to take part in Kovyktas development,
Russias prime minister ordered that Sidancoa newly ormed regional oil
company owned jointly by Russia Petroleum (RP) and the Export-Import Bank
o Russiashould become the major Russian stakeholder in the project. In
1996 a subsidiary o South Koreas Hanbo Group, the East Asia Gas Company(EAGC), took the initiative o purchasing 27.5% o the equity shares in the
project or $25 million and promoting early development o East Siberias
oil and gas reserves.21As a result the Hanbo group (with 46.1% ownership)
became the largest shareholder o the project. Having invested $40 million
in the field development, the consortium began looking or supplemental
oreign investment by 1997. Tat year Russias Ministry o Fuel and Energy
and China National Petroleum Corporation (CNPC) signed an agreement to
bring Kovykta gas to northeast China via Mongolia. At that time total projectcosts were expected to amount to $57 billion.22
South Koreas stake in the project was short-lived; in 1997 a bankrupted
Hanbo Group was orced to sell off a majority o its equity shares. British
Petroleums $571 million purchase o the bulk o Hanbo shares lef EAGC with
just a 7.5% share. Sidanko and BP established a strategic alliance to develop
the project.23Projections at this time or the proposed pipeline put delivery
20 Ekonomicheskii Soyuz Supplement, Rossiskaya gazeta, March 30, 1996.
21 Unless noted otherwise, all monetary values are in U.S. dollars.
22 Russia and China to Build Gas Pipeline to Yellow Sea, BBC Monitoring Service: Former SovietUnion, July 18, 1997.
23 Jeanne Whalen, BP and Uneximbank Close Sidanko Deal,Moscow imes, November 19, 1997.
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o Kovykta gas to China at 20 bcm per year, with the possibility o extending
pipelines to service Korean and Japanese markets. In 1998 Russia, Japan,
China, South Korea, and Mongolia signed a memorandum o understanding
to execute a easibility study.24During this phase o negotiations the pipeline
route deemed most economical was one running rom Irkutsk to Beijing via
Ulaanbaatar, Mongoliaa total distance o 3,364 km.Te planned 1,420 mm-
diameter pipeline would require capital investments o nearly $7 billion.25
Several issues began suracing at this time. Although the proposed route
was the most economical, China was staunchly opposed to Mongolia as a
transit country. Additionally, although China was the main market or the gas
a large portion o the investments would need to come rom South Korea and
Japan. Under these prerequisites, companies rom the two countries wouldneed to be rewarded with larger stakes in the pipeline development. Project
plans collapsed at a December 1998 meeting. In 1999 the development o the
pipeline was revived by a cooperation agreement signed in February 1999
between the prime ministers o Russia and China, Yevgeniy Primakov and
Zhu Rongji.26By the end o 1999 China and Russia had invited South Korea
to join in another easibility study that began in early 2000. Te remainder o
that year was defined by BP taking urther control o RP with the acquisition
o EAGCs remaining shares.
he hree-Country Feasibility Study (200003)
During a November 2000 meeting in Beijing, the BP-controlled RP
signed a new tripartite agreement with CNPC and KOGAS or a easibility
study.27 Shortly afer the agreement, South Korea proposed that the study
include the potential or North Korean participation in the project. South
Korean energy experts and politicians emphasized that by giving NortheastAsia a truly integrated pipeline system the North Korean routing option
would both minimize the unstable political situation in the Korean peninsula
and promote mutual economic prosperity or each participating state.
In 2002, beore the easibility findings were even announced, yumen
Oil Company (NK)a significant shareholder (26%) o RPproposed the
24 E. Siberia Gas Feasibility Study to Be Agreed, Reuters, September 23, 2006.
25 Keun-Wook Paik and Jae-Yong Choi, Pipeline Gas rade between Asian Russia, Northeast AsiaGets Fresh Look, Oil and Gas Journal95, no. 33 (August 18, 1997): 4145.
26 Russian Agency Details Sino-Russian Energy Cooperation Projects, BBC Monitoring: Asia-Pacific, February 24, 1999.
27 Russia, Platts Oilgram News 78, no. 215, November 7, 2000.
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idea o completely bypassing China by directing the pipeline to Nakhodka
or LNG exportation.28A year o shuttle diplomacy and wrangling between
stakeholders, local and ederal governments, and Russian gas giant Gazprom
ensued, due in large part to Moscows 2002 appointment o Gazpromnot
even a stakeholderas the main coordinator or all gas exploration and
production (E&P) and export projects in east Siberia. Moscow specifically
asked Gazprom to coordinate all o Russias gas sales to the Asian markets,
as the company does with European exports.29In February 2003 Gazprom
chie Alexei Miller visited Seoul to discuss KOGASs proposal to build
the Kovykta pipeline into China through North Korea, finally reaching
Pyongtaek in South Korea. NK and BP (which had merged in 2003 giving
the new company NK-BP a 62.5% stake in RP) strongly opposed the routethrough North Korea, however, because o the increased costs and potential
political risks. South Korea eventually abandoned the idea and returned to
the original plan to lay the pipeline on the bottom o the sea between China
and South Korea (see Figure 4).
Te three-country easibility study was eventually conducted and finalized
in the summer o 2003. Te study ound that the project was commercially
sound and projected that the total production volume o gas rom the Kovykta
field would reach 3035 bcm per year, o which China would receive 20 bcmper year and South Korea would receive 10 bcm per year. Te proposed gas
pipeline would have a total length o 4,887 km, starting rom Irkutsk, wrapping
around the southern tip o Lake Baikal, running parallel with the Mongolian
boarder, and crossing the Russia-China boarder at Manzhouli (Manchuria).
In China the pipeline would run through Qiqihaer, Harbin, Changchun, and
Shenyang. From Shenyang the pipeline would splitone line going to Beijing
and the other line going to Dalian. From Dalian a pipeline would run 536 km
under the Yellow Sea to the Korean city o Pyongtaek.30Te study also ound
that the pipeline would take five to six years to build and could ultimately
supply South Korea with gas beginning in 200910. Te study projected that
the project costs would reach $17 billion. According to KOGAS, the price
28 Russian NK Urges OK or Kovykta-Nakhodka Gas Pipeline, Dow Jones International News,March 15, 2002.
29 Gas Pipeline to China and Korea, APS Downstream Review rends, September 4, 2006.
30 Jiqiang Ma, Substantial Result Achieved or Russia-China-ROK Gas Cooperation Project, ChinaOil and Gas, no. 4 (2003): 4245.
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o Kovykta pipeline gas would have been 20% to 30% lower than Koreas
established LNG prices.31
Gazproms Strong-arm (2004Present)
Beore the three parties were able to sign an intergovernmental
agreement, however, Gazprom declared that it would support neither the
proposal nor the export o Kovykta gas to international markets, arguing that
the gas should be sold on Russias domestic market.32During a January 2004
meeting with NK Chairman Viktor Vekselberg, Gazprom Chairman Alexei
Miller declared that Gazprom would not permit the field to be developed
outside Gazproms control and insisted that the priority should be Russias
31 Chang Duckjoon, Northeast Asia Energy Cooperation and the Russia Far East, Korea Focus,MayJune 2004u http://www.koreaocus.or.kr/essays/view.asp?volume_id=34&content_id=8&category=G.
32 Gazprom Says Kovykta Project Unattractive in Current Version, Prime-ASS Energy Service,January 29, 2004.
FIGURE 4
Kovyktas Proposed Pipelines
Source: K. Kanekio, Northeast Asia Natural Gas rade Study: Developing Stable Supply o Cleaner Energy
or Sustainable Development (presented at the World Bank workshop, Beijing, June 24, 2004).
Nakhodka
Khabarovsk
Skovorodino
Dalian
Changchun
Harbin
Daqing
Manzhouli
Irkutsk
Kovykta Gas Field
ChayandinskoyeGas-Oil Field
Beijing
Ulaanbaatar
Pyongtaek
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[ ]
domestic market, noting that supplying gas to Russian consumers must be
a priority in development o East Siberia. Tis principle is not reflected in the
easibility study. Nor are the costs o gasiying regions around the field taken
into account or the potential or developing petrochemical projects using
resources rom Irkutsk fields.33wo months later, Gazprom even suggested
that Kovykta gas be linked to the unified system o gas supply to be diverted
toward European markets.34 Alexander Medvedev, deputy chairman o
Gazprom stated: we told [NK-BP] that we could consider Kovykta as a part
o the export base, but in no way we would discuss supplies rom Kovykta to
China. Tat makes no economic sense.35
Gazprom clearly desired an equity stake in the project, larger than the
11% share that Irkutsk State Property Committee had offered. As holder othe largest stake in the project, NK-BP quickly became Gazproms target.
Although realizing early on the need to effectively work with Gazprom, NK-
BP sought to bring Gazprom in only i on air commercial grounds.
Working through the Ministry o Natural Resources, Gazprom
soon brought to the limelight some o the details in NK-BPs license
agreement and the possible consequences or NK-BP o not meeting the
contract terms. Under this agreement, NK-BP was required to produce
a minimum o 9 bcm per year rom the Kovykta field by 2006 or risklosing the project. In a last-minute effort NK-BP built a small pipeline
rom the Kovykta field to Zhigalovo, a logging village with only 5,000
residents. NK-BP sold the gas or $30 per thousand cubic meters, well
below market prices; Gazprom sells gas to Europe at an average price o
$250 per thousand cubic meters.36
When NK-BPs deadline closed in June 2007, Gazprom agreed to
make a nominal payment o $700900 million to NK-BP and promised
shares in other projects in Russia in return or NK-BPs 62% stake in
Kovykta. Although not yet having made public its official export plans,
Gazprom officially stated that China and South Korea are regrouping on
gas talks.
Although some analysts believe that takeover o the project by Gazprom
could actually expedite the development o an export route (whether
33 Gazprom Outlines Disagreements with NK-BP over Kovykta Project, Platts Commodity News,January 29, 2004.
34 Nodari Simonia, Russian Energy Policy in East Siberia and the Far East, James A. Baker IIIInstitute or Public Policy, Rice University, October 2004, 11.
35 Gazprom: Gas Deal with China to Be Finalized by First Hal o 2006, Caijing Magazine, September26, 2005u http://www.caijing.com.cn/newcn/English/Industry/2005-10-03/13870.shtml.
36 Te Russian Oil and Gas Producers, APS Review Downstream rends, August 21, 2006.
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through China and South Korea or to Nakhodka or LNG shipment) such
an outcome is doubtul or several reasons. Most recent reports suggest
that Kovykta gas will not be completely developed until 2017, ten years
later than originally planned. Te next section analyzes both past and
current obstacles or successul development and export o Kovyktas gas
into Northeast Asia.
Since discovery o the Kovykta oil fields, companies and governments
rom Europe and Asia have been vying or a stake in their development.
Most o the European companies, however, quickly abandoned their interests
deeming the project uneconomic. Since these companies backed out, efforts
on the part o both Russia and Asia have notably shifed largely to rom
company level to that o the state. Te companies have merely been appointed
as negotiators on behal o the states involved. As such, state enthusiasm has
been trumped by several economic realities. Tis next section overviews
several o the prevailing economic obstacles to Kovyktas development.
ransit Country Problems
From 1995 to 2007 the Kovykta project has had five major ownership
changeseach bringing a change in routing options. Although proven reserves
o the field have increased by 1 trillion cubic meters, the cost o the proposed
pipeline has increased by $10 billion (see Table 1). Te periodic inclusion
o Mongolia and North Korea has indeed hindered plans or development
o the Kovykta pipeline and has highlighted the complexities involved when
companies and governments are orced to balance the economic validity o
the project with regional politics and international security.
Te South Korean government has ofen discussed energy cooperation
between the two Koreas, apparently with the primary goal o constructing
an integrated pipeline and electricity network across the Korean Peninsula.
Both China and South Korea are clearly aligned in desiring a stable and
benign North Koreaand resolving North Koreas energy insecuritiescould undoubtedly help achieve this goal. Tough the political costs and
risks associated with North Korea are well known, the extension o Russian
pipelines to South Korean (and Northeast Asian) markets via North Korea
has economic as well as political merit. A Northeast Asian pipeline system
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[ ]
ABLE 1
Historical Changes in Routes, Ownership, Costs,
and Reserves of Kovykta
Year(s)Proposed
pipeline routeDistance
(km)Shareholders
Projectedcosts (b)
Estimatedreserves(bcm)
199596 Russia
Yellow Sea
Sidanco, 50%
Russias Export-Import Bank, 50%
$57
199697 Kovykta
Irkutsk
MongoliaBeijing
Dalian
Yellow Sea
South Korea
3,819 km Sidanco, 38%
EAGC, 28%
Irkutsk regional
administration,19%
Irkutskerergo,14%
$10 ~1,000
2002 Kovykta
Irkutsk
Manzhouli
Harbin
Shenyang
Dalian
North Korea
South Korea
4,065 km BP, 33%
TNK, 29%
Interros, 26%
Irkutsk regional
administration,11%
~$12 ~1,900
2003 Kovykta
Irkutsk
Manzhouli
Harbin
Shenyang
Dalian
Yellow Sea
South Korea
4,249 km TNK-BP, 62%
Interros, 26%
Irkutsk regionaladministration,11%
$17 ~2,000
2007 Kovykta
Nakhodka?
Gazprom, 62%
Interros, 26%
Irkutsk regionaladministration,
11%
~2,000
Source: Keun-Wook Paik, Pipeline Gas Introduction to the Korean Peninsula, Chatham House, January2005; and various news reports.
Note:Dash indicates no data is available.
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that is unable to traverse North Korea might inevitably leave both suppliers
and consumers alike worse off. Without competitive market outlets or
Russian gas, LNG supplies rom the Middle East and Australia could take
over the gas markets in Asiaa situation that would leave less market share
or Russia and higher energy costs or Northeast Asian and U.S. consumers.37
Chinas recent LNG deals with Australia highlight this growing trend. North
Korea lies directly between Northeast Asias major buyers and sellers. Leaving
North Korea out o Northeast Asias energy corridor would have world-wide
commercial and political implications.
Te inclusion o North Korea in the route, however, temporarily
increased both commercial and political costs to the pipeline. Te additional
246 km o pipeline needed or the North Korea route increased costs by $2billion. Moreover, routing the pipeline through North Korea could have
allowed Pyongyang to easily control the flow o gas to South Korea or
strategic purposes. Although some sectors o the South Korean government
and some in various international organizations agreed in principle to this
route, the 2003 easibility studyled by NK-BPruled out this option on
both commercial and political grounds.38Te six-party talks, however, are
becoming more sanguine. Given that pipeline projects are extremely slow to
develop, the possibility or North Korea to take part in a regional pipelinescheme in the uture is not completely out o the question.
Mongolia also figured in the pipeline scheme in 1997. Although the
most economic and cost-effective way to transport gas rom Kovykta into
China, this possibility o routing the pipeline through Mongolia was quickly
abandoned by China due to domestic concerns. China eared both that the
autonomous region o Inner Mongolia might demand to be a beneactor o
transit ees along with Mongolia and that social unrest might occur i Chinas
ethnic Mongolians elt that they were receiving the short end o the stick.39
China worried that Mongolia could easily become an eastern Ukraine that
would siphon off gas supplies en route to China. More recently China has had
concerns that Mongolia has become too subject to U.S. influence, especially
given Mongolias support or the war on terrorism afer September 11, 2001.
37
Peter Hartley, Amy Myers Jaffe, and Kenneth Medlock, Economic Issues o Natural Gas rade inNortheast Asia: Political Bridges and Economic Advantages, in New Paradigms or ranspacificCollaboration, Korea Economic Institute, Academic Study Series, 2006 uhttp://www.keia.org/2-Publications/2-3-Monograph/Monograph2006/04Jaffe.pd.
38 Pyongyang Could Be Lef Out o Russian Gas Pipeline to Korean Peninsula, Agence FrancePresse, November 12, 2003.
39 Kaoru Yamaguchi and Keii Cho, Natural Gas in China, the Institute o Energy Economics, Japan,August 2003.
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[ ]
Te inclusion o both North Korea and Mongolia in the Kovykta routing
options would have been both economically and politically beneficial. Te
Mongolian route was the cheapest option or all parties involved. Bypassing
Mongolia by instead routing the pipeline through the permarost lands
in Siberia would have significantly increased project costs. Although
more expensive than the Mongolian route, the North Korean option was
considerably cheaper than the most current route consisting o an underwater
pipeline rom Dalian to Pyongtaek. Te higher construction costs o the
diversions will increase the end-user gas price; Russia will have little room lef
to negotiate gas pricing with China, and South Korea will continue to rely on
imported LNG as a more attractive option.
Complexities of Gas Investments
Not ofen reported in the media is the act that natural gas is intrinsically
more difficult to trade than oil and requires greater confidence, many more
guarantees, and much more money rom investors and governments. Te
Kovykta pipeline deal is no exception. Pipelines are rather inflexiblethey
require substantial reserves at one end to sustain and fill the pipeline and
a significant market at the other end to justiy the investment. Once built,pipelines cannot be moved and thus lock the seller and buyer into a long-
term relationship. Whether by LNG or pipeline, the natural gas market is
vastly different than the oil market. Tere is in act no world gas marketthe
majority o the worlds gas is both produced and consumed domestically and
hence lacks a standardized benchmark price. Furthermore, striking natural
gas deals between two parties (let alone three or more parties) involves a
highly sophisticated set o plans and calculations. Te huge amounts o ront-
end investments and the difficulties and expense o storage and transportationorce parties to make long-term all-or-nothing deals. Gas trade has been
traditionally characterized by extremely inflexible contracts arranged between
one concrete buyer and one concrete seller. On average, gas supply contracts
commit two parties to a business relationship or twenty years under tough
take-or-pay and destination clauses that essentially prohibit buyers rom
either decreasing supplies or selling surplus supplies to third parties. Oil, on
the other hand, is a widely traded commodity that has matured to a stage
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where uniorm benchmark prices are firmly in place.40In the world oil market,
as long as consumers have spare refinery capacity, engaging in a short-term,
low-risk, low-investment contract with a producer is airly easy. Likewise,
having surplus oil allows producers to find a willing buyer with relative ease.
Te combination o the benchmark pricing system and the fluidity at which
physical commodities can be bought and sold with little risk and investment
makes oil deals much less cumbersome and much less strategic than is the
case with gas.41
Tough Kovykta has been proposed as a cross-border pipeline project,
Gazprom has recently avored having the Kovykta pipeline ollow the
proposed East Siberian-Pacific Ocean (ESPO) oil pipeline route. Tis route
would not cross international boundaries but would run rom Irkutsk toNakhodkaa pipeline over 4,000 km in length. A LNG terminal would be
built at Nakhodka so that LNG could be shipped to several Northeast Asian
states without relying on only one or two markets. Tis proposal, however,
poses several technical and commercial challenges or Gazprom. First,
although extremely capable in pipeline construction, the company has no
experience with LNG. Gazprom would need a major international partner
to provide the technology and experience required not only to build and
operate the terminal but also to manage the LNG supply chain. Second, thisproposal makes little economic sense. LNG is a capital-intensive business
and requires up-ront investments in a acilities chain (upstream production
rigs, liqueaction acilities, LNG tankers, regasification acilities, and local
distribution pipelines). Such a chain could cost as much as $5 billion.42For
LNG to be a profitable business, the gas deposits need to be relatively close
to the terminal; most LNG gas thereore has come rom fields just offshore.
Furthermore, LNG acilities are usually upgraded beore new terminals
are built. Te cost o an upgrade, however, is astronomical in comparison
to an equal capacity upgrade or a pipeline. Roughly speaking, pipelines
can double capacity or only an additional 1020% o original investment;
LNG, however, would require an additional 5060% or the same capacity
40 Te marker crude system was introduced in the mid-1980s. Te spot trade o three main typeso crude (West exas Intermediate, Brent Lend, and Dubai) acts as a barometer o the overall
market level. Using this pricing system, different grades o oil are priced on negotiable differentialsto the marker grade. Te rationale is that the spot price represents the balancing point o supplyand demand. Even though the volumes o oil that trade daily on a term-contract basis betweencompanies or governments are much larger than those that traded on a spot basis, price isdetermined at the margin in the spot market.
41 Te authors would like to thank Mikkal Herberg or bringing these points to their attention.
42 Linda Cook, Te Role o LNG in a Global Gas Market (presentation at the 27th Annual Oil &Money Conerence, London, September 1819, 2006).
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upgrade.43Afer decades o technological advances that have slowly reduced
construction costs o LNG plants, costs are now again on the rise. In 2005
LNG plant construction was below $200 per ton per year o production
capacity. Due to rising raw materials and equipment costs and a growing
shortage o experienced engineers, today these costs are around $500 per
ton per year, with some projects even approaching $1000 per ton per year.
Tese cost hikes have caused delays o up to three years or several new LNG
projects.
In sum, whether by pipeline or LNG, gas investments are extremely
complex and risky. Gas projects not only need reliable, long-term commitments
rom consuming countries but also require financial commitments and
technological expertise to sustain a profitable gas business. Kovykta hasbeen and will remain subject to these problems, which are inherent in gas
investment and export.
Demand Security and Pricing
During the ten-plus years o negotiating over the price and timing o the
Kovykta pipeline, gas markets have gone through three distinct phases. During
the first phase (19962000) gas contracts were extremely rigid and prices werehigh. During this period South Korea and Japan, the only importers o natural
gas in the region, had government policies and inrastructure that avored the
use o gas. Te second phase (200005) was a buyers market; this phase was
defined by lower oil price linkages, lower gas prices, and more flexible contract
terms. Te third (and current) phasea sellers marketis characterized both
by prices that link closer to oil and by stricter contract terms. Since the price
o gas and contract terms determine the pace and time o the development o
the gas pipeline as well as the will o oreign investors, the characteristics oeach phase have had distinct implications or the development o the Kovykta
gas pipeline. Furthermore, each party involved in the Kovykta pipeline
negotiations has had different alternatives or gas useand thus has employed
a different set o calculations when ormulating the price o Kovykta gas. For
South Korea the main alternative to pipeline gas is LNG, and or China the
main alternative is coal.
First phaseuDuring the first phase, rom 1996 through 1999, Chinas
domestic gas production o 17.9 bcm per year could clearly cover the countrys
domestic consumption o 17.4 bcm per year. Gas in China was (and today
43 Al roner, Natural Gas: A Natural Choice? CLSA Quarterly1, no. 4 (February 2007): 76.
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largely still is) used to produce ertilizer, rather than in gas-fired power plants.
Gas pipeline grids were sparse, and industrial gas use was concentrated in
Chinas northeastern coastal cities. Tus during this phase high costs and
inflexible contract terms made gas a less competitive option compared to
Chinas domestic coal supplies. Tough indeed having much potential, China
simply did not have a gas market. South Korea thereore was brought in to act
as a stable anchor or the projecta new actor that could make the Kovykta
pipeline easible.
In the wake o the Asian financial crisis, however, gas development plans
in all o Asia slowed to a snails pace. South Koreas gas demand decreased by
800,000 Mt (or 1 bcm).44KOGASs LNG storage was at ull capacity, and rom
1997 to 2002 South Korea abandoned a total o 76 energy projects.45
As oneexample, the Hanbo Group lost most o its stake in the Kovykta project afer
going bankrupt in 1997. China, less deeply affected by the financial crisis,
became the silver lining in the project.
Tere is no consensus as to just how Chinese gas demand will take
shape in the next twenty years. Projections o Chinas energy demand made
by various energy agencies differ by as much as 143 bcm (see Figure 3).
Tis projection gap is roughly equivalent to the average capacity o 47 LNG
terminals or around five Kovykta fields. At a March 2005 seminar the NationalDevelopment and Reorm Commission (NDRC), Chinas main economic
and energy policymaking apparatus, projected that Chinas energy demand
could reach 250 bcm per year by 2020representing a 200% increase over
todays figures.46Even with an optimistic domestic gas production outlook
o 150 bcm per year China would still be required to import approximately
100 bcm per year. Beijings plans to build ourteen more LNG terminals by
2020 calls into question the need or Kovykta gas, given that the capacity o
these proposed LNG terminals is roughly equivalent to 48 bcm per year. I
Russian, Eurasian, and Southeast Asian pipeline gas is introduced, supply
would be approximately 36 bcm per year above projected demand.47Although
44 Asia-Pacific Gas Projects Hit the Wall amid Regional Economic Slump, Oil and Gas Journal97,no. 6 (February 8, 1999): 2327.
45 Keun-Wook Paik, Valerie Marcel, Glada Lahn, John V. Mitchell, and Erkin Adyiov, rends in
Asian NOC Investments Abroad, Chatham House, Working Background Paper, March 2007.46 See Akira Miyamoto and Chikako Ishiguro, Pricing and Demand or LNG in China: Consistencybetween LNG and Pipeline Gas in a Fast Growing Market, Oxord Institute or Energy Studies,NG-9, January 2006.
47 Tese figures include high projections o proposed pipelines rom Kazakhstan, urkmenistan,Myanmar, as well as Kovykta and Sakhalin in Russia. See Price, Russia Weaken Case or ChinaLNG, Petroleum Intelligence Weekly44, no. 44 (October 31, 2005); and Miyamoto and Ishiguro,Pricing and Demand or LNG in China.
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development o several o these pipelines is highly speculative, building the
Kovykta pipeline to China presents a potentially nightmarish investment
decision. I anticipated sales all through because China is unable to pay or
the gas, investors will have no way to recover sunk costs.
Few experts doubt that in the near uture Chinas gas consumption
will undergo extraordinary growth; yet how China will rapidly develop the
countrys gas market is unclear. o what extent will gas account or Chinas
power generation? How much investment will China make in municipal
gas distribution systems? Developments related to these questions could
ultimately affect the uture o the Kovykta pipeline.
Second phaseuDuring the second phase in natural gas markets,
negotiations over the pipeline were promising but slow-going. With rigorousdiplomatic support, China aggressively pursued development o an LNG
industry. In 2003 North West Shel Australia LNG won a tender to supply
Chinas Guangdong LNG terminal with 3 bcm per year or twenty years at
approximately $3.20 per million British thermal unit (Btu). At that time the
cost o coal in China was approximately $2 per million Btu and the average
cost o Chinas domestic natural gasspecifically rom the arim Basin
was close to $4 per million Btu. Te anticipated price o natural gas rom
the Guangdong LNG terminal, however, is $2.80 per million Btu (includingreight) plus $0.40 per million Btu or regasification.48 At a price o $3.20
per million Btu, coal lost some o its competitive edge, making gas a more
attractive option.
Tird phaseuSince 2006 the global gas market has experienced a third
phasea sellers market. Russia has recently demanded higher prices or
nearly all o the countrys exported gas, including gas rom Kovykta, insisting
on the need to be competitive with LNG rom the Middle East. China is in no
rush, however, to commit to such a high price. In early 2007 Russia offered gas
to China or $300 per 1,000 cubic meters ($8.24 per million Btu), yet China
claims that the country can afford to pay only $180 per 1,000 cubic meters
($4.90 per million Btu).49In the industry $3.34 per million Btu is a significant
price gap to overcome; that China and Russia are arguing over dollars rather
than cents suggests that the issues will not be quickly resolved.
Recent developments, however, indicate that China might be ready
to accept higher prices or gas imports. In September 2007, afer years o
48 2006 World Energy Outlook, U.S. Department o Energy, Energy Inormation Administration,2006, 4546u http://www.eia.doe.gov/oia/ieo/pd/0484(2006).pd.
49 Chinas Foreign Plans Have a Long Way to Go, International Gas Report, no. 568, February26, 2007.
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hesitation, China secured a long-term LNG supply contract with Australias
Woodside Petroleum worth $45 billion. Russia was quick to express
satisaction, as a China that is prepared to pay market prices to Australia might
likewise be willing to pay what Russia wants. Tis optimism, however, ignores
two possibilities: that China may be demonstrating a preerence or LNG over
pipeline gas, and that Australia is associated with much less political risk than
is Russia.
As outlined above, many impediments to development o the Kovykta
project have been economic in nature. In the context o Gazproms recent
takeover o the Kovykta project, however, understanding how the changing
economic environment has affected the political and legal landscape in
Russias energy sector is particularly important.
As the result o postSoviet era economic reorms, Russias energy
industry had become increasingly competitive and privatized by the
mid-1990s. Within ten years o the Soviet Unions demise the coal and
oil industries were nearly completely privatized and product prices were
deregulated. According to some calculations, government ownership o
oil and coal companies was below 10% by 2004.50 Russias gas industry,
however, has not seen similar reorms or several reasons. First, gas has been
a more stable contributor to Russias economy than oil, providing the ederal
government with a steady revenue stream throughout the periods o steep
decline in oil prices and production. In 2006 gas alone accounted or around
50%or $200 billiono Russias total oil and gas rents.51Second, although
having the largest proven gas reserves in the world, Russiawhich consumesapproximately 70% o the countrys total gas productionranks second in the
world in natural gas consumption (see Figure 5). Domestic oil consumption,
on the contrary, constitutes only 30% o total production. Although rising,
Russias domestic gas prices are fixed well below market price, especially or
residential users. Tese price distortions have kept domestic demand high,
tightly linking the gas sector to economic development and social stability.
50 Vladimir Milov, Leonard L. Colburn, and Igor Danchenko, Russias Energy Policy: 19922005,Eurasian Geography and Economics47, no. 3 (2006): 286.
51 Clifford Gaddy and Fiona Hill, Te Russian Federation, Brookings Institution, Energy SecuritySeries, October 2006, 10.
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During the presidency o Boris Yeltsin (199199) world oil prices
averaged around $14 per barrel, dropping as low as $8 per barrel in the late
1990s (see Figure 6). Under these conditions, Russia became more open to
oreign investments and began to allow oreign ownership o energy resources.
Since Vladimir Putins rise to the presidency in 2000, however, skyrocketing
oil prices have brought the average world crude price over the past seven years
to approximately $34 per barrel.52In the last two years crude oil prices have
hovered around $70 per barrel and even topped $100 per barrel. By some
estimates ederal earnings rom oil and gas under Putin are ten times greater
than under Yeltsin.53
As oil and gas have become central to Russias economy, Putin has
taken great strides toward gaining control o the energy industry. In 2001
Putin appointed three high-level executives at Gazprom, all o whom were
either riends o Putin or ormer Putin administration officials.54 As aptly
52 Based on authors own calculations using Crude Oil Price Summary, Energy InormationAdministration, 2007uwww.eia.doe.gov.
53 Gaddy and Hill, Te Russian Federation, 7.
54 Tese appointees are Dmitry Medvedev (chairman), Aleksei Miller (president), and Igor Yusuov(board o directors). See Michael Fredholm, Te Russian Energy Strategy and Energy Policy:Pipeline Diplomacy or Mutual Dependence? Conflict Studies Research Centre, September 2005.
FIGURE 5
Distribution of Russias Oil and Gas Production, 19912006
Source: BP Statistical Review o World Energy 2007.
Consumption Exports
Billioncubicmeters
Year
1991
1993
1995
1997
1999
2001
2003
2005
0
100
200
300
400
500
600
700Gas
Millionbarrelsperday
Year
1991
1993
1995
1997
1999
2001
2003
2005
0
1
2
3
4
5
6
7
8
9
10Oil
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[ ]
characterized in a Swedish deense analysis, Putin is creating a culture o
a politically correct market economy.55With the oligarchs that run Russias
energy companies voluntarily and naturally placing state interests on par with
commercial ones, direct state intervention no longer seems necessary.
In the mid-1990s when Asian companies entered into the Kovykta
pipeline negotiations, energy prices were low and the Kremlin was weak. Te
autonomous rights o regional authorities (such as those in Sakha and Irkutsk)
were also at a peak, enabling these locales to have greater influence and
independent decisionmaking regarding resource planning and management.
Irkutsks remoteness rom Moscow contributed to this autonomy as well.
Known as the two key system, Russias Subsoil Law o 1992 gave both the
regional (oblast) and ederal governments authority over subsoil use. With
the assignment o Gazprom as chie negotiator o Kovykta and a series o
amendments to the law, however, regional authority over subsoil use was
55 Robert Larson, Russias Energy Policies: Security Dimensions and Russias Reliability as an EnergySupplier, Swedish Deence Research Agency, Deence Analysis, March 2006uhttp://www2.oi.se/rapp/oir1934.pd.
FIGURE 6
Crude Oil Price per Barrel, 19702006
Price($)
Year
Source: BP Statistical Review o World Energy 2007.
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
0
10
20
30
40
50
60
70
80
90
100
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[ ]
stripped and all rights over the issuing or revoking o subsoil licenses were
solely retained by the Kremlin.56Apart rom a role as a small shareholder, the
Irkutsk regional government was removed as the central negotiating authority
in the Kovykta pipeline.
In response to these power shifs, China, South Korea, and NK-BP
became heavily involved in a type o shuttle diplomacy, with representatives
travelling between Irkutsk and Moscow in attempts to figure out who was
in charge. Both China and South Korea were ofen conused as to with
whom or what companythe projects main shareholder and operator
(NK-BP), Russias export monopoly (Gazprom), or the ederal government
(the Kremlin)negotiations ought to be conducted. On the sidelines o
recent Kovykta negotiations South Korea and China uncharacteristicallypublicized rustration regarding Russias ambiguities. Discussing the state o
Sino-Russian energy cooperation and the proposed pipeline, in an interview
in 2006 Zhangguo Bao, ormer vice-director o Chinas NDRC made the
ollowing statement:
Currently, the Sino-Russia pipeline question is one step orward,two steps back. oday is cloudy with a chance o rain whiletomorrow is sunny with a chance or clouds, just like a weatherorecast. One minute Russia has said they have made a decision,
the next saying that no decision has been maderuthully,weve been in contact with Russia or such a long time, but westill dont understand Russia, I eel. We dont know who canmake a decision, or who to seek outWeve talked to Putin anddepartment heads. Weve talked to everyone in the government.Tey say they cant make a decision, and that we should talk to theprivate sector. Weve meet with every company. Tey say they cantsign an agreement and we should talk to the government.57
Te lack o transparency in Russias energy policy has clearly lef all
negotiating parties in limbo.
Balancing Russias Domestic and European Demand
Gazproms entire gas production (apart rom that which is consumed
domestically) is exported directly to European and Eurasian markets;
Germany, Italy, and urkey are Gazproms largest and most important
customers. Nine out o Russias top fifeen importers rely on the company
56 Jennier Joseson, Policy Challenges: A Russian Perspective, in Energy Futures, ed. Ral Boscheck(New York: Palgrave MacMillin, 2007), 98107.
57 China Energy Report Weekly, Interax Inormation Services, March 410, 2006, 2728.
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or over 50% o their gas needs.58Some European counties, although hoping
to diversiy gas imports, are locked in to dependence on Russian imports
by decades-old pipelines. Because Russia keeps domestic prices well below
international market prices Gazprom is completely reliant on Europe or
revenues. Geopolitically, Gazprom is currently attempting to create a European
monopoly by undermining efforts by Iran, urkmenistan, and Kazakhstan to
export gas to the European market. Because the majority o Russias pipelines
are aimed toward Europe, Gazprom has ocused on Europe and placed Asia
on the backburner.
Russian domestic demand is another actor behind the politicization o
Russias gas industry. Although Russia currently ranks second in the world
in gas use (behind the United States), the Russian economy is only one-twentieth the size o the U.S. economy. Low-priced gas uels much o Russias
industrial sector, and fixed prices allow household energy bills to remain
low. Although Gazprom is lobbying hard or a sharp increase in domestic
prices the Kremlin remains reluctant to raise prices or ear o provoking
economic and social stresses.
Te political aspects o the recent price debacle with Ukraine received
much attention, yet the move to shut off the gas spigot clearly was an indication
o Russias ear o overstretching Gazproms other export commitments.59Anovercommitment to European consumers would require Russia (Gazprom)
to decrease supplies (i.e., raise prices) to domestic users. Either choice packs a
political punch that neither Gazprom nor the Kremlin wants to eel.
In a worst-case scenario, Russia could also connect Kovykta with the
countrys existing unified gas supply system or domestic consumption in
order to relieve other gas fields that could supply exports to Europe. I Russia
continues to ocus on Europe without increasing production, raising domestic
gas prices, and curbing domestic demand, how can Gazprom justifiably export
Kovykta gas to a China that reuses to pay market prices?
Russias New Subsoil Law
As mentioned above, Russias subsoil law, implemented in 1992, gave
considerable power to regional authorities over subsoil exploitation. Te law
58 Country Analysis Brie: Russia, U.S. Department o Energy, Energy Inormation Administration,April 2007u http://www.eia.doe.gov/emeu/cabs/Russia/Background.html.
59 Due to disagreements over natural gas prices, Gazprom shut off gas supplies to Ukraine on January1, 2006, a move that also affected gas supplies to other parts o Europe. According to the U.S.Department o Energy, this was the first time that a supply disruption rom Russia affected flows toEurope.
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has, however, been amended several times since then. In 2005 the Kremlin
submitted to the Duma a new subsoil lawthe Draf Lawthat merely legally
enorces what has already been in practice or several years. Te major issue
that concerns international oil companies (NK-BP in this case) is the clause
on oreign ownership and strategic resources. According to the new law, no
oreign entity can have controlling stakes (over 50% plus one share) in any o
Russias strategic resources. Te Draf Law defines as strategic (1) various
rare resources such as diamonds, uranium, or quartz; (2) deposits rom any
oil field containing over one billion barrels or any gas field containing over one
trillion cubic meters o gas; and (3) any reserve in close proximity to a military
base.60With two trillion cubic meters o gas, Kovykta is deemed a strategic
resource. As stipulated in the law, neither Gazprom nor the government couldstrip any oreign owners o their assets i a license or production-sharing
agreement (PSA) was conducted beore the amendments to the law came into
effect. Aware that NK-BP was not living up to its production requirements,
Gazprom waited to legally take over the project.
Kovyktas Periphery
For years Gazprom has considered several pipeline options to Chinaand East Asia and even the construction o an integrated oil and gas supply,
storage, and transition system that would tie together all o the countrys
major fields or export to Asia and beyond. In an energy strategy document
the Russian Ministry o Energy outlines the countrys ar-reaching goals to
take over 25% o Northeast Asias gas market beore 2020.61 Russia has no
pipelines in the region, however, and until recently Gazprom has had no
major stakes in any o the key fields in East Siberia and the Russian Far East.
As such, Gazprom has begun to orce its way into all o the major oil and gasfields in the region; using environmental NGOs and the Ministry o Natural
Resources to sofen up the international oil companies (IOC), Gazprom has
managed to get in on avorable terms. Gazprom is in essence expropriating
these fields with a nominal financial recompense.62Tis use o strong-arm
tactics by Gazprom shows that Russia is bent only on controlling these last
strategic resources on the countrys rontier, not on controlling the actual
60Joseson, Policy Challenges, 1045.
61 Te Summary o the Energy Strategy o Russia or the Period o up to 2020, Ministry o Energyo the Russian Federation, (Moscow 2003), 12 uhttp://ec.europa.eu/energy/russia/events/doc/2003_strategy_2020_en.pd.
62 KovyktaWhy Not Call It Expropriation, Energy Economist, no. 309 (July 2007): 3.
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means o gas transportation and export. Because Gazprom lacks an open and
coherent strategy and Russias PSA laws are deteriorating, both international
oil companies and East Asian consumer countries have come to seriously
question Russias reliability as an energy partner. Both the IOCs and Russia
have been competing to gain entry into Asian markets, peripheral export
options that have also undermined Kovyktas positioning.
Altaiu Gazproms most recent gas export proposal to China has not
been Kovykta but Altai. Gazprom has proposed building a pipeline to China
that crosses the western most point o the Russia-China border over the Altai
(or Altay) mountain range. According to Russia, the Altai pipeline is to be the
first o two potential pipelines to China. Altai gas would come rom fields in
Western Siberia and connect with Chinas West-East pipeline, which carriesgas rom fields in Xinjiang to markets in Shanghai.
Notable, however, is that the Altai pipeline proposal was set orth shortly
afer the Ukrainian gas price debaclewhich temporarily halted gas exports
to many European countrieswhen European policymakers began discussing
diversiying gas sources. Viewed by analysts more as a political rebuttal
than as a sound commercial pursuit, this proposal seems designed to show
that Russia can easily divert gas away rom Europe to other markets should
Moscow choose to do so. Moreover, political leaders in the Republic o Altaihave expressed ears that Chinese labor could expand Chinas influence and
presence in the region.63
ChayandauWith gas reserves o 1.2 trillion cubic meters, the
Chayandinskoye (Chayanda) field in Yakutia (like Kovykta) was officially
deemed strategic in 2005. Although Chayanda contains only approximately
hal as much gas as Kovykta and is ar behind Kovykta in the development
process, Russia seems determined to develop this field beore Kovykta. Te
Sakha government has held several meetings with representatives rom China
and South Korea over uture exports. In an effort to undermine Kovykta,
the Republic o Sakha ormed a strategic alliance with Gazprom in 2002 and
began promoting the development and export o Chayanda gas. For Gazprom,
the Chayanda field represented a timely and strategic potential investment.
Chayanda was in act one o the only major fields in Russias eastern rontier
that was not operated by international oil companies. Gazprom could thus
63 Altai Community Approves Gas Pipeline Construction to China Following Harsh Argument,Republic o Altaiu http://eng.altai-republic.ru/modules.php?op=modload&name=News&file=article&sid=597.
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use the threat o Chayanda exports to bypass NK-BPs export plan.64Tere
have even been reports o Russia offering China 10% o Sakha reserves ree o
charge i China were to commit to early development o the field.65
In 2003 the Kremlin held a cabinet meeting to discuss the concept o
a unified pipeline system in Eastern Siberia and the Far East. Tis concept
envisioned a pipeline network connecting all the major eastern gas fields
omsk (which would link up to Russias western gas supply system), Chayanda,
Khabarovsk (where the pipeline would connect to a pipeline that routed the
off-shore Sakhalin gas), and Vladivostok (where it would terminate).Expected
to extend more than 6,000 kilometers, this pipeline did not, however, include
Kovykta in the first set o plans. Since Kovykta was at that time majority owned
by NK-BP, Gazprom viewed Kovykta exports as endangering not only themerit o the other fields in the region but also the potential company and state
revenues that could be gained rom Chayanda.66
Since gaining control o Kovykta, however, Gazproms tone has changed.
Kovykta will be included in this proposed pipeline system, though the time
line is or Chayanda to be online by 2016 and Kovykta by 2017. Large-scale
exploration is not yet underway and may not even begin until Gazprom
has an exploration permit. Gazprom has been aggressively negotiating with
the Ministry o Natural Resources to receive a production license or theChayandinskoye field without having to compete with other companies in
an open auction. Looking at Gazproms record, it will be surprising i the
company ails to take over this project.
Sakhalinuo date Sakhalin has been the most successul o the oil and
gas fields in eastern Russia. Sakhalins success is largely due to act that or the
most part oreign oil companies have undergone the exploration, production,
and development o these fields, which are protected under a PSA.67Because
the three largest gas marketsJapan, the United States, and South Korea
are in such close proximity to the projects, Gazprom has grown convinced
that the company would miss out on a huge commercial opportunity i not
involved. Sakhalin also represents a good opportunity or Gazprom to begin
64 Jonathan Stern, Te Future of Russian Gas and Gazprom(Oxord: Oxord Institute or EnergyStudies, 2005), 1556.
65 Xu Yihe, South Korea May Lose Out on Russia Gas, Dow Jones Newswire, March 7, 2001.
66 Keun-Wook Paik, Pipeline Gas Introduction to the Korea Peninsula, Chatham House, January 2005.
67 For in-depth analyses o the tax structures and PSA arrangements o the Sakhalin projects, seeJudith Tornton, Sakhalin Energy, Comparative Economic Studies43, no. 4 (Winter 2001): 932.For a good comparative overview o energy fiscal regimes, see David Johnston, Petroleum FiscalSystems: Royalty/ax Systems, Production Sharing Contracts and Service Agreements Compared,in Boscheck, Energy Futures, 2771.
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learning the LNG business. For Russia, LNG exports are both commercially
and geopolitically saer than cross-border pipelines, given that LNG can more
easily avoid being trapped in a monopsony.
O the six Sakhalin projects Sakhalin-1 and -2 have the greatest
production potential and have moved along the astest. Tough not yet
exporting LNG, Sakhalin-2 has already committed all o the projects uture
LNG exports.68Afer months o complaining about environmental concerns
and increasing costs associated with Sakhalin-2, Gazprom managed to obtain
Shells position as majority shareholderacquiring a 50% (plus one share)
stake in the project or $7.45 billion in December 2006. Not surprisingly
Gazprom ceased accusations over the projects negative environmental
impacts afer the takeover.Exxon operates Sakhalin-1 and or years has had plans to build a pipeline
to China. In 2006 Exxon signed an agreement with CNPC to supply China
with 8 bcm o gas. Sakhalin-1 is currently the only PSA project outside
Gazproms control, and Exxons unilateral export o this gas could potentially
undermine Gazproms price negotiations with China over gas supply rom
any field. Gazprom has thereore severely criticized Exxons plan, claiming
that the company will buy all uture gas production rom the consortium to
supply the domestic market in the Khabarovsk and Primorye regions.
Gazproms consolidation o gas projects in Siberia and the Far East has
allowed Russia to present several export options to Northeast Asia. Including
Kovykta, Russia has proposed nearly 60 bcm o gas to both China and South
Korea. As a result o Gazproms aggressive behavior in eastern Russia andthreats to target proposed gas or domestic use, Northeast Asian countries
have been turning elsewhere or gas supplies. China in particular is hedging
its bets by looking to urkmenistan and Myanmar or pipeline gas and to
Australia or LNG. urkmenistan is vitally important to Russia, which is
dependent on urkmen gas imports to meet European export obligations.
Tat China has approached urkmenistan could set a negative tone or any
Russian-Chinese gas discussions.69China has also been courting Myanmar,
68 O the total supplies 2% are being retained or operational flexibility. See Michael Bradshaw,Sakhalin-2 in the Firing Line: Environmental Protection or Administrative Leverage, PacificRussia Oil & Gas Report, Winter 2006, 118.
69 Rachel Graham, What Gazprom Wants Gazprom Gets, Energy Economist, no. 309 (July, 2007): 27.
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and the junta recently awarded CNPC with a supply contract o 16 bcm per
year. Te deal is geopolitically strategic in nature or China; not only does
negotiating with Myanmar place China in a stronger position to negotiate
with Russia and Iran over gas supply contracts, but a pipeline rom Myanmar
to Kunming would also establish the groundwork or building additional oil
pipelines that would allow Chinas imports to bypass the Malacca Strait.
Although Gazproms takeover o the project in the summer o 2007 could
in theory expedite the development o Kovykta, other considerations suggest
that the pace may not increase. Gazprom has now assumed controlling stakes
in the largest gas projects in Eastern Siberia and the Russian Far East and is
able to coordinate all gas exports to China, South Korea, and Japan. Gazproms
controlling stakes give the company the upper hand in price negotiations withNortheast Asia, as countries rom the region can no longer negotiate with
the international oil companies to get a lower price. Te uture o Kovykta,
thereore, now depends both on the resolution o price negotiations between
Russia and China and on Gazproms ability to successully finance and operate
several new projects simultaneously in eastern Russia.
Even i China and Russia should reach a price agreement will Gazprom
be able to competently finance, operate, and manage all o these new projects?
Gazprom is among the worlds least efficient energy companies; the companyuses export earnings to subsidize loss-incurring domestic sales at only
approximately 20% o world market prices. Although Gazprom has access to
oreign lending to und its capital expenditure, the companys investment plans
are affected by high levels o debt and continued uncertainty about gas market
reorm. Te government hopes that by removing the ring-encelimiting
oreign share ownership in the companyGazprom will be better positioned
to raise much-needed investment capital. Foreign banks have, however, been
slow to come orward with unding or Gazprom lately. Te European Bank
or Reconstruction and Development, or instance, pulled out o negotiations
on providing $600 million worth o unding Sakhalin-2 afer Gazprom took
control o the project.
When Gazprom controls all the major fields in Eastern Siberia and the
Russian Far East, the company will have to reevaluate its relationships with the
IOCs. Although in some regards Gazprom has an advantage in that the IOCs
have ewer places to turn or new investments, Gazprom will neverthelessneed to rely on the technology and management skills o these IOCs to
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effectively develop and export Eastern Siberian and Russian Far Eastern
gas. As a notable observer o the Russian Far East has observed, only the
IOCs have the experience to delimit the reserves and deliver a commercially
viable development strategy.70 Judging rom the act that Gazprom revises
its investment program several times per year, Gazprom evidently has ew
strategies or plans to deliver such skills. Political expediency has thus ar
dictated Gazproms export policy. Although some oreign investors remain
in Russia, the IOCs will likely reassess political and commercial risk at some
point, which may have consequences or any uture investment.
With Gazproms attention on Sakhalin and urther European expansion,
or the oreseeable uture Kovykta will likely either sit idly or be used to supply
the domestic market. Tough neither option may be the most attractive orGazprom, the company can afford to allow either to happen in this high-price
environment. Both o these scenarios present ormidable implications or
Northeast Asia and the United States. Japan, South Korea, and the United
States are the worlds largest natural gas consumers, and China will join the
ranks. I Russias giant gas fields are not permitted significant market outlets in
Asia, global supply will all, thus effectively keeping gas prices higher than they
would be otherwise. he ate o Kovykta thereore has direct energy security
implications or the United States. As seen through its recent Australian deal,China is turning toward LNG rather than waiting or the Kovykta pipeline
issue to be resolved. Increasingly China, South Korea, and Japan will look
urther west o the Malacca Strait or LNG supplies as well, putting those
countries in direct competition with the United States and potentially reducing
LNG supplies to the U.S. West Coast. Increased competition or new supplies
may also give urther impetus to perceptions o energy insecurity among the
consumers. Although competition