Alternative Pipeline Routes To Korea

asia policy , number 5 ( january 2008 ) , 10540
http://asiapolicy.nbr.org
research note
Northeast Asias Kovykta Conundrum: A Decade of Promise and Peril

Se Hyun Ahn & Michael T. Jones
se hyun ahn is Assistant Professor at the Government and International
Relations Programme in the Division of Humanities and Social Science in the United International College, Zhuhai, China. He was previously a research fellow at the Asia Research Centre at the London School of Economics and Political Science. He can be reached at <ahns131@gmail.com>.
michael t. jones is a project manager at The National Bureau of Asian
Research. He has a degree in Chinese language and literature from the University of Washington. His primary areas of research include energy security, politics of economic development, and Asias relations with the developing world. He can be reached at <mjones@nbr.org>.
note u The authors would like to thank Mikkal Herberg and two
anonymous reviewers for helpful insights.
keywords: northeast asia; natural resources; natural gas; oil;

pipelines; energy policy; russia; kovykta
asia policy
executive summary
This article seeks to explain whydespite the potential for gas from Siberia and the Russian Far East to provide greater energy security for Northeast Asiaa decade of negotiations has still not resulted in an agreement to construct the Kovykta pipeline.
main argument
Gas from Russias Kovykta field has the potential not only to drastically reduce Northeast Asias energy shortage but also to help diversify Northeast Asias traditional sources of energy away from the Middle East. The potential for Kovykta gas to reach any Northeast Asian country, however, has been delayed for over ten years due to the following factors: The politics of route determination u Though routing the pipeline via North Korea and Mongolia would be cheaper, government and private sector sensitivities have resulted in proposed routes that circumvent the two countries and thus drive up the costs of any such pipeline. Inherent complexities of gas investments u Natural gas is intrinsically more difficult to trade than oil, and gas deals require much more confidence, guarantees, and money from investors and governments. Demand security u Chinas market is important to Kovyktas success. Despite plans for further gas market development, however, Chinas reliance on cheap coal has created a soft market for higher-priced gas. Russias resource nationalism u Rising oil prices have given Moscow impetus to renationalize Russias energy sector, thereby both complicating negotiations and causing investors to be wary of a Russia that could use energy as a political weapon.
policy implications
Though a more centralized role for 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 fate of the pipeline. Gazprom is currently focused on other projects, however, and Kovykta will possibly remain idle for several years to come. Not allowing Russias giant gas field to have significant 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 for Asia to increase ties to rogue gas-supplier states such as Iran and Myanmar.
ahn & jones northeast asias kovykta conundrum
nergy security is gradually replacing the previous ideological confrontation that was characteristic of the Cold War to form a new security paradigm in the Asia-Pacific. Maintaining strong relations with Russia is extremely advantageous to regional states given that the import of oil and gas from Russias Far East has the potential to enhance Northeast Asias energy security interests by reducing domestic energy shortages and diversifying energy imports. Since the end of the Cold War, Russia has often been portrayed in Asia as a waning political and economic force. Since the dissolution of 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 energy supplier. In the last several years in particular Russia has demonstrated power and influence in the new geopolitical environment of 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 AsiaPacific region. Despite this great potential, the reality is that Russian energy projects have not emerged as a substantial functioning unit of economic activity thus far. The many efforts in the last ten years by Northeast Asian statesnotably China, South Korea, and Japanto exploit opportunities in Russias Far East have had only marginal success. Gazprom is now in the midst of taking over controlling stakes in Russias remaining foreign-owned energy projects. In mid-June of 2007 Gazprom took a majority share of the Kovykta gas field project by forcing TNK-BP out of the consortium. For ten years this gas field, located in Russias Irkutsk region, has promised to be a keystone for physically connecting the nations of Northeast Asia in a way that no other energy project could. Though governments of China, Mongolia, South Korea, North Korea, and Japan have actively discussed Kovyktas development over the last decade, the development of gas pipelines from Russia has been extremely slow. Several factors 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 of the energy sector. Gazproms focus on westward exports and lack of technological expertise could seriously impair Russias prospects for a greater share of 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 fulfill future
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gas needs. With little development having ensued since Gazproms takeover of the Kovykta project, the fate of this venture is uncertain. This article uses the case study of the Kovykta gas pipelines proposed in the region to illustrate both the potential for and the major obstacles to Russia becoming a major provider of energy security for Northeast Asia. This article is divided into five sections:
u
pp. 10814 examine both the current state of natural gas development in South Korea and China and the overall benefits of potential Kovykta gas exports to the two countries pp. 11421 outline Kovyktas changing development and export plans over the last ten years pp. 12129 analyze the major economic obstacles to the development and export of Kovykta gas to Northeast Asia pp. 12937 examine Russias resource renationalization and other domestic factors that have impinged on the export of Kovykta gas to Northeast Asia pp. 13740 consider the future outlook for Kovykta gas introduction into Northeast Asia and the geopolitical and economic implications for Asia and the United States
the potential benefits of kovykta gas development

Russias Untapped Potential
Russia has been described as the worlds treasure trove of gas. Around twenty new giant gas fields have been discovered in the last couple of decades, each containing over 500 billion cubic meters (bcm). These twenty fields comprise close to three-quarters of Russias total gas reserves. Capable of producing as much as 130 bcm of natural gas by 2020equivalent to the current level of Russias gas exports to Europethe Russian Far East can play a very important role in shaping cooperative energy schemes in Northeast Asia.1 In the last ten years Northeast Asian governments and companies have made several attempts to capitalize on a number of major energy projects in the Russian Far East.
1 See Stephen White, Is Russia a Country in the Globalization Era? (presentation prepared
for conference on the Regional Cooperation of Northeast Asia and Russias Globalization for 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 (Tokyo: Japan Center for International Exchange, 2000), 141.
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One of Russias largest gas fields is the Kovyktinskoye (Kovykta) gas condensate field. Discovered in 1987, this field contains an estimated two trillion cubic meters of natural gas and condensate.2 Put into perspective, Kovykta contains more gas than the entire nation of Canada, the major supplier of gas to the United States. Due to the sheer size and location of the field, Kovyktas development represents a timely and important opportunity for China and South Korea. Development of 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 for Russia. Development at this level could facilitate diversification of Russias Europe-centric export market, increase government revenues, spur economic development in the desolate regions of the Russian Far East and Siberia, and promote regional energy integration. With Gazproms recent takeover of the project (discussed in detail below), pipeline development into Northeast Asia couldif planned carefully represent a significant opportunity for Russia. The projected $1.21.4 billion per year in annual tax revenues from the export of Kovykta gas by 2020 would benefit both the federal and local governments.3 In 2006 gas rents accounted for approximately half of Russias total energy rents. Furthermore, Gazprom currently exports all of Russias gas to Europe and Eurasia; a major pipeline to Northeast Asia could therefore diversify the companys export portfolio. In 2006 Gazprom produced 556 bcm of gas and exported around 260 bcmapproximately half the totalto Europe, the Baltic States, and Central Asia.4 Thus, potential Kovykta gas exports of around 30 bcm per year would represent over 10% of Gazproms current exports. As of early 2007, however, domestic consumption of gas supplied from the Kovykta field amounted to only 2 bcm. The main consumers of this initial production have been the sparse populations of Angarsk, Sayansk, Irkutsk, and Usolye-Sibirsk.5 These populations will never consume as much gas as this field could potentially produce. For the benefit of both the project consortium and the Russian state, Kovykta gas must reach Asian markets.
2 Kovykta Project, TNK-BP u 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.pdf.
5 Ibid.
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South Koreas Looming LNG Supply Gap

In the last few decades, South Korea has been one of Asias fastest-growing and most dynamic economies. Vast amounts of natural resources will be needed to maintain this economic growth. Due to the expansion of energyintensive industries and to increases both in income and in the number of motor vehicles, total primary energy demand in South Korea has skyrocketed to 226 million tons of oil equivalent (mtoe) in 2005, approximately 78 mtoe higher than in 1995.6 Having very limited domestic sources of energy, South Korea relies almost completely on imports. Energy imports as a percentage of total demand rose from 73.5% in 1980 to 96.8% in 2005. The worlds fourth largest oil consumer, South Korea presently relies solely on imports to meet oil needs and uses oil as the primary fuel source; demand for oil as a percentage of total energy demand is, however, projected to fall from 53% in 2003 to 39% by 2030.7 In the mid-1980s Seoul introduced tax incentives to promote widespread use of natural gas. With the rapid expansion of the countrys natural gas industry from 1987 to 2002 and establishment of a nationwide trunk pipeline network, South Korea has become one of the worlds most dynamic gas markets. Natural gas continues to be the fastest-growing energy resource in South Korea due both to the convenience and to the environmental friendliness of natural gas relative to oil. As such, forecasts are that South Koreas demand for gas will increase by 150% (from 20 bcm in 2000 to 53 bcm) by 2020.8 In short, natural gas has been and will remain the fastest-growing energy source in South Korea. South Korea is currently the second-largest importer of liquefied natural gas (LNG) and home to the worlds largest LNG importer, Korean Gas Corporation (KOGAS). KOGAS has a de facto monopoly on South Korean gas imports, which thus far have been exclusively in the form of LNG.9 KOGASs imports have traditionally come from Southeast Asia; many of these longterm KOGAS contracts are ending in 200708, however, and their renewal
6 BP Statistical Review of World Energy 2006, BP p.l.c., June 2006. 7 Ministry of Commerce, Energy, and Industry of the Republic of Korea (MOCIE) u http://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 of 500,000 tones of LNG in 2006. POSCO and K-Power also signed a long-term LNG contract in 2004 for 550,000 and 600,000 million tons respectively of LNG from Indonesias Tangguh project that will be delivered by the end of 2008.
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is not always certain.10 Therefore a growing proportion of South Koreas LNG is coming from the Middle East. South Korea began importing LNG from Oman and Qatar in 1999 and has secured a contract for large shipments from Yemen beginning in 2008. By 2020 nearly 80% of South Koreas LNG imports will come from the Middle East (see Figure 1). Imports of 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 facing a shortage in liquefaction capacity, traditional LNG suppliers (Yemen, Oman, and the United Arab Emirates) all have virtually run out of new supplies, and approximately 80% of the potential LNG supplies of Qatarjust emerging as one of the worlds largest LNG exportersare already committed.11 For South Korea, these phenomena make neighboring Russia an extremely attractive source of 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 supplydemand 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 forbid customers to sell excessive supplies to third parties, South Korea has in effect been forced to buy contracted gas below demand and to make up the difference with spot-market cargoes.12 South Koreas 2005 spot-market purchases came to around 8 mtoe of gasor approximately 9 bcman amount the equivalent to about one-third of the countrys total gas consumption (see Figure 2). Reliance on the spot market to make up for gas shortfalls is a major problem for 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 of South Koreas LNG in the 1990s came from
Indonesia, the future of Indonesias LNG industry is uncertain. Due to a lack of both favorable investment policies and general resource nationalism, this OPEC country became a net importer of oil in 2004, with plans to further develop the countrys LNG for export currently in limbo. An overall push to develop a domestic gas market is emerging to make up for this energy gap. Indonesia already has to import LNG from other countries in order to meet existing long-term supply contracts. Conclusions! (presentation given at the 27th Annual Oil & Money Conference, London, September 1819, 2006).
11 Fereidun Fesharaki, Energy Issues in Iran: It Helps to Know a Few Facts Before Reaching
12 Spot markets allow producers of surplus gas to instantly locate available buyers, negotiate prices,
and deliver actual commodities to the customer in real time and are either privately operated or controlled by industry organizations or government agencies. Spot markets frequently attract speculators because spot market prices are known to the public instantaneously.
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figure 1 Share of South Koreas LNG Imports by Source, 19902020

100 90 80 70 Percentage 60 50 40 30 20 10 0 1990 1995 2000 2005 Year Southeast Asia Middle East Other 2010 2015 2020
Source: KOGAS 2005 Annual Report, Korea Gas Corporation, 2006 u www.kogas.or.kr.
contracts, including pipeline gas.13 Kovykta could be a source of both stable and predictably priced gas for South Korea. As mentioned above, South Korea is solely reliant on LNG. The proposed Kovykta pipeline would therefore allow Seoul to diversify not only the sources of gas but also the modes of 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 from the Middle East.
Chinas Promise as a Gas Market

Natural gas currently comprises only 3% of Chinas total energy consumption mix, a percentage that is significantly less than the world
13 The growth of the spot market in Asia is in part due to South Koreas seasonal gas demand swings, a
nuclear plant shutdown in Japan, and gas supply interruptions in Indonesia.
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figure 2 South Koreas Growing Gas Supply-Demand Gap

50 45 Million tons of oil equivalent 40 35 30 25 20 15 10 5 0
1990 1995 2000 2005 Year 2010 2015 2020
Demand Supply gap Supply contracts
Source: Outlook for Energy Consumption in 2010, MOCIE u www.mocie.go.kr; BP Statistical Review of World Energy 2007, BP p.l.c., 2007; and KOGAS 2005 Annual Report. Note: Data for 2010, 2015, and 2020 is projected.
average of approximately 23%.14 The lack of gas demand is predominately due to Chinas reliance on coal for electricity. Accounting for 70% of total energy consumption in China, coal is slated to remain king in Chinas energy mix for the next several decades. Beijing is, however, beginning to realize the limitations of coal for providing a stable supply of electricity in China. 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 of the country. Faced with these coal shortages, many manufacturers have resorted to using gas- and diesel-powered generators to meet factory electricity needs, a substitution that in turn raises Chinas overall oil demand. The grave environmental and health implications of Chinas coal use have received extensive media coverage. The International Energy Agency (IEA) predicts that China will overtake the United States in carbon dioxide
14 BP Statistical Review of World Energy 2006.
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emissions in 2008.15 Additionally, the coal industry in China sorely lacks safety standards. In 2005 nearly 6,000 deaths in coalmine accidents were reported in China. According to Zhao Tiechui, chief of China's State Administration of Coal Mine Safety, China closed a total of 8,984 small coalmines in the first half 2007 and will close another 2,811 small coalmines by the end of the year.16 Chinas coal industry will require around $100 billion in further investments to meet projected demand in 2025.17 Rather than making these needed investments in the coal industry, China could direct investment toward establishment of an integrated gas system. With 70% of Chinas economy relying on the coal industry, prospects for diversified gas introduction will remain a top priority for Beijing. Investments in efficient and clean gas-fired power stations would play a critical role in alleviating many of Chinas coalrelated environmental and health problems. Domestic gas production has risen dramatically, up 17% between 2005 and 2006. Despite this change, China must increasingly look abroad for supplemental gas supplies. Until recently China was completely self-reliant on domestically produced gas. Because Chinas national gas network is not even remotely comparable to that of 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 Chinese gas demand will take in the next twenty years (see Figure 3). As economic development and manufacturing further stretch into Chinas hinterland, Beijing will need to build gas pipeline networks and effectively implement policies for promoting pipeline use. As the majority of 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 for transport to China.
the fight for kovykta

In 1989 Chung Ju-Yung, chairman of the Hyundai Group, proposed running a gas pipeline from 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 Times, 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 of Rising Chinese Energy Demand (paper presented at
annual energy security conference of The National Bureau of Asian Research, Washington, D.C., September 2526, 2005).
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figure 3 Projections of Chinas Gas Demand

300 NDRC (250)
250 Billion cubic meters
200 APERC (153) EIA (134) IEA (107)
150
100
50
0 2006 Year
2020
Source: BP Statistical Review of World Energy 2007; 2006 Energy Demand and Supply Outlook, AsiaPacific Energy Research Center (APERC), 2006; 2004 World Energy Outlook, International Energy Agency (IEA), 2004; and 2006 International Energy Outlook, Energy Information Administration (EIA), 2006. National Development and Reform Commission (NDRC) figure cited in Akira Miyamoto and Chikako Ishiguro, Pricing and Demand for LNG in China: Consistency between LNG and Pipeline Gas in a Fast Growing Market, Oxford Institute for Energy Studies, NG-9, January 2006. Note: Actual figure in 2006 is 56 bcm.
and advance the idea of a unified Korea.18 In 1994 the presidents of South Korea and Russia agreed to jointly develop natural gas from a field in Yakutia (Republic of 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 of the two countries[and] contribute to forming a basis for unification of the two Koreas.19 In late 1995 Moscow and Seoul completed a preliminary study of the technical and economic feasibility of Sakha gas development. Under the agreement a 6,600 km (4,125 mile) natural gas pipeline would extend from Sakha through Khabarovski and Primorski krais. Expectations were that the annual output of gas would total 30 to 45
18 Keun-wook Paik, Gas and Oil in Northeast Asia: Policies, Projects, and Prospects (London: The
Royal Institute of International Affairs, 1995). Service: Asia Pacific, June 3, 1994.
19 Russia and South Korea Agree to Develop a Gas Field and Construct a Pipeline, BBC Monitoring
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bcm, 15 to 28 bcm of which would be exported to the Korean Peninsula and that the project would be shared between Russia (70%) and foreign investors (30%). Pyongyang approved the transit of the gas pipeline through North Korean territory because the project would be economically beneficial to the country. Estimates for the total cost of the project were between $17 and $23 billion, with supplies expected to last fifty years.20 The 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 of this length and the harsh climate and geological conditions but also to the uncertainty of future South Korean demand for gas. International focus thus quickly turned to the Kovykta gas field in Irkutsk.
The Five-Country Feasibility Study (19962000)

Following the discovery of 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 formed regional oil company owned jointly by Russia Petroleum (RP) and the Export-Import Bank of Russiashould become the major Russian stakeholder in the project. In 1996 a subsidiary of South Koreas Hanbo Group, the East Asia Gas Company (EAGC), took the initiative of purchasing 27.5% of the equity shares in the project for $25 million and promoting early development of East Siberias oil and gas reserves. 21 As a result the Hanbo group (with 46.1% ownership) became the largest shareholder of the project. Having invested $40 million in the field development, the consortium began looking for supplemental foreign investment by 1997. That year Russias Ministry of 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 project costs were expected to amount to $57 billion.22 South Koreas stake in the project was short-lived; in 1997 a bankrupted Hanbo Group was forced to sell off a majority of its equity shares. British Petroleums $571 million purchase of the bulk of Hanbo shares left EAGC with just a 7.5% share. Sidanko and BP established a strategic alliance to develop the project.23 Projections at this time for 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 Soviet
Union, July 18, 1997.
23 Jeanne Whalen, BP and Uneximbank Close Sidanko Deal, Moscow Times, November 19, 1997.
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of Kovykta gas to China at 20 bcm per year, with the possibility of extending pipelines to service Korean and Japanese markets. In 1998 Russia, Japan, China, South Korea, and Mongolia signed a memorandum of understanding to execute a feasibility study.24 During this phase of negotiations the pipeline route deemed most economical was one running from Irkutsk to Beijing via Ulaanbaatar, Mongoliaa total distance of 3,364 km. The planned 1,420 mmdiameter pipeline would require capital investments of nearly $7 billion.25 Several issues began surfacing 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 for the gas a large portion of the investments would need to come from South Korea and Japan. Under these prerequisites, companies from the two countries would need to be rewarded with larger stakes in the pipeline development. Project plans collapsed at a December 1998 meeting. In 1999 the development of the pipeline was revived by a cooperation agreement signed in February 1999 between the prime ministers of Russia and China, Yevgeniy Primakov and Zhu Rongji.26 By the end of 1999 China and Russia had invited South Korea to join in another feasibility study that began in early 2000. The remainder of that year was defined by BP taking further control of RP with the acquisition of EAGCs remaining shares.
The Three-Country Feasibility Study (200003)

During a November 2000 meeting in Beijing, the BP-controlled RP signed a new tripartite agreement with CNPC and KOGAS for a feasibility study.27 Shortly after the agreement, South Korea proposed that the study include the potential for North Korean participation in the project. South Korean energy experts and politicians emphasized that by giving Northeast Asia 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 for each participating state. In 2002, before the feasibility findings were even announced, Tyumen Oil Company (TNK)a significant shareholder (26%) of 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 Trade between Asian Russia, Northeast Asia
Gets Fresh Look, Oil and Gas Journal 95, no. 33 (August 18, 1997): 4145. Pacific, February 24, 1999.
26 Russian Agency Details Sino-Russian Energy Cooperation Projects, BBC Monitoring: Asia 27 Russia, Platts Oilgram News 78, no. 215, November 7, 2000.
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idea of completely bypassing China by directing the pipeline to Nakhodka for LNG exportation.28 A year of shuttle diplomacy and wrangling between stakeholders, local and federal governments, and Russian gas giant Gazprom ensued, due in large part to Moscows 2002 appointment of Gazpromnot even a stakeholderas the main coordinator for all gas exploration and production (E&P) and export projects in east Siberia. Moscow specifically asked Gazprom to coordinate all of Russias gas sales to the Asian markets, as the company does with European exports.29 In February 2003 Gazprom chief Alexei Miller visited Seoul to discuss KOGASs proposal to build the Kovykta pipeline into China through North Korea, finally reaching Pyongtaek in South Korea. TNK and BP (which had merged in 2003 giving the new company TNK-BP a 62.5% stake in RP) strongly opposed the route through North Korea, however, because of 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 of the sea between China and South Korea (see Figure 4). The three-country feasibility study was eventually conducted and finalized in the summer of 2003. The study found that the project was commercially sound and projected that the total production volume of gas from the Kovykta field would reach 3035 bcm per year, of which China would receive 20 bcm per year and South Korea would receive 10 bcm per year. The proposed gas pipeline would have a total length of 4,887 km, starting from Irkutsk, wrapping around the southern tip of 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 of Pyongtaek.30 The study also found that the pipeline would take five to six years to build and could ultimately supply South Korea with gas beginning in 200910. The study projected that the project costs would reach $17 billion. According to KOGAS, the price
28 Russian TNK Urges OK for Kovykta-Nakhodka Gas Pipeline, Dow Jones International News,
March 15, 2002.
29 Gas Pipeline to China and Korea, APS Downstream Review Trends, September 4, 2006. 30 Jiqiang Ma, Substantial Result Achieved for Russia-China-ROK Gas Cooperation Project, China
Oil and Gas, no. 4 (2003): 4245.
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figure 4 Kovyktas Proposed Pipelines

Chayandinskoye Gas-Oil Field
Kovykta Gas Field Irkutsk Manzhouli
Skovorodino
Ulaanbaatar
Khabarovsk
Daqing Harbin Changchun Beijing Nakhodka
Dalian Pyongtaek
Source: K. Kanekio, Northeast Asia Natural Gas Trade Study: Developing Stable Supply of Cleaner Energy for Sustainable Development (presented at the World Bank workshop, Beijing, June 24, 2004).
of Kovykta pipeline gas would have been 20% to 30% lower than Koreas established LNG prices.31
Gazproms Strong-arm (2004Present)

Before the three parties were able to sign an intergovernmental agreement, however, Gazprom declared that it would support neither the proposal nor the export of Kovykta gas to international markets, arguing that the gas should be sold on Russias domestic market. 32 During a January 2004 meeting with TNK 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 2004 u http://www.koreafocus.or.kr/essays/view.asp?volume_id=34&content_id=8& category=G. January 29, 2004.
32 Gazprom Says Kovykta Project Unattractive in Current Version, Prime-TASS Energy Service,
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domestic market, noting that supplying gas to Russian consumers must be a priority in development of East Siberia. This principle is not reflected in the feasibility study. Nor are the costs of gasifying regions around the field taken into account or the potential for developing petrochemical projects using resources from Irkutsk fields.33 Two months later, Gazprom even suggested that Kovykta gas be linked to the unified system of gas supply to be diverted toward European markets.34 Alexander Medvedev, deputy chairman of Gazprom stated: we told [TNK-BP] that we could consider Kovykta as a part of the export base, but in no way we would discuss supplies from Kovykta to China. That 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 of the largest stake in the project, TNK-BP quickly became Gazproms target. Although realizing early on the need to effectively work with Gazprom, TNKBP sought to bring Gazprom in only if on fair commercial grounds. Working through the Ministry of Natural Resources, Gazprom soon brought to the limelight some of the details in TNK-BPs license agreement and the possible consequences for TNK-BP of not meeting the contract terms. Under this agreement, TNK-BP was required to produce a minimum of 9 bcm per year from the Kovykta field by 2006 or risk losing the project. In a last-minute effort TNK-BP built a small pipeline from the Kovykta field to Zhigalovo, a logging village with only 5,000 residents. TNK-BP sold the gas for $30 per thousand cubic meters, well below market prices; Gazprom sells gas to Europe at an average price of $250 per thousand cubic meters. 36 When TNK-BPs deadline closed in June 2007, Gazprom agreed to make a nominal payment of $700900 million to TNK-BP and promised shares in other projects in Russia in return for TNK-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 of the project by Gazprom could actually expedite the development of an export route (whether
33 Gazprom Outlines Disagreements with TNK-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 III
Institute for Public Policy, Rice University, October 2004, 11.
35 Gazprom: Gas Deal with China to Be Finalized by First Half of 2006, Caijing Magazine, September
26, 2005 u http://www.caijing.com.cn/newcn/English/Industry/2005-10-03/13870.shtml.
36 The Russian Oil and Gas Producers, APS Review Downstream Trends, August 21, 2006.
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through China and South Korea or to Nakhodka for LNG shipment) such an outcome is doubtful for several reasons. Most recent reports suggest that Kovykta gas will not be completely developed until 2017, ten years later than originally planned. The next section analyzes both past and current obstacles for successful development and export of Kovyktas gas into Northeast Asia.
obstacles to the development of the kovykta gas pipeline

Since discovery of the Kovykta oil fields, companies and governments from Europe and Asia have been vying for a stake in their development. Most of the European companies, however, quickly abandoned their interests deeming the project uneconomic. Since these companies backed out, efforts on the part of both Russia and Asia have notably shifted largely to from company level to that of the state. The companies have merely been appointed as negotiators on behalf of the states involved. As such, state enthusiasm has been trumped by several economic realities. This next section overviews several of the prevailing economic obstacles to Kovyktas development.
Transit Country Problems

From 1995 to 2007 the Kovykta project has had five major ownership changeseach bringing a change in routing options. Although proven reserves of the field have increased by 1 trillion cubic meters, the cost of the proposed pipeline has increased by $10 billion (see Table 1). The periodic inclusion of Mongolia and North Korea has indeed hindered plans for development of the Kovykta pipeline and has highlighted the complexities involved when companies and governments are forced to balance the economic validity of the project with regional politics and international security. The South Korean government has often discussed energy cooperation between the two Koreas, apparently with the primary goal of 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 insecurities could undoubtedly help achieve this goal. Though the political costs and risks associated with North Korea are well known, the extension of 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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Table 1 Historical Changes in Routes, Ownership, Costs, and Reserves of Kovykta

Year(s) 199596 Proposed pipeline route Russia Yellow Sea 199697 Kovykta Irkutsk Mongolia Beijing Dalian Yellow Sea South Korea 2002 Kovykta Irkutsk Manzhouli Harbin Shenyang Dalian North Korea South Korea 2003 Kovykta Irkutsk Manzhouli Harbin Shenyang Dalian Yellow Sea South Korea 2007 Kovykta Nakhodka?

Distance (km)
Shareholders Sidanco, 50% Russias ExportImport Bank, 50% Sidanco, 38% EAGC, 28% Irkutsk regional administration, 19% Irkutskerergo, 14%
Projected costs (b) $57
Estimated reserves (bcm)
3,819 km
$10
~1,000
4,065 km
BP, 33% TNK, 29% Interros, 26% Irkutsk regional administration, 11%
~$12
~1,900
4,249 km
TNK-BP, 62% Interros, 26% Irkutsk regional administration, 11%
$17
~2,000
Gazprom, 62% Interros, 26% Irkutsk regional administration, 11%
~2,000
Source: Keun-Wook Paik, Pipeline Gas Introduction to the Korean Peninsula, Chatham House, January 2005; 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 for Russian gas, LNG supplies from the Middle East and Australia could take over the gas markets in Asiaa situation that would leave less market share for Russia and higher energy costs for 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 of Northeast Asias energy corridor would have world-wide commercial and political implications. The inclusion of North Korea in the route, however, temporarily increased both commercial and political costs to the pipeline. The additional 246 km of pipeline needed for the North Korea route increased costs by $2 billion. Moreover, routing the pipeline through North Korea could have allowed Pyongyang to easily control the flow of gas to South Korea for strategic purposes. Although some sectors of the South Korean government and some in various international organizations agreed in principle to this route, the 2003 feasibility studyled by TNK-BPruled out this option on both commercial and political grounds.38 The six-party talks, however, are becoming more sanguine. Given that pipeline projects are extremely slow to develop, the possibility for North Korea to take part in a regional pipeline scheme in the future is not completely out of the question. Mongolia also figured in the pipeline scheme in 1997. Although the most economic and cost-effective way to transport gas from Kovykta into China, this possibility of routing the pipeline through Mongolia was quickly abandoned by China due to domestic concerns. China feared both that the autonomous region of Inner Mongolia might demand to be a benefactor of transit fees along with Mongolia and that social unrest might occur if Chinas ethnic Mongolians felt that they were receiving the short end of 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 for the war on terrorism after September 11, 2001.
37 Peter Hartley, Amy Myers Jaffe, and Kenneth Medlock, Economic Issues of Natural Gas Trade in
Northeast Asia: Political Bridges and Economic Advantages, in New Paradigms for Transpacific Collaboration, Korea Economic Institute, Academic Study Series, 2006 u http://www.keia.org/2Publications/2-3-Monograph/Monograph2006/04Jaffe.pdf. Presse, November 12, 2003. August 2003.
38 Pyongyang Could Be Left Out of Russian Gas Pipeline to Korean Peninsula, Agence France 39 Kaoru Yamaguchi and Keii Cho, Natural Gas in China, the Institute of Energy Economics, Japan,
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The inclusion of both North Korea and Mongolia in the Kovykta routing options would have been both economically and politically beneficial. The Mongolian route was the cheapest option for all parties involved. Bypassing Mongolia by instead routing the pipeline through the permafrost 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 of an underwater pipeline from Dalian to Pyongtaek. The higher construction costs of the diversions will increase the end-user gas price; Russia will have little room left 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 often reported in the media is the fact that natural gas is intrinsically more difficult to trade than oil and requires greater confidence, many more guarantees, and much more money from investors and governments. The 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 justify the investment. Once built, pipelines cannot be moved and thus lock the seller and buyer into a longterm relationship. Whether by LNG or pipeline, the natural gas market is vastly different than the oil market. There is in fact no world gas marketthe majority of 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 of plans and calculations. The huge amounts of frontend investments and the difficulties and expense of storage and transportation force 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 for twenty years under tough take-or-pay and destination clauses that essentially prohibit buyers from 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 uniform benchmark prices are firmly in place.40 In 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 fairly easy. Likewise, having surplus oil allows producers to find a willing buyer with relative ease. The combination of 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 Though Kovykta has been proposed as a cross-border pipeline project, Gazprom has recently favored having the Kovykta pipeline follow the proposed East Siberian-Pacific Ocean (ESPO) oil pipeline route. This route would not cross international boundaries but would run from Irkutsk to Nakhodkaa 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. This proposal, however, poses several technical and commercial challenges for 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, this proposal makes little economic sense. LNG is a capital-intensive business and requires up-front investments in a facilities chain (upstream production rigs, liquefaction facilities, LNG tankers, regasification facilities, and local distribution pipelines). Such a chain could cost as much as $5 billion.42 For LNG to be a profitable business, the gas deposits need to be relatively close to the terminal; most LNG gas therefore has come from fields just offshore. Furthermore, LNG facilities are usually upgraded before new terminals are built. The cost of an upgrade, however, is astronomical in comparison to an equal capacity upgrade for a pipeline. Roughly speaking, pipelines can double capacity for only an additional 1020% of original investment; LNG, however, would require an additional 5060% for the same capacity
40 The marker crude system was introduced in the mid-1980s. The spot trade of three main types
of crude (West Texas Intermediate, Brent Lend, and Dubai) acts as a barometer of the overall market level. Using this pricing system, different grades of oil are priced on negotiable differentials to the marker grade. The rationale is that the spot price represents the balancing point of supply and demand. Even though the volumes of oil that trade daily on a term-contract basis between companies or governments are much larger than those that traded on a spot basis, price is determined at the margin in the spot market.
41 The authors would like to thank Mikkal Herberg for bringing these points to their attention. 42 Linda Cook, The Role of LNG in a Global Gas Market (presentation at the 27th Annual Oil &
Money Conference, London, September 18 19, 2006).
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upgrade.43 After decades of technological advances that have slowly reduced construction costs of LNG plants, costs are now again on the rise. In 2005 LNG plant construction was below $200 per ton per year of production capacity. Due to rising raw materials and equipment costs and a growing shortage of experienced engineers, today these costs are around $500 per ton per year, with some projects even approaching $1000 per ton per year. These cost hikes have caused delays of up to three years for 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 from consuming countries but also require financial commitments and technological expertise to sustain a profitable gas business. Kovykta has been and will remain subject to these problems, which are inherent in gas investment and export.
Demand Security and Pricing

During the ten-plus years of negotiating over the price and timing of the Kovykta pipeline, gas markets have gone through three distinct phases. During the first phase (19962000) gas contracts were extremely rigid and prices were high. During this period South Korea and Japan, the only importers of natural gas in the region, had government policies and infrastructure that favored the use of gas. The second phase (200005) was a buyers market; this phase was defined by lower oil price linkages, lower gas prices, and more flexible contract terms. The third (and current) phasea sellers marketis characterized both by prices that link closer to oil and by stricter contract terms. Since the price of gas and contract terms determine the pace and time of the development of the gas pipeline as well as the will of foreign investors, the characteristics of each phase have had distinct implications for the development of the Kovykta gas pipeline. Furthermore, each party involved in the Kovykta pipeline negotiations has had different alternatives for gas useand thus has employed a different set of calculations when formulating the price of Kovykta gas. For South Korea the main alternative to pipeline gas is LNG, and for China the main alternative is coal. First phaseu During the first phase, from 1996 through 1999, Chinas domestic gas production of 17.9 bcm per year could clearly cover the countrys domestic consumption of 17.4 bcm per year. Gas in China was (and today
43 Al Troner, Natural Gas: A Natural Choice? CLSA Quarterly 1, no. 4 (February 2007): 76.
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largely still is) used to produce fertilizer, rather than in gas-fired power plants. Gas pipeline grids were sparse, and industrial gas use was concentrated in Chinas northeastern coastal cities. Thus during this phase high costs and inflexible contract terms made gas a less competitive option compared to Chinas domestic coal supplies. Though indeed having much potential, China simply did not have a gas market. South Korea therefore was brought in to act as a stable anchor for the projecta new factor that could make the Kovykta pipeline feasible. In the wake of the Asian financial crisis, however, gas development plans in all of Asia slowed to a snails pace. South Koreas gas demand decreased by 800,000 Mt (or 1 bcm).44 KOGASs LNG storage was at full capacity, and from 1997 to 2002 South Korea abandoned a total of 76 energy projects.45 As one example, the Hanbo Group lost most of its stake in the Kovykta project after going bankrupt in 1997. China, less deeply affected by the financial crisis, became the silver lining in the project. There is no consensus as to just how Chinese gas demand will take shape in the next twenty years. Projections of Chinas energy demand made by various energy agencies differ by as much as 143 bcm (see Figure 3). This projection gap is roughly equivalent to the average capacity of 47 LNG terminals or around five Kovykta fields. At a March 2005 seminar the National Development and Reform 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.46 Even with an optimistic domestic gas production outlook of 150 bcm per year China would still be required to import approximately 100 bcm per year. Beijings plans to build fourteen more LNG terminals by 2020 calls into question the need for Kovykta gas, given that the capacity of these proposed LNG terminals is roughly equivalent to 48 bcm per year. If Russian, Eurasian, and Southeast Asian pipeline gas is introduced, supply would be approximately 36 bcm per year above projected demand.47 Although
44 Asia-Pacific Gas Projects Hit the Wall amid Regional Economic Slump, Oil and Gas Journal 97,
no. 6 (February 8, 1999): 2327.
45 Keun-Wook Paik, Valerie Marcel, Glada Lahn, John V. Mitchell, and Erkin Adyiov, Trends in
Asian NOC Investments Abroad, Chatham House, Working Background Paper, March 2007.
46 See Akira Miyamoto and Chikako Ishiguro, Pricing and Demand for LNG in China: Consistency
between LNG and Pipeline Gas in a Fast Growing Market, Oxford Institute for Energy Studies, NG-9, January 2006.
47 These figures include high projections of proposed pipelines from Kazakhstan, Turkmenistan,
Myanmar, as well as Kovykta and Sakhalin in Russia. See Price, Russia Weaken Case for China LNG, Petroleum Intelligence Weekly 44, no. 44 (October 31, 2005); and Miyamoto and Ishiguro, Pricing and Demand for LNG in China.
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development of several of these pipelines is highly speculative, building the Kovykta pipeline to China presents a potentially nightmarish investment decision. If anticipated sales fall through because China is unable to pay for the gas, investors will have no way to recover sunk costs. Few experts doubt that in the near future Chinas gas consumption will undergo extraordinary growth; yet how China will rapidly develop the countrys gas market is unclear. To what extent will gas account for Chinas power generation? How much investment will China make in municipal gas distribution systems? Developments related to these questions could ultimately affect the future of the Kovykta pipeline. Second phaseu During the second phase in natural gas markets, negotiations over the pipeline were promising but slow-going. With rigorous diplomatic support, China aggressively pursued development of an LNG industry. In 2003 North West Shelf Australia LNG won a tender to supply Chinas Guangdong LNG terminal with 3 bcm per year for twenty years at approximately $3.20 per million British thermal unit (Btu). At that time the cost of coal in China was approximately $2 per million Btu and the average cost of Chinas domestic natural gasspecifically from the Tarim Basin was close to $4 per million Btu. The anticipated price of natural gas from the Guangdong LNG terminal, however, is $2.80 per million Btu (including freight) plus $0.40 per million Btu for regasification.48 At a price of $3.20 per million Btu, coal lost some of its competitive edge, making gas a more attractive option. Third phaseu Since 2006 the global gas market has experienced a third phasea sellers market. Russia has recently demanded higher prices for nearly all of the countrys exported gas, including gas from Kovykta, insisting on the need to be competitive with LNG from the Middle East. China is in no rush, however, to commit to such a high price. In early 2007 Russia offered gas to China for $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).49 In 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 for gas imports. In September 2007, after years of
48 2006 World Energy Outlook, U.S. Department of Energy, Energy Information Administration,
2006, 4546 u http://www.eia.doe.gov/oiaf/ieo/pdf/0484(2006).pdf. 26, 2007.
49 Chinas Foreign Plans Have a Long Way to Go, International Gas Report, no. 568, February
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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 satisfaction, as a China that is prepared to pay market prices to Australia might likewise be willing to pay what Russia wants. This optimism, however, ignores two possibilities: that China may be demonstrating a preference for LNG over pipeline gas, and that Australia is associated with much less political risk than is Russia.
russias resource renationalization

As outlined above, many impediments to development of the Kovykta project have been economic in nature. In the context of Gazproms recent takeover of 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 of postSoviet era economic reforms, Russias energy industry had become increasingly competitive and privatized by the mid-1990s. Within ten years of the Soviet Unions demise the coal and oil industries were nearly completely privatized and product prices were deregulated. According to some calculations, government ownership of oil and coal companies was below 10% by 2004. 50 Russias gas industry, however, has not seen similar reforms for several reasons. First, gas has been a more stable contributor to Russias economy than oil, providing the federal government with a steady revenue stream throughout the periods of steep decline in oil prices and production. In 2006 gas alone accounted for around 50%or $200 billionof Russias total oil and gas rents. 51 Second, although having the largest proven gas reserves in the world, Russiawhich consumes approximately 70% of 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% of total production. Although rising, Russias domestic gas prices are fixed well below market price, especially for residential users. These 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 Economics 47, no. 3 (2006): 286. Series, October 2006, 10.
51 Clifford Gaddy and Fiona Hill, The Russian Federation, Brookings Institution, Energy Security
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figure 5 Distribution of Russias Oil and Gas Production, 19912006

700 Billion cubic meters 600 500 400 300 200 100 0 Gas Million barrels per day 10 9 8 7 6 5 4 3 2 1 0 Oil
19
91 993 995 997 999 001 003 005 1 1 1 1 2 2 2

Year Consumption
19
91 993 995 997 999 001 003 005 1 1 1 1 2 2 2

Year
Exports
Source: BP Statistical Review of World Energy 2007.
During the presidency of 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 foreign investments and began to allow foreign ownership of 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.52 In the last two years crude oil prices have hovered around $70 per barrel and even topped $100 per barrel. By some estimates federal earnings from 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 of the energy industry. In 2001 Putin appointed three high-level executives at Gazprom, all of whom were either friends of Putin or former Putin administration officials.54 As aptly
52 Based on authors own calculations using Crude Oil Price Summary, Energy Information
Administration, 2007 u www.eia.doe.gov.
53 Gaddy and Hill, The Russian Federation, 7. 54 These appointees are Dmitry Medvedev (chairman), Aleksei Miller (president), and Igor Yusufov
(board of directors). See Michael Fredholm, The Russian Energy Strategy and Energy Policy: Pipeline Diplomacy or Mutual Dependence? Conflict Studies Research Centre, September 2005.
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figure 6 Crude Oil Price per Barrel, 19702006

100 90 80 70 Price ($) 60 50 40 30 20 10 0
82 00 79 85 70 91 73 94 76 88 97 19 20 03 20 19 19 19 19 19 19 19 19 19 20 06
Year
Source: BP Statistical Review of World Energy 2007.
characterized in a Swedish defense analysis, Putin is creating a culture of a politically correct market economy.55 With 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. The autonomous rights of 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 from Moscow contributed to this autonomy as well. Known as the two key system, Russias Subsoil Law of 1992 gave both the regional (oblast) and federal governments authority over subsoil use. With the assignment of Gazprom as chief negotiator of Kovykta and a series of amendments to the law, however, regional authority over subsoil use was
55 Robert Larson, Russias Energy Policies: Security Dimensions and Russias Reliability as an Energy
Supplier, Swedish Defence Research Agency, Defence Analysis, March 2006 u http://www2.foi.se/ rapp/foir1934.pdf.
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stripped and all rights over the issuing or revoking of subsoil licenses were solely retained by the Kremlin. 56 Apart from 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 shifts, China, South Korea, and TNK-BP became heavily involved in a type of shuttle diplomacy, with representatives travelling between Irkutsk and Moscow in attempts to figure out who was in charge. Both China and South Korea were often confused as to with whom or what companythe projects main shareholder and operator (TNK-BP), Russias export monopoly (Gazprom), or the federal government (the Kremlin)negotiations ought to be conducted. On the sidelines of recent Kovykta negotiations South Korea and China uncharacteristically publicized frustration regarding Russias ambiguities. Discussing the state of Sino-Russian energy cooperation and the proposed pipeline, in an interview in 2006 Zhangguo Bao, former vice-director of Chinas NDRC made the following statement:
Currently, the Sino-Russia pipeline question is one step forward, two steps back. Today is cloudy with a chance of rain while tomorrow is sunny with a chance for clouds, just like a weather forecast. One minute Russia has said they have made a decision, the next saying that no decision has been madeTruthfully, weve been in contact with Russia for such a long time, but we still dont understand Russia, I feel. We dont know who can make a decision, or who to seek outWeve talked to Putin and department heads. Weve talked to everyone in the government. They say they cant make a decision, and that we should talk to the private sector. Weve meet with every company. They say they cant sign an agreement and we should talk to the government.57
The lack of transparency in Russias energy policy has clearly left all negotiating parties in limbo.
Balancing Russias Domestic and European Demand

Gazproms entire gas production (apart from that which is consumed domestically) is exported directly to European and Eurasian markets; Germany, Italy, and Turkey are Gazproms largest and most important customers. Nine out of Russias top fifteen importers rely on the company
56 Jennifer Josefson, Policy Challenges: A Russian Perspective, in Energy Futures, ed. Ralf Boscheck
(New York: Palgrave MacMillin, 2007), 98107.
57 China Energy Report Weekly, Interfax Information Services, March 410, 2006, 2728.
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for over 50% of their gas needs.58 Some European counties, although hoping to diversify 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 for revenues. Geopolitically, Gazprom is currently attempting to create a European monopoly by undermining efforts by Iran, Turkmenistan, and Kazakhstan to export gas to the European market. Because the majority of Russias pipelines are aimed toward Europe, Gazprom has focused on Europe and placed Asia on the backburner. Russian domestic demand is another factor behind the politicization of Russias gas industry. Although Russia currently ranks second in the world in gas use (behind the United States), the Russian economy is only onetwentieth the size of the U.S. economy. Low-priced gas fuels much of Russias industrial sector, and fixed prices allow household energy bills to remain low. Although Gazprom is lobbying hard for a sharp increase in domestic prices the Kremlin remains reluctant to raise prices for fear of provoking economic and social stresses. The political aspects of the recent price debacle with Ukraine received much attention, yet the move to shut off the gas spigot clearly was an indication of Russias fear of overstretching Gazproms other export commitments.59 An overcommitment 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 feel. In a worst-case scenario, Russia could also connect Kovykta with the countrys existing unified gas supply system for domestic consumption in order to relieve other gas fields that could supply exports to Europe. If Russia continues to focus on Europe without increasing production, raising domestic gas prices, and curbing domestic demand, how can Gazprom justifiably export Kovykta gas to a China that refuses 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. The law
58 Country Analysis Brief: Russia, U.S. Department of Energy, Energy Information Administration,
April 2007 u 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 January
1, 2006, a move that also affected gas supplies to other parts of Europe. According to the U.S. Department of Energy, this was the first time that a supply disruption from Russia affected flows to Europe.
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has, however, been amended several times since then. In 2005 the Kremlin submitted to the Duma a new subsoil lawthe Draft Lawthat merely legally enforces what has already been in practice for several years. The major issue that concerns international oil companies (TNK-BP in this case) is the clause on foreign ownership and strategic resources. According to the new law, no foreign entity can have controlling stakes (over 50% plus one share) in any of Russias strategic resources. The Draft Law defines as strategic (1) various rare resources such as diamonds, uranium, or quartz; (2) deposits from any oil field containing over one billion barrels or any gas field containing over one trillion cubic meters of gas; and (3) any reserve in close proximity to a military base.60 With two trillion cubic meters of gas, Kovykta is deemed a strategic resource. As stipulated in the law, neither Gazprom nor the government could strip any foreign owners of their assets if a license or production-sharing agreement (PSA) was conducted before the amendments to the law came into effect. Aware that TNK-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 China and East Asia and even the construction of an integrated oil and gas supply, storage, and transition system that would tie together all of the countrys major fields for export to Asia and beyond. In an energy strategy document the Russian Ministry of Energy outlines the countrys far-reaching goals to take over 25% of Northeast Asias gas market before 2020.61 Russia has no pipelines in the region, however, and until recently Gazprom has had no major stakes in any of the key fields in East Siberia and the Russian Far East. As such, Gazprom has begun to force its way into all of the major oil and gas fields in the region; using environmental NGOs and the Ministry of Natural Resources to soften up the international oil companies (IOC), Gazprom has managed to get in on favorable terms. Gazprom is in essence expropriating these fields with a nominal financial recompense.62 This use of strong-arm tactics by Gazprom shows that Russia is bent only on controlling these last strategic resources on the countrys frontier, not on controlling the actual
60 Josefson, Policy Challenges, 1045. 61 The Summary of the Energy Strategy of Russia for the Period of up to 2020, Ministry of Energy
of the Russian Federation, (Moscow 2003), 12 u http://ec.europa.eu/energy/russia/events/ doc/2003_strategy_2020_en.pdf.
62 KovyktaWhy Not Call It Expropriation, Energy Economist, no. 309 (July 2007): 3.
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means of 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 of the Russia-China border over the Altai (or Altay) mountain range. According to Russia, the Altai pipeline is to be the first of two potential pipelines to China. Altai gas would come from fields in Western Siberia and connect with Chinas West-East pipeline, which carries gas from fields in Xinjiang to markets in Shanghai. Notable, however, is that the Altai pipeline proposal was set forth shortly after the Ukrainian gas price debaclewhich temporarily halted gas exports to many European countrieswhen European policymakers began discussing diversifying 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 from Europe to other markets should Moscow choose to do so. Moreover, political leaders in the Republic of Altai have expressed fears that Chinese labor could expand Chinas influence and presence in the region. 63 Chayandau With gas reserves of 1.2 trillion cubic meters, the Chayandinskoye (Chayanda) field in Yakutia (like Kovykta) was officially deemed strategic in 2005. Although Chayanda contains only approximately half as much gas as Kovykta and is far behind Kovykta in the development process, Russia seems determined to develop this field before Kovykta. The Sakha government has held several meetings with representatives from China and South Korea over future exports. In an effort to undermine Kovykta, the Republic of Sakha formed a strategic alliance with Gazprom in 2002 and began promoting the development and export of Chayanda gas. For Gazprom, the Chayanda field represented a timely and strategic potential investment. Chayanda was in fact one of the only major fields in Russias eastern frontier that was not operated by international oil companies. Gazprom could thus
63 Altai Community Approves Gas Pipeline Construction to China Following Harsh Argument,
Republic of Altai u http://eng.altai-republic.ru/modules.php?op=modload&name=News&file=arti cle&sid=597.
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use the threat of Chayanda exports to bypass TNK-BPs export plan.64 There have even been reports of Russia offering China 10% of Sakha reserves free of charge if China were to commit to early development of the field.65 In 2003 the Kremlin held a cabinet meeting to discuss the concept of a unified pipeline system in Eastern Siberia and the Far East. This concept envisioned a pipeline network connecting all the major eastern gas fields Tomsk (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 of plans. Since Kovykta was at that time majority owned by TNK-BP, Gazprom viewed Kovykta exports as endangering not only the merit of the other fields in the region but also the potential company and state revenues that could be gained from Chayanda. 66 Since gaining control of Kovykta, however, Gazproms tone has changed. Kovykta will be included in this proposed pipeline system, though the time line is for 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 of Natural Resources to receive a production license for the Chayandinskoye field without having to compete with other companies in an open auction. Looking at Gazproms record, it will be surprising if the company fails to take over this project. Sakhalinu To date Sakhalin has been the most successful of the oil and gas fields in eastern Russia. Sakhalins success is largely due to fact that for the most part foreign oil companies have undergone the exploration, production, and development of these fields, which are protected under a PSA.67 Because 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 if not involved. Sakhalin also represents a good opportunity for Gazprom to begin
64 Jonathan Stern, The Future of Russian Gas and Gazprom (Oxford: Oxford Institute for Energy
Studies, 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 of the tax structures and PSA arrangements of the Sakhalin projects, see
Judith Thornton, Sakhalin Energy, Comparative Economic Studies 43, no. 4 (Winter 2001): 932. For a good comparative overview of energy fiscal regimes, see David Johnston, Petroleum Fiscal Systems: Royalty/Tax 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 safer than cross-border pipelines, given that LNG can more easily avoid being trapped in a monopsony. Of the six Sakhalin projects Sakhalin-1 and -2 have the greatest production potential and have moved along the fastest. Though not yet exporting LNG, Sakhalin-2 has already committed all of the projects future LNG exports.68 After months of 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 for $7.45 billion in December 2006. Not surprisingly Gazprom ceased accusations over the projects negative environmental impacts after the takeover. Exxon operates Sakhalin-1 and for years has had plans to build a pipeline to China. In 2006 Exxon signed an agreement with CNPC to supply China with 8 bcm of gas. Sakhalin-1 is currently the only PSA project outside Gazproms control, and Exxons unilateral export of this gas could potentially undermine Gazproms price negotiations with China over gas supply from any field. Gazprom has therefore severely criticized Exxons plan, claiming that the company will buy all future gas production from the consortium to supply the domestic market in the Khabarovsk and Primorye regions.
future outlook
Gazproms consolidation of 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 of gas to both China and South Korea. As a result of Gazproms aggressive behavior in eastern Russia and threats to target proposed gas for domestic use, Northeast Asian countries have been turning elsewhere for gas supplies. China in particular is hedging its bets by looking to Turkmenistan and Myanmar for pipeline gas and to Australia for LNG. Turkmenistan is vitally important to Russia, which is dependent on Turkmen gas imports to meet European export obligations. That China has approached Turkmenistan could set a negative tone for any Russian-Chinese gas discussions.69 China has also been courting Myanmar,
68 Of the total supplies 2% are being retained for operational flexibility. See Michael Bradshaw,
Sakhalin-2 in the Firing Line: Environmental Protection or Administrative Leverage, Pacific Russia 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 of 16 bcm per year. The deal is geopolitically strategic in nature for 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 from Myanmar to Kunming would also establish the groundwork for building additional oil pipelines that would allow Chinas imports to bypass the Malacca Strait. Although Gazproms takeover of the project in the summer of 2007 could in theory expedite the development of 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 with Northeast Asia, as countries from the region can no longer negotiate with the international oil companies to get a lower price. The future of Kovykta, therefore, now depends both on the resolution of price negotiations between Russia and China and on Gazproms ability to successfully finance and operate several new projects simultaneously in eastern Russia. Even if China and Russia should reach a price agreement will Gazprom be able to competently finance, operate, and manage all of these new projects? Gazprom is among the worlds least efficient energy companies; the company uses export earnings to subsidize loss-incurring domestic sales at only approximately 20% of world market prices. Although Gazprom has access to foreign lending to fund its capital expenditure, the companys investment plans are affected by high levels of debt and continued uncertainty about gas market reform. The government hopes that by removing the ring-fencelimiting foreign share ownership in the companyGazprom will be better positioned to raise much-needed investment capital. Foreign banks have, however, been slow to come forward with funding for Gazprom lately. The European Bank for Reconstruction and Development, for instance, pulled out of negotiations on providing $600 million worth of funding Sakhalin-2 after Gazprom took control of 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 fewer places to turn for new investments, Gazprom will nevertheless need to rely on the technology and management skills of these IOCs to
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effectively develop and export Eastern Siberian and Russian Far Eastern gas. As a notable observer of 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 from the fact that Gazprom revises its investment program several times per year, Gazprom evidently has few strategies or plans to deliver such skills. Political expediency has thus far dictated Gazproms export policy. Although some foreign investors remain in Russia, the IOCs will likely reassess political and commercial risk at some point, which may have consequences for any future investment. With Gazproms attention on Sakhalin and further European expansion, for the foreseeable future Kovykta will likely either sit idly or be used to supply the domestic market. Though neither option may be the most attractive for Gazprom, the company can afford to allow either to happen in this high-price environment. Both of these scenarios present formidable implications for 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. If Russias giant gas fields are not permitted significant market outlets in Asia, global supply will fall, thus effectively keeping gas prices higher than they would be otherwise. The fate of Kovykta therefore has direct energy security implications for the United States. As seen through its recent Australian deal, China is turning toward LNG rather than waiting for the Kovykta pipeline issue to be resolved. Increasingly China, South Korea, and Japan will look further west of the Malacca Strait for 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 for new supplies may also give further impetus to perceptions of energy insecurity among the consumers. Although competition is indeed a positive factor in the energy industry, in an environment of high prices and limited supplies company-level competition can quickly turn into state-level competition, especially given the growing perception that many oil companies are partially controlled by their home governments. In the absence of Russian gas supplies, China, Japan, and South Korea may decide to increase diplomatic and strategic ties with many of the gas-producing countries that the United States deems unsavory particularly Iran and Myanmar. Therefore, should Russia increase supplies to Northeast Asian markets not only will those consumers directly benefit but the United States will indirectly benefit from declining prices, easing anxiety
70 Michael Bradshaw, Striking a New Deal: Cooperation Remains Essential, Pacific Russia
Information Group, Pacific Russia Oil and Gas Report, Summer 2007, 14.
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over supply security, and softening (potentially) greater strategic ties between Northeast Asian states and problem gas-producers. To paraphrase Daniel Yergin, the largest obstacles to the development of new supplies are not the factors below ground, such as geology, but are rather factors above ground, such as international affairs, politics, and investment.71 The Kovykta pipeline is merely a microcosm of the major energy issues entrenched in the region. Kovykta or any other trans-border project in the Russian Far East will not materialize unless such projects are actively supported by favorable domestic and international policies. Regional long-term gas deals also require competent corporate management, contract sanctity, and adequate and secure financing. Most of these necessities are, however, far from being in place in Russias Far East.
71 Daniel Yergin, Ensuring Energy Security, Foreign Affairs (March/April 2006): 75.
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asia policy , number 5 ( january 2008 ) , 10540

Northeast Asias Kovykta Conundrum: A Decade of Promise and Peril

se hyun ahn is Assistant Professor at the Government and International

michael t. jones is a project manager at The National Bureau of Asian

keywords: northeast asia; natural resources; natural gas; oil;

ahn & jones northeast asias kovykta conundrum

the potential benefits of kovykta gas development

ahn & jones northeast asias kovykta conundrum

2 Kovykta Project, TNK-BP u http://www.tnk-bp.com/operations/exploration-production/

3 Ibid. 4 Gazprom Annual Report 2006, OAO Gazprom, 2006 u http://www.gazprom.com/documents/

South Koreas Looming LNG Supply Gap

ahn & jones northeast asias kovykta conundrum

figure 1 Share of South Koreas LNG Imports by Source, 19902020

Chinas Promise as a Gas Market

nuclear plant shutdown in Japan, and gas supply interruptions in Indonesia.

ahn & jones northeast asias kovykta conundrum

figure 2 South Koreas Growing Gas Supply-Demand Gap

Demand Supply gap Supply contracts

14 BP Statistical Review of World Energy 2006.

the fight for kovykta

ahn & jones northeast asias kovykta conundrum

figure 3 Projections of Chinas Gas Demand

250 Billion cubic meters

200 APERC (153) EIA (134) IEA (107)

The Five-Country Feasibility Study (19962000)

Union, July 18, 1997.

ahn & jones northeast asias kovykta conundrum

The Three-Country Feasibility Study (200003)

March 15, 2002.

Oil and Gas, no. 4 (2003): 4245.

ahn & jones northeast asias kovykta conundrum

figure 4 Kovyktas Proposed Pipelines

Kovykta Gas Field Irkutsk Manzhouli

Daqing Harbin Changchun Beijing Nakhodka

Gazproms Strong-arm (2004Present)

MayJune 2004 u http://www.koreafocus.or.kr/essays/view.asp?volume_id=34&content_id=8& category=G. January 29, 2004.

January 29, 2004.

Institute for Public Policy, Rice University, October 2004, 11.

26, 2005 u http://www.caijing.com.cn/newcn/English/Industry/2005-10-03/13870.shtml.

ahn & jones northeast asias kovykta conundrum

obstacles to the development of the kovykta gas pipeline

Transit Country Problems

Table 1 Historical Changes in Routes, Ownership, Costs, and Reserves of Kovykta

Projected costs (b) $57

Estimated reserves (bcm)

TNK-BP, 62% Interros, 26% Irkutsk regional administration, 11%

Gazprom, 62% Interros, 26% Irkutsk regional administration, 11%

ahn & jones northeast asias kovykta conundrum

Complexities of Gas Investments

ahn & jones northeast asias kovykta conundrum

Money Conference, London, September 18 19, 2006).

Demand Security and Pricing

ahn & jones northeast asias kovykta conundrum

no. 6 (February 8, 1999): 2327.

2006, 4546 u http://www.eia.doe.gov/oiaf/ieo/pdf/0484(2006).pdf. 26, 2007.

ahn & jones northeast asias kovykta conundrum

russias resource renationalization

figure 5 Distribution of Russias Oil and Gas Production, 19912006

91 993 995 997 999 001 003 005 1 1 1 1 2 2 2

91 993 995 997 999 001 003 005 1 1 1 1 2 2 2

Source: BP Statistical Review of World Energy 2007.

Administration, 2007 u www.eia.doe.gov.

ahn & jones northeast asias kovykta conundrum