Russian natural gas supplies make up 25 percent of Europe's total imports and 40 percent of the European Union's imports. In 2011, Russia exported 150 billion cubic meters (bcm) of natural gas to Europe, generating some 80 percent of Russian natural gas giant Gazprom's revenues. Europe's dependence on Russian energy supplies over the years has allowed Moscow to raise its natural gas prices from the low $300s per thousand cubic meters (mcm) on average during the mid-2000s to between $450 and $550 per mcm in recent years. The importance of Russian energy to European customers has also given Moscow political leverage, since it has shown in its past willingness to cut supplies for political or security reasons.
Although Russia has been the dominant partner in its energy relationship with Europe for years, Moscow is now concerned that its natural gas could become uncompetitive amid increasing alternative supplies, such as liquefied natural gas (LNG) from other exporters such as Qatar. Russia wants to lock many of its key natural gas customers into long-term contracts that assure a certain level of exports at a given price. But to do this, Moscow has had to back away from its aggressive pricing and contract structure with those customers.
Russia has already lowered its prices for Italy's ENI and France's Gaz de France, which signed 10-year agreements with Moscow in early 2012. The contracts are renegotiated every three years and include discounts of between 2 and 10 percent.
But deals with France and Italy are small in comparison to a contract with Germany, because Germany is Russia's largest natural gas export customer — it imported approximately 30 bcm of Russian natural gas in 2011. Moreover, Moscow sees Berlin as its premier strategic partner on the Continent. Of all its relationships in Europe, Russia's ties with Germany have received the most attention from the Kremlin. Moscow's desire to solidify its relationship with Berlin led Russia to complete the Nord Stream pipeline (costing approximately $17 billion) in 2011, directly connecting Russia to Germany via the Baltic Sea.
Russia gave Germany's E.On and RWE short-term price breaks that began in March while Gazprom was negotiating the long-term contract with E.On. Under the July 3 agreement, E.On will receive a 10 percent discount on top of its temporary discount and enter into a 15-year contract at the current supply volume. The agreement retroactively adopts the pricing condition to the fourth quarter of 2010, includes the option of renegotiating every three years, and requires E.On to drop its international arbitration against Gazprom over natural gas pricing. This means the companies can move forward on other joint projects, such as the construction of natural gas power plants in Germany.
Germany's main demand in its new contract with Gazprom was for Russia to stop indexing a percentage of its natural gas price to oil prices — a practice that created higher and more volatile prices — and Russia agreed to raise the percentage of the natural gas price indexed to less price-volatile commodities, dropping oil indexing for most of its supplies to Germany. This is a compromise for Moscow, which has indexed its natural gas prices to oil for approximately 40 years, though it has not gone so far as to index its prices to spot global market natural gas prices.
Other European natural gas consumers' reactions to the E.On-Gazprom deal will be worth watching. Gazprom is currently negotiating natural gas prices with Poland's PGNiG. Poland already pays one of the highest prices for Russian natural gas — $550 per mcm, compared to the European average of $450 per mcm. Poland is not one of Russia's major consumers, like Germany, and only imports approximately 10 bcm annually. However, that amount accounts for 70 percent of Poland's natural gas demands, and it is expected to increase its use of natural gas over the next decade as it moves away from coal as the base of its energy production.
The talks between PGNiG and Gazprom were initially expected to end July 1, but they seem to have been extended after it became clear that Germany was getting a better deal than other European consumers. Polish media now claims that PGNiG wants a 20 percent discount for Russian natural gas. Russia could start offering such price cuts to other consumers, though it would want concessions in return. For Moscow, the most important concessions it could gain would be long-term contracts with these countries that guarantee Gazprom a significant market presence for years to come and allow it to maintain its strong position in Europe's energy market.
