Western Sanctions on Russia May Crimp China Gas Deal

An analysis by Michael Lelyveld
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China's President Xi Jinping (R) and Russia's President Vladimir Putin attend the giant energy agreement signing ceremony in Shanghai, May 21, 2014.

Western sanctions on Russia could stall its plans to export natural gas to China, energy analysts say.

Sectoral sanctions imposed by the United States and the European Union over the Ukraine crisis have specifically targeted equipment for Russian oil projects and exploration, reflecting concerns about EU reliance on Russian gas.

But some spillover seems likely in the gas sector, which uses some of the same technologies, materials and services as oil development.

Despite the effort to exempt gas, the restrictions "could lead to complications because in many cases oil and gas are produced with much of the same equipment and from the same locations," The New York Times reported on July 30.

Both the U.S. and EU sanctions focus on offshore oil exploration and production, arctic projects and oil extraction from shale. But the overlap with equipment or technology needed for gas development may be difficult to define.

"The big question is going to be where they draw the line," said Michael Levi, senior fellow for energy and environment at the Council on Foreign Relations in New York. "I don't know how they're going to do that. I think that's really to be determined," he said.

Any additional hurdles for Russia could complicate already difficult efforts to develop East Siberian resources for gas exports to China.

In May, Russia's monopoly Gazprom signed a 30-year export agreement with state-owned China National Petroleum Corp. (CNPC), pledging annual deliveries of 38 billion cubic meters (1.3 trillion cubic feet) of gas starting in 2019.

The U.S. $400-billion (2.4-trillion yuan) deal has been seen as a financial lifeline for Russia as it faces growing resistance in Europe since the annexation of Crimea in March.

But effective bans on western oil exploration and production technologies like horizontal drilling and hydraulic fracturing, or fracking, for sanctioned purposes could raise the bar for East Siberian development.

Highly prized

Some items on the sanctions lists of modern equipment and materials have become more widely available on international markets, but U.S. exploration expertise and oilfield services remain highly prized.

"Both the drilling technology, the special muds, the technology for fracturing those shales and bringing it back up -- all that was invented by U.S. companies and U.S. technology," said David Goldwyn, a former State Department official and president of Goldwyn Global Strategies, in a National Public Radio interview.

Much depends on how sanctions are interpreted and enforced, and how western exporters of equipment and technology react to diversion risks.

One sensitive use of horizontal drilling could affect Gazprom's ability to meet its commitment for supplying gas to China through its planned 4,000-kilometer (2,485-mile) Power of Siberia Pipeline.

Just days before the sectoral sanctions were announced, Gazprom disclosed that it may need to use horizontal drilling on the banks of the Amur River on the border with China to avoid unacceptable environmental damage from the pipeline's river crossing. The waterway is known as the Heilong Jiang River on the Chinese side.

"Gazprom would like to avoid building trenches to cross the river, a method that usually causes great harm to the environment," Interfax reported, citing the company's engineering subsidiary VNIPIgazodobycha.


It is unclear whether Russia would be able to accomplish a major horizontal drilling project without U.S. equipment or technology.

"My guess is no," Levi said.

Under terms of the U.S. sanctions, exporters of horizontal drilling equipment for the project could be held liable if materials are diverted for other purposes, such as shale or deepwater oil development.

The Commerce Department rule imposes controls on "the export, reexport of transfer" of items when the supplier "knows or is informed" they will be used "directly or indirectly" for controlled purposes, "or is unable to determine whether the item will be used in such projects in Russia."

The "catch-all" language could convince exporters to stay away.

In addition, the regulation requires individual export license reviews for items that have "the potential to produce (either) oil or gas," although only items for oil production appear to be subject to a "presumption of denial," imposing an effective ban.

The reviews could at least discourage exports for arctic and offshore gas development. Although supplies for the China pipeline are expected to come mainly from onshore fields, obstacles to Russian production from other sources could raise the stakes for making the China deal work.

Too early to assess

Edward Chow, senior fellow in the energy and national security program at the Center for Strategic and International Studies in Washington, said it may be too early to assess the effect of export curbs on the China pipeline.

"The Russia-China gas pipeline is too uncertain yet and too far off still, so for me it depends on the duration of the sanctions," said Chow.

But international financial sanctions and borrowing restrictions may raise Russia's costs in any case.

"The Power of Siberia project will already be impacted by Gazprom's increased cost of capital and reduced capacity to borrow externally," Chow said.

The EU's attempt to single out oil development seems ineffective, he added, since Russia could simply "start describing every petroleum project as gas."

A more immediate threat to China's interests may come from sanctions on independent Russian gas producer Novatek, which plans to sell liquefied natural gas (LNG) to China from its arctic Yamal Peninsula field, Chow suggested.

"Yes, we need U.S. technology," said Yves-Louis Darricarrere, head of exploration and production at France's Total oil company, in a Financial Times interview in June. "That's why we need cooperation, not confrontation."

Novatek, Total and CNPC are partners in the complex U.S. $26.9-billion (166-billion yuan) Yamal project, which plans to supply 3 million tons of LNG to China annually for 20 years.

CNPC acquired 20 percent of the venture in January. First production has been scheduled for 2017.

Financial sanctions

But the U.S. Treasury Department slapped financial sanctions on Novatek on July 16, narrowing its access to capital markets.

The new round of sectoral sanctions may be seen as raising risks for Yamal LNG further, although Novatek initially insisted that the sanctions would not affect the "planned pace" of its projects.

On July 31, Novatek CEO Leonid Mikhelson sounded more cautious in comments reported by Interfax.

"Together with partners, we are now analyzing the effect of imposed sanctions on the realization of the project, and we believe we'll be in the position to carry out the schedule approved for the project," Mikhelson said.

The project had planned to finance 70 percent of its costs with borrowing, according to Interfax. "We are now reviewing more pessimistic plans," Mikhelson said.


Complications may also arise because of differences in the sanctions issued by the EU Council on July 31 and by the U.S. Commerce Department on August 1.

The EU curbs exempt exports required under contracts signed before July 30, but the U.S. sanctions do not appear to provide any similar exclusions.

Non-U.S. exports to Russia could also be affected by content restrictions, known as the "de minimis" rule, which can apply U.S. controls if the value of U.S. content exceeds 25 percent.

Officials at the Commerce Department Bureau of Industry and Security (BIS), which administers the export controls, were not available to comment on how the sanctions would be applied.

Application could be crucial for complex projects like LNG production or horizontal drilling, which may rely in part on U.S.-origin components and technology.

A larger policy question is whether Russia's energy deals with China will be seen as giving Moscow an escape hatch to make the current sanctions ineffective, creating pressure for tougher enforcement or more sectoral curbs.

Supply target up

Michael Herberg, energy security research director at the Seattle-based National Bureau of Asian Research, said China recently raised its annual gas supply target for 2020 substantially to 420 billion cubic meters (1.5 trillion cubic feet).

The previous consumption estimate was 350 billion cubic meters (1.2 trillion cubic feet). The increase means that China will try to boost its gas imports from Central Asia if Russia faces problems with deliveries, Herberg said.

Russia's recent success in concluding gas deals with China may not be as complete as first thought.

For the past month, reports have been circulating that the widely publicized U.S. $400-billion gas deal between Gazprom and CNPC was not a contract, as Russia claimed in May, but only another in a long series of preliminary agreements. One sign is that the issue of a U.S. $25-billion (154-billion yuan) prepayment from China remains unsettled.

"I think the Chinese were willing to sign the rough outlines of this deal and see if the Russians really build that Power of Siberia pipeline and really commit the investments needed to do it," said Herberg.

The wait-and-see status of the project may make Russia more responsive to sectoral sanctions than Kremlin statements suggest.

But obstacles to completing the project could also make the Kremlin more desperate.

"This would certainly be something that the Chinese would be very unhappy about. The Russians obviously would be extremely unhappy about it," Herberg said.


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