RUSSIA - The Gas Market.

The state-controlled Gazprom has a monopoly over domestic gas market and exports, being Russia's largest earner of hard currency and its tax payments account for around 25% of federal tax income. Despite its enormous size and significance, however, Gazprom faces domestic regulation. By law, it must supply the gas to heat and power Russia's vast domestic market at government-regulated prices (about $28 per 1,000 CM), regardless of profitability. Domestic gas prices in Russia are a mere fraction of the EU market rate at which Russia's gas is sold.

A gap has opened between Gazprom's stagnant production and its growing commitments to internal and external consumers of its gas. The gap looms even wider between Gazprom's projected output in the years ahead and its multiplying offers to external customers for the same years, in addition to its internal supply obligations. Moscow has indirectly confirmed this situation in July but seems at a loss for a way to remedy the problem.

Anticipated by independent experts in the West and Russia but otherwise widely ignored, Gazprom's gas deficit by 2007 had become a reality. But Russia was able to hide it temporarily through imports of Central Asian gas, which it used partly for Russia's internal use and partly for re-export as "Russian" gas. This method no longer suffices to cover the deficit, as top officials in Moscow are forced to admit, albeit obliquely.

According to Gazprom CEO Alexei Miller on July 4, Russian gas output will remain constant 2009. In fact, output growth slowed down and stopped altogether after 2006. In 2006 gas output was 556 BCM/y, just 1 BCM more than in 2005. The output fell for the first time in 2007 to 548.5 BCM/y, or 1.3% less than in 2006. Miller attributed the fall to warm winter in Europe, but many said that was incorrect. This, however, could justify the decrease in exports but not in output, particularly considering Russia's fast-growing internal demand. Miller declined to forecast the output for 2008. Output projections envisage some 670 BCM/y to be extracted in Russia by 2020. Drafted in 2007, those projections may already have been over-taken by Gazprom's chronic under-investment in new major fields. Even if fulfilled, however, those projections would imply an output growth rate of 20% in a 12-year period, clearly below the growth rates in internal and external demand anticipated for the same period.

In 2007 Gazprom declined for the first time to set a target figure for gas production in the planning time-frame to 2011. Evidently it anticipated stagnant or declining output and wanted to delay admitting it publicly. The landmark year 2011 is when Russian internal prices for gas are scheduled to reach the level of Gazprom's netback prices in Europe (sale price minus transportation costs). Such equalisation is a center-piece in the proposed reform of Russia's energy sector and a political commitment to the EU within the energy dialogue.

Russia in 2007 adopted a four-year schedule for gradual implementation. Moscow, however, is back-tracking on that intention. On July 8 Miller and Putin confirmed on TV that the state would continue subsidising domestic gas consumption for an unspecified period after 2011 - many say the target date now is set for 2015. This announcement seems to cancel the annual increments which had been scheduled to bring the internal gas price to European netback levels. But the annual 25% price hikes remain in effect for industrial consumers, at least until further notice.

Cheap gas for the "social-communal sector" (households and municipalities) will therefore continue to encourage waste and discourage conservation. Subsidised gas is also an element in the authoritarian government's social contract with its subjects.

Putin on July 11 chaired an energy sector leadership conference in Severodvinsk, with the participation of petroleum (oil & gas) industry top management and relevant government ministers. Miller then reported two key facts: Russia's internal gas consumption was growing faster than the growth rate in Russia's contractual commitments for export. And, crucially, each one of those curves, internal and external obligations, was rising faster than Russia's gas output.

This statement clearly suggests Russia cannot keep up with either of the two demand curves, let alone with both, from Russia's internal production alone. And it suggests obliquely that Russia will hasten to absorb more Central Asian gas to cover at least part of the deficit. Faced with conflicting priorities, the leadership conference in Severodvinsk apparently opted to give priority to the internal market over exports.

The meeting focused on two internal priorities: expansion in gas deliveries to the electricity sector and "gasification" (i.e., building gas supply grids) in Russia's territories which are not connected to the central grid. But the vast "ungasified" territories necessitate capital expenditures to the detriment of investments in E&P. To offset the shortfalls in gas production, Moscow is pressuring oil companies to deliver associated gas from the oil wells.

At the Severodvinsk conference, Putin termed the flaring of gas at the well "a barbaric practice" and demanded that the gas be captured and used commercially. This is a chronic problem not only in Russia, but its scale there is unparalleled. A government programme now requires oil firms to capture and use 95% of the associated gas by 2011. Implementation, however, is lagging badly. According to Putin in Severodvinsk, the fall will be extended to 2012. The current, record-high oil and gas prices render that programme less prohibitive economically, but it could hardly resolve the growing problem of Russia's deficit of natural gas.