China and Russia Gas Trade: Is There a Common Ground ?

Chi Zhang, Vladimir DrebentsovNew Delhi, November 21, 2008

Content

Introduction and summary of conclusions

Overview of market trends

Future gas demand and supply

Russia’s plans for developing gas supply in Eastern Siberia and the Far East

Central Asian gas, where will it go?

Pricing issues in China and Russia

Is there opportunity for Russian gas in China?

Introduction and summary of conclusions

Key issue: What will feed growing demand

China’s natural gas consumption growth stronger than expected, promoted by

− Rapid economic growth

− Cheap natural gas price

− Environmental concerns

− Government strategy for increasing gas penetration

− Major supply hike is required to meet expected demand growth:

− Indigenous

− Imports: LNG, pipeline gas

Difficult negotiations to bring stranded Russian gas to China via pipelines:

−Original plans: 68 bcma export to China by 2020

−West Siberia (2011), East Siberia (2016)

−Yet there is no agreement on price:

−Russia wants market price for its gas (LNG price or the price Europe pays)

−China considers that price non-competitive

•There is more progress in bringing Central Asian gas to China

Bilateral history: Long and protracted negotiations

Sticking questions

−Will China really have huge demand growth, as projected, and what price levels will support high growth?

−Given “market demand” and alternative import options, is Russian gas competitive?

China’s natural gas demand will remain price sensitive. Gas prices are regulated, and in many regions are lower for residential and commercial consumers than those actually paid for imported LNG.

If market prices are introduced, gas consumption, particularly by power generators, will depend on policy support (subsidy)

The main risk is that the actual gap between domestic demand and supply may be much smaller than currently assumed, if government allows market pricing

Chinese gas market is likely to remain compartmentalized with low-income consumers supplied from domestic sources

In either current or market environment, Russian gas will likely be able to compete only with LNG, and/or in major industrial centers where economics/geography may favor Russian gas over Central Asian supplies

Key findings

Overview of market trends

0

10

20

30

40

50

60

70

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

-0.5

4.5

9.5

14.5

19.5Consumption (lhs)

Growth rate (rhs)

Fast consumption growth,enabled by increase in domestic supply

bcm

Source: IAEA and EcoWin

%

3%7%

20%

70%

In spite of impressive growth, China’s gas market is still in its infancy, what will future hold?

3% 3%

20%

73%

2007 Energy consumption

Primary Power

Coal

Natural gas

Oil

1980 Energy consumption

Coal

Primary powerNatural gas

Oil

0

10

20

30

40

50

60

1995 2000 2003 2006

Consumption by Sector

EU

EU

bcm

Residentialfuel

Industrialfeedstock

Industrialfuel

Oil production

Power gen.Rest

Current policy: End-users are prioritized

Priority Residential sector

Encouraged Industrial fuel for high value- added production and reduction of environmental impact (glass, porcelain)

Restricted Power generation

Forbidden Chemical feed stock (methanol, DME)

0

10

20

30

40

50

60

1995 2000 2006

Consumption by region: Most gas is used in producing provinces

EU

NE China

bcm

North China

East China

South China

Resourceprovinces

Central China

West China

Demand and supply projections

Domestic supply

LNG import

Demand to be met by PNG

0

40

80

120

160

200

240

280

320

2005 2008 2011 2014 2017 2020

Bcm

Expected demand by sector in 2020

bcm

Domestic supply 200

Total demand 302

Industrial fuel 150 Compete against oil products

Residential 60 Compete against LPG

Transportation 20

Industrial feedstock 20 Not compete against coal

Power generation 52 Not compete against coal, nuclear

Source: CERA

Rapid growth backed by new discoveries and increased proven reserves (3.7 Tcm increase in 10 years to reach 5.36 Tcm in 2006)

Infrastructure developments: existing pipelines (West-to-East 1; Shanxi-to-Beijing); planned pipelines (West-to-East 2; Sichuan-to-Shanghai); new LNG liquefaction terminals (Sichuan) – for domestic shipments by road transport

Import LNG projects underway, mostly for Eastern and Southern China markets

− LNG (1 bcma)

− Competes when alternatives are oil based products and LPG

− Competes when end-users include residential customers

− Does not compete when end-users are large power generators

− Pipeline (70 bcma by 2015)

− Import deals signed with Kazakhstan and Turkmenistan (40 bcma)

− MoU on Russian gas (30 bcma from Far Eats by 2015, as Russia abandoned Altaj pipeline)

Natural gas supply potential

Possible import pipeline options for China

China

Mongolia

North Korea

SouthKorea

AralSea

India

Iran

Kyrgyzstan

Kazakhstan

Russia

SakhalinIsland

LakeBaikal

BeijingSeoul

Dauletabad

ArabianSea

PacificOcean

Kovykta

Proposed GasPipeline Routes

Astana

Almaty

Pakistan

Shurtan

Tashkent

Samarkand

Shymkent

Bishkek

Urumqi

Alashankou

AtasuZhanazholAtyrau

Novokuznetsk

Parabel

Kemerovo

KazachinskoyeFrom W. Siberia

Tynda

Komsomolsk

Khabarovsk

Harbin

Shanghai

Russia’s plans for developing gas supply in Eastern Siberia and the Far East

Originally Russia was envisaging supplying gas to China from West and East Siberia and the Far East via two pipelines (Altaj and Pacific) and as LNG (from Sakhalin and Vladivostok area)

In Gazprom’s General Scheme of Development to 2030, Russia has recently focused its targeting of China’s market (North-East and Central provinces, bay of Bohai area), and abandoned Altaj pipeline to save West Siberian gas for domestic and European destinations

The General scheme envisages deliveries of pipeline gas to China and South Korea commencing only by 2020. And the projected range is broad; 25050 bcma

Russia has recently committed 10 bcma to South Korea for 30 years beginning in 2015. The new pipeline will go South from the Vladivostok area (either via North Korea or via the sea)

Hence Russia is prepared to commit 15 to 40 bcma of pipeline gas to China

Additionally Russia will offer LNG from new trains in the Far East

Russia’s plans for developing gas supply in Asia-Pacific

Central Asian gas, where will it go?

There are various plans for shipping Turkmen gas West- and Northbound (currently there is only 40 bcma Northbound exports via/to Russia, and 10-14 bcma Southbound exports to Iran). Yet among new routes, there is more progress on Eastbound routes

Turkmenistan has committed 30 bcma of gas to China via Turkmenistan-Kazakhstan-China pipeline, construction of which has already commenced (First stage shall be launched in 2009, with full capacity reached in 2011). The pipeline will source West-to-East 2 pipeline

Kazakhstan has committed 5-10 bcma from Urikhtau field (developed jointly by KazMunaiGaz and CNPC) and 5 bcma from Aktobe field (developed by CNPC) via Kazakhstan-China pipeline (10 bcma, with potential expansion to 15 bcma)

China and Turkmenistan agreed on $195/mcm (likely to be the same for Kazakh gas). Hence China will be getting 40 bcma of imported gas for below $200/mcm

Central Asian gas going eastbound

Pricing issues in China and Russia

Regulated natural gas price

Upstream price is low for indigenous gas, lower than price of imported natural gas

Retail price are high for consumers, higher than competing fuels

−Twice as expensive as syngas in Shanghai

−More than double the wholesale price for residential and industrial users

−Much more expensive than coal for power producers

Domestic gas pricing

Approval from NDRC Approval from local price bureau

Upstream/Exploration

Midstream/Transport

Downstream/Distribution

Wellhead price

Transport. price

Cost Plus Pricing

End user tariff

Distribution cost + margin

Gas price regulation

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10

12

WEP citygate

Industryfuel

ResidentialPower gen

Shanghai gas prices

$/MMBtu$/MMBtu

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10

12

LNG SichuanPNG

WEP 1PNG

OffshorePNG

City Gate Retail

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3

6

9

12

15

Shenzhenspot

Industryfuel

ResidentialPower gen0

2

4

6

8

10

ShenzhenContract

Shenzhen Spot

Guangdong gas prices

$/MMBtu$/MMBtu

City Gate Shenzhen

At market price, gas-fired power generation can be limited without policy support; demand may also be smaller from other sectors

The supply gap may be smaller than expected, and be filled without the need for a second pipeline, perhaps until after 2020

Market Demand will be price sensitive

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Nuclear Coal Gas Wind Oil

Guangdong power on-grid tariff (gas at 5.83/MMBtu)

$/MWh

Market pricing reform with ultimate goal of integration of domestic with international gas markets

Government is committed to market based pricing, but also with some social economic constraints

LNG and international fuel prices effectively become benchmark for new domestic supplies

Gas pricing may change

European markets (primarily in Germany, France and Italy) are key for Russian gas exports, absorbing ca 150 bcma in 2007 (total Russia’s gas exports were 180 bcma). European contracts are long-term and oil-indexed (with a 9 month lag). In the fourth quarter of 2008, an average price for Russian gas in Europe will be $500/mcm (yielding Russian netback of close to $400/mcm).

In spite of EU’s desire to diversify gas imports, Russia will remain the key European supplier in the foreseeable future (Russia currently supplies 26% of European gas consumption)

Lower oil prices will mean lower European prices for Russian gas. Yet if the oil price does not average below $60/barrel for a prolonged period, netback for Russian gas sold in Europe is likely to remain around $100/mcm.

Russian domestic gas prices are envisaged to reach European netback level in/or after 201. Gazprom has recently requested that government introduces a guaranteed minimum domestic price of $80/mcm beginning in 2011

Gas pricing in Russia

Is there opportunity for Russian gas in China?

Price at the border

$/mcm LNG price formula based on JCC at $70/bbl with slope of 0.124

Transmission cost based on WEP !: CNY1 for 4,500 km within China

Exchange rate $1 = CNY 6.83

European parity price at Altai-China border:

Source: xyz energy

0

100

200

300

400

China LNG Vladivostokborder

netback

Europeanparity atborder

Russian pipeline gas may compete against LNG for market

Geography and government policy will be crucial factors determining whether Russian pipeline gas would be able to compete with other exporters of pipeline gas to China

If China’s gas demand does not exceed 200 bcma, there will be only very limited scope for Russian pipeline exports to China

Russian opportunity