By Michael J. Economides and Nicholas Mitsos

Russian involvement in natural gas developments in the eastern Mediterranean is motivated by more than a desire for profit or the pursuit of political ends.  It is also a defensive action to protect Russia’s national income from competitive supplies of natural gas from new prospective exporters into Europe.

Russia depends on oil and natural gas revenues for at least 70% and perhaps 80% of its federal budget.  This causes the Russian government to be vulnerable to declines in international oil and gas prices, to international competition for oil and gas sales, and to disruptions or complications relating to its domestic production and processing.

In 2013, regarding natural gas it will export to Europe, Russia anticipates a price decline from $11.33 per Mscf (thousand cubic feet) to $10.50/Mscf.  Russia exports about 5 Tcf per year to Europe, so this price decrease will lower Russia’s annual export revenues by over $4.5 billion, or 1.25% of Russia’s $360 billion total federal budget.  Russia is also vulnerable to oil price declines; for every $1 per bbl decline in oil prices, Russia’s export revenue falls by 0.7%.

Discoveries of large quantities of natural gas in offshore Israel and Cyprus, and the likely discoveries of deposits in offshore Greece, present the most obvious direct threat to Russian federal receipts, because the most likely market for this gas is Europe.  Gas production in Norway, the second largest exporter of gas into Europe, is gradually declining as its fields mature.  With regard to natural gas from Iraq, Iran and the Caspian, the Nabucco pipeline to deliver this gas to Europe may never be built.  Due to the membership of Cyprus and Greece in the Eurozone and to the enormity of their probable reserves, it is in Russia’s national interest to seek to participate in developments there – but not in ways to promote maximum production quickly.

The financial rationale is simple.  When Russia exports gas from its domestic fields, it receives 100% of the revenue.  But if Russia produces and exports gas from foreign blocks, at best it can expect to receive 30% of revenues in standard production sharing agreements. Furthermore, adding new supplies of natural gas into the European system will harm Russian income.  As the recent experience of the US with shale gas shows, gas demand in the medium term is inelastic so that increases in supply cause sharp price declines.

If Cyprus were to construct three LNG trains for exporting 20 million metric tons (MT) per year to Europe, this would equal 20% of Russia’s current total exports to Europe, which would be sufficient to lower gas prices.  Greece has the possibility of developing its natural gas fields and exporting even more gas than Cyprus into Europe via pipeline, further driving down gas prices and Russian export revenues.

Russian officials no doubt were aware of these realities when the Greek government recently conducted a bidding round to sell its controlling interest in DEPA, the national gas company.  DEPA owns and operates the gas pipeline bringing gas to Greece from Russia.  Although DEPA attracted no major Western European bidders, it did get a bid from Gazprom.  It is obvious that if Gazprom wins control of this pipeline, Gazprom will be uncooperative if and when the pipeline flow should be reversed to sell Greek natural gas into the European grid.

In Cyprus last month, a Russian company was selected by the Cypriot cabinet as part of the winning bidders for Block 9, even though the bid was ranked fourth by the evaluation committee.  There were allegations in the press that this award was motivated by a desire of Cyprus’s President to secure for the country a desperately needed €1 billion loan from Russia in advance of the national elections in early 2013.  Subsequently this bid was abandoned, for unclear reasons.  But the pattern seems to be that Russian generosity to the Cypriot government has an implicit quid pro quo involving natural gas.

It is clear that if oil and gas prices fall from recent levels, the Russian government will be forced to run larger budget deficits.  It is not a simple matter for Russia to make up a revenue shortfall by exploiting new domestic deposits because they mostly are in or near the Arctic.  Drilling for oil and gas in blizzards is not simple or cheap.

It is not in Russia’s national interest for its government to help Greece and Cyprus become significant exporters of natural gas.  The governments of the eastern Mediterranean should be mindful of this reality as they seek partners to develop their game-changing hydrocarbon resources.

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