US-Russia Policy Hits European Energy Supply

Unilateral Sanctions as a Tool of US Russia Policy

Even during the Cold War, the US government relied primarily on unilateral eco­nomic sanctions to weaken the Soviet leadership in this conflict of systems. This sanctions policy started out as a strict uni­lateral export control regime for dual-use and military goods which, in coordination with the Western allies, eventually became a multilateral embargo. Washington also denied the Soviet Union and its successor, the Russian Federation, Most Favoured Nation status in bilateral trade relations between 1951 and 1992. Once the Cold War was over, the US government imposed unilateral sanctions on the now Russian defence firms for their exports to Iran, thereby excluding them selectively and temporarily from the US market. Since the end of 2012, the US government has re­fused to issue visas to Russian officials accused of human rights abuses and cor­ruption and has frozen their assets where they are under US jurisdiction.

The US government imposed far more extensive sanctions in March 2014 in re­sponse to the incorporation of the Black Sea peninsula of Crimea into the Russian Fed­eration in contravention of international law, as well as to Moscow’s destabilisation policy in eastern Ukraine. Initially, the US Departments of Commerce and State tightened export controls on dual-use and military goods, technology and services. At the same time, the Office of Foreign Assets Control (OFAC) within the US Department of the Treasury began listing Russian in­di­viduals and entities belonging to Presi­dent Vladimir Putin’s inner circle as Specially Designated Nationals (SDNs) and Blocked Persons. This measure allows any assets they own under US jurisdiction to be fro­zen. In addition, US persons are prohibited from entering into business relationships with those listed as SDNs. The prohibition is enforced under civil and criminal law and extends to entities that are more than 50 percent owned or controlled by listed Russian individuals or entities.

The reasons for being listed as an SDN are set out in four Executive Orders (E.O.) issued by President Obama between March and December 2014, and codified into law by Congress in August 2017. These include “asserting government authority over the Crimean region without the authorisation of the Ukrainian government, undermining democratic processes or institutions in Ukraine and threatening the peace, secu­rity, stability, sovereignty or territorial in­tegrity of Ukraine; and also misappropriat­­ing the state assets of Ukraine or of an eco­nomically significant entity in Ukraine” (E.O. 13,660). High-ranking members of the Russian government and their supporters (particularly the so-called oligarchs), but also persons active in the Russian defence sector (E.O. 13,661; 13,662) or trading and investing in Crimea (E.O. 13,685) can also be listed as SDNs.

The more than 30 unilateral US sanctions regimes that address, inter alia, the prolif­er­ation of weapons of mass destruction, trans­national crime and a series of state and non-state actors have repeatedly tar­geted Russian individuals, organisations and in­stitutions. Current listings were based on Russian activities in relation to certain states such as Syria, Iran and North Korea, as well as in connection with alleged cyber attacks and meddling in the 2016 US presi­dential election campaign. Once the US Department of State had determined that the Kremlin was involved in the poisoning of former Russian intelligence officer Sergei Skripal in the UK, Washington imposed further trade sanctions on Russia, the first wave of which came into force in August 2018.

Economic Impact

Since the current US sanctions are designed to complicate future oil and gas exploration and extraction for Russian companies, their impact on Russia’s current oil and natural gas production and energy exports has so far been rather minimal. However, they have dissuaded companies from investing in expensive projects and developing new large deposits, instead encouraging them to concentrate on boosting production from previously developed fields and re-opening small fields. As a result, current production and exports of crude oil and natural gas in­creased despite the sanctions.

The Yamal project, led by the Russian energy group Novatek and costing 27 bil­lion US dollars, extracts natural gas, transforms it into LNG and then exports it via the Arc­tic port of Sabetta in the east of the Yamal peninsula. Novatek, the China National Petroleum Corporation, the Silk Road Fund and French company Total are all involved in this project. The project was launched at the end of 2013 and began exporting in 2017. It has an annual capacity of 16.5 mil­lion tonnes of LNG. In January 2018, it even supplied the US city of Everett in Massa­chusetts, demonstrating the competitive­ness of Russian LNG. Despite the current sanctions against participants in the Rus­sian project, the sale could legally be bro­kered by a French dealer and shipped on a French tanker.

Among the projects that are directly affected by the US sanctions is one in the Kara Sea initiated by Russian company Rosneft in conjunction with US company Exxon, a project in the Barents Sea with Italian company ENI and another in the Black Sea with Exxon and ENI. In addition, the British-Dutch company Shell withdrew from the offshore production of natural gas on Sakhalin after the US Department of Commerce classified the enterprise as an oil production project. Overall, the impact of the sanctions on Russia’s energy industry was far less significant than the halving of the oil price between mid-2014 and the end of 2016, which was followed by a sluggish recovery in 2017 and 2018. However, the impact of the oil price decline on the ener­gy industry was largely mitigated by the devaluation of the ruble, as this reduced company losses.

Yet, it is uncertain whether Russia will be able to continue exporting the same vol­umes of oil and gas in the future. Hydraulic fracturing is considered an indispensable technology for keeping Russia’s oil produc­tion at a stable level in the longer term. This technology is needed both for current brownfields and for the development of new non-conventional deposits. US sanc­tions on hydraulic fracturing and non-con­ventional production mainly affected joint ventures involving Shell and French firm Total (Bazhenov Formation in Western Siberia), but also Exxon.

The longer US sanctions persist, the faster and greater the decline in Russian oil production could be. The respective invest­ment cycles are at least five to seven years, but more likely, depending on the size of deposits, 10 to 12 years. This means that after 2022–2025 there could well be a sharp fall in Russian oil (and natural gas) production, which could have a lasting impact on already very volatile markets.

The structural consequences from US sanctions also include restricting the global activities of Russian corporations and slow­ing down their internationalisation activi­ties – as in the case of privately owned Lukoil. The state-dominated Russian cor­porations, on the other hand, benefit from direct recourse to public funds and were able to further expand their share in Rus­sian exploration and production. The im­pact of the sanctions is counterproductive to the interests of the EU and the US gov­ernment. Moreover and even more seri­ous­ly, the US sanctions are creating a large legal grey area with high risks for Western companies. These risks have to be included into the cost-benefit considerations of com­panies doing business in and with Russia. The main focus here is on measures aimed at the financial sector. As energy relations between the United States and Russia have declined, the extraterritorial reach of US sanctions is particularly serious for third parties, especially for European companies. In fact, US sanctions are putting increasing pressure on European energy companies to stop engaging in the Russian market, there­by weakening their market positions.

The resulting vacuum allows competitors from China, India and also from the Middle East to expand their activities. The crux of the matter is that state-dominated oil and gas companies can expand their market shares in leaps and bounds, which could have an impact on liberal trade and pricing mechanisms in the medium term. The uni­lateral US sanctions against Russia, Iran and Venezuela result in state interventions gain­ing ground. Politicisation and the political instrumentalisation of the energy markets is increasing. All of this could have far-reach­ing consequences for Europe’s energy security, which will then depend increas­ingly on supplies from these state-owned companies.

US LNG Exports to Europe

The Shale Revolution has made the United States a key player in world oil and gas markets. Between 2010 and 2017, domestic energy companies increased their daily oil production by 73 percent, according to data from energy company BP. Exports rose by 157 percent. Nearly 28 percent more natu­ral gas was produced during the same period. In 2017, the United States was the world’s largest producer of both crude oil and natural gas. Since Congress lifted the export ban on crude oil at the end of 2015, exports increased from 465,000 barrels a day to just under 1.2 million barrels a day in 2017, according to the US Energy Infor­mation Administration. The International Energy Agency forecasts that the US will meet 80 percent of global demand growth for crude oil over the next decade.

As oil prices pick up, US oil production will continue to rise and, as a by-product, more natural gas will be produced. There are two terminals in operation in the US, Sabine Pass since 2016 and Corpus Christi since November 2018. The two plants have an export capacity of 35 billion cubic metres annually and another 55 billion cubic metres of capacity are to be added in 2019. This is roughly equivalent to Germany’s annual gas consumption. By 2020, export capacity could reach around 100 billion cubic metres per year. In 2017, more than ten percent of US LNG exports went to Europe.

The availability of secure and compete­tive energy in the US shields it from devel­opments on the energy markets. As a result, the US is now self-sufficient, meaning that the US government has achieved a major foreign policy goal and gained considerable clout in its international relations.

US-based production is so huge that bottle­necks exist in the processing and transport of crude oil and natural gas. In order to sustain the production boom, US companies are looking for foreign markets for their liquefied natural gas. Consequent­ly, not only are US sanctions based on geo­political considerations to reduce European dependence on Russian energy imports, they also fuel Washington’s vested econom­ic interests, such as reducing the US trade deficit and creating domestic jobs. For Presi­dent Trump’s policy of ‘America First’, energy dominance is both the means and the end. With him in the White House, the thought has become entrenched that the main aim should be the pursuit of profit and pure profit maximisation and that balancing the interests of long-time part­ners and allies in the field of energy and (climate) policy is no longer relevant. Ger­many’s export surplus is a thorn in his side. If Berlin had to import more LNG from the US, the balance sheet would shift in Washington’s favour. This would also cement the energy price spread between the US and Europe, with negative implications for Europe as an industrial location and for European competitiveness. It would also have considerable effect on energy prices as a whole for private households.

In the trade dispute between the US and the EU, LNG imports from the US have be­come a negotiating item, as the meeting in July 2018 between President Trump and the President of the European Commission, Jean-Claude Juncker, demonstrated. In any case and irrespective of the political noise, LNG has become an increasingly important component of the portfolio management and trading business of European import­ers. LNG is one of those commodities where political and business interests coincide. For example, in 2013, the German government guaranteed a loan for an LNG terminal in Goldboro, Canada. In Germany, the con­struction of LNG terminal(s) is currently under discussion with potential sites in Stade, Brunsbüttel and Wilhelmshaven.

There are presently no indications that US LNG will be able to undercut the short-term and long-term marginal costs of Rus­sian pipeline gas in the European market. US LNG is still too expensive to be really competitive. The European gas market is currently the market that absorbs quanti­ties not purchased elsewhere because other customers are more attractive since they pay higher prices. The price differences between the Far East and Europe are still significant. LNG in Asia is priced at 9.8 US dollars per MmBtu (million British Thermal Units, average for 2018) and at only 7.7 US dollars per MmBtu on the British exchange. In addition, major buyers are all located in the northern hemisphere and, therefore, consumption follows the same seasonal curve. European LNG terminals can handle a capacity of 150 billion cubic metres per annum, but are currently operating at less than a quarter of their capacity. However, if Russian supplies are to be replaced on a large scale, the terminals could reach their limits.

European gas consumers have benefited from competition in the gas markets result­ing from the shale gas boom in the US and the surplus of LNG on the markets. Prices fell, even though long-term contracts with minimum purchase obligations (take-or-pay) with European companies will secure Gazprom’s sales in the medium term. Gaz­prom’s market share in the EU of around 35 percent is the result of long-term con­tracts and price signals.

But pressure is likely to continue to rise on Europe to import more US LNG. For example, a cross-party majority in Congress is pushing to prevent the construction and operation of Russian gas pipelines. In ad­dition, in the current trade dispute with Washington, the Chinese government recently imposed a ten percent tariff on US imports of LNG.

The increasing focus of US sanctions policy on Russian natural gas supplies is remarkable. Since oil exports contribute far more to the Russian budget, limiting the budgetary scope of the Russian government in this area would be far more effective. Nevertheless, in December 2018, the Trump administration insisted that production levels not be significantly reduced in the run-up to the OPEC+ meeting. In doing so, the Trump administration had in mind its own electorate and its re-imposed sanctions against Iran. If it were to target Russian gas exports and their market share in the EU instead, it would not only receive applause from Poland, but it would also give US com­panies an advantage in the face of intense competition for market share. What would be detrimental to European import options from a market point of view would be ad­vantageous to the Trump administration.

Conclusions

The geopolitical dispute between the US and the Russian Federation threatens the stability of European and German energy supplies. If the US government were to target Russian gas exports in the future, this would seriously impact Europe’s industrial base and its competitiveness. Considering the rapidly declining production of natural gas in the EU itself, the need for imports is already higher than was forecasted just a few years ago. Demand for gas has recov­ered in Europe since 2017, and e.g. the phase-out of coal in Germany will have an effect here as well. Thus, it is safe to assume from a market perspective that Russian natural gas will cover the EU’s ‘base load’ well into the 2020s. After Gazprom sup­plied a record 194 billion cubic metres to Europe in 2017, exports are likely to have increased in 2018. There are three econom­­ic reasons for this: not only does Russian natural gas come from the largest reservoir in terms of volume, it is also currently the most cost-effective. The fields in Western Siberia and on the Yamal Peninsula have excess supplies of between 130 and 150 bil­lion cubic metres per year. Moreover, Gaz­prom has the necessary and diversified ex­port infrastructure which allows the com­pany to react flexibly to competitors. But Russia is also increasingly orienting itself towards Asia. This will further change the setting and the dynamics of the gas mar­kets, also making diversification an impera­tive for the EU.

Nevertheless, pressure will continue to come from Washington, especially with regard to Nord Stream 2. If this project were hit with secondary sanctions from the US, the EU would have to rely more on a func­tioning Ukrainian transit corridor and buy LNG. Russia’s export pipelines were run­ning at almost full capacity during the period of cold weather in February and March 2018. A strong signal that sufficient import capacity will be needed in future.

In any case, US secondary sanctions would severely curtail Europe’s ability to act autonomously. It should, therefore, be possible to build a consensus in the EU. No matter where Brussels or the Member States stand on Nord Stream 2, the decision about what to do should be a sovereign one for Europeans. The impact on EU-based com­panies described above, or on specialist European companies laying pipelines for offshore and subsea construction, is serious. Not only are private economic interests affected by unilateral US sanctions, but also skills and technical know-how that are stra­tegically important for Europe.

In order to guarantee not only their ener­gy supply in the long term but also their strategic autonomy in this important policy area, Europeans need to find a common response to Washington and Moscow. As a first step in this direction, the European Council should swiftly add all the relevant US legal bases to the annex of the EU “block­ing legislation”. As a precautionary mea­sure, the Instrument in Support of Trade Exchanges (INSTEX) to facilitate payments outside the dollar area should, in addition to Iran, also include business with Russia. Finally, the EU and Germany should con­tinue to focus on diversification, including higher LNG imports, not least as a political signal to Washington and Moscow.