Is Russia’s Deal with China a Threat to Canadian LNG?

With Russia's $400 billion deal to supply natural gas to China, the global liquefied natural gas (LNG) market just got a bit more complicated. And that should be a wake-up call to the various constituencies in Canada that have taken the country's resource riches for granted by repeatedly stymying the energy sector's efforts to develop export infrastructure.

Although much of the entrenched political opposition is certainly in earnest, you don't have to be a cynic to note that these projects eventually get approved once each party has extracted their requisite pound of flesh. Of course, this process not only increases the cost of regulatory compliance, it also further delays projects that already take years to build.

It turns out Canada didn't have the luxury of time these players thought it did. Indeed, if all goes according to plan, the first gas will flow through Russian pipelines to China in 2018, about a year ahead of when Canada's first export facility is expected to be ready to ship LNG to Asia.

The good news is that global demand for Canadian LNG should still be ample. But now that China has secured a significant amount of natural gas at a favorable price, the question remains how this deal will affect LNG prices.

Production from prolific shale plays has created a veritable glut of cheap natural gas in the US and Canada, which has helped keep prices low in North America, recently near USD4.39 per MMBtu.

By contrast, the Asian supply of natural gas has failed to keep pace with growing demand, which means the region must import significant quantities of LNG. As such, there's a huge spread between prices of North American natural gas and LNG that's shipped to Asia.

For instance, the forward price of the generic contract for LNG scheduled for delivery to northeast Asia in the next month is currently USD14.40, though that price was as high as USD18.95 last November.

The opportunity to exploit the pricing differential between these two markets has prompted numerous energy companies operating in at least two dozen countries to pile into the LNG export arena.

In Canada, at present, there are 14 LNG projects proposed for construction along British Columbia's coast that have filed for export licenses with the country's National Energy Board, with seven licenses granted so far. Malaysian state-owned energy company Petronas' Pacific NorthWest LNG is expected to be the first project to actually commence commercial operations, in early 2019, assuming it decides to proceed with building it.

In fact, The Wall Street Journal notes that no company has formally committed to constructing an LNG export facility in Canada thus far, in part because of uncertainty over British Columbia's tax and environmental policies. Underscoring the lackadaisical approach resulting from thorny provincial politics is BC Premier Christy Clark's wan optimism that they'll get final investment decisions on "one or two" projects later this year.

Of course, she expressed the same sentiment almost exactly a year ago. And negotiations have been protracted despite the fact that she's championed LNG because she believes these projects will spur both employment growth and tax receipts for the province.

But we probably shouldn't give Canadian politicians too much of a hard time. After all, it wasn't like the deal between China and Russia happened overnight. Indeed, it was only consummated after about 10 years of negotiations, which included prior supply agreements with pricing a perpetual sticking point–until now.

Western efforts to isolate Russia both financially and politically for its involvement in Ukraine's political crisis may have caused it to finally make the pricing concessions necessary to overcome the impasse.

According to Leslie Palti-Guzman, a senior energy analyst at New York-based Eurasia Group, political fallout from the Ukra! ine crisi! s threatened Russian access to Western credit in the short term, while likely eroding Russia's share of the European gas market in the long term.

Moscow's sudden financial needs coalesced with China's aggressive environmental strategy to curb emissions by switching from coal to gas-fired power generation–the country wants cleaner-burning natural gas to account for 10 percent of its fuel mix by 2020, up from 6 percent currently. As a bonus, both countries also get to demonstrate their political and economic independence from Western powers.

The deal signed between Russia's state-controlled OAO Gazprom and the state-owned China National Petroleum Corp (CNPC) encompasses a 30-year contract to supply 38 billion cubic meters (bcm) per year, with the potential to expand pipeline capacity to 61 bcm per year.

Although the two countries did not disclose many of the terms of the deal, including pricing, analysts estimate China will be paying around USD10 per MMBtu, which is far less than the cost of LNG imports and even somewhat cheaper than gas supplied to China via an existing pipeline from Turkmenistan. Not only that, this price is lower than the USD12 per MMBtu reportedly necessary for Gazprom to break even when accounting for pipeline construction.

In exchange for this rock-bottom pricing, it's believed that China will prepay about USD22 billion in order to help finance the construction of about 4,000 kilometers of pipelines, which are expected to cost about USD55 billion altogether.

Even though the numbers involved appear staggering, there's still plenty of space at the Asian LNG table for Canada.

For one, both Japan and South Korea are also major importers of LNG. And according to analysts with Calgary-based Ziff Energy, these two countries are unlikely to secure a similar deal, in part because exporters won't be able to ship gas to them as cheaply since they're "victims of geography." For this reason, one analyst with the firm even went so far ! as to ass! ert that the deal with Russia would have "zero impact" on Canadian LNG projects.

Beyond Japan and South Korea, China also remains in play. Because of the Middle Kingdom's enormous and growing energy demand, its contract with Russia only covers a slim percentage of future energy demand.

By 2020, China is projected to consumer around 420 bcm per year, which means that roughly two years after gas starts flowing from Eastern Siberia to China, the imports under this contract will only account for about 9 percent of the country's demand. And the International Energy Agency forecasts China's natural gas demand will quadruple by 2035.

China's insatiable demand means that it can't rely on any one country for supply, regardless of proximity or abundance of resources. Indeed, the country intends to fulfill its energy needs by diversifying among a number of different countries and even has ownership stakes in LNG projects in both Canada and Australia.

Though massive energy projects often face substantial domestic political opposition, in the end Canada boasts one other attraction that Russia does not: dependability. As Ms. Clark observed in the wake of the deal's announcement, "We've certainly seen the way that Russia likes to do business these days, and we certainly know that the Chinese want a dependability of supply. We can supply that."

The key now is for Canada to greenlight its export infrastructure quickly and for its gas producers to reliably export a high-quality, low-cost product. Fortunately, analysts say that most Canadian LNG projects can run economically at USD10 per MMBtu to USD13 per MMBtu, which puts them in the competitive pricing zone. The rest is up to the country's government.