In just the first three weeks of the year, one of the key players on energy policy, Sen. Byron Dorgan, D-N.D., has announced his retirement and the special election to replace the late Sen. Edward Kennedy, D-Mass., has sent shock waves through the Democratic Party.

Republican state Sen. Scott Brown’s stunning victory over Democrat Martha Coakley not only takes away the Democrats’ 60-vote majority in the Senate, it puts a chill on major initiatives in this Congress. The unexpected result in the bluest of blue states sent a strong message against the current direction in Washington and is likely to make Democrats very nervous about enacting any new big government programs like a cap-and-trade law.

The retirement announcements by Dorgan, chairman of the Senate Appropriations Subcommittee on Energy and Water Development; Sen. Christopher Dodd, chairman of the Senate Banking Committee; and a half dozen Democrats in the House, including Science and Technology Committee Chairman Bart Gordon, D-Tenn., and Rep. Brian Baird, D-Wash., chairman of the Science and Technology Subcommittee on Energy and Environment, have added to a sense of turmoil in the Democrat majority.

Dorgan’s decision not to seek a fourth term in the Senate this year is especially unsettling for energy policy. Dorgan, a House member for 12 years and a senator for 18, was among the top candidates for Energy Secretary at the start of the Obama administration. In his retirement announcement, Dorgan said that after Congress he would “like to work on energy policy in the private sector.” The odds are it would be for the coal industry, since North Dakota is a major coal state.  That makes it even more likely Dorgan will oppose a cap-and-trade system to control greenhouse gas emissions, which would be costly for coal-fired power plants.

Dorgan has already come out against an emission-trading system run by the financial markets.  “I want to find ways to protect our environment and I support reducing carbon,” he said in a recent op-ed for North Dakota newspapers. “But it makes no sense to me to hand Wall Street a new trillion-dollar carbon securities market so they can engage in the kind of speculation that steered our economy into the ditch.”

Opposition from key Democrats like Dorgan makes one thing crystal clear: Climate-and-energy legislation passed by the House last summer is a non-starter in the Senate.  Even some House Democrats who voted for the bill, including Agriculture Committee Chairman Collin Peterson, D-Minn., now say they would oppose the measure if it comes back for final action.

Senate Energy and Natural Resources Committee Chairman Jeff Bingaman, D-N.M., has acknowledged there is little chance of the Senate approving the kind of cap-and-trade program included in the House bill.  “I do think opponents of cap-and-trade legislation have done a pretty effective job of portraying the proposal as a tax on energy use,” Bingaman told New Mexico reporters on Jan. 11.

“My own sense is at this time that we have strong support in the Senate to do something significant to move toward more use of renewable energy and more efficient use of energy,” Bingaman said.  “I don’t know that we have the votes for any cap-and-trade proposal that I have seen floated here in the Senate.”

Bingaman and Dorgan want the Senate to at least move forward on the bill approved by the Energy and Natural Resources Committee last June, with provisions for more alternative energy, grid development, carbon-storage technology and conservation. Dorgan also added a section to expand drilling in the eastern Gulf of Mexico, which geologists say includes at least 21 trillion cubic feet of natural gas and 3.7 billion barrels of oil.

Of course, many Democrats are still advocating for a broader approach that includes some effort to tackle climate change. Sen. John Kerry, D-Mass., a chief sponsor of the bill approved in November without Republican participation by the Senate Environment and Public Works Committee, acknowledges it will be difficult to move the measure, largely modeled after the House-passed bill.  But Kerry argues that the pressure for an international agreement on climate change—even the minimal goals outlined in Copenhagen in December—“can be a catalyzing moment” for the Senate.

Environmentalists like Daniel Weiss, a former Sierra Club lobbyist now with the Center for American Progress, note that China and India made their first real commitments in Copenhagen to reduce rates of pollution growth relative to their economies, which should help convince skeptics that the United States needs to show leadership, too. Weiss also said on the environmental news Web site Grist that with the EPA poised to act on greenhouse gases if Congress does not, there is a “sword of Damocles hanging over the Senate should it fail to act.”

Sen. Lisa Murkowski, R-Alaska, the ranking member of the Energy and Natural Resources Committee, has pledged to bring a bill to the Senate floor soon aimed at blocking EPA regulation of greenhouse gases for at least a year. Murkowski appears to have some support from Democrats who prefer that Congress act first, but even if her measure passes it would be difficult for both the House and Senate to muster the two-thirds majority needed to overcome a certain veto by President Obama.

But the biggest obstacle to climate legislation is probably the struggling economy. After the wrenching and divisive debate on health care, it is unlikely many Democrats have the stomach for another bruising battle in which they would be accused of killing jobs and hindering economic growth.

The anxiety will only intensify in the buildup to the November elections. Democrats know that the party in the White House historically loses congressional seats in midterm elections, and political analyst Charlie Cook says Democrats hold 40 of the 50 most competitive House districts at the start of the 2010 campaign season.

In the Senate, Majority Leader Harry Reid is well down in the polls as he seeks a fifth term in Nevada.  And several strong GOP candidates—former Hewlett Packard CEO Carly Fiorina, state Sen. Chuck DeVore and former U.S. Rep. Tom Campbell—are vying to take on Sen. Barbara Boxer, D-Calif., leader of the Environment and Public Works Committee.

While Republicans have worries of their own in the Senate with six announced retirements, none of them are game-changers on the climate change legislation. The six retirements are Sens. George LeMieux of Florida, Sam Brownback of Kansas, Jim Bunning of Kentucky, Kit Bond of Missouri, Judd Gregg of New Hampshire and George Voinovich of Ohio.

What spells more trouble for climate change proponents are recent and continuing developments at the state level. The election of Republican Gov. Bob McDonnell in Virginia signals the kind of changes that may be in store for the states, as well. McDonnell pledged in his Jan. 16, 2010, inaugural speech to open more offshore areas to drilling in his administration.

And California Gov. Arnold Schwarzenegger, a Republican who has made action on climate change a hallmark of his administration, is on his way out this year after opting not to seek another term. He won a special recall election in 2003 and a full term in 2006. During his tenure Schwarzenegger pushed through a law capping the state’s greenhouse gas emissions at 1990 levels by 2020, with a goal of cutting emissions to 80 percent below 1990 levels in 2050.

Critics say the climate effort is one reason California has an unemployment rate over 12 percent, but it remains to be seen whether state leaders will try to backtrack on climate regulations once Schwarzenegger leaves office.

With an uncertain electoral future ahead, Democrat leaders are still clinging to the notion that a climate bill can be passed by this spring. The Abraham Energy Report believes it is unlikely as the election heats up in states that have been hit hard by the economic crisis and that are still powered by heavy industry.

The more likely scenario is that the renewable and other clean energy provisions pushed through Bingaman’s Senate Energy and Natural Resources Committee will pass as a stand-alone bill or be attached to the Senate “jobs” stimulus bill, which is currently being assembled by Majority Whip Dick Durbin and Dorgan.  Without such an innovative compromise, energy legislation—and most certainly a climate bill—will be on hold until 2011 at the earliest.

The Economy.  According to the World Bank and others, global real GDP contracted by approximately 1.5 percent in 2009.  Hopefully the worst is behind us. Expectations now put global real GDP growth at around 3.2 percent in 2010, but the growth is likely to be very uneven, with the BRIC countries (Brazil, Russia, India and China) and emerging markets rapidly establishing their dominant position in the global economy.  High and rising government deficits, high unemployment and growing protectionism increase the possibility of a slower than normal economic recovery in the Organisation for Economic Co-operation and Development (OECD) nations.

The positive initial effects of the G-20’s coordinated response to the financial crisis and the ensuing economic meltdown may not be sustainable in all countries.  Many problems persist, particularly in the developed world, in housing, autos, household expenditures, and public sector balance sheets.  This coincides with a rapid rebound in economic activity in the emerging economies in the past two quarters. This growth has already sparked fears of a new economic bubble in some areas and talk of mounting international imbalances.  Just how these divergent paths will interact to steer global economic prospects is largely unknown and a major source of uncertainty for the year ahead.

Oil Market.  The oil market has weathered another boom-and-bust cycle, and global oil demand, after declining for two years in a row (the first time in 25 years), appears set to grow once again.  Commercial oil inventories are high, and there are comfortable margins of unused production capacity both upstream in crude oil production and downstream in the refining sector.  Peak oil fears about supply constraints have been pushed to the back burner for the time being, and there is enough supply around to fuel even the most wildly optimistic economic growth scenarios for the next two to three years at the very minimum.  How peak oil scarcity plays out in the medium- and long-term is still an open question, but in the absence of some outside shock to the system, it shouldn’t be a factor in 2010.

On the basis of market fundamentals alone then, 2010 should be a fairly calm year for the oil market.  Demand prospects should gradually turn around and are likely to strengthen throughout the year.  Oil prices (average NYMEX closing price for the front-month WTI contract), which were about $62 per barrel on average in 2009, could be expected to gradually strengthen further as the global economy continues to transition from recession to renewed growth.

While the demand side could be expected to exert some upward pressure on prices, high inventory levels and ample margins of spare production capacity should keep any price increases to moderate levels.  Oil futures prices indicate that investors generally expect oil prices to rise in 2010, but in the absence of any major unexpected shock to the system, which could turn out to be an understated qualification, an oil-price spike seems unlikely.

The market appears set to support an oil price this year that is higher than 2009’s average of $62 per barrel, but not as high as the $99 per barrel average seen in 2008.  Prices at the higher end of this range may not be sustainable.  They could undermine the economic recovery and oil demand.  They are also likely to provoke additional regulatory responses aimed at restricting “speculation” in the oil-futures markets.

Other Views.  As economic growth and oil demand recover, most large investment banks expect oil prices in 2010 to average between $75 and $92.50 per barrel, a 20 percent to 50 percent increase year-on-year.  The latest U.S. Department of Energy Short Term Energy Outlook predicts prices will average about $79 per barrel in 2010, which is close to but higher than the pre-crisis average of $73 per barrel of 2007.  Most analysts expect the first half of the year to be weaker than the second half.

The more bullish members of this group see the market’s preoccupation with weak demand and surplus inventories gradually turning, once more, into supply-side concerns about the oil market’s ability to fuel rising global demand in the years ahead.  They believe that traders and investors will begin positioning themselves to take advantage of tighter markets in the future, and that supply-side concerns will again dominate market expectations and oil price formation.  The most bullish of these analysts say they would not be surprised to see oil prices make a few, brief excursions to $100 per barrel or more in 2010.

The role that geopolitical concerns and other developments play in these forecasts of potential price spikes in 2010 is unclear at best.  In addition, while it is clear that a transition is underway and that demand is set to resume its overall growth path, the strength of this transition and its exact arrival will depend on a number of factors.  The timing and magnitude of inflows to oil and commodity futures markets in the period ahead will mark the strength of investors’ belief in future supply tightness and higher prices.  These flows of funds will depend not only on the forecast for the recovery itself, but also the outlook for major geopolitical upsets, inflation, the status of the dollar, and equity and bond market performance across a diverse group of investment vehicles.

Expect the Unexpected.  Most forecasts are predicated on the absence of unforeseen developments or unexpected shocks to the global oil market, of which there could be plenty in 2010.  In the first few days of trading in 2010, oil prices broke out of their fairly stable trading range and rose to a 15-month high of more than $83 per barrel.  Prices were being driven by news that Russia had cut off oil shipments to Belarus, that production in China’s industrial and manufacturing sectors was exceeding all growth expectations, and that persistent, colder-than-normal temperatures had overtaken much of the Northern Hemisphere in North America, Europe and Asia.  A declining dollar and expectations of a stock market correction also fueled the flow of funds into oil futures.

These day-to-day fluctuations are to be expected, but they accumulate and affect our view of the long-term outlook. The volatility in the first week of trading could be only a sneak preview of the uncertainties that lie ahead in 2010—uncertainties that could turn what otherwise might be a fairly stable-but-growing market into a wildly schizophrenic, volatile ride.

On the economic side, 2010 is likely to be affected by persistent declines in home prices, tight credit, and high unemployment, which will plague household balance sheets, particularly in the U.S. and the European Union.  Business investment and confidence will continue to be shaken by uncertainties over high and rising government deficits, and unresolved political issues related to future taxation, revenue shortfalls, social entitlements, carbon mitigation policies, financial sector regulatory reform, and growing protectionism in trade policy.  G-20 governments all face issues regarding the future timing and pace of their fiscal and monetary stimulus programs.  On the political side, upcoming elections in Iraq, Brazil, the U.S., U.K. and many other countries are looking more and more contentious, with outcomes that are highly uncertain.

On the geopolitical side, even the unthinkable is quickly becoming possible in 2010.  Most of the uncertainty here stems from escalation of the war in Afghanistan, and the start of new efforts to rein in terror, not only in Yemen, Pakistan, Iraq and other parts of the Middle East and Africa, but across the globe.  Potential developments in Iran are likely foremost on everyone’s mind.  Negotiations over its contentious nuclear program could come to a head in 2010 and possibly lead to responses as diverse as increased sanctions and outright military confrontation, which could have direct and possibly severe consequences on global oil markets.  Growing dissatisfaction with the clerical government could also lead to major internal strife, a leadership crisis, possible regime change, and a temporary crippling of Iran’s already weakened economy.

Depending on how all these things play out, 2010 could go from being an orderly transition from recession to growth to a wild, volatile ride.  That’s the question, and it all depends on a large number of unknowns that more than stretch human ability to see around corners and into the future.  While admitting that anything can happen, and that 2010 will bring its own share of surprises to the market, it is nevertheless useful to review what we think we do know about the things most likely to affect the market in business as usual circumstances.

Economic Outlook.  World real GDP now appears to have contracted by 1.5 percent in 2009, with the industrialized OECD economies contracting at –3.5 percent and accounting for most of the decline.  Global growth is expected to return to positive territory in 2010, and register real GDP growth of around 3.5 percent, which is fairly anemic when compared with past recoveries.  Again, BRIC countries and emerging markets are expected to lead the expansion in both the timing and pace of recovery, with real GDP growth rates of 5 percent to 6 percent for the group.  China is expected to grow by 9 percent or more in 2010.  The Middle East, parts of Africa, and Asia (except Japan) are all expected to experience the most robust growth.

The OECD recovery is expected to begin a bit later, with real GDP growing somewhat slower than in past recoveries, at less than 2 percent in 2010.  The U.S. is expected to grow the fastest, at nearly 2.5 percent, with EU growth of less than 1 percent and Japan somewhere in between.  If anything, we entered the New Year on a positive note, with fresh reports of inventory rebuilding and industrial output around the globe generally exceeding expectations.  Unemployment in the OECD is likely to remain persistently high in 2010.  Views about the strength of the economic recovery in the OECD nations shift almost daily from optimism to pessimism and back again, depending on the latest economic reports.  Expectations of a double-dip back into recession or a prolonged L-shaped recovery still abound, but they’re not as prevalent as before.

Oil Demand.  World oil demand reached a peak in 2007, and has declined for two years in a row in 2008-09—a first in 25 years.  Most forecasts expect world oil demand to turn around and grow in 2010 by somewhere in the range of 0.5 to 1.5 million barrels per day (mmbd).  If demand grows at the midpoint of this range (1.0 mmbd), global demand in 2010 will rebound to about the same level last seen in 2006, but it will still be about 1.0 mmbd below the previous peak in 2007.

The BRIC countries alone were responsible for almost 60 percent of the entire growth of world oil demand in the last decade.  Together the BRIC countries and emerging market economies are the new epicenter of oil demand, and they are expected to account for virtually all of the growth in global oil demand in the years ahead.  It is interesting to note that more than 13 million new cars were sold in China alone in 2009, compared with about 10 million in the U.S.

Oil demands in the U.S. and in the OECD as a whole have been declining at a rate of just over 1.0- percent per year for the last four years from the peaks reached in 2005.  Some forecasts expect this long-term trend away from oil to continue in 2010, with OECD demand falling by 0.2 mmbd, in spite of the projected economic recovery. Others expect demand to recover and grow by about 0.2 mmbd.  Most forecasters see demand in Europe and Japan continuing to stagnate or decline, so the disparity is largely due to differences in opinion about the strength of U.S. oil demand in 2010.  We are inclined to take the middle road and assume that OECD oil demand (and U.S. oil demand) will remain flat in 2010.

Oil Supply.  Non-OPEC supplies of all conventional and non-conventional liquid fuels rose about 0.5 mmbd in 2009, and are expected to grow by about 0.2 mmbd in 2010.  Biofuels and other non-conventional fuels have managed to slightly offset the trend decline in non-OPEC conventional crude output for the past five years.  Near the end of 2008 and early 2009, biofuels briefly lost some ground during the oil price collapse, but appear set to recover in 2010 and beyond.

Exploration and development expenditures are on the rise again, stimulated in part by the decline in the prices of oil field equipment and services.  Natural decline rates in many oil-producing countries are a force to be reckoned with. Nevertheless, the eventual production of new offshore reserves in West Africa, Brazil and many other places, plus planned expansions of biofuels and unconventional resources, could hold the overall non-OPEC supply curve level for some time to come.  Brazil is set to pass Venezuela as Latin America’s largest producer this year.  They have been invited to join OPEC but declined.

OPEC crude oil production fell by about 2.2 mmbd from 2008 to 2009, while its overall production capacity, as a result of ongoing investment, continued to rise.  As a result, OPEC’s surplus crude oil production capacity rose to near 4.5 mmbd by the end of 2009, a level not seen since the beginning of the last decade.  OPEC’s crude oil production capacity is expected to rise again in 2010 and beyond, due to ongoing expansion projects in Qatar and Angola, and new contracts in Iraq.  Extra production from Nigeria is also possible as a result of the cease-fire in the Niger Delta.   In addition, OPEC production of natural gas liquids (NGLs), which falls outside its production quota system, has been rising by about 0.5 mmbd per year in the past few years.

This trend is expected to continue in 2010 and beyond as OPEC members exploit their gas reserves for both domestic consumption and liquefied natural gas (LNG) exports.  Total liquids production capacity (crude and NGLs) in OPEC, including Iraq, could rise by 1.0 mmbd in each of the next several years.  This would just about meet the expected increases in world demand over that period while allowing OPEC to maintain its current level of spare production capacity.

OPEC. As expected, OPEC Ministers meeting in Angola on Dec. 22, 2009, on the heels of the Copenhagen climate talks, decided once again to roll over their previously agreed production quotas and keep output for the OPEC 11 unchanged at 24.845 mmbd.  In the communiqué issued following the meeting, it was clear that OPEC believed that the world economic recovery and the demand for oil was still weak, saying that its decision was intended to strike a balance between oil price stability and the needs of a growing world economy.

Declining compliance with the quotas was one of the major topics of the meeting, and the Members once again pledged to do their share for the common good.  They also called upon non-OPEC oil producers to become more involved in the process and undertake cooperative action with OPEC.  The non-OPEC countries of Egypt, Bahrain, Indonesia, and Oman attended as observers.

For the most part, OPEC members were happy to see a resumption of gradual and steady growth in oil demand, and most were satisfied with the price recovery that took place in 2009.  Saudi Minister Ali Naimi said after the meeting that the market was good and that “the price was excellent.”  It seems clear that as long as the price stays in a comfortable range above $70 per barrel, most OPEC Members are unwilling to risk the appearance of unity for an internal fight over compliance.  It also appears that rising production in Iraq, Angola, Qatar and Nigeria may eventually push the group to revise its quotas, but with some luck and growing demand, this is unlikely to happen in 2010.  OPEC’s own forecast expects the demand for OPEC oil to rise slightly in 2010.

Copenhagen and Carbon Mitigation.  The failure of the Conference of the Parties (COP) to agree on binding targets for carbon mitigation provided many oil producers with a temporary sigh of relief.  The upcoming elections in the U.S. are also likely to forestall any congressional action on cap and trade or new energy taxes this year.  Nevertheless, the energy policies already in place to promote energy efficiency and the development of new and renewable energy resources will continue to nibble away at the demand for oil and other carbon-based fuels this year and in the foreseeable future.

The automobile companies are slated to introduce plug-in electric and electric hybrid vehicles this year, and government incentives to scrap less efficient vehicles (like “Cash for Clunkers” in the U.S.) are ongoing in many countries.  In the medium- and long-term, a race is developing between rising oil and other energy demands, and the ability of the global economy to both improve efficiency and develop clean and affordable supplies of conventional and new energy.  In this environment, global oil demand is likely to grow more slowly than it has in the past.

Admittedly, the outlook contains a large number of unknowns on both the political and economic fronts.  Depending on how these factors play out, 2010 could turn out to be anything from a calm orderly transition from recession to growth to a wild, volatile ride.

Analysis by Abraham Energy Report Contributing Editor John Brodman

Key Concepts:

• The global economic recovery is underway, but growth is likely to be very uneven between the emerging and developed countries.  The possibility of a slower than normal economic recovery in the OECD is a major concern for the outlook.
• On a business as usual basis (that is, based on the assumption of no major, unexpected economic or political shocks to the system), global oil demand should recover and grow once again in 2010, with virtually all the gains registered by the emerging markets.
• Commercial oil inventories are high, and there are comfortable margins of spare production capacity in both crude production and refining. In the absence of some outside shock to the system, peak oil concerns should not be a factor in 2010.
• The market appears set to support a price higher than 2009’s average annual price of $62 per barrel, but not as high as 2008’s average price of $99 per barrel. Prices could wind up somewhere in the $80 to $90 per barrel range on average for the year.

Much of the country’s fate over the last decade has been tied to the ascendancy of Vladimir Putin, of course. His Presidency started on Jan. 1, 2000, and lasted eight years before he “stepped down” to serve as Prime Minister in 2008.  Russia’s fortunes changed dramatically during Putin’s tenure as the economy stabilized and grew significantly in the last 10 years, reflecting the rapid rise of the oil and gas markets on which so much of Russia’s economy is based. Not surprisingly given its over-dependence on energy markets, the global economic crisis and the collapse of energy prices had a disproportionate impact on Russia, causing its economy to falter and natural resources production to slow.

While the roller coaster ride is likely to continue in Russia and its energy markets, it does beg the question: What can Russian leaders do to encourage stability in its volatile oil and gas markets today and into the future?

Russia: The Past

Russian oil production showed tremendous growth early in the decade and then reached a plateau as it neared 10 million barrels per day.  Russian oil production averaged 6.9 million barrels per day for 2001 (the first year of the new century and decade). By the beginning of 2010, Russian oil production crossed the 10 million barrels per day threshold.  Growth was quite uneven, with annual average production surging in the early years between 500,000 and 700,000 barrels per day (2001-2004), and then tapering off to annual average increases of 200,000 barrels per day (2004-2007).  This high growth was due to a number of key factors, including:

• The significant increase in oil prices. World oil prices increased from an annual average of about $26.00 per barrel in 2001 to a high of an annual average of $100 in 2008, declining to an annual average of $62 in 2009. Today, the current oil price is just over $80 per barrel;
• The application of modern technology to Russia’s aging West Siberia oil fields; and
• The devaluation of the ruble, which lowered production costs.

Russia’s economy surged during this period as high taxes on oil production and exports contributed significant revenues for Russia’s expanding state budgets.  In 2004, a new oil export tax was imposed. Marginal tax rates on oil exports exceeded 90 percent, adding to the already-burgeoning monies in the oil trust fund and allowing Russia to use these tax funds for its growing annual budgets. With oil reaching a peak of $147 per barrel in July 2008, future prospects seemed rosy.

Yet the precipitous decline in oil prices in December 2008 to about $35 per barrel in conjunction with the world economic crisis led to a shift in Russian oil production.  As discussed in a previous article in the Abraham Energy Report [Russian Oil Production Slides, April 2009], the impact of lower oil prices and the high Russian oil export duty led to a decline in oil production starting in September 2008, lasting six months through February 2009.  By March 2009, Russian oil production increased year-on-year and has continued to increase to the present.

As increases in Russian oil production slowed and reversed in 2008, Russia enacted tax incentives to encourage new production in high-cost producing areas, especially in the northern provinces and in East Siberia.  New production from Sakhalin Island came on line in 2007-2008, which masked the decline in Russia’s old West Siberian oil fields.  The combination of new incentives, Sakhalin production and a small number of new fields in East Siberia led to the marginal increases in Russian oil production during the remainder of 2009 to the present.  As of January 2010, Russian oil production has increased nearly 45 percent since 2001.

Russian gas production did not fare as well, although it did grow over the same period by about 14 percent (latest annual figures are for 2008).  Since Gazprom accounts for about 85 percent of Russian gas production, the industry’s fortunes are tied strongly to Gazprom.  Growth in gas production and exports to Europe, Russia’s primary market, grew consistently from January 2001 until 2007.  A warm winter in 2007 in both Russia and Europe led to a decline in consumption and production.  Russian production rebounded in 2008, although Gazprom’s production hardly increased that year.  While figures for 2009 are not available, Russian gas production in 2009 is likely to decline precipitously because of the two-week disruption in gas supplies to Europe due to the Russian-Ukrainian gas dispute in January 2009 (80 percent of European gas supplies transit through Ukraine) and the sharp decline in European gas demand stemming from the economic crisis.  Gazprom has been stretching production at its existing gas fields and has postponed investments in new gas fields in Yamal (Bovanenko) and offshore (Shtokman).  As an interim strategy Gazprom buys large volumes of gas from Central Asia (66 billion cubic meters in 2008).

A December 2009 article in the Abraham Energy Report [Central Asia: Pipelines are the New Silk Road] examined the fight over natural gas hegemony in Central Asia. The article concluded that Russia’s dominance was dwindling as Azerbaijan, Kazakhstan and especially Turkmenistan sought alternatives to Russia for selling their natural gas.  In December 2009, Turkmenistan opened its gas pipeline to China.  The opening of the pipeline was a wake-up call for Russia.  Within weeks, Russian President Dmitry Medvedev was in the capital of Turkmenistan, Ashkabad, seeking to improve relations with Turkmen President Gurbanguly Berdymukhammedov.  At the same time, Gazprom indicated that it had smoothed over its gas pipeline dispute with Turkmenistan stemming from an April explosion that halted all Turkmen gas exports to Russia.  Gazprom’s Alexander Medvedev said that it will resume purchases of Turkmen gas in 2010.  Gazprom also agreed to expand the Prikaspiiski pipeline running along the Caspian to Russia and to build the east-west pipeline linking eastern Turkmen gas fields to the Prikaspiiski pipeline route.  Obviously, the fear of losing Turkmenistan’s natural gas market to China and possible western routes spurred Gazprom and Russia to renew its energy relationship with Turkmenistan.  The open question is whether Russia’s effort is too little, too late.

A previous Abraham Energy Report article [The EU and the Great Pipeline Game, June 2009] discussed the many new pipelines (oil and gas) that Russia is proposing to construct to enhance its export opportunities or to bypass recalcitrant partners.  The proposed Nord Stream natural gas pipeline to carry gas from Russia to Germany under the Baltic Sea now has garnered all the construction permits required by the affected states—Finland, Sweden and Denmark—with German and Russian permits either in hand or to be issued soon.  The U.S. also appears to have scaled back its criticism of this pipeline as it increasingly becomes a reality.  On the other hand, the South Stream pipeline that would carry gas across the Black Sea to Bulgaria and then into Central Europe still appears mired in problems, including its astronomical cost, and does not appear to be any closer to reality.

Russia is proceeding with its oil pipeline across East Siberia to the terminal at Kozmino, near the port city of Nakhodka and near Vladisvostok in Russia’s Far East.  The first phase of the East Siberian Pacific Ocean (ESPO) is some 1,700 miles long. It is complete from the existing West Siberian pipeline system connecting at Taishet in the Irkutsk region and extending to Skovorodino, 45 miles from the Chinese border.  Transneft, Russia’s oil pipeline monopoly, is building a pipeline connection to its border with China in order to connect with China’s oil pipeline system. The pipeline will be able to carry up to 300,000 barrels per day, supplementing rail shipments of oil to China. This oil pipeline connection is part of the deal worked out earlier in 2009 between Russia and China in which China loaned Russia $25 billion for future oil deliveries. The remaining 1,300-mile section of the ESPO pipeline is under construction and expected to be completed by 2012.  Total cost of the pipeline is about $22 billion. Until the pipeline is completed to Kozmino, Russian oil will move by rail from Skovorodino to Kozmino, with Rosneft, TNK-BP and others planning to use this new port for oil exports to Far East customers.

Russia: The Present

The start of a new year almost invariably brings another crisis between Russia, Europe and its transit countries.  In January 2006 and January 2009 Russia created turmoil in natural gas markets when it halted gas deliveries to Ukraine.  Ukraine’s natural gas pipelines, built during the Soviet era when it was part of the USSR, carry 80 percent of Russia’s natural gas exports to Europe.  Russian gas accounts for between 25 percent and 30 percent of European Union gas consumption and about 35 percent of its natural gas imports. Some European countries depend on Russia for most of their gas supply, so any disruption has serious repercussions.  A similar gas disruption was averted this year as Russia and Ukraine agreed on terms of a new gas agreement, including market pricing. However, Ukraine’s ability and inability at times to pay its gas bills has left many Europeans on edge since Russia threatens to cut off Ukraine if it fails to pay its bills. Serious economic problems exist in Ukraine due to the world economic crisis, and it remains on IMF life support to prop up its economy. Another factor is the Presidential election in Ukraine. Incumbent President Viktor Yuschenko of Orange Revolution fame lost in the first round of voting. Opposition leader Viktor Yanukovych and Prime Minister Yulia Tymoshenko face each other in the run-off on Feb. 7. All these factors leave Europe in suspense as to whether Ukraine can meet its monthly gas bills.

Even as a crisis was averted in Ukraine, Belarus reared up to present additional problems.  On Jan. 1, 2010, Russia cut off oil shipments through the Druzhba pipeline (Druzhba means “Friendship”) that transits Belarus and provides about 10 percent of Europe’s oil supplies.  This stoppage is reminiscent of a similar dispute in January 2007, when Russia halted similar oil shipments.  Oil flows to Europe (primarily Germany and Poland) continued despite the Jan. 1 stoppage, while supplies to refineries in Belarus were directly affected. Why cut off the flow? Belarus refiners pay about one-third of Russia’s export tax rate due to previous tariff agreements between Russia and Belarus, so surplus products refined in Belarus are sold in Europe at a lower price than products from Russian refiners.  Russia wanted to raise tariffs for the Belarus refiners after the tariff agreements expired on Dec. 31, 2009, so that Belarus refiners would pay the same export tax rate as all others.  The new tax could cost Belarus as much as $5 billon annually, more than 10 percent of its gross domestic product.  The dispute escalated on Jan. 4, 2010, when Belarus threatened to cut off electricity to Russia’s Kaliningrad region, a small Russian enclave sandwiched between Poland and Lithuania and adjacent to Belarus. Russia immediately resumed all oil shipments. Negotiations between Russia and Belarus are ongoing. For the EU, the stoppage came as an unexpected and unwelcome New Year surprise, despite the EU and Russia putting an early warning mechanism into place last year to avoid these kind of bombshells.

Russia: The Future

For the future, Russian energy will continue to be an important part of the country’s domestic economy until it finds a way to diversify away from oil and gas.  Russia is pulling out of its economic crisis, assisted by higher oil prices in the last six months.  Oil production has stabilized and is increasing slowly, surpassing the 10 million barrel-per-day level in late 2009 and headed for 10.2 to 10.5 million barrels-per-day by the end of 2010, due to increasing production from East Siberian oil fields. Natural gas prices are likely to increase in 2010 since natural gas contracts with European buyers are linked to oil prices, although with a six to nine month lag.  If oil prices stay in the $70 to $80 range (or higher), expect European prices for Russian natural gas to rebound later this year.  Russia is keeping a careful eye on developments in Central Asia, its economic backyard, and is working to offset gains made by China and the EU.  Russia is slowly moving forward with its natural gas pipelines, with Nord Stream the most advanced.  In oil, it is moving rapidly ahead on its pipeline to the Far East, which can give Russia another outlet for its oil and will lessen its reliance on western oil markets.  It also is working to complete oil pipeline bypasses to Belarus, eliminating another thorn in its energy picture.

As the nation with the largest natural gas reserves and the eighth largest oil reserves, Russia’s energy future appears more than stable. The question is whether Russian leaders are able to leverage their natural resources to keep their economy afloat, maintain a reliable level of oil and gas production, and preserve viable trading relationships. In oil, after almost a decade of rapid growth, its oil production is reaching a plateau, and its success going forward will depend on its ability to provide sufficient incentives for development to occur in East Siberia and its Arctic offshore tracts. At present, its strategy appears to be working.

In natural gas, Gazprom continues to delay investments in new production, seeking to buy gas from other countries or from other domestic producers.  How long it can continue to play this game is an open question.  Its delays are worrisome to its long-term stability and to its ability to meet its long-term export commitments.