“Building the Power of Siberia 2 gas pipeline from Russia to China is a rational decision that would have made sense even before the war, but the project will never be able to replace Russia’s decimated gas trade with Europe,” Sergey Vakulenko, an independent energy analyst and consultant to a number of Russian and international global oil and gas companies, says in an article for Carnegie Endowment for International Peace, asking if China can replace the EU to buy Russian gas.

Before the invasion of Ukraine, Russia used to sell over 150bn cubic metres of gas annually to Western countries, earning around $20–30bn in rent each year and also benefiting from considerable political leverage over the European Union.

The landscape has dramatically changed since then. The state owned gas champion Gazprom's once-thriving pipeline to Europe has withered, compelling Russia to seek alternative markets for its gas, particularly from the gas rich and largely untouched Yamalo-Nenets region.

The most viable alternative for Russia is the vast and fast growing Chinese market. Discussions about constructing a gas pipeline from Russia's Yamal Peninsula to China have been ongoing for nearly two decades, but the collapse of Russia’s European business has lent those talks an urgency brought on by Russia’s geopolitical isolation from the West. One pipeline has already been built, Power of Siberia 1 (PoS1), but now Russia needs to add a second and even larger pipeline, Power of Siberia 2 (POS2). Talks have been going on for years, but now are expected to accelerate, potentially culminating in a formal agreement soon.

Less profitable

The Chinese are playing hardball on prices and while the European business was very lucrative, the POS2 already looks like it will be much less profitable.

Gazprom's gas was a major energy source for Europe, with different routes including through Belarus and Poland, and major pipelines like Nord Stream and through Ukraine, each offering varying costs and revenues. The profitability of these routes was significant. In 2015–2019, Germany—the key market—paid an average of $220 per 1,000 cubic metres for its gas imports and the average netback earnings reached up to $155 per 1,000 cubic metres after accounting for transportation costs and taxes, says Vakulenko.

Yamal-Germany gas export prices by route

“The cost of supplying gas via Nord Stream was $65 per 1,000 cubic metres, compared with $85 through Ukraine. Since Germany was paying $220, the netback (i.e., gas revenues minus transportation costs) was $155 or $135, respectively, per 1,000 cubic metres of gas before the deduction of the mineral extraction tax (MET) and export duty,” says Vakulenko, who adds that the average price of Brent at the time of these calculations was $58 per barrel.

In contrast, the envisioned Power of Siberia 2 pipeline, aimed at channelling gas to China, anticipates a lower capacity of 50bn cubic metres and reduced profitability.

“Even if Power of Siberia 2 is successfully implemented, it will not be able to compensate fully for the loss of the European market. In 2019, Russia sold 165bcm of pipeline gas to Europe and Turkey. Power of Siberia 2’s potential capacity is far smaller, at just 50 bcm,” says Vakulenko.

Not only are the prices lower, but the costs of sending gas on the much longer route to China are higher. The cost of transportation can be calculated at $97 per 1,000cubic metre of gas.

The same calculations for China are based on the price of Brent oil at $60 per barrel, and the price formula used in the contract with China for the original Power of Siberia pipeline, which delivers gas to China from eastern Siberia. While the average revenue from gas deliveries to China is projected at $170 per 1,000 cubic metres, the transportation costs and a longer route could compress netback to only $73 per 1,000 cubic metres.

“Of course, that’s a lot less than the $135–155 netback from sales to Germany, but $73 isn’t bad either, and it could increase to $100 if Gazprom manages to keep the capital expenditure of building a new onshore pipeline from exceeding that of building Nord Stream across the seabed, which sounds entirely feasible,” says Vakulenko.

 

Cost and characteristics of Russia’s export pipelines

Is POS2 worth it?

Natural resources rent is calculated as the excess left after total spending on production and transportation and a reasonable rate of return (i.e., one that corresponds to competitive industries with similar economic risks) have been factored in, explains Vakulenko.

“The expert consensus on the total cost of gas production at the Yamal deposits ranges from $15 to $25 per 1,000 cubic metres, excluding MET and duties. The regulated sale price for industrial consumers in gas-producing regions is about $40, all taxes included,” calculates Vakulenko. “Combining these calculations with the parameters of Power of Siberia 2 shows that the gas pipeline could bring in rent of $2.5bn to $4.3bn per year. That’s a far cry from the $20bn per annum in rent lost from the gas trade with Europe, but still a significant amount.”

The deal also makes the Russian budget money. If MET and export duty are levied on these sales at the standard rate (15% and 30%, respectively), then the state would get $76.50 per 1,000 cubic metres exported, which might leave Gazprom in the red after transportation costs, but the government generally issues tax breaks for such projects, including Power of Siberia 1.

It also compares favourably to LNG projects, since the cost of liquefaction at Yamal LNG is close to the median for such projects, and more expensive than U.S. and Qatari projects, for example, reports Vakulenko. Even without taking into account the cost of transporting LNG, the pipeline is close in cost to the LNG option.

POS2 also has the advantage of being an entirely made in Russia product, now that Russia is cut off from the West, and that could make it cheaper to build than POS1.

The first 1,500km of Power of Siberia 2 could go along the existing pipeline route to Tomsk and Kuzbass, and then along the Trans-Siberian Railway to the Mongolian border followed by the railroad to Beijing.

The pipeline will be built by Russian companies in Russian factories using steel made in Russian mills from Russian deposits of iron ore and coal. All of these industries lost their export markets in 2022.

Taking this into account the construction of POS2 could be finished in 5-6 years and it could go into operation the same day taking over the idled gas that used to go to Europe.

“There are, however, two major risks involved. Gazprom has no reasonable alternatives to the oil-pegged formula it agreed to for the first Power of Siberia back in relatively prosperous 2014. That formula guarantees a certain level of profit for Gazprom, but no more. Realistically, there is very little chance of convincing Beijing that this time the price should be higher,” says Vakulenko.

Comparing the netbacks for Russia’s export pipelines

With no one else able to buy Russia’s gas, China has Gazprom over a barrel. Chain also buys gas from Turkmenistan and Kazakhstan and in addition the LNG market is developing rapidly, giving Beijing yet another alternative supply. Both the US and Qatar are rapidly expanding their LNG production.

With multiple sources to choose from Beijing is expected to take full advantage of its leverage to beat Gazprom down to rock bottom prices and will potentially delay talks until 2025–2026 when new LNG capacities are expected to come online in both the US and Qatar that will lower prices further.

In Gazprom’s favour is that while China has the option to increase its gas purchases from Turkmenistan further, the leadership’s preference is to diversify supply sources to enhance energy security. China’s energy development forecasts are based on demand for gas increasing through at least 2040 and then remaining stable for at least another decade.

"This is a market with many suppliers, and China has plenty of alternatives, even without taking relatively expensive LNG into account," said Vakulenko.

However, overland gas delivery from an enslaved Russia would be a net plus for China’s energy security and this will tell with Beijing as the route could prove critical if US sanctions or trade conflicts disrupt maritime LNG deliveries.

But even if the project goes ahead, unlike the original Soviet gas pipelines to Europe, the green transition means the gas business has a limited lift time as fossil fuels are eventually phased out.

“The fundamental difference between now and the 1960s–1980s, when the Soviet Union successfully monetized the vast gas reserves of Yamal by building a pipeline to Czechoslovakia, then Austria, and then West Germany, recouping construction costs several times over, is that back then the prospects for the development of the European gas market seemed unlimited. There was no hint that demand for gas would ever start to decline, and indeed, the Russian-European gas trade exceeded all Soviet-era calculations,” says Vakulenko.

“Now, however, the gas trade between Russia and China is likely to end by about 2060 or even earlier as a result of the global energy transition. Any hopes of developing this cooperation further (by increasing supply volumes, extending contracts, and so on) amounts to a risky bet that the transition to renewable energy will not happen as planned. In all likelihood, within a few decades, Power of Siberia 2 will become obsolete,” Vakulenko concludes.