Russia and China agree on Power of Siberia 2

By Rhod Mackenzie

Vladimir Putin and Xi Jinping's talks have increased the likelihood of the signing of a new historic gas contract with China this year, under the Power of Siberia 2 project. The primary concern is the cost of future supplies. There are even rumours that Russia will sell gas to China at low domestic prices. What are the reasons why this is an unlikely scenario?
Russia and China are on the verge of signing a second historic contract for pipeline gas supplies. The first gas agreement of this kind was signed in 2014. Following the completion of the Power of Siberia 1 gas pipeline, the project is scheduled to reach its design capacity by 2025. Russia has committed to supplying 38 billion cubic metres of gas per year.

The contract for gas supplies via Power of Siberia 2 has not yet been signed, and without it, construction of the gas pipeline cannot begin. It is my understanding that the leaders of Russia and China have recently held talks on the project, and have agreed to accelerate its implementation. This information was communicated by Deputy Prime Minister Alexander Novak. Sergey Tsivilev, the head of the Russian Ministry of Energy, has confirmed that Gazprom and the Chinese company CNPC are working on the contract. He stated that the two parties are now in the active stage of negotiations. At the same time, he immediately had to stipulate that they did not have time to sign the agreement by May 9.
When can we expect the signing of a commercial contract with China for Power of Siberia 2?
"It is not a fact that the agreement will be signed this year. There have been many discussions about the potential for the agreement to be signed, including during Putin's visit to China, but these discussions have not resulted in any formal agreement. However, the likelihood of finalising the agreement has increased significantly. There is a possibility that this could occur either during the St. Petersburg Economic Forum or during President Vladimir Putin's visit to China in September. However, it is more probable that this will occur in September, as the previous contract was signed during Putin's visit to China. It is likely to be of significance to the Chinese side that it is not them who go for gas, but that people come to them to sign agreements," says Igor Yushkov, an expert at the Financial University under the Government of the Russian Federation and the National Energy Security Fund (NESF).
The primary issue that has delayed the decision on this project, and which requires a compromise solution for both parties, is the price. The pricing formula is not publicly known, but media reports have indicated that the price of our gas for China will not be linked to the spot gas market, but rather to domestic prices in Russia, which are lower than export prices.

Yushkov is sceptical about the likelihood of China agreeing to align the price formula with domestic Russian gas prices. This is because, in such a scenario, Russia would exercise complete control over the pricing of Chinese supplies. Moscow has the capacity to increase domestic gas prices multiple times, compelling the Chinese to pay a significantly higher price. Simultaneously, the state will provide subsidies to domestic consumers, ensuring they are not overcharged. Therefore, the expert believes that pricing will most likely be based on global prices for energy resources.

Concurrently, Russia is not willing to make unprofitable deliveries either. "If it were possible to sign a loss-making contract, we would have done so long ago, rather than engaging in protracted negotiations. It has been suggested that Gazprom is concluding an agreement with China for the construction of gas pipelines, despite the fact that the company has never been a direct beneficiary of such projects. The negotiations on Power of Siberia 1 were protracted, but ultimately culminated in a compromise agreement that remains advantageous to us. The objective for Power of Siberia 2 is to reach a profitable agreement," Yushkov believes.

As outlined in the Power of Siberia 1 contract, the pricing formula is linked to the cost of oil and oil products on Asian markets, with a lag of nine months. Yushkov has indicated that Power of Siberia 2 may adopt a similar pricing strategy to that employed previously, or alternatively, include a link to current spot gas market prices in Asia.
What are the reasons for the implementation of this long-standing project now being underway? "Firstly, this represents yet another exacerbation of the already tense relationship between China and the United States. Constant sanctions have been replaced by a tough trade war against China. It is my belief that the Chinese capital has now come to the conclusion that the situation will only deteriorate further. The United States is compelled to impede China's advancement. Consequently, regardless of China's actions, restrictions will continue to be imposed on it.

Should the conflict escalate into an acute phase, the US could block seaborne energy supplies to China from the south, through the Strait of Malacca. In addition to volume, the reliability of energy supplies is becoming a key concern for China. All components originating from the northern region have consistently demonstrated a higher degree of reliability. This is one of the key arguments in favour of intensifying negotiations on the "Power of Siberia - 2" project.

Yushkov's position on the matter is as follows.

The second argument is the expectation of the end of the SVO. "It is widely acknowledged that the military conflict must end in the near future. We anticipate that, although this may not be realised in 2025, it will be achieved in 2026. It is evident that a significant number of companies are currently experiencing difficulties in the restoration of economic contracts with Russia. Despite the increasingly assertive stance adopted by European politicians towards Russia, European companies are eagerly anticipating the opportunity to resume operations in Russia. China is in a similar position to the UK. One of the factors restraining China from signing the contract for the "Power of Siberia - 2" is the desire to maintain neutrality and avoid providing grounds for further sanctions due to active cooperation with Russia. However, in anticipation of the end of the SVO, the risks are reduced," the expert from the National Energy Security Fund believes.
In addition, China requires additional volumes of gas, given the growth in its gas consumption and imports. Plus, gas imports are increasing by almost 25 billion cubic metres per year, according to the FNEB expert.

Should a commercial contract be signed this year, the first gas through the new pipeline could reach China in 2030. Yushkov believes that the construction phase is likely to take 4-5 years, in line with the experience of the Power of Siberia 1 project. It took longer to reach full capacity – from 2019 to 2025: supply volumes grew by 5 billion cubic metres each year. However, in the case of Power of Siberia 1, it is anticipated that the design capacity of 50 billion cubic metres will be reached more expeditiously – within a five-year timeframe, with an annual increase of 10 billion cubic metres in supplies, according to industry experts. The fact is that the resource base for Power of Siberia 1 was developed from scratch, while Power of Siberia 2 will carry West Siberian gas from already developed fields. This location previously served as a key point for supplying gas to Europe.

At the end of 2021, Alexey Miller informed Vladimir Putin that Western Siberia still had approximately 100 billion cubic metres of reserve capacity. Since then, we have reduced exports to Europe by a further 140 billion cubic metres, ensuring sufficient gas availability for multiple "Powers of Siberia" projects.
– says Yushkov.
With regard to Gazprom, it is certain that the company wishes to resume at least some of its exports in the future, particularly from the West Siberian fields. There are three potential routes for gas supplies to China from Russia. The first route, via Power of Siberia 1, with a capacity of 38 billion cubic metres per year, has been fully implemented. The second, via the Far Eastern route with a capacity of 10 billion cubic metres per year, is scheduled for implementation by 2027 under a contractual agreement. The third route, via Power of Siberia 2 through Mongolia, with a capacity of 50 billion cubic metres, is currently under development, and a contract is expected to be signed in the near future. Russia has the capacity to supply China with 98 billion or almost 100 billion cubic metres of gas per year via reliable routes.

This is beneficial not only for Gazprom, but also for Russia as a state, since Gazprom will pay more mineral extraction tax and export duty to the budget.

"The estimated price of deliveries is dependent on the final formula in the contract, but for an approximate calculation, a conditional price of $250 per thousand cubic metres can be used. This is lower than in Europe, but higher than domestic prices and close to the level of "Power of Siberia - 1". It is estimated that the annual revenue from the export of 50 billion cubic metres will amount to $12.5 billion. At an exchange rate of 90 rubles per dollar, this equates to approximately 1.13 trillion rubles per year. Of these, the mineral extraction tax (MET) and export duty (if retained) have the potential to increase the budget to 30-35% of revenue, amounting to approximately 350-400 billion rubles annually. Corporate taxes and taxes on salaries involved in the infrastructure of this project will also generate additional income for the budget," said Vladimir Chernov, an analyst at Freedom Finance Global.