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Regular version of the site

The Natural Gas Deal with China Won't Help Russia's Economy

Russia's cooperation with China ona natural gas deal over the next few years will marginally improve Russia's economic performance and bring additional revenues, but is unlikely to offset the country’s sluggish economic growth rates, according to the recent issue of New Comments on the State and Business published by the HSE Centre of Development Institute

On May 21, 2014, Gazprom signed a contract with China National Petroleum Corp (CNPC) to supply natural gas to China for 30 years. This deal can be viewed from at least two perspectives: microeconomic (Gazprom) and macroeconomic (the Russian economy). Looking at the situation from Gazprom's perspective is difficult, as some of the deal's parameters – any of which may have huge implications for its profitability – are kept private. In any event, the deal is signed, and Gazprom will have to follow through with it, whether or not it is profitable. It is possible, however, to estimate the contract’s potential macroeconomic effect despite these uncertainties.

The gas project broadly consists of two parts: investment in infrastructure and gas exports. Russia's capital investment will total US$ 55 billion; it follows from Gazprom's statements that investment will start in 2014, and the essential infrastructure will have been created by the end of 2018 to support the launch of gas production in the Chayandinskoye field. We can assume that investment in infrastructure will continue for two more years (2019 and 2020), and after that, Gazprom will make no further investment in this project with China.

Based on the above, we assume that Gazprom will invest US$ 3 billion in 2014, US$ 7 billion in 2015, and US$ 9 billion each year between 2016 and 2020, a total of US$ 55 billion; converted into Russian roubles (at 4.5% annual rouble depreciation), this translates into an average annual investment of some 330 billion roubles and a total project cost of 2.3 trillion roubles.

Table 1: Estimated stimulating effect of Gazprom's investments under the gas deal with China (gas exports growth not considered)

Gazprom's investment under the contract with China, billions of dollars 37999990
Investment growth,% (base case)99.796.6100.6102101.7102102.4102.1102.2
Investment growth, % (investment)99.797.3101.6102.4101.7102102.4102.1100.2
Effect of the investment, pp 0.810.40000-2
GDP growth, % (base case)101.399.9101.5101.7101.4101.5101.6101.5101.5
GDP growth, % (investment)101.3100101.7101.8101.4101.5101.6101.5101
Effects of the investment, pp 0.5

Source: The HSE 'Centre for Development' Institute

The macroeconomic effect of these investments during the investment period (other than the increase in productive capacity, which is the direct purpose of the investment) depends on the proportion of imports in the investment project and on whether the project has a multiplier effect by triggering more investment among domestic suppliers.

Gazprom CEO Alexey Miller said almost a year ago that Russian producers of large-diameter pipes (LDP) already had the expertise and capacity to meet all of Gazprom's current and potential future needs. It is not clear, however, whether Russian LDP manufacturers can do so without imported steel billets (strips) which amount to more than half of the product cost – even though in recent years, Russia's reliance on imports of these products has dropped.

In addition to this, Gazprom requires equipment for natural gas production, transportation, and processing facilities, an area in which Russia is still somewhat dependent on imports. Moreover, the gas-producing fields are located in geologically difficult areas and thus will require high-quality imported technology. We assume in our estimates that the share of imports will stand at 20% of the total cost of investment, with a side note that even reducing it to 10% or 5% will make little difference.

We do not expect a strong multiplier effect from Gazprom's investments, as Gazprom's suppliers already have excess production capacity largely due to the fact that in nominal terms, Gazprom's investments reached their peak in 2011, and then dropped by almost 20% to 2013.

Graph 1. Gazprom's capital investments, billion roubles

Source: Gazprom, estimates by the HSE 'Development Centre' Institute.

Perhaps the most obvious example are Russian LPD manufacturers whose capacity utilisation, according to the Russian Pipeline Manufacturing Development Fund, may be as low as 35% in 2014, due not only to the gas giant's lower investment activity, but also to a decrease in global demand for metals and metal products which has been seen over the past two years. Under such circumstances – even if Gazprom's investments increase to the same level as in 2011 in nominal terms circumstances – its suppliers will be better off using their profits to repay debt rather than to increase production capacity.

Based on the above estimates and our projections of moderate growth rates in the medium and long term, Gazprom's 'U-turn' to China will contribute an average of 0.7 pp domestic investment growth between 2014 an 2016, with the average investment growth rate increasing from -0.3% to +0.5%, and a cumulative effect of 2.2 pp. Then the impact on investment will drop to zero between 2017 and 2020, when no increase incapital investment is planned, and will drop even further and stand at -2.0 pp by the end of the investment project in 2021.

Likewise, real GDP growth will increase by an average of 0.16 pp between 2014 and 2016 (from 1.0% per year to about 1.2% per year, with a 0.5 pp cumulative effect over three years) and remain unchanged between 2017 and 2020, followed by a slowdown of 0.5 pp in 2021 (this GDP dynamic takes into account both the direct effects of investment and import growth and indirect effects, such as household income growth).

As to the other aspect of the deal with China, i.e. 38 billion cubic meters of natural gas exports beginning in 2019, once again, GDP growth requires that exports increase annually relative to the baseline scenario. Assuming, in line with Gazprom's own statements, that an increase in gas exports will only occur in 2019, the combined direct and indirect effects will stand at 0.8 pp of GDP growth in 2019, with zero effect in subsequent years.

In fact, the economic decline observed in Russia in 2012-2014 has unfolded despite huge commodity exports, and nothing other than a one-time increase of exports will take place in 2019.

The only recurrent positive effect will be the gas export tax revenues to the federal budget (even though the Russian authorities have promised to waive the mineral extraction tax on natural gas exported from the fields covered by the project) at the current rate of 30% of the price, which amounts to 0.15-0.25% of GDP, depending on the dollar exchange rate.

To conclude, the Treasury is the single biggest beneficiary of the U-turn to the East, even though other beneficiaries include Russian private companies, such as steelmakers suffering losses from the drop in domestic and global demand and prices, natural gas consumers in the Far East, and some others. However, the overall impact on Russia's economic growth will be limited.

Nikolai Kondrashov


June 04, 2014