photo credit: Tennen-Gas

On September 8, Russian gas giant Gazprom signed a deal with Japan to sell liquefied natural gas (LNG) from a future terminal in eastern Russia. To be built by Russia and a consortium of Japanese companies, the deal would lead to the construction of a $13 billion LNG export facility in the Russian city of Vladivostok. The deal was announced by officials during a meeting of the Asia-Pacific Economic Cooperation (APEC) forum, currently underway in Vladivostok.

For Gazprom, the deal could not come soon enough. Russia produced about 23 trillion cubic feet in 2010, making it the second largest producer of natural gas in the world after the United States. However, several factors in recent months have conspired against Gazprom.

The economic pain in the Eurozone has dampened demand for Russian gas. As Gazprom’s most important customer (the EU receives about 36% of its natural gas from Russia, but for individual countries, that share is much higher), shrinking economic activity in the Eurozone is hurting business. Also, the shale gas bonanza in the United States has freed up LNG around the world, further pushing down demand. Demand is also down in Russia’s domestic market. And higher taxes from the Russian government, which uses gas revenues for social and political purposes, have made marginal gas projects unprofitable.

Low prices have forced Gazprom to limit production. Gazprom announced that it would shelve plans to develop the Shtokman field, one of the largest and most-hyped natural gas fields in the world, citing high costs and low prices.

Gazprom also suspended gas purchases from independent suppliers within Russia. Intended to deal with a glut of gas, the decision will force drillers to curtail Russian production.

On top of supply and pricing problems, the European Union filed an antitrust lawsuit against Gazprom for allegedly unfairly raising prices on gas.  Gazprom follows a pricing formula of linking natural gas prices to oil prices, which are much higher. The lawsuit may force Gazprom to pay fines or restructure contracts. Russia’s EU Ambassador said he hopes the two sides can reach an agreement diplomatically and avoid a larger conflict.

The string of bad news has hit Gazprom’s profits, which declined 24% ($11 billion) for the first quarter.

With no end in sight to Europe’s economic problems, Russia is looking east. The deal with Japan will lead to the construction of Russia’s second LNG terminal (the other is located on the island of Sakhalin), and should double Russia’s LNG export capacity.

The deal makes sense for Japan as well. Already the world’s largest LNG importer, Japan is scrambling to supply enough power to its economy after shutting down all 54 nuclear power plants following the Fukushima meltdown. Although the Japanese government decided to restart two reactors, Japan will still need significant amounts of LNG to fill the void.

Undoubtedly, Gazprom needs to shift its sights to East Asian customers as any significant demand growth from Europe is unlikely. So, this deal is a step in the right direction. However, over the next few years, Gazprom will continue to struggle with weak demand, low prices, and declining production.

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