In mid-April, the Council of the European Union (EU) adopted an amendment to the existing Gas Directive with the goal of "closing a legal gap in [its] regulatory framework and boosting competition in the gas market". The amendment solidifies anti-monopoly clauses and requirements for pipeline third-party access, as well as tariff transparency, extending them to pipelines arriving into the EU from "third countries". The project most threatened (some would argue targeted) by the new law is Gazprom's Nord Stream 2, currently under construction in the Baltic Sea and planned to be completed by end-year. While a compromise was reached in February, theoretically putting the final decision to apply the law in the hands of the EU state in which the pipeline lands (in this case Germany, the project's main supporter), not to mention allowing for the possibility for derogations and exemptions, Nord Stream 2's woes may be far from over. The modified Directive will enter into force in the coming months, 20 days after its publication in the Official Journal of the European Union, long before the pipeline is completed and presumably clear of all roadblocks.

With the goal to complete it by end-year, operator Gazprom announced this month that more than 1,100 km of pipes had been laid on Nord Stream 2, which consists of twin 48" lines extending over more than 1,220 km under the Baltic Sea from Russia, across the maritime territories of Finland, Sweden and Denmark to Germany. With an identical combined throughput capacity of 55 Bcm/y (5.2 Bcf/d), the original twin lines of the first Nord Stream were commissioned in 2011 and 2012. While most Western European countries support the expansion, others (namely Denmark) have been reticent to approve the second phase, as it is heavily opposed by several member states that object to Russia's bypassing of Ukraine as a transit hub. Gazprom was already able to take pressure off its Eastern European transit lines thanks to the original Nord Stream project, which reached its highest utilisation rate yet in 2018 (some 58.8 Bcm, even higher than nameplate throughput capacity), and a second set of twin lines would presumably further diminish the need for gas transit via Ukraine, which nets Ukrainian state company Naftogaz hundreds of millions in transit revenue. The Nord Stream 2 operating company recently submitted its third application to the Danish government, with the new proposed route to avoid the country's territorial waters and only pass through its Exclusive Economic Zone (EEZ) south of Bornholm Island. Denmark and Poland signed a maritime boundary agreement last year and the modified route takes advantage of newly demarcated areas, although it may add 25 km to Nord Stream 2's length.

Nord Stream 2 remains a key project for Germany, which will use more gas as part of its move away from nuclear and coal power generation, and once completed could further increase the share of Russian gas (still the most economical import option) in the country's supply mix. The German government was undoubtedly relieved earlier this year upon the conclusion of a compromise that would leave the project's destiny more in its hands and allow it to reach a workable compromise with EU regulations, such as the requirement that the gas exporter be separate from the producer. While Nord Stream 2 has several Western financiers in the form of Shell, Engie, OMV, Uniper and Wintershall, Gazprom will not give up its full control over the supply chain without a fight. In fact, it would be completely unworkable, as the state giant remains the only game in town for Russian gas exports (aside from LNG exports by Novatek and LNG trading by Rosneft).

But there is still staunch opposition to the project, within Europe and without. The US Trump administration previously threatened to impose sanctions on companies participating or providing financial support, claiming that Russia is using the project to exploit Europe's dependence on its gas supplies. German officials have played down the threats, with the chief of OMV notably stating that it would be preferable for the United States to provide competitively priced LNG instead. Yet more danger looms in the form of the EU's Parliamentary Elections, due to take place in late May. While it may amount to political posturing, a candidate from Germany representing the European People's Party, Manfred Weber, recently stated that he will block construction of Nord Stream 2 if he succeeds Jean-Claude Juncker as president of the European Commission. In fact, the accelerated passage of the latest amendments was perceived by some as an intentional move to complete the process before new, less friendly representatives are elected.

With pipelaying and construction of infrastructure onshore Germany well under way, the Nord Stream 2 operating company is taking the potential challenges seriously. It was revealed last month that it has asked in an official letter for the EU to clarify whether Nord Stream 2 qualifies for a derogation as a "completed" project, stating that a refusal would be "unreasonable, arbitrary and discriminatory" and lead to significant losses in addition to the EUR 5.8 billion (USD 6.5 billion) already invested in the EUR 9.5 billion (USD 10.64 billion) undertaking. The prior completion derogation will presumably be applied to existing gas supply pipelines to the EU from third countries (such as Algeria, Libya, Morocco, Norway, Russia, Tunisia and, post-Brexit, the United Kingdom), but Nord Stream 2's timing may prove less clear-cut, despite Gazprom's insistence to the contrary.

The worst-case scenario is still not out of the question, as Gazprom learned earlier this decade with South Stream in the Black Sea. Originally envisioned as twin 920-km subsea pipelines from Russia to Bulgaria, each with a capacity of 15.75 Bcm/y (1.5 Bcf/d), the project was scuttled in 2014 due to the aforementioned EU Gas Directive rules regarding unbundling of producer and seller companies. Construction of onshore infrastructure in Bulgaria had already begun and pipe fabrication was completed. Only last week, nearly five years later, did Gazprom and Saipem, the original pipelaying contractor for South Stream, reach an amicable agreement regarding cancelled pipelaying works in the Black Sea, avoiding a drawn-out legal battle over a USD 850 million claim filed by the Italian company at the International Chamber of Commerce. The project was ultimately re-routed to Turkey, renamed TurkStream and is now due for completion later this year, with half of the exports to remain in Turkey and the other half sent on to Europe (although not until the 2020s). With time running short to have an option to bypass Ukraine entirely if necessary (existing transit contracts conclude on 31 December 2019) and a friendlier and more influential EU state in its camp in the form of Germany, Gazprom is moving full steam ahead and banking on different results with Nord Stream 2. A compromise will likely be found, but a change in EU leadership is on the horizon, and, even with the billions in sunk costs, Gazprom may once again be testing the union's tolerance for its tactics of asking for forgiveness rather than permission.

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Sergey Myakishev is a Senior Editor at IHS Markit

Posted 6 May 2019

This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.