Here's How the U.S. Will Play the Russia-China Oil Deal

Pundits have been quick to label last week's mammoth gas deal between Russia and China as "historic."

That may be true. But the fact is there are a number of important elements in the $400 billion agreement that have yet to be decided.

For one, Moscow and Beijing have a fundamentally different view of what the delivery pipeline should look like. China wants two pipelines, while Russia is interested in a single line that China would have to share with South Korea and Japan.

The issue, as with everything else that is still up in the air, revolves around cost and revenues.

The pipeline is going to cost at least $22 billion to build. But if Gazprom has to run two satellite lines just for China, it will cut into already strained profit margins.

Meanwhile, if additional contracts with Korea and Japan require separate pipelines, another set of major capital expenditures would emerge.

Even if the pipelines are funded with pre-payments on deliveries (which amounts to an advanced credit), that would simply lock Gazprom into specifying a fixed price up front for the initial multi-year consignments.

This is a big problem, especially where the price has yet to be finalized...

The Problems with the Pact

This "historic" pact may talk about providing 38 billion cubic meters annually over 30 years at a price tag of some $400 billion. But the actual price is a closely guarded secret (the norm in such deals) and remains a matter of some dispute.

In fact, the Russians must match the price of gas exports to Europe, running at about $309 per 1,000 cubic meters, with an additional increase pending. That's because the cost of the gas is adjusted based on the price of a basket of crude oil and oil products. This basket is becoming more expensive, bringing the price of gas up right along with it.

And if the Russians provide the kind of discount China wants, Gazprom will open itself up to arbitration suits from existing contracts servicing a number of European end users.

And in this case, Beijing has an ace in the hole.

Put simply, China does not need, nor can it absorb, the volume called for in this deal. At present, gas accounts for no more than 30% of China's energy needs.

What's more, that total is already completely met for at least the next six years, with a combination of domestic production (which is going to increase - China has the largest extractable shale gas reserves in the world) and ongoing import accords with Turkmenistan and Myanmar.

Also, the infrastructure doesn't even exist to use what Russia expects to sell. It might in a decade, but Gazprom needs the revenue now.

And that brings us to the counter-reaction that is already underway. China is also opening its market to liquefied natural gas (LNG) deliveries, reflecting moves that are already well underway elsewhere in Asia.

That sets the stage for a direct confrontation with the as-yet unresolved Russian agreement.

In fact, the announcement has already introduced some rather rapid moves to obstruct Russian control over access to the Asian market.

Already, members of the U.S. Congress are demanding that American LNG exports be expedited to blunt the Russian move into Asia.

Now realistically, no LNG exports are possible for at least a year or more. But remember, this is a 30-year deal - allowing for some time to undermine Gazprom's plans, assuming they can even be introduced.

After all, the previous oil deal between the two countries had the same bravado at the beginning, only to fall into a heated and protracted pricing dispute.

But here's the key in what is certain to become the next chapter in the growing geopolitical contest over energy deliveries. Asia in general (and China in particular) is where demand is exploding. Every analysis points toward the fulcrum of global energy trade gravitating to the Asian and Pacific market.

The contest over who wins this trading battle will move progressively to overland pipelined gas versus LNG arriving by tanker as the way of supplementing domestic supplies. The entire continent wants to move away from the environmentally devastating use of inferior local grades of powdery coal, with gas being the obvious choice as a replacement.

Currently, Gazprom can argue (quite correctly) that deliveries of LNG cost about twice as much as gas via pipeline. But over time that will be reduced as the volume increases.

Yet what is already disconcerting for the Russians are these two facts...

Where the Deal Could Really Go Wrong for the Russians First, LNG provides the prospect of establishing genuine spot markets that will undermine pipeline prices. As we have already seen, increasing (and reliable) LNG consignments into Europe have established local spot markets surrounding receiving terminals like Rotterdam Gate in the Netherlands, creating major competition to existing Gazprom contracts.

As a result, European end users are now demanding the Russians factor in the lower spot prices from LNG imports into the longer-term pipeline gas price calculations. Spot sales are ad hoc and quick (usually over and done in 72 hours). Provided the volume is guaranteed, the resulting prices will usually undermine longer-term pipelined gas based on oil prices.

We are not talking about the importing cost but the wholesale spot price at the terminal. That is a distinction Gazprom would prefer people not notice.

From the standpoint of Washington, however, there is a second and even more vulnerable point in this latest version of the Cold War. Remember this one, because it is likely to be the Achilles' heel of the Russian-Chinese deal, at least in regard to what Moscow needs to get out of this.

This is something with which I have some personal acquaintance, given some of my previous public sector assignments in the energy sector.

To undermine the deal, it is not necessary for the U.S. to replace all or even most of the Russian gas with a more attractive combination of LNG deliveries and technical support for Chinese shale gas projects.

The truth is, replacing only 8% to 10% of the annual total will be enough to destabilize this 30-year deal. As we know from private sector transactions, profits are made at the margin.

In "The Great Game" of geopolitics, a competitor's policies can be undermined exactly the same way.