How the Game Is Played: The Life and Death of South Stream

6 MINS READSep 17, 2015 | 09:18 GMT
Series: Veins of Influence
Editor's Note

Stratfor closely monitors the ebbs and flows of world energy. Aside from production, the transportation of crude oil, natural gas and petroleum products is of paramount concern for oil-producing nations. For energy consumers, transit routes are indispensible lifelines. A huge amount of the world's energy is transited through pipelines, across the Eurasian landmass in particular. In this periodic series we will examine some of the most geopolitically significant pipelines running through Europe and Asia. In this installment, Stratfor examines the political machinations behind South Stream, the precursor to TurkStream, and how the game of pipelines is played.

Russia once again finds itself locked in a battle with Europe over a new proposal for a natural gas pipeline. Like the push for and ultimate failure of South Stream, the fight for TurkStream — a project that would bring Russian natural gas to Europe by way of Greece and Turkey — is riddled with potential roadblocks, including heavy political resistance from European consumers.

But this time, the competition may end in Russia's favor. Having learned from its past missteps, and with few options left for circumventing Ukraine, Moscow is determined to keep TurkStream from sharing South Stream's fate.

The South Stream pipeline project arose during a series of natural gas disputes between Ukraine and Russia's state-controlled natural gas monopoly, Gazprom, in the mid-2000s. Russia, seeking the payment of debts owed by Ukraine's Naftogaz, cut off Ukraine's natural gas supplies in the hope of pressuring Kiev to pay out. Ukraine, the most important transit state for Russian natural gas heading to Europe at the time, responded by simply diverting supplies that were meant for consumers on the Continent. Gazprom eventually shut off all the natural gas flowing through Ukraine, albeit for a limited time, which by default halted flows to Europe as well.

Gazprom's decision forced the company to consider the impact that similar disputes with Ukraine might have on its European customers in the future. The fallout from the disagreement gave both Russia and Europe an incentive to look for ways to diversify away from pipeline routes passing through Ukraine. As a result, two options emerged: South Stream, a route that would bypass Ukraine to the south, and Nord Stream, a pre-existing proposal that would bypass Ukraine to the north, via Germany.

As One Pipeline Rises, Another Falls

Several factors ultimately led to Nord Stream's success and South Stream's failure. At the inception of the South Stream proposal, tensions between Europe and Russia over Gazprom's anti-competitive practices still simmered beneath the surface; they had not yet boiled over into the highly publicized legal dispute they would eventually become. In addition, the European Union had not yet designed its Third Energy Package, meaning Bulgaria — the newly added EU member that was slated to become a key transit state along the South Stream route — was not subject to heavy European regulations.

Even with the Third Energy Package's adoption in 2009, Russia held out hope that Nord Stream and South Stream would be able to at least partially avoid the new restrictions. And it was right, to some extent: Nord Stream, a project that grew out of bilateral relations between Russia and Germany, managed to secure its status as part of the Trans-European Networks (TEN). This exempted Nord Stream and its associated projects from several Third Energy Package stipulations, including requirements for guaranteeing third-party access and unbundling ownership from supplies, enabling Gazprom to reserve pipeline capacity for itself that it otherwise would have had to auction off to other companies.

South Stream, on the other hand, was not so lucky. Despite Russia's attempts to obtain the same exemptions for the southern pipeline route, Europe refused to grant it TEN status. With the Ukrainian natural gas cutoffs still fresh in the minds of European consumers, Brussels wanted to diversify its supplies away from Russia. On top of that, South Stream had pitted itself directly against Europe's Southern Gas Corridor projects, which aimed to bring natural gas to the Continent from the Caspian and Middle East. Europe therefore gave TEN status to South Stream's primary competitor, Nabucco, and a third-party exemption to the Trans-Adriatic Pipeline, another competitor. South Stream received neither. Brussels' move reflected its larger Southern Gas Corridor strategy of facilitating the construction of non-Russian pipelines by offering incentives and exemptions to Russia's competitors — a strategy it is likely still pursuing today.

Despite these initial obstacles, Russia chose to move forward with the South Stream segments that lay within its borders so that it could transport more natural gas to the Black Sea while it waited for the pipeline politics to shake out, as they had for Nord Stream. And until late 2013, Russian officials were optimistic about South Stream's future; Moscow had secured the funding and partnerships needed for the project, and it had already begun awarding contracts to lay the first two legs of underwater construction. Meanwhile, Bulgaria had started building South Stream's onshore segment.

The Turning Point

The outbreak of the Ukraine crisis in November 2013 marked the beginning of the end for the South Stream project. Western countries responded to Russia's annexation of Crimea in early 2014 with a series of sanctions that targeted a number of Russian officials. The subsequent crash of Malaysia Airlines Flight MH17 after being shot down over Ukraine in July 2014 led to the sanctions' expansion, this time against the Russian banks that were financing South Stream. The sanctions limited Gazprom's ability to raise dollars to build the expensive pipeline project.

At the same time, the European Commission had begun to formally investigate Gazprom's monopolistic practices and threatened to take action against Bulgaria over South Stream's construction. The commission argued that the construction contracts had not been awarded according to rules set forth in EU legislation. Facing stiff pressure from the European Union and the United States, Bulgaria halted construction in summer 2014, leaving the future of the entire South Stream project uncertain.

With no guarantee that the legal dispute would be ruled in its favor — and consequently, no guarantee that it would ever be able to make use of the pipeline — Gazprom was forced to abandon the project. Relations between Russia and the West had hit an all-time low, and it would likely be years before they thawed enough to revive South Stream's viability. While Gazprom could have started over and revamped the project to bring it in line with its new regulatory realities, it would have taken years to complete, and Gazprom had already spent about 20-40 percent of its budget for the first half of the South Stream project.

And so, Gazprom was faced with yet another tough decision: Build a pipeline whose future was questionable at best, or find an alternative route. Given the financial pressure sanctions were putting on the company, as well as the lasting tension between Russia and the West, Gazprom's decision to shutter South Stream was hardly surprising. Nor is it a surprise that the alternative route Gazprom has now turned to is Turkey, the only path to Europe left that does not rely on EU transit states. Gazprom's contract with Naftogaz is set to expire at the end of 2018, and Russia is eager to prove to Europe that it will no longer use Ukraine as a transit state once it does. As Gazprom races against the clock to bring the TurkStream alternative online, it will bear in mind the lessons it learned from South Stream's untimely demise.

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