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Russian decree on Sakhalin II threatens Japan’s LNG imports

Japan’s LNG imports may be jeopardised by a recent decree signed by the Russian president to give complete control of Sakhalin II (9.6 mtpa) to a new Gazprom subsidiary – Gazprom Sakhalin Holding. In response, Japan will have to use several countermeasures such as increase its nuclear and coal power generation, and introduce curbs on energy consumption to avoid an energy crisis in winter.

The Russian order could be seen as a retaliation to the EU sanctions which have disrupted the country’s energy exports and investments in current and future projects. This order is also designed to put foreign companies (which have exited or are planning to exit Russian projects) on the backfoot.

The order mandates the existing foreign partners in the project – Shell (27.5%), Mitsubishi (10%), and Mitsui (12.5%) – to reapply to the new entity for regaining their status in the project. Russia’s gas monopoly Gazprom, which is owned majorly by the Russian government, holds a 50%-plus-one-share stake in Sakhalin Energy and will hold the same stake in Gazprom Sakhalin Holding Ltd. The latter will be the new operator for the project.

Sakhalin II’s existing partners will be offered new shares proportional to their old stakes and will be given a month to accept the new terms. Even if the former partner agrees to the new terms, the Russian government could refuse to offer them a share in the new entity and instead sell the foreign-held stakes within four months to a Russian buyer. Furthermore, the proceeds from the sale could either be sent to the foreign shareholder or retained by the Russian government as payment for unspecified damages.

Japan intends to remain vested in the project, and has asked Mitsui and Mitsubishi to maintain their share. Meanwhile, the Japanese government has also asked its LNG companies to identify alternative supplies. Sakhalin II is of significant importance to Japan which sourced 9% of its total LNG imports (around 100 cargoes) from the Russian project in 2021. Meanwhile, Shell is assessing the decree after its earlier plan to exit all Russian projects including the Sakhalin II.

There is a dramatic transformation in Japan’s outlook toward Russia as the former has been siding with the West by raising sanctions against the latter. Japan froze assets of 28 Russian companies while Japanese financial institutions have refused loans to major Russian energy projects. Japan has also stopped its import of Russian coal and gold, supporting the European sanctions on the latter. However, Japan’s LNG imports from Russia have remain unaffected with volumes reaching 3.7 million tonnes in 1H22, which is up 4.5% YoY.

As of now, the existing LNG contracts between Japanese energy companies and Sakhalin II for 5 mtpa (half of the project’s capacity) are intact, but any deterioration in the relations between the two countries could potentially end the current contracts.

Russia and Japan are technically still at war as they have not signed a peace treaty after World War II. The two countries are also embroiled in a long-standing dispute over the Kuril Islands, which are expected to have rich oil reserves. The islands are strategically located as they give the Russian Naval fleet at Vladivostok access to the Pacific Ocean. Drewry believes Russia, which has occupied the Kuril Islands, will use them as leverage when finalising the stake of Japanese firms in Sakhalin II and their long-term SPAs.

As a result, European LNG imports surged at end 2021 topping 7 million tonnes in December alone, with most supply sent from the US. Cargoes from other LNG exporters – Qatar, Oman, Peru, Nigeria and Russia – also discharged at European terminals in this period while some cargoes were also sourced from as far as Indonesia and Australia.

At present, Japan is faced with power shortages due to the severe heat wave. The country is forced to reconsider the restart of nine nuclear plants which would secure around 10% of the country’s energy consumption and prevent a similar situation in the winter. JERA, the largest Japanese power generation company, is looking to restart the 600 MW gas-fired Anegasaki Thermal Power and Chita Thermal Power Station. JERA is also planning to start two new gas-powered plants in August.

Japan has already started to curb the consumption of LNG with the government, for the first time after 2015, requesting households and industries to conserve electricity for three months starting July 2022 due to tightness in LNG supply.

Japan has experienced sudden shocks in its energy demand before as the Fukushima disaster in 2011 shut down around 30% of the country’s electricity production. The country had then used the demand-side measures to reduce its peak energy demand by 20% and staved off an energy crisis.

It may be unlikely for the Russians to keep Japan out of the Sakhalin II project as the latter imports 60-70% of the LNG produced annually from this plant, and Russian energy exports are presently threatened by the Western sanctions. However, geopolitical ambitions may throw caution to the wind and create woes for Japan’s LNG supply.

We believe Japan will be able to absorb the loss of Sakhalin II cargoes with alternative supply and demand-side measures creating a ripple effect on the global market.

1) Japan will be challenged to completely substitute the Sakhalin II quantities. Sakhalin II is the closest LNG project to Japan (at 1,100 nautical miles) with shipping costs at $0.46 per MMBtu in 2Q22.

2) The cancellation of contracts would compel Japan to source alternative supplies in a market where flexible LNG is hard to come by. Japan will most likely source the alternative quantities from the US, which would force it to compete with Europe for flexible LNG at much higher prices.

3) The lack of spare supply could impact global shipping with differing impacts – Sakhalin II could export to other Asian countries such as China and India while Japan importing from farther destinations will marginally add to the tonne-mile demand. Additionally, Japan would also have to bear increasing shipping costs and the risks of delays at Canal transits.

4) On the flip side, Japan’s conservatory measures and high spot prices will lower the number of cargoes reaching the country, creating vessel oversupply in the global market. Most ships on the Sakhalin-Japan route are older steam turbine vessels that if idled would find it hard to gain alternative employment, especially with the upcoming EEXI regulations.

Japan would also need to sign SPAs with upcoming LNG projects in the US, Canada and Qatar to secure long-term LNG supply and offset the Sakhalin II volumes, which can spur orders for modern vessels. Moreover, tight shipbuilding capacity till 2027 and the increasing importance of LNG supply could also incentivise Japanese shipbuilders to re-enter LNG shipbuilding.
Source: Drewry

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