On Pipelines



During their summit in late August, President Dmitry Medvedev said that Kim Jong-il had agreed to create a tripartite commission to discuss the construction of a gas pipeline to South Korea via the DPRK. This mega-deal was interpreted by some Russian analysts, including Gregory Toloraya, as a positive sign. Yet like Kaesong and Kumgang, the project carries enormous risks. It looks very much like the kind of pure rent-seeking that the regime favors over meaningful reform and investments that would increase productivity and citizen—rather than elite—incomes.

First, some history, courtesy of a useful paper by Richard Weitz for the Korea Economic Institute on Russia’s relations with the two Koreas. During the Lee-Putin summit in September 2008, Russia and the ROK signed a natural gas deal estimated to be worth as much as $90 billion, under which South Korea would import 10 billion cubic meters of Russian gas annually for 30 years beginning in 2015. A subsequent agreement authorized two state-controlled entities—Russia’s Gazprom and Korea’s Kogas--to oversee the deal. Initially, a $3 billion overland pipeline was contemplated that would run from Vladivostok through North Korea to the South.

But according to Weitz, the pipeline idea “faced repeated difficulties owing to commercial infighting among Russian energy companies, the inability of Russia and China to negotiate a mutually acceptable agreement that would allow Russia to send gas to both the PRC and the ROK, and North Korea’s erratic position on the trans-peninsular pipeline project.” Even the Russian Ambassador expressed skepticism of North Korea’s reliability. With a more hostile stance toward North Korea under Lee, the Russian and South Korean parties started to consider an underseas pipeline that would bypass North Korea altogether.

But pipelines cost money—big money. The most simple back-of-the envelope net-present value calculations show significant cost increases if South Korea is on the hook for financing any part of the project.

In August 2009, Kogas announced that it was scrapping consideration of the project in favor of importing gas in liquefied (LNG) form. Under an agreement signed in 2004, Russia extended generous prices for imports from 2009 forward (equivalent to about $25-a-barrel oil). Not surprisingly, we have yet heard little from South Korea on the pipeline idea. Why get involved in a messy pipeline deal if you can import what you need in LNG form at low prices?

Were the pipeline to move forward, the hold-up problem is almost too obvious to mention; the UNDP and World Bank have an excellent overview of the political economy of pipelines in a 2003 report. The problem is not only that supplies would be subject to interruption were tensions to escalate; look at the interruptions in electricity to the South in the period immediately following the end of the Second World War or the far more recent problems with Kumgang for a preview. But given the interest of the Kims in pure rents, the temptation to exploit the obsolescing bargain will also be substantial, as Kaesong re-negotiations have shown. These problems are compounded by high fixed costs, which means that full-capacity operation is extremely important; this only serves to increase the potential leverage Pyongyang holds.

Which brings us to the issue of project financing. Who is going to finance this thing? The structure of pipeline costs is characterized by high fixed costs and low variable costs; the only costs of operation are fueling the pumps. Given the extraordinary upfront costs, pipeline financing is often done on a project basis, with investors taking some equity stake in the project but much of the financing provided by debt. If Gazprom finances this, fine; if not, the project financing community—the Lazards of the world—will have to buy into it. Needless to say, they are going to ask very tough questions about political risk, which are likely to end either with a market veto or expensive money.

Over the long-run, this project is a win-win for South Korea and Russia, but with the cost of granting huge rents to the North Koreans that they are likely to dissipate in continued intransigence. Our suspicion is that market forces--both in the gas market and the project financing market--are likely to delay the project.

But for the record, it should be noted that President Lee Myung Bak apparently disagrees with us. During a televised debate last week, LMB said that the project could move forward “faster than expected,” and that bilateral talks with the Russians were already in train. (Analyst Peter Beck was appropriately “shocked” at the announcement, which could have to do with the GNP's gradual retreat from a hard line.) Georgy Toloraya parses recent Russian policy toward the peninsula for the 38th Parallel, arguing that the Putin—I mean Medvedev—administration is looking to regain an Asian presence.

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