LONDON (Reuters) - In accepting a price cut for its gas supplies to Europe and paying billions to build the South Stream pipeline, Gazprom (GAZP.MM) is paying a high short-term price to protect its long-term position as Europe's dominant gas supplier.
Earlier this week, Russia's Gazprom gave in to customer pressure and offered German utility E.ON (EONGn.DE) a price cut on its long-term gas supplies, boding well for Germany's RWE (RWEG.DE) and Poland's PGNiG PGNI.WA, who are also seeking to renegotiate.
While the deal means lower revenues for Gazprom in the short-term, the Russian company said it safeguarded its pricing model - with contracts that can span over 10 years and which are indexed to the oil market.
The move comes as Europe's domestic natural gas resources dwindle and Gazprom faces rising supplier competition as well as from other fossil fuel sources.
Around 150 billion cubic meters (bcm), or 40 percent of the European Union's gas imports, are currently supplied by Russia, while 80 percent of Gazprom's revenues come from European customers.
"The price adaptation in the long-term contract with E.ON will increase the competitiveness of Russian natural gas and, enhance Gazprom's market position," Sergei Komlev, Gazprom Export's head of contract structuring and price formation told Reuters.
Gazprom has been under pressure from its clients to loosen its contractual links with the oil market and allow more spot market pricing into its contracts.
"Gazprom had to give up some price concessions as Europe is in recession and as gas is being displaced ... (in) power generation in favor of coal," Societe Generale analyst Thierry Bros said.
Lower coal prices have made coal-fired power generation in Europe much more profitable than gas, which is linked to the firmer oil market.
E.ON said that the reduced price meant that a "major milestone" had been reached in restoring the competitiveness of long-term gas contracts.
Komlev said that the agreement with E.ON meant that Gazprom had defended its price model.
"The overall discount remained within Gazprom's set range of no more than 7-10 percent (and) the oil-linkage in this long-term contract was preserved intact," he said.
Although some analysts say that the pricing debate will re-emerge after 2015, when new gas sources to Europe become available, most say that Gazprom has defended its pricing model.
"The gas pricing debate in Europe is nearing an inflection point with more and more counterparties accepting the oil-price-link over the spot pricing model," Russian brokerage Otkritie Capital said in a research note.
Gazprom has already reached agreements with Italy's Edison SpA EDN.MI and Greek gas company DEPA through making price concessions that in turn keep long-term, oil-indexed contracts in place.
South Stream map: link.reuters.com/sas29s
Another strategy for Gazprom to safeguard its role as Europe's dominant gas supplier is through spending huge sums on expanding a pipeline network which avoids transit through Ukraine, where most of Russia's gas to Europe currently passes through.
Its main project to expand its network is the South Stream pipeline.
At an expected cost of over $20 billion, it would be able to pump 63 bcm of natural gas to Italy or Austria per year, outsizing European Union-backed pipeline projects that aim to diversify Europe's gas supplies away from Russia by transporting non-Russian central Asian gas into the EU.
The pipeline would be big enough to cover 75 percent of Italy's annual gas demand or 10 percent of Europe's total needs, and analysts see Gazprom's aim in building South Stream as long-term and strategic.
Standoffs between Kiev and Moscow over unpaid gas bills have crippled gas flows across Ukraine to Europe on more than one occasion, hurting Russia's reputation abroad as a reliable gas supplier.
"After Ukraine shut down Russian natural gas shipments to Europe in January 2009, Gazprom felt it necessary to mitigate the transit risks in order to be able to meet its contractual obligations," Komlev said.
Gazprom has already built its Nord Stream pipeline, which avoids Ukraine by pumping gas from Russia across the Baltic States into Germany.
Nord Stream and South Stream combined would almost equal the amount of gas presently transiting Ukraine, significantly reducing Ukraine's leverage as a key transit state, SocGen's Bros said.
European domestic gas production in Britain and the Netherlands is falling, creating new demand for imports beyond 2020, and competition for Russia is rising.
Gazprom says it could build South Stream by 2015, the same year that U.S. gas companies hope to begin to export liquefied natural gas (LNG).
"We envisage gradual gas demand growth in Europe and the need for imported gas against the decline of domestic production," Komlev said.
"In fact, many other pipelines, in addition to South Stream, will be needed to cover the additional demand."
By supplying Europe with its gas at reduced prices, Gazprom will create a glut that will make it less attractive for market entrants to compete.
Qatar has become a major supplier through sending LNG tankers mostly to countries in Western Europe, while LNG development in central Europe, where Gazprom's supplies dominate, have so far failed to have a big impact.
Other new supply sources in the coming years will be Azerbaijan, which plans to pump 16 bcm of gas per year to Europe from 2017.
Gazprom said it does not feel threatened by these new sources.
"The Azeri natural gas reaches Europe in rather modest quantities, and the American gas exports are yet to be spotted on these shores," Komlev said.
Additional reporting by Vladimir Soldatkin and Melissa Akin in Moscow, and Oleg Vukmanovic in London; editing by Jason Neely