Nord Stream AG, the project company that will build a gas pipeline under the Baltic Sea from Russia to Germany, expects to come to market for a Eu3.5 billion ($4.88 billion), 14-year project financing before September.

Euler Hermes and SACE, the German and Italian export credit agencies (ECAs), originally agreed to cover Eu1 billion each. But during a market sounding earlier this year, banks expressed concern about the difficulties of raising Eu1.5 billion of uncovered commercial debt in current dire market conditions. In response, Nord Stream – which is owned by Gazprom (51%), Wintershall, a BASF subsidiary (20%), E.ON Ruhrgas (20%) and Gasunie (9%) – has asked the ECAs to guarantee a larger portion.

The German government is also considering untied loan guarantees (UFKs) for a portion of the deal, under legislation that provides for these to be used to support projects that enhance German energy security.

Nord Stream will be a 1,220km, two-string pipeline with 55 billion cubic metres (bcm) per year capacity, from Vyborg in north-west Russia to Greifswald in Germany. The total cost is estimated at Eu7.4 billion, of which 70% will be borrowed.

This year's financing pays for the first string, which is due to be commissioned in 2011. Nord Stream plans to return to the market early next year for Eu1.5 billion to finance the second string, build it straight after the first, and commission it in 2012. Given depressed forecasts of European gas demand, however, there is a possibility of that being delayed.

The robust German and Italian backing for Nord Stream is a reminder of the pro-Russian element in those countries' energy supply policy. Some European politicians have opposed Nord Stream on the grounds that reducing dependence on Russia for energy is an overriding priority. But Germany, Italy – and the largest European energy companies – think otherwise. Although the project is still awaiting environmental permissions from Sweden, there are few doubts that it will go ahead.

The financing challenge

Nord Stream has appointed Commerzbank-Dresdner, Societe Generale and RBS as its financial advisers. It is preparing to approach the bank market with a request for proposals and supporting documents, including a detailed term sheet, due diligence reports and a financial model.

Nord Stream's chief financial officer, Paul Corcoran, says discussions are still in progress with EulerHermes and SACE over a possible extension of their loan guarantees. "We are also investigating the possibility of obtaining untied loan cover, but that's not at a very advanced stage". The ECA cover will come in the form of traditional export credit guarantees; there has been no discussion of direct loans from ECAs.

Nord Stream's Paul Corcoran

The global recession put paid to the idea of financing both strings of the pipeline in one go, and has made even the Eu3.5 billion package a tall order. Not only is increased ECA cover and other state support vital, but the banks have told Nord Stream that the maximum tenor for the commercial portion will be ten years. "A year ago, a longer tenor would certainly have been possible. In today's market it's much more difficult," says Corcoran. ECA-covered funding will be for 14 years.

There will also be tough talking over pricing. The deal is expected to be structured as a standard project financing, with shareholder guarantees falling away at completion in 2011, and bankers are looking for a margin of 250bp or more over Libor.

Nord Stream is also having to negotiate with more lenders. "Banks' individual capacity is limited," says Corcoran. "Two years ago we could have done this deal with three or four banks: now we're looking at a significantly higher number." Furthermore, for many international lenders the issue will be Russia country limits, more than pricing. And the options to borrow locally are limited. Russian banks, natural partners for Nord Stream, will find it more difficult to participate, because their cost of capital has risen sharply.

Corcoran stresses that while the financial crisis has compelled the company to make the finance package more attractive to lenders, it has had "no impact whatsoever" on the project's fundamental economics, which rest on assumptions of higher long-term energy demand in Europe.

The gas market story

The case for Nord Stream is, first, that European gas demand will continue to rise for the foreseeable future, and much of this gas will come from Russia; and, second, that it offers a route that avoids Ukraine and Belarus, whose gas disputes with Russia have disrupted transit.

The International Energy Agency's most recent reference scenario, published in November last year, showed EU gas demand rising from 528bcm in 2006 to 600bcm in 2015, 623bcm in 2020 and 673bcm in 2030 – while the EU's own production will continue to fall.

Even if the most optimistic forecasts of increased imports from elsewhere are realised, more Russian gas will be needed. And Gazprom has signed preliminary sales contracts for 22.5bcm of additional volumes – 1bcm to Dong Energy, 4bcm to Ruhrgas, 2.5bcm to Gaz de France, 6bcm to Gazprom Marketing & Trading and 9bcm to Wingas – to be delivered via Nord Stream from 2011.

In the short term, the economic recession has dealt severe blows to gas demand. IEA statistics for OECD Europe showed that demand in the first quarter was down 5.4%, and imports down 13%. Gazprom said that its exports were down by 30% in the same period. Neither is the Russian company forecasting a rapid pick-up: it has produced 640-665bcm annually in recent years, but its production chief Aleksandr Ananenkov recently said he expects output to fall to 450-510bcm this year and to recover only to 523bcm by 2012.

Gazprom has revised its investment programme, and recently announced a one-year delay, to 2012, of the start-up of the giant Bovanenkovo field on the Yamal peninsula. Further postponement of the Yamal development, which is central to Gazprom's long-term strategy, is unlikely. But it is still unclear whether smaller projects, such as the Shtokman field in the Barents sea – which could be a future supply source for Nord Stream – may be delayed by longer. The speed of the recovery of the economy, and of gas demand, will make a difference.

Nevertheless, no-one inside or outside Gazprom expects European demand to stay so low for so long that the new sales via Nord Stream will not be needed. So the commercial viability of the first string of the pipeline seems assured.

Could the second string be delayed? Nord Stream insists that there's no reason to do so. The company has tendered for the steel pipes but not signed a purchase contract. Some delay might allow steel prices to fall and the project finance market to improve – but a substantial break in pipe laying work would obviously deprive Nord Stream of economies of scale.

As for gas volumes, the additional 22.5bcm per year of Gazprom sales are almost enough to fill the first string. Even without further contracts, the second string could be offered as an alternative to transit through Ukraine.

In Germany, Nord Stream is seen as central to a strong and expanding gas relationship with Russia. Kirsten Westphal, researcher at the German International Institute for Security Affairs in Berlin, says: "The companies have successfully presented the economic and commercial rationale for the project. There's a cross-party political consensus that it is important to energy security."

Other gas projects enhance the German-Russian relationship. EON.Ruhrgas and BASF, as well as investing in Nord Stream, have taken equity shares in Severneftegazprom, which is producing gas at the Yuzhno Russkoye field, much of which will also be exported via Nord Stream. A deal bringing E.ON Ruhrgas into the project was finalised in June, and a bridging facility of over $1.5 billion for Wintershall and Gazprom, on which Societe Generale advised, has gone out to the market. Commerzbank, KfW, BNP Paribas and Dexia are among the participants. The bridge is expected to be refinanced by a longer-term project finance package.

At the other end of Nord Stream, the gas distribution company Wingas, a Gazprom-Wintershall joint venture, is sponsoring the OPAL and NEL pipelines, due for completion in 2011, which will carry gas from Greifswald, where Nord Stream comes ashore, to existing German and Czech networks. Commerzbank, RBS and Landesbank Hessen-Thueringen are among the reported arrangers of a $418.2 million financing for these projects.

Nord Stream vs Ukraine

The Russo-Ukrainian gas dispute in January, which resulted in supplies for European customers being reduced for two weeks – and in the case of many in the Balkans, cut off all together – was a turning point in Russo-European energy relations and forms a key part of the context for the Nord Stream pipeline.

Both Russia and Ukraine blame each other for starting the dispute, and once it began neither hastened to end it. But while Gazprom's previously spotless reputation as a reliable supplier suffered – and politicians hostile to Russia claimed that Moscow had been more than happy with the disruption caused – the European gas industry concluded, above all, that the priority was to reduce reliance on Ukrainian transit.

More than 70% of Russia's gas exports to Europe go through Ukraine, and the rest go through Belarus. In successive disputes with Russia over the last two decades, largely over the cost of Ukrainian gas imports, politicians in Kiev have been prepared to use the ultimate sanction of diverting gas supplies bound for Europe from pipelines.

Some European politicians reacted to the dispute by redoubling support for projects such as the Nabucco pipeline, aimed at bringing non-Russian gas from the Caspian to Europe and reducing Russia's share of imports. But contracts for gas deliveries on which the ambitious Nabucco project depends have yet to materialise, and it will only change the picture over the longer term. On the other hand the dispute made Gazprom's big European customers still more enthusiastic about Nord Stream.

Nord Stream and Gazprom executives have repeatedly insisted that the pipeline's aim is to supplement, and not replace, Ukrainian transit. But its existence will end Ukraine's near-monopoly. As Corcoran said: "One of the benefits of Nord Stream is that it is a diversification of supply routes, and that by definition is a contribution to supply security."

Nord Stream's first string will probably add to the reduction of transit volumes through Ukraine caused by the downturn in demand, reduce Ukraine's bargaining power, and make a repeat of the January dispute far less likely. Once the second string is built, the reduction in Ukrainian transit could be quite substantial.

Simon Pirani is a senior research fellow on the Natural Gas Research Programme at the Oxford Institute for Energy Studies