The Gas War: A Monumental Russian Mistake edit

Jan. 6, 2006

Early on January 4, Gazprom and Ukrainian gas officials reached an agreement on gas deliveries to Ukraine in Moscow. This was in many ways an excellent agreement, but most of all so for Ukraine.

-->First, it is a five-year agreement lasting till the end of 2009, which means that stable conditions for gas deliveries should have been accomplished. Amazingly, Russia is offering Ukraine five years of stable natural gas prices at a time of rising gas prices and increased gas scarcity, while most countries face annual price revisions.

Second, a consortium is being set up that involves gas deliveries from four producers, Russia and Turkmenistan, but also Kazakhstan (whose production of associate gas is rising fast) and Uzbekistan (a marginal exporter), and at least one consumer, Ukraine. To Ukraine, this means that it obtains access to gas also from Kazakhstan and Uzbekistan. It appears as if Russia is reinforcing its control over gas deliveries from Central Asia. The formation of such a consortium, though not concluded, should stabilize gas trade relations.

Third, the price agreed - $95 per 1,000 cubic meters (mcm) seems perfectly sensible. It is almost twice what Ukraine paid last year, but less than the $110 per mcm that Georgia and Armenia are to pay, and the Baltics are supposed to pay slightly more, and far from the 230 per mcm that Gazprom originally demanded. The Russian claim that Gazprom would be paid $230 per mcm seems nothing but a face-saving devise. Possibly, the portion of Russian gas delivered to Ukraine will decline so much that this becomes true.

Fourth, the transit fee situation is improving considerably. Ukraine will now be paid its transit fee in cash from Gazprom rather than through barter. The transit fee through Ukraine rises from $1.09 per 1 mcm and 100 km to $1.60, which is a more reasonable though somewhat low price. In addition, Ukraine will buy all gas from Russia and Central Asia at the Russian-Ukrainian border, while it previously bought gas on the Russian-Turkmenistan border being compelled to haggle over the transit fee with Gazprom. Therefore, Ukraine is not likely to actually pay more for the Central Asian gas than the $44 per mcm it paid last year, though it is said to pay $65 per mcm this year.

The only really disturbing element is that the enterprise Rosukrenergo will be in charge of the gas deliveries to Ukrane. It is a joint venture between Gazprom and a legal entity under the auspices of Raiffeisen Bank, which took over two years ago from Euraltransgaz, which took over in 2001 from Itera. These companies appear to have been created only to skim off profits from Gazprom. Hermitage Fund assesses that the unjustified profit of the Raiffeisen entity is $500 million a year. The US government alleges that the partners of this entity are the organized criminal Semen Mogilevich (Ukrainian who lives in Moscow), former Naftohaz Ukraina chairman Boiko and top people in the Kremlin. Prime Minister Yekhanurov emphasized that Russia insisted on Rosukrenergo's involvement and that the Ukrainian government was not involved in it.

The economic outcome is relatively easy to calculate. If Ukraine will import 60 bcm of natural gas this year, it would have to pay $5.7 bn to compare with $2.9 bn for 62 bcm last year, that is, an increase of $2.8 bn. However, from this we need to deduct an increase transit income of Ukraine of $500 million and decreased transit costs for Turkmen gas of about $800 million, which leaves us with a net increase of $1.5 bn or barely 2 percent of Ukraine's GDP. Given how energy prices have risen around the world, this appears a very good deal indeed for Ukraine, and the question arises whether Russia will really stick to this settlement.

Two industries in Ukraine will be hit by the higher gas prices, the chemical industry (especially mineral fertilizers) and the steel industry, which are very dependent on gas and in direct competition with Russian industries that only pay $35 per mcm for gas.

For Russia, the whole gas conflict appears a monumental mistake for at least six different reasons.

-First, in spite of market economic arguments, the massive price discrimination ranging from $47 per mcm for Belarus to $250 per mcm for Western Europe makes clear that the conflict is really political.

-Second, for long the Kremlin has made clear that its main objective has been to influence the Ukrainian parliamentary elections on March 26 to the benefit of Yanukovich's party the Regions. This is bound to backfire to the benefit of Yushchenko and Yekhanurov. Once again, the Kremlin is running Yushchenko's election campaign for him.

-Third, Russia does not appear to have realized that it has a very weak position in gas negotiations with Ukraine. Much of Russia's export gas is virtually worthless without Ukraine's gas pipeline, which is the only road to the outside world for most of the gas until 2009, when the St. Petersburg LBG plant and the North European pipeline to Germany are supposed to come on line. Gazprom is under the heel of Ukraine's transportation monopoly. Russia was cheated by Ukraine persistently from 1992 to1999 but does not appear to have learned to appreciate its weakness.

-Fourth, legally Russia was bound by a five-year agreement concluded with Yanukovich in 2004, guaranteeing Ukraine the price of $50 per mcm. Ukraine could have taken Russia to international arbitration in Stockholm and would no doubt have won.

-Fifth, by taking immediate and drastic action, reducing gas supplies to much of Europe, Russia has severely damaged its reputation as a reliable supplier of gas that it has nurtured for the last four decades. Two days of minor disruption are evidence enough. At a time when much of Europe is considering the choice between Russian gas through pipelines or LNG from anywhere this can potentially be highly damaging, as energy decisions tend to be more political and emotional than rational. Especially considering that this happens at the very time that Russia becomes chairman of G-8, the damage to Russia's international reputation is likely to be palpable.

-Sixth, the Kremlin's insistence on using the non-transparent vehicle Rosukrenergo is likely to increasingly discredit it as people realize what it actually is.

In short, Russia could hardly have done worse until the agreement today. It has appeared aggressive, uninformed, reckless and foolhardy.

For Gazprom, however, this does not look all too bad. It has shown that it is really interested in raising prices to a reasonable level to boost its profits. It has reached a sensible agreement pretty fast, even if it could have left the prices to be renegotiated each year or raised by some formula, which Ukraine accepted. The big question is how seriously two days of minor supply disruption will be taken by potential European customers.