Inside Washington's Headlines

by Ken Feltman

A counter-intuitive analysis

Moments after the new year began, Gazprom workers near the Russian-Ukrainian border began closing off some of the flow of natural gas from Russia into the pipelines feeding Ukraine and, beyond, much of Europe. The Russians said that they were reducing the flow only by the amount that had previously been allocated to Ukraine because Ukraine refused a price increase.

Within hours the flow had diminished enough to reduce the supply in many parts of Europe. Howls of protests followed. Western media decried the ‘Soviet-style’ cut-off. Soon, amid claims by Russians that Ukraine was siphoning off gas intended for Europe, the supply was restored and Ukraine signed a new pricing agreement with Gazprom. The cold winter crisis was over. Or was it only beginning?

What do we know for sure?

Europe relies on Russia for about a quarter of its imported gas. About 80 percent of that imported gas crosses Ukraine to Europe. Gazprom is approximately 51 percent owned by the Russian state. In November Russian President Vladimir Putin appointed a protégé, Dmitry Medvedev, as first deputy prime minister. Medvedev is the chairman of Gazprom. Thus, with the appointment of Medvedev, Putin seemed to place Gazprom in a political as well as commercial position.

Gazprom is the world’s largest natural gas supplier. During the Cold War, Gazprom sold gas to Soviet satellite states at bargain rates - a sort of foreign aid. By agreement with the government, Gazprom continues to provide gas to Russian consumers at below-cost rates. To compensate for this domestic subsidy, Gazprom is attempting to convert all customers outside Russia to market rates.

In the run-up to the 2004 Ukrainian election, Gazprom struck a deal to supply gas to Ukraine at $50 per 1,000 cubic meters, well below the current market price of $230. The Orange Revolution swept Ukraine and Russia’s preferred candidate lost the election to U.S.-educated and pro-Western Viktor Yushchenko.
 

Gazprom soon demanded that Ukraine pay higher rates for natural gas. Ukraine refused. As Gazprom cut the supply in the early hours of January 1, Europe felt the cold. Ukraine agreed on January 4 to a new five-year pricing agreement with Gazprom. The contract permits - for the first time - the Central Asian states of Kazakhstan, Turkmenistan and Uzbekistan to transmit their cheaper-to-produce natural gas through Russia to market in Ukraine. The price will be $95 per 1,000 cubic meters. Any Russian gas added to the Central Asian gas will be priced at $230.

So the crisis was averted. The Central Asian states, previously limited to selling natural gas only in price-controlled Russia, gained an export market at nearly double the previous revenue per cubic meter. The Ukrainians will pay that nearly doubled price - but still far less than the more than quadrupling demanded by Gazprom. Gas flowed again.

The media portrayed the Russians as heavy-handed. European leaders condemned the cut-off as cruel and uncaring. U.S. Secretary of State Condoleezza Rice tongue-lashed Russia for an ‘ironic and not good’ beginning to Russia’s ascendancy to the G-8 presidency. Politicians and pundits shook their heads at a ‘Soviet-era’ blunder. Russia and Putin were cast as the big losers.

I disagree. Russia and Putin are the big winners. Other winners are the trio of Central Asian gas-exporting countries and investors in Gazprom. The big loser? As counter-intuitive as it may seem, I believe that the U.S. may be the big loser.

What can we surmise?

The devil is in the details and the details show that the transmission prices that Ukraine may charge Gazprom on gas sent through Ukrainian pipelines to Europe are already below market rates and Ukraine has now agreed to freeze those low prices for 25 years. In addition, it seems that Gazprom may raise prices charged to Ukraine beginning in a few months. Finally, the deal calls for a Swiss company to broker the buying and selling of gas. The company seems to be a sham, possibly involving Russian and Ukrainian politicians and criminal elements. Money that would have gone to the Ukrainian treasury will now go to undisclosed, shadowy figures.

The result? Suddenly, Russia has a stronger hold on Ukraine and neighboring areas. Ukraine has been moving toward Europe and the West. The January 4 agreement ties Ukraine closer to Russia.

This crisis was all about two linked things. First is Russia’s desire to move Gazprom to a more stable financial footing so that Gazprom may become a more reliable partner for Western firms in joint ventures. One such venture broke ground in December: the North European Gas Pipeline will cross the Baltic Sea from Russia to Germany and on to Britain. Currently, Britain imports no Russian gas. Completion of the pipeline is scheduled for 2010. Gazprom is partnered with BASF, a huge German company with securities traded worldwide. Gazprom securities also trade around the world, including the U.S., and have soared in the past year.

Another venture is the Shtokman gas find in the Barents Sea. Once developed, this find should make Gazprom a major player in the growing world market for liquefied natural gas. LNG can be transported by tankers to markets everywhere (including the world’s largest economy, the U.S.) and bought and sold like crude oil.

The commercial side of Gazprom is compelling for investors. But the political side of the Gazprom action against Ukraine is an intriguing geopolitical study, in part propelled by a Russian identity crisis. That is the second element behind Russia's action.

The very heart of Russia’s self-esteem as a nation has been rocked in the past two decades. If Ukraine slips to the West, will Russia’s last hope to reassert herself as a major power be lost? Ukraine, then, is a prize worth fighting for.

To the leadership in Moscow, success for Ukraine’s Orange Revolution was unthinkable. Means beside cheap natural gas (possibly including a failed assassination attempt) were tried in the unsuccessful effort to stop Yushchenko's election. In picking up the pieces, Moscow saw clearly what Europe and the U.S. may realize only now: The United States had a big hand in Yushchenko’s victory but a limited risk. Europe bore the greater risk and Europe has just learned that Gazprom can be bluntly arbitrary.

More caution in Europe?

Will Europe be more cautious in attempting to bring Ukraine into the European sphere of influence? Will Europe react differently now that it realizes that it has more to lose than the U.S. in any confrontation over Ukraine? Will this realization cause another split between Europe and the U.S.?

Of course, Putin hopes so. He remembers a Soviet Empire that stretched west of Berlin. Now, Europe’s declared border has crept through Hungary, Poland, Latvia and Lithuania right to Moscow’s doorstep. Much of Russia’s ‘near abroad’ has been gobbled up by NATO and the European Union. If Ukraine goes, will Belarus be next? Its major transport route is the Dnieper River, which flows south into Ukraine. Its commercial and energy links are as extensive with Poland and the Baltic states as with Russia. If Belarus goes, then what? China is pressuring in the East. The Caucasus is restless. Will all hope of regaining influence in the former Soviet republics be gone? Worse, will what remains of the Russian Federation fracture again?
 

Ukraine is central to Russia’s future just as Ukraine is a central part of Russia‘s past. Long before the founding of the Soviet Union, Ukraine and Russia were melded first into an agricultural and then into an industrial giant. A joint infrastructure crisscrossed the two regions and Ukraine became Russia’s gateway to the West by rail, by road and by the warm-water Black Sea port of Sevastopol. From Ukraine, the Soviets extended their dominance over Romania, Moldova and Bulgaria to the Balkans in the West, and over Armenia, Georgia, Azerbaijan and Chechnya to the East.

Realizing the weakening hold, Russia determined to shore up other former republics while intimidating potential rivals from grabbing hold of Ukraine. The deal that permits the three Central Asian states to supply Ukraine with gas enriches those states and draws them closer to Russia - and, not so coincidentally, further from their more recent suitor, energy-hungry China.

Misjudging the shrewd bear

The Ukrainians misjudged Moscow. Yushchenko assumed that Russia would not risk alienating Europe to punish Ukraine. He was wrong. The Russians meted out just enough cold to wake up the Europeans to their peril if the stalemate continued. In those few cold days, Putin shook Europeans out of decades of complacency toward Russian power and resources. Those cold days ended with Yushchenko knowing that the relationship with Europe was now compounded by the politics of energy.

The Europeans misjudged Moscow. Europeans assumed that Russian rhetoric was unpredictable but delivery of needed resources was unfailingly reliable. The gas kept coming despite war, political turmoil, the breakup of the old Soviet Union, and provocations such as the enlargement of NATO and the E.U. Then, on New Year’s Day, Europeans were left to wonder what they got out of this American-incited Orange Revolution. After all, the U.S. supplies no natural gas to Europe. The U.S. imports no Russian gas. Europe has a new awareness of Russia’s desires and powers.

The Americans misjudged Moscow. They assumed that they had little or no downside to their wooing of Ukraine. Now, Moscow has used Ukraine as a wedge between the U.S. and Europe. To keep the heat coming, Europe must take Russia’s concerns about Ukraine more seriously. The U.S. confronts a stark reality: Gazprom is becoming a bigger force in European energy supplies and guess which country is the most viable alternative supplier?

The answer is Iran. This is hardly the stuff of an American victory, unless you are an American investor in Gazprom.

January 1 may turn out to be not just the day that Gazprom turned the heat down in Ukraine and Europe. January 1 may turn out to be the day that a reinvigorated Russia first reappeared on the world stage.  

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copyright © 2006 Radnor Inc.