Wednesday, January 04, 2006

Russia Shuts the Gas Off

Gazprom, the Russian natural gas monopoly that controls one-third of the world’s reserves, announced on New Year’s Day that it was reducing gas deliveries to Ukraine. The consequences were felt immediately in Europe, which receives a substantial amount of its natural gas from Russia via Ukraine by pipeline. Poland’s gas deliveries fell by 35%, Austria’s fell 33%, France and Slovenia were short 30%, and Italy 24%. In the ensuing storm of protest, Moscow declared that it had cut only Ukraine’s supply and that Ukraine likely siphoned off what it needed from the gas transiting the country on its way West, a charge that Kiev denied. Despite the fact that Gazprom had restored gas deliveries to normal levels by Tuesday, gas prices were continuing to edge upward across Europe admidst fears that the still unresolved dispute would lead to more shortages. Wholesale prices rose as much as eight percent in Great Britain.

While Gazprom was ostensibly demanding nothing more than market prices for its natural gas, concerns about Russian energy policy and its implications for global energy security quickly overwhelmed the purely economic issues and assumed center stage in the dispute , strengthening Ukraine’s hand in the negotiations. By Wednesday, Gazprom capitulated. The Russians, who sought a four-fold increase for their natural gas, settled for a two-fold increase as well as an increase in the transit price paid to the Ukrainians.

The proximate cause of Gazprom’s action were the deadlocked negotiations over natural gas prices to be paid by Ukraine. The Russians wanted Kiev to pay $230 per 1,000 cubic meters, a price that is lower than that charged to Western Europe. That seems fair enough, but it would have been more than a four-fold increase from the previous price of $50 per 1,000 cubic meters. Aruging that its weak economy could not absorb such a shock, Kiev wanted the price increases to be phased in. There was also the issue of how much the Ukrainians could charge for the Russian’s use of their territory to supply gas to the European Union. The Russian natural gas pipeline transits Ukraine. The Ukrainians claimed the right to fifteen percent of the natural gas going through the pipeline. (They also stated that they would take gas from the pipeline, with or without an agreement, should temperatures fall below freezing, a declaration that further unsettled the EU.) While Moscow offered at the last minute to place a moratorium on the introduction of market prices until the end of winter, Ukraine walked out of the negotiations; and Gazprom announced the reduction in gas deliveries.

The shock to world energy markets that Gazprom’s action created reopened the political differences between the West and Moscow that emerged during the Orange Revolution in the wake of the 2004 presidential elections. Moscow backed Viktor Yanukovich in those elections while the West backed Viktor Yushchenko. Yanukovich was initially declared the winner; however, Yushchenko eventually took office following a tense period during which crowds of Ukrainians swelled the streets of Kiev in protest of obvious, massive electoral fraud. The timing of Gazprom’s action, coming as it did just months away from the Ukrainian parliamentary elections, fueled the perception that Russia was using energy to both punish Ukraine and influence the election results. The U.S. charged that Russia was using energy supplies as a political weapon against Ukraine. Whether true or not, the rising perception threatened to prove as damaging to Russia as the Arab oil boycott of 1973, which left the West determined to be less dependent on Arab oil. The EU announced a series of high level discussions on how to reduce energy dependence on Russia. Worse still, Germany, Russia's biggest natural gas customer, expressed concerns about Moscow’s dependability as an energy supplier.

Perceptions of manipulating energy dependence for political gain quickly began to threaten political costs for Russia as well. As Moscow prepared to take the presidency of the G-8 for the first time, the dispute refocused attention on its abysmal human rights record, the worrisome erosion of democracy, and pervasive state interference in the market. Further, the crisis promised to boost the electoral fortunes of President Yushchenko’s party in the upcoming parliamentary election as nationalist sentiments were stirred up by the standoff with Russia.

All of this was too much. At the Kremlin’s apparent insistence, Gazprom signed a five year deal guaranteeing natural gas to the Ukrainians at $95 per 1,000 cubic meters and raising transit fees that the Ukrainians charge. The latter will now be paid in cash instead of natural gas.

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