Risk of new gas war stirs Europe into action

By bne IntelliNews September 19, 2011

Tim Gosling in Moscow -

Ukraine's year-long bid to get Russia to renegotiate the pricing formula for its natural gas supplies has been stepped up in the last few weeks, leading to an undignified series of threats and insults. However, the spat is unlikely to explode into another full-scale "gas war", as both Kyiv and Moscow have too much to lose.

While tensions are high, neither side can afford to upset Europe by causing yet another cut-off of Russian gas exports as was seen in 2006 and 2008-09. Europe depends on Russia for about a quarter of its total gas supplies, some 80% of which transits Ukraine. Brussels has offered its services to audit the contract between the pair - an attempt to derail the spiralling tension around Kyiv's threat to take the issue to international arbitration - but it's a half-hearted offer, signalling Brussels is trying to stay out of the latest spat as it looks to diversify its gas supplies by sourcing more from Central Asia.

Merge or pay

Kyiv has been pressing for a year or more to renegotiate the pricing formula in the current gas contract, which was signed by former prime minister Yulia Tymoshenko in January 2009. However, Moscow has staunchly refused to discuss the matter unless Ukraine either agrees to a merger between its Gazprom and the Ukrainian energy firm Naftogaz, which would effectively hand the Russian company control of the Ukrainian gas transport system (GTS), or the country joins the Moscow-led Customs Union, which also includes Belarus and Kazakhstan. Kyiv has flatly refused; the first would lose it an asset seen as a guarantor of sovereignty, and the latter would halt its progress towards the EU (as is clearly the intention).

Since then, much of the mudslinging has surrounded the actual price of gas in the contract. Kyiv claims it's paying the highest prices in Europe, despite the fact it costs Gazprom little to transport it there. Moscow claims Kyiv is paying less than many European countries. As Maryan Zablotskyy at Erste points out, "the gas market in Europe is far from transparent, which makes presenting elegant arguments to the broader public difficult."

Tymoshenko signed a deal that set a price of $450 per 1,000 cubic metres (cm), multiplied by a factor dependent on oil prices, according to Slawomir Matuszak at the Centre for Eastern Studies. In April 2010, the Black Sea Accords (BSA) saw Moscow grant a 30% discount in return for a low-cost and long-term lease on the Russian naval base in Sevastopol. But with the oil price rising, the gas price that Ukraine pays (including the $100 BSA discount) has risen from $236 in the second quarter of 2010 when the BSA was signed, to $354 currently. European prices average around $340 analysts say, although many contracts are discounted due to Gazprom's part ownership in transit infrastructure in various countries. Gazprom has been fighting off demands to renegotiate contracts with several major European customers over the past two years, with German utility operators E.On and RWE currently working on bringing their deals to international arbitration. "If one deducts the transit cost through Ukrainian territory and adds the discount for the military fleet base," points out Zablotskyy, "Ukraine's gas import price would be the highest in Europe."

Meanwhile, Ron Smith at Citigroup points out that Ukraine is "Gazprom's most profitable export market," but that the current contract is simply unsustainable for Kyiv. That's not least because it also obliges Ukraine to take a minimum of 33bn cm per year - a challenge for a country struggling to recover from the battering it took from the global crisis - while also prohibiting re-exporting any unneeded gas. At the same time, volumes transported through Ukraine's pipelines to the EU have no similar guarantee.

While Gazprom has made concessions to some customers - such as Italy's Edison - it's playing a waiting game with Kyiv as pressures mount on the government. It's a similar tactic to the one Moscow has used with Minsk. As the Belarusian economy heads into meltdown, Gazprom looks to have landed control over its neighbour's gas transportation system in return for a discount on gas.

In Ukraine, President Viktor Yanukovych is playing off macro-economic pressure against domestic politics. On the one hand, the International Monetary Fund (IMF) has suspended its $15bn standby programme until Kyiv reduces the hole in the state budget caused by Naftogaz's parlous finances. However, without lowering the cost of gas imports, the only option to achieve that is to raise domestic gas tariffs significantly. With parliamentary elections set for October 2012 and the government facing rapidly falling approval ratings following the austerity measures already implemented, it is trying - and failing - to talk the IMF round.

Upping the ante

Ukraine has committed to honour the gas contract until it can secure a new one, and can do so for the meantime thanks to a current account in unusually rude health thanks to borrowing. However, it's hard, in an increasingly precarious global environment, to predict if it will continue to enjoy such access to debt markets. Hence, after a year or so of failing to persuade Moscow to renegotiate, it has upped the ante in the last couple of months with a cascade of badgering and threats clearly designed to get Russia to think again.

One option is to take the issue to international arbitration on the basis that the market has significantly changed since the contract was signed. Analysts are split on whether such a move would succeed or not, but it's clear Moscow would regard it as a hostile move.

Therefore, a stream of alternative ploys have flowed in recent weeks, with Kyiv suggesting it could void the contract by breaking up Naftogaz, announcing plans to slash gas imports by 75% by 2015, sending high-profile delegations to potential alternative suppliers such as Azerbaijan and Turkmenistan, and even suggesting it could scrap its GTS if Russia drops transit volumes significantly.

Moscow has responded with disdain and jibes. It played a trump card in early September when it began pumping gas through the new Nord Stream pipeline that bypasses Ukraine altogether by running beneath the Baltic Sea direct to Germany. While the 27bn cm/year first phase of Nord Stream should only take 20% off European export volumes running through Ukraine, there will follow a second phase of the pipeline to take its capacity up to 55bn cm/y, as well as the potential 63bn cm/y South Stream pipeline that will bypass Ukraine to the south, the final agreement on which was just signed on September 16.

In short, Kyiv is running out of leverage, and appears to have few options. Either it will have to find a convincing case to take to Stockholm's arbitration court, or find a compromise that will persuade Moscow to renegotiate while at the same time keeping the electorate at home and the EU happy.

Has Europe had enough?

Even though Brussels has been trying to keep out of the whole mess, it holds significant sway. It's likely only the potential fallout in Europe that's preventing the situation descending into an all-out gas war, with both Moscow and Kyiv aware that the EU is obsessed with energy security. Yanukovych has extra incentive to keep Brussels sweet, having stated that joining the 27-member bloc is his top priority.

However, Moscow and Kyiv may have already pushed it too far. In early September, EU Energy Commissioner Gunther Oettinger proposed legislation giving the commission the power to block bilateral energy deals - a clear attempt to disrupt Gazprom's success in dividing Europe by striking up such individual agreements with EU states.

Then on September 12, the European Commission secured a mandate from the 27 EU governments giving it - for the first time - the power to negotiate energy supplies on behalf of the whole bloc. It will now negotiate an agreement with Azerbaijan and Turkmenistan to build a gas pipeline across the Caspian Sea, with the ultimate aim of bringing direct to Europe Turkmen gas, which is currently only available via Russia.

Should the deal with the former Soviet states go through, it would be a fillip for the struggling Nabucco pipeline project - which is proposed to carry Central Asian gas to Europe bypassing both Russia and Ukraine, but has been plagued by questions of where it would find the gas to fill it. That has seen progress slow significantly since the furore over the last gas war in 2008-09 died down.

Should that link to Turkmenistan kickstart Nabucco, it would send up a serious red flag in both Moscow and Kyiv. That, presumably, is the half the point. It clearly rattled Moscow, with the Russian Foreign Ministry responding immediately to condemn the plan for ignoring what it regards as an agreement between the five littoral states of the Caspian - Russia, Kazakhstan, Turkmenistan, Azerbaijan and Iran - not to build such infrastructure until "the current international, legal and geopolitical situation in the Caspian basin" has been resolved.

A day later, a newly combative Oettinger responded to the news of the South Stream signing by threatening Gazprom with problems on European contracts if it continues to expand its network connecting to Europe.

The Tymoshenko conundrum

The trial of Tymoshenko parcels all the issues facing Ukraine into one not-so-neat package. The idea is that if the former prime minister is found guilty of abusing her office in signing the 2009 gas deal, it will lay the ground for taking the issue to international arbitration.

At the same time, the case seeks to ease domestic political pressure on the Ukrainian government, as a conviction would rule out Tymoshenko - the only opposition figure with the potential to challenge President Viktor Yanukovych - from future elections.

Meanwhile, the EU - happy to swallow the superior PR skills of the Tymoshenko camp for years now - has sent mixed messages to Kyiv. On the one hand, it suggests that Ukraine's progress towards an Stabilization and Association Agreement (SAA) - the initial step towards full membership in the European club - could be scuppered by the shift towards authoritarianism, selective justice and abuse of human rights. On the other hand, more senior figures have suggested Brussels should step up the pace on cementing closer relations with Kyiv - apparently aware of the pressure being applied from Moscow.

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