Nicholas Watson in Prague -

CEE states are well aware there are few short-term solutions to the long-term problem of over-reliance on Russian gas.

Long before the European Commission singled out Russia as a problem in its Green Paper on energy security released in March, the countries of Central and Eastern Europe (CEE) were questioning Moscow's commitment to meeting its role as a reliable energy supplier. Unfortunately, these countries are also well aware there are few short-term solutions to this long-term problem.

Russia's reputation as a dependable supplier of gas was finally shattered when the cold snap in mid-January caused temperatures to plummet below -30oC and forced the state-controlled Gazprom to reduce gas flows for the second time in less than three weeks to states in the Balkans, CEE and as far west as Italy and Austria.

According to analysts, the worst affected countries were Bosnia & Herzegovina and Serbia & Montenegro, which saw as much as a 25% cut in gas volumes, though other countries which reported a drop in volumes included Croatia, Hungary and Finland.

While European governments were mostly ready to give Gazprom the benefit of the doubt for the weather-related drop in supplies, few were as forgiving over the interruptions at the beginning of the year when Moscow unilaterally cut gas exports to Ukraine over a dispute over prices. Given that around 80% of the 120 billion cubic metres (cm) of Russian gas sent to the EU in 2005 transits Ukraine, the quarrel inevitably impacted on supplies to many European states and was widely condemned by Brussels and Washington.

“The combination of risks from Russia's climate and its government's use of gas supplies as a tool of foreign policy could light a fire under the debate in Europe about reducing dependence on Russian gas,” says Andrew Neff, an analyst at the Washington-based consultancy Global Insight.

There are signs that it already has.

POLICY PAPER

In its new Green Paper on European Energy Policy, published on March 8, the European Commission sets out six priority areas, including the creation of a common European external energy policy towards its main suppliers, specifically Russia.

“A new initiative is particularly opportune with regard to Russia, the EU's most important energy supplier,” the Commission says in the report. “Work should start on an energy initiative [and] the results could be integrated into the framework of EU-Russia relations due to replace the current EU-Russia Partnership and Cooperation agreement in 2007.”

The Commission's explicit mention of Russia pleased CEE states, which have long complained about its big neighbour's bullying over the gas that is used primarily for heating and for use as feedstock in industrial processes. What especially worries these countries, and by extension should concern the rest of the EU, is that this is very unlikely to be the last of such spats with Russia.

FIRST OF MANY

While the latest dispute with Ukraine was ostensibly about raising prices as punishment for the country's drift west, the reality is more complicated. Armenia has maintained friendly relations with Russia yet it too faces a doubling of its bill, from $56 to $110 per 1,000 cm from April. According to analysts, the reason for this is that both Ukraine and Armenia have refused to give up control of their pipeline networks.

“Gazprom is effectively linking the issue of pipeline control with that of prices for gas supplied to a transit country,” says Stephen O'Sullivan, head of research at United Financial Group in Moscow. “In Belarus, where Gazprom has full control of the pipelines, the gas price for 2006 was kept at a low level.”

Even if these countries were to capitulate to Gazprom and hand over control of their pipelines, analysts warn there is no guarantee that Russia would continue to supply the gas at a discount given its tendency to force the renegotiation of contracts that haven't yet expired.

For example, Gazprom has brought Bulgaria back to the negotiating table over its gas supply contract even though the current one doesn't expire until 2010.

Admittedly, the fault here lies not solely with Russia. Ukrainian politicians are still bickering over the deal signed in January with Moscow to resolve the gas dispute, which lacks transparency and many important details appear unresolved.

Many analysts don't consider the contract, which calls for a hike in prices to $95 per 1,000 cm from $50 and includes the use of an obscure third party, RosUkrEnergo, to act as an intermediary to handle Central Asian gas, to be stable in the long term.

BROKEN CONTRACTS

Likewise, Georgia's opposition politicians complain that the terms of the recently concluded one-year gas supply contract with Russia, which stipulates that Gazprom will supply some 2.5 million cm of gas for $110 per 1,000 cm, are simply unacceptable. The spat with Georgia took a violent turn when gas supplies were halted altogether following the January 22 explosion of two gas pipelines in Russian territory, an act of sabotage that Georgian President Mikhail Saakashvili blamed on Russia's security services. Russia accused Saakashvili of being “hysterical.”

“The major fallout of all this has been that contracts are now broken and revisited with alarming frequency - it sets a terrible precedent,”

says Michael Lelyveld, a senior analyst with PFC Energy's Caspian and Russian service.

The danger, therefore, is that today's deals won't form the foundations for future cooperation between Russia and its former vassals, but will become what Vladimir Milov, president of the Institute for Energy Policy in Moscow, calls “time bombs”, which will lead to future conflicts. With more disputes over supplies almost inevitable, therefore, the task of finding ways to diversify gas sources becomes all the more pressing.

One of the most obvious solutions is to import gas from other places. With North Sea gas running out and Norway already stating it is operating at full capacity and would be unable to make up any shortfall from Russia, European governments are looking further afield.

In the energy Green Paper, the Commission calls for independent gas supplies from the Caspian region, North Africa and the Middle East to be pumped “into the heart of the EU,” as well as Central European oil pipelines bringing Caspian crude to the EU through Ukraine, Romania and Bulgaria.

NABUCCO

A long-planned but challenging project that could get a boost from the dispute is the Nabucco gas pipeline project, not least because one of its principal backers is Austria's OMV and Austria currently holds the rotating EU presidency.

This pipeline plans to transport gas from the Caspian and Iran - and eventually even from Iraq and Egypt - down through Turkey, Bulgaria, Romania and Hungary to OMV's gas hub at Baumgarten.

The estimated length of the pipeline will be 3,300 km and have an initial capacity of 25 billion cm per year (cm/y) when it begins operating sometime after 2011.

The project's development has been delayed by financial, regulatory and political issues, but a sign of its increasing importance was the January announcement by the five partner companies implementing the venture - Botas, Bulgargaz, Transgaz, MOL and OMV - that they have received eight applications from large companies seeking to join the project, including offers from Total, Gaz de France (GdF), E.ON and RWE.

“We decided to look for new shareholders one year ago because it is such a huge project and for financing reasons we need to minimize the risk better,” explains Otto Musilek, chairman of the Nabucco Steering Committee.

Mr Musilek said the decision over which new shareholder is invited to join the project would be made not just on the basis of money, but on what else the company could bring to the project, such as in terms of gas supplies or access to large markets, such as Germany or France.

While Nabucco would be the first pipeline to bring Caspian gas to Europe, EU governments are also looking to expand imports from existing sources.

ALTERNATIVE SUPPLIERS

In 2004, Algeria supplied about 35 billion cm of gas, or 12.5% of the EU's total consumption, through two pipelines - one to Italy (via Tunisia) and the other to Spain (via Morocco). As well as plans to increase the capacity of these two lines, construction is scheduled to start this year on two more pipelines for Algerian gas to Spain and Italy, which will each have capacities of 8 billion cm/y. Libya also supplies a modest amount of gas through the new Green Stream pipeline, which was opened in 2004, and volumes through that are increasing.

Paradoxically, the pipeline most bitterly opposed by CEE states, the North-European Gas Pipeline (NEGP) between Russia and Germany, could actually end up enhancing their energy security, not diminishing it as they have argued Poland and several Baltic states could barely disguise their fury when in September Germany signed the deal with Russia to build a $5 billion gas pipeline under the Baltic Sea, since it effectively bypasses these transit states and removes an important bargaining chip with Moscow.

“Everything was done behind our backs,” muttered Lithuanian Prime Minister Algirdas Brazauskas to the German newspaper Bild. “I don't know who is trying to play around with us - Russia, or maybe Germany.”

However, Paul Stewart, an energy analyst with the consultancy Datamonitor, believes the NEGP could actually help offset problems these states may have with Russia by allowing Germany to re-export the gas it receives though the pipeline.

“The idea is that although Russia may threaten Poland, it would never threaten Germany, so Poland should have the option of buying the gas that Russia exports to Germany,” says Mr Stewart. “In short, the more interlinked the EU states become, the harder it is for gas producers to threaten any individual EU member.” Perhaps, though it is not certain that Russia won't one day feel bold enough to threaten Germany, which through the NEGP will have increased its dependency on Russian gas at a time when the rest of Europe is looking to reduce that dependency.

“In 2004, 52% of Germany's gas came from Russia, so if you add the NEGP, the question is whether you are increasing security or not?” says Mr Lelyveld.

LIQUID GOLD

The recent difficulties with Russia have also renewed interest in liquefied natural gas (LNG) as a way to diversify from piped Russian gas. LNG offers the advantage of bringing in a whole new raft of suppliers as far afield as Trinidad and Tobago and Venezuela, who otherwise would not be able to transport their gas to Europe by pipeline.

In January, GdF confirmed it is still interested in cooperating with Poland's gas monopoly PGNiG in building an LNG terminal there.

Though details are still sketchy, the terminal would have a capacity of 3- 5 billion cm/y. GdF stressed, however, its participation would depend on the results of a feasibility study, which PGNiG is currently working on producing. Another possible LNG project is Croatia's Krk island LNG scheme.

However, both these have been on the drawing-board for some time - 15 years in the case of Krk island - and experts say projects are rather like houses in that if one has been on the market for some time, it usually means there's something wrong with it. Datamonitor's Stewart argues that a large reliance by CEE countries on LNG is unlikely for several reasons, including the high cost of investment, which would make the gas uncompetitive compared with the subsidized Russian gas, especially in landlocked states such as the Czech Republic, Hungary and Slovakia. According to the consultancy Oxford Analytica, building the terminal on the Adriatic would be extremely costly, at around €3 billion- €5 billion, which equates to the cost of building 3,000 kilometres of pipeline.

“Traditionally, CEE countries have paid below market rates for gas - moving to LNG would be a price shock,” says Mr Stewart.

“Only in the instances where Gazprom shut off the taps would it become competitive, but it would be a very expensive safeguard for a rainy day.” The problem with building new pipelines and LNG facilities, though, is that both are essentially long-term solutions to what is an immediate problem. “There really is no quick fix,” says PFC's Lelyveld. “The reliance on Russian gas has been built up over decades and you can't just flip a switch and reverse that.”

One of the few realistic policies is to concentrate on improving conservation and efficiency of the gas these countries use for heating and feedstock in industrial processes.

Ironically, one effect of the price rises from Russia may be to force users to conserve more gas, which has not been a priority for states weaned on subsidised prices. One of the worst offenders, Ukraine, says it intends to reduce gas consumption at state power stations this year by 3.7% to 8.4 billion cm in 2006.

However, the best short-term solution to the problem, argues Stewart, is simply not to get on the wrong side of the Russians. Given the region's history and Russia's legendary prickliness, though, that may be asking a bit too much.

BOX: The third place

Dominic Swire

Should Europe be worried about its reliance on Russian gas? Until recently there were two reasons why the answer to this question might be “yes.”

Firstly, many doubt whether the infrastructure of Russia's gas system is capable of delivering what has been promised.

Secondly, the heavy handed approach employed during the Ukrainian price dispute left many wondering where the foreign ministry ends and Gazprom begins. Now there is a third concern: China.

The agreement signed in March between Gazprom and China National Petroleum Corporation (CNPC) involves Russia building two pipelines into China, one from west Siberia and one from the east. The project is estimated to cost up to €€8.2 billion and will supply up to 80 billion cm of gas - twice China's current consumption. The western pipe, purportedly planned to enter China at the border crossing between Kazakhstan and Mongolia, could be up and running as soon as 2011.

This Sino-Russian deal is historic.

Not since the 1950s have these two countries had such good relations. China is hungry for energy and Russia is increasingly happy to supply it.

Not only this, but both countries also have an interest in counterbalancing the global power of the US.

Analysts have speculated the deal has another benefit for Russia in that it sends a message to European states that it has other markets for its gas out there. Indeed, Russia looks to be aiming to play one side off against the other. “Gazprom will fulfill all its current contracts and obligations to Europe,” says Sergei Kupriyanov, a spokesman for the Russian gas company.

However, the future increases in gas supplies to Europe - in response to its growing demand will be subject to arbitrage between China and European countries.”

Michael Lelyveld, senior analyst at PFC Energy's Caspian and Russian service describes the China deal as a pre-emptive strategy” on behalf of the Russians who are expecting Europe to reduce its dependence on them in the future. At this point, he says, it's really a chess game on a hypothetical plane.