Gas: The power of deprivation

Alarms bells were belatedly ringing in Brussels on Tuesday when it became apparent that Russia’s gas dispute with Ukraine was more than a commercial dispute between two companies, as originally defined by the EU Commission. Bulgaria, Poland, Romania, Croatia, Bosnia, Macedonia, Turkey, Greece, Italy, Slovakia, the Czech Republic, France and Austria, are all now affected by supply restrictions. Even E.ON Ruhrgas has warned of an imminent supply failure in Germany.

While pricing spats between Ukraine and Russia have been rumbling for a number of years, as with previous disputes, this crisis will be resolved sooner rather than later given the "collateral damage" being imposed on European states that Russia can ill afford.

This latest row underlines the major challenge Europe faces not only to reduce its dependence on Russian gas in the future, but the increased willingness of Moscow to deprive its key European consumers of gas should it consider it commercially critical to do so. This is a line that Russia had previously not dared cross, and is one that the EU will want to quickly redraw, but how and where it does so, could prove to be critical to the future of European energy supplies.  

Old wine, new bottles

Russia and Ukraine have been at odds for some time over gas price disputes. The tape currently being played in Moscow and Kiev is a similar recording to that of 2006, when the last major price dispute “flared” up, resulting in the taps being cut and Ukraine accused of siphoning off the difference.

Fast forward to 2009: Russia has accused Ukraine of refusing to pay its dues with the flow of gas being cut to make up the difference. Supplies to Ukraine were reduced from 390mcm to 300mcm on 1 January (the 90mcm difference more or less accounts for Ukraine’s agreed supply for 2008). Yet Gazprom has also gone a step further in reducing the exports bound to Western Europe via Ukraine by 65mcm, the same amount that it accuses Ukraine of diverting for internal consumption, lowering total throughput to 225mcm.

On the B side, Ukraine has denied any wrong doing, other than resisting price increases in Russian gas to US$250 per 1,000 cubic meters from the current US$179.50 and a "new" Russian price of US$418 rising to $450 for the same volume in order to bring Kiev in line with prevailing European prices. Ukraine has also claimed it is only diverting enough fuel (around 21 mcm) to power compresses while meeting internal demand from storage and domestic production. The rest of the supply shortages are purely a function of reduced Russian supplies.

The truth behind all this will remain as opaque as it is likely a combination of the two narratives, particularly as intermediaries in the Russo-Ukrainian gas trade do little to improve transparency, but a great deal to line RosUkrEnergo’s pockets by exploiting arbitrage opportunities from Russian and Turkmen gas transiting the country.

What makes the dispute strategically concerning for the EU is that the cuts constitute not only a Russian fuel embargo of Ukrainian supplies, but are directly hitting European consumers across a number of member states. Gazprom knew full well that supplying additional gas to Europe through Belarus and the Blue Stream pipeline to Turkey was never going to be sufficient to breach the Ukrainian supply gap. Rather, Russia has forced the EU to the negotiating table either to make Ukraine pay a revised price for the gas, or to help Kiev make such payments given its current fiscal crisis. Failure to do so will keep Russian supplies offline to the rest of Europe. Bulgaria has suffered a 100 percent reduction of Russian gas supplies, Italy a 90 percent loss, a 70 percent loss in Slovakia and even a 20 percent loss in France.  

At the heart of the cuts resides the fact that Moscow can no longer afford to sell its gas at Soviet rates, either internationally to former client states or domestically if it wants to insure that it has sufficient funds to plough back into upstream investment in the longer term to meet demand. Shorter term political factors are also in play, particularly as Putin badly needs to replenish state coffers to reseal opening political schisms in Russia, but at the same time, Gazprom is highly leveraged, owing around US$60 billion and has increasingly lost the ability to buy Central Asian gas at Soviet prices amid increased Chinese and US interest in the region. The days of cheap Central Asian re-exports to competitive European markets are thus coming to an end, which means passing costs through to Ukraine is fast becoming a commercial and political priority for Russia, even if it means jeopardizing European supplies in the process. 

2006 is not 2009: The risks are growing  

Needless to say, this is a pricing game the EU would rather not be playing, particularly as it serves as another potential flashpoint between Europe and Russia following the August 2008 conflict in Georgia. One option for the EU is of course, to do nothing and play for time. Russia will only be willing to damage itself for so long in feeding its lucrative Western European markets, the vast majority of which still transits Ukraine. As with previous Russian supply cuts, they will ultimately prove to be temporary (if not particularly selective anymore), which is a line that the Czech Presidency has been more than happy to take when issuing a “bold” statement noting “different viewpoints [...]  make agreement between Naftogaz and Gazprom difficult.”

But the problem for the EU is that it can only duck this issue for so long, both in an immediate and long term sense. Within a number of weeks, if not days, it simply isn’t a viable option for the lights to go out in EU states should a solution fail to materialize. In this sense, the Czechs are right. Russia is still highly unlikely to go down this route for any length of time, but the crisis also provides a telling insight into the future difficulties the EU will face in relation to safeguarding post-Soviet space from Russian encroachment in future. In effect, this hits on a critical geopolitical flaw in the EU’s energy policy: Member-states will continue to put their own interests ahead of the EU as a whole, irrespective of the geopolitical costs this might inflict on others to achieve the "holy grail" of greater energy security. 

Collective solidarity or individual exposure

Such a strategy is highly misplaced. Russia has already used the crisis as evidence in favor of building new pipelines, most notably Nord Stream and South Stream as safer supply routes. While few would doubt that such pipelines remain important factors in meeting projected European gas demand, in both instances, it would radically reduce Russia’s dependence on Ukrainian transit routes. The idea that Russia would somehow not use this new found leverage to maximum effect against Ukraine and other former Soviet states either to exact higher gas prices or greater political influence - or indeed, a combination of both - is a strategic reality the EU, and more importantly, individual member-states must face up to. Russia will be banking on EU members to look after their own bilateral energy security interests rather than safeguarding the autonomy of post-Soviet states in future pricing disputes. Nowhere will this be more evident than in countries where Russian cuts can be executed without effecting broader European supplies: a key geopolitical artery linking Europe to post-Soviet space will thus have be severed.  

While a number of European states will continue to argue this isn’t really "their problem" this badly overlooks the broader threat Russia now poses to European energy security as a whole. Gazprom has made no secrets of its aggressive internationalization strategy spanning Central Asia, the MENA region and West Africa to control the lion’s share of European supplies while opening up its own supply options to Asia. True; the fears of increased arbitrage capabilities between East and West, and the supposed specter of gas cartelization that sits beneath it remain vastly overblown at this stage, but Europe has still failed to fully wake up to the potential for bilateral price collusion among its key suppliers as a realistic future threat.

On this note, even Germany has expressed interest in establishing a gas partnership with Algeria. The score of analysts belittling the proposal on the grounds that it would fail to reduce Berlin's overall gas dependence on Russia missed the bigger point: Germany is slowly trying to build bilateral relations with Algiers should ostpolitik turn sour and, at the very least, was trying to complicate Russian-North Africa relations. A similar logic applies to member-states racing to increase gas storage and LNG regasification capabilities; it will never come close to fully bridging Russian supplies, but underlines that a number of member-states are increasingly seeing Moscow both as the main source, but also the main risk to security of supply.

Yet the "catch 22" here is that these same member-states still can’t resist the temptation of striking long term GPAs with Russia on a bilateral basis in the name of greater security of supply. This was exactly what happened in Italy, Germany and France after the 2006 crisis, and could well happen again now.  Just take a brief glance at the dismal status of the EU inspired Nabucco pipeline to see where the European “collective good” ultimately comes in member-state deliberations: a distant second.  

Ominous sign for the future

All that said, Russia will still strike a deal with Ukraine in the near future to ensure gas is delivered to its main European consumers - Moscow simply can’t afford not to at this stage.

But the EU needs to draw some far bigger lessons from this crisis. Europe's real path to diversifying supply will not be found in bilateral measures with Russia, or indeed by elaborate plans to fill Nabucco from Middle East and Central Asian supplies as the latest peccadillo of the European Commission, but rather by developing an integrated internal market to reduce bilateral pressures felt from key suppliers in the East and West (Gazprom) and Sonatrach in the South. This won’t be a panacea by any means (particularly as European gas demand will continue to rise as a by product of its drive towards cleaner forms of energy), but without greater internal market liberalization and European solidarity to enhance bargaining positions, it will all too easy for Russia to use its hydrocarbon endowments to optimal bilateral effect.

Even if such a line in the sand is drawn, it may be too little too late for those on the wrong side of it.