Addicted to the Gas War: Russia’s Anti-Market Pricing

They say that for many, addiction is not a choice, but a disease. And for those of us who are Russia news junkies, we have lately had to subsist on a steady diet of repetitive, off-target reports on the Russia-Ukraine energy dispute. It’s easy to get lost in all the circular logic, and many people have already floated away from rationality.  Now that the dispute appears to be wrapping up with an agreement for monitors, it’s time to ask ourselves some questions as part of a postwar autopsy. Have we learned anything from the last time around? It certainly doesn’t seem so, and the fact that there are no blameless parties is serving to blind us further.  On the one hand, Europe is increasingly accepting of whatever destabilizing conduct Russia see fit, while also becoming tired of the soap opera of Ukrainian politics, stunting progress in a country that deserves better.  However, just because we’ve become addicts of the gas wars, that doesn’t mean there aren’t very important and worrying trends unraveling right under our noses.

Consider some of the important lessons to be drawn from the situation:

#1: The “normalization” of supply cuts is setting a dangerous precedent.The fact that Gazprom and its political masters in the Kremlin -really, let’s not create imaginary divisions between the two – haveconvinced Europe that it is normal and tolerable to completely cut offall the flow of natural gas through Ukraine is nothing short ofremarkable. There should be wide consensus on just one point: it isunacceptable and wholly irresponsible for Russia to interrupt thesupply of natural gas to Europe because of a dispute with one country.Eighteen countries now have been deeply affected, with freezing homesin Bulgaria, dwindling reserves in the Balkans, and slowing industryacross a wide region. The economic damages caused by the deployment ofthe energy weapon are staggering – exacerbating the current financialwoes of Europe and putting a drag on the global economy in a moment ofcrisis.

Despite all this, we have Italian corporate leadersexpressing serenity, a former chancellor of Germany pitching a pipelineto the country’s new colonial master to the East, and a parade ofGazprom-funded talking heads dominating the European press. Take a deepbreath, and repeat after me: cutting off the taps is not normal.

#2: Ukraine has to pay its debts and pay a higher price for gas, and that does not justify the supply cut.Various media sources have noted how much better prepared the Russiangovernment and Gazprom were for the current gas war – including anexpensive troika of three of the world’s best public relationsagencies, Omnicom’s Ketchum, GPlus Europe, and Gavin Anderson. Onesource told an industry publication: “The amount of money they spend onPR is phenomenal.” They even launched a slick website: http://www.gazpromukrainefacts.com/.These efforts have been successful in communicating three directthemes: Ukraine owes us $1.5 in past gas debts (plus a $600 million late fee), they need topay market rates for gas now after enjoying too many years ofSoviet-era subsidies (which Gazprom claims would be $450 per 1,000cubic meters), and lastly, Kiev has been committing “energy blackmail“by siphoning off gas destined for Europe.

The subtext ofall these messages, which is quickly spreading as an accepted myth, isthat this dispute justifies the supply cut, and that the nature of theconflict is “purely commercial.” Ukraine paid a very low price in 2008,$179.50 per 1,000 cubic meter, and there is little doubt that they canand must pay more (in many reports Naftogaz made offers between$201-230). Ukraine must also repay their debt of $1.5 billionimmediately (the $600 million late fee, a 40% penalty, is politicallydesigned to be un-payable), but this in no way negates Russia’scontractual obligations to continue supplying paying customers andarbitrate any dispute under the terms of the Energy Charter Treaty(which the Kremlin has signed but not ratified). Gazprom’s insistenceon $450 is improbably ridiculous for several reasons, outlined below.

#3: The gas war cannot be “purely commercial” when Russia has imposed an anti-market pricing regime.What is very disappointing about all the press coverage and televisiontalking heads debating the issue as a tit-for-tat business fight isthat there has been remarkably little investigation of what the actualmarket value of natural gas in Europe should be, and how we arrived atthis hostage ransom of $450 per 1,000 cubic meters. Although Gazpromprepped for the gas war by appropriating the vocabulary of markets(portraying themselves victims of energy blackmail, and calling fortransparency, competition, and fair market prices), the actual conductof the company has consistently tilted toward monopolistic practices and distortions in prices.

Don’t take it from me – the warning was made plain and clear byVladimir Putin a few days before Christmas, who boldly declared that”the era of cheap gas is over” as part of his keynote speech to thenewly formed gas OPEC group (Venezuela, Iran, Qatar, and others). Thegoal of such a group, just like their counterparts in the petroleumtrade, is to coordinate their activities, investments, and productionwith the end goal of raising prices above true values. In additionto these longstanding anti-competitive practices, let us not forgetthat Gazprom is the only company in the world to hold a de factomonopoly over the pipelines of Russia by presidential decree, and madethe momentous decision to buy all of Turkmenistan’s gas in an effort tomonopolize the Central Asian supply (a similar offer was made to Libyafor all of its gas, and if the company can get back on its feet, Iwouldn’t be surprised to see something similar in Bolivia and Iran incoming years). Gazprom got ripped off by the surprisingly cleverTurkmen negotiators, allegedly paying somewhere around $340 per 1,000cubic meters for the inflated privilege of preventing exports to China.

It is easy to see why Russia wants Ukraine to assume the burden ofthese anti-market prices, which of course means that eventually Europewill be forced to subsidize their very own stranglehold by Russianpipelines. In addition to the monopoly premium, we should alsorecognize that natural gas prices are linked to crude oil pricefluctuations, lagging behind by 6-9 months. Author and journalist SteveLeVine has an excellent blog post breaking down the considerable gapsbetween oil prices and the Kremlin’s demands … for example, Ukraine isproposing to pay a price for the gas assuming that oil averages around$40 a barrel for 2009, while Gazprom’s demand for $450 per 1,000 cubicmeters assumes there will be an average price of $80 per barrel. Bycomparison, as market trading closed on Friday in the United States,natural gas prices went down to about $195 per 1,000 cubic metersdespite some of the coldest temperatures in 15 years. Given that oilprices are currently struggling to stay above $40 despite war in Gaza, Russia might actually begetting a very good deal by locking the Ukrainians in at the proposedprice.

#4: Russia has successfully pre-empted competing supply routes. Withinhours of Vladimir Putin putting out the call to shut off the gas toEurope, everyone started talking about committing to alternativesupply sources – however fewer reports noted whether thesealternatives would still be controlled by Russia or not. For example,the Nord Stream pipeline (from Russia directly to Germany, controlledby Gazprom) appeared to be given its biggest boost – something that wasnot lost upon its supporters. This financially unfeasible project(projected costs are more than three times more expensive per meter ofpipe compared to an overland route) not only poses significantecological questions, but also will represent the de facto severing ofthe European Union into two halves – surrendering the Baltics, Poland,and Czech Republic to Russia’s sphere of influence and impunity tomanipulate with future energy cutoffs (this time without theinconvenience of upsetting the Germans). That’s why Nord Stream hasbeen described as a new version of the Molotov-Ribbentrop Pact.

OK, so the northern route for gas is already comprised. How aboutlooking down south to our friends in Africa? Doesn’t Nigeria have theworld’s eighth largest proven reserves of natural gas, and isn’tAlgeria also boasting more than 200 trillion cubic feet in reserveswith great pipelines to Europe? This was precisely the argument putforward recently in the Wall Street Journal by Francis Ghilès of theEuropean Institute of the Mediterranean in Barcelona. In response tothe Ukraine cut off, and the unreliability of Russia in general, Ghilèsargues that “The EU should make a bold proposal to southern-rimMediterranean countries and maybe Nigeria, bearing in mind the level ofenergy interdependence which already exists: More than 80% ofhydrocarbon exports from Algeria, Libya and Egypt go to Europe, while46% of southern European needs are met by their neighbors across thesea. These three North African countries boast almost 5% of world-widegas and oil reserves.“

That sounds all good and well, but just like their capture of CentralAsia, Gazprom has already been thinking three steps ahead of theEuropeans, and acting strategically. As part of the three-prongedmethodology which I describe as “disaggregation, preemption, andcooptation,” Russia has already positioned itself as one of the primeplayers in both North Africa (even Muamar Gadhafi recently pitched histent in the gardens of the Kremlin) as well as Nigeria, and were thefirst to propose mega-billions for the country and financing for thepipeline up to the Mediterranean from the Gulf of Guinea. The visit toNigeria by EU Energy Commissioner Andris Piebalgs was much too littlemuch too late, and appeared mainly to be a response to Russia’sinvasion of Georgia.

Russia has worked hard and spent a lot of money to create anear-complete preemptive noose, by gaining access and often controlover all competing natural gas suppliers to Western Europe (Norwaydoesn’t really count here). The policy has been a tremendous success,and if Europe does not act quickly to stand up to preserve competition,it will be too late.

#5. If we are going to point fingers, point them at the corruption ofgas trading intermediaries. Politics certainly plays a major role inthis dispute, but like any good fiasco in today’s Russia, it alsoinvolves some run-of-the-mill state-aided theft and extortion. It ismore than just a little suspicious that a mysterious Austrian-basedcompany, owned half by Gazprom and half by a group of Russian andUkrainian oligarchs I shouldn’t even name for fear of lawsuits (thoughone of them is in prison now), which owns no gas nor pipelines norphysical storage or distribution assets, should grab itself a 20%commission on all gas sales from Turkmenistan to Ukraine. The operations of RosUkrEnergo represent anoutrageous scandal, yet has hardly raised a murmur of objection inEurope despite the fact that on Monday we’ll likely see gas rationingin Vienna, where some of these warring businessmen do their bankingwith Raiffeisen, allegedly hiding away millions in kickbacks on bothsides of the border.

Author Marshall Goldman writes in his latest book, “Petrostate”, aboutthe well-known opacity and corruption of RosUkrEnergo (the material isslightly dated): “Such shadowy entities linking up Russia and Ukrainecast doubt on the integrity and the transparency of the economicinteractions between Russia and Ukraine. The Russians’ argument thatUkraine deserved to pay the market price for gas was weakened when itbecame known that at least 60 percent of the gas supplied to Ukraineactually came from Turkmenistan, not Russia. Nor did Gazprom winsympathy for itself when it was learned that at the time Gazpromrefused to pay Turkmenistan more than $46 per 1,000 cubic meters. Onlyin February 2006 did Gazprom agree to pay a comparable amount for itsTurkmenistan purchases. Gazprom control of the pipeline linkingTurkmenistan with the West, a legacy of the Soviet era, allowed Gazpromto squeeze Turkmenistan this way. Gazprom agreed to raise the price to$130 in 2008, but that remained far below the $354 Gazprom expected tocollect from its sales to Europe.” (pp.148)

However this time around, Gazprom has indeed won sympathy from Europe,though the fighting between the RosUkrEnergo owners over who gets alarger slice of the corrupt pie continues just as it did back in 2006.Because of these intermediaries, some have described the gas wars asnothing more than “a quarrel among thieves.“

#6. Europe’s longstanding preference for bilateral energy relationswith Russia has been proven as a dismal failure. Aside from thenormalization, the anti-market pricing, and the corruption of theintermediaries, there are other strong undercurrents to this story thatbring into question some of the very existential questions and threatsto the future of the European Union itself.

It is curious that bothRussia and Ukraine shared a consensus about one thing – thatintervention by Europe into the dispute would best serve theirinterests. Ukraine obviously wanted Europe to feel the chill of Russia,and to aid them in a time of extraordinary political and financialweakness. Russia, on the other hand, has demonstrated that the wholenarrative of “Gazprom is a reliable supplier” has been hastilydiscarded in favor of the political benefits of going into a “cold” warwith Europe. Russia’s stock markets have lost some three quarters oftheir value since May, the chief export upon which the economy isdependent has collapsed to a quarter of its previous value, one quarterof the country’s currency reserves has been depleted in three months,the ruble is down approximately 20% and counting, and job losses areleading to widening discontent and social unrest. In other words, it isthe perfect time for a distraction and a reminder of the threat ofoutside enemies. But only one party can be right about Europe, and I’mafraid that Russia has likely correctly judged the response.

For several years, attempts by the European Commission to engineer acommon energy policy for all member states to negotiate with Russiahave been undermined by large bilateral deals between Gazprom and thegovernments of Germany, Italy, France, and others. Ukraine is of coursenot a member of the EU, but as of today at least nine member stateshave been affected by this deployment of the energy weapon. Yet thecommon response has been every man for himself, so to speak. Since thebeginning of the year I have seen numerous government officials,analysts, and businesspeople appear on television news shows, expressing extreme pragmatism and disregarding whatever “political” problems existbetween Ukraine and Russia, and just asking what they can doimmediately to get Moscow to turn the taps back on. However in this case, “pragmatism” is sending a strong message to Russia, which might bethe clearest sign of disunity and weakness ever since then-Presidentof the EU Nicolas Sarkozy unilaterally called for the resumption oftalks towards a new Partnership and Cooperation Agreement despiteRussia’s conspicuous refusal to fulfill the conditional requirements ofthe Georgia ceasefire.

Last year my colleagues and I published a “Prescription for Europe“paper with recommendations to ease the risks of overreliance on Russianenergy, and in many ways these ideas are apt for application to recoverfrom Gas War II. Whether it happens in Portugal or the Czech Republic,when one member state’s energy supply is cut off, the EU needs to reactwith prompt and coherent action, with the same urgency as if it hadhappened to them as individual countries. But thanks to the fragmentednature of the EU, outside countries, including both the United Statesand Russia, have adroitly learned how to exacerbate specific cleavages,splitting the continent and rendering it politically ineffectual onthis issue.

Hopefully the events of early 2009 will constitute the last time thatEurope falls victim to a political manipulation of energy, the lastwinter when homes and businesses go cold while an authoritarian seizesback a former sphere of influence, and the last time that Europeblindly subsidizes the deepening of its own dependency. But it willlikely not be the last time, and we should not be so naïve as to thinkthat these problems would conclude even with the reversal of the OrangeRevolution.

Top photo: Photo shows the front pages of the major Bulgarian newspapers in Sofiaon January 7, 2009. Bulgaria announced that cuts in supplies of Russiangas had thrown it into a “state ofcrisis” on January 6, saying that transiting supplies to Greece,Macedonia and Turkey had been halted overnight. (AFP/Getty Images)