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

#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 - have convinced Europe that it is normal and tolerable to completely cut off all the flow of natural gas through Ukraine is nothing short of remarkable. There should be wide consensus on just one point: it is unacceptable and wholly irresponsible for Russia to interrupt the supply of natural gas to Europe because of a dispute with one country. Eighteen countries now have been deeply affected, with freezing homes in Bulgaria, dwindling reserves in the Balkans, and slowing industry across a wide region. The economic damages caused by the deployment of the energy weapon are staggering - exacerbating the current financial woes of Europe and putting a drag on the global economy in a moment of crisis.

Despite all this, we have Italian corporate leaders expressing serenity, a former chancellor of Germany pitching a pipeline to the country's new colonial master to the East, and a parade of Gazprom-funded talking heads dominating the European press. Take a deep breath, 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 Russian government and Gazprom were for the current gas war - including an expensive troika of three of the world's best public relations agencies, Omnicom's Ketchum, GPlus Europe, and Gavin Anderson. One source told an industry publication: "The amount of money they spend on PR is phenomenal." They even launched a slick website: http://www.gazpromukrainefacts.com/. These efforts have been successful in communicating three direct themes: Ukraine owes us $1.5 in past gas debts (plus a $600 million late fee), they need to pay market rates for gas now after enjoying too many years of Soviet-era subsidies (which Gazprom claims would be $450 per 1,000 cubic meters), and lastly, Kiev has been committing "energy blackmail" by siphoning off gas destined for Europe.

The subtext of all these messages, which is quickly spreading as an accepted myth, is that this dispute justifies the supply cut, and that the nature of the conflict 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 can and must pay more (in many reports Naftogaz made offers between $201-230). Ukraine must also repay their debt of $1.5 billion immediately (the $600 million late fee, a 40% penalty, is politically designed to be un-payable), but this in no way negates Russia's contractual obligations to continue supplying paying customers and arbitrate any dispute under the terms of the Energy Charter Treaty (which the Kremlin has signed but not ratified). Gazprom's insistence on $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 television talking heads debating the issue as a tit-for-tat business fight is that there has been remarkably little investigation of what the actual market value of natural gas in Europe should be, and how we arrived at this hostage ransom of $450 per 1,000 cubic meters. Although Gazprom prepped for the gas war by appropriating the vocabulary of markets (portraying themselves victims of energy blackmail, and calling for transparency, competition, and fair market prices), the actual conduct of 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 by Vladimir Putin a few days before Christmas, who boldly declared that "the era of cheap gas is over" as part of his keynote speech to the newly formed gas OPEC group (Venezuela, Iran, Qatar, and others). The goal of such a group, just like their counterparts in the petroleum trade, is to coordinate their activities, investments, and production with the end goal of raising prices above true values. In addition to these longstanding anti-competitive practices, let us not forget that Gazprom is the only company in the world to hold a de facto monopoly over the pipelines of Russia by presidential decree, and made the momentous decision to buy all of Turkmenistan's gas in an effort to monopolize the Central Asian supply (a similar offer was made to Libya for all of its gas, and if the company can get back on its feet, I wouldn't be surprised to see something similar in Bolivia and Iran in coming years). Gazprom got ripped off by the surprisingly clever Turkmen negotiators, allegedly paying somewhere around $340 per 1,000 cubic meters for the inflated privilege of preventing exports to China.

It is easy to see why Russia wants Ukraine to assume the burden of these anti-market prices, which of course means that eventually Europe will be forced to subsidize their very own stranglehold by Russian pipelines. In addition to the monopoly premium, we should also recognize that natural gas prices are linked to crude oil price fluctuations, lagging behind by 6-9 months. Author and journalist Steve LeVine has an excellent blog post breaking down the considerable gaps between oil prices and the Kremlin's demands ... for example, Ukraine is proposing 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 cubic meters assumes there will be an average price of $80 per barrel. By comparison, as market trading closed on Friday in the United States, natural gas prices went down to about $195 per 1,000 cubic meters despite some of the coldest temperatures in 15 years. Given that oil prices are currently struggling to stay above $40 despite war in Gaza, Russia might actually be getting a very good deal by locking the Ukrainians in at the proposed price.

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

OK, so the northern route for gas is already comprised. How about looking down south to our friends in Africa? Doesn't Nigeria have the world's eighth largest proven reserves of natural gas, and isn't Algeria also boasting more than 200 trillion cubic feet in reserves with great pipelines to Europe? This was precisely the argument put forward recently in the Wall Street Journal by Francis Ghilès of the European Institute of the Mediterranean in Barcelona. In response to the Ukraine cut off, and the unreliability of Russia in general, Ghilès argues that "The EU should make a bold proposal to southern-rim Mediterranean countries and maybe Nigeria, bearing in mind the level of energy interdependence which already exists: More than 80% of hydrocarbon exports from Algeria, Libya and Egypt go to Europe, while 46% of southern European needs are met by their neighbors across the sea. These three North African countries boast almost 5% of world-wide gas and oil reserves."

That sounds all good and well, but just like their capture of Central Asia, Gazprom has already been thinking three steps ahead of the Europeans, and acting strategically. As part of the three-pronged methodology which I describe as "disaggregation, preemption, and cooptation," Russia has already positioned itself as one of the prime players in both North Africa (even Muamar Gadhafi recently pitched his tent in the gardens of the Kremlin) as well as Nigeria, and were the first to propose mega-billions for the country and financing for the pipeline up to the Mediterranean from the Gulf of Guinea. The visit to Nigeria by EU Energy Commissioner Andris Piebalgs was much too little much too late, and appeared mainly to be a response to Russia's invasion of Georgia.

Russia has worked hard and spent a lot of money to create a near-complete preemptive noose, by gaining access and often control over all competing natural gas suppliers to Western Europe (Norway doesn'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 of gas trading intermediaries. Politics certainly plays a major role in this dispute, but like any good fiasco in today's Russia, it also involves some run-of-the-mill state-aided theft and extortion. It is more than just a little suspicious that a mysterious Austrian-based company, owned half by Gazprom and half by a group of Russian and Ukrainian oligarchs I shouldn't even name for fear of lawsuits (though one of them is in prison now), which owns no gas nor pipelines nor physical storage or distribution assets, should grab itself a 20% commission on all gas sales from Turkmenistan to Ukraine. The operations of RosUkrEnergo represent an outrageous scandal, yet has hardly raised a murmur of objection in Europe despite the fact that on Monday we'll likely see gas rationing in Vienna, where some of these warring businessmen do their banking with Raiffeisen, allegedly hiding away millions in kickbacks on both sides of the border.

Author Marshall Goldman writes in his latest book, "Petrostate", about the well-known opacity and corruption of RosUkrEnergo (the material is slightly dated): "Such shadowy entities linking up Russia and Ukraine cast doubt on the integrity and the transparency of the economic interactions between Russia and Ukraine. The Russians' argument that Ukraine deserved to pay the market price for gas was weakened when it became known that at least 60 percent of the gas supplied to Ukraine actually came from Turkmenistan, not Russia. Nor did Gazprom win sympathy for itself when it was learned that at the time Gazprom refused to pay Turkmenistan more than $46 per 1,000 cubic meters. Only in February 2006 did Gazprom agree to pay a comparable amount for its Turkmenistan purchases. Gazprom control of the pipeline linking Turkmenistan with the West, a legacy of the Soviet era, allowed Gazprom to squeeze Turkmenistan this way. Gazprom agreed to raise the price to $130 in 2008, but that remained far below the $354 Gazprom expected to collect 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 a larger slice of the corrupt pie continues just as it did back in 2006. Because of these intermediaries, some have described the gas wars as nothing more than "a quarrel among thieves."

#6. Europe's longstanding preference for bilateral energy relations with Russia has been proven as a dismal failure. Aside from the normalization, the anti-market pricing, and the corruption of the intermediaries, there are other strong undercurrents to this story that bring into question some of the very existential questions and threats to the future of the European Union itself.

It is curious that both Russia and Ukraine shared a consensus about one thing - that intervention by Europe into the dispute would best serve their interests. Ukraine obviously wanted Europe to feel the chill of Russia, and to aid them in a time of extraordinary political and financial weakness. Russia, on the other hand, has demonstrated that the whole narrative of "Gazprom is a reliable supplier" has been hastily discarded in favor of the political benefits of going into a "cold" war with Europe. Russia's stock markets have lost some three quarters of their value since May, the chief export upon which the economy is dependent has collapsed to a quarter of its previous value, one quarter of the country's currency reserves has been depleted in three months, the ruble is down approximately 20% and counting, and job losses are leading to widening discontent and social unrest. In other words, it is the perfect time for a distraction and a reminder of the threat of outside enemies. But only one party can be right about Europe, and I'm afraid that Russia has likely correctly judged the response.

For several years, attempts by the European Commission to engineer a common energy policy for all member states to negotiate with Russia have been undermined by large bilateral deals between Gazprom and the governments of Germany, Italy, France, and others. Ukraine is of course not a member of the EU, but as of today at least nine member states have been affected by this deployment of the energy weapon. Yet the common response has been every man for himself, so to speak. Since the beginning 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 exist between Ukraine and Russia, and just asking what they can do immediately to get Moscow to turn the taps back on. However in this case, "pragmatism" is sending a strong message to Russia, which might be the clearest sign of disunity and weakness ever since then-President of the EU Nicolas Sarkozy unilaterally called for the resumption of talks towards a new Partnership and Cooperation Agreement despite Russia's conspicuous refusal to fulfill the conditional requirements of the Georgia ceasefire.

Last year my colleagues and I published a "Prescription for Europe" paper with recommendations to ease the risks of overreliance on Russian energy, and in many ways these ideas are apt for application to recover from 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 react with prompt and coherent action, with the same urgency as if it had happened to them as individual countries. But thanks to the fragmented nature of the EU, outside countries, including both the United States and Russia, have adroitly learned how to exacerbate specific cleavages, splitting the continent and rendering it politically ineffectual on this issue.

Hopefully the events of early 2009 will constitute the last time that Europe falls victim to a political manipulation of energy, the last winter when homes and businesses go cold while an authoritarian seizes back a former sphere of influence, and the last time that Europe blindly subsidizes the deepening of its own dependency. But it will likely not be the last time, and we should not be so naïve as to think that these problems would conclude even with the reversal of the Orange Revolution.