Russia and Ukraine: Cold Snap

Much more than just a disagreement over prices is pushing Moscow to take a hard line in its gas dispute with Kiev

Late on January 8th, after intensive European mediation, Russia and Ukraine concluded an accord that should get Russian gas flowing again to the sixteen E.U. member states that have been largely left out in the cold since New Year’s Day, when Russia began reducing the flow of gas through Ukraine, with the final cutoff coming on January 6th. The deal leaves unresolved the key issues – prices and transit fees—that ostensibly provoked the row in the first place. But the deal’s stipulation that E.U. observers must henceforth monitor the pipelines has, for now at least, sufficiently satisfied the Russians, who say that they will resume shipments. So, within a few days, once monitors are in place and the pipelines can be repressurized, Russian gas should begin surging westward.

But Russian Prime Minister Vladimir Putin has made clear that this should not be regarded as a capitulation. And there are signs that the dispute is far from settled. Indeed, an anonymous Ukrainian diplomat told the Washington Post this week that the agreement is only temporary, and that, “We will not let our people freeze because Europeans are a little bit cold." The upshot is that the crisis is not over; Russia and Ukraine are playing hardball, and Europeans are suffering as a result.

This is the second major hydrocarbon pricing squabble between Moscow and Kiev in recent years. The gas spat of New Year’s 2006 was only settled after Moscow turned off the taps for three days, resulting in minor shortages downstream in Europe. The current crisis has already lasted nearly two weeks, and has led to a total cutoff of Russian gas to Europe. Given the inevitable PR troubles that were bound to follow a stoppage of heating fuel supplies to Europe during a brutal cold wave, what can Russia have been thinking?

The relevant fact are as follows. Gazprom, the largely state-owned Russian gas monopoly, pumps 80 percent of the gas that it sells to the European Union (its highest-paying customer) through pipelines that were laid across Ukraine during the Soviet era. As the expiration date for Gazprom’s 2008 contract with Ukraine’s state gas company (Naftogaz) approached, negotiations faltered. Naftogaz rejected Gazprom’s proposed 2009 price hike, which would have more than doubled the price from $179.50 per thousand cubic meters of gas to $418. Naftogaz instead offered to pay $201. In response, Russia cut its price to $250, which Putin dubbed “a humanitarian gesture,” made in awareness of Ukraine’s deepening economic crisis, and pointing out that real-world gas market prices are roughly double that amount. (Though for years it has warned former Soviet republics that it would start billing them at market rates, Russia has continued to subsidize Ukraine, Belarus, and Moldova with cheap gas.) Ukraine balked at $250, and counter-offered $235. At this point Gazprom abruptly reinstated its previous quotation of $418 per 1,000 cubic meters.

In the midst of this impasse, Kremlin bells rang in the New Year. Since no agreement had been reached, Russia reduced the flow of gas it pumped to (and across) Ukraine by the amount previously slated for the Ukrainian market. Yet gas continued to heat Ukrainian homes and fuel their stoves. (Certainly it did in Kiev, where I was at the time.) There was a simple explanation for this. As Gazprom boss Aleksey Miller informed Putin in a televised conversation on January 6th (which is Christmas Eve by the Russian Orthodox calendar), Ukraine was “stealing” 15 percent of the transshipped gas, and the percentage was rising “hour by hour.” (Ukraine responded that it was only collecting “transit fees” in kind.) Never one to issue an empty threat, Putin, who had already warned Ukraine of “severe consequences” should it interfere with Gazprom deliveries to Europe, promptly announced that Russia was turning off the gas. Eastern Europeans thereupon began freezing in their homes, and diminished gas flows were perceptible as far away as France and Italy. As bad as things were, they might have been worse had some European countries not mandated increased gas stocks to meet such an eventuality in the aftermath of the 2006 crisis.

As for the compromise deal that was eventually struck on the 8th, it does not specify how much Russian gas will cost Ukraine this time, but in a phone call on January 7th, Russian President Dmitry Medvedev told Ukrainian President Viktor Yushchenko that, “For the resumption of natural gas supplies to Ukrainian consumers, it is necessary to conclude a new contract between Gazprom and Naftogaz at the market European price without discounts and privileges.” If that’s true, then Ukraine has badly overplayed its hand. Just as its economy is tanking, Ukraine may have lost vital Russian gas subsidies.

Why, one might ask, was Putin, the final arbiter of Gazprom’s actions, willing to jeopardize relations with the E.U. – Gazprom’s largest and best-paying customer – in order to settle a seemingly routine pricing dispute with Ukraine? Putin has not expounded on his motives, but the geopolitical calculus by which he must have operated could hardly be more evident. Yushchenko’s aspiration to enroll his country in NATO, and his fervent public support of Georgian President Mikheil Saakashvili (also a NATO aspirant) during last summer’s Russia-Georgia war, surely played into Russian decisions about which former Soviet republics to favor with cheap gas. According to Putin’s calculus, Why should Russia help finance the economy of a sizable, strategically located country on its southern flank that is striving to join the West’s preeminent military bloc against it? (For a detailed exposition of Russia’s stance vis-à-vis Ukraine and NATO, see my Atlantic dispatch of September 8, 2008, "The Next Flash Point: Ukraine.")

Despite the fact that NATO wisely decided during its December 2008 summit not to offer Ukraine a Membership Action Plan, the alliance still intends to induct the country at some point. Moreover, on December 19, just as negotiations between Gazprom and Naftogaz were heating up, Condoleezza Rice flew to Crimea to sign a Charter on Strategic Partnership, intended to "strengthen Ukraine's candidacy for NATO membership" by “enhancing training and equipment for Ukrainian armed forces." This Charter can only have provoked Moscow’s ire and emboldened Kiev to take a tougher stance in talks with Gazprom. Surely this move is partly to blame for the current gas mess.

Putin may also have concluded that by making life miserable for Ukrainians now, he might prompt them to vote pro-Western Yushchenko out of office later, in the elections scheduled for January 2010, thereby helping to instate Yushchenko’s nemesis, the Russophile Viktor Yanukovych. Of course such a move could also provoke the opposite result, stirring Ukrainian nationalism against Moscow. But most likely any crisis for Yushchenko is a boon for Putin. Additionally, Putin’s allegations that Ukraine was stealing gas are credible (Ukraine is known to have filched gas during the dispute of 2006). Putin may have been hoping that this would dishonor Ukraine in Western eyes, perhaps lessening Kiev’s chances of joining NATO.

During the Gazprom-Naftogaz talks, Putin also tried (together with Ukrainian Prime Minister and longstanding Yushchenko rival Yulia Tymoshenko) to persuade Yushchenko to drop the Switzerland-registered company, RosUkrEnergo, that serves as an intermediary between Russia and Ukraine in gas dealings. Yushchenko refused. RosUkrEnergo is an opaque entity, owned 50 percent by business allies of Yushchenko, 50 percent by Gazprom. In a January 8th report, the New York Times made note of Putin’s concern that RosUkrEnergo might provide “financial resources in future political campaigns” – doubtless an allusion to Yushchenko’s coming bid for office in 2010.

In a superb Washington Quarterly essay, “Where East Meets West: European Gas and Ukrainian Reality” (January 2009), energy experts Edward Chow and Jonathan Elkind gave heavy scrutiny to RosUkrEnergo, explaining that in Ukraine,

non-transparency reaches its peak in international natural gas trade and transit, where the poster child is the shady middleman, RosUkrEnergo. . . . The company’s role is a political bone of contention in that an entity with no assets, no track record, and no transparency [stands] at the very center of the Ukrainian gas economy.

The authors go on to point out that Ukraine is in fact gas-rich, with substantial reserves that could easily, if properly exploited, satisfy its energy needs. They document the inefficiency, corruption, and malfeasance that, since Ukraine declared independence, have led to the virtual collapse of the domestic gas industry, reducing production levels from almost seventy billion cubic meters in 1975 to the current twenty billion. (Ukraine consumes seventy billion cubic meters of gas a year, but wastes much of it, and so could get by on less.) Yushchenko and his team have made many promises about reforming the industry, but they have fulfilled none of them. Elkind and Chow’s conclusions are grim:

The current form of the country’s energy sector … needs to be seen for what it is, a major threat to itself and to its neighbors… The parties who control the Ukrainian oil and gas sector use their positions to block development, to extract economic rent, and to pick commercial winners and losers for their personal convenience. . . . If Ukraine fails to modernize its energy sector practices, the sector will continue to undermine Ukrainian politics, economy, and energy security. Most importantly, it will threaten Europe’s own energy security.

It is hardly surprising that Putin doesn’t wish to enrich or do business with an entity that both interferes with the course of gas negotiations and may finance the political campaign of a president working to wrest Ukraine free of the Russian sphere of influence.

Putin also has pressing domestic incentives for cutting Gazprom-dependent nations like Ukraine no slack. With the global economic crisis starting to bite, Russia’s once-booming economy may slip into recession this year, and the country needs every dollar it can collect from its hydrocarbon contracts. The dramatic fall in oil and gas revenues, which account for half of Russia’s budgetary receipts and 65 percent of its exports, poses potentially grave problems for the autocratic petro-state. Moreover, since coming to power in 2000, Putin has enjoyed high approval ratings, based in part on his hard-line stance against the West, and in part, or perhaps mostly, on his perceived return of Russia to solvency after years of impoverishment under Yeltsin. High oil prices actually deserve much of the credit. “You can take away our liberties, as long as we have steady jobs and a decent income,” many Russians would say. But now, unemployment is spreading and the ruble is losing value by the day, notwithstanding expensive government efforts to prop it up. According to official reports, Russia’s hard currency reserves have dropped from almost $600 billion in August to $435 billion in December.

Given its autocratic proclivities, what would the Russian leadership do if currency reserves were to dry up and the ruble collapse, as it did in 1998? (Let us first dispense with the baseless fatuity, beloved of some American newspaper columnists, that soaring oil revenues foster aggressive behavior by petro-dictators, whereas low oil receipts help promote democracy. What petro-state has begun democratizing since oil prices fell last year? Saudi Arabia? Venezuela? Iran?...) The Russian government, showing clear signs that it is worried about how economic hardship might affect its popularity (and thus its political survival), has already rammed a constitutional amendment through parliament that increases presidential terms from four years to six. With the two-consecutive-term limit still in place, this amendment could help ensure twelve straight years of the next Putin presidency. The government has also abolished jury trials for crimes against the state, and is planning to broaden the legal definition of treason, which would make it easier for the Kremlin to deter or imprison potential dissidents. Thus, as the economic crisis cuts into energy revenues, Putin’s regime looks set to tighten the screws domestically to stay in power.

There are darker reasons still for Putin to maximize Gazprom’s profitability. Gas- and oil-derived graft greases the cogs of the petro-state, and easy money has softened the infighting among Russian elite clans that raged most notably up until the elections of last year that installed Dmitry Medvedev as Putin’s (nominal) successor. If the easy money starts to disappear, the clans will undoubtedly fight one another tooth and nail for dwindling petro-cash. So far, it has only been Putin’s powerful Chekist state and the flow of revenues from the energy sector that has kept them in line.

None of this is much consolation to Europeans now shivering in their homes downstream from Ukraine. They may take even less solace in knowing that more trouble may be on the way unless one of the following developments occurs: Russia and Ukraine find a way to amicably resolve their energy disputes (unlikely, as long as Ukraine aspires to join NATO); Ukraine revives production in its own paralyzed energy sector (improbable, if Yushchenko’s record in office is any indication); or Russia comes up with another source of bountiful rent (no sign of this).

In sum, even if the two countries manage to patch things up for now, as they appear to have done in their compromise accord, another gas crisis may be in the cards. Just wait until next Christmas.