Wednesday, January 4, 2012

Russia on Top in Ukranian Energy Dispute

In 2011, Ukraine was faced with a combination challenges: former Prime Minister Yulia Tymoshenko had saddled the country with a long term contract committing the country to paying $400 per thousand cubic meters on a "take or pay" basis; the government was in a dispute over its share of revenues for gas passing through the country to Europe; it was threatened by the creation of alternate pipelines that would remove its importance to the European energy grid; its sovereign control over its energy assets were threatened. As 2012 arrives, it appears that Ukraine is losing on all counts.

Until three months ago, 80% of all Russian natural gas exported to Europe flowed through the Ukrainian pipeline system. This vital energy artery was initially constructed by the Soviet Union. Through age, use and lack of proper maintenance, the pipeline faces obsolescence. Ukraine has long wanted to renovate the pipeline, but has lacked the funds. In June, Ukrainian President Viktor Yanukovych invited Russia and the European Union to finance the renovations, in return for price concessions. Naftogaz officials estimated the cost of renovations would be $3.5 billion, a bargain compared to the $11 billion Nord Stream project or $21.5 billion South Stream project. Faced with a lack of Russian interest, in July Ukrainian Prime Miniter Mykola Azarov announced it was beginning to upgrade its pipeline system itself. The European Bank for Reconstruction and Development (EBRD and the European Investment Bank (EIB) signed memorandums commiting 300 million Euros to Naftogaz for the upgrade.

Meanwhile, Prime Minister Azarov demanded that Russia release it from the 2009 gas contract. When Tymoshenko signed the contract, she was hailed as a hero because it promised that Russia could not cut the gas supply to Ukraine as it had only months before. In 2011, however, as the cost of natural gas plummeted around the globe, the contract was perceived as a criminal conspiracy to defraud the Ukraine and Tymoshenko was jailed.

Russia hinted that the contract could be renegotiated, but only if Ukraine joined in a customs union with Russia and Belarus. Alternatively, Gazprom's leader Alexei Miller offered to lower prices if Naftogaz merged with the larger Gazprom. Azarov feared either option would destroy the country's soveriegnty and refused.

To cancel the contract, Azarov announced he would disband Naftogaz. "Naftogaz as a company will cease to exist. There will be a liquidation period. Some time later, after all necessary formalities are taken care of, entirely new companies will begin to operate on the market. As a result, all existing agreements will be revised," Ria Novosti quoted Azarov as saying.

Yanukovich also threatened to take Russia to the Stockholm Arbitration Panel to get the contract voided. This action appeared to be an empty threat, however, as within a week Ukranian Foreign Minister Kotyantyn Gryschchenko was stating he wanted to find a solution without going to the court. "There is one group of people which is always interested in court action--lawyers," he said. "We should probably do everything possible to make their life easier and find a natural decision in the bilateral format."

In September, Russia turned up the heat by formally opening the Nord Stream pipeline. This route goes under the Baltic Sea directly to Germany, and avoids transiting Ukraine or other countries. Ukraine's transit revenues are expected to decline. Vitaliy Lukyanenko, spokesman for Prime Minister Azarov, demanded that Russia and Europe make its plans known. "Since Russia is building pipelines bypassing Ukraine, Ukraine wants to get a clear answer, whether Russia intends further to use the Ukrainian gas transport system...And from Europe, Ukraine wants to know its plans regarding the Ukrainian gas transportation route," quoted the Kyiv Post.

The Ukranian government took a deep breath, and analyzed what was going on. Why would Russia refuse to cooperate to repair an inexpensive route for their gas shipments, and insisting to pay tens of billions more for alternative routes (one of which has yet to be built)? Given the fact that the Russians had offered deals in return for the Custom Union or other connections to Russia, they concluded that they were not involved in an economic contest, but a political one.

According to Voice of America, in August President Yanukovych announced Ukraine would join the European Union in ten years. This goal is suppoted by 70% of Ukrainians, according to Viktor Chumak, director of the Ukrainian Public Policy Institute. Oleg Voloshyn of the Foreign Ministry said that Ukraine aspired to be a member of the European Union, and Russia was attempting to force Kyiv into the customs union, instead. Gazprom leader Miller also hinted that Russian plans to build the South Stream pipeline might be a pressure tactic against the Ukrainians. "South Stream has always been linked to Ukraine," he said.

Faced with a looming shutoff of gas from Russia, Yanukovych turned to Turkmenistan. Russia had stopped buying Turkmen gas in April 2009, so there was a mutuality of interests in the connection. Turkmen gas would not free Ukraine from Russian dependency, however, as the pipelines between Turkmenistan and Ukraine passed through Russian territory. In October, Prime Minister Azarov relented, and agreed to join the CIS Free Trade Zone. Azarov said that once the agreement goes into effect, Turkmen gas would be able to transit Russia within six months.

The Ukrainians then renewed its proposal for a pipeline consortium consisting of Naftogaz, Gazprom and the EU to repair the pipeline network. According to Reuters, Gazprom chief Alexi Miller met in December with Ukrainian Energy Minister Yuriy Boiko and removed the EU from the equation. New estimates, however, place the cost of repair at $20 billion. Combined with the domestic price reductions that Ukraine is demanding ($9 billion annually), the negotiations have bogged down again. Russia has returned to its previous position that it might finance pipeline upgrades, but only if the Naftogaz pipeline system becomes part of Gazprom.

Negotiations between the two sides begin again on January 15. Ukraine has been seriously weakened in its strategy. It has acquiesced to a Free Trade Zone, thereby threatening its chance at a European orientation; it has been unable to obtain a break in the price of gas it will use domestically despite its legal threats; it has moved toward creating an energy consortium that will allow Gazprom to eventually take over control of the pipeline system; Nord Stream is completed and South Stream continues to progress in its planning. Russia continues to get top dollar for its gas, and is slowly pressuring Ukraine to accept all its demands to keep that country within Russia's shadow.