James J. Coyle: Energy is the key to making Moscow pay

Published in the Orange County Register on May 17, 2014. To access the original article, click here.

Russian President Vladimir Putin is engaging in a shadow dance – maskirovka – to prove to the world he is not behind the May 11 separatist referendum in eastern Ukraine.

He has called on his allies in Donetsk and Luhansk to cancel the vote, and he endorsed the May 25 presidential election as a “step in the right direction.” He also claims Russian troops have withdrawn from the border. Pro-Moscow separatists ignored the president’s words and the Pentagon has seen no evidence of a withdrawal.

The referendum will, no doubt, show voters supporting independence. This result will be a lie. The majority of people in the East, as shown from the first vote for independence in 1991 to a Pew Research Poll taken in April, have consistently supported remaining in a unified Ukraine.

The U.S. has threatened additional sanctions if the referendum is held. Canada and Japan have already joined the United States and the European Union in leveraging sanctions against Russia for its actions in Ukraine. These measures, targeting individuals and companies instead of the Russian population as a whole, appear to be a tepid response to recent events.

However, the threat of additional sanctions is having an effect on the international financial community.

The rating company Standard and Poor’s has downgraded Russian sovereign debt from BBB to BBB-, one step above junk status. As a result, Western banks are refusing to refinance Russian debt. Moscow has had to cancel some bond auctions for lack of buyers. The Russian 10-year bond yield stands at 9.7 percent, higher than Eurobond yields from such troubled countries as Greece and Portugal.

Citigroup has reduced its exposure by 9 percent, JP Morgan has reduced its exposure by 13 percent, and Bank of America has reduced its exposure by 22 percent. Capital flight from Russia in the first quarter of 2014 was over $63 billion, approximately the same amount as left the country in all of 2013.

The actions of the financial community by itself may not be enough. In his keynote address to the Baltic American Freedom League’s annual dinner on Saturday, U.S. Congressman Ed Royce, R-Fullerton, noted the way to make Moscow pay for its behavior is through energy policy. Royce noted that 52 percent of the government of Russia’s annual budget comes from hydrocarbon revenues. “If you want to hurt Moscow,” he said, “drive down the price of energy.”

Royce proposed exporting liquefied natural gas, also known as LNG, from the United States to Europe.

This would reduce Europe’s dependency on Russia for its gas and oil, increase the depressed prices in the United States, and decrease the price for gas in Europe. In addition to the congressman’s suggestions, there are a number of other steps the world community could take.

The European Union can stand fast in opposing the construction of the Gazprom-owned and operated South Stream pipeline. This energy conduit is designed to send 63 billion cubic meters per year of natural gas to Europe. The pipeline will not increase the total amount of Russian gas delivered, however, as its sole purpose is to bypass the pipeline through Ukraine. This will allow Russia to squeeze Ukraine whenever Moscow desires, while keeping Europe “hooked” on Russian energy.

At the same time, the EU can support the Southern Energy Corridor, designed to bring non-Russian natural gas to Europe. Kazakhstan could increase its flow of oil to Europe through the underutilized Baku-Tblisi-Ceyhan pipeline.

Poland, Hungary and Slovakia can reverse the flow of natural gas in the pipelines transiting those countries, to provide Ukraine with non-Russian gas at prices at least $100 per thousand cubic meters less than what Russia is charging that country.

Middle Eastern energy production should be maximized. This requires a number of political advances. If peace were restored in the Libyan Civil War, harmony brought to the warring factions of Iraq, approvals granted to the Kurdish regional government to export its product, Iranian production brought back into the international mix and the gas deposits of the Eastern Mediterranean exploited, the quantity of oil and gas would increase markedly and Moscow’s revenues would decline precipitously.

James J. Coyle, Ph.D., is the Director of Global Education at Chapman University, and the Executive Director of the Caspian Research Institute, an online think tank.

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European Responses to Gazprom Delivery Cuts

In February 2012 Gazprom reduced its deliveries of natural gas to Southern Europe to meet domestic demand in Russia.  This was the third time in six years that Gazprom cut deliveries to Europe:  2006, 2009 and 2012.  Unlike the first two interruptions which appear to have been politically motivated (aimed at influencing Ukrainian politics), this cutoff was precipitated by high demand--and Gazprom's inability to meet that demand.

Following the first two cutoffs, Europe united in demanding the creation of an alternative natural gas source.  Just as the gas outage was different than the first two, reactions have also differed.  In fact, European countries have diverged wildly as to their reactions.

The first to react was Russia itself.  On February 1, Gazprom acknowledged there had been increased demand, caused by the coldest weather to hit Europe in decades.  They pointed out that even though not everyone was getting all the gas they wanted, that Gazprom was honoring all its contractual obligations--a point acknowledged by the Europeans themselves.  Citigroup analysts in Moscow Ronald Smith and Alexander Bespalov released a note that read, "Gazprom will almost certainly meet its minimum contract requirements."  Gazprom Deputy Chairman Andrei Kruglov informed then-Prime Minister Putin that Gazprom could not increase gas deliveries to Europe.  Putin gave orders for Gazprom to do whatever was needed--but not at the expense of Russia's inhabitants.  "I am asking you to make a real effort to supply the demands of our foreign partners given that the top priority of our energy companies, including Gazprom, is to supply Russian customers," he said.

Gazprom's admission that they had cut back on deliveries was given hesitantly, however.  At first, they blamed Ukraine for the shortage--stating that Ukraine was stealing excess gas from the pipeline that passes through that country (See my blog entry "South Stream Advancing", June 12, 2012.)  When it became apparent that domestic demand was taking all the gas, Gazprom's other deputy chair, Alexander Medvedyev, admitted gas demand exceeded expectations by 50%.  Deputy Kruglov then stated the cuts had lasted several days, and had reached up to ten percent.  Officials in Austria and France reported shortages of 30%, and Italy reported shortages of 24%.  Ukraine itself claimed it was receiving 15% less gas.

IHS regional energy analyst Andrew Neff stated the obvious:  "The cold weather spike in demand raises questions about...Europe's apparent expectation that Gazprom can quickly ramp up export volumes as a "swing supplier,"  reported AFP.  East European Gas Analysis chief Mikhail Korchemkin explained why:  "Turkmenistan and storage gas could have contributed some 240 million cubic meters per day--enough to provide a stable gas flow to Europe," noted the same report.  But that gas was not available, because Gazprom has been building its network instead of storage facilities.  Deputy Chief Medvedyev conceded the problem and said, "We cannot promise that this will not happen again next winter or over the next five years..That is why we have given the green light to a program aimed at doubling the volume of our European storage facilities."

Jonas Gratz of the Center for Security Studies in Zurich, notes the paradox that while Russia can no longer play supplier of last resort, many European countries are rewarding Russia instead of seeking alternatives.  "The premise of stable supplies from Russia is crumbling fast," he wrote.  "Gazprom is not the "reliable supplier" that the Soviets may once have been (in the eyes of Western Europe).  Gazprom's market share in the EU turns out to be already too high for the sort of power play Moscow wants to pull off with the EU.  By exploiting irregularities and crises to display and test the EU's vulnerabilities, Russia strives to derail the EU's market liberalization agenda...Many EU member states and institutions have so far rather rewarded Russia's unreliable behavior...Instead of rewarding Russia, the EU and its gas industry have to focus on diversifying suppliers."

Europe's dependency of Russian energy will continue to grow in the future.  A doctoral student at Old Dominion University, Katerina Oskarsson, compiled an interesting report.  She wrote that the EU's gas imports are projected to accelerate due to a depletion of indigenous gas resources.  The European Commission estimates that the proportion of EU gas consumption met from imports is set to rise from 60% to 73-79% by 2020 and 81-89% by 2030.    These statistics, while alarming, need to be kept in perspective.  Russian gas only accounts for 6.5% of the EU's primary gas consumption.  The issue, however, is regional.  In Central and Eastern Europe, all states reply on Russia for at least 50% of their natural gas, and six countries get over 80% of their supply from Gazprom.

The Cold Snap has brought home the European need for non-Russian sources of natural gas.  As Nabucco is replaced by TANAP, however, the only non-Russian sourced pipeline is reduced to delivering less than 2% of Europe's energy needs.  Europe's dependence on Russia appears destined to continue, unless a combination of LNG, shale gas, and unconventional fuels can break it.

US Policy for Russia and Central Asia

Richard Morningstar recently spoke before the US House Foreign Affairs Committee, and outlined United States policy toward Russia and Central Asia, reports the Asia Times. Morningstar reaffirmed that "Europe is our partner on any number of global issues from Afghanistan to Libya to the Middle East, from human rights to free trade." As a result, the United States intends to be deeply involved in Europe's energy security. In that regard, the US will work for Europe's "diverse energy mix" in regards to supply, transportation routes, and types of energy.

Morningstar then made the following points:

1. The US will encourage Central Asian and Caspian countries to find new routes to market;


2. The US will push for the privatization of the energy sector;


3. The US remains as committed to the Southern energy corridor as it was under presidents Clinton and Bush, and will promote all three possible routes (Nabucco, ITGI and TPA) as possibilities;


4. Turkmenistan can be a major supplier of gas to Europe through the Southern Energy Corridor;


5. The Baltics should be integrated into the European energy market so it is not as vulnerable to Russian pressure;


6. The US will challenge Russia's efforts to monopolize Ukraine's energy sector;


7. European countries should not negotiate energy deals unilaterally with Russia, but should negotiate together as a single energy market;


8. Europe should consider shale gas as an alternative to Russian natural gas; and,


9. Europe should not allow Gazprom to penetrate the European retail market.

Morningstar's message places US interests in the region clearly in opposition to Russia's. Diversity in energy sources, new Caspian energy routes, the Southern gas corridor, etc. all are designed to limit Russian energy dominance of the Eurasian land mass. What was missing from Morningstar's testimony, however, were plans on how the United States was going to implement the goals he outlined. Implementation will require more attention to the region than the current US administration has given it, to date. While the Ambassador can claim that the commitment to the Southern corridor is as strong today as previously, the last two presidents at least had ambassadors appointed to all the countries in the area--something President Obama has not done after three years in office.

Natural Gas: Alternative to Oil

While hydrogen-powered automobiles may still be in the future, there is a cheap, clean alternative to oil: natural gas. Often a by-product of oil production, natural gas was considered a waste material that was burned off at the well head.

Use of natural gas has doubled from 1973 (671 Metric Tons of Oil Equilvalent) to 2007 (1296 MTOE). Energy consumption has increased at such a rate, however, that this represents only a minor increase in the OECD percentage of fuel consumed. In 1973, Gas was 14.4% of the 4675 MTOE; by 2007 that share had only increased to 15.6% of the 8286 MTOE (International Energy Agency, Key World Energy Statistics 2009).

Natural gas has a major drawback: it is difficult to transport to the end user. Experts in the field such as Adam E. Sieminski (Siminski, World Energy Futures, in Kalicki and Goldwyn, eds., Energy and Security; Baltimore: Johns Hopkins Press, 2005, 40-43) and Daniel Yergin (Yergin, Energy Security and Markets, in Kalicki and Goldwyn, ibid, 58-60) describe the growth of liquified natural gas (LNG) as the solution to the transportation problem. But LNG has its own drawbacks: the equipment to cool natural gas to minus 240 degrees, keep it at that temperature during transit, and then reconverting the liquid to its natural form are all expensive. It is also dangerous: Sempra Energy wanted an LNG terminal to service Southern California, but residents' fears of LNG storage tank explosions forced Sempra to build in Mexico.

Trade in LNG is certainly increasing, but until these problems are resolved the major way of moving natural gas is via pipeline. Construction of these delivery networks are expensive and represent a fixed capital investment for the pipeline owners. There is therefore little competition in the natural gas market, as it is too expensive to build multiple pipelines to deliver product to the same location. This means that whoever controls the pipeline controls both the producer output and the consumer price.

Russia, through the semi-autonomous pipeline owner Gazprom, has used this situation to develop a monopoly over natural gas delivery from the former Soviet Union. In 2008, Russia produced 20.9% of the world's supply of natural gas, consumed natural gas domestically, but still exported 23.4% of the supply. (IEA, World Energy Statistics, 2009). Whether the gas originates in Kazakhstan, Azerbaijan, or Turkmenistan the only way to get the gas to the European market is through the Gazprom-controlled pipelines. Vladimir Putin, former Russian president and current Russian premier, has commented on this situation by noting that control of Gazprom is a matter of state policy. Pipeline projects to break the Russian monopoly represent, therefore, a direct threat to Russian economic interests.

Dr. James J. Coyle is available to speak to your organization or at your event. Please contact him at jimcoyle@verizon.net.