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Making sense of the Russian-Ukrainian gas spat

by Jerome a Paris Fri Dec 30th, 2005 at 05:47:05 AM EST

I have written various short comments dismissive of the whole story (see various European Breakfasts in recent days, as well as dvx's diary, but have not justified properly my position.

In order to do this, I will quote verbatim articles that I wrote in 2002 on the exact same topic, and which apply just as well today.

This article is a fairly long analysis of how Gazprom works. I consider it still valid today, despite the changes in leadership since then.

GAZPROM'S GOT WEST EUROPEANS OVER A BARREL was published in the WSJ on 8 November 2002 and deals specifically with the issue of the Ukrainian pipes.

Some extracts below.

Any gas sold by another Russian company would reduce Gazpromís market share (and revenues) and not add to it. Therefore, as Gazprom already produces enough for all its needs from its existing fields (and will continue to do so for many years), any non producing asset is currently not worth much to the company, nor to anyone else.

Unless, of course, those other potential producers have the possibility to sell gas where Gazprom cannot, or somewhere where it can get a better price than Gazprom. This is the case in some former Soviet republics or in some cases inside Russia, where Gazprom cannot charge for its deliveries, or cannot enforce payments, whereas a (well-connected) private company may do so.

This was the original rationale behind the creation of Itera : to sell Russian gas in Ukraine where Gazprom could not get paid for its deliveries. Gazprom has practically never been able to extract cash payments for gas delivered to Ukraine. This does not mean that gas was not paid for by consumers (for part it was not, as in Russia), but that the Ukrainian payment collector chose not to pay Gazprom because it could (for the very simple reason that it controls the pipelines through which 90% of Gazpromís export to Europe flow). Gazpromís solution was to have the gas delivered by someone else, would could cut off supplies to Ukraine without risking retaliation as Gazprom could not (each time it reduced its deliveries to Ukraine, deliveries to the West were effectively cut off). Gas was procured by Itera from Turkmenistan to build the fiction that it is not delivered from Russia. In practice, this meant that money that would go to Gazprom in an ideal world now went into the pockets of people with links to Gazpromís management instead of into the pockets of people with links to Ukrainian authorities. There was no loss for Gazprom, but only in the narrow sense that money would not have reached the company in any case. Today, Gazprom delivers to Ukraine approx. 25-30 bcm per year as payment of transit tariffs for its export gas (by the way, this payment in kind can be legitimately accounted for at many different prices, as there is a set-off for another service, transport, which can also have many realistic prices). Another 25-30 bcm of gas are shipped every year from Russia, by Itera or others and not by Gazprom (who still acts as transporter of the gas to the Ukrainian border). If that gas came from Russia, any positive price that Gazprom gets is pure profit for Gazprom, because it previously had to deliver this gas without getting any payment. The question that arises is then a question of the fairness of the allocation of that payment between Gazprom and Itera (which is a legitimate question with Itera a vehicle for Gazprom-related investors), but not whether Gazprom lost out in the deal, because it did not, as far as the Ukrainian market is concerned. (If financial guarantees, or preferential transportation tariffs have been provided by Gazprom to Itera, this may need to be reassessed, but information on that subject is hard to come by). To improve the situation for Gazprom shareholders, the gas market in Ukraine would need to be changed. It is not clear at all here that competition between Russian exporters for access to Ukrainian pipelines would bring any improvement to this situation.


The fate of Ukrainian gas pipelines has long been an object of concern for followers of the gas industry in Europe. Ninety percent of Russian exports to Europe must go through them, and Ukraine has been regularly accused of siphoning this gas. Yet this accusation has been true in only three well publicized incidents, in 1992 and 1993. What happened back then was very simple: Russia tried to cut off its gas deliveries to Ukraine, which were not being paid for, and Ukraine retaliated by reducing deliveries on the export lines to Europe. This situation lasted only a few days; in each instance, Western buyers immediately panicked, then Russia backed off and resumed supplies to Ukraine. But deliveries to Europe have not been interrupted a single time since 1993.

Gazprom understands very well that the reliability of its supplies is essential in its relationship with European purchasers, and it took the decision then to deliver to Ukraine whatever was necessary to get the exports out on the other side. Indeed, this situation was really no worse than what was happening elsewhere in the region, with gas delivered and not paid for -- except that no other customer of Gazprom held a stranglehold on the company quite like the Ukrainians did.

Luckily for Gazprom, no other customer was also quite so bumbling. The only thing that the Ukrainians managed to achieve in return for controlling absolutely 25% of Russian exports was a dwindling supply of gas, which was wasted with the same abandon as in the Soviet period. No reforms were engaged to reduce consumption, or to try to grab the export market from Gazprom by buying the gas from them and on-selling it to Europe. Instead, the Ukrainians let Gazprom slowly take over their industry.

Corruption in the Ukrainian gas industry meant that certain officials took advantage of Gazprom's inability to enforce payment in order to enrich themselves. As in Russia , the final consumers in Ukraine quite often paid for their gas, but the bill collector chose not to pass on these revenues to Gazprom (in Russia for political reasons, and in Ukraine thanks to control over the export routes).

Gazprom's brilliant solution was to have Russian gas delivered by someone else, a private entity not affiliated to Gazprom which could cut off supplies to Ukraine without risking retaliation like Gazprom: Itera. Itera found accomplices among Ukrainian factions able to take control of the gas distribution business, and it sold directly to such private entities and not to Kiev's state gas company.

Gas was procured by Itera from Turkmenistan to build the fiction that it was not Russian gas being delivered (a scheme made all the easier because Turkmenistan was in such a weak bargaining position, with all its pipelines going straight to Russia ). The revenues collected in Ukraine from distribution of non-Gazprom gas -- whether in the form of money, goods or ownership of local production assets -- were shared between the new Ukrainians, Itera and its partners in Russia and Turkmenistan.

The fact that Itera, and Itera alone, was able to ship large volumes of gas through Gazprom's pipeline network between Central Asia and Ukraine strongly suggested to observers that it had close relations with Gazprom's top management, although this has always been denied by both Gazprom and Itera and never has been conclusively proven by outsiders. In any case, such a sort of arrangement seemed to make sense: It reduced Gazprom's deliveries to Ukraine and extracted some revenue for Gazprom from that country (whatever was paid by Itera for gas transport which would have taken place anyway) and it was a perfect opportunity for well-connected individuals to benefit. This led to massive corruption and nasty political battles inside Ukraine, to take part in this juicy business, with the population, as usual, the main victim.

Meanwhile, as Itera officials stepped in with its deliveries, Gazprom's deliveries were quickly reduced to a volume of 25-30 billion cubic meters per year, which is the volume where Gazprom loses no money in Ukraine, because the value of that gas roughly corresponds to a reasonable transit tariff payable to Ukraine for all the volumes exported to Europe through Ukraine, which is some 120 bcm a year. Ukrainians still do not pay for that gas, but they do not incur new debts (the $1.4 billion debt figure quoted all the time is essentially the debt incurred in 1992-93 which is rescheduled every other year.) Gazprom does not get cash but gets value for its gas. This can be accounted at production cost or at any equivalent transit tariff value, depending on the reporting requirements of the day -- the difference between the two extreme options can represent an extra $2 billion per year in Gazprom's declared revenues and profits.

Today, Ukraine receives 50 bcm of gas per year from, or, in the case of Turkmen gas, through Russia (compared to close to 100 bcm in 1990). Half of it is delivered by Gazprom directly, the other half by Itera or other similar "independent" traders. Gazprom's exports flow to Europe unhindered, with plenty of spare capacity (thanks to deliveries to Ukraine having fallen overall faster than Gazprom's exports to Europe have grown), and its deliveries to Ukraine bring it a decent level of revenue.

So, why would Gazprom want to bother now taking over the assets? The simple explanation is that it represents a great opportunity to make the European purchasers pay for the maintenance of the Ukrainian pipelines. Gazprom has a long history of making its clients pay, willingly or not, for its investments. For instance, Ruhrgas purchased shares in Gazprom at a time when nobody wanted to invest in Russia , in exchange for the shelving of Gazprom's expansion plans in Germany (via its Wingas venture with BASF). The Italian energy company ENI invested in the Blue Stream pipeline, which significantly increases Gazprom's export capacity to Turkey, at the same time that Gazprom's plans to develop in Italy with Edison were abandoned.

This time, the idea is to build on the bad reputation earned by the Ukrainians (since "thieves" wouldn't bother to maintain their pipeline network) to once again get the likes of Ruhrgas, ENI and Gaz de France to pay for new Gazprom investments. After all, even if they pay for truly needed work in Ukraine, it frees Gazprom resources for other projects.

It still applies. The differences today are twofold:

- Ukraine is seen as more hostile than 4 years ago

- gas prices in Europe have increased significantly

Thus two reasons to rattle the cage. Another unsaid reason is probably that the Ukrainian partners of Gazprom were oligarchs now out of favor with the new government, and new arrangements for control of that business are being hammered out. The "noise" in the Western media is part of these internal negotiations which are never talked about between the Ukrainian metal barons (the biggest users of gas), the guys that control the Ukrainian gas pipelines, the Gazprom managers in charge of these flows (the export managers, and those that control the transit from Turkmenistan), and which are certainly pretty tough.

And just one item: the Russian ambassador to Kiev is V. Tchernomyrdin, the former Prime Minister of Elstin and, more importantly, the former chairman of Gazprom before that, at a time when pretty much the whole management of Gazprom was Ukrainian, because that's where the Soviet gas industry was born.

If the people that control the dirt your pipe runs through don't want you to use it, you have real problems.

Ukraine has boths ends of the pipe by the short and curlies.  They have 3 choices.  Take Ukraine by force, pay whatever they charge.  Find another way to sell/buy gas. Not very good choices really.

by HiD on Fri Dec 30th, 2005 at 07:39:39 AM EST
A friend made a good comment on this...W. Europe is Russia's customer...does Russia want to piss off its customer? Doubtful.

"Once in awhile we get shown the light, in the strangest of places, if we look at it right" - Hunter/Garcia
by whataboutbob on Fri Dec 30th, 2005 at 10:40:21 AM EST

But Russia doesn't have a long history of acting in its own best interest.

Or of good customer service.

Those who can make you believe absurdities can make you commit atrocities. -Voltaire

by p------- on Fri Dec 30th, 2005 at 01:08:31 PM EST
[ Parent ]
Inspired by Jerôme's dairy ::
EU Gas Transport to be Cut?
Ukraine Politics, Jobs, Fees, Pipeline & Ecology ◊
@BooMan's Tribune

Ukrainians protest against
Russian gas demands

"Treason doth never prosper: what's the reason?
For if it prosper, none dare call it treason."

▼ ▼ ▼ MY DIARY

'Sapere aude'

by Oui (Oui) on Fri Dec 30th, 2005 at 12:39:44 PM EST
Oui, I have to let a primal scream at you, for consistently writing my first name with an odd number of accents... . Please use the even versions: Jérôme, the right one, or Jerome, the tolerable English version.

Good job on your diary otherwise.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Fri Dec 30th, 2005 at 01:52:30 PM EST
[ Parent ]
it is ... Oui!

Not always available on every keyboard:
so I need to memorize - é Alt 0233 and ô Alt 0244.

I think I've got it.

"Treason doth never prosper: what's the reason?
For if it prosper, none dare call it treason."

▼ ▼ ▼ MY DIARY

'Sapere aude'

by Oui (Oui) on Fri Dec 30th, 2005 at 03:04:32 PM EST
[ Parent ]
I'm not quite as sanguine as you. I'd grant that a tipping over into full blown crisis - i.e. Russia 'cutting off' Ukraine by reducing supplies, Ukraine responding by still taking 'its' share from the Europe bound gas and then a full cut off is unlikely, however, I don't see it as completely implausible.

We're not in the early nineties here. The Russian leadership has changed. Putin is not Yeltsin and is much more interested in reestablishing hegemony over the former parts of the Russian empire, he is also quite a bit more ruthless, and Russian public opinion is more likely to be solidly supportive (and if not, it is in any case a lot less significant).  A second factor is Russia's economic position. In the early nineties it was quite shaky, now it is in very good shape. As a result the immediate economic impact on Russia of a short to medium term cut off of gas (say a few weeks to a few months) would be minor. In the longer term Europe would be rattled and wish to reduce its dependence on Russian fossil fuel, but considering the supply situation, that isn't that easy, and the Russians are also looking at expanding markets in Asia. On the other side the immediate impact on Ukraine would be devastating. Same goes for Poland which also has very poor relations with Russia. The impact on other European countries - the ones Russia is cultivating - would be unpleasant, but far less severe.  

All of that is a long way of saying that a Russian decision to cut off gas is both politically and economically all too possible.

by MarekNYC on Fri Dec 30th, 2005 at 04:31:07 PM EST
and I am preparing a much longer post to explain why.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Fri Dec 30th, 2005 at 04:55:17 PM EST
[ Parent ]

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