Europe Cannot Do Without Putin’s Gas

 Soviet Russia established itself as a reliable supplier of reasonably priced gas to Western Europe during the Cold War. It is easy to forget how unlikely this seemed at the time. The driver was the development of colossal Siberian gas reserves that far exceeded the requirements of the Soviet Union and its Comecon satellites. Relatively modest relationships were established in the Seventies with companies in West Germany, France and Italy, but larger and more ambitious contracts, and the pipelines to go with them, were forged in the early 1980s in the teeth of opposition from Ronald Reagan and Margaret Thatcher.
These contracts have been expanded and adapted since the Soviet Union’s collapse, and post-Soviet Russia remains an integral part of Europe’s energy industry, supplying 24 per cent of the EU’s gas last year. Revenue from energy exported to Europe is equally important to Russia, representing about a fifth of its GDP.

But when the foundations of this trade were laid, Ukraine was part of the Soviet Union, and there seemed no danger in running all the export pipelines across its soil. That calculation looks very different now to people in the West, but to be fair to the Russians, it has seemed problematic since the breakup of the USSR.

Natural gas is the Achilles heel in Ukraine’s relationship with Russia, and by extension Europe’s as well. Ukraine imports 60 per cent of its gas supply from Russia, and transits a much greater volume of Russian gas to the markets of Western Europe especially to Germany and Italy.

Yet geography and its consequent dependencies are only the start of the picture. Since independence in 1991, Ukraine has had an unhealthy commercial relationship with Russia. Essentially, Ukraine has purchased Russian gas at a steep discount to the prices charged to Western customers. This gas comes from Gazprom, the Russian giant, or one of several shadowy trading companies linked to powerful figures in the Kremlin or Central Asia.
But while Ukraine has enjoyed cheap gas, the quid pro quo is that it has charged Gazprom a cheap tariff to transit gas to Western Europe through the pipelines owned and operated by Naftohaz Ukrainy. This arrangement worked primarily to the advantage of Gazprom, as it reduced its cost of supply to Europe, while maintaining, at a relatively low cost, its stranglehold over the Ukrainian gas industry.

However, Ukraine chronically fails to pay even its reduced bills on time, and it is this poor record that has led in the recent past to the supply interruptions that so frightened Western consumers in 2006 and 2009.

In that regard, the Russians arguably are more sinned against than sinning, and if Ukraine had got its act together at any time in the past 23 years, it would be in an economically and morally stronger position. But it hasn’t. Whatever the merits of the new untested leadership in Kiev, their predecessors, including the inexplicably much-lauded Yulia Tymoshenko, have been more concerned with lining their own pockets, and those of the oligarchs behind them, than in implementing the reforms needed to prise Ukraine out of the Russian orbit.

In the case of the gas industry, the corruption goes very deep indeed. Ukrainian sources say that key people in the energy ministry and the main state-owned companies are effectively also working for Moscow. “Gazprom has total visibility throughout the decision-making and managerial processes in Kiev,” one old hand told me.

On one level that may not be so surprising: after all, the Ukrainian and Russian gas systems were once inseparable, and there are strong cultural ties, especially in the senior ranks whose careers were nurtured in the old Soviet Ministry of Gas (now known as Gazprom).

Perhaps most disturbing is the strong possibility that Russia has prevailed on Ukraine not to exploit its own rich indigenous reserves of natural gas, thereby reducing Russian sales and influence. It is hard to prove a negative, but there is much circumstantial evidence.

The original Soviet gas industry was founded on Ukrainian gas fields in the 1930s. When these were overrun by the Germans in the Second World War, development moved east, first to the Volga-Urals region, then after the war to Central Asia, and in the 1960s and ’70s to Western Siberia. Ukrainian gas production did revive, but it was on a small scale compared to the “supergiants” in Turkmenistan and the Tyumen region of Siberia. These colossal gas provinces provided the fuel for postwar Soviet industry and the big export contracts signed with German, French and Italian buyers from 1973 onwards. It is unsurprising, particularly given the way the Soviets always went for big developments a kind of industrial gigantism that Ukraine received little investment.

But once Ukraine became independent, common sense would suggest that it should look to its own resources. By and large it failed to do so.
In 1985, Ukraine produced 39 billion cubic metres (bcm) of gas, nearly 7 per cent of the Soviet total. By 1991, Ukrainian production had halved, while Russian production had risen 40 per cent. In the years of independence, production in Ukraine and Turkmenistan dwindled as Russian output boomed. The Soviet pipeline system gathered gas from Central Asia and Siberia and delivered it to Moscow and other Soviet population centres as well as to Western markets via Ukraine. In the Soviet era, Turkmenistan was guaranteed a certain level of production and a share of the hard currency export proceeds. All that died with the USSR. Turkmenistan could not export its gas unless it suited Gazprom, but it did at least have enough for its own needs. Ukraine didn’t. And while there was plenty of foreign interest in helping Kiev out, matters proceeded at a snail’s pace.

In the late 1990s, a Western oil company with a concession to revive an old Ukrainian gas field had some modest success. This field accounted for perhaps 3 per cent of Ukrainian output, and it was clear the company could double this without trouble. The obstacle was the small diameter of a short section of pipe connecting the field to the national transmission network. The company did not control this piece of pipe, and asked the authorities to replace it with something bigger. The request was ignored, and then after some months turned down. The company offered to arrange and pay for the work itself. Again, permission was refused.

This is extremely odd, but the stakes here were relatively small, though of great importance to the company. The same cannot be said of the wider Ukrainian gas resource, which has lain dormant since 1991. Ukraine has well-known and potentially very rich hydrocarbon resources in several areas. But until very recently Kiev showed little interest in exploring these prospects. This inactivity might just be indolence and stupidity, compounded no doubt by greed — all foreign oil companies are subject to egregious demands for “sweeteners”. But Russia has a clear interest in discouraging Ukraine from developing its oil and gas resources. Given the links between the Kremlin and all Ukrainian leaders since independence in 1991, it is not hard to see how this might happen. There is great interest from Western oil companies. Last year Shell signed a $10 billion contract to explore for shale gas in the eastern (Russian-speaking) part of the country.  No work had been done before the Crimean crisis blew up, and now the new parliament in Kiev is demanding that the contract be revisited. More problematic, given the focus of current tension, are the rich waters of the Black Sea south of Crimea, where Exxon Mobil has an exploration deal. Although deep and therefore expensive to develop, this area may contain enormous amounts of oil and gas. If Russia successfully annexes Crimea, it will gain control of this resource as well.

The Russians regard Ukraine as a terrible liability which threatens their vital gas trade with Europe. The original Soviet export pipelines all transited Ukraine, but since 1991 the Russians have been finding ways to bypass the bottleneck. First they built the Yamal-Europe pipeline, which transits Belarus and Poland. Then, with the help of former German Chancellor Gerhard Schröder, they built the North Stream pipeline, which runs offshore through the Baltic to Germany. This has reduced the leverage that Ukraine has over Russian exports, but in 2013 55 per cent still passed through Ukraine. This could be reduced to about a third by maximising usage of North Stream.
Whatever happens with Crimea, Europe is relatively insulated from further supply shocks in 2014. The mild winter has left high levels of stocks in Western Europe and in Ukraine itself, and heating demand will fall further as spring progresses.

That may not bother Putin unduly. If, as seems likely, the campaign to drag Crimea and eastern Ukraine back to Mother Russia is intended as a long one, he will be content that European consumers are not worried about supplies in the short to medium term.

There has been much loose talk in recent weeks about US shale gas coming to the rescue of Europe. This is not a runner. Although the US is allowing the construction of a number of LNG terminals intended to liquefy its shale gas surplus for shipment to world markets, first exports are 18 months away, and the huge volumes that would be needed to replace Russian supply to Europe are at least a decade off. More importantly, US LNG will follow the market, and that means, for the time being, shipping to the Far East, which is prepared to pay almost twice what Europe pays for Russian gas.

As Vladimir Putin might say, not such a bad deal after all.

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