ANALYSIS: By Peter Lavelle, United Press International (UPI)
Moscow, Russia, Tuesday, December 20, 2005

MOSCOW – A little more than two weeks ago, the Russia-Ukraine natural gas war appeared to have been all but settled.

Then last week, Alexei Miller, the head of Russia’s energy giant Gazprom, not only denied a deal had been agreed, but Gazprom’s position significantly upped the ante: Ukraine must pay market prices for imported natural gas from Russia and be reasonably compensated for transit of natural gas through its territory supplying European markets.

What explains Gazprom’s hardened position?

Gazprom originally wanted a new natural gas contract with Ukraine starting next year that includes abandoning the current barter system of payments for gas transportation services, as well as demanding Kiev pay the same price for natural gas as its European customers — $150-160 tcm vs. the current $50 tcm of natural gas sold to Gazprom’s Ukrainian counterpart, Naftogaz. Needless to say, Ukraine claims this price increase is out of the question.

In 2004, Ukraine’s natural gas consumption exceeded 70 bcm while domestic production was 20 bcm. Gazprom covered part of this deficiency by providing Ukraine 29.2 bcm as payment to Naftogaz for transportation services.

Ukraine’s competitive advantage in dealing with Gazprom is its geographic location. The firm transits its natural gas through Ukraine to sell in other foreign markets. Naftogaz is key to Gazprom’s international operations and this is the leverage Ukraine has in any agreement over the price it pays for Russia’s natural gas, as well as transit fees.

Gazprom’s dependence on Ukraine is almost absolute. It earns most of its income from exports, and its main export route runs directly across Ukraine. Naftogaz has an extensive network of pipeline corridors that end in Europe. Gazprom shipped 138 bcm of its total European exports of 153.2 bcm through the Naftogaz pipeline system in 2004.

Gazprom pays Ukraine a transit tariff of $1.09/mcm/100 km and has proposed $1.75/mcm/100 km. Ukraine is demanding an increase to $3, which would essentially cover the cost of the country’s imports from Russia.

In an effort to go around Ukraine, Gazprom plans to build a pipeline that will link the Russian port of Wyborg and the town of Greifswald in northeastern Germany, running underwater for almost 744 miles. It will initially provide gas to Germany, and offshoots may subsequently be built to link it with several other countries, including Britain. The pipeline is forecast to deliver 20 bcm of natural gas a year, a trifle compared with its present total export regime.

At loggerheads for months and with the current natural gas delivery agreement to expire at the year’s end, Russian Prime Minister Mikhail Fradkov paid a short visit to representatives of the European Commission in early December. Almost immediately, EU Energy Commissioner Andris Piebalgs said Russia and Ukraine had developed a draft protocol that will have Ukraine shift to a world gas price regime by 2010.

If agreed to by both governments, the protocol will maintain natural gas tariffs at current levels in 2006; prices and transit tariffs will then gradually rise in 2007-09. The document suggests Ukraine’s Naftogaz has moved closer to Gazprom’s original proposal.

The Russian energy giant hopes to increase the price of gas delivered to Ukraine to $160/tcm, with transit tariffs it pays also rising from the current $1.09/tcm/100 km to $1.75/tcm/100 km.

The agreement would also bring Ukrainian gas prices to $163/tcm by 2010, according to current oil price assumptions. This is in line with the gas price of $160/tcm proposed by Gazprom.

According to the protocol, Naftogaz will pay current prices in 2006, then $90/tcm in 2007, $109/tcm in 2008, $133/tcm in 2009, and $163/tcm in 2010. The substantially higher payments, approximately $2.5 billion a year, for Russian gas will be somewhat offset by an increase in transit tariffs for Gazprom.

When Miller appeared on Russia’s English language television station RT last week he said no protocol was being finalized and Gazprom had not only changed its negotiating position, but threatened to turn off the taps to Ukraine (and Europe). Shortly after Miller’s television appearance, Deputy Chairman of Gazprom’s Managing Committee Alexander Medvedev declared Gazprom had upped its price demand to $220-230/tcm.

Why the sudden about face? Two issues appear to be in play.

[1] First, most of the talk and bitterness about the negotiations have come from the companies most involved — Gazprom and Naftogaz. When Medvedev dropped his bombshell that Gazprom’s price demand is now much higher, the politicians entered the fray.

Presidents Vladimir Putin and Viktor Yushchenko have sought to cool tempers. Putin’s statement that the gas dispute should not hinder Russia-Ukraine relations appears to be directed to Europe to apply pressure on Ukraine to compromise.

Whatever the final compromise — most likely similar to the one described by EU Energy Commissioner Andris Piebalgs — Putin intends it to be only a commercial victory for Gazprom, but a political victory for Russia. The Kremlin wants the EU to see Russia as a trustworthy partner.

[2] The second issue is how this dispute will be perceived by other former Soviet republics importing Russian natural gas. The drawn-out negotiations with Ukraine send the powerful message that the days of cheap Russian natural gas are coming to a close.

Moldova, Georgia and the three Baltic states — and even Belarus — have watched the Russia-Ukraine spat closely and come to the conclusion that playing hardball with Gazprom is a losing proposition.

The lesson to be learned from the Russia-Ukraine face-off is obvious: Gazprom is a business and the Kremlin will do what it can to make its assets generate as much income as the market can accept. -30-

Peter Lavelle is a Moscow-based analyst who writes for RIA Novosti.

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