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Russia piles gas pressure on Ukraine

Both the EU and Russia have the same objective, to ensure gas supply to Europe. But both are approaching their goals in very different ways

As Europe edges slowly towards building gas-import pipelines from Central Asia, Russia is feeling the pressure to secure its own transport routes.

The EU earlier this week granted the European Commission a mandate to represent its 27 members in talks with Azerbaijan and Turkmenistan to build a subsea gas pipeline across the Caspian. The initiative was unveiled as Total announced a large gas find at Azerbaijan’s Absheron block in the Caspian Sea – a discovery that may help allay fears that there will be insufficient gas to fill planned export pipelines from the region.

But while Europe is looking at Azerbaijani gas and various Southern Corridor import projects to reduce its reliance on Russia, Gazprom is making its own bid to entrench its position as Europe’s dominant gas supplier. The Russian game plan involves stripping out gas-transit middlemen – all former-Soviet states – and securing ownership of export pipelines carrying its gas to Europe.

Stable gas supplier

Gazprom’s plan for ensuring stable supply to Europe has already begun. Gas began flowing through the first of the twin Nord Stream pipelines in early September. Nord Stream runs direct to Germany, under the Baltic Sea, avoiding the need for transit countries. The $10 billion pipeline will have a capacity of 55 billion cubic metres a year (cm/y) when completed in late 2012 (PE 6/11 p25).

“We are slowly and surely turning away from the dictates of transit states,” claimed Russian prime minister Vladimir Putin when first Nord Stream flows were announced.

And Russia has already dealt with one troublesome transit state. In August, Putin said Belarus would pay reduced prices for Russian gas under a new formula to be implemented from 2012. Under the deal, Belarus will sell its 50% of Beltransgaz to Gazprom for around $2.5 billion, giving Russia 100% ownership of the former state-owned company. The deal, likely to be signed in December when the present gas contract expires, will see Russia take control of a route that carries around 20% of its exports to Europe.

Russia is expected to export 158 billion cubic metres (cm) of gas to Europe this year, up from 130.6 billion cm last year, according to Cedigaz; while average 2011 oil-indexed prices are expected to rise to around $460/’000, compared with $360/’000 cm last year, because of rising crude prices.

Ukraine’s prized assets

But the real prize for Gazprom is the Ukrainian gas-transit system (GTS), which, with a capacity of 141 billion cm/y, accounts for around 80% of Russian exports to Europe. Unlike Belarus, however, Ukraine will not hand over its gas network without a fight. “Belarus is following its path, and Ukraine has its own,” Ukraine’s prime minister, Mykola Azarov, said of the Russian deal for Beltransgaz.

While a complete take-over of Ukraine’s gas network is unlikely, Gazprom might be satisfied with a controlling stake. “Russia’s chances of asserting outright control of the GTS are small, but substantial functional control through an internal consortium is a real possibility,” said Arthur McCallum, head of strategy at Ukrainian investment banking firm Eavex.

“Even partial management control of the Ukrainian GTS would be highly advantageous for Gazprom in the near term. It would allow substantially more flexibility in production and flow rates [using Ukrainian storage capacity] and, most importantly, provide direct influence over gas deliveries in the event of a crisis – whether technical, financial or political,” he added.

Political gas pressure

Russia is also using its gas grip on Ukraine to try to push the country away from joining a European free-trade zone and into a Russian-sponsored Customs Union, despite President Viktor Yanukovych’s outright rejection of the offer last year. (As well as being a vital transit route for Russian gas, Ukraine is reliant on gas imports from its neighbour: 33 billion cubic metres last year according to BP’s Statistical Review.)

And while fending off Gazprom, Yanukovych has had to deal with western criticism over the trial of former prime minister Yulia Tymoshenko. She is accused of abusing her powers and signing a 10-year gas contract with Russia in 2009, which agreed lower gas prices, but committed to very high minimum volumes of 33 billion cm/y. According to reports, next year, Ukraine will pay an average of between $414 and $416/’000 cm for Russian gas, up from $354/’000 cm.

Critics within and outside Ukraine claim the case against Tymoshenko is politically motivated – she defeated Russia-backed Yanukovych in the 2004 prime-ministerial election, but her 2010 bid for the presidency failed, with Yanukovych snatching a narrow victory. A decision in the Tymoshenko case is expected at the end of September. While a guilty verdict may jeopardise Ukraine’s EU’s free-trade zone entry, it would support attempts to cancel the 2009 contracts.

To complicate matters further, national oil company Naftogaz Ukrainy is being restructured with a view to raise $5 billion to $10 billion from an initial public offering of its exploration division. “Naftogaz will no longer exist after the restructure … and all agreements will be reviewed,” Azarov told Russian news agency Interfax, referring to the Tymoshenko-era contracts.

Ukraine, which is particularly hard-headed when dealing with Russia, may not just use the Naftogaz restructuring as a trigger for contract renegotiation, it could challenge Gazprom through international lawsuits and arbitration. It would join, among others, German utilities RWE and E.On in taking the Russian monopoly to court over expensive oil-linked gas prices. Ukraine wants not only a cut in prices, which are above hub-market prices, but also to reduce minimum volumes to 27 billion cm/y.

Caspian gas to the rescue?

Europe’s talks with Azerbaijan and Turkmenistan over a trans-Caspian pipeline and the Absheron discovery give Ukraine extra leverage. Initial results from the Absheron X-2 well confirmed “a potential several trillion cubic feet (cf) of gas and associated condensates”, Total said. And Absheron’s reserves could be even larger – Total is set to start an appraisal programme.

But Absheron production is unlikely to start before 2020. And although the EU talks with Azerbaijan and Turkmenistan offer hope that there may one day be the necessary infrastructure to import volumes from the Caspian, there is no real threat to Gazprom’s dominance until the first concrete steps are taken to build a pipeline.

“It is significant that the EU is taking a more proactive leadership role in seeking to implement the vision of the Southern Corridor, but time will tell if there's any real meat to this development, or if it is just more talk from the EU,” said Andrew Neff, senior energy analyst at IHS Global Insight.

Russia has tried to derail Caspian pipeline plans before, claiming that nothing can be built until the Caspian Sea has internationally accepted status from the five littoral states (Azerbaijan, Russian, Kazakhstan, Turkmenistan and Iran), but its argument looks weak.

“This lack of agreement has not stopped each of the countries developing their own sector of the Caspian, nor prevented bilateral deals to jointly develop fields that straddle the agreed maritime border. The legal challenge to building a trans-Caspian pipeline is more bluster,” Neff said.

For years, Europe has been looking to central Asian and Middle East gas supplies as an alternative to Russia. The Southern Corridor pipeline projects include the EU-backed 31 billion cm/y Nabucco, the 11 billion cm/y Interconnector Turkey-Greece-Italy, and the 7 billion cm/y Azerbaijan-Georgian-Romanian Interconnector. But, of course, Gazprom trumps them all with its rival 63 billion cm/y South Stream project.

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