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Russia's New Gas War with Ukraine

Relations between Moscow and Kiev are getting sourer by the day over the prices for Russian gas deliveries to Ukraine. President Viktor Yanukovich's government believes that Ukraine is forced to purchase the Russian gas at unfair and even exorbitant prices, set by the price formula in the 2009 gas contract between Gazprom and Naftogaz, negotiated with the direct participation of Russian Prime Minister Vladimir Putin and Ukraine's former Prime Minster Yulia Tymoshenko. Are we on the brink of a new gas war between Russia and Ukraine, albeit now with a technically pro-Russian government in Kiev? Who would the European public blame more for another gas cut-off ­ Ukraine, or Russia's Gazprom?

Indeed Ukraine pays well over $300 for 1,000 cubic meters of Russian gas, which is more than Germany, the Baltic States and even some Italian companies that have just renegotiated their contracts with Gazprom pay.

Tymoshenko is currently on trial in Kiev for allegedly having gone beyond her negotiating mandate in the gas deal of 2009, thus causing serious financial damage to the state of Ukraine (apart from having the bad luck of opposing Victor Yanukovich in the last presidential elections of 2010). Many in Kiev believe that the Tymoshenko trial, besides making the leader of the opposition ineligible to stand in the 2012 parliamentary elections, would provide legal grounds for abrogating the gas contract with Gazprom or for taking the case to the International Arbitration Court in Stockholm.

No wonder Moscow is looking at Ukraine's maneuvers with barely concealed disgust. The Russians think that they already gave Ukraine a "political discount" by agreeing to cut the delivery price for Russian gas by $100 per 1,000 cubic meters, after Ukraine agreed to extend Russia's lease on its naval base in Sevastopol for another 25 years.

Moscow is using the gas pricing issue as leverage to secure further geopolitical concessions from president Yanukovich, like getting Ukraine to join the Customs Union with Russia, Kazakhstan and Belarus (while cancelling plans to establish a free trade zone with the EU, where negotiations have entered the final stage). Another of Moscow's demands has been that Ukraine sell Russia's Gazprom the controlling stake in Ukraine's gas pipeline and gas storage system, or allows Naftogaz Ukraini, Ukraine's state oil and gas company, to merge with Gazprom at market valuations.

Russian President Dmitry Medvedev recently declared that Ukraine should follow the Belarusian example and receive an "integration discount" for Russian gas if it joins the Customs Union or cedes control over its gas pipeline network (Belarus has just sold its stake in the Beltransgaz company to Russia's Gazprom). Medvedev also cautioned Ukraine against seeking interim arrangements, like the "3+1" formula proposed by Kiev for Ukraine's relationship with the Customs Union. Medvedev scolded Ukraine's government for "behaving like beggars" to secure the gas discount, instead of offering political incentives and lucrative deals to Russia to consider a price break for Ukraine.

The Ukrainian government responded with plans to reduce purchases of Russian gas next year to 27 billion cubic meters, as opposed to the 52 billion cubic meters stipulated in the 2009 agreement, or the 37 billion cubic meters purchased last year. The 2009 contract requires Kiev to pay for at least 33 billion cubic meters a year on a "take or pay" basis, even if the actual gas deliveries are less than that.

Ukraine hopes to diversify its gas supplies and reduce its dependence on Russian gas by drilling for shale gas (it has just signed an $800 million contract with Shell for shale gas drilling in the Donbass Region), by building a liquefied gas facility on its Black Sea coast to receive LNG shipments from Qatar, and by purchasing gas from Azerbaijan and Turkmenistan (although how they can do that bypassing Gazprom is less clear).

By the end of last week, the Ukrainian government announced that it is liquidating the state oil and gas company Naftogaz Ukraini, the legal party to the infamous 2009 contract with Gazprom, claiming that that would render the contract null and void. Gazprom begged to disagree, claiming that the contract stands. Gazprom's Chairman Alexei Miller said that Ukraine could sell Naftogaz to Gazprom and this would result in a new legal situation that would require new gas contracts with likely lower gas prices for Ukrainian consumers, now Gazprom's direct customers. President Medvedev again warned that existing contracts should be fulfilled, while stopping just short of saying that a cut off in gas deliveries could ensue were the contract to be violated by Kiev.

Are we on the brink of a new gas war between Russia and Ukraine, albeit now with a technically pro-Russian government in Kiev? Has Moscow overplayed its energy hand in extorting painful geopolitical concessions from Ukraine, essentially demanding that it leave aside its European aspirations and return to Russia's fold? Was it a feasible strategy? Can the Yanukovich government abrogate the 2009 contract without being blamed for disrupting gas deliveries to Europe? Who would the European public blame more for another gas cut-off ­ Ukraine, or Russia's Gazprom? What would another gas war do to Gazprom's reputation as a reliable energy supplier to Europe? How would it affect its market share in Europe? What would be the EU's reaction to another gas war between Russia and Ukraine? Would Medvedev benefit politically for standing firm in defense of Russian interests before the unreliable Ukrainian leadership? Is the Medvedev-Yanukovich partnership and Russia's rapprochement with Ukraine over?

Vlad Ivanenko, Ph.D. economics, Ottawa

"You can't blame the mirror for your ugly face," says a Russian proverb. Russian Prime Minister Vladimir Putin can only blame himself for finding his match in Ukrainian President Victor Yanukovich.

Not long ago Western pundits claimed that Yanukovich's victory in the Ukrainian presidential race of 2010 would usher in an era of Russian dominance in this country. Their prediction has come true, albeit in a peculiar sense. The Ukrainian president has not become a Moscow puppet. Instead, it was the Ukrainian political system that has embraced Russian political culture, creating problems for the Kremlin. But in order to understand the reasons for the current Russo-Ukrainian confrontation, it is necessary to review the main rules of the game that the Kremlin has chosen to play in internal politics and in international affairs in the post-Soviet space.

The rules are pretty simple: it is the war of "every man against every man" that lasts as long as more than one center of power exists. Following the turbulent 1990s, the Kremlin has consistently built up a strictly hierarchical structure of governance, and become a single command center in Russia. It controls the underlying layers of public service and promotes the extension of this structure to lower, regional and municipal, ranks. Each participant of the system possesses certain rights and recognizes certain obligations defined by higher ranks. Conflicts among lower ranks of power are resolved through intermediation of a higher level of authority, while at the top the center passes internal reorganization through negotiation among key power brokers.

The only way to preserve a modicum of internal solidarity within such a system is to establish dependencies among players that none of them can challenge. And here lies a structural problem that Moscow does not know how to handle. As a subject of international politics, Ukraine (as well as Belarus) represents the center of supreme power that the Kremlin cannot control directly. Instead, it has to "negotiate" with its supposed peer, hoping to make it an offer it "can't refuse." Necessarily, such bargaining involves the elements of "foul play," which are all considered to be ethically acceptable "normal business practices." Since the other side employs the same tools of trade ­ infraction of contractual rights, double crossing, and coercion ­ confrontations are not only inevitable but, in fact indispensable for the parties to arrive at a "mutually-acceptable solution."

The double play that Yanukovich conducts toward the two largest Ukrainian trade partners (Russia and the EU) is nothing more than a bargaining tool to solicit favors from the weakest party in the game. Unfortunately for him, he is that weakest party. Ukraine runs a persistent trade deficit (about $9 billion in 2010) and needs a similar inflow on the capital account that, for now, it can receive only from Russia and Germany. The trouble for Ukraine is that Russia, despite its formal rhetoric, is not fully committed to its self-proclaimed goal of creating a Eurasian Economic Union, but instead it strengthens economic ties with the EU, particularly with Germany. How can Yanukovich set one side against the other if they have interests far exceeding the gains Ukraine can offer?

In fact, wider circumstances do not instill confidence that the current showdown would be successfully resolved, either. On the one hand, the approaching global storm may capsize the Ukrainian economy altogether. The EU is not immune to troubles as well, as it ponders how to address accumulated economic misbalance within its "old core." Meanwhile, the Kremlin is incapable of going beyond the logic of domination and subordination dealing with Russian neighbors. For example, when I suggested the merger of Gazprom and Naftogaz (see my article in Russia in Global Affairs), I meant that such a deal could "prevent conflicts associated with the distribution of energy gains within the union." Unfortunately, it is not a result that the Kremlin finds preferable.

Alexandre Strokanov, Professor of History, Director of Institute of Russian Language, History and Culture, Lyndon State College, Lyndonville, VT

It seems that the Russian leadership is finally beginning to follow Russian national interests, and is at the same time taking integration processes on the post-Soviet space seriously. It is quite clear that the mission of the Commonwealth of Independent States (CIS) is coming to the end, the divorce is final and the role of the CIS as a mechanism of implementation is coming to its logical end.

However, any objective observer of the events on the territory of the former Soviet Union over the past 20 years will agree that post-Soviet countries have great potential for new forms of integration that will be mutually beneficial for all participants. The majority of Russian, Belarusian and Ukrainian people will support closer ties among these Slavic peoples and their countries. The success of this integration will be beneficial for the European Union and the United States, because it will minimize the chances of radicalization of regimes in Central Asia, as well as allowing all states involved to improve living conditions and their economic standing. The Customs Union and the Collective Security Treaty Organization (CSTO) are two major forms of this new integration. In both, the key role today is played by Russia, Belarus and Kazakhstan. Meanwhile, Ukraine's participation in both of these projects, but primarily in the Customs Union, is critical.

For many years since independence, the Ukrainian leadership has tried to play one and the same game, expressing desire to join the European Union but promising Russia its strategic partnership and enjoying benefits from economic cooperation with its eastern neighbor. In different circumstances this game could be played endlessly, but it was the EU that first demanded that the Ukrainian government make up its mind. In April of this year, European Commission President Jose Manuel Barroso said: "It is impossible to integrate into the Customs Union and have a deepened all-covering free-trade zone with the EU." In other words it was the ultimatum issued by the EU for the Ukrainian government.

Russia simply reminded Ukraine that this is really the time to decide. Will the Ukrainian government wish to enjoy the benefits of economic integration with the Customs Union, or will it continue to wait for a "carrot" from the West? And this is only the beginning, because if Ukraine really achieves a free-trade regime with the EU and Ukrainian goods begin to lose the competition with European products, they will flow to Russia and countries of the Customs Union, which will have to take reasonable measures to protect their own producers and markets. The current economic crisis is making this reality even harsher.

Ideally, the free-trade zone should be established from the Atlantic to the Pacific, as we dreamed of in the middle of the 1980s ­ it would really benefit the EU, Ukraine and the Customs Union states. It seems that instead the EU leadership simply wants to cut off Ukraine's ties with Russia, following the Cold War mentality rather than thinking within the new paradigm of the post-Cold War reality.

The main loser will most likely be Yanukovich personally ­ he won the presidential elections by waiving the partnership flag with Russia and promised to make Russian language an official language in Ukraine. It is obvious today that he failed to implement both his pledges. Now he brings this dispute over the gas price to the public, and makes statements that annul the possibility for future compromise. At the same time, the tough position taken by president Medvedev will certainly add some points to his chances to run again in 2012, since the majority of the Russian people will support his views in this conflict.

In general, Russia's position is much more clear and understandable. There is the contract signed in 2009, and as any contract, it should be followed. I have to pay much more for natural gas to heat my own home today than I paid in 2009, and this is the reality of the market, whether you like it or not. Understandably, if Ukraine wants a different price formula than it agreed to two years ago, it should provide Russia with an offer that will be acceptable to the other side. Just begging to lower the price and comparing its own price with the prices paid by other consumers will not necessary work. However, Russia has to be much more media and politically active, explaining this situation to the European public. Otherwise, this story will be presented by biased Western media in a completely different way, accusing Russia of all sins and presenting it as an unreliable partner for Europe. As stated earlier, the Cold War mentality is still alive. It is time for Russia to learn some lessons from the conflicts with Ukraine in 2006 and in 2009.

Russian partners in the Customs Union should join these efforts also, and explain their positions clearly, because this situation is important for them as well. It is time to ask the Ukrainian leadership where it sees its country in the future. And, if the decision of the Ukrainian government does not go in line with the Customs Union, it has the right to treat Ukraine accordingly.

Vladimir Belaeff, Global Society Institute, San Francisco, CA

"Gas war" is a bit too strident a definition. In fact, to date natural gas deliveries to Ukraine and through Ukraine are continuing uninterrupted, and Ukrainian payments for Russian gas deliveries are also current at this time.

Additionally, Ukraine continues to receive handsome fees for gas transit from Russia to Europe.
There is a challenge to the terms of the 2009 gas contract, raised by Ukraine, which wants to negotiate the price even further below the under-market rates it obtained earlier. At present, the annual price subsidy that Ukraine gets from Russia for the gas it purchases under the 2009 agreement is $4 billion; which adds up to $40 billion over the life of the contract. It is supposed that some (much?) of the gas sold to Ukraine at below market rates by Russia might be re-sold at spot-market prices elsewhere, with the profit also accruing to the buying entity.

It is notable that the contractual challenge by Ukraine has emerged only now, years after the contract was signed. Suddenly Ukraine objects to an agreement made many months ago. Why?
It is generally recognized that Ukraine's economy is in trouble, in particular after several years of the global financial crisis. Maybe it is even a bigger mess than is generally reported, and that country cannot meet its current account deficit? There has been some bailout funding by the IMF, but given the strains of national finances worldwide, the possible defaults of several large economies and the downgrading of American sovereign debt, Ukraine's needs for an additional bailout may not be satisfied, especially if there is little hard evidence that the IMF's conditions for the earlier assistance were successfully met.

Hence, the ploy to lower the price for Russian gas deliveries. It seems, however, that Moscow's largesse and patience have reached a limit. In the past Russia gave Ukraine every substantial economic concession, in the expectation of good-neighborly relations. Ukraine accepted the largesse (and now is demanding even more), but was not very forthcoming with reciprocal actions. The upsetting, though symbolic, events that really stained Ukraine in the eyes of Russia were street fights this summer, when Ukrainian nationalists who claim Ukrainian Nazi collaborators as their heroes attacked Ukrainian citizens, including World War II veterans, commemorating the events of the war. These episodes had strong resonance in Russia; strangely, the Western media barely reported on the actions of Ukrainian Nazi sympathizers.

Reason would suggest to Ukraine that joining an integrated economic space with Russia and Kazakhstan would solve many of its problems. In particular, Ukraine's relative influence in the Customs Union would be very high. Instead, some Ukrainian politicians fantasize about joining the EU ­ which is currently struggling with several weak economies that should not have joined the EU to begin with, and has neither the excess funds nor the political stamina to accept another dysfunctional member.

Relying on coal or extraction of gas from shale would cause environmental protection problems under the rules of the very EU that Ukraine's policymakers hope to join. Building LNG terminals or alternative gas delivery systems requires direct investment, which is not so readily available. All these feeble and far-fetched schemes are in contrast with a simpler, more productive and rational solution: join the Customs Union and benefit from enhanced access to a BRICS economy.

The threats to dismantle Naftogaz are infantile. Contracts have routine provisions, which transfer the responsibilities of a defunct enterprise to its successors or buyers ­ or to its creditors under the contract, among whom Gazprom would be prominent. Ukrainian policymakers are not following a logical course of action. As a consequence, they may harm their personal interests and those of their country.

James Jatras, Deputy Director, American Institute in Ukraine, Kiev

Are we on the verge of a new gas war between Russia and Ukraine? The answer is as simple as it is sad: yes. It is a war that could easily be avoided if the Kiev administration were willing to take realistic stock of Ukraine's options and face the fact that the outcome of the looming crisis will not benefit Ukraine.

With this week's opening of Nord Stream, Russian Prime Minister Vladimir Putin observed: "Like any transit country, [Ukraine] is tempted to benefit from its position. Now this exclusive right disappears. Our relations will become more civilized." Or to put it another way, Kiev ­ whether under the previous anti-Russian "Orange" regime or now with President Yanukovich's putatively pro-Russian administration ­ can no longer pretend that the laws of geography and of supply and demand do not apply to Ukraine's energy transit policy. Simply put, the Europeans, especially the Germans, want to buy, the Russians want to sell, and Ukraine is not the only way to get gas from point A to point B.

No one should expect that European opinion, with Germany in the lead, would blame Russia if a gas war were to break out. Ukraine has a point in complaining about the price of gas, but then Russia has proposed no dearth of possible remedies. The prospect of Ukraine obtaining the lower gas prices it so desperately needs to revitalize its economy would greatly improve if Kiev would negotiate seriously with Moscow. Instead, it relies on legal gimmicks, such as seeking to invalidate the 2009 energy pricing agreement with Russia (while conveniently eliminating Tymoshenko as a rival), and playing clever games with Naftogaz's legal structure. The fact is, Moscow has options and Kiev does not.

It is understandable that Ukraine would resist Moscow's pressure to merge Naftogaz and Gazprom, and to join the Customs Union (although the prospect of Ukraine joining a free trade zone with the European Union offers far fewer tangible benefits). But the terms for securing the nation's energy future ­ and at an acceptable price ­ are not going to get any better. No amount of environmentally hazardous "fracking" for shale gas on the Black Sea shelf is going to change Ukraine's energy picture any time soon, if ever (if Nord Stream reduces Ukraine's transit leverage, South Stream would virtually eliminate it).

So why would Ukraine opt for a war it cannot win? Some speculate that Ukraine does not really have a "national" energy policy at all, but one dictated by the interests of various oligarchs. Others maintain that policy decisions are motivated by personal animus between various combinations of top Russian and Ukrainian politicians. While not entirely discounting the "personal" element in politics, such explanations are too facile by half. To be sure, Yanukovich seems to have allowed himself (probably against his better judgment) to be painted into a corner on the prosecution of Tymoshenko, perhaps on the advice of some smart lawyer who suggested that convicting her would provide Ukraine a deus ex machina escape from the current pricing deal. Once started down that road, it's hard to turn back without embarrassment. Or perhaps Kiev intends ultimately to accept Moscow's terms, and is only pretending to resist (as some Orange critics have suggested) so as to counter accusations that it sold out too readily.

Both Ukraine and Russia have a clear interest in avoiding a new gas war. To do so, Ukraine must negotiate seriously with Moscow along lines that are perfectly obvious to everyone ­ in the context of accession to the Custom Union, at which point, Russia would charge Ukraine domestic Russian rates for gas, as Moscow has already offered; or in the context of a possible merger of Naftogaz and Gazprom, whereby Kiev would seek the best possible gas pricing deal, while its pipeline system still retains some viability as a strategic asset.

The best way forward is through personal negotiation between presidents Medvedev and Yanukovich. It would be, as Medvedev's prime minister has said, the "civilized" way to proceed.

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