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Kyiv and Moscow dig in over gas

Kyiv and Moscow dug into their trenches at this weekend's CIS summit, despite claiming that there is no gas war on the horizon. Whilst things remained civil at least, the hardline statements leave little room for manoevuer, making it hard to see a route that will allow both to retreat with honour.

After Kyiv said on Friday that it is to break up Naftogaz, and that will mean new companies which will need to negotiate new contracts, Gazprom CEO Alexei Miller responded by mimicking Ukriane's Prime Minister Mykola Azarov.

Reports later the same day suggested that President Viktor Ynaukovych hoped to meet with counterpart Dmitry Medvedev on the sidelines of the summit in Dushanbe in Tajikistan. However, the Kremlin dismissed the idea, leaving the debate to continue to be held via the media.

Moscow is offering no leeway, insisting that the current gas contract - which makes Ukraine Gazprom's most profitable export market - must be respected, unless Kyiv agrees to either join the customs union or merge Naftogaz with Gazprom, thus handing over control of its gas transportation system (GTS).

A spokeswoman for President Dmitry Medvedev said the current contract must be realized and cannot be revised in a "sole direction," reports RIA Novosti. "Russia is ready to defend its stance on the agreement in any court authority and will act strictly in accordance with this document."

Yanukovych however stated Ukraine's determination, and confirmed that the country will take the issue to international arbitration if needs be. "We have faced a situation in which Ukraine is losing big money ... If Russia does not agree with it, certainly, we will have to go to the International Court," he told reporters, before adding: "I hope we will have enough wisdom to find a common solution, without the court. I consider the court to be the last resort."

However, the president also spoke of Kyiv's rising anger, which last week also saw Medvedev call Ukraine's position "sad" and said it is trying to "sponge" from Russia.

"We will not allow [them] to talk to us in such way," said Yanukovych. "They pushed us in the corner, at first, and then started to dictate terms. Today it humiliates not only me, but it humiliates the state, and I cannot allow it,"

As it moves into final talks on taking possession of the gas transit system in Belarus in return for a discount on exports, Moscow is hoping the economic and political pressure in Ukraine will force a similar conclusion, and, with gas prices likely to close on $500 per 1,000 cubic metres in the fourth quarter of the year, is happy to wait it out.

Kyiv needs to break this vicious circle, which pits its macro-economic situation and the IMF against parliamentary elections next year. However, the GTS is seen as a guarantor of sovereignty, whilst joining the customs union would disrupt Kyiv's progress towards EU integration. Ukraine has never showed any hint that it would agree to either, and Yanukovych was just as definite at the weekend. "It will not happen," he told reporters unequivocally.

Something has to give, and the intransigence of their positions clearly suggests that the pair risk another gas war, such as cut off European customers of Russian gas in 2006 and 2009.

However, Azarov said in a TV interview at the weekend that Ukraine is going to play it by the book. "No one will ever live to see any war, including a gas [war] with our strategic partner - Russia," he said according to RIA Novosti. Instead, he claimed, Ukraine will continue to fulfill the valid contract until there is an agreement on a new price.

With its bid to cement closer ties with the EU and an eventual membership, Kyiv's position is that it will play by Western rules this time. One difference this time around is that it can afford to do that for the meantime, given that it currently has record high international reserves. However, it suggests that the legal move to annul the contract could come sooner rather than later. The trial of former Prime Minister Yulia Tymoshenko or the unbundling of Naftogaz - which, not by coincidence, will satisfy the European bloc's third energy package which Moscow is fighting so hard against via Gazprom - are likely to be the triggers then.

Given the advantageous conditions under the current contract however, it's no surprise that Gazprom is loathe to give up on the current contract, points out Dmitry Loukashov of VTB Capital. "Ukraine is supposed to buy 52bcm of gas annually. This amount could be decreased 20% (to 41.6bcm) by a two-party agreement, and Ukraine ultimately has to pay for 80% under current take-or-pay contracts, or 33bcm. Current prices for Ukraine are very close to those for Europe (including USD 100 discount) approximately USD 350mcm for Ukraine against USD 340 for Europe. Ukraine might consider this approach as unfair due to the difference in transportation."

"The current scheme is very profitable for Gazprom as the company does not pay custom duties for deliveries to Ukraine (while getting European prices). So if Ukraine achieved its goal of a contract revision, it might negatively affect Gazproms financial results. Revision of the current agreement may also affect the company in the longer term as Ukraine is the largest Russian gas consumer among CIS countries."

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