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Russian gas cuts - why there is no need to worry

As expected, following its threats in recent weeks (made in order to get an increase in the price Ukraine "pays" for its gas) Russia has somewhat reduced its deliveries of gas to Ukraine, and as expected, Ukraine has retaliated by reducing transit gas to the West, thus reducing supplies to Hungary, Austria, Slovakia and other countries further downstream.

Europe is worried, and newspapers are making big headlines about a new kind of "cold war", or, more ominously, the "first war of the 21 century" (Le Monde, in French).

I have written about this extensively last week (see this diary Ukraine vs Russia: Tales of pipelines and dependence and follow the links from there) and will say it again: THERE IS NOTHING TO WORRY ABOUT. Let me tell you my theory on what's going on.


Again, if you are genuinely interested in this topic and have not read it yet, go read the above-linked diary first. It will explain why I think I can write authoritatively on this topic, and it will give you a lot of background on the dispute. Plus, there are great maps!

Here they are again:

250 kb version: http://www.eurotrib.com/...
500 kb: http://www.eurotrib.com/...
Good EIA map of the region: http://www.eurotrib.com/...

Additional links (today's discussions over at Eurotrib):


Now, that said, here are a few more tidbits and some theorising.

Ukraine gets 25 bcm/y (billion cubic meter per year, that's 2.5 bcf/d in US units) from Gazprom, and about 35 bcm/y from Turkmenistan. The price which is being disputed publicly is that on the 25 bcm whereas I think that the dispute is really about who gets paid for the 35 bcm. What is never mentioned anywhere is that these 35 bcm go from Turkmenistan to Ukraine using Gazprom's pipelines, and are thus totally under the control of Gazprom's management. These 35 bcm are paid by Ukrainian consumers - at market rates - to shady companies that act as intermediaries between Ukraine and Turkmenistan but are really controlled by top Gazprom people. These companies collect a lot of money, because, as I said, the Ukrainian consumers are already paying for their gas at "real" prices (not European prices, but higher than in Russia). They are paying because the seller can enforce discipline by threatening to cut off deliveries without fear of retorsion on the transit routes to Europe, as the seller is not Gazprom. That money is split between the Turkmens (who get a smallish slice), the Ukrainians who run the distribution and enforce payments locally, and the Russians.

I suspect that since last year's election in Ukraine, tht business has been disturbed by the arrival on the scene of new players - the new team in power in Kiev. Either some of them wanted to get a slice of the pie, or President Yushenko tried to put a stop to that dirty business. I think (but I have no proof either way, this is just an educated guess) that Iushenko's first prime minister, Yulia Timoshenko was in the first group (remember, she made her fortune in that same business a few years ago, before being kicked out by a new clique, so she may well have wanted to come back in the game), and that Yushenko is in the second category. That may be naive, but I don't see any other reason for the Russians to be making that spat so public and so dangerous to themselves by bringing in Western oversight - they want to teach Yushenko a public lesson so that he will stop meddling.

The reason why the dispute is about the 25 bcm delivered by Gazprom is because these are delivered by Gazprom to the Ukrainian state company at no cost (i.e. the price is equal to the price of transport of Russian exports to Europe and there is no monetary payment) so this is the volume that the Ukrainian public authorities get to "play" with - and to distribute to the population (or friends) at subsidised prices, the rest being delivered at "real" prices. So threatening these 25 bcm is a direct attack on the Ukrainian state. But it can work ONLY if the West gets involved, because Gazprom has no leverage there (they need the export pipes even more than Ukraine needs that gas, and they ABSOLUTELY KNOW that Ukraine will divert volumes from the export quantities if Gazprom cuts off deliveries - that's what's always happened, and it duly did again this time), unless the West is somehow coaxed to blame Ukraine for the mess and puts pressure on Kiev. But this works better if the threat is not enacted, thus the long buildup in pressure over the past 3 weeks, with many public declarations to get Europeans to notice. They did notice, but wisely remained noncommittal. Now, the stakes are much higher, because gas is actually being cut, and the West will have to react.

If Europeans have any backbone, they won't pressure the Ukrainians in any way, but will tell the Russians: we have contracts with you, you deal with it. If you can't, we'll switch the contract point of sale to the Russian border (as opposed to the Czech border today) and deal with Ukrainian transit ourselves. I must say I am pleased with the US reaction which has squarely put the blame on the Russians for these games.

Gazprom is playing a very dangerous game, because they need their exports for more than their usual income (which is by no means small beer, as it represents around 25% of all hard currency income of Russia and about 10% of federal budget income) but also to borrow the funds they absolutely need to invest in their infrastructure. If this crisis lasts, Russia's reliability as a gas supplier will be compromised, and its ability to borrow money from Western banks on future receivables (i.e. the expectation of steady revenues over many years under stable contracts) will be damaged - and they vitally need that ability, and Gazprom knows it. In good times, like today, sure, they can borrow easily, but in troubled times like 1998-2001, it was the ONLY way they borrowed ANYTHING. The gas business is a very long term business, they cannot afford to lose trust for a temporary commercial advantage. And if Europe gets jittery, they may decide to build a few more LNG terminals to import African gas (from Algeria, Egypt, Nigeria or Angola) rather than pay to build another pipeline form Russia like the currently mooted Nordpipe under the Baltic Sea to Germany.

In the end, I expect the usual fudge for public consumption: a compromise whereby gas "prices" will be increased, but a bit less than the Russians asked for; gas transit "fees" through Ukraine will also be increased, but not enough to compensate for the increased price in gas for the Ukrainians, and loans will be provided for the difference - and will never be paid. Thus, as for the past 15 years, Gazprom will deliver 25 bcm of gas to Ukraine at no cash cost but against the ability to use Ukrianian pipelines for their export deals. It's a more than fair deal
for Russia, and they know it well.

An additional point to note is that Yushenko's stand is not necessarily incompatible with wanting market prices. Currently, some customers (those controlled by the Ukrainain/Russian/Turkmenistan clique) pay the full price, and the money leaves the country directly, whereas others pay very little officially - which of course means that they pay the bureaucrats which have the power to allocate them gas. So, the gas business in Ukraine is both very unfair AND totally corrupt. By cleaning up both sides, it is quite likely that most Ukrainians would not pay more for gas than today in practise, the Ukrianian state would see more of the money, but the local oligarchs and their Moscow friends would lose out a lot - and Gazprom would probably win in the process, as they make zero from their deliveries to Ukriane today. This spat in not driven by Gazprom, it is driven by well-placed individuals in Gazprom and the Russian government.

(And as a note to analysts that follow Gazprom, and people that invest in Gazprom shares - I have never understood how that 25 bcm vs transit fees trade was accounted for in Gazprom's annual accounts. For some purposes, it is counted at Western prices (to inflate income, costs and average price), for other purposes it is accounted for a prodution prices (usually for tax purposes - don't ever think that the various branches of the Russian State and Gazprom have an harmonious relationship, the infighting is really ugly). In one case, the gas is worth about $5 billion, in the other, less than $100 million... You can manipulate a lot of ratios and numbers with that kind of flexibility to play with...)

As a general note, what is happening behind the scenes has little to do with what's in the headlines. The West should stay calm, remind the Russians of their contractual obligations, and remind them that they have to be serious if they want to be taken seriously.

Editorial Notes: This article was also posted on Daily Kos, where author Jerome a Paris writes regularly on energy and politics. (See Jerome's current postings.) Many comments on the article follow the article in both Daily Kos and the European Tribune. Last November Energy Bulletin published an analysis by Serhiy Blavatskyy: Natural gas dilemma in Ukraine. The Le Monde article quoted by Jerome at the start of his article is indeed ominous:
La première guerre du XXIe siècle est déclarée. Un pays vient de couper l'approvisionnement en énergie d'un autre parce qu'il ne se conforme pas à ses exigences. La Russie, premier producteur mondial de gaz, vient d'appuyer sur le bouton de l'arme énergétique. En plein hiver, Vladimir Poutine ferme le robinet qui permettait à 50 millions d'Ukrainiens de se chauffer et de faire tourner leur économie. Avec le développement mondial accéléré et l'essor des géants consommateurs comme la Chine et l'Inde, les matières premières sont devenues des armes de dissuasion sinon de destruction économique massive.
. A first translation (better translations are invited!):
The first war of the 21th century has been declared. One country cuts the supply of energy to another, because it does not respond to its demands. Russia, the premier world producer of natural gas has just pressed the button of the energy weapon. In the midst of winter, Putin has closed the faucet which had permitted 50 million Ukrainians to keep themselves warm and run their economy. With accelerating world development and the emergence of giant consumers like China and India, primary materials have become weapons of dissuasion, if not weapons of massive economic destruction.

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