In defence of Gazprom

The Russian gas giant's recent price dispute with Ukraine has not given it the best start to the year, but the cat calls of political bullying are not deterring Gazprom's European customers, writes Oliver Holtaway

Russian gas giant Gazprom has its sights set on building stronger commercial relationships in Europe. It is widely anticipated that Europe will depend more on imports for its gas needs in the future - and Gazprom is positioning itself as a reliable supplier. But 2006 has got off to a rocky start.

A series of supply shocks has damaged Gazprom's reputation. Now that the dust has settled, however, it is clear that coverage of the affair has relied too much on a simplistic political reading of the issue. The major incident was a price dispute between Gazprom and Ukrainian gas company Naftogaz, which ended with Gazprom cutting off gas supplies to Ukraine for the first three days of the year. With the EU energy summit on the horizon, Russia's reliability as a secure supplier of natural gas was called into question.

The call for diversity of supply, always an important issue, suddenly took on urgent tones. EU energy commissioner Andris Pieblags renewed his call for a common European energy policy. In response to the crisis, Germany - a major Gazprom customer - even announced that it would reconsider its intention to decommission its nuclear capacity.

Political risk added an extra dimension to the crisis. In the pages of European news-papers, the events were seized on as evidence of Russia's new foreign policy position as the 'energy bully' of Europe. The supply disruption was not commercially motivated, the argument went - Russian president Vladimir Putin was punishing Ukraine for electing a pro-Western government intent on EU and Nato membership.

Three weeks later, freak temperatures in Russia forced Gazprom to keep gas supplies earmarked for European export for domestic use. This reduced supplies to Hungary, Austria, Italy and the Balkan states, although Gazprom maintains that it has not breached any contracts. Italian utility ENI was forced to cut off supplies to some industrial customers, prompting ENI chief executive Paolo Scaroni to warn that Russia's willingness to assert its national interests was creating "a new uncertainty" in energy markets.

Finally, three pipelines exploded in southern Russia on January 22, cutting off supplies to Georgia and sparking a minor diplomatic row between the two nations.

According to Gazprom, Ukraine took 224mmcm from supplies destined for Europe during the dispute in early January. Energy companies in Austria, France, Germany, Hungary, Italy, Poland, Romania, and Slovakia all reported shortfalls in deliveries. But despite this, Gazprom's existing European customers seem unfazed by the dispute. Polish gas monopoly PGNiG claims that it was able to cover the shortfall of Russian gas by using its own storage reserves, although the Pulawy nitrogen processing plant had its deliveries reduced owing to a quirk in the supply infrastructure.

A spokesman for Gaz de France says that gas supply for its customers was not disturbed in any way: "We received only 80% of the Russian gas we were expecting, but there was no disruption to our customers. We have a strong policy of diversification and storage." He says GdF's confidence in its commercial relationship with Gazprom has not been disturbed by the dispute: "We have been partners with Gazprom for 30 years."

Austrian oil and gas group OMV expressed similar support for its trading relationship with Gazprom, noting in a statement that Gazprom had delivered gas to OMV since 1968 without any disruption of service. "Gazprom/Gazexport has been a completely reliable supply partner, in full compliance with all contract provisions," says Werner Auli, managing director of OMV Gas.

The disruptions caused in late January by extreme weather in Russia are of even less concern, say market participants. A spokesman at an Italian utility says that such disruptions are nothing out of the ordinary. "Every year, there is a slight mismatch between the amount of gas we request and the amount that is delivered," he says. "We have the storage capacity to take care of this - there is no cause for alarm."

The spokesman suggested that the recent dip in supply owing to the weather had attracted attention only because it occurred so soon after the dispute with Naftogaz, and that confidence in his utility's relationship with Gazprom had not been dented.

But further disputes are likely as Russia ratchets up the price it offers Ukraine to European levels. The present agreement between Gazprom and Naftogaz will see the gas price renegotiated in five months. "Such disputes must be of some concern for Europe," says Jonathan Stern, director of gas research at the Oxford Institute of Energy Studies. "The latest agreement is a sticking plaster - it doesn't provide for the future beyond June."

However, the episode has shown that Gazprom can compensate for as much gas as Ukraine siphons. "This is not the first time Gazprom has had problems with its pipeline suppliers," says Jeffrey Woodruff, credit analyst at Fitch Ratings in Moscow. "But the fact that it was resolved quickly is good for both companies."

There is no doubt that there was a political element to the Gazprom/Naftogaz dispute, but this does not mean that European energy companies took on a significant degree of political risk when accepting Gazprom as a trading counterparty. "Politics is just one factor among many," says Muhammad Ali Zainy, senior energy economist at the Center for Global Energy Studies. "Gazprom would genuinely like to sell at international prices. Ukraine is notorious for not paying gas bills and taking gas without authorisation."

Politics and the gas trade are closely intertwined in Eurasia: supply and transit agreements are signed by presidents and prime ministers. And it is fair to assume that the recent crisis would not have occurred if the Ukrainian government had not been so keen to move away from Russia's sphere of influence by seeking to join the EU and Nato.

But to paint Russia's price hike as a punishment for pro-Western leanings is a distortion. Ukraine was, after all, receiving heavily subsidised gas in return for its strategic realignment with Russia: a nominal price of $50/mcm compared to over $200/mcm for European nations. "I don't think Russia intended or expected to bring down the Ukrainian government, or expected it to adopt a pro-Russian stance," says Stern.

In fact, Russian president Vladimir Putin even offered his Ukrainian counterpart Victor Yushchenko a three-month price freeze - meaning that Ukraine would not have started to pay higher prices until after the Ukrainian parliamentary elections in March.

If anything, Gazprom's recent behaviour towards Ukraine and other transit countries suggests that it is actively seeking to take the politics out of its trading relationships, and move towards more rational, market-based business models. "This latest dispute is different from previous disputes, insofar as it has created a paradigm shift in CIS trade," says Stern. "The future is CIS countries paying European prices - the only discussion is how quickly this will happen."

Gazprom has long subsidised both Russia's domestic consumption and that of its neighbours, relying on revenues from European imports to keep afloat. During this decade, however, it has taken steps to reform its business model at home and abroad, pushing towards market conditions. Gone are the gas-for-transit barter deals with Ukraine - instead, Gazprom is seeking more transparent cash-based arrangements.

It is also trying to cancel its barter arrangements with Moldova and Bulgaria, and replace them with all-cash deals. The exception is Belarus, which will continue to enjoy a price of $46.7/mcm this year. Gazprom owns the major export pipeline running through Belarus, however, and the two countries are currently in the process of unification.

The World Trade Organisation has backed the transition, and experts believe that Gazprom's adoption of market principles is good news for European customers. "The Russians are moving closer to a market-like approach to their gas trade relationship with Ukraine," says Zainy. "Once Ukraine starts paying higher prices, and stops taking gas from pipelines illegally, this would produce more stability in Europe."

If anything, says Stern, EU countries should worry that Gazprom may find selling gas to CIS countries at market prices will become more profitable than selling gas further afield, and will limit expansion of supply purely for market reasons. It would be difficult for Europe to reduce significantly its dependence on Russian gas imports. "Long-term changes away from gas would require lead times of five to 15 years, and would cost tens of billions of euros," says Stern.

And if Europe decides that Russian gas supply is too laden with delivery and political risk to be considered reliable, it will have to turn to other sources. But given that the country with the second largest gas reserves is Iran, this may not be such a palatable option.

A significant communication regarding a common European energy policy is expected from the EU summit in March. "The move for a common EU energy policy was not prompted by the recent crisis," a spokesman says, "but the crisis is evidence that we will be more dependent on imports."

Diversification is important. But rather than switching from gas, the appropriate European response may well be to focus on shoring up its relationship with Russia. The EU has had a formal dialogue with Russia over energy policy since 2000, and similar dialogues with other suppliers and transit countries. "These dialogues help us forecast problems before they occur, rather than extinguishing fires," says the EU spokesman.

Russia will chair the G8 for the rest of 2006, and has indicated that security of energy supply will be its main priority. This gives an opportunity for the EU to put pressure on Russia to ratify the Energy Charter Treaty (ECT), a multilateral framework of rules governing international energy co-operation that came into full legal force in 1998.

Russia is an ECT signatory and has implemented some aspects, but is yet to ratify. A move towards a process based on international law could do much to enhance Gazprom's commercial prospects in Europe.

GAZPROM'S DISPUTE

By late 2004, it seemed that the required elements for regularising the Russian-Ukrainian-Turkmen gas trade were in place for the next five to 10 years.

That summer, the Russian government, Gazprom and the Ukrainian government agreed the arrangements for delivery of Central Asian (mostly Turkmen) gas to Ukraine, and settlement of past debts were agreed. A Gazprom loan to the Ukrainian gas company Naftogaz allowed it to pay past gas debts, and to provide an agreed foundation for at least five years of deliveries of Turkmen gas and transit of Russian gas to Europe.

This agreement foresaw deliveries of Russian gas to Ukraine of 21-25bcm/year for the period 2005-09, as a barter payment for transit of gas to Gazprom's European customers. For this barter agreement, the notional price of Russian gas sold to Ukraine was $50/mcm and the notional tariff for transit of Russian gas across Ukraine was $1.09375/mcm/100km.

In December 2004, the election of President Yushchenko in Ukraine was followed in 2005 by dramatic developments in Ukrainian-Russian gas supplies. In early 2005, the Yushchenko administration suggested that gas transit tariffs should be moved to 'European' levels and paid in dollars. Gazprom received this proposal with enthusiasm, as it raised the possibility that the latter would consider paying European market prices for Russian gas.

By late 2005, the $50-$80/mcm that CIS countries were paying for Russian gas contrasted sharply with European border prices of three to four times that level (although because of the barter arrangements, the prices are not strictly comparable). But during the final three months of 2005, negotiations between Gazprom and Naftogaz failed to make progress.

Following nine months of negotiations, Gazprom demanded that Ukraine must pay European prices of between $160-$230/mcm from the beginning of 2006, unless it was prepared to consider allowing Gazprom an equity stake in its transit pipeline network. Ukraine responded that it was prepared to pay market prices for gas, but that these must be phased in over a period of time and that the maximum it was prepared to pay in 2006 was $80/mcm.

Unable to reach agreement, Gazprom cut off gas supplies to Ukraine at 10.00am Moscow time on January 1, 2006.

The impact of Gazprom action on European countries was immediate - the fall in volumes caused an outcry all over Europe. On 2 January, Gazprom pumped an additional 95mcm per day into the network to compensate for Ukrainian withdrawals. By January 4 Russian gas deliveries to Europe were back to normal levels, although these were affected by the very cold weather that arrived two weeks later.

On January 4, 2006, Gazprom and Naftogaz announced an end to the dispute with the signing of a five-year contract with the following terms:

- Gazprom will pay Naftogaz a tariff of $1.60/mcm/100km for transit of gas to Europe

- RosUkrEnergo will be the company that delivers gas to Ukraine. Gazprom will not deliver Russian gas to Ukraine, and Naftogaz will not export any gas that it has received from Russia

- RosUkrEnergo's annual gas balance will consist of:

- 56bcm of Central Asian gas purchased from Gazprom/Gazexport

- Up to 17bcm of Russian gas purchased from Gazprom with a base price of $230/mcm

- A joint venture between RosUkrEnergo and Naftogaz will sell 34bcm of gas at $95/mcm during the first half of 2006 for the Ukrainian market, without the right to re-export

- In 2007, 58bcm of gas will be sold by the joint venture to the Ukrainian market, without the right to re-export

- 15bcm of gas may be exported in a joint programme with Gazexport.