Russia Launches Gas Attack on Ukraine

In a compromise deal struck on January 4, the price that Ukraine pays for Russian gas will rise from $50 to $230 per one thousand cubic meters. This is less of a blow to Ukraine than it seems.

The country will switch to Turkmenistan as its principal gas supplier and also purchase gas from Kazakhstan and Uzbekistan for about $95 per thousand cubic meters for five years—about a third of the price that Western Europe pays for gas. Ukraine will still buy Russian gas, but much less than in the past.

By more than quadrupling the price of Russian gas, Moscow has attempted to deal a decisive blow to President Victor Yushchenko, whom Russian leaders perceive as pro-American and anti-Russian, and to influence the outcome of Ukraine’s March parliamentary elections. Ukraine will pay a heavy price: between 5 and 10 percent of its GDP will go to cover the new energy costs, and its economic growth in 2006 and beyond could stagnate.

The attack may also have been a misstep: Russia’s willingness to excessively politicize its energy supplies delivered a blow to the country’s image as a reliable energy producer. Tens of billions of dollars in future foreign investments and contracts may be now at risk—much more than the value of Ukraine’s gas imports.

As a result of Moscow’s ill-considered gambit, Europeans are likely to turn to Turkmenistan, Azerbaijan, Algeria, Nigeria, Qatar, and Iran to diversify their gas supplies. They will be wary of over-dependence on Gazprom. Ironically, Russia, which just assumed chairmanship of the G-8, and has proclaimed energy and energy security as a central focus of its term.

Blame Both Ways

Ukraine is also to blame: it ignored the problem of subsidized gas and did not prepare its economy for inevitable price hikes by increasing energy efficiency and improving management. The price of Russian gas supplied to Ukraine during 2004-2005 was less than one-third of what Europeans were paying, and it was clear that the gravy train would end after the Orange Revolution, which Russia decried.

Ukrainian leaders should have taken steps, such as creating a larger gas reserve, setting money aside to ease the transition to higher prices, and signing contracts with other suppliers. But they did not. Instead, the Yushchenko administration found itself rudderless in economic policymaking and failed to repair relations with Russia so that Moscow would give Kyiv a break, as it had in the past. Russia is now accusing Ukraine of siphoning off gas set aside for sale in Europe, something Ukraine claims it has the right to do. Ukrainian companies and officials were also allegedly reselling subsidized gas to Europe at market prices.

The new arrangement makes things even more complicated, as it hands over all Ukrainian gas imports to a Swiss-based company, RosUkrEnergo, half of which belongs to Gazprom and the other half of which is managed by the Austrian Raifeissen bank on behalf of undisclosed shareholders. There are published allegations that RosUkrEnergy is non-transparent and even may have ties to organized crime.

Recommendations for the Administration

The U.S. is interested in political stability, transparency, and economic growth in Ukraine and Central Europe. Washington has invested heavily in the Yushchenko administration and would not want it to fail prior to the crucial March parliamentary election. Voters are likely to blame an already-unpopular Mr. Yushchenko for failing to keep gas prices low.

The U.S. has also high stakes in successfully integrating Russia as a major energy supplier into the world economy—if at all possible in view of the current energy power grab by the state. Turning oil and gas into the tools of statecraft—just as the Organization of Petroleum Exporting Countries (OPEC) did in the 1970s—runs against Western interests. Furthermore, U.S. energy companies hope to expand their energy partnerships with Russia, including the development of the giant Shtokman gas field in the Barents Sea and investment in new fields such as the three Sakhalin Island projects in the Pacific.

In light of these considerations, the Bush Administration should:

  • Support a gradual transition to market energy prices and better management for Ukrainian industry. This can only be accomplished by making Ukrainian industry more energy-efficient and thus, more competitive in a higher energy price environment. Such transition will save Ukrainian economy billions of dollars. U.S. Departments of Commerce and Energy and the private sector should work with the Government of Ukraine to develop and implement a three year transition program to achieve western energy consumption standards in the industry.
  • Work with the Ukrainian government on a medium- and long-term energy security plan to diversify energy sources for Ukraine in both oil and gas. This should include a plan to purchase oil from Kazakhstan and Azerbaijan and gas from Turkmenistan and Azerbaijan, including building a trans-Caspian oil and gas pipelines.
  • Clarify to Russia that its heavy-handed energy geopolitics will backfire. Moscow risks undermining its claim to become a major energy player in Europe and the world, hurting perspectives for joint ventures, investment, and energy trade. The U.S. Department of Energy should explain this to its Russian counterparts while promising serious U.S. energy investment if Russia returns to privatization of its oil and gas companies and pipeline consortia.
  • Insist that Russia’s World Trade Organization accession negotiations include full separation of Gazprom’s production and transportation (pipeline) assets and that both Russian and Western private investors’ representatives on the Gazprom board of directors be fully involved in strategic decision making. Such participation would mitigate abuse of Gazprom as a tool of foreign policy by politicians and the federal bureaucracy.

Shared Interests

It is in the best interest of Russia, Europe, and the U.S. to move to a gradual schedule of price increases, energy efficiency, good management and transparency in Ukrainian economy. It is equally in Russian and the U.S. interest for all parties involved to focus on energy economics that benefits both countries, while avoiding provocation and escalation.