Eastern Europe says “nyet” to Russian gas

KYIV, Ukraine — Moscow flexed its geopolitical muscles last week with the welding together of two pipes in southern Russia: the formal launch of construction on a new natural gas pipeline to southern Europe.

The $20 billion project, called South Stream, is the latest bid in the Kremlin’s drive to “divide and fuel” the European energy market by making lucrative deals with individual countries. They are undermining the European Union’s efforts to lessen dependence on Moscow by building its own pipeline that would avoid Russia.

Europe currently depends on Russia for a quarter of its gas, a fact laid starkly bare in 2006 and 2009, when the state gas giant Gazprom shut off supplies to Ukraine after price disputes, cutting deliveries to other European countries during bitterly cold winters. South Stream is partly aimed at eliminating a reoccurrence by circumventing Ukraine.

However, it’s not clear how well that strategy will work as countries in Central and Eastern Europe that rely heavily on Russian gas begin to diversify their supplies.

New alternative sources are pushing down global prices and raising serious questions about Gazprom and its long-term strategy. The energy landscape is changing even here in Ukraine, the very symbol of energy dependence on Russia.

Among the gas industry’s new developments, a revolution in the exploitation of shale gas in the United States is set to turn the former importer into a major exporter, with the unintended consequence of freeing up supplies from the Middle East just as European countries are looking to diversify.

At the same time, the development of liquefied natural gas, or LNG, that can be shipped around the world, is fuelling a boom on the so-called spot market in Europe.

“Gas prices in the United States are about half of the spot market prices in Europe and the spot market prices are about half of Gazprom’s European prices,” says Anders Aslund of the Washington-based Peterson Institute. “This can’t go on. And in particular, Gazprom has to lower its prices.”

Seeing an opportunity, Eastern European countries are seeking to revise long-term contracts with Gazprom, spurred on by a European Commission probe into gas price-fixing by the Russian monopoly.

Launched in September, the investigation is examining alleged attempts to monopolize markets in Bulgaria, Poland and other countries.

Lithuania has also sued Gazprom for $2.5 billion in damages caused by the gas giant's alleged price distortions in 2004-2012.

Poland, which imports two-thirds of its gas from Russia, renegotiated its deal with Moscow Gazprom for an estimated 15 percent discount in November, a year after filing a case against the company at the Stockholm arbitration court.

Poland’s position has been strengthened by the discovery of shale gas deposits estimated at 350-760 billion cubic meters, far above annual consumption of 14 billion cubic meters. The government is currently issuing exploration licenses.

Those developments are being closely watched in Ukraine, Gazprom’s single biggest client. The country has the most to fear from Russia’s circumventing South Stream pipeline because it will lose transit fees. Gazprom has already diverted some supplies to the North Stream pipeline, a new route that pumps Russian gas directly to Germany.

Ukraine’s economy has been crippled by high energy costs, made far worse by its low energy efficiency — just 60 percent of the European average, according to the International Monetary Fund.

Unable to strike a new deal with Gazprom, Ukraine is promising to cut its foreign gas consumption by more than half by 2013, despite warnings from Moscow that it will bill Kyiv $2-3 billion in line with a clause in their current agreement obligating Kyiv to “take or pay" for the agreed amount.

Russia has said that any discounts are conditional on Ukraine's selling stakes in pipelines and other key energy infrastructure, or the country’s accession to a customs union between Russia, Belarus and Kazakhstan.

Nevertheless, Ukrainian President Viktor Yanukovych recently announced that Kyiv will reduce state consumption from around 40 billion cubic meters in 2011 to 27 billion this year and 18 billion in 2013.

"Our only lever to affect the situation is to continue reducing the volumes of Russian gas purchases," he said.

To make up the rest, Ukraine is looking to tap unconventional sources and import Russian gas through Germany, which could cost $40-70 less per 1,000 cubic meters than supplies directly from Russia, according to Ukraine's energy minister.

The country is also working to expand alternatives. The state oil and gas company Naftogaz is signing deals on exploring its potential 0.8-1.5 trillion cubic meters of shale gas deposits. Last summer, Kyiv signed production-sharing agreements with ExxonMobil and Royal Dutch Shell to boost offshore production. It also wants to build an LNG terminal.

On Monday, Naftogaz announced a deal to borrow $3.7 billion from the China Bank Development Corporation to transform utilities from gas to coal power.

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Russia still has more than a few cards up its sleeve. South Stream will probably sink any hopes for the EU-sponsored Nabucco pipeline project, which promised to access bountiful Central Asian fields.

But that doesn’t mean building South Stream will pay off. Analysts are also questioning the viability of other Gazprom projects also seen as politically motivated — such as plans to build a pipeline through Siberia to China, which currently prefers cheaper gas from Turkmenistan.

Mismanagement and inability to innovate have helped Gazprom’s income to drop while keeping costs high. That has contributed to a drop in Gazprom’s revenues of 50 percent in the second quarter of the year, while the company’s market value is down threefold from its peak in 2008, when it was set to become the world’s biggest corporation.

Aslund believes corruption is turning Gazprom from the world’s most profitable company into a Russian Enron just as new technologies are beginning to hit its revenue stream. That will only increase the leverage of European countries as they diversify their supplies.