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Russia economy: The gas weapon?
[December 23, 2005]

Russia economy: The gas weapon?


(EIU Viewswire)COUNTRY BRIEFING

FROM THE ECONOMIST INTELLIGENCE UNIT

Russias move to hike gas prices for many former Soviet states, in particular Ukraine, is widely regarded as an exercise in muscle-flexing designed to punish its rivals in the CIS and reward its friends. The reality is less straightforward, for pro-Russian states are also being affected while the cheap-gas deal with Belarus is actually highly beneficial for Gazprom. Primarily, the government-backed policy of price increases is being driven by a mix of commercial considerations, although specific political objectives are also in play.



In recent months, as the north European winter has approached and spot prices for gas were driven ever higher by record-high oil prices, Russias state-controlled gas monopoly, Gazprom, has sought push through large rises in gas prices for former Soviet states from the start of 2006, thereby ending the practice of subsidising neighbouring economies. It has sought, and obtained, a near-doubling of the price paid by Georgia, from US$60 per 1,000 cubic metres to US$110, and has raised gas prices paid by Estonia, Latvia and Lithuania from the current level of US$85-90 per 1,000 cu metres to US$120-125. Moldova, which has sought to pursue a pro-Western foreign policy course within the last 18 months, is facing a demand for prices to double from the current level of US$80 per 1,000 cu metres. And most controversially, Russia is now demanding that Ukraine pay up to US$230 per 1,000 cu metres for gas deliveries in 2006, representing a massive hike on the current price of US$50 per 1,000 cu metres.

Political pricing?


The fact that Gazprom has decided to keep prices unchanged for Belarus, at US$46.68 per 1,000 cu metres, has stoked speculation that Russia is seeking to punish those former Soviet states that have not been loyal to Moscow. Belarus is Russias closest ally in the CIS. By contrast, the Baltic states have sought to distance themselves from Russia as much as possible and are now members of NATO and the EU, while Moldova has backed away from its pro-Russian course and Ukraine and Georgia have adopted firm pro-Western policies since their colour revolutions. Viewed from this perspective, the case for outright political pricing seems undeniable.

Yet this is not the case. If Russia were rewarding its friends and punishing its rivals, then pro-Russian Armenia would not be facing a demand for gas tariffs to double from their current level of US$54 per 1,000 cu metres to US$110. Moreover, pro-Western Azerbaijan would be asked to pay significantly more for its gas than Armeniain fact, the tariff that Gazprom is now demanding from Azerbaijan is lower than that for Armenia.

Even the case of Belarus, which would appear to be a clear example of favouritism, is less than clear-cut. Belarus and Ukraine differ from the other former Soviet states in that they are transit states for the highly lucrative trade that Gazprom has with Western Europe. The prices that they have enjoyed up to now have been concessionarybut so too have been the transit fees that they have levied on Gazprom.

A comparison of the profitability of the Ukrainian and Belarusian gas trade (sales and transit) for Gazprom is instructive. In the case of Ukraine, which pays US$50 per 1,000 cu metres and levies a transit tariff of US$1.09 per 1,000 cu metres per 100 kilometres, Gazprom breaks evenpayments and receipts each equal US$1.2bn. With regard to Belarus, Gazprom is paid US$980m for the 21bn cu metres of gas it supplies. On transit, it pays a tariff of US$0.46 per 1,000 cu metres per 100 km via the Yamal-Europe pipeline (which it owns) and US$0.75 per 1,000 cu metres per 100 km for using the Beltransgaz network. On transit volumes of around 41bn cu metres per year, two-thirds of which goes via Yamal-Europe, this amounts to a total fee of US$144m. As a result, Gazprom makes a profit of over US$830m on its gas trade with Belarus.

On this basis, there is clearly less of a financial rationale for Gazprom to revise the terms of its gas trade with Belarus than with Ukraine. Moreover, the relations between Gazprom and Belarus are qualitatively different from Gazprom-Ukrainian ties, as the Belarusian government has allowed Gazprom to acquire the Yamal-Europe pipeline while the Ukrainian government has refused to cede ownership of the pipelines crossing its own territory. As a result there is a solid, non-political basis for Gazprom to treat Belarus differentlynot least because it creates an incentive for Ukraine to accede to Gazprom proposals for joint ownership of the gas pipelines on Ukrainian territory.

Down to business

If an outright political motive can be discountedalthough Belarus does appear to be getting special treatmentwhat is behind Gazproms move, with outright government support, to hike gas prices?

For the company itself, this is a further step on the long road to improved financial performance. Gazprom is still reliant on three gigantic fields for over three-quarters of its output, but at least one of these fields is nearing the point when production will decline. The company controls all the licences for the most promising deposits, but the development costs for these zonesmost of them in the Arctic circle and some offshore tooare enormous. Therefore it needs to increase revenue, to boost the funds for new investment and to service additional loans. The fact that Gazprom will soon be open to a much higher level of foreign portfolio investment, when the so-called ring fence is lifted, will bolster the drive for a stronger focus on the bottom line. This is a direction that the Kremlin wants to see Gazprom take, given its importance for the federal budget and its role as a (state-controlled) national champion with ambitions to be a global energy player, with exposure to oil and electricity as well as gas at home and abroad.

The fact that European gas prices have nearly doubled over the past two years has widened the differential between the price that Gazproms EU exports command and the fixed tariffs paid by the CIS states. With European prices set to rise even further in 2006, now is a reasonable time to move its gas trade with the CIS states onto a more market basis. Gazprom would stand to gain substantially if both gas prices and transit fees moved up to EU levels.

In the case of Ukraine, the decision to push up the demanded price for gas in 2006 from US$160 per 1,000 cu metres to US$220-230 per 1,000 cu metres is partly a consequence of the very tense initial negotiations. Yet it suggests that Gazprom is seeking leverage over Ukraine, in order to force Kyiv to share or cede ownership of export pipelines. For Ukraine, this is an issue of national security yet it is equally sensitive for Gazprom. Although only one-third of its output goes to Western Europe, two-thirds of its revenue comes from the region and 80% of that trade passes through Ukraine. Thus Gazproms financial stability is dependent on a pipeline network that it does not control, and this constitutes one of the greatest business risks facing the Russian gas monopoly.

Power plays

Russias government, which has become more directly involved in the gas price dispute with Ukraine as tensions have flared, shares Gazproms commercial concerns. Particularly in Vladimir Putins second presidential term, it appears that what is good for Gazprom is good for Russia. Nevertheless, the government has its own reasons for approving the gas price rises to the CIS.

First, it is a symbolic act that demonstrates Russia is more closely focused on its own interestsa clear sign of the hard-headed approach that Mr Putin was supposed to have brought to policy soon after his election. This symbolic act, moreover, will have a direct effect on the vulnerable economies of a number of states with which Russia has recently enjoyed tense relationsin particular Georgia and Moldova. Even though the price rises will also hurt some of Russias close CIS allies, such as Armenia, the overall approach will be popular among nationalist constituencies in Russia that regard the Baltic states, Georgia, Moldova and Ukraine as having benefited undeservedly from cheap gas supplies for too many years.

Second, the price hike for Ukraine would appear to have specific potential benefits. There is a strong possibility that a gas price hike to US$230 per 1,000 cu metresor even to US$160will cause a major disruption to the Ukrainian economy. It could, conceivably, cause stagnation in 2006 and tilt the decisive March parliamentary election away from the supporters of President Viktor Yushchenko and in favour of more pro-Russian parties, including that of the former premier and defeated presidential candidate Viktor Yanukovych. Because Russia chose openly to back Mr Yanukovych in the 2004 presidential electionMr Putin made two visits to the country in the space of a month, sent some of his leading political technologists to advise the Yanukovych campaign and congratulated Mr Yanukovych on his victory before the results were even confirmedthe Orange Revolution was a huge setback for Russia. To undercut Mr Yushchenkos presidency would, perhaps, be suitable revenge and would send a signal across the CIS about the dangers that could follow another peoples revolution leading to the establishment of a pro-Western government.

The extent to which these political objectives can be achieved is unclear and will depend on how quickly the CIS states adjust to higher gas pricesand in the case of Ukraine, how high gas prices actually rise. The business benefits for Gazprom appear to be rather more certainas do the strains for its former Soviet customers, even though in the long run market-pricing for gas will help them too.

SOURCE: ViewsWire Eastern Europe

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