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Ukraine, Russia’s Gas, and the EU’s (lack of) Options

 

After the seventh round of trilateral negotiations fell through, Russia acted upon its earlier threats and cut off gas to Ukraine at 10:00 a.m. Moscow time on Monday, June 16.  Gazprom announced that it will now “supply Ukraine only the amount of gas that has been paid for, and the amount that has been paid for is zero.” In a press conference, Gazprom CEO Alexei Miller reported that the conditions Gazprom had offered the current Ukrainian leadership were significantly more favorable for Ukraine than those granted when Yanukovich was President. In particular, he stated that Russia had proposed a discount of $100 per thousand cubic meters, bringing the price to $385 through 2019, and waived the required minimum purchase volume. Still, Naftogaz, the national oil and gas company of Ukraine, rejected the offer. According to Gazprom, Ukraine currently owes $4.5 billion for 11.5 billion cubic meters of gas.  Moscow is demanding that Kiev settle the debt for November and December 2013 ($1.451 billion) and demonstrate progress in paying off the April and May debts ($500 million). Following the termination of gas supplies, both Gazprom and Naftogaz filed arbitration claims to the Stockholm Chamber of Commerce. In the meantime, the cutoff is no small matter for Kiev--Ukraine imported 63 percent of the natural gas it consumed in 2012 from Russia. Technically, Gazprom’s contractual supplies to the European Union are uninterrupted at the present time, with Russia claiming it will deliver the precise volume under existing contracts with EU countries. While there is no metering station on the Eastern border of Ukraine, metering equipment in Russia and the European Union can be used to determine if Ukraine is tapping the gas flows through its borders. Ukraine is currently estimated to have enough natural gas via domestic production and storage to sustain its consumption through early December. However, disruption risks in the mid- to long-term still remain for the EU. Energy analysts and general media have long classified Russia as a petro-state heavily reliant on exports of oil and gas.  Whilst natural resources are vital to the Russian economy, their role in the country’s macroeconomic reality varies considerably.  According to the Oxford Institute for Energy Studies (“Oxford Institute”) latest research, oil and gas exports constitute 54 percent and 12.5 percent respectively of the total exports by value and 42 percent and 6.3 percent respectively of Russia’s federal budget revenues. Therefore, although oil and gas exports are often described jointly as being equally valuable to Russia’s internal budget, oil exports carry far more weight than gas exports in terms of revenue. In other words, Russia has more leverage when it comes to cutting off gas exports, than Europe does by reducing imports. The European Union imports 82 percent of its oil and 57 percent of its gas from third-party states, and over one third of its gas imports come from Russia.  Therefore, as we know, in the event of a real dispute between Europe and Russia, Moscow is in a position to use gas as a political tool given EU’s vulnerability to potential gas disruptions. Ukraine is suffering such a fate as we speak. The question then is what steps should the EU take to mitigate its exposure to Russian exports?  One prospect would certainly be to increase the use of renewable energy sources.  Although Europe has already made significant steps in this direction, the share of renewable energy is only 12.7 percent.[1]  No doubt this share will continue to gradually rise over the next couple of decades, particularly given the continent’s relatively aggressive approach to carbon emissions reduction. However, it is hard to imagine that renewables will fully offset the EU’s gas dependence within the next few decades. That being said, replacing Gazprom supplies is a daunting task for the EU, at least for the foreseeable future. First, there is the existence of long term “take or pay contracts.”  According to the Oxford Institute, European buyers have contractual commitments until at least 2030 whereby they are obligated to purchase at least 10-15 billion cubic feet of gas per annum from Gazprom under international contracts with legally binding arbitration clauses. Very conservative calculations estimate that it would cost the EU $400-600 billion to buy out these contracts. Second, although importing LNG could be a viable option for the EU in the long-term, it is not a particularly cheap insurance policy. It requires a complex and extremely expensive infrastructure to deliver the energy.  If Europe wants more LNG, it will have to pay about twice what Russian pipeline gas currently costs.  As the Financial Times notes, “The continent spends about $11 per million Btu for gas, while in Asia, LNG fetches about $15 per million Btu.”[2]  Moreover, political excitement about the idea of America’s shale gas helping Europe out tends to overlook the practical difficulties, including the lack of sufficient network facilities. Right now, the United States has no LNG export capability for two reasons: first, it remains a net importer of natural gas, and second, potential LNG export terminals are still under construction or awaiting permit from the State Department. Additionally, the construction of new LNG terminals requires a large scale financing—current LNG terminal construction contracts are in the range of 500 million euro. Given the dynamic nature of the industry, as well as substantial policy uncertainty, the capital requirement for large-scale LNG regasification facilities is not without substantial risk—risk that would likely need absorbing in large part by private sector developers, not EU governments. Third, shale gas development will not replace Russian supplies either. The ongoing shale gas operations in Germany, Poland, and Romania may play a positive role in helping Eastern European countries to wean themselves off imported fuel from Russia. Nevertheless, the experts agree that the long-term effects in terms of resolving Europe’s overall energy security are marginal.  By 2035, shale gas is estimated to be meeting no more than 3-10 percent of EU gas demand.[3]  Furthermore, the recovery of European shale gas triggers various environmental challenges and receives strong public opposition in some member states.  For instance, France and Bulgaria have banned hydraulic fracturing processes altogether due to chemicals used and their potential for contaminating drinking water. Fourth, the absence of coherence in formulating common policies and the growing division between the EU member states mark another key concern in relations with Russia.  Evidence shows that when it comes to natural gas diplomacy, European countries have their own competing interests that are difficult to unite under one flag.  Putin has long been able to take advantage of chaotic EU politics by playing nations against each other and successfully adopting divide and conquer tactics to neutralize criticism.  Consequently, numerous bilateral agreements on natural gas supply were concluded with Russia.  Each agreement had significantly varying terms with respect to the price, duration, and total volume of natural gas.  By the end of 2006, Gazprom had negotiated deals with energy companies in nearly all EU countries, with especially notable ones signed with Germany, Belgium, France, Italy, Hungary, and Austria.[4] Existence of numerous bilateral agreements illustrates the EU members’ radically different levels of exposure to Russia.  This fragmentation leads each national government to view the Russian challenge independently, and pursue strategies that are at best uncoordinated and at worst mutually exclusive. There are a few options for Brussels as it takes on this challenge. The EU could create a pan-European regulatory framework and an integrated network of gas pipelines.  Building a single market for gas is imperative if the EU hopes to manage the Kremlin’s ability to play the interests of different countries against each other within the continent. Discrepancies in national regulatory approaches inhibit the ability to protect the countries that suffer most from Gazprom’s discretionary ruling.  A unified European market will help equalize bargaining power between Brussels and Moscow and simultaneously align the interests of the European states.  

[1] Energy: Renewable Energy Progress Reports, European Commission, available at http://ec.europa.eu/energy/renewables/reports/reports_en.htm
[2] Guy Chazan, “Europe Seeks Alternative Gas Supplies,” Financial Times, (April 27, 2014), available at http://www.ft.com/intl/cms/s/0/b943b2c4-b8ed-11e3-98c5-00144feabdc0.html#axzz30inYjYWk
[3] Arthur Neslen and Frederic Simon, “Europe Abandons Hopes of US-Style Shale Gas Revolution,” (February 28, 2014), available at http://www.euractiv.com/specialreport-industrial-renaiss/Europe-abandons-shale-gas-revolution-news-533546
[4] Richard Youngs, “Energy Security: Europe’s New Foreign Policy Challenge,” (London and NY: Routledge, 2009), p. 82.