Commentary: Russia and Ukraine — The Energy Angle

Even with all the speculation and debate about Vladimir Putin’s nationalistic motives for Russia’s annexation of the Crimea, there still seems to be room for more thoughtful consideration of the oil and gas aspects of the conflict. Putin may be a nationalist and he may primarily worry about Russia’s national cohesion and periphery but Russia is fundamentally a petro-state and it is important not to forget that fact in analyzing the thorny problem of Ukraine.

Russia relies heavily on oil and gas for its national budget and has been under pressure from the prospects of increased competition. So far, that competitive pressure is limited to the natural gas side but prospects that either Iraq or shale oil could uptick in the coming years pose a long term threat as well. When Putin analyzes who to back in the Middle East, he most certainly needs conflict to stifle oil and gas production expansion there. Mideast conflict is also good for Moscow’s budget woes.

Gazprom saw an 8 percent loss in export market share to Europe in 2012 and the problem is likely to get worse, not better, over time. The most important aspect of Gazprom’s export conundrum is not the revenue loss per se, though that is problematical. It is that Putin’s real inner circle is made up of oil and gas barons and there isn’t enough growth to go around. The European pie is shrinking and that leaves Igor Sechin (Rosneft), Gennady Timchenko (Novatec) and Alexey Miller (Gazprom) with a problem with each other. Novatec has picked off the plum domestic industrial customers for gas inside Russia, leaving Gazprom under even more pressure. All three entities are actively trying to capture the Asian market, so far without much luck. China has been favoring liquefied natural gas (LNG) imports from Australia and elsewhere and piped gas from Central Asia, and prospects for Arctic development by Russia’s state behemoths looked highly risky even before the Ukraine mess.  

The Ukraine protests, in a way, took an already acrimonious discussion about what to do about future Russian energy strategy and made it worse. For sure, the Kremlin cannot allow its own citizens to ask how Putin himself, Igor Sechin, Gennady Timchenko or Alexey Miller and their investor cadres got their wealth. So by extension, it cannot have the citizens of the Ukraine investigate how Dmitry Firtash made his. The gas trading schemes between the Ukraine and Russia are about as opaque as they come, with some analysts actually speculating that Russia has operatives inside the Ukraine who steal Russian gas as “Ukrainians” under orders from the Kremlin specifically so that Russia can intervene. Russia has made no secret that it is trying to use debt or other means to buy up critical energy infrastructure assets in Eastern Europe, including in the Ukraine, and European capitals now need to give pause before offering any more of its energy assets for sale.  One Gazprom ploy has been to solicit France’s Total, Norway’s Statoil, Italy’s ENI and Germany’s Wintershall with investment goodies to try to weaken European political resolve on borders, supply contracts, liberalization and overall security relations.

Coming up with an effective European strategy on Ukraine will be difficult given the continent’s and Ukraine’s dependence on Russian energy. Ukraine counts on Russia for over half its natural gas needs and Moscow’s cancellation of Kiev’s 33 percent import discount is going to be painful to obviate. Russia transported 300,000 b/d to market via Ukraine in 2013 and supplied Ukraine with 70,000 b/d. Europe has similar Russian supply woes. Some 65% of Russia’s 4.8 million b/d of oil exports went to Europe in 2013, of which 1.28 million b/d was transported out the Baltic Sea and 730,000 b/d out the Black Sea. The Drukhzba pipeline which has legs through Belarus to Poland, Hungary, and other Eastern European destinations, also carried 1 million b/d. Germany is the largest importer of Russian oil, followed by Poland, the Netherlands, Belgium and Italy.

For now, markets are not reacting out of the belief that Russia needs the European market as much as Europe needs Russian energy. But perhaps oil prices are also stuck because the consequences of a deepening European-Russian geopolitical divide are so complex, it is hard to make a logical bet on the outcome.  

Preliminary research on the geopolitics of natural gas by Harvard University’s Kennedy School and the James A. Baker Institute’s Center for Energy Studies and UC Davis Graduate School of Management shows that Europe’s best long term option is to liberalize its energy and electricity markets and open freer energy trade inside the EU. Liberalization is the path that best reduces Europe’s long term dependence on Russian energy at the lowest possible cost, according to the Harvard/Baker/UCDavis analysis. It also happens to be a scenario that benefits the United States as a LNG exporter and global superpower. The United States has long advocated for open markets and free trade in energy (see Senate Testimony) and the conflict with Russia just underscores the importance of accelerating this policy. But this is a long term response. For now, limited responses to the energy piece will have to include showing Moscow that the OECD is willing to use strategic stocks as a credible response to supply threats and that accerlated investment in European natural gas resources could be back on the table. A stronger announcement out of the Arab Gulf about rising oil supply sales and price discounts to Europe would also be helpful to focus minds in Moscow. Finally, as the West targets “bank accounts” and “assets” abroad, it should not forget that the inner circle includes not just military-security folk, but Russia’s oil barons who have their own personal wealth on the line in the value of the company shares on Western stock markets and in holdings in Western banks.