Publication: Eurasia Daily Monitor Volume: 3 Issue: 7

The abortive interruption of Russian natural gas supplies to Ukraine on January 1 was a humiliating diplomatic blunder. It was an unnecessary crisis, and one that Russia clumsily lost in the court of world public opinion.

While Ukraine was threatened with a gas blockade, Russia was voluntarily submitting itself to a two-week information blockade. The entire country was given a holiday from January 1 to 10, with even the newspapers shuttered. The political class fled to their holidays in the sun, and none of the usual Kremlin spin-doctors were deployed to staunch the flood of Western criticism.

The Russian case simply did not get an airing in the international media. Moscow never stood a chance. There is a case to be made for Russia: not a strong one, but a case, nevertheless. It consists of the following elements.

First and foremost, why should Russia continue to supply Ukraine with gas at a price one-quarter of that paid by Europeans? The anomaly is not the insistence on market pricing; the anomaly is the August 2004 deal promising Ukraine cheap gas, offered in a reckless (and fruitless) bid to boost Viktor Yanukovych’s chances in the December 2004 presidential race. Charging market prices should have been welcomed by the West as a step away from such political maneuvering – but instead it was seen as just the opposite.

The subsidy implicit in gas priced at $50 per 1,000 cubic meters amounts to some $3-5 billion per year. Ukraine had been taking some of its discount gas and selling 5-6 billion cubic meters to Western customers (worth $1 billion in clear profit). In October, Ukraine pocketed $4.8 billion from the sale of its major steel mill, Kryvorizhstal, to India’s Mittal Steel, so Russia could be forgiven for thinking that it was ready to pay market prices for fuel (that makes up 70% of the cost of steel). This impression was confirmed by the EU’s decision to grant Ukraine “market economy” status in December.

Far from being arbitrary and thuggish, Russia had tried in repeated meetings since June to persuade the Ukrainians to sign a new agreement. The problem was that the Ukrainian government was in chaos. First there was Prime Minister Yulia Tymoshenko’s populist posturing, including her effort to freeze gasoline prices. Months of faction fighting followed by her dismissal in September threw the government into complete disarray, with President Viktor Yushchenko striking a deal for parliamentary support with his former adversary Yanukovych. There was nobody with the political authority to make a deal with Russia, one that would invariably involve increased prices. So the Ukrainian leadership let the clock run out with no deal signed. The problems Russia faced in negotiating with Kyiv were underlined by the dismissal (or maybe not) of the government on January 10 by a parliament unhappy with the January 4 deal.

Critics protest that Russia was contractually obliged to deliver $50 gas to Ukraine for the next five years. However, none of the Western commentators have seen the full text of the August 2004 contract: only selected parts were published. And even from those it seems clear that the $50 discount price applied only to gas to be supplied in exchange for transit fees, about 15 billion cubic meters. Ukraine did not have carte blanche to take as much gas as it wanted.

Few Western commentators mentioned that the August 2004 deal was connected to a Ukrainian government pledge to develop a joint consortium, with Russia and Germany, for the management and development of the pipeline infrastructure. Yushchenko dropped that commitment once he took office. Fewer still reported that the deal was also connected to the rescheduling of the $1.6 billion that Ukraine owes Russia for unpaid deliveries from 1997-2000. Also in August 2004, as a political gesture Putin waived the VAT on energy exports to Ukraine — worth another $1 billion to Kyiv. With all those factors in its favor, Moscow should have been able to make a much better case to the international community.

Economic theory is of no help. There is no agreed principle for dividing the rents from energy between a producer and a downstream pipeline carrying it to market. The market solution would be to look for alternative routes, and fix a price that makes it just profitable for Russia to build across Ukraine. But this would take 5-10 years to execute. No such calculations were made, and no binding contracts were signed, when the pipeline was built in the 1980s.

In the meantime there is no fair price, nor a market price. There is only a political price. It came down to a game of chicken: who would lose more from a shutdown of the pipeline, Moscow or Kyiv? After 10 hours Moscow blinked, and turned the gas back on. But Russia has so many economic levers at its disposal, from the tax treaty to visa-free travel, that they were able to wring a favorable deal out of Kyiv by January 4. By then, however, the damage to Moscow’s international prestige had been done.

In recent years Putin has generally won recognition as a skilled and cautious diplomat, somebody who learned English in two years in order to schmooze with the masters of globalization. And he is supposedly served by the wily and experienced ex-Soviet diplomatic corps, trained to manipulate the nuances of international public opinion. Where were they — before and after January 1? Whatever happened to the Russia that was playing chess while Uncle Sam was playing checkers?

(www.gazprom.ru; Ukrayinska pravda, December 29; Kommersant, December 16, 29; Strana.ru, January 4)