Russian Gas to Europe, Part Deux.

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The recurring crisis in the shipment of Russian gas to the European continent is now moving from an annual to a monthly event. Much like a television soap opera, the theme remains the same; each crisis is followed by a resolution of all pricing and payment disagreements only to be followed by another conflict. The Russians want to be paid, the Ukrainians want some combination of higher transit fees and lower prices, and the Europeans just want assurances that the gas will be delivered. In an EPRINC assessment published in March 2009, we concluded that Gazprom, as a price-taker, had incurred substantial losses from the low oil price environment and recurring gas disputes with Ukraine, thereby, highlighting that dependence goes both ways ? Russia needs the European market as much as the latter needs Russian gas.
Furthermore, we concluded that Ukraine could lose considerable economic leverage if Russia built either the Nord Stream or South Stream pipelines. While Russia is determined to charge ahead with building both pipelines, it is suffering from declining revenues from lower sales into Europe. Unless the Ukrainian transit issue is resolved, we are likely to see another cycle of payment disputes.

All three sides have a lot to gain through a long term resolution of the transit conflict, so why is it so difficult to obtain a stable agreement? In many respects the ongoing dispute over Russian gas deliveries represents a three party confrontation in which each party brings a unique, but constantly changing risk profile, and both the Russians and Europeans are seeking strategies for the other party to do more to get the Ukrainians to cooperate. However, a broad range of interests in Ukraine are facing severe economic and political pressures, and all of these stakeholders are well aware that Ukraine is the transit point for over 80 percent of Russian access to the European market. Kyiv remains in a position to extract higher fees or lower gas prices (economic rents) by diverting transit gas to domestic uses. While new pipelines are likely to diminish the importance of the Ukrainian transportation corridor, this traditional transit route will remain important when European gas demand recovers.

Although the Russians are actively pursuing alternative delivery routes to their European customers, for the time being, they are stuck with the Ukrainian transit corridor. The Russians can deny the gas to the Ukrainians, but all the parties involved also know that such cutoffs will result in reduced or no gas flow to Europe and at the same time further damage Russia?s reputation as a reliable supplier. Furthermore, conditions in the world gas market may now pose additional risks to the Russians.

Although oil prices have recovered somewhat from their collapse in late 2008 and early 2009, we are likely entering into a market where natural gas prices will remain relatively low, at least for an interim period. European gas demand has risen between April and June, however, the EU has reduced its take from Gazprom. Some Russian officials are divided on the reasons why this happened. While Russia?s Deputy Energy Minister, Sergei Kudryashov, argues that Gazprom?s strict pricing drove European buyers to other gas suppliers who have raised their market share in the EU by granting discounts, the company?s CEO, Alexander Medvedev, claimed that Europe reduced its purchase of Russian gas between October 2008 and March 2009 due to lower gas spot market prices, which were half the cost of the long-term contracts. For the Russians, the cost of cutting supplies to Ukraine are rising and the prospects for the Ukrainians to seek higher rents are improving, but the outcome remains uncertain as there is no clear path to resolution.

Against this background of a recurring dispute over transit arrangements, Gazprom is now facing one additional risk. As illustrated in Fig. 1, extensive discounting of gas to oil has been a feature of the U.S. gas markets, which may emerge into a longer term characteristic of world oil and gas