Who will blink – Russia, Ukraine or someone else

There is a fascinating game being played today that has nothing to do with American college football. The results of the contest will have far reaching, long term implications that will affect the lives and livelihoods of millions of people. Some of the effects have already begun.

The Game pits the Russians, led by Vladimir Putin against the Ukrainians, led by Viktor Yushchenko. The field of play is the European natural gas pipeline system, but observers that limit their attention to that field are missing some compelling sideline and background tales. Though each team and leader has some key assets going into the game, most people would agree that Russia is in a significantly stronger position. The outcome, however, might depend on factors that are not immediately apparent.

Here is the basic situation. Until a day or so ago, Russia has been selling the Ukraine natural gas for $50 per thousand cubic meters, a price that dates back to the Ukraine’s days as a member of the Soviet block. The average price for gas in the European Union is about $240 per thousand cubic meters, almost five times higher. For comparison, the current price at a key node in the US natural gas distribution network – Henry Hub – converts to about $336 per thousand cubic meters and has been as high as $500 per thousand cubic meters on some days during the past three months.

In other words, the Ukraine has been getting a very good deal that subsidizes its industrial producers, especially those that compete in energy intensive industries like metals and chemical production. Ukrainian steel companies, for example, have been major contributors to an impressive series of growth years for the Ukrainian economy, averaging more than 9% per year since 2000. According to the CIA Factbook on the country, industrial production contributes more than 45% of the Gross National Product, indicating just how important energy is to Ukraine’s economic well being.

The gas prices that are such a good deal for Ukraine, however, are not such a good deal for Gazprom, one of the largest producers of natural gas in the world. That company, which is controlled by the Russian government, understandably wants to sell its gas for the most profitable price it can obtain. It has been frustrated by the fact that the Ukrainian discount amounted to a deficit of more than $1 Billion per year compared to the European market price.

After much discussion between businessmen and politicians, Russia began reducing its flow of gas into Ukrainian pipelines on 1 January 2006. Ukraine simply refused to pay Russia’s price, so Russia decided to stop suppling the gas.

However, this is not a time to declare “game over.” Ukraine just happens to own the ground that hosts the pipes through which most of Russia’s gas supply to Europe flows. In fact, more than 80% of the gas that Russian sels to European Union member countries flows through Ukraine, using exactly the same pipes that Russia uses to supply Ukraine itself.

Not surprisingly, several other Russian gas customers, notably Hungary, Austria, Slovakia and Italy have already reported that their supplies are being affected by the attempt to stop supplying Ukraine with natural gas. MarketWatch is reporting that supplies are reduced all over Europe.

Fingers are pointing all over the place, with some blaming Russia, some blaming Ukraine and others just wanting gas. Remember, it is winter and pretty darned cold in Central Europe. Though there are plenty of press reports that are focusing on the effects of the supply interruption on consumers, do not forget the effect of the interruption on industrial production. It is certainly bad to sit in a cold apartment; it is worse to have to do that when the factory where you should be working has been shut down because it cannot buy the gas needed to keep the furnaces in production.

An interesting background story, however, is how European actions during the past decade have increased the importance of the gas supply from Russia. The EU’s stubborn demand, for example, to shut down a number of well operated nuclear power plants with excellent safety records has caused a rapid increase in the use of natural gas to supply electricity and to supply domestic heating systems that were previously supplied with nuclear power.

One reason that I really like nuclear power plants as a source of energy is the fact that it is very difficult for anyone other than the owner to take actions that slow their output. Gas fired power plants can be shut down by anyone with access to the fuel supply, since very little fuel can be stored on site. Coal and oil fired plants have a little more immunity; they often store a few weeks worth of fuel on site either in piles or in large tanks. Nuclear plants, on the other hand only need new fuel every 18-24 months and it is very easy for the owner to purchase and store as many years worth of fuel as deemed necessary. With known technology, it is quite possible for nuclear plants to run for decades without needing any outside fuel supplies.

Of course, the aspect of nuclear power that makes it so attractive to me makes authoritarian natural gas suppliers quiver with frustration. They like making people dependent on their fuel; what good it is to use all of their skills to produce good energy addicts if the addict can declare its independence from the gas pipeline “needle”.

One particular human interest story that is beginning to be understood is that of Gerhard Schroder, Germany’s former leader. He was a huge advocate for Germany’s plan to shut down its nuclear power stations well before the end of their useful life and to move the country to a greater dependence on windmills and natural gas. After he was defeated in a recent election, he accepted a new job as the head of a Gazprom unit that is building a new natural gas pipeline that will directly link Germany to Russia without passing through the Ukraine. (See Schroder under fire for taking gas pipeline top job.)

In my estimation, this just might be the story of a man who sold out an entire continent for a lucrative job and a big payday.

One particularly worrisome aspect of the story is that Russia has a history of establishing its own rules for the games that it plays. Ukraine is in a reasonably powerful position with its physical control of existing gas pipelines, but that control rests on a potentially fragile assumption. What if Russia decides to reestablish its physical presence in the country?

There is a very interesting post on The Moderate Voice titled Russia Cuts Off Ukraine’s Gas And It Has Implications that I highly recommend for even more thought provoking discussion.

Additional Links:

• Ukraine stealing Europe’s gas BBC – 2 January 2006
• Energy and the new world power play BBC – 1 Jaurary 2006
• Germany warns Russia over Ukraine gas Reuters – 2 January 2006
• Leave politics out of energy dispute, US urges Russia Sydney Morning Herald – 2 January 2006
• Turning off the pipes threatens to leave Putin out in the cold Times Online (The Times UK) – 3 January 2006
• British energy company draws up plans to increase production Times Online (The Times UK) – 3 January 2006