Streetwise Professor

January 5, 2009

It’s a Gas

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 9:34 pm

Russia’s cutoff of gas to Ukraine is now into its sixth day, with no immediate resolution in sight. Many analysts had expected that this episode would have ended by now with some sort of deal because Gazprom could not afford damaging its reputation as a reliable supplier. Those forecasts are evidently wide of the mark.

The wider world first became aware of the contentious relationship between Russia and Ukraine over natural gas three years ago, when Russia/Gazprom cut off shipments to Ukraine. Gazprom indeed suffered a major black eye in Europe, and soon cut a deal through murky intermediaries with highly disreputable connections, even by the region’s notoriously low standards.

But just because 2006 was the first time that world attention focused on the gas wars doesn’t mean that was the year of the first battle of that war. In fact, it had been raging since the collapse of the USSR. This ongoing struggle is driven by economics, the historical legacy of the USSR, geopolitics, and domestic politics in the two countries.

So what is going on now? The situation is complex, and extremely opaque, which makes it difficult to proceed with any confidence–but hey, that’s never stopped me before. So, here are a few thoughts.

First, if any economics student wants a great example of Williamsonian holdups in action–here it is. Russia has the gas. Ukraine has the pipelines needed to get that gas to those willing to pay the highest price for it. There is a bilateral monopoly. There are large economic rents at stake, and the contenting parties have a tremendous incentive to use whatever means at their disposal, fair or foul, to get the biggest share of these rents. In these situations, brinksmanship and holdup s(Russia denying gas to Ukraine, Ukraine siphoning gas from Russia destined for Europe) are inevitable.

In normal, commercial relationships, vertical integration is one way of solving the problem. Uniting the ownership of the gas with the ownership of the pipes eliminates the potential to battle over rents. Indeed, that’s what the USSR was–a vertically integrated energy supplier. 1991 dis-integrated the industry, with the consequences we observe today.

This is, in fact, an acute problem throughout the CIS, and even within Russia. The USSR set up many large scale, and in some cases monopoly, enterprises. Central command authority mitigated holdup problems between these enterprises. With privatization, and the breakup of the USSR, these once integrated enterprises became separate business, creating incentives for both ex ante and ex post opportunism. Monopoly markups and higher transactions costs were the result. Where complementary activities found themselves located in different nations, these transactions costs became especially acute. The gas wars are only the most public, and most spectacular, manifestation of this.

Second, matters are complicated tremendously by the cross currents of private and government interests, and conflicting factions within each country. The gas intermediaries–notably RusUkrEnergo in the present instance–reflect these conflicts.

To the best I am able to piece things together, these intermediaries first developed as a result of the opening of the gas wars in the early-1990s. Ukrainian industrial firms paid Naftohaz Ukrainy (the Ukrainian national gas utility) for gas. NU got the gas from Gazprom–but didn’t pay for it. The intermediaries formed, and offered Ukrainian buyers a price lower than NU. But where could the intermediaries get the gas? It couldn’t come from Gazprom directly–so enter deals with Turkmenistan. But this gas had to travel through Gazprom pipes. So, directly or indirectly, high level people from Gazprom were involved in the intermediaries, and lined their own pockets in the bargain. The Ukrainian government still had considerable leverage due to its control over the pipelines, so those with connections were able to get a piece of the action; that is, partial ownership of these intermediaries. (RusUrkEnergo is 50 pct Russian owned, 50 pct Ukrainian.) In essence, these intermediaries facilitate the privatization of monopoly rents in the Russia-Ukrainian gas trade.

This means that in some sense viewing the current standoff as the Russian government (or Gazprom) vs. the Ukrainian government is misleading. There are very powerful private interests in each country–some of whom are also in the government, or who work for government enterprises–that privately profit from the trade, and who want to ensure that the gravy train continues, and that they continue to ride it.

Interestingly, it is very curious that Gazprom and the Russian government are front and center in the dispute. Formally, NU doesn’t owe Gazprom or Russia anything–it owes RusUrkEnergo. It claims it has paid RUE. The intense interest of Gazprom and Russia in these matters suggests that RUE is nothing but a stalking horse for interested parties in Gazprom and the Russian government.

A third aspect of the conflict is that it is playing out against the backdrop of the financial crisis, and Gazprom’s acute economic difficulties. Gazprom has been the Russian government’s cash cow–but the cow is running dry. Its revenues on sales to Europe are contractually tied to the lagged oil price. That lagged price is high now, but will drop in coming quarters due to the recent fall in the oil price. Gazprom is already deep in debt, makes little on its domestic sales, and is facing a sharp decline on its revenues from sales to Europe. Squeezing Ukraine for a higher price would help that situation some. Gazprom CEO Alexi Miller is demanding the Ukrainians pay a “European” price of above $400/mcm for gas in 2009–but that’s a European price that was based on 2008 oil prices. The European price for most of 2009 will be well below that due to the sharply lower 2009 oil price. Moreover, Ukraine is already an economic basket case, and has been hit even harder by the world economic crisis than Russia. Its heavy industries cannot afford a $400+ price.

A smart monopolist would price discriminate, and charge Ukraine a lower price than it charged Europe. At $400/mcm, Ukrainian consumption would plunge. Charging an extremely high price and selling low volume is not profit maximizing. Miller’s extreme demands are economically irrational–they are based on obsolete economic circumstances, and would not maximize Gazprom’s profit. Thus, Miller seems to be posturing. But his demands are so unrealistic, and his negotiating position is so weak due to the Ukrainian stranglehold on the pipelines, it is highly unlikely that he will get anything close to that price–nor should he want to if profit maximization is his true goal.

But that’s where things get really complicated. Maximizing Gazprom profit may not be the only, or even primary motivation on the Russian side. Outrageous Gazprom demands create a pretext for another face saving deal where an intermediary provides gas at a lower price–and where the profits can conveniently flow into private pockets (or the private pockets of public officials.) Moreover, there is a geopolitical angle here. Putin and Russia want to undermine the sovereignty of Ukraine, and torpedo the Orange forces in that country. That is a sufficiently large prize that Putin et al may be more than willing to sacrifice some profit. That is, the payoff from stiffing the Ukraine is not economic, but geopolitical.

The crazed Ukrainian domestic situation adds yet another layer of complexity. I’ve analogized Ukrainian politics to the three way gunfight at the climax of the spaghetti western “The Good, the Bad, and the Ugly”, and that tragicomic standoff continues. Each of the three major antagonists in Ukrainian politics wouldn’t consider a prolonged standoff and economic pain a bad thing–as long as the one (or both) of the other two takes the blame. The private economic interests of these individuals, their parties, and their associates, also affect their motives and behavior.

In a word: A mess.

It does seem that Gazprom and Russia have the most to lose, and has the weakest hand. Gazprom’s already dodgy reputation in Europe will suffer from another extended cutoff. It has no other way to reach Europe except via Ukraine. Ukraine is already an economic basket case, and although it would suffer somewhat reputationally from a protracted standoff, it doesn’t have the same ambitions and value as Gazprom. It has enough supply stored to get through the winter.

My prediction–albeit offered far more tentatively than my usual fearless forecasts;-)? If economics is the driver, there will be a deal, probably executed through an intermediary, if not RusUkrEnergo, then through some made to order substitute. The price will be lower–far lower–than Miller is demanding. Such a deal will maximize the profits of those who matter–in both Russia and Ukraine.

But I am less than confident that economics will be the driver. The geopolitical stakes have risen dramatically since the Russo-Georgian War, and Putin badly wants to bring Ukraine to heel for both political and personal reasons (the Orange Revolution being a stinging personal defeat.) Moreover, humbling a nation many Russians perceive as an American lackey would be quite welcome given the discontent arising from the economic crisis. Furthermore, it takes more than one to tango, and the vicious political riptides in Ukraine undermine the potential for a deal.

As a result, I place high odds on a protracted standoff. If and when a deal gets done, it will likely be through an intermediary that funnels cash to connected parties in both countries, and at a price that is far below what Gazprom’s Miller is demanding.

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  1. […] Professor analyzes a few factors of significance for the ongoing gas war between Russia and Ukraine. Posted by […]

    Pingback by Global Voices Online » Russia-Ukraine: Variables of gas war — January 6, 2009 @ 4:53 am

  2. May I suggest, if you haven’t already done so, looking at Kremlin, Inc., a blog by a Fullbright scholar from Dartmouth?

    He lays out in some detail the things that you have already covered – but I think the detail is very informative.

    As a reminder – back in July, there was an agreement reached to 1) cut out RosUkrEnergo and 2) have a 3-year transition to increased prices (I don’t want to say “market prices” for reasons that you have already covered).

    In September, gas talks were put on hold because of political instability in Ukraine – Yushchenko was pushing for pre-term parliamentary elections, and everyone else was against that.

    So here we are. But what is astounding to me is how horribly incompetent both sides are in this whole mess.

    It’s either that, or corruption is driving the whole thing, and noone has yet figured out a mechanism for a replacement for the RosUkrEnergo scheme.

    Apparently, this was the first time anyone thought of multi-year contracts, but noone appears to grasp the concept of pricing adjustment clauses within a contract. And the Ukrainian side was comfortable with waiting for a delay, in hopes of prices going down, while Russia was comfortable in waiting for a delay in hopes of prices going up.

    Between horrible incompetence plus horrible corruption, which permeates Russia and Ukraine – this is what you get.

    And Russia can’t seem to shake the sovok propaganda habit. They have resorted to it mightily and massively. As clumsy and non-credible as its PR is, they would have been far better off to do without it. Noone outside of Russia believes the PR, but they seem either not to care about that, or get infuriated that noone believes them. Old sovok habits die hard, it seems.

    So far, my 2 favorite Russian PR gambits were: “we were offering ‘humanitarian’ prices, now you have to pay the ‘full’ price” and the outrage that “Ukraine prepared for the gas dispute and gas cutoff by storing gas.” Apparently, it’s some sort of insult to Russia and Gazprom if people prepare for disaster.

    Here’s the link. The links pointing to the dispute are easy to find, but I would be happy to provide those if requested.

    Comment by elmer — January 11, 2009 @ 11:24 pm

  3. OK, riddle me this, Professor. This is a question that I saw over on LR, and I think it is an excellent question.

    When I saw it, I hit one of those “duh” moments.

    Where is it written into the contracts with Germany, Bulgaria, Poland, Austria, etc., that Gazprom has the right to simply stop shipments of gas to Western Europe if Gazprom, through RosUkrEnergo, has a dispute with Ukraine?

    Doesn’t the contractual obligation with those countries continue regardless of any disputes that roosha may have with Ukraine?

    Even if roosha thinks that gas is being “stolen”?

    Comment by elmer — January 12, 2009 @ 9:32 am

  4. That is a good question Elmer. It relates to an issue I raised in an earlier post, namely, what business to Gazprom, let alone the Russian government, have in inserting themselves into a billing dispute between RosUkrEnergo and Naftohaz Ukrainie? If RUE is REALLY the counterparty, then it’s none of Gazprom’s/Putin’s business. Non-payment is RUE’s problem.

    I do not know the details of Gazprom’s European contracts. It would surprise me, however, that the actions of a third party (Ukraine) could relieve Gazprom of its obligations under these contracts. If Ukraine truly stole gas, Gazprom would have a claim against the thief. (Although I don’t know the forum in which such a claim would be heard.)

    All of this just illustrates the Kabuki-theater nature of the whole sordid affair, and gives the lie to Putin’s/Gazprom’s assertions that the dispute is merely a commercial one being handled using standard commercial remedies.

    The ProfessorComment by The Professor — January 12, 2009 @ 7:05 pm

  5. The former Soviet territory always had two troubles: roads and fools. But life goes on, and the list of troubles gets certain national colour. It seems, that in Ukraine now it is necessary to be afraid not only of “fools” and “roads”, but “ crisis struggle” and “Euro 2012 preparation”.

    Comment by Alex — February 5, 2009 @ 4:16 pm

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