Eye On The Energy Threat: Ukraine’s Geopolitical Impact

A recent top business story in the Russian Times included a short article on Ukraine’s failure to pay state-owned Russian gas giant Gazprom $2.4 billion in debt.

This impasse between Ukraine and Russia is nothing new, yet there are multiple contributing factors that make Ukraine an important country in our global macro dialogue, including: (1.) the geographic significance of a major Russian gas pipeline running through the country that services Europe, (2.) the politically divided Ukraine with recent signs of EU-centric orientation, and (3.) heightened policy between “The West” and Russia, including measures by the European community to reduce its dependence on Russian energy.

Ukraine’s geographic location is an important one that plays into its geopolitical influence. It’s situated with Belarus to the north as a strategic land buffer between Russia and Europe. While increasingly more pipelines are being built to service oil and gas from Russia and the Caucasus to Europe that don’t directly cross Ukrainian or Bulgarian territory (e.g. under the Black and Baltic Seas), currently the Russian pipeline Druzhba (or “Friendship”) running across Ukraine services 80% of the gas the EU receives from Russia. This is a considerable number, especially with context—Russia exports about a quarter of the EU’s gas.

For years, Ukraine enjoyed cheap gas prices as part of the Soviet legacy. That changed in 2005 when Ukraine decided to switch to market prices for transit through the country. Gazprom, the largest extractor of natural gas in the world, was all too happy to accommodate Ukraine and consequently drove up the price of gas. Ukraine’s first refusal to pay higher prices resulted in Gazprom shutting off supply on January 1, 2006. Hoping to circumvent the action, Kiev decided to siphon off gas from the pipeline, which resulted in the disruption of gas deliveries to Europe.

At the end of October 2008, Gazprom and Ukraine’s state-controlled Naftogaz Ukrainy signed a long-term agreement for direct gas supplies from Russia to Ukraine with the abolishment of the intermediary company RosUkrEnergo, which is 50% owned by Gazprom. While the agreement did not set out the volumes of gas Ukraine would buy from Gazprom in 2009 and beyond, nor a price or pricing mechanism, the signing of the deal was seen as a positive step in Ukrainian-Russian relations. Yet this relationship has soured in recent months due to Ukraine’s failure (or as some see it inability) to pay off its debt of $2.4 billion in gas back payments to Gazprom on behalf of RosUkrEnergo.

Now that the holiday season and colder temperatures have arrived, observers speculate that Gazprom may have another stand-off with Ukraine, which could have repercussions in European supply.
It is Ukraine’s geographic location that makes it of such political importance for both the European Union (The West) and Russia (The East). Ukraine’s political trend-line has been gradually changing towards a pro-EU orientation, with pro-Western parties and coalitions coming to power, as demonstrated by the victory of President Viktor Yushchenko’s Orange Revolution five years ago. Yet still, observers struggle to qualify the “democratic” nature of the country’s leadership. After entering office, President Yushchenko banned Ukrainian cable companies from showing Russia’s Channel One to limit the Kremlin’s voice, demanded Ukrainian language instruction from kindergarten to university level, and instituted a remembrance holiday to acknowledge the genocide of Ukrainians by Russian commissars during the famines in the 1930s. Such measures didn’t go over so well with all Ukrainians, for a larger percentage of eastern Ukrainians still strongly identify with Russia.

Both the EU and Russia have made attempts to reign in on Ukraine. While Russia has exercised its influence through leveraging its energy price, the EU has made a number of concerted efforts. Just last week NATO foreign ministers met in Brussels to discuss whether Ukraine and Georgia should be allowed into the military alliance. Ultimately Western Europeans, led by Germany and France, blocked US efforts to offer Ukraine and Georgia membership, yet the discussion furthered the debate to recognize Ukraine as a “Western” country.

In another EU gesture to extend its hand to Ukraine, European Commission President Jose Manuel Barroso unveiled an Eastern Partnership package last week to give Ukraine and five other former Soviet states access to €350 million of financial aid, free-trade pacts, and hassle-free visas. In addition Ukraine has already received more than a quarter of the $16.4 billion rescue loan from the IMF. This comes at a time when its currency, the hryvnia, has deeply devalued to historic lows against the dollar.

Russia, on the other hand, has done little to repair its reputation with Ukraine. Ukraine officially denounced Russia’s invasion of Georgia. In fact its aggression further confirmed to many Ukrainians that when it comes to political and economic issues, they trust Europe more. Even the politically significant balance of power between Washington and Moscow over such controversial issues as the US proposed missile defense shield in Poland and the Czech Republic has Ukraine leaning westward.

Yet the icing on the cake to disrupt the political significance of Russia may result solely from its oil-levered economy. Oil prices from a high of $147/barrel in July are down 70% today. Further, the EU is taking steps to limit its dependence on energy imports, including gas. In November, the European Commission convened and came up with The New Energy Policy, a plan by 2020 to reduce carbon dioxide emissions and total demand for energy by 20% and to increase the share of renewable energy sources.

While the plan didn’t explicitly aimed to reduce the EU’s dependence on energy sources from Russia, the implication was understood. Irrespective of the EU’s ability to meet The New Energy Policy, Russia’s bottom line will be affected. Investment is already being made by many European countries in liquefied natural gas (LNG) facilities that would allow gas to be transported via ship. LNG benefits would include the ability to store reserves for times of shortage, and rely on the world’s natural gas reserves rather than solely Russia’s.

While the European Union is not ready to extend membership to Ukraine, it has taken numerous measures to placate the country. With oil’s global demand destruction, Russia’s energy “authority” will be vulnerable, especially if the EU becomes less dependent on Russia for its supply. Ukraine remains an important country that can tip the East-West balance of powers. We’ll be following this global macro event as it plays out.

Matthew Hedrick
Analyst