Editorial
The Misperception of the Russian-Ukrainian Gas Problem
By Dr. Gary K. Busch, 12/1/09
Jan 12, 2009 - 2:07:18 PM

The current faceoff between Russia and the Ukraine is deeply worrying and disruptive to the countries of Europe. They are, to a large degree, dependent on gas supplies from Russia for their heating and lighting. It is a serious matter.

However, the perception of the motives for this confrontation is askew. This is a ritual confrontation between Russia and the Ukraine and derives from corruption, and only marginally for a search for political ends. The control, ownership and operating procedures of the suppliers of Russian gas are only marginally less transparent than the murky world of the gas intermediaries in the Ukraine.

The Soviet gas industry was set up in the Ukraine in the 1930s; and the infrastructure was built from there. The Ukraine is still a central part of the gas pipeline network even as the focus of activity for new gas fields has moved to Western Siberia. At the end of the Cold War, the division of the Soviet Union along Republic borders made for an often unworkable allocation of physical assets. Nowhere was this more true than for gas. The consequence is that vital assets for Gazprom (the massive Russian state gas company) are located in Ukraine and thus no longer under its direct control.

Ukraine is a key transit centre for Russian natural gas exports to Europe. According to the Oil and Gas Journal, Ukraine has roughly 40 trillion cubic feet (Tcf) of natural gas reserves, from which roughly 0.68 Tcf was produced in 2005. In 2006, Ukraine produced 0.67 Tcf and consumed 3.1 Tcf of natural gas, making it the former Soviet Union's largest natural gas net importer (2.4 Tcf, or 78 percent of consumption). Ukraine is the sixth-largest consumer of gas in the world and consumes more gas than Poland, the Czech Republic, Hungary, and Slovakia combined. Since the early 1990s, Ukraine’s usage of natural gas as a share of its total energy consumption has increased by 10 percent to comprise over half of Ukraine’s energy usage.

Ukraine holds 1.1 Tcf of natural gas in storage, and in January 2006 Prime Minister Yekhanurov announced a plan to increase the capacity at Ukraine’s 13 existing storage facilities to 1.2 Tcf by 2009. The six major facilities, most of which are depleted gas fields, are located in the provinces of Lvov, Kiev, and Chernigov. Ukrainian storage is held by Naftogaz Ukrainy, RosUkrEnergo and Ukrgazenergo, with a few small contracts with other companies. Ukraine can withdraw gas at around 7.1 Bcf/d (200 mmcm/d).

Ukraine plays a significant role as an intermediary connecting Russia, the world's largest natural gas producer, with growing European markets. Under the Soviet Union the nations of Eastern Europe were supplied from the USSR through the mechanism of the COMECON and led to an almost total dependence on the USSR gas supply. Now many of these former Soviet satellites are part of the European Union (‘EU’) and look to the EU for a co-ordinated European response to the regular supply of energy.

Also, as gas exports from the Caspian to Europe and Russia grow, Ukraine serves as the largest market for this natural gas. UkrTranzGaz estimates that in 2006 approximately 4.5 Tcf (128.4 Bcm) of Russian natural gas transited Ukraine en route to Europe or to be consumed domestically. In 2007, Gazprom and Naftogaz Ukrainy agreed to transit roughly 4.1 Tcf (116.8 Bcm). According to Gazprom, sales to domestic consumers in Ukraine in 2006 totalled 2.1 Tcf (59 Bcm). The remainder, around 2.4 Tcf (69.4 Bcm), is sold to other consumers that are connected to Ukraine’s transit lines. Some of these countries are entirely dependent on this natural gas for their gas consumption.

Europe’s dependency on natural gas exports from Russia drew worldwide attention in January 2006 when a longstanding dispute over price and payment mechanisms in the in-kind agreements caused Gazprom to shut off gas supplies to Ukraine. Supplies to Europe were also affected. Eventually, Russia’s natural gas company agreed to sell its natural gas to RosUkrEnergo, a Zurich-based trading company, 50 percent-owned by Gazprom, at the market price of $6.51/mcf ($230 per thousand cubic meters). RosUkrEnergo also acted as an intermediary in the acquisition of supplies of natural gas from Kazakhstan and Turkmenistan

The current dispute is a mirror of the 2006 faceoff. Russia wants a higher price for gas from the Ukraine and the Ukraine wants lower prices and higher transit fees for gas that passes through the Ukraine. Importantly the Ukraine has a very large storage facility for natural gas and the Russians do not. That has mean that the Ukraine has storage space to divert and store gas destined for other European customers while the dispute goes on, which is why the Russians turned off the taps entirely.

However, the nub of the dispute is that no one really knows how much Russia is getting paid for its gas and no one really knows how much the Ukraine is paying for the gas or is charging Gazprom for transit fees. The entire business is cloaked behind layers of secrecy by both sides as the Russian oligarchs and the Ukrainian oligarchs plunder the common pot of money without restraint or accountability.

Gazprom has always been the cash cow of the Russian establishment. Massive amounts of cash are washed through Gazprom, some of which is declared and paid to the Russian Treasury. In the wake of Putin’s accession to the highest offices the control of Gazprom has been taken over by two factions of the siloviki (the oligarchs in epaulets); the former Chekists who have ascended to economic and political power in Russia. The first group is led by Igor Sechin, now Deputy Premier and also head of Rosneft (the oil company). He and his colleagues control much of what Gazprom is up to. The second is Putin himself, and the former Gazprom head, Dimitry Medvedev (now President). Right now the 50% of Gazprom formally owned by the Russian State is split between two public bodies controlled by different senior Kremlin insiders. These are the owners of the Gazprom share of the Swiss intermediary RosUkrEnergo which is charged with handling the oil and gas trade between the Russians and the Ukrainians. There is no transparency at all.

It is no different on the Ukrainian side. It wasn’t pure chance Yulia Tymoschenko made her fortune in gas trading in the 1990s or that Yanukovich represents some of the largest gas-users from heavy-industry in Eastern Ukraine. The prime mover has been Dmytro Vasylevich Firtash who has been shown to be the beneficial owner of a 45 percent stake in RosUkrEnergo, the company that imports Russian and Turkmen gas into Ukraine.   Firtash’s involvement in RosUkrEnergo was a closely-held secret until April 2006, and the revelation of his ownership has made him one of the most mysterious and controversial figures in the Ukrainian energy sector.

Firtash has been a central figure in the Ukrainian gas trade for a decade, previously serving as a principal of Itera and Eural Trans Gas.   Firtash and RosUkrEnergo were at the centre of the controversial January 2006 gas deal between Russia and Ukraine.   This deal gave RosUkrEnergo a monopoly over imports of Russian and Turkmen gas to Ukraine and nearly doubled gas prices in Ukraine.

Dmytro Vasylevich Firtash is one of the most mysterious and talked-about figures in the Ukrainian energy sector.   He was nearly unknown until April 2006, when the leak of a PricewaterhouseCoopers audit report revealed that Firtash is the co-owner of RosUkrEnergo, the controversial, multibillion-dollar company that holds a monopoly on importing Russian and Turkmen natural gas into Ukraine.   This revelation thrust Firtash into the public and media spotlight and puts him at the centre of the critical gas trading negotiations between Moscow and Kyiv.

Since his association with RosUkrEnergo became public, Dmytro Firtash has been dogged by rumours that he is linked to Semyon Mogilevich, a notorious organized crime figure who is wanted by the FBI and Interpol on charges including racketeering, money laundering and securities fraud.   This assertion was repeated by former Ukrainian Security Service (SBU) Chairman Oleksandr Turchynov, who reportedly was investigating the links between Firtash and Mogilevich when he was dismissed from his position in 2005.

According to reports by investigative journalists, Mogilevich may have been involved in the founding of Eural Trans Gas.   According to published reports, Mogilevich convinced Firtash to register Eural Trans Gas.   Notably, the company was registered in Hungary by Mogilevich’s lawyer, Zeev Gordon.   Turchynov has alleged that Mogilevich has used Eural Trans Gas and RosUkrEnergo to launder money. Firtash admits that he has met Mogilevich several times, but denies that they have ever had a business relationship.   However, Firtash admitted to the Wall Street Journal that Mogilevich’s wife was a shareholder in Highrock Holdings.   Otherwise, no definitive connections between Firtash and Mogilevich have been proven to date.

By 2004, Gazprom wanted a more direct stake in the gas transit trade.   It secured a new arrangement with Firtash in the form of RosUkrEnergo, which began operating in 2005.   The trader’s role expanded significantly in the resolution to the January gas crisis between Russia and Ukraine; under the 4 January 2006 deal that resolved the crisis, RosUkrEnergo was given a monopoly on supplies of Russian and Central Asian gas to Ukraine, and the price for this gas nearly doubled.  The deal received harsh criticism, particularly from Yulia Tymoshenko and her supporters, and was a major centrepiece in the conflict between Tymoshenko and the Yushchenko government in the 2006 Verkhovna Rada elections.

Firtash, who controls a 45 percent stake in RosUkrEnergo, shares ownership with Gazprom, which controls 50 percent, and a Ukrainian banker, Ivan Fursin, who controls the remaining five percent stake.   Fursin and Firtash own their shares beneficially through Centragas Holding AG, a trust with Austria’s Raiffeisen Bank.   Centragas was reportedly under investigation by the US Department of Justice when it became known that Fursin and Firtash were beneficial owners.

Naftohaz Ukrainy, as the state gas company of Ukraine, is also involved in the trading of gas to and through the Ukraine. Gazprom, as a supplier of gas, has a commercial interest in this market too. The question is “What is the commercial rationale for involving RosUkrEnergo, a company with no track record in the gas industry? What service does RosUkrEnergo provide to the gas trade that cannot be provided by Naftohaz Ukrainy?”

RosUkrEnergo made profits of over US$700 million in 2005. Meanwhile, Naftohaz Ukrainy has accrued debts of over US$500 million, mostly to RosUkrEnergo. What can possibly be the commercial reason for Naftohaz to be so indebted to this private company, or for Ukraine to cede half of its domestic market to RosUkrEnergo via the new joint venture UkrGazEnergo?  

Perhaps one reason is that, according to a RosUkrEnergo internal document dated July 2004, Ihor Voronin, the current deputy chairman of Naftohaz Ukrainy, was nominated a member of RosUkrEnergo’s co-ordinating committee – an important body in charge of the company’s strategy. So was Mr Yuri Boiko, then the chairman of Naftohaz Ukrainy. This document explicitly states that Mr Voronin and Mr Boiko were “nominated by Centragas” onto the RosUkrEnergo co-ordinating committee. In effect, these two men were on the committee of a private company at the behest of private investors (Firtash and Fursin), while serving as senior officials of a Ukrainian government company whose demand for gas was a major source of RosUkrEnergo’s profits .

The relationship between Russia and the Ukraine is not an arm’s length relationship. The oligarchs behind Gazprom realised that it could not get any money out of official deliveries to Ukraine. It "solved" that problem by privatising a portion of the gas trade to Ukraine - the portion going to customers able to pay for their gas. These customers used to pay the central Ukrainian gas company, Naftohaz Ukrainy, which did not pass on that money to Gazprom; what was put in place was a mechanism whereby these customers would pay less for their gas, but would pay directly another supplier, formally unrelated to either Ukrainian gas authorities or Gazprom.

Of course, only gas coming from Russia could be delivered, and it still needed to use Ukraine's gas infrastructure, so the active cooperation of Gazprom and the Russian and Ukrainian siloviki was required to put that trade in place. In that type of system the real money generated did not need to go either to Kiev or to Moscow but could go to Switzerland. This is immensely profitable to both the Russian and Ukrainian siloviki.

Now, such an amazingly profitable business has attracted potential new partners, keen to get in on the action. In the Ukraine the political infighting mirrors the fight for access to this gas bounty. The political conflict between Tymoschenko, Yanukovych and Yuschenko mirrors the search for acceptance as the Ukrainian partner. This, too is mirrored in the steel pipe trade

So although this conflict is steeped in the political rhetoric about NATO recognition, independence of the Ukraine and European unity the actual battle is over which thief gets the biggest portion of the profit from the trade. It is inevitable that a compromise will be reached, perhaps with monitors, assuring Russian supplies transit the Ukraine properly. What will not be settled is exactly what the Ukraine is paying for gas, how much the Russians are getting for their gas or how much they are paying for transit. These are state secrets and only Firtash, Putin and Sechin really know for sure.

In the pre-Christmas season in England it is a tradition to put on pantomime productions, with ‘baddies’ whom one hisses and shouts at and  ‘goodies’ whom the audience warns For those who don’t want to go out to hear shrieking children they can always study the Russian-Ukrainian gas delivery battle. It’s just as realistic.

Note:

This article contains material previously published by Jérôme Guillet at the European Tribune (http://www.eurotrib.com/story/2009/1/3/786/89128) and The Oil Drum (http://europe.theoildrum.com/node/4929). Dr Guillet is not responsible for any other parts of the article, or any errors contained therein