The Bear flexes its muscle

Early on New Year's Day, Ukraine lost about thirty percent of its natural gas supply as Gazprom, the Russian state-controlled natural gas giant, shut off its supply of natural gas to Ukraine. There appear to be many different reasons for this decision; the official one being that Gazprom wants an almost five-fold increase in the price of natural gas being sold to Ukraine to bring prices in-line with Gazprom's other customers. Ukraine has refused to accept the price increase, claiming that it will harm the Ukrainian economy (although they were willing to accept a phased-in increase in price) and pointing to neighbouring countries that are not being subjected to the same level of increase. The dispute allegedly centers on a Soviet-era contract that allowed the Ukrainians to pay about $1.40 per 1,000 cubic feet of natural gas; Gazprom (and the Russian government) want to increase this to about $6.50 per 1,000 cubic feet, the rate charged by Gazprom to many of its other European customers.

The initial war-of-words and the subsequent shutting off of supply is more than a simple squabble between an energy supplier and one of its customers. On one level, the Russian government is no longer willing to continue subsidizing the sale of natural gas to Ukraine. The fact that there is a great deal of animosity between the two governments, coupled with upcoming Ukrainian parliamentary elections, is also adding fuel to the fire (the pro-western, pro-NATO Ukrainian government came to power late in 2004 after the "Orange revolution" peacefully ousted the previous pro-Russian government).

Whatever the real reasons for this dispute, it shows the vulnerability of countries with limited indigenous supplies of energy. Although Ukraine's natural gas production meets about one-quarter of its needs, the remainder must be purchased and imported from Russia and Turkmenistan. Ukraine's vulnerability to supply disruptions (deliberate or otherwise) is made all the greater by its reliance on Turkmen natural gas that must be shipped via pipeline through Russia. Whether Ukraine will be getting any Turkmen natural gas is also open to question, as Gazprom has apparently purchased all of Turkmenistan's production for the next three months.

This dispute has wider implications than simply being an issue of Ukraine's energy security. Almost all member states of the European Union rely to varying degrees on Russian natural gas, 80 percent of which flows through Ukraine. With the UK's North Sea natural gas production peaking in 2000, other countries that were once independent of Russian natural gas may soon be relying on it.

In response, the EU has called for an emergency meeting of its energy ministers on 4 January to discuss energy security and the need for stability in energy markets. However, with the EU's commitment to natural gas as an alternative to coal and nuclear power, it is unlikely that their reliance on Russian natural gas will end anytime soon. Quite simply, finding new suppliers of natural gas and building new supply chains (pipelines or liquefied natural gas facilities) will take years.

When it comes to natural gas, Russia holds all the cards: it has over one-quarter of the world's proved reserves of natural gas and meets almost twenty-two percent of the world's demand. By controlling its output of natural gas, Russia can become the world's swing producer of natural gas, just as Saudi Arabia is the world's swing producer of crude oil.

As importantly, Russia straddles both Europe and Asia, meaning that it can deal with the EU, China, and India, or it can play one off against another, demanding whatever price it wants. Russia will become a truly global player when it starts to ship LNG to North America. Natural gas will allow Russia to regain super-power status, something it lost with the fall of the Soviet Union; countries will have to listen to what Russia dictates, as the Ukraine is now learning.

2 January 2006