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Economy, Politics Stoke Russia-Ukraine Gas Quarrel
Deliveries Halted To European Users As Feud Deepens

By Philip P. Pan
Washington Post Foreign Service
Thursday, January 8, 2009

MOSCOW, Jan. 7 -- Since the fall of the Soviet Union, Russia and Ukraine have wrangled over fuel prices, with both sides holding a powerful bargaining chip. Russia has had the natural gas Ukraine needs to power its industries. Ukraine has owned the pipelines Russia depends on to transport the gas it sells to Europe.

The two have often engaged in brinkmanship, threatening to cut off deliveries. But they have never followed through on the threats for very long -- until now.

A confluence of factors tied to the global economic crisis and political uncertainty in both countries have altered the dynamics of the annual dispute. For the first time, Russian gas deliveries to Europe through Ukraine came to a complete halt Wednesday, as the standoff between the two countries stretched into a seventh day.

Russia accused Ukraine of shutting down pipelines that deliver a fifth of the continent's fuel, while Ukraine charged that Russia had simply stopped sending gas. With more than a dozen countries scrambling to maintain heat and electricity amid a bitter cold snap, the European Union urged both countries to accept international monitors to verify gas flows.

Direct talks were scheduled to resume Thursday, but analysts said progress would be difficult for the same mix of economic and political reasons that led the two nations to dig in this week instead of compromising, as they had done in years past.

With its economy in deep trouble, Ukraine has little to lose by using its control of European fuel shipments to resist Russia's demand for a price increase. By contrast, Russia is suffering huge losses in immediate gas revenue and enormous damage to its reputation as an energy partner seeking European investment. Yet political considerations seem to have prevented the Kremlin from surrendering.

Russian Prime Minister Vladmir Putin is confronting the most severe economic crisis he has faced since taking power as president in 2000, with the ruble falling, a stock market that has crashed and unemployment soaring. After delivering growth for eight years, Putin remains popular but appears politically vulnerable, with social unrest on the rise and polls showing discontent with the government climbing.

In such an environment, it would be risky for him to back down in the standoff with Ukraine, said Lilia Shevtsova, a political scientist at the Carnegie Moscow Center and author of a study on Putin's leadership. At the same time, she said, a conflict with Ukraine gives him a chance to "distract" the public from the economic slowdown.

"If Putin decides to get soft with our neighbors and the West, it could be viewed in Russia and by his own gang as an expression of weakness," Shevtsova said. "Toughness is approved by Russian society."

The Kremlin's relations with Ukraine have been strained since the 2004 street demonstrations known as the Orange Revolution, which resulted in a pro-Western government in the former Soviet republic that is seeking membership in NATO and the European Union. Ties worsened last year after Ukrainian President Viktor Yushchenko vocally backed Georgia in its August war with Russia.

Putin later accused Ukraine of secretly supplying arms to Georgia before and soon after the fighting broke out. Some analysts say he is trying to using the fuel cutoff to damage Ukraine's reputation in the West and sink its NATO bid while undermining Yushchenko. Russian officials have singled out Yushchenko for criticism in the standoff, saying he refused to authorize Ukrainian negotiators to sign a deal on New Year's Eve.

"Russia is trying to browbeat us," said Ivan Lozowy, president of the Kiev-based Institute of Statehood and Democracy. "Polls show that Russians are more concerned about the loss of superpower status than poverty or economic issues. And for Russia to reestablish itself as a great power, Ukraine is critical."

Politics have also contributed to Ukraine's unwillingness to back down. Yushchenko's popularity has plunged over the past year, and analysts say he may be making a desperate attempt to rally the nation around him. He is also locked in a feud with his former Orange Revolution ally, Prime Minister Yulia Tymoshenko, who is expected to challenge him for the presidency next year. Each has accused the other of mishandling the gas dispute with Russia, and it is unclear who has the final word over negotiations.

"They're really in conflict, and it's difficult for Yushchenko to sign off on any deal because he is afraid Tymoshenko will attack it, and vice versa," said Yuri Vitrenko, a former senior official at Naftogaz, Ukraine's state energy firm. "Frankly, nobody has full control of the situation."

Yushchenko and Tymoshenko issued a joint statement outlining a common bargaining position when the talks first collapsed, but Tymoshenko has said little in public about the gas dispute since, a sign that differences may remain.

Tymoshenko, who took a more cautious position on the Georgian war and is less vocal about NATO membership, has tried to present herself as the candidate better able to negotiate with Russia. She signed a deal with Putin last year outlining a possible gas compromise, agreeing that Ukraine should pay more for fuel while Russia should pay more to use its pipelines.

But the most notable point in the agreement was a decision to eliminate the role of shadowy middleman company RosUkrEnergo in Ukraine's purchases of gas from Russia. Tymoshenko has described the firm -- a joint venture between Gazprom, the Russian gas monopoly, and two Ukrainian tycoons -- as a vehicle for corruption for Yushchenko.

The Ukrainian Energy Ministry, which reports to Tymoshenko, issued an unusual statement Wednesday suggesting that the standoff stemmed from an attempt to keep the intermediary firm in place, a view that a Gazprom spokesman then endorsed in an interview with the Interfax news agency.

Rory MacFarquhar, a Goldman Sachs managing director in Moscow, said the intermediary firm gave officials in Russia and Ukraine a "personal stake" in ensuring that talks succeeded. Without it, officials may be more reluctant to compromise, he said.

But Ukraine's economic troubles may be the key factor. Despite a $16.4 billion loan from the International Monetary Fund in November, the country appears on the verge of economic meltdown, with a currency slide increasing the risk of massive defaults on loans taken out in dollars.

The steel industry, which accounts for 40 percent of exports, has been hit especially hard, with production falling by half in November as world demand plummeted. A gas price hike would make matters worse because many of Ukraine's inefficient factories depend on cheap fuel from Russia to be competitive -- and the businessmen who own those factories wield great influence over government policy.

Russia has sold gas to Ukraine and other former Soviet republics at prices below what it charges the rest of Europe, a vestige from the Soviet era that Gazprom is trying to end. But Ukraine struggled to keep up with payments even at last year's lower prices, running up a debt of $1.5 billion and $600 million in disputed late fees as the economy tumbled in the autumn.

Ukraine also says it has enough gas in storage to last until early April, which means it can afford to be patient. Gas prices in Europe are generally set by a formula using the price of oil, but the recent collapse in oil prices will not be factored in until April. Once it is, Ukraine will have a stronger case against a sharp price increase.

Analysts said Ukraine risks a backlash in Europe if the standoff drags on, but Russia is in a more vulnerable position because it is losing revenue and also expected to face costly lawsuits. In the long term, Europe could turn against Russia as an energy partner and seek alternative supplies.

Those costs could outweigh the estimated $2 billion to $4 billion difference in the last negotiating positions disclosed by the two sides, given that Gazprom reported revenue of $70 billion in 2007.

"Everything about this dispute is negative for the Russians," said Jonathan Stern of the Oxford Institute for Energy Studies. "And if everyone blames the Russians, Ukraine has nothing to lose."

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