Russia Makes Moves for Ukraine’s Naftogaz

2010/10/16

an Stratfor annalissys

Russia and Ukraine are expected to discuss several issues and possibly sign some major agreements at a bilateral economic forum Oct. 3-4. Russia’s influence in Ukraine has increased since Ukrainian President Viktor Yanukovich took office, but Moscow has not yet been able to gain a larger stake in Naftogaz, Ukraine’s state energy firm and the most strategic company in the country. A court ruling requiring Naftogaz to pay for natural gas siphoned off from another company in 2009 could change that, however.

Analysis

Russian and Ukrainian officials are set to meet Oct. 3-4 at a bilateral economic forum in southern Russia to discuss a number of issues and possibly sign some major deals, ranging from energy to security matters. Since Ukrainian President Viktor Yanukovich came into office in early 2010, Russia has increased its influence significantly in Ukraine’s economic, military and security spheres. The one area that has proved elusive to Moscow is gaining a greater stake in Ukraine’s most strategic company, state energy firm Naftogaz — but that could soon change.

Russia considers Ukraine the most strategic state in its former Soviet periphery, in no small part because 80 percent of the energy supplies Russia sends to Europe traverse Ukrainian territory. This makes it critical for Moscow that Ukraine have a pro-Russian government that does not jeopardize the interests of the Kremlin, which uses its energy exports as both a political and an economic tool in its relations with Europe. Ukraine’s previous administration — that of the pro-Western Viktor Yushchenko — did not protect the Kremlin’s interests, and the result was frequent energy cutoffs that not only soured relations between Russia and Ukraine but also left the Europeans out in the cold numerous times.

With Yanukovich in office, energy ties (and relations in general) between Ukraine and Russia have improved dramatically. There have been no cutoffs between the two in 2010, and indeed, Ukraine served as an alternative transit route when Russia temporarily cut off natural gas to Ukraine’s northern neighbor, Belarus. In addition, a landmark deal was signed in April that saw Russia lower the price of natural gas it charges to Ukraine by $100 per thousand cubic meters (tcm) to $250 per tcm in exchange for extending the lease of Russia’s Black Sea Fleet in Crimea by 25 years.

But Moscow wanted to take this a step further. Shortly after the deal was announced, Russia proposed a merger between Russian natural gas giant Gazprom and Naftogaz. Due to Gazprom’s size in terms of assets and political heft, Gazprom essentially would swallow and gain control over Naftogaz under such a deal. The Ukrainian government, therefore, has been extremely reluctant to accept this proposal, as Naftogaz and the pipeline transit system it operates are essentially the country’s most valuable assets. As recently as early September, Ukrainian officials like Prime Minister Nikolai Azarov and Energy Minister Yuri Boiko said any agreement regarding Naftogaz should be made on a “parity basis” and should strictly abide by “national interests,” adding that a merger did not conform to these interests.

Instead, Ukraine has been advocating a natural gas consortium that would involve the Europeans along with the Russians and would include Ukraine as a member of equal importance and authority. Recently, Ukraine also signed on (pending parliamentary approval) to join the European Energy Community, which is meant to ensure transparent fuel price setting, encourage investment in the industry and include Ukraine in the European market. The signing of the agreement doesn’t mean much in practical terms, but at least on the surface it makes Ukraine appear to be leaning toward cooperation with the Europeans and away from ceding complete control to Russia. An additional problem for Russia is that Ukrainian legislation does not allow Naftogaz to participate in any joint venture that includes the sale of assets.

But Russia has not backed off its merger proposal, with Gazprom CEO Alexei Miller saying that without such a deal, “it is not advisable for the Russian company to modernize the Ukrainian gas transit system.” And while modernizing Ukraine’s pipeline system — which is made up of decaying Soviet-era infrastructure — has long been mentioned, the matter has taken on a new sense of urgency, as Naftogaz is currently in serious financial trouble. Over the summer, a Ukrainian court — on orders of the International Arbitration Tribunal in Stockholm — ruled that Naftogaz must return 11 billion cubic meters (bcm) of natural gas it siphoned off from RosUkrEnergo (RUE), a joint venture between pro-Russian Ukrainian oligarch Dmitry Firtash and Gazprom, during the natural gas cutoffs in January 2009. The 11 bcm of natural gas is equivalent to roughly $3 billion, an amount that Naftogaz simply does not have. Paying the fee would bankrupt the company. Also, the Ukrainian government cannot borrow money to pay the sum, since it is currently on an International Monetary Fund loan program and must bring its budget deficit down in order to maintain this lifeline. The government and Naftogaz have already raised gas prices domestically by 50 percent, and the government cannot repeat such a move without taking a huge hit in popularity and domestic backlash. In short, Ukraine is in a bind.

But according to STRATFOR sources in Moscow, Naftogaz chief Yevgen Bakulin is extremely close to Firtash and Boiko, and the three are planning some creative ways to get out of this financial predicament. They have come up with a scheme to sell the most lucrative portions of the Ukrainian gas market — the distribution networks — to RUE. While the ban on foreign companies running and developing the Ukrainian gas transport system still exists, shareholders of Gazprom and Naftogaz are now saying that a process has been initiated in which this ban could soon be lifted. There has been a massive surge in lobbying from Russia on the issue, with a leading Gazprom official saying that jointly managing the pipeline system would allow Gazprom to have “better insight on which sections of the pipeline need to be modernized,” a barely veiled reference to the economic incentive for Naftogaz to lift the ban and partner with Gazprom.

This scheme is being planned and executed very carefully, given that it is such a highly controversial issue in Ukraine, but it is expected to pick up momentum after Ukraine’s regional elections on Oct. 31, when the government is no longer consumed by internal politics. Until then, Bakulin, Firtash and Boiko are blaming the tough situation on the old cadre who was in charge of handling the issue before Yanukovich came into office — which includes former Prime Minister Yulia Timoshenko and Igor Didenko, the former chairman of Naftogaz who has been in custody over the payment owed to RUE. In the meantime, Russia will continue working behind the scenes to make sure it gets greater control of Ukraine’s energy infrastructure and decision-making process. And after the election, Russia and Ukraine could make some very significant moves in the energy sphere.

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