GAS CRISIS RESOLUTION LEAVES ROOM FOR FUTURE

C O N F I D E N T I A L SECTION 01 OF 05 MOSCOW 000153 SIPDIS DEPT FOR EUR/RUS, FOR EEB/ESC/IEC GALLOGLY AND WRIGHT EUR/CARC, SCA (GALLAGHER, SUMAR) DOE FOR HEGBURG, EKIMOFF DOC FOR JBROUGHER E.O. 12958: DECL: 01/23/2018 TAGS: EPET ENRG ECON PREL RS UP SUBJECT: GAS CRISIS RESOLUTION LEAVES ROOM FOR FUTURE PROBLEMS REF: A. MOSCOW 105 ¶B. 08 MOSCOW 2947 ¶C. 08 MOSCOW 722 Classified By: DCM Eric S. Rubin for Reasons 1.4 (b/d) ¶1. (C) Summary. Confirming press reports, Gazprom told us January 21 that supplies to Europe and Ukraine had been restored "in full." An EU representative told us January 22 that monitors have confirmed flows are "on track" and have reported no problems. As has been widely reported, the gas flows to Europe restarted following the signing of a new ten-year contract. The contract contains a number of key provisions relating to pricing for gas sales to Ukraine, transit fees, and resale, all of which, however, leave points open to interpretation or future negotiation; raising the very real prospect that we have not seen the last of these disputes. Russian media have generally painted the resolution of the crisis as a win for Russia. However, neutral observers and analysts believe that both sides have lost ground, pointing in Russia's case to the large short-term economic losses and to the longer-term reputational damage that may affect its energy relations with Europe. End summary. Gas flows resume following new contract -------------- ¶2. (SBU) Gazprom's Foreign Relations Director, Ivan Zolotov, told us on January 21 that gas shipments from Russia to Europe and to Ukraine were "being satisfied in full" at 423 million cubic meters (mmcm) per day. He said gas began flowing following an agreement between PMs Putin and Tymoshenko and the signing of a new contract for gas deliveries and transit between Gazprom and Ukrainian gas company Naftohaz. According to Zolotov, of the total amount, 78 was intended for Ukrainian consumption, but that Ukraine had already returned, with Gazprom's agreement, some 30 mmcm reducing total Ukrainian consumption to less than 50 mmcm. An EU contact told us on January 22 that as of January 21 EU monitors had confirmed that deliveries were on track to reach normal levels and that they had reported "no problems." Price -------------- ¶3. (SBU) Zolotov said the ten-year contract between the two gas companies stipulates that Ukraine will pay full "European" (market) prices for gas in 2010 and receive a 20% discount on those prices for 2009. He said the price would readjust every quarter, but was unable to provide a dollar figure for the price. Press reports and various investment house newsletters put the current figure, including the discount, at $360 per thousand cubic meters (mcm) for the first quarter of 2009, using a European price of $450 per mcm. Alfa Bank analysts told us they put the figure at slightly less, given the shorter transit to Ukraine. While this price is far higher than the $179.50 Ukraine paid in 2008, and higher than the $250 Gazprom reportedly offered in December, the price is expected to drop dramatically in the 2nd and 3rd quarters of 2009 as the European gas price is tied to oil prices with a six-month lag. With oil prices having hit a peak in the summer of 2008, gas prices are just now coming off their recent high of almost $600 per mcm. ¶4. (SBU) Alfa estimates that at a $40 barrel price for Brent crude, European gas prices would drop later in the year to $175 per mcm and average $273 for 2009. This would imply a price to Ukraine of just $132 per mcm later this year and an average 2009 price of $218. Gazprom Deputy CEO Alexander Medvedev reportedly told analysts on January 20 that Gazprom expects an average European price of $280 per mcm in 2009. Doug Busvine, Russia/CIS analyst for Medley Global Advisors, noted to us on January 21 that with Ukraine likely to use up as much stored gas as possible during the first quarter, thus limiting purchases from Russia when prices are high, the average price faced by Ukraine will be even lower than currently forecast. Furthermore, according to Busvine, Ukrainian demand for 2009 may be as little as 40 bcm, down from an estimated 55 bcm in 2008. Under the lower demand scenario, even at an average price of $240 per mcm, Gazprom's MOSCOW 00000153 002 OF 005 revenues from Ukraine could shrink by close to $300 million over last year's subsidized sales. ¶5. (C) In sum, Gazprom appears to have negotiated a discounted price for direct sales to Ukraine that currently is higher than its reported "best offer" during the December negotiations, and has successfully tied the price to the European market price. In addition, the Russians reportedly have succeeded in moving up the date for full conversion to market prices by a full year -- to 2010 rather than the 2011 envisaged by the previous agreement (ref B). The Russians are certainly arguing that, while they did not come anywhere close to their demand for $450 per mcm, they still came out ahead on the price issue. It should be noted, however, that press reports are already referencing a supposed Ukrainian desire to negotiate a discounted rate for 2010. Thus, while the price issue appears to be clearly dealt with in the contract, various parties still appear to have differing interpretations of the provisions. In addition, many independent analysts note that the issue of future Ukrainian arrears, made more likely by higher prices, could cause future disruptions. Transit -------------- ¶6. (SBU) Zolotov also confirmed that Russia would continue to pay the 2008 transit price of $1.70 per mcm per hundred km for transit of gas to Europe in 2009, but that this price would rise to European levels in 2010. He did not estimate what the 2010 price might be, but Gazprom's Medvedev reportedly told analysts the price would be $2.50 (press reports have indicated much higher prices). Zolotov was not sure (and there have been conflicting press reports) whether the agreement on transit prices is separate from the contract on gas sales to Ukraine or merely separate provisions within a single contract. ¶7. (C) The Russians are arguing that they also "won" this battle, as they will continue to pay a reduced rate this year and will be able to "negotiate" a transit rate for next year that, while based on "European levels," would still be subject to negotiation between the Russian and Ukrainian entities. However, a senior Russian official at Lukoil took a different tack with us, arguing that the transit fees will be so high as of 2010 (approaching $5 billion per annum) that they will make both Nord Stream and South Stream more commercially attractive for Gazprom, regardless of the projects' high costs. Elimination of RUE -------------- ¶8. (C) Perhaps most importantly, the contract also calls for the elimination of gas trade intermediary RUE (ref C). (Comment: RUE is a completely non-transparent company set up in 2006, reportedly at Putin's behest and with Yushchenko's acquiescence, that is believed to be owned 50% by Gazprom and 50% by Ukrainian businessmen. We and other analysts have presumed its role to be to facilitate corruption in the gas trade, on behalf of unknown beneficiaries on both sides of the border. End comment.) According to Zolotov, this provision is with immediate effect and, as of January 20, Gazprom is buying gas from Turkmenistan and selling it directly to Naftohaz. He praised this development, claiming (incredibly) that RUE was a corrupt Ukrainian creation in which Gazprom doesn't play a role. (Note: RUE's own website lists Zolotov's direct boss as a board member. End note.) ¶9. (C) Although Gazprom and the Russians are claiming victory on this point, most independent analysts here believe that Tymoshenko is the real beneficiary of RUE's demise. Moreover, while many analysts, including Smith and Busvine, have touted RUE's demise as a victory for the forces of transparency and good governance, it remains to be seen whether direct Naftohaz - Gazprom dealings will be more open and less corrupt than the prior arrangement. Technical Gas -------------- MOSCOW 00000153 003 OF 005 ¶10. (C) Zolotov was surprisingly unclear about how the new contract deals with the issue of technical gas (gas needed by Ukraine to pump volumes to other European customers) -- an issue at the heart of the recent dispute. He was not sure if the volumes being delivered to Ukraine include the 21 mmcm per day that Ukraine says it needs as technical gas. Alexander Medvedev has reportedly said that Ukraine will pay a discounted $153.90 per mcm for technical gas. Press and other expert commentary are also very mixed on this point, with much speculation about the amount of technical gas promised in the current contract (reportedly significantly more that Ukraine has used in the past and more than independent analysts believe is needed to run the pipeline system). Some analysts speculate that Ukraine will draw from stored gas (in Ukraine) that is owned by RUE to supply the technical gas in the near term, but we have not been able to confirm anything regarding the technical gas issue other than the price. ¶11. (C) Once again, the Russians claim victory on this point, arguing that the contract clearly places responsibility for supplying the needed technical gas with the transit state -- Ukraine. However, given that the contract includes delivery of the technical gas at a highly discounted rate and given the vagueness of the information available regarding the quantity of technical gas to be provided in the future, analysts are less sanguine, identifying this issue as yet another area of potential future discord. Resale -------------- ¶12. (C) Zolotov also noted that the contract is clear in prohibiting the resale of discounted gas (whether gas destined for the domestic Ukrainian market or "technical gas") by Ukraine to Europe. The opportunity for this profitable resale has been rumored as one possible source of illicit gain for Tymoshenko (via GOU-controlled Naftohaz.) Acknowledging this to be a possible cause of future disputes, Zolotov said Ukraine's return of 30 mcm on January 21 (that it could have presumably kept and resold),was due to the presence of EU monitors. Monitors -------------- ¶13. (C) The monitors, however, will likely soon be gone. The ten-year contract reportedly does not contain any provisions related to monitoring and an EU contact told us on January 20 that the Commission's position on monitors was that they would only stay as long as requested by the parties. The EU believes that there would likely no longer be such a request. Prime Minister Putin indicated immediately following the resolution of the crisis that "additional monitors would no longer be needed." This left many analysts wondering whether he was referring to new additional monitors (as had reportedly been suggested during the standoff) or the current monitors. However, Zolotov clarified that it means all monitors, who would likely be gone in "days, not weeks." As to why Gazprom wouldn't prefer to keep monitors for a while, Zolotov said that the company would "sort problems out directly with the Ukrainians" in the future. Reputational damage -------------- ¶14. (C) With the immediate crisis now apparently over, pundits have begun analyzing its impact. Although the largely state-controlled Russian media has largely depicted the result as a triumph, more neutral observers see both sides as having lost ground. With respect to Russia, these observers point to the damage the Russian economy has clearly suffered; at a time when the economy is already in the early stages of a potentially severe recession. The direct economic losses to Russia include well over $1 billion just in gas sales and, according to one estimate, an additional $500 million in revenue to the GOR budget. ¶15. (C) More importantly, cutting off gas to its best customers has severely tarnished Gazprom's reputation, earned MOSCOW 00000153 004 OF 005 over decades, as a reliable supplier of energy. This damage is likely to be even greater if, as appears increasingly likely, Russia and Gazprom are unable to substantiate their charges of Ukrainian gas theft in early January, the ostensible reason for shutting off the gas to Europe. ¶16. (C) According to local analysts, this reputational damage could hinder Russia's ability to maintain its current strong position in European energy markets. Alfa Bank Chief Strategist Ron Smith told us January 20 he believes that, due to the reputational hit alone, Gazprom is a net loser from this exchange. He argued that Russia may have succeeded in spurring the EU as a whole and individual consuming countries and entities to redouble their efforts on creating a single market, on conservation, on alternative fuels, and on alternative supplies and routes for gas. He noted that this damage comes as Gazprom's stock has already dropped by over 70% from its peak and as the company is dealing with the problem of significant non-payment from Russian domestic gas consumers. ¶17. (C) Busvine also told us that Russia and Gazprom have caused long-term damage to themselves with respect to their most cherished customers in Europe. He added, however, that despite stepped up efforts by the EU on alternative supplies and routes, Russia will likely maintain its market share of European natural gas imports for the time being. Alternative routes get a boost? -------------- ¶18. (C) Echoing our Lukoil contact, Zolotov maintained that the crisis had been a boost for Russian-backed alternative routes to Europe (Nord Stream and South Stream). However, other local observers are not convinced, noting that these routes do nothing to diversify the source of European gas away from Russia, which in the wake of the damage to Russia's reputation as a reliable supplier may very well emerge as an EU goal, albeit a longer-term goal. In that regard, these observers thought increased support for the Nabucco pipeline, a South Stream rival seeking to bring Central Asian gas directly to EU consumers, could result from the crisis. Yet as Uralsib Chief Strategist Chris Weafer noted, by the time these pipelines are built, Nabucco included, they will likely only carry enough gas to cover the future growth in European consumption and would still carry less gas than currently traverses Ukraine. Given that fact, he said the potential supply problems arising from Ukraine's role as the major transit route for Russian gas to Europe are not going away anytime soon. Future problems? -------------- ¶19. (C) As the analysts with whom we discussed the agreement made clear, its terms clearly leave room for future gas supply disputes and disruptions. As we noted earlier, there will always be the question of what happens if ("when" according to Smith) Ukraine falls behind on its payments. Given the reputational damage Gazprom has suffered, Smith expects that going forward Gazprom will avoid any future cutoff of gas to the EU, even if Ukraine falls behind in its payments as Smith expects it will. (N.B. Experts believed the same to be true in December 2008 -- and were proven wrong.) ¶20. (C) Both Zolotov and Ukrainian embassy Economic Counselor Oleg Gutsulyak told us that the contract calls for Ukraine to pre-pay for gas if it falls behind in payments. Neither saw the irony of such a clause and both suggested future disputes over payments would be dealt with through negotiations. Both, however, also suggested that future disputes are inevitable, with each claiming that the other side was responsible in this case and would be responsible for any future problems. Leaving open the possibility of a future crisis, Zolotov said: "We see the light at the end of the tunnel with Ukraine, but we're just not sure if it's sunlight or an on-coming locomotive." -------------- COMMENT MOSCOW 00000153 005 OF 005 -------------- ¶21. (C) Notwithstanding Russia's arguments that it prevailed in this "gas war" with Ukraine, we believe that Russia and Gazprom have suffered blows to their reputations as a result of this crisis (along with Ukraine). Moreover, given the political motivations that led to the dispute (ref A) and the deal that resolved it, and the many holes in the Putin-Tymoshenko agreement, we believe that a future dispute leading to a disruption in supplies to Europe is highly likely. In that regard, the key question seems to us to be whether the EU will be more proactive this time around in shielding itself from another crisis. RUBIN