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The Economist: A bear at the throat

The Economist - Russian Bear

European energy security

The European Union is belatedly grasping the riskiness of its dependence on Russian gas, but it is disunited and short of ideas for how to reduce it

By Kevin Kallaugher

RUSSIA’S president, Vladimir Putin, must be feeling smug. His strategy of using the country’s vast natural resources to restore the greatness lost after the break-up of the Soviet Union seems to be paying off. If power is measured by the fear instilled in others—as many Russians believe—he is certainly winning.

The Soviet Union relied on its military machine for geopolitical power: its oil and gas were just a way to pay for it. In today’s Russia, energy is itself the tool of influence. To use it the Kremlin needs three things: control over Russian energy reserves and production, control over the pipelines snaking across its territory and that of its neighbours, and long-term contracts with European customers that are hard to break. All three are in place. For all the talk of a common strategy towards Russia, the EU is divided and stuck for an answer.

Gazprom, Russia’s energy giant, cherished by Mr Putin as a “powerful lever of economic and political influence in the world”, has long-term supply contracts with most European countries, including France, Germany, Italy and Austria. It also has direct access to these countries’ domestic markets. The EU reckons that half its gas imports now come from Russia. Newer EU members, such as Hungary and the Czech Republic, are almost entirely dependent on Russian gas. Moreover, a pipeline network that it inherited from the Soviet Union gives Russia control over gas imported from Central Asia.

The EU has few ideas for how to deal with its chief energy supplier. “We know we should do something about Russia, but we don’t know what,” one Brussels official says. “In the EU we negotiate on the rules, whereas Russia wants to do deals.” The deals are coming thick and fast. Last month, Russia secured one to build an oil pipeline from Bulgaria to Greece that will bypass the Bosporus. Symbolically, it will be the first Russian-controlled pipeline on EU territory. The pipeline will carry Russian and Central Asian oil straight to the EU, avoiding Turkey.

Oil can at least be bought from elsewhere. The bigger worry is about the EU’s dependence on Russian gas. The flow of natural gas depends on the routes and control of pipelines, as European consumers were reminded when Russia switched off the gas supply to Ukraine just over a year ago and Ukraine started to steal Russian gas that was destined for the EU. Russia’s pipeline routes encircle the EU from the north and south.

Russia and Germany have teamed up to build a gas pipeline under the Baltic Sea, bypassing Ukraine and Poland (see map). Gerhard Schröder, a former German chancellor signed up by Mr Putin to preside over this Nord Stream pipeline, claims that it will make Europe safer. But a study by Sweden’s Defence Research Agency concludes that it will divide the EU and increase dependence on Russia. It will let the Kremlin turn off gas supplies to Ukraine, Poland and Belarus without affecting “more important” customers. Understandably, Poland is anxious. The pipeline will increase the flow of gas to Germany and hook in countries that do not yet consume much Russian gas, including the Netherlands and Britain.

In the south, Russia has a pipeline across the Black Sea which supplies gas to Turkey. Now Russia wants to extend this Blue Stream pipeline to Hungary. That would compete directly with Europe’s own plan to build a pipeline called Nabucco from Turkey to Austria. Nabucco has been one of the EU’s few concerted responses to Russian domination of its gas supplies: it would be filled up with gas from Central Asia and thus bypass Russia altogether. But it is now creating more friction than unity.

Hungarian rhapsody

Last month Hungary’s prime minister, Ferenc Gyurcsany, called Nabucco a “long dream”. Instead, he suggested that Hungary would support the extension of Blue Stream. Gazprom already supplies 80% of Hungary’s gas and has promised to build a large gas-storage facility that could be a hub for central Europe. “Blue Stream”, enthused Mr Gyurcsany, “is backed by a very strong will and a very strong organisational power.” (When Hungary was accused of undermining the EU’s common energy policy, the tart response was that it was impossible to undermine something that did not exist.)

As well as controlling pipelines, Gazprom has also been busy buying up pieces of Europe’s gas infrastructure. It owns 35% of Wingas, a German distribution company, and also has stakes in the Baltic countries’ distributors. It has 10% of the interconnector pipeline between Belgium and Britain and wants a similar share of a British-Dutch link. It is also muscling its way into electricity, oil and liquefied natural gas (LNG) projects. “It is not enough for us to meet 25% of global gas consumption. We want to be the biggest energy company in the world,” Alexander Medvedev, Gazprom’s deputy head, has said of his company’s modest ambition.

Most European governments have been careful not to alienate Russia. As long as Gazprom plays by the rules, they say, it should be allowed to invest in their markets. Belgium recently said it had no problems with Gazprom owning parts of its infrastructure. Russia, in contrast, has a big problem with foreign companies owning, let alone controlling, any of its natural resources. It has bullied Royal Dutch Shell into ceding control of the Sakhalin-2 project in the far east of the country; it has blocked BP’s plan to develop a gas field in eastern Siberia; and it has kept foreign companies out of the development of the giant Shtokman field in the Barents Sea, saying that it will go it alone.

In the same spirit, the Kremlin has flatly ruled out ratifying the EU’s energy-charter treaty, which would require it to open up its gas pipelines to other countries and other suppliers. The Russians have made a mockery of a joint declaration on energy issued at the G8 summit they chaired in St Petersburg last July. The declaration called for more honesty, competition and transparency. Yet just two days later, Mr Putin enshrined into law Gazprom’s monopoly position as the sole exporter of gas.

Then there is the talk of creating a gas equivalent to the OPEC oil-exporters’ cartel. On April 9th Russia joined other gas producers in Qatar to discuss the possibility, and offered to lead a study into gas pricing. The next meeting of the group will be in Moscow. With almost 60% of the world’s gas concentrated in just three countries —Russia, Iran and Qatar—the notion of a cartel sounds appealing. But fixing prices for a commodity that is not traded on world markets will prove much harder than it has been for oil. Even so, as Mr Putin said earlier this year, “it would be a good idea to co-ordinate our activities.”

Gazprom has already signed a memorandum of understanding with Algeria’s Sonatrach to co-operate in gas production. This has unnerved European consumers, as Algeria is their third-largest supplier of gas, after Russia and Norway. America, too, is nervous. “Russia’s commercial and political shadow over the governments in central Europe makes it harder for us to deal with our allies,” says a senior State Department official.

The EU’s dependence on Russian energy is hardly new. Nor is tension between Russia and America. “The Americans were constantly telling us we were too dependent on Russian gas in the 1970s and 1980s,” says Sir Rodric Braithwaite, a former British ambassador to Moscow. Yet, throughout the cold war, Russia remained a reliable gas supplier. Why should things be different now?

First, says, Cliff Kupchan, director of the Russian programme at Eurasia Group, a consultancy in Washington, DC, the Soviet Union was politically more predictable than its successor. “It was run by geriatrics, but we knew that one geriatric would succeed another.” Russia’s political stability is ephemeral. It relies on Mr Putin’s will, not on an institutional transfer of power. With nationalism on the rise, it is anybody’s guess who will be in charge of Russia in ten years’ time.

A second difference is that the energy relationship between the Soviet Union and the West stopped at the border—albeit the border of the Soviet block. The oil and gas ministry, Gazprom’s predecessor, did not try to take over any of western Europe’s infrastructure. Gazprom has no scruples about using its muscle to buy such assets. Gazprom’s desire to control their pipelines has been central to Russia’s recent clashes with Ukraine and Belarus.

Third, the Soviet energy business was run by technocrats who implemented centrally planned decisions. Today, it is controlled by former KGB men obsessed with money and power. Gazprom has several ex-KGB members on its board of directors. Rosneft, the state-controlled oil champion, is chaired by a former agent who is now deputy chief of the Kremlin staff. “People in Europe have a natural apprehension about their homes being heated by these people,” says one commentator on Russia.

Yet dependence cuts both ways. Europe may depend on Russia for half its gas imports, but Russia is dependent on Europe for the bulk of its export revenues. Repeated threats by the Kremlin to divert the flow of gas to China mean little without pipelines that it would take many years to build. Switching off gas to Europe will never make commercial sense for Gazprom. The fear in some EU countries is that commercial interests may one day become secondary to political ones. Of 55 cut-offs, explicit threats or coercive price actions by Russia since 1991, only 11 had no political underpinnings, according to the Swedish defence study.

Running on empty

If all this is not worrying enough, there is another, more immediate source of concern for the EU: that Russia may be physically unable to produce enough gas to satisfy demand. Even worse than being dependent on a company like Gazprom may be to be dependent on a Gazprom that is short of gas.

The output of Gazprom’s three super-giant fields, which account for three-quarters of its production, is declining at a rate of some 6-7% a year. Output from a new gas field brought on stream in 2001 has already peaked. Last year, Gazprom decided to develop a massive field in the Yamal peninsula—frozen and barren Arctic land—but that will take years. Meanwhile, Russia’s domestic demand for gas is growing by more than 2% a year. For all its swagger, Russia is short of gas, a problem that is already affecting its electricity-generation capacity. This does not reflect any lack of reserves—Russia has the world’s biggest—but rather a longstanding failure to invest enough in their development.

Gazprom has argued that it will invest in new fields only if it can pre-sell the output to Europe. Instead it has been spending lavishly on pipelines and downstream assets. This has a certain monopolistic logic. Raking in the middleman’s profits from exports is easier and more lucrative than investing billions in developing new fields for a domestic market which, although it consumes two-thirds of Gazprom’s production, generates hardly any profits, as regulated Russian gas prices are much lower than most European ones.

Meanwhile, Gazprom relies on Central Asia, especially Turkmenistan, to plug the gap in gas supplies, which makes many investors and consumers nervous. A study by UBS, a bank, concludes that Turkmenistan may have signed contracts to supply twice as much gas after 2009 as it can actually produce. The nervousness over potential shortages of gas, though, plays in Gazprom’s favour: as with talk of a gas OPEC, it prods the Europeans into striking special deals with Gazprom.

Gazprom’s position is reliant on support from Europe’s national energy champions such as Gaz de France, ENI of Italy and Ruhrgas of Germany. Companies such as Ruhrgas and Gazprom have each other’s interests at heart. Indeed, Ruhrgas owns about 7% of Gazprom, worth some $17 billion, and has a seat on Gazprom’s board. ENI and Enel of Italy this month acted directly for Gazprom when they bought the expropriated gas assets of the bankrupt Yukos company in a controversial auction. Under a pre-arranged deal, the two Italian companies agreed to cede control of these assets to Gazprom, which was too cautious to bid in its own name. In return ENI and Enel were given a foothold in Russia’s gas fields and possibly a seat on the board of Gazprom’s oil company. Gazprom also has long-term gas contracts with ENI, which gives it direct access to Italian consumers.

Gazprom has similar arrangements in Germany and France. Vladimir Milov, the head of the Institute of Energy Policy in Moscow, says that the links between Gazprom and its European counterparts amount to a cartel between wholesale buyers and sellers. The losers in this game are European consumers who are forced to pay gas prices that are several times higher than the wholesale price which their national companies pay to Gazprom.

Trying to persuade Russia to break up Gazprom’s monopoly is a futile task. The best way to increase the EU’s energy security would be for it to liberalise its own market and unbundle its national utilities. This would cut profit margins in gas distribution, and thereby reduce Gazprom’s appetite for European domestic assets. It would encourage European network operators to invest in interconnectors between electricity grids and pipeline networks, weakening Russia’s ability to play off one customer against another. No wonder Gazprom does not warm to the idea of European energy liberalisation, which it has called “the most absurd idea in the history of the world economy”.

Break it up

The European Commission has been urging EU members to break up their vertically integrated energy companies, but France and Germany are resisting. The problem, says the commission, is that national governments do not understand the link between liberalisation and greater energy security. “New member states equate security with nationalism. But the only alternative to integration is isolation,” says one senior EU official.

At the most recent EU summit in Brussels, heads of governments pledged to separate their energy supply and production activities from transport networks, which will be managed independently. This falls short of an ownership break-up but it should increase competition. EU leaders accepted the need to link their energy networks, allowing more cross-border trade and thus both boosting competition and reducing Gazprom’s power. Europe is also talking of building more LNG terminals that can be stocked by other suppliers.

The EU’s imports of LNG will certainly rise in coming years. The International Energy Agency (IEA) estimates that European imports of gas from Africa and the Middle East, mainly in the form of LNG, will quadruple by 2030. But LNG is expensive, and generally involves inflexible long-term sales contracts. Moreover, the IEA’s projections assume that the Europeans overcome their squeamishness about building ugly LNG terminals. Equally improbably, they assume that Russia will not find some way to impede the emergence of rival exporters.

Getting direct access to Central Asian and Caspian gas is vital to European energy security. The Russians are well aware of this, as are the Americans, who have been active in the region and brokered the deal to build the twin oil and gas pipelines that now run from Azerbaijan to Turkey via Georgia. The Americans would like this gas to be carried on from Turkey to central Europe via the Nabucco pipeline, rather than the extension of Blue Stream.

But Azerbaijan’s resources are not enough to make a material difference to European energy security. The big strategic battle now will be over gas-rich Central Asia. The Americans have revived their old plans to build a trans-Caspian pipeline and are actively courting the region’s politicians, however dictatorial and disreputable. A change of government in Turkmenistan has given these efforts new impetus. But transporting Central Asian gas to the EU without Russian involvement will be testing. Apart from the unpalatable option of building a pipeline through Iran, the only way to get Turkmen gas to Europe would be across the bottom of the Caspian Sea. But a long unresolved dispute over the ownership of the Caspian between Iran, Kazakhstan, Azerbaijan and Russia makes this option explosive.

Russia has been jealously guarding its control over the Central Asian markets. It has more than doubled the price it pays for Turkmen gas and now claims to have a deal to buy all the gas the country can produce for the next 25 years. Last week Sergei Lavrov, Russia’s foreign minister, went to Turkmenistan to promote “close co-operation”, which means rejecting any American overtures. Russia cannot afford to lose control over gas exports from Central Asia because that would severely undermine its power over Europe.

The Kremlin’s determination to keep a grip on their gas supplies should be an obvious worry for Europeans. But it could carry dangers for Russia too. If the EU ever manages to find an alternative to Russian energy, in the form of more LNG, Iranian gas, renewable energy or a pipeline under the Caspian, Russia would lose control of its key market. Even if it does not, the Russian economy will become ever more dependent on natural resources.

As Mr Putin contemplates a gas OPEC, he should remember that although the 1973 OPEC oil shock extended the life of the Soviet regime, it also left a Russian economy trailing behind its Western peers. “Basing national power and prosperity on an inadequate monoculture is as risky as basing them on rockets in the cold war,” argues Sir Rodric Braithwaite. Still, Russia’s ability to cause harm to itself and to others in the cause of proving its greatness should never be underestimated.

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