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Andrei V. Belyi – March 19th 2014
Senior Researcher at the University of Tartu, Estonia
Visiting Honorary Lecturer at the Centre for Energy, Mineral Law and Policy of the University of Dundee, UK
Member of Brussels Energy Club
Current developments surrounding Russia-Ukraine relations once again spur attention. A crisis of international governance spreads into the political sphere and puts under peril the peace between the two countries. In addition, there is an unprecedented tension between Russia and the West, with their mutual accusations of double standards and Russia’s explicit revision of international norms. The political rhetoric from Brussels, Moscow and Washington increasingly resembles that of the Cold War.
Many ask if there are serious implications in security of energy supply, as well as in investment and trade, either among causes or consequences of current events. The fact is that Russia remains the world’s biggest oil and gas supplier, and Ukraine remains one of the most important transit states. Markets tend to become more vulnerable in times of new political unpredictability. However, the current situation also demonstrates a deep vulnerability of states in the face of markets.
Background
Unlike the so-called transit conflicts of 2006 and 2009, when issues of gas supplies were in focus, the current Russia-Ukraine conflict witnesses a more general collapse of political relations. The Maidan revolt of February 2014 in Ukraine did lead to a change of government and, most importantly, in the previously pro-Russian political orientation of the state. An unexpected refusal of the previous government to conclude an Association Agreement with the EU was one of the main motives for the revolt, along with rising corruption and poverty in the country. As a result, a new provisional government is now in place in order to organize elections to be held in May 2014. However, the ousted President of Ukraine, Mr Yanukovich, refused to resign and instead appealed to re-establish “order” in the country. Backed by Russia, which has offered him refuge, the ousted president remains supported as the legitimate leader of Ukraine by some regional governors, including the one in Crimea.
Geopolitically, Russia is concerned that the new political regime in Ukraine might integrate the country into NATO and/or reconsider the Black Sea Fleet leasing agreement. Just for reference, the Russian Black Sea Fleet has been located in Sevastopol, Crimea, which appeared to be on Ukrainian territory since its independence. Russia immediately used the deepening crisis between the new Ukrainian government and some of its regions to its advantage. The culmination of tensions between Kiev and some regions is a coup in Crimea, which ended in a seizure of power by some Russian speaking nationalist groups. Subsequently, Crimea requested independence from Ukraine and conducted a controversial referendum on independence. In turn, Russia backed both Yanukovich and the new Crimean leadership, while ignoring the new provisional government in Kiev. As a result, on 18 March 2014, following the results of the Crimean “referendum”, Russia decided to incorporate Crimea and Sevastopol into the Federation[1].
The Russian political establishment perceives the actions in Ukraine as part of a general defense of geopolitical positions[2]. Indeed, an expansion of European markets and norms is viewed in a rather negative light by the Kremlin. For the new Ukrainian authorities, the events reflect a general weakness of the state, which is unable to control its own territory and therefore appealed to the West for political support. Furthermore, the dependence on Russian energy supplies comes back once again to the policy agenda.
While analysing various statements from the EU, its Member States and the U.S., we can also see that there are increasingly ambivalent positions. On the one hand, western states and investors would like to not endanger their relations with Russia and lose large amounts of investments and profits. On the other hand, their support towards the Ukrainian government is coupled with an indignation about the violation of one of the core principles in international relations, which is the territorial sovereignty of states.
Russia and the U.S. conducted a number of meetings in order to find a solution. No compromise was found and instead, the U.S. announced it was ready to impose sanctions against Russia. In turn, the Russian Parliament voted on a motion stating that in case of sanctions, Russia might freeze the assets of international businesses operating in the country. Quite interestingly, both Russia and the West avoided using the energy factor in their mutual sanctions. For Russia, cutting supplies would mean significant financial losses, whereas for the West, particularly in the EU, it seems practically impossible to replace Russia’s 10 billion barrels a year of oil supply and to reduce the significant dependency on Russian gas. Hence, energy seems to be set apart from the current crisis. Nevertheless, implications for energy are still quite important. In this context, a number of questions emerge about energy supply and energy investment risks related to the current crisis. Although the situation is increasingly less predictable, it demonstrates a very strong interdependence between Russia and the West in both energy and finance.
Three groups of energy implications need to be analysed: transit-supply flows, investments and effects of sanctions.
Transit-supply gas flows
Since the Ukrainian crisis started, the country faces serious issues with its fiscal solvability. This actually means that the country might face difficulties in repaying their debts, particularly in regard to gas purchases. Considering the inflexible position of Russia towards the provisional government in Kiev, new supply risks are certainly possible. Moreover, Gazprom’s CEO clearly stipulated that “we are now facing a similar context to the one of January 2009”. In practice, this would mean that both Gazprom and the Kremlin would use the gas price issue in order to demonstrate Ukraine’s vulnerability. Moreover, failure of the Maidan revolt would then be a signal for any political opposition in Russia that overthrowing a regime would only worsen a situation. Nevertheless, aside from abandoning a price discount, Russia has avoided using gas supply pressure on Ukraine.
Moreover, growing political instability in Ukraine puts the proper functioning of pipelines and underground storages under threat. Therefore, Kiev has increased its military control over infrastructure[3]. It is interesting to note that in spite of tensions with Moscow, Ukraine has not attempted to use its transit position as leverage.
Significantly, the European Commission stipulated a desire to freeze the development of the South Stream pipeline project. In practice, this means that Gazprom might lose a chance to completely bypass Ukraine with an additional 63 bcm per year of gas volumes. If the South Stream project is abandoned, Russia’s dependence on Ukrainian transit will remain. Hence, Russia still needs to negotiate with Ukraine, even if it does not recognize its government. With an annexation of Crimea, Russia will face a need to ensure not only transit to Europe, but also to the disputed peninsula. Although politically weak, Ukraine remains Europe’s largest underground storage holder and underground storages are necessary to mitigate fluctuations in the gas demand [4].
Paradoxically enough, Gazprom attempts to assure western partners of its own reliability by proposing price discounts for European companies [5]. Hence, gas price remains an important source of soft power, attempting to counterbalance the hard political considerations of border changes.
In the longer term, Gazprom, as well as any other gas supply company, will find it difficult to argue that Russia is a reliable energy supplier. Although the current crisis has not yet affected any supply-transit flows, a general perception of risk has increased. The U.S. has already promised to supply LNG to some European terminals, in particular to the planned terminal in Klaipeda (Lithuania), to ensure Baltic energy independence.
Risks for investments in Russia
Obviously, the issue of western sanctions and Russia’s retaliation to them represents bad news for a number of British, French, German, Italian and Finnish energy companies that operate in Russia. Therefore, European states have not been keen to apply hardline sanctions on Russia. Instead, their positions have been rather hesitant, balancing between avoiding hardening their relations with Russia and increasing support for Ukraine.
On the stock exchanges, Russian RTC dynamic demonstrated a very important decline in mid-March 2014. This prompted a certain reshuffle of positions, as many Russian companies lost capitalization and hence their shares were bought by others. The most interesting example is the state-owned company Rosneft, which reinforced itself as a new predominant player among Russian oil companies. The crisis provides a large chance to further reinforce Russia’s national oil company.
Paradoxically enough, international energy companies are not keen on leaving Russia in spite of a possible asset freeze. For many of them, Rosneft remains a reliable partner. One of the reasons lies in the fact that Russia is still committed to a number of Bilateral Investment Treaties and therefore would not dare to risk getting involved in new compensation claims. As one could remember, Yukos shareholders are claiming about 100 billion USD from Rosneft for the creeping nationalisation of 2004 [6].
Although international energy companies operating in Russia seem to be among the least concerned, the long term dynamic might still be negative for Russia. Capital outflows could reach 50 billion USD in the next quarter of 2014. This situation goes entirely against Russia’s policy of stipulating a need to increase investment inflows. Therefore, Russia’s takeover of Crimea can become a pyrrhic victory, especially regarding further economic development of the country.
Sanctions and their possible effects
It is premature to analyse the effects of sanctions on energy investment and trade. As has been mentioned above, the West avoided the of use energy import sanctions, demonstrating a certain vulnerability, particularly on the part of European states. However, sanctions create serious difficulties for Russian state-owned companies. In particular, some investment banks (i.e. Morgan Stanley [7]) plan to cease operations with Rosneft. Hence, part of the financial plan of Rosneft is now lost. Difficulty in attracting loans for Russian companies will increase still for future investment plans. However, freezing investment plans also puts under risk the reimbursement of corporate loans, which are valued altogether at approximately 740 billion USD [8]. In the context of a chronic lack of cash, a refusal or delay in payment will generate further financial difficulties for western banks. Moreover, Russian companies have concluded financial agreements with China, such as regarding oil and LNG exports to Asia. Other sanctions have either a limited effect or are not related to the oil and gas business.
Conclusions
Concluding remarks are necessary, although some of them might still seem premature. First of all, we are experiencing a highly interdependent world with an ongoing collapse of Pan-European political order, which might have further impacts on energy business. Risks for transit-supply gas flows and for investments in Russia have dramatically increased. Nevertheless, we also observe that both states and market actors are attempting to avoid involving the energy business in the conflict. Hydrocarbons are not currently used as a political weapon by the world’s largest producer, nor are they used as part of an economic embargo by importers. In spite of strong declarations from the Russian Parliament on asset freezing, international companies do not seem to be in peril. Instead, they will use both political ties with Kremlin and legal protection provided by international investment arbitration as protection. Finally, imposition of sanctions does strongly concern Russian state owned hydrocarbon companies, but this might have a double trenchant. Russian corporate loans are some of the world’s largest, and banks would have difficulties in finding alternative opportunities.
At the same time, the crisis surrounding Crimea creates an additional negative image of Russia, which has long term repercussions. In addition, capital outflows weaken the national currency and create a serious economic situation domestically. Quite interestingly, being an energy-export dependent state, Russia does not have any economic rationale in annexing a new territory [9], which will require new federal budget expenses. In the longer term, it will demonstrate a limit of the traditional geopolitical approach, which might have serious repercussions for Russia itself later on. However, restricting Russian imperialism will not occur from sanctions and/or related diplomatic actions from the West, but from growing internal inconsistencies between reviving imperialist logic of territorial expansion and the nature of the rentier state.
Hence, the Crimean crisis demonstrates the following implication for energy: there is a further deepening interconnectedness between states’ strategies and energy markets. Western politically-backed sanctions are limited by strong business interdependencies with Russia. Russia’s geopolitical aspirations are also restricted by markets and economic trends. At the same time, a collapse of international political governance of inter-state relations increases the risks for energy markets even when policy makers intentionally avoid involving such a strategic sector. In turn, the ‘energy weapon’ of Russia is strongly overestimated, and western sanctions seem ineffective.
If the Crimean crisis is the start of a new Cold War, it will be very different from the bipolar world struggles of the past. Instead of two strong political and ideological blocs, we are experiencing a struggle between economically vulnerable states. Hence, the main energy implication is an increased vulnerability of states and markets together.
[2] See S. Karaganov, “Russia has to defend with an iron fist” in Financial Times, 07.03.2011
[6] See for details investment disputes under the Energy Charter, at www.encharter.org
[9] Some discussions exist around gas reserves in the Black Sea shelf, which is now annexed to Russia. Nevertheless, up to now, gas extraction activity has been low and international companies demonstrated little interest in developing the fields. Russian oil and gas experts claim that the exploration of hydrocarbons might be difficult and costly in the region. In any case, these are rather long term benefits and are hard to assess currently.
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