2 March 2016

The Kremlin may have overplayed its energy policy hand


The military might of the Soviet Union once dominated the Eurasian continent. While weapons exports remain a powerful tool of Russian policy, in Europe, energy is now king.

With the lowest gas production costs in the world, Russia has a strong policy card to play with its natural resources. However, this does not give Russia an ace it can play at any opportunity.

Russia supplies around 30 per cent of European coal and solid fuels, 35 per cent of European crude and 40 per cent of European natural gas. With an overall stake of 50 per cent in Gazprom, the state gas company, and with close ties between the Kremlin and senior Gazprom executives such as Alexey Miller, Putin’s St Petersburg town hall contemporary, the government can use gas supplies, or the lack thereof, as a powerful policy tool.

We have seen this directly, with the 2006 and 2009 gas supply disputes with Ukraine, and the 2007 dispute with Belarus. Russia used its energy might to get what it wanted in terms of payment, influence and a higher gas price.

European fears of further gas disruptions were a powerful tool to compel EU states to accept its influence in the former states of the Soviet Union. Indeed, it is this energy interdependence that provided strong internal resistance to European sanctions on Russia during the 2014 Ukraine crisis, especially from states on the eastern border of the union.

That said, Russia’s more assertive role on and beyond its borders is creating longer term problems for its energy exports.  Instability in Ukraine has meant Gazprom has had to fundamentally rethink how it can supply Europe. As a source close to Gazprom put it:

“A significant percentage of Gazprom’s exports to Europe go through Ukraine.

Leaving aside the geopolitics, looking at it on a basic engineering level, Ukrainians haven’t maintained their pipes. Even if there wasn’t a low intensity conflict going on, Gazprom would have a major long term viability question about that export route. If you don’t maintain gas pipelines, they stop working.”

Indeed, political instability in Ukraine, as a result of pro-Russian separatism in the east, has forced the country to buy guns rather than gas pipelines. In the polarised political climate, there is little the Russian gas giant can do to alleviate this directly.

As a result, the Russian gas firm has been forced to invest billions in alternative pipelines to mitigate both political and pipeline failure risks within Ukraine. As the source put it:

“It’s like getting insurance on your house. You might not want the outlay but we live in a complex world, and it’s better than the alternative.

While Nord Stream was aimed at meeting EU demand up to the late 2020’s, South Stream and Turk Stream were explicitly about bypassing Ukraine.”

Despite the cancellation of the latter two projects due to other political fall outs, notably the shooting down of a Russian warplane on the Turkey-Syria border, Nord Stream 2, increasing the density of pipelines under the Baltic to Germany, will allow Gazprom the practical means to achieve its plan of ending gas supplies to Europe through Ukraine by around 2019.

It will be clear in the minds of European policy makers, and especially those in Kiev, that while non-Ukrainian supply routes would increase the reliability of supply, it would also free Russia and Gazprom to be more aggressive in its chasing of non-payments by Ukraine. Without the threat to European supplies, it will be able to simply turn off the taps.

China is also set to become far more central to Russian energy policy, following the landmark trade deals between Gazprom and the Chinese National Petroleum Company in 2014 and 2015.

As the source close to Gazprom put it:

“The two pipelines going in will make China (through CNPC) Gazprom’s single largest customer.”

That China is willing to put any reliance on Russia supplies shows how far relations between the two states have come from the border skirmishes of the Cold War.

However, Russian assertiveness on and beyond its borders, combined with the oil price crash, has had a severe impact on how effectively it can use its energy supplies for political gain.

Russian government coffers are reliant on income from oil and gas revenues from firms such as Rosneft and Gazprom, with over 50 per cent of Russian federal incomes coming from mineral extraction taxes and export customs duties. The 70 per cent fall in oil price since June 2014 has cut into these significantly, leaving the government short of foreign exchange.

A run on the rouble and withdrawal of foreign investment, partly the result of limited European sanctions, have further pressured the coffers. Russian foreign exchange reserves have fallen from highs of $540 billion to lows of $350 billion at the start of 2015, and they has recovered little after de-escalation in Eastern Ukraine.

Low costs and a weak rouble have allowed the Russia oil companies themselves to weather the storm. Rosneft still makes a lot of money. However, cuts in oil incomes have driven the government to come knocking for tax, which could spell further domestic political instability problems for Russia. Clashes between Kremlin power brokers seem inevitable.

While both Western and Chinese buyers are more than happy to continue to take up cheap Russian oil and gas, they are not willing to become too reliant on them. With a bitter history of the Sino-Soviet conflict of the Cold War, and a new Great Game for influence looming in Central Asia, no self-respecting premier in Beijing would allow this to happen.

For coal-reliant China, while Russia may provide up to 17 per cent of Chinese gas by 2020, this will be just 1.7 per cent of overall Chinese energy demand.

Likewise, Europe has made provisions to ensure backwards flow, alternative supply from Algeria and the North Sea and Liquid Natural Gas from the U.S and elsewhere, as well as shoring up EU legal requirements to force gas sharing between member states in times of shortage.

By failing to mitigate fear among its customers that energy will be used in an overly coercive manner, Russia placed itself in the difficult positon of overreliance on its energy resources for economic survival. Its use of hard power has led to a counterbalancing reaction that has not served its interests well.

In the current energy market, Europe has limited fears, and China almost none from Russian posturing, as Russia simply needs the incomes from gas more than it can afford to risk through excessive political interference. With even the relatively small-scale Syrian intervention costing the Russian taxpayer $4 million a day as of October, there is simply not the financial clout for a long and drawn out gas battle with Europe.

Gorbachev’s dream of perestroika was for a diversified and technically adept Russian economy to be able to compete on equal terms with those of the West, by catching up and exploiting the information revolution. Russia will need to rekindle these dreams, if its foreign policy is not to be beholden to the notoriously fickle international energy market. It needs its whole economy to be influential, not just its energy sector, if it is to have real future bargaining power in Brussels or Beijing.

George Greenwood is a freelance political journalist, published in the New Statesman, The Independent and The International Business Times.