08.05.2006
Ukraine – Growth and Gas
№2 2006 April/June
Leonid Grigoriev

Leonid Grigoriev is chief advisor to the head of the Analysis Center under the Government of the Russian Federation, Head of the World Economy Chair of the World Economy and International Affairs Department of the National Research University–Higher School of Economics.

 

The drama of the New Year’s gas conflict between Russia’s
Gazprom and Ukraine’s Naftogaz can be understood only if one takes
into consideration the underlying economic causes of the problem.
These should be analyzed from the corporate, economic and political
points of view, while remembering that certain norms, as well as
the slant of the global mass media, play a part in the analysis.
Leaving aside the political aspects, let us focus on the corporate
and economic features of this conflict.

THE DRIVING FORCES OF UKRAINE’S ECONOMY

Economic growth in Ukraine in 2000-2005 was so great that it
aroused euphoria and influenced the situation in the country, not
to mention other members of the Commonwealth of Independent States
(see Diagram 1). The Orange Revolution in Ukraine in the autumn of
2004 took place against the background of a considerable increase
in the standard of living and macroeconomic stabilization,
characterized by a budget surplus and a decrease in inflation to a
level below that in Russia. One could expect that after such an
improvement in the financial status of Ukrainian citizens, they
would begin to demand greater social justice, a more responsible
government and the reduction of corruption. The democratic
component of the Orange Revolution arouses natural sympathy and
corresponds to the transition from a protracted crisis to the
normalization of economic and political life. At the same time, in
the political arena of transitional economies the interests of
conflicting financial and industrial groups, for which access to
power is a critical factor of existence and development, usually
play a major role. These interests certainly played a role during
Ukraine’s power struggle in the autumn of 2004, and influenced
Kiev’s policy in 2005.

In order to continue reforms amidst competition between various
public forces and financial groups, and to avoid administrative
obstacles to reaching decisions, Ukraine needs a sophisticated
mechanism for compromise decision-making. The threat from the new
government, led by Yulia Tymoshenko, to nationalize and
re-privatize 3,000 enterprises in 2005 failed. Only the
Krivorozhstal steel company, which was a matter of principle for
the government, was re-privatized – and at a very high price.
Several controversial (one might add “non-market”) moves by that
government proved fatal for it. On January 10, 2006, Verkhovna Rada
voted to fire Prime Minister Yuri Yekhanurov, who had earlier
replaced Tymoshenko at the post, and his Cabinet; they were
permitted to serve as acting ministers until elections in March.
The legislators thus disassociated themselves from the government’s
unpopular decisions.

Diagram 1. Dynamics of a real GDP of Poland, Russia
and Ukraine, 1990 — 2005
  

Source: national statistics committees

In a democratic country, the future of the economy and the
investment climate largely depend on the government’s
predictability, responsibility and consistency of its actions. The
transition from a presidential to a parliamentary-presidential
republic, and with the potentially more politically versatile
composition of Verkhovna Rada after the March 2006 elections, may
add to the instability of the future government of Ukraine. It is
in Russia’s interest to have a stable, compromising neighbor that
would not turn economic and, more importantly, corporate relations
into issues of domestic and foreign policy.
In the last five years, several factors may explain the economic
growth in Ukraine. Some of the explanations were typical of all CIS
countries in this period, while others were characteristic of the
Ukrainian economy only. Growth in exports to the European Union and
Russia, caused by economic growth in these large regions, was a
common trend in many CIS and East European countries. The price of
Ukraine’s traditional exports rose very quickly, so regularly low
gas prices only contributed to this growth, reducing costs and
improving the positions of Ukrainian manufacturers in comparison
with their rivals. A World Bank report of July 5, 2005 on the
Ukrainian economy said that Ukraine’s recent economic growth rested
on the non-diversified yet resilient growth of exports in economic
sectors controlled by financial and industrial groups that operate
by their informal relations and special privileges.

This growth was based on a certain reserve of production
facilities, high global market prices of raw materials, and a low
currency exchange rate – exactly as the case was in Russia. At that
time, Ukrainian industry, which relied on the same production
potential as Russia (ferrous metallurgy, chemical and fertilizer
production), received certain advantages. One such advantage
involved the export of steel pipes to Russia whose oil industry had
entered a phase of significant growth in output, which required the
modernization and development of its infrastructure.

The overall competitiveness of Ukrainian industry was based on
several factors, among them a lower wage level (Table 1), a low
exchange rate of the Ukrainian hryvnia to the Russian ruble, the
mild climate of South Ukraine, and the proximity of convenient
ports on the Black Sea – something that Russian industry lacks
completely or to a large extent. Wages have been rising fast
throughout Eastern Europe. In the Ukrainian economy this growth is
faster than in Russia or Poland, but the absolute wage gap (which
is important for estimating production costs) is growing as well.
In 2003, a Ukrainian worker earned U.S. $475 less in official wages
than a Pole and $92 less than a Russian. The respective figures for
2005 amounted to $611 and $134.

The Russian market plays a major role for the export of
Ukrainian industrial products: without considering energy imports
from Russia, Ukraine’s trade balance with Russia is positive.
Vladimir Malinkovich, a Ukrainian political scientist, accurately
expressed the logic of the Ukrainian side: “For us it is extremely
important to maintain stable relations, especially in the area of
energy supply (at reasonable prices, of course)… We are not ready
to compete in European markets; therefore we are interested in
Russia as an extensive market for Ukrainian goods… We are
interested in selling more goods to Russians than today – at
advantageous prices, of course.”

For their part, enterprises of the Russian metallurgical
industry have been complaining about the level of competition from
Ukrainian enterprises, some of which, incidentally, produce more
sophisticated and better-quality products, such as large-diameter
pipes. This factor, as well as many characteristics of the Russian
and Ukrainian economies, is the direct result of the “distribution
of productive forces” program developed during the Soviet planned
economy. In some cases, Ukraine deliberately resorted to non-market
measures to ensure its competitiveness, thereby forcing the Russian
government to introduce antidumping duties in late 2005 against
Ukrainian industrial pipes of small and medium diameter, for
example, for a period of five years.

Table 1.  Average Wages in Ukraine, Russia and
Poland  (dollars per month)

Source: National statistics committees, estimates by the
Institute of Energy and Finance

Another factor that has played an enormous and underestimated
role in Ukraine’s economic growth involves money transfers from
labor migrants working abroad; these transfers are estimated at
several billion dollars a year. Millions of Ukrainians have for a
long time been working in Russia and Eastern Europe. Moreover,
since 2004, migration to the EU-15 has sharply increased. Low-paid
Ukrainian workers have begun replacing Polish manpower in some
member states and economic sectors of Europe. Considering the low
hryvnia rate, the contribution of these transfers to the Ukrainian
economy has been very high, plus they help to maintain the
consumption level and have a positive effect on housing
construction. So it must be admitted that Ukrainian citizens
working in Ukraine, Russia and the EU have ensured success for
their country.

Kiev’s successful fiscal policy, as well as in some other areas,
has also contributed to the stabilization and growth of the
national economy. Ukraine has begun to rise, together with Russia
(after the financial crash of 1998) and the EU, and most notably
between 2004 and 2005. The transitional crisis in the previous
years was very acute, and Ukraine’s GDP still remains low against
the 1990 level (see Diagram 16). It is closer to the GDP of Georgia
and Moldova, which have gone through civil conflicts and still have
unsolved territorial problems; these factors have greatly
complicated their development in the period between 1990 and 2005.
If the Ukrainian economy continues to grow at an average rate of
5.5 percent a year, it can achieve the 1990 level only by 2015,
while Russia can achieve this figure by 2007. These estimates do
not take into account the shadow sector, which, like in Russia, is
a major factor in the incomplete collection of taxes; yet it helps
to maintain a high level of private consumption and housing
construction.

Diagram 2. The GDP rate of Poland, Russia and Ukraine
(the 1990 levels equals 100 percent)
 

Source: national statistics committees, IMF

Economic growth in transitional economies is a fragile matter:
all factors may promote growth in a country, which may help to
normalize the budgetary process, cut inflation, increase
consumption and attract more investment. However, if the nature of
the effect of external factors suddenly changes, the growth of
export markets slows down, the cost of imported energy resources
(most importantly, oil) dramatically increases, while the pressure
of populists on the budget grows, thereby sparking inflation. A
growth in wages starts overtaking labor productivity, thus
provoking a decline in profitability and competitiveness of
products. Ukraine has found itself exactly in such a situation –
and just before elections. More importantly, there has also
recently emerged the problem of price hikes on gas that Ukraine
buys from Russia. This is a difficult situation even for the
political elite of a country that enjoys a very stable democracy
and government. In the meantime, in Ukraine there are three leading
parties with an electoral ceiling of about 15 to 20 percent each,
plus many small parties, lots of interests, and regional imbalance
(the politically influential Western Ukraine economically depends
on the Eastern industrial areas). Given these factors, the
politicization of these issues is inevitable, not to mention
increased attention on the part of the media and various interested
groups.

GAS AND ECONOMIC TIES

From an objective point of view, the rapid increase in the
demand for natural gas in Europe is a reflection of its economic
and ecological advantages. In the sphere of energy consumption, gas
has begun to replace oil and coal, while nuclear power engineering
has been in a state of stagnation since 1986. Western Europe has
long been pegging the price of its gas to the price of oil and oil
products; this explains why the jump in oil prices prompted a rise
in gas prices. This principle of price formation is a reality that
helps to achieve balance and save energy resources. Against the
European Commission’s expectations, the formation of a spot gas
market in the EU countries has failed to bring down gas prices; on
the contrary, it has brought about the opposite result: in late
2005, spot prices soared high above the prices established in
long-term contracts.

In the post-Soviet space, gas prices until recently were
maintained at a low level for political reasons, although this
practice should have been stopped long ago. Naturally, even then a
price hike could have been described as a political move. The price
level of $50 per 1,000 cubic meters was set in the second half of
the 1990s when export prices in the European gas market stood at
about $70 dollars per 1,000 cubic meters and when relations with
East European countries in the gas sphere still preserved vestiges
of agreements set down in the days of Comecon. So the gap in prices
was quite comparable with transit costs on the way from Ukraine to
the EU-15 market, while the growth in gas prices in the EU-25
market in 2004-2005 was so great that it has made the situation
dramatic.

The intricate overlapping of economic ties, corporate relations
and political problems has made the issue of Gazprom’s relations
with gas consumers in the CIS countries very difficult, and here we
have an interesting case where the Russian side is objectively
interested in depoliticizing economic relations. Thus, Gazprom has
finally found it advantageous to introduce more transparent
corporate relations and contracts. Nevertheless, economic actors in
particular consumer countries (particularly energy companies and
gas-consuming industries) have a natural temptation to politicize
the problem in a bid to preserve low prices and rents wherever
possible.

The circumstances surrounding the 2004 presidential elections in
Ukraine, together with the clumsy participation of Russian advisers
and politicians in the campaign, give grounds to believe that the
recent gas price hike was some sort of revenge on the part of
Russian political circles for those events. The opposite cannot be
proved, of course, especially when we are speaking about forces
that are traditionally suspicious of Russia’s actions. Actually,
there are many coincidences here. The negotiations on price hikes
as of January 1, 2006 were set to begin several months before the
year’s end. By that time it had become clear that Ukraine was not
interested in joining a Common Economic Space (CES) with Russia as
previously planned. Thus, there were no grounds left for special
economic relations between the two countries, not to mention
politically motivated low oil prices.

Purely economic reasoning was strong enough to increase prices
for large consumers, which corresponded with the general tendency
throughout Europe. This was the “last price shock” in the CIS
countries since they had switched to world prices in the early
1990s; it was also the last shock since the 75-percent devaluation
of the ruble in 1998. In the autumn of 2005, trade in all raw
materials – from bananas to crude oil – was already being conducted
at world prices. Gas remained the last vestige of the once-unified
Soviet infrastructure that preserved a dubious sort of unity and
added an excessive degree of politicization to the pricing issue.
The division of the two largest economic entities in the
post-Soviet space, that is, Russia and Ukraine, was the longest and
most painful. The end of the “political divorce” has freed economic
relations from the political component. From the economic point of
view, the timing was quite propitious for such an event considering
that there had already been five to six years of economic growth.
As for the political circumstances, it is difficult to imagine any
“right” time for abolishing cheap gas for some Ukrainian
industries, which certainly believed there would never be a right
time. The transition to normal relations was delayed for years,
which resulted in losses for Russia’s gas sector and in indirect
subsidizing of the competitive Ukrainian industry. Tensions over
this issue were inevitable, as was its politicization inside and
outside Ukraine.

The gas price hikes in the CIS and especially in Ukraine have
triggered such a strong reaction because they have affected
deep-rooted gas interests and rents. The international mass media
describes the role that gas plays in Ukraine’s energy sector and
economy as artificially inflated and politicized for several
reasons. First, the Ukrainian economy receives gas either directly
from Russia or via Russia (excluding Ukraine’s own gas output,
which meets 25 to 30 percent of the country’s consumption needs),
which makes this situation a bilateral problem. Second, 80 percent
of Russian gas transported to Europe passes through pipelines
across the Ukrainian territory. These two factors immediately turn
a normal item of trade into an issue of bilateral or even
international policy.

Naturally, all interested parties receive an excellent
opportunity to defend their profits and rents with the help of
various political combinations. The competitiveness of some
Ukrainian industries (metallurgy, the production of ammonia and
nitrogen fertilizers, and others) greatly depends on Russian gas
prices. At the same time, the household sector has an immunity to
gas price fluctuations for several reasons. First, nuclear power
plants produce about half of Ukraine’s electricity supplies (which
make up only 20 percent of all electricity-generating facilities),
whereas gas, in contrast to Russia, does not dominate in this area.
Second, Ukraine extracts about 20 billion cubic meters of natural
gas, which meets the requirements of the local population.
(Incidentally, since Soviet times Ukrainian rural areas have been
better supplied with gas than the Russian provinces.) Now that the
Ukrainian economy is on the rise, the price of imported gas
influences the profitability of individual industries only and is
not critical for other economic sectors. Also, the growth in oil
prices has not produced a strong political reaction from Ukraine’s
industrial circles, although Ukraine imports oil from Russia at
increased prices calculated according to the situation on the
global markets.

Naturally, Ukraine’s habit of buying gas at prices below those
in Europe has created a strong interest in preserving these
subsidies for industrial enterprises. There is a well-entrenched
suspicion that (politicized) long-term price regimes introduce
hidden subsidies, which translate into huge profits for
re-wholesalers and those who have access to the gas tap. The
aggregate volume of cheap gas bought by Ukraine from Russia and
Turkmenistan exceeded the country’s domestic requirements and
enabled it to resell surplus gas to the West.

GAS HISTORY

The Russian-Ukrainian negotiations held in 2005 and 2006 on new
gas prices had a history. For a long time, especially in the 1990s,
Gazprom repeatedly had difficulties receiving payment for gas
supplied to Ukraine or siphoned off by the Ukrainian side from
transit pipelines. From time to time those debts were written off
or rescheduled within the frameworks of broader agreements. On the
one hand, there was a surprising contrast between the transparency
and stability of Gazprom’s contracts with Western buyers, while on
the other hand there was a surprising lack of transparency of
contracts for the delivery of gas to Ukraine, including the terms
of its transit to Europe. Assuming that the transparency of
contracts and pricing mechanisms are indisputable advantages of
market relations, then steps to normalize the system of access to
transit flows and pricing can only be welcomed. Yet, in a way, it
was the streamlining of the contract system that caused such a
conflict.

Technically speaking, Russian gas passes through the gas
transport system in Ukraine and, depending on the seasons, travels
to underground storage facilities from where it is sent to Europe
under special agreement. Ukrainian gas companies are actually the
executors of Gazprom contracts. The entire system was created as a
single complex, yet it lacked time-tested mechanisms. There
repeatedly emerged conflicts over supplies and “unauthorized
siphoning.” Perhaps the gas accounting system was imperfect along
this route that is so vital for Europe. Wintertime fluctuations for
demand in Ukraine exerted pressure on the system, although the
capacities of Ukraine’s storage facilities were constructed to
compensate for these fluctuations. In early 2005, there erupted a
scandal after several billion cubic meters of gas failed to reach
the proper destination in time, as agreed under contracts. Kiev
offered several explanations of the situation, which ranged from
“we did not have this gas” to “we’ve found it;” eventually the
conflict was soon settled. Yet this episode made Gazprom
contemplate about the future. Another episode of unauthorized gas
siphoning in mid-January 2006 – a mere two weeks after Moscow and
Kiev signed an agreement – attested to the gravity of Ukraine’s
internal problems with managing the industry and fulfilling its
part of the contracts.

As gas prices continued to climb in 2005, the situation became
increasingly acute: the gas rent in Ukraine grew, political
relations between the two countries were strained, and the economic
growth in both countries slowed down (the growth rate in Ukraine
fell by about 60 percent). Gazprom extended its long-term
investment plans and was interested in additional incomes. Such was
the mise-en-scène for the brief, nervous and very unpleasant
gas conflict, which will have serious consequences for companies,
economies and politics of the countries involved.

Gazprom’s move to announce its pricing plans to the business
circles of Europe in advance, and explain its investment plans and
difficulties in relation to the transit of gas, showed the
corporate nature of the conflict. According to mass media reports,
Gazprom preventively employed a Western auditing firm in order to
ensure the transparency of gas accounting. As the conflict was
settled out of court, the details of what happened in early 2006
are known only in the form of statements. Gazprom must have
thoroughly prepared for legal proceedings, and this factor may have
played a role in the drama.

The most important thing was, of course, Gazprom’s determination
not to back down and raise prices, as well as demand cash payment
for transits. In the corporate world, proper settlements and
prudent conduct are no less important than in politics; any loss of
face may result in huge losses in the future. On the whole, both
parties checked the strength of each other’s positions: in the
absence of a mutual price agreement, Gazprom began to cut gas
deliveries only to cover transit supplies to the EU, while Ukraine
began to siphon this gas. Naftogaz’s actions (considering Gazprom’s
preparations) cannot be defended in court – one cannot simply take
gas without a contract; explaining why a particular amount of gas
was taken is impossible. Gazprom’s position was vulnerable from a
legal point of view for rather strange reasons: How can it fulfill
its obligation to supply gas to the EU under long-term contracts,
while it does not have a new transit contract? Naftogaz’s
explanation that it took Turkmen gas from the pipeline (January
1-3, 2006) was unjustified, as it did not have a contract for gas
transit via Russia.

The parties finally realized the absurdity and hopelessness of
such developments and reached a compromise. Importantly, this was
not a zero-sum game – many parties have gained. However, in this
case there are two monopolies involved – gas and gas transit – and
there could not be an easy solution to the problem. (Russia, for
its part, has a monopoly on the transit of Central Asian gas.)
Ukraine and Russia have found a level of understanding in the new
agreement, and the monopolies are not paralyzing each other and not
infringing on the interests of third parties. The drama at the
beginning of the year would not have occurred had the parties
earlier realized the inevitability and normalcy of changes in this
area.

Many people in Russia and around the world failed to understand
how difficult it was for the Ukrainian side to conduct these
negotiations. Until recently, Ukrainian companies experienced
difficulties receiving payments for gas and electricity supplies
inside the country. It was only recently that this internal problem
was solved, although the financial position of the energy companies
remains problematic. Thus, the World Bank cited this realm as one
of its projects for Ukraine: it will be pushing for transparency,
together with an estimation of the situation in addressing energy
sector problems, including old debts and restructuring of property
and owner rights necessary for attracting new investments. For
those who are familiar with the World Bank’s politically correct
language, it is obvious that the management and finances of energy
companies in Ukraine are in a difficult position, which only
impedes the solution of interstate problems when import prices are
raised.

We may question how feasible it was for the Ukrainian
government, whose powers were set to expire in March, to agree in
January to changes in its generous gas contract with Russia, thus
endangering rents, hidden subsidies and profits of interested
circles. Considering the heavy publicity that the conflict
attracted, possible interference by the West, and the growth of
nationalistic tendencies in its relations with Russia, it was
extremely difficult for Ukraine’s economic and political leadership
to sign a new agreement. The new agreement requires a revision of
the 2006 budget (already approved with a deficit), thereby
concluding new internal contracts, as well as the implementation of
extensive organizational work that Ukrainian economic agencies
should have conducted throughout the autumn of 2005. The
developments of mid-January 2006 proved that this work had not been
done.

WHO STANDS TO WIN?

The objective results and terms of the contract meet Gazprom’s
business strategy. The economic aspect of the agreement is very
simple:

– Gazprom receives its $230 per 1,000 cubic meters of gas within
the limits of 17 billion cubic meters, although indirectly
(actually, this is the cost of gas resale to the West);
– Gazprom pays $1.6 per 100 km for every 1,000 cubic meters of gas
pumped across the Ukrainian territory;
– cheap Central Asian gas and expensive Russian gas are supplied in
a package deal through an intermediary legal entity, Rosukrenergo,
so Naftogaz pays a weighted price of $95;
– the resale of Russian gas without participation of the Russian
party is ruled out.

The consequences of the new deal require in-depth analysis, so
let’s consider the gains and losses of the major parties
involved.

The main beneficiary of this agreement is the European Union and
countries that rank as main gas consumers. They do not need any
conflict concerning the basic routes of gas transit to Europe.
Besides, the EU has long sought a stable outlet for Central Asian
gas into Europe. Now (at least, in 2006) Central Asian gas supplies
will flow in maximum volumes through Ukraine, and the released
Russian gas will go to the EU. The cost of gas and the cost of
transit have been divided. This is a step forward, although this is
not quite in line with the wishes of the European Commission, which
is interested in the free movement of gas supplies across Russia
and other CIS countries. If there arises – in earnest, not just as
a subject for discussion in the mass media – the issue of
diversifying gas supply sources to the EU, the Russian-Ukrainian
conflict may have interesting consequences, such as a renewed
search for alternative energy sources and a rethink of the role of
coal and nuclear energy in some countries (Germany, Great Britain,
etc.).

The second major beneficiaries to the agreement are the Central
Asian countries – Kazakhstan, Uzbekistan, and Turkmenistan – which
have stable contracts for the export of gas to Ukraine. Naftogaz is
now likely to reduce imports of expensive Russian gas in favor of
Central Asian gas. Such developments may bring about a situation
where Gazprom would only supply gas to countries west of Ukraine,
while relations between the Russian and Ukrainian parties would be
reduced to issues involved in “mutual transit:” from Russia via
Ukraine to the EU, and from Asia via Russia to Ukraine. Such a
situation would equally suit both Gazprom and Naftogaz, whose
mutual settlements would then be reduced to payments for
transit.

The third beneficiary is Gazprom. It has released huge volumes
of gas (more than 20 billion cubic meters a year compared to 2005),
which previously was used as payment for its gas transit across
Ukraine at a cost of one-fifth of the established market price ($50
as opposed to $230). Gazprom has cut the actual volume of payment
for transit, if calculated in gas rather than in dollars.
Estimations of the aggregate additional income that the agreement
provides the Russian party vary, but all of them put it at over $2
billion. Gazprom has also secured itself against the possible
resale of its gas to the EU. At the same time, the deal provides
certain benefits for the Ukrainian side since it now has a more
convenient mechanism for receiving Central Asian gas supplies; the
Russian side has assumed the risk of high payment costs for its gas
transit, while ensuring a steady source of income for the Ukrainian
party. Also, Gazprom has taken additional measures to improve its
gas accounting, thus reducing the probability of unauthorized
siphoning of its gas. Yet, Gazprom has losses as well: the image of
a huge and merciless company may be rated highly in Eastern Europe
or, perhaps, in Asia, but not in Western Europe.
Ukraine has received a complex package, in which its gains or
losses are not obvious. In particular, it has settled the conflict
with a large gas supplier, which is also a potential investor and
partner. Furthermore, Ukraine’s Naftogaz has shed its tainted
reputation as a company that engages in the unauthorized siphoning
of gas (for which it gave vague explanations) and has thus improved
the position of its country, especially as the latter has ratified
the Energy Charter Treaty. Also, it has ensured the supply of
relatively inexpensive gas, the access to which is provided by the
same partner.

The growth in gas prices was inevitable, yet it took place
amidst economic growth and amounted to about 40 percent of the
price paid by the majority of West European countries. The price
rise was a shock for some industries, but it was not a tragedy. A
gradual price hike is a rational yet belated idea – all reforms of
the early 1990s, or adjustments made following the 1998 financial
disaster, should have been carried out step by step. This would
have made life easier for those citizens living within the
post-Soviet space.

The main losers from the New Year gas conflict are those who
made profits from the price differences. For example, in 2005
Russia supplied its gas to Ukraine for $50 per 1,000 cubic meters,
whereas prices in the EU exceeded $200 for the same amount. Other
losers include the chemical and metallurgical enterprises. On the
other hand, why should Gazprom subsidize Indian-born British
billionaire Lakshmi Mittal, for example, who purchased Ukrainian
steel giant, Krivorozhstal? Objectively, economic actors, namely
Ukrainian enterprises, must pay an additional three billion dollars
for its gas (60 billion cubic meters at $95 per 1,000 cubic meters,
instead of $40 to $50).

There is yet important question to this new agreement: How will
the gas price hikes affect economic growth in Ukraine? Estimates by
the World Bank (October 2005), which predicted that Ukraine would
experience a decrease of four percentage points in 2006, stemmed
from the supposition that gas prices would be raised to $115-$125
per 1,000 cubic meters. The main problem with such estimations
involves the quality of the model and its prerequisites, as well as
the general dynamics of the economic situation. The growth in gas
prices proved to be half the expected figure (in the first six
months of 2006; it is still unclear how the situation may develop
in the second half-year); economic growth in the world continues,
while Ukrainian exports are expected to continue growing. Given
these factors, the possible slowdown in Ukrainian economic growth
can be estimated at just two percentage points. Determining a
reference point from which to calculate a decrease in Ukraine’s GDP
growth rate, however, is a difficult problem. In 2005, despite low
gas prices and the favorable conditions of the global economy, the
growth rate of Ukraine’s real GDP plummeted from 12 percent to 4.4
percent – entirely due to internal factors. If the main parameters
(growth, inflation, and budget) of the national economy remain
within reasonable boundaries in 2006, which is quite probable, the
shock will be absorbed. But if growth rates fall too sharply, it
will take a serious analysis to divide the objective economic
processes, the negative influence of internal political processes,
and the gas shock from each other in the short and long term.

The savings rate in the Ukrainian economy is higher than the
accumulation rate, so at the aggregate level additional payments
must not undermine the balance of payments and financial resources
for accumulation. There will be difficulties with administrative
problems and the national budget, considering the urgent need to
adapt to the new prices. Tariffs inside Ukraine have in the last
few years been paid 100 percent, but there may arise problems with
the collection of payments, which will present a burden for the
next government. So this subject is going to be interesting for the
analysts for a long time, it appears. Ukraine has already been
recognized as a democratic country; now it arouses sympathy as a
“victim.” Any continuation of the conflict would inflict more
damage on Ukraine than Gazprom, as businesses in Europe understand
the importance of stable gas supplies.

Table 2.  Ukraine’s Major Economic Indicators,
2000-2005

Source: Statistics Committee of Ukraine, National Bank of
Ukraine, estimates by the Institute of Energy and Finance

GLOBALIZATION IS INTERDEPENDENCE

The Russian government managed to depoliticize the negotiations
as much as it could. At the same time, it could not avoid
accusations that it “punished Ukraine for the so-called Orange
Revolution” – the decision to shut off gas supplies as of January 1
had a bad press. One reason for this bad press was the nature of
Gazprom’s ‘propaganda’ campaign that was targeted at unbiased,
well-informed and rational market-economy experts. But experts and
businessmen in Europe understood the economic roots of the conflict
even without an explanation; the rest of the story fell into a
political context. Overt attempts to reach understanding before the
inevitable conflict possibly played a role among experts and
businessmen, but failed with regard to politicians and public
opinion. Surprisingly, Gazprom may have believed that transparent
market relations were the basis that would ensure understanding and
support for its decision in Europe. The obvious fact that many mass
media and politicians in the world would have been against Gazprom
(that is, Russia) irrespective of its actions makes intensive
planning, rather than neglect, all the more necessary. The
situation is not much different from the inherent bias in figure
skating – if you do not trust judges, make a six-turn toe loop
jump. But Gazprom, trying to present this conflict as
non-political, either pursued a too narrow strategy, or did not
want to violate unwritten business ethics and reveal something
about its negotiating partners.

It is probable that repeated statements by the presidents of
Russia and Ukraine about the “non-political” nature of the conflict
helped to reduce the parties’ losses and reach agreement. Some
politicians and mass media in Russia, which are now celebrating the
“victory,” are wrong in principle. Similar statements by the
Ukrainian side about a “victory” are forced for internal political
reasons. From our point of view, this is a rare, even unexpected,
case of a victory of common sense over conflict, of economics over
politics, and of long-term stable relations over short-term rents.
Sober-minded observers say “we saw an appropriate shift from
political to market pricing, not vice versa as commonly
represented.” (White Paper: Russia-Ukraine Natural Gas Dispute.
PACE Global, 13 January 2006, p. 12. www.paceglobal.com)

Ukrainian President Victor Yushchenko holds the same point of
view: “The gas compromise came unexpected to many in Ukraine.
Oligarchs were against it, as it meant an end to the largest
bartering scheme in Europe”. But external consequences overshadowed
the corporate and rent nature of the conflict. The unauthorized
siphoning of gas by Naftogaz in the first few days of 2006,
combined with the heavy financial losses suffered by Gazprom, were
a violation of contractual principles of the market economy, yet
not dramatic enough for politicians and mass media in the rest of
the world to feel sympathy for Russia’s gas Leviathan. The essence
of economic problems for the European member countries of the CIS
has so far remained obscure to Western political circles, mass
media and the public. These problems must be delineated in a more
delicate and patient way, with more simplicity and clearness.
Instead, we shocked Europe with news of an unprecedented reduction
of non-contractual gas supplies, thus provoking mass media stories
about the “gas threat from the East.” If someone wanted to tarnish
Russia’s reputation, he could give the following advice to our
negotiating partners: “Price growth is inevitable, but let these
Russians show their true colors – let them cut off gas supply at
least for one hour, and conclude an agreement with them on January
4.” Noteworthy in this respect was an attempt by some mass media to
reduce the conflict either to Russia’s “pressure on Ukraine,” or
only reporting on the gas cut-off without mentioning the
contractual aspect of the conflict.

It is important to note that there is neither a reasonable
purpose nor a reasonable scenario for Russia wielding its energy
resources as some kind of a weapon, which began to be widely
discussed in the CIS and Europe. Obviously, neither the foreign
critics, nor the hotheads in Russia have been able to prove such a
scenario. Interestingly, the Soviet Union supplied Western Europe
with oil and gas throughout the 1980s, but Europe did not fret much
about that.

Russia does not need to use energy resources as a “weapon;”
moreover, the very idea is highly disadvantageous to it. Of course,
Europe increasingly depends on the Russian economy as regards oil
and gas supplies, but Russia also depends on Europe to a high
degree: the larger part of Russia’s imports come from Europe.
Furthermore, Russia finances its own development with revenues from
oil and gas exports. Diversifying sources of energy supply is a
good thing, but it takes much money and time. At the global level,
everything is mixed together, thus, the world cannot afford to let
even one large oil exporter (for example, Iraq) reduce its level of
extraction since oil prices would soar immediately. Interdependence
is universal; such is the nature of the contemporary world. To put
it differently, the world is interested in political and economic
stability in Russia, because market regularity largely depends on
Russia’s energy exports.

A fundamental issue for Russia is the re-investment of revenues
from the export of raw materials and energy resources toward the
modernization of the economy. But politics is a tricky thing, and
one can always find ways to invent threats from the East. The
corporate nature of the Russian-Ukrainian conflict, that is, the
energy rent that Ukrainian industrial enterprises received and will
continue to partly receive as compared with the rest of Europe,
remains on the sideline of the debate for experts and
businessmen.

But the more dramatic images of the conflict remain in the
memory of the Europeans who tend to view Russia as the cause of
that drama. In the European countries, tenants who fail to pay the
rent are evicted, but this is done by a court decision and in a
humane way. The gas conflict, especially the abrupt halt of gas
supplies, is viewed in Europe as a problem of human dimensions; a
drama of human relations, which must be treated accordingly.
Ultimately, however, it was simply the sad continuation of the
fifteen-year history of the breakup of this once single economic
space.

Pre-election tensions prevented politicians in Ukraine and many
mass media around the world from assessing Russian-Ukrainian
relations in an unbiased way. But Russian analysts and mass media
must and can be more far-sighted and self-critical so that the
country’s long-term interests are not damaged, while ensuring that
Russia’s methods for solving economic problems are clear to the
rest of the world. Civilized market-based economic relations on the
post-Soviet space can be beneficial for all, although they should
include the interests of Russian enterprises and Russia’s national
budget. If Russia is to stop playing the role of the Big Brother in
the CIS – in line with the wishes of policymakers in other
countries, then it is not intended to support (and especially,
subsidize) the development of its neighbors to a greater extent
than any other country. This is especially fair as the results of
the transition crisis are unsatisfactory for us as well; unlike
Poland, for example, Russia has not yet achieved the 1990 GDP
level.

Finally, there inevitably arises the question as to what effect
the gas conflict will have on the Group of Eight summit to be held
in Russia’s St. Petersburg in July 2006 and that will focus on
energy security. Interestingly, the world is divided on the notion
of “energy security” and has not agreed on a shared energy policy.
The world’s reaction to high oil and gas prices shows that all
groups of countries interpret energy security in their own way, as
part of their own agenda of development and economic growth. Russia
has not yet presented, at least publicly, its own concept of this
notion or measures to ensure energy security. Therefore, it is
difficult to estimate the immediate consequences of the gas
conflict for the negotiating process. Of course, the January 2006
developments will influence the negotiations and the St. Petersburg
summit. It is important to distinguish objective factors behind
tendencies in the energy sphere from their political,
propagandistic context.

Russia must present a serious plan on this subject of energy
security. The problem remains, however, that the world’s energy
industry deals not only with objective data pertaining to the
extraction, energy infrastructure, prices and energy consumption,
but also with billions of people who live in the troubled and
unstable 21st century. The world’s multilateral energy
interdependence makes policymakers particularly responsible for
ensuring energy security and inspiring confidence in this security
for all nations involved.