Ukraine – Growth and Gas

8 may 2006

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.

Marsel Salikhov

Resume: 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.


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.


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.


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.


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.


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


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.

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.

Last updated 8 may 2006, 10:34

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