With President Yanukovych's ouster from Kiev and the occupation of Crimea inviting mounting pressure from the United States, Moscow is now signalling its intentions to utilize Europe's high dependence on Russian natural gas to exert greater influence over the political situation in Ukraine. Closely following Russian Prime Minister Medvedev's refusal to recognize the interim government in Kiev, Russia's state-owned gas giant Gazprom (OTC:OGZPY) declared that it will cancel the natural gas price discount promised to the Yanukovych government in 2013, which had brought prices down from $400 per 1000 cubic meters to $265.50. This has significant ramifications for the interim Ukrainian government, which is struggling to pay back its existing import bill of $1.55 billion and had already asked Gazprom to allow a payment deferral until April 15.
In addition to reminding Kiev of its financial and economic vulnerabilities, Gazprom has also begun to pressure the West, asserting that the European community will become increasingly more dependent on Russian supplies as British and Norwegian gas production decline.
The message from the Kremlin is clear: If Europe responds to the crisis in Ukraine with financial or economic levers, then Russia too will use its assets to punish the West. Although the relatively milder winter this year has left Europe with higher storage levels at the main gas hubs, the European community is taking the Russian threat seriously, hesitating to get on board with sanctions proposed by the United States. Sure enough, the reduced risk of escalating tensions have led both Russian stocks and the ruble to rally after a steep fall early in the week.
But what about long-term ramifications?
While Gazprom might be patting itself on the back for its leverage over the West, there will be long-term consequences for the company's close cooperation with the Kremlin to further Russia's foreign policy objectives. First and foremost, it added greater risk to the critical pipeline deal with China. Beijing has so far refused to finalize the long-delayed agreement because of concerns over Gazprom's gas prices, which stand much higher than the Henry Hub Spot Price in the United States.
For Gazprom, this deal is absolutely critical for the company's future performance as massive amounts of capital have already been invested to develop the gas assets in the Russian Far East, like the $46 billion Power of Siberia project, which will connect the Chayandinskoye oil field to Vladivostok. And with Japan increasingly leaning toward restarting its nuclear power plants, secure long-term imports from China will make or break the company's Asian operations.
While Beijing and Moscow have stood together on many recent international issues, by no means do the two countries see one another as eternal allies. In fact, the fierce rivalry and conflict between the two countries defined the course of the Cold War in Northeast Asia. Even with the recent conflict in Ukraine, while the Chinese government remained empathetic to Russia's position, Beijing chose to obfuscate its own opinions on the crisis, perhaps recognizing that Moscow's policy of championing the self determination of Crimean Russians might impact sensitive ethnic issues within China like Tibet.
These small but noticeable political divergences between the two countries, alongside Russia's liberal use of the gas supply as leverage against import-dependent Europe, will force Beijing to reconsider the strategic ramification of becoming heavily dependent on Russian natural gas imports. Moving forward, it is most likely that China will seek to diversify its supply through partnerships such as the one with Total SA (NYSE:TTE) to develop oil and gas assets in Tajikistan, which offers a potential gas reserve of 3.22 trillion cubic meters and bypasses Russian suppliers.
No better way to spur supply diversification
During the American civil war, the secessionist southern states believed that Britain's high dependence on imported cotton would lead to political recognition of the Confederacy. Instead, the war and the South's instance on recognition simply led to British textile industries turning to Egypt and other nascent cotton-growing markets for imports.
Similarly, the recent crisis in Ukraine will simply goad the European community to further diversify its gas imports, which it had already been doing for the past two decades. In the early 1990s, Russian natural gas accounted for 70% of Europe's imports. By 2003, that figure had dropped to 45% and after the traumatic gas crisis in January 2009, Europe managed to reduce the gas imports from Russia to just under 30%. Although Eastern Europe remains largely dependent on Russian supplies, Europe is continuing to develop projects that will further reduce its heavy reliance on Gazprom.
While no single new supplier to the European market will become a game changer, the many changes around the world will collectively alter the supply dynamic for Europe. For instance, recognizing the great progress in liquefied natural gas delivery and reacting to the crisis in Ukraine, Finland and Lithuania have signed a preliminary agreement on March 1 to build their own LNG terminals and pipelines connecting the two countries. This and other developments like the shale gas exploration in Poland and expansion of output from fields in the Eastern Mediterranean and Azerbaijan will bolster Europe's energy security in the coming five years.
In addition, while existing Norwegian fields might be reducing production as noted by Gazprom, Norway is continuing to explore and develop new oil and gas fields, such as the Aasta Hansteen field, which will provide room for Europe to further develop the infrastructure necessary to reduce its dependency on Russian gas.
Gazprom's posturing has so far taken advantage of the existing vulnerabilities in the European market; however, in the long-run, these politically motivated maneuvers have done much to damage the company's future prospects with potential importers in Asia and existing importers in Europe.