Poland, Belarus & Ukraine Report: December 29, 2006

DOES MINSK STAND A CHANCE IN GAS WAR WITH GAZPROM? Gazprom and Minsk have managed to agree on one thing -- Belarus's asking price of $2.5 billion for a 50 percent stake in the state pipeline operator Beltranshaz.

Gazprom spokesman Sergei Kupriyanov has confirmed that concession to Belarus:

"We have agreed to the most comfortable conditions for Belarus," Kupriyanov said on December 27. "We want to obtain 50 percent [of Beltranshaz], not control over it, and we are [offering] a price that is even higher than the market one."

But the two sides remain at loggerheads over how the Beltranshaz stake will be paid for. Belarus is demanding cash, while Gazprom is insisting that it be paid in the form of gas supplies as part of the deal it is trying to work out with Minsk for gas supplies in 2007 and beyond.

According to Gazprom CEO Aleksei Miller, such a payment plan could be extended until 2011, when Gazprom intends to switch exclusively to cash payments for gas at market prices.

Minsk, meanwhile, sees the possible Beltranshaz share sell-off and its contract with Gazprom for future gas supplies as separate issues.

And on the issue of gas rates -- regardless of the Beltranshaz stake -- the two sides do not see eye to eye.

Gazprom is asking $105 per 1,000 cubic meters of Russian gas next year, up from the $46.68 Belarus is currently paying. With the Belatranshaz stake thrown in -- at a rate of $30 a share -- Belarus would end up paying $75 per 1,000 cubic meters.

Minsk is willing to pay $75 per 1,000 cubic meters -- period.

Belarus's chief negotiator in gas talks with Gazprom, First Deputy Prime Minister Uladzimir Syamashka, went so far on December 26 to characterize Gazprom's negotiating position as a "provocation."

Syamashka claimed Gazprom had the day earlier agreed to sell gas to Belarus in 2007 for $75 per 1,000 cubic meters without linking the transaction to Beltranshaz.

Anything greater than that amount, Syamashka said, is simply not feasible.

"We cannot put our signature under a collapse of our economy," he said. "In this case our situation is sort of desperate because we are tied to the Russian pipeline, to the Russian gas-distribution network."

It is debatable whether this gas-price hike could have such a disastrous impact on Belarus's economy.

What is obvious is Minsk's general reluctance to share Beltranshaz with Gazprom. Minsk has managed to defer this issue for nearly five years. A protocol with Gazprom on the establishment of a joint venture to run Beltranshaz was signed by the Belarusian government as far back as April 2002.

Under the circumstances of Moscow's increased assertiveness in using gas supplies as a tool for political and economic extortion, Belarus appears to treat Beltranshaz as a strategic asset directly linked to the country's sovereignty and security.

Currently 44 billion cubic meters of Russian gas, or some 24 percent of Russian gas exports in the European direction, transits Belarus. Gas pipelines in Belarus fork into six routes: Lithuania-Kaliningrad Oblast, Poland-Germany, Poland-Czech Republic, Poland-Slovakia, Poland-Slovakia-Hungary, and Ukraine.

Therefore, Minsk seemed to be fairly unmoved by Miller's threat on December 27 that Gazprom could interrupt gas supplies to Belarus unless a valid supply contract for 2007 is signed by January 1.

"If the contract for gas deliveries for next year is not signed," Miller said, "Gazprom does not have any basis for gas deliveries to Belarus as of January 1st, 2007, as of 10:00 [a.m.] Moscow time."

Syamashka promptly responded that Gazprom has no gas transit contract with Belarus for 2007.

"We are interconnected. I do not have a contract with Mr. Miller for gas deliveries to Belarus, while Miller does not have a contract with me for gas transit through Belarus," Syamashka said. "And I should say that 44 billion cubic meters of gas transits through Belarus."

Syamashka appears to be confident that while Gazprom might lower the volume of gas flowing across Belarus in January to only the amount intended for Europe, it would never dare to turn off the gas tap completely. In such a case, the economic and political damage incurred by Gazprom would surely be greater than that caused to Belarus.

Therefore, Syamashka's ostensible composure in the face of Miller's threat just might mean that Minsk is prepared to siphon off Russian gas intended for Europe in order to make it through the winter. In the absence of a valid transit contract, Minsk would theoretically be justified in considering Russian gas flowing across its territory on its way to Europe as "contraband."

On the other hand, Miller on December 27 stopped short of announcing the possibility of a total shutoff of gas flowing across Belarus.

Gazprom will supply gas to its European consumers on the Belarusian border at full volume and in accordance with [current] contracts. Gazprom today shipped gas to its partners in Lithuania, Poland, and Germany and sent them a letter about the supply situation regarding Belarus," Miller said.

And this means that the gas talks between Minsk and Gazprom -- even if they now seem deadlocked considering the frosty rhetoric from both sides -- will be resumed sooner or later, and a compromise solution will be found, as was the case during the short gas-supply crisis involving Ukraine in January 2005.

As for Europe, which pays some $250 for 1,000 cubic meters of Russian gas, it is hardly imaginable that it could publicly sympathize with Belarus's desire to pay just $75. But one also should not expect any harsh public condemnation from Europe over Minsk's attempts to bargain for the best possible gas deal with Moscow.

It would seem that an obvious solution would be for all of Russia's neighbors to pay a set market price plus transportation costs. But Ukraine will pay $130 in 2007, Moldova $170, and Georgia $235.

For the past 12 years, Moscow has made every effort to make everybody believe that Belarusians under the rule of President Alyaksandr Lukashenka deserve to pay significantly less than other states.

Persuading everybody -- and especially Belarusians -- to drop that notion may take longer than the last four days of 2006. (Jan Maksymiuk)

ENTRY TO RUSSIA'S ENERGY MARKET DISCUSSED. Following his talks in Kyiv with visiting Russian President Vladimir Putin on December 22, Ukrainian Prime Minister Viktor Yanukovych announced that they had discussed the possibility of their countries jointly producing Russian and Caspian gas and oil.

Yanukovych told the press that discussions about joint energy production with Russia have been under way for some time now, saying that "a 50-50 arrangement is better than a concession."

Many analysts, however, believe that Naftohaz Ukrayiny, Ukraine's state-owned oil and gas monopoly, does not have the funds needed to enter the Russian or Caspian gas- or oil-production market. The general thinking is that the most Ukraine could provide would be expertise and skilled workers.

Furthermore, Ukraine, which has its own modest gas reserves, has not been able to develop them sufficiently and continues to rely largely on imported Turkmen gas and Russian gas and oil. This situation has opened the door to Ukraine's fuel-production market to a number of Western companies.

Yanukovych also pitched his joint-venture proposal during a December 22 meeting with Ukrainian energy officials and managers and owners of RosUkrEnergo, the Swiss-based middleman company that has monopoly rights to deliver Turkmen gas to Ukraine.

The Ukrayinski novyny news agency reported that "Yanukovych called on the participants in the meeting to assist Ukraine in the extraction of natural gas on the territory of Russia as well as in countries in the Caspian region."

In addition, according to the agency, Yanukovych praised RosUkrEnergo's activities in Ukraine and "thanked the leadership of Gazprom and [RosUkrEnergo part owner Dmytro] Firtash for the work that ensured steady delivery of natural gas to Ukraine during the first half of 2006.... We have learned to work in difficult conditions and adapt to very difficult issues."

RosUkrEnergo is 50 percent-owned by Gazprom and 50 percent by two Ukrainian businessmen: Firtash, who owns 45 percent, and Ivan Fursyn, who holds 5 percent. On December 22, "The Wall Street Journal Europe" reported that a number of Western law enforcement agencies are currently investigating Firtash for his alleged connections to organized crime. Firtash has denied any such links.

By inviting cash-rich RosUkrEnergo into this project, Yanukovych is apparently attempting to expand the obscure company's role from that of a middleman to a full-scale oil and gas company. Last year, Firtash applied for a license to drill for gas in Russia but his application was rejected.

In the past, Ukraine has offered to work with various countries to help develop their energy resources. A few weeks ago, Deputy Prime Minister Andriy Klyuev announced that Ukraine is seeking to help Egypt develop its gas resources. Ukrainian delegations have visited Libya on numerous occasions over the past five years and offered the country's services in helping develop Libyan gas fields. These offers have yet to yield any results, but the Ukrainian government continues to persist.

One private Ukrainian company, the Industrial Union of the Donbas (ISD), has been successful in working to develop Uzbekistan's gas infrastructure in return for gas. However, in 2006 RosUkrEnergo warned the ISD that it is the only company allowed to deliver Central Asian gas to Ukraine, requiring that the ISD work with RosUkrEnergo if it wants to continue its work in Uzbekistan.

Yanukovych may be hoping that renewed good relations with Gazprom will make his offer acceptable. He failed to mention what exactly he expects in return, but it is widely believed that Ukraine will insist on a percentage of the gas produced by such a joint effort.

But it is also worth noting the possibility that, in return for allowing Ukrainian participation in Russia, Gazprom might insist on a quid pro quo and demand to be allowed to drill for gas in Ukraine, thus gaining a larger role for its already substantial presence in the Ukrainian gas market. (Roman Kupchinsky)

QUICK, DIRTY FIX TO A LONG-TERM ENERGY PROBLEM. Officials have recently touted plans to diversify Ukraine's energy balance by turning to a familiar and readily available resource -- coal.

The specifics of Ukraine's coal initiative have been made more clear since Prime Minister Viktor Yanukovych first floated the idea during his visit to the United States.

During his speech at the Center for Strategic and International Studies in Washington on December 4, Yanukovych reasoned that Ukraine's coal reserves would be an obvious solution to the country's efforts to reduce its dependence on natural gas.

Upon his return, Yanukovych and Coal Industry Minister Serhiy Tulub announced that Ukraine plans to build seven new coal mines.

"We will begin developing the technical-economic projections next year," Tulub told Interfax, adding that construction would begin in 2008.

Coal Industry Ministry officials estimate that Ukraine would have to invest 20 billion hryvnyas ($3.9 billion) into the project at a time when it is being prodded by the West to close down inefficient mines and retrain miners.

Ukraine's coal production is already significant. In 2004, Ukraine imported 6.5 million tons despite mining 59.7 million tons of washed coal of its own. The new mines would increase annual output by 17.7 million tons.

Estimates of the country's coal reserves vary. The World Energy Council estimates Ukraine's reserves at 52 billion tons -- 8th largest in the world. The Ukrainian government in 2006 put its estimate at 117.5 billion tons.

Ukraine's appetite for coal is voracious. It currently accounts for 40 percent of the fuel used in power plants, 10 percent in district heating plants, and 45 percent in industry.

But the country's dependence on foreign gas is equally great -- and the immediacy of its need to address the issue became crystal clear early in the year when Russian gas cut-offs and price negotiations made life miserable for citizens and the politicians who represent them.

The suggestion of increasing coal production as a solution to Ukraine's overdependence on Central Asian and Russia gas is not a new one. It has been mentioned numerous times by the various administrations in Kyiv, yet none went so far as to construct new mines.

A lack of urgency -- one that no longer exists -- was one factor. When Turkmen and Russian gas destined for Ukraine was priced artificially low, former President Leonid Kuchma's government did not see the need to rush into expanding coal production.

Rampant corruption within the coal industry was another reason. Long regarded as one of the most corruption-prone industries in Ukraine, coal mining is the mainstay of regional coal barons and clans in the Donbas region. These powerful figures have been able to exercise their political influence by calling strikes that can threaten to cripple the national economy. Few in Kyiv have been willing to challenge the barons -- or hand them more power by building new mines.

In addition, the overall inefficiency of coal mining in Ukraine has scared away foreign investors, while geological factors have made coal mining in Ukraine an expensive, inefficient, and dangerous business.

In the Donbas region, for instance, 35 percent of the coal beds are "steep enough to make extraction of coal possible only by hand," according to the International Energy Agency (IEA). This leads to highly dangerous working conditions and accounts for the high mortality rate among coal miners in Ukraine.

These realities have led the World Bank and other lending institutions to suggest for years that Ukraine would be better off giving up on trying to rehabilitate its aging and injury-plagued mines.

The construction of seven new large mines would mark a complete reversal of this thinking.

More miners would be needed, requiring the construction of housing, medical facilities, sports and recreational clubs, schools, and transportation networks.

A determination would also have to be made on whether the new mines would be state-owned or private.

In 2001, the government launched a program whereby it would first denationalize mines, then corporatize them, and finally auction them off to strategic investors. By 2003 privatizations were delayed and the mines were reorganized into state enterprises.

An underlying, and potentially more serious long-term issue, however, is Yanukovych's readiness to resort to a quick fix to Ukraine's energy crisis when the opportunity to implement conservation programs and find efficient fuel alternatives has presented itself.

Ultimately, the increased use of its coal reserves will reduce Ukraine's dependency on Gazprom and Turkmen gas. But that success will come at the expense of efforts to lower carbon emissions and to correct environmental damage incurred from past abuses. In addition, the country will be missing the chance to adopt a forward-thinking solution to the problem of ensuring future energy supplies. (Roman Kupchinsky)