Behind the Russia-Ukraine Gas Conflict

[Ed. note: This is an updated version of a story originally published Jan. 3.]

It has become a New Year's tradition: With the clock inching closer to midnight, Russia and Ukraine trade threats and accusations as talks over the next year's gas contract come down to the wire. The two neighbors squabble over the price Ukraine will pay for Russian gas—and the tariffs Russia will pay Ukraine for the use of pipelines that cross its territory, sending Russian gas to Europe.

Only once before did the situation get so dire that Gazprom GAZP.RTS, Russia's state-run gas monopoly, followed through on threats to turn off the taps. That was in January 2006, when Russia sought to hike prices sharply in the wake of the Orange Revolution that ushered a Western-leaning government into power in Kiev. But once again, Gazprom cut gas transmission to its Ukraine market on New Year's Day, arguing that Naftogaz, Ukraine's state-run gas company, had failed to pay its gas bill in full and that talks on a price for 2009 had stalled completely.

What's behind the dispute? Gazprom maintains that the conflict is purely commercial. In fact, both economic and political considerations are at play in both countries. That makes it likely the fight will drag on for several days or longer—in contrast to 2006, when the neighbors found a resolution within three days. Coming less than five months after Russia's heavy-handed war with Georgia, the dispute will surely raise questions about Russia's intentions toward its ex-Soviet neighbors, as well as its ability to reliably supply gas to Europe. The European Union imports about a quarter of its gas from Russia, and 80% of that amount travels through pipelines that cross Ukraine. The conflict with Ukraine also comes at a time when Russia has been trying to increase its sway among global oil and gas players, regularly attending OPEC meetings and floating the idea of setting up an OPEC-style group for the global gas industry.

Ukraine's paralyzed politics

The stakes are high. "There is potentially a lot more at stake here than just money," says Chris Weafer, chief strategist at UralSib, a Moscow investment bank. "Russia needs to win the PR war on this issue as much as it needs the higher price." Russia, he says, needs the EU to help fund new projects in the Arctic and East Siberia, which are costly because of the difficult environmental conditions but necessary to boost Russia's lagging production. "Russia will not be able to do that alone and will need the EU both as a customer and an investor," Weafer adds.

Both Russia and Ukraine have been hit hard by the global financial crisis. Ukraine is one of the few countries that appealed to the International Monetary Fund for help, taking a $16 billion loan in November. Its currency has lost half its value since September, its economy is in deep recession, and thousands face layoffs as its mining industry grinds to a halt. The government, plagued by infighting between President Viktor Yushchenko and Prime Minister Yulia Tymoshenko, is paralyzed.

This state of affairs hasn't been lost on Russia, whose own economic miracle has been jeopardized as the financial crisis spreads to the real economy. The country's financial markets have lost three-fourths of their value since August. Industrial production slowed by 8.7% in November—the most since the 1998 financial crisis. And the ruble has lost over 15% of its value in a managed devaluation that has squandered over $160 billion in foreign reserves since mid-November. Russian officials expect economic growth, which averaged 7% over the past five years, to dip to 2% this year.

A nationalist Distraction

Gazprom itself is mired in debt, and was recently included on a list of companies eligible for a government bailout.

Credit Crisis: The Risk Hits Russia

The Financial Crisis Deepens in Russia

Economic state may affect spending