December 4, 2009 2:00 am

A slight thaw

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Daniela Ignatova remembers the shock in her home citylast winter when Bulgaria's gas supply was cut off just as it started snowing - followed by a government announcement that warned: "We are in a crisis situation."

The headmistress recalls: "The panic here in Varna and at my school now seems to have been more frightening than what actually happened. We had to close down, but only for a day."

This winter, Mrs Ignatova has already received a letter from the heating utility reassuring her that "contingency planning" means this year's supplies are "guaranteed".

Across Europe, energy companies are making similar promises: with the continent still in recession, there is plenty of gas available this year and storage tanks are full. The European Union, for its part, is encouraging the construction of new intra-EU interconnecting pipelines. A HungaryRomania link is opening this winter. Routes connecting Bulgaria with Romania and Greece are on the drawing board.

Nonetheless, another supply crisis in eastern Europe cannot be ruled out. The threat, like last winter, is of a dispute between Russia, Europe's biggest gas supplier, and Ukraine, a transit country for 80 per cent of its larger neighbour's exports. Energy was placed at the top of the agenda when EU leaders met Russian president Dmitry Medvedev in Stockholm last month and will be again when they meet their Ukrainian counterparts at a summit in Kiev today.

Although both Russian and Ukrainian leaders have pledged this year's supplies will flow normally, political tensions are running high in Kiev, with presidential elections due next month, the first since the country's 2004 pro-west Orange Revolution. Andris Piebalgs, the outgoing EU energy commissioner, told a conference last month that while he believed the Commission had done everything to avoid another crisis with Russian supplies, "There are issues which are not settled and I believe there is a possibility that we could have a crisis and that is why we are taking [further] measures."

The gas trade divides the EU almost as much as it unites it. About 85 per cent of Russian gas consumed in the union goes to western Europe. The EU's new member states buy only 15 per cent - but depend on it to a far greater degree than western Europe does. Russian gas constitutes 15-40 per cent of the primary energy supply of the most vulnerable countries, including Bulgaria, the Baltics, Slovakia and Hungary - but just 5 per cent of the whole EU's. Little wonder that big western customers such as Germany, Italy and France are in a position to strike bilateral deals with Moscow while eastern states plead for EU-wide solidarity.

Concern about Russian gas is linked to a host of other EU gas issues, including the supply-demand outlook, the availability of alternative sources and EU market integration. "Energy is everywhere but so far it has been nowhere in EU policy considerations," says Carl Bildt, Sweden's foreign minister.

The immediate challenge is avoiding a rerun of the January 2009 crisis in which Gazprom, the Kremlindirected gas group, cut supplies to Ukraine for nearly two weeks, and Kiev stopped sending gas downstream to other countries. Vladimir Putin, Russian prime minister, and Yulia Tymoshenko, his Ukrainian counterpart, ended the dispute with a deal, billed as heralding a new era in gas. Meeting last month in the Ukrainian resort of Yalta, Mr Putin and Ms Tymoshenko promised to stick to it. "It would be very good to meet the new year without any shocks," said a good-humoured Mr Putin.

But the atmosphere in Kiev is charged, with Ukraine's leaders running against each other in the presidential race. President Viktor Yushchenko, hero of the Orange Revolution, appears certain to lose either to Ms Tymoshenko, his former ally, or to Viktor Yanukovich, his 2004 opponent. Moscow, which backed Mr Yanukovich five years ago, is signalling that either Mr Yanukovich or Ms Tymoshenko would be acceptable but is quietly keeping its distance.

Paradoxically, perhaps the biggest political risk to gas supplies comes from the Ukrainian president. Anders Aslund of the US-based Peterson Institute says: "On the whole, the risk of a new gas disruption is small. The only relevant party that may have an interest in a new Russian-Ukrainian gas conflict is Mr Yushchenko, who is toying with the tactic, 'the worse the better'."

With gross domestic product down about 15 per cent this year, Ukraine is in deep recession. A $16.4bn International Monetary Fund rescue has saved Kiev but payments were suspended last month after Mr Yushchenko approved big pre-election pay and pensions increases. The central bank has about $28bn in reserves but money is needed to support the budget and the currency, down more than 40 per cent since mid-2008. Even state-owned companies struggle with debt repayments - including gas utility Naftogaz, which narrowly averted default this autumn when creditors agreed to roll over $1.6bn. But Naftogaz has not missed any of Gazprom's $400m-$700m monthly supply bills.

Fortunately for Kiev, gas prices have fallen following the drop in global oil prices. Under a complex oil-linked formula, prices of Ukraine's Russian gas imports have come down from $360 per 1,000 cubic metres in early 2009 to about $200. The 20 per cent discount Ukraine has enjoyed in 2009 ends this month but a price rise to about $300 will be partially mitigated by increases in the transit fees Moscow pays Kiev.

With 2009's 40 per cent fall in Ukrainian gas consumption, Kiev has cut imports to about half of what it agreed to buy - and as a result was threatened with fines for breaking "take-or-pay" contract clauses. But Moscow last month cancelled fines racked up this year and accepted a 35 per cent reduction in import volumes for 2010.

On one level, Moscow is bowing to economic reality. However, Kiev may yet have to pay a political price. Russia has long sought a stake in Ukraine's pipelines. Mr Yushchenko has resisted any suggestion of giving up control of the network, but a new president might come under even greater pressure.

If Mr Putin sits out the winter without rocking the Ukrainian boat, Gazprom will do the same. The company badly needs to bolster its finances as it struggles with the economic crisis: net profits were down 48 per cent in the first half of 2009 to $10.6bn on a 30 per cent decline in exports and a 30 per cent increase in debt. Alexei Miller, chief executive, has seen a modest recovery in exports in recent weeks - and expects more next year. He will not want a supply row. Gazprom said yesterday: "If Ukraine fulfils all its obligations, including payment and transit, everything should be fine."

The manoeuvring around Ukraine must be seen in a wider economic and structural context. With the recession biting, European gas consumption is down this year for the first time ever. As the International Energy Agency said in a report last month, this has coincided with technological breakthroughs in the exploitation of gas-rich shales in north America that will reduce its gas imports - leaving even available more for Europe.

Although Russia is developing new gas fields in its far east for Asian markets, its focus remains fixed firmly on Europe. This year, as in previous years, Gazprom has been busy boosting its presence in the EU. For example, it has profited from Mr Putin and Ms Tymoshenko's joint decision to exclude from the Ukraine gas trade Rosukrenergo, an intermediary trader.

Meanwhile, Gazprom is pursuing three strategic goals - bidding to circumvent the transit states of Ukraine and Belarus by building Nordstream and Southstream, two costly new pipelines; deepening ties with big west European energy groups; and developing huge new gas fields in Russia's far north for the European market.

Last month's summit with France illustrates Russia's ambitions. The two countries backed plans for EdF, France's biggest utility, to join Gazprom and Italy's Eni in the consortium preparing Southstream, the Black Sea-Balkans-Italy pipeline. GDF Suez, the French company operating the EU's biggest gas network, said it was negotiating a stake in Nordstream, the northern route planned to link Russia and Germany via the Baltic seabed. Total, the French oil group, is already a 25 per cent partner in Gazprom's giant Shtokman Arctic Ocean gas field. Similar agreements link Gazprom with German and Italian utilities.

Many east European observers are concerned that these deals exclude them. Radoslaw Sikorski, Poland's foreign minister, three years ago compared Nordstream to the Nazi-Soviet pact that divided eastern Europe in 1939. He has toned down his rhetoric but the doubts remain. Agata Loskot-Strachota, of Warsaw's Centre for Eastern Studies, says: "Some countries feel vulnerable."

T he EU is responding on three levels. Alongside the planned pipelines, it is also pushing ahead with its long-term effort for an integrated EU gas market. Brussels has strengthened key rules - for example, outlawing Gazprom's ban on its EU customers from re-exporting - but still faces opposition from utilities reluctant to open markets to intra-union competition. Pierre Noël, of the European Council on Foreign Relations, says: "I am not so optimistic about the single market as Brussels."

Third, the EU supports diversification both of gas supplies and of energy sources. On the gas front, it is encouraging investments in liquefied natural gas terminals from Rotterdam to Gdansk. It also backs the ambitious Nabucco pipeline linking the Caspian and the EU via Turkey and the Balkans. In July, the transit states signed a long-awaited legal agreement. At Austrian energy group OMV, Wolfgang Ruttenstorfer, chief executive, says an investment decision is due next year. But first Nabucco must secure gas supplies from either Azerbaijan or Iraq - and neither deal is certain.

So while Russia pushes ahead with its plans to consolidate Gazprom's influence, the EU must spend time on long negotiations both outside the union and within. As one European gas industry executive says: "Mr Putin is lucky. He doesn't have 27 partners."

Additional reporting by Roman Olearchyk in Kiev, Thomas Escritt in Budapest and Nikolai Petrov in Sofia

Flow rate

Europe's long-term dependence on gas imports will grow from 59 per cent to 83 per cent by 2030, according to the International Energy Agency, the developed world's industry forum.

Reduced demand as a result of the economic slowdown has given companies such as Russia's Gazprom an opportunity to delay investments and save cash. But demand will recover. As North Sea output declines, Europe will buy liquefied natural gas from the Middle East and elsewhere. But its principal imports will come via pipelines from Russia and from the emerging producers of the Caspian basin, including Azerbaijan and Turkmenistan - with Russia as "far and away the biggest exporting country".

Supply and storage

A sector where partners can at the same time be potential threats

For Zsolt Hernadi, keeping an eye on Moscow goes with the job.

Russian companies are both partners and potential threats to the independence of Mol, the Hungarian energy group Mr Hernadi heads. Gazprom is its main gas supplier while Surgutneftegaz, a Russian oil company with close Kremlin ties, this year unexpectedly turned up as the unwelcome owner of a 21 per cent stake in Mol.

Surgutneftegaz bought its shares from OMV after the Austrian group pulled out of a €20bn ($30bn, £18bn) bid for Mol amid opposition from the company and the Hungarian authorities. Mr Hernadi, who has led Mol since 2000, accused OMV of acting as a "front" for Russian interests. OMV denied the claim. But relationships remain difficult in spite of the fact that Mol and OMV co-operate on issues including the strategic Nabucco pipeline.

Like other energy groups, Mol - which has big investments in Slovakia and Croatia and interests in the Middle East and Pakistan - is struggling with the recession. Net profits in the first nine months fell 75 per cent to Ft42.9bn ($240m, €159m, £145m).

Mr Hernadi does not expect a winter gas supply crisis, saying Moscow did not want to be seen to be influencing Ukraine's January presidential election: "Storage is full. Demand is weak, spot prices low. I don't see too many interests in [creating] this kind of crisis."

Hungary supplies about 15 per cent of its gas from domestic production, with the rest coming from Russia. With few other energy resources, it is more dependent than other EU members on gas, which accounts for 40 per cent of primary energy consumption.

After the 2006 Russia-Ukraine gas dispute, Budapest ordered the construction of a $850m strategic store to supplement commercial storage. This was completed in October and the country can now store half its annual consumption, a capacity among Europe's highest.

Mr Hernadi says Hungary last year assisted gas-short neighbours and would do so again. An interconnector to Romania is due to be completed this year and one to Croatia by 2011. Mol is a partner in Nabucco as well as a liquefied natural gas terminal planned for the Croatian island of Krk.

Better energy links could lead to an integrated regional market with "good negotiating power", says Mr Hernadi. In central and eastern Europe, "with 150m people we have a gas market close [in size] to the German market".

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