By JEROME GUILLET
The Wall Street Journal
New York, New York
Friday, November 8, 2002

The recent announcement by Russia and Ukraine that they were creating a joint enterprise to jointly manage the export gas pipelines going through Ukraine -- from Russia to Europe -- has struck fear in the hearts of many. Ukrainians are afraid that their country's newly achieved independence will end with their main enterprises taken over by the Russians. Russians are worried that they are going to end up paying for the pipeline maintenance not done by their poorer cousins in Kiev; and Western Europeans worry about the reliability of their gas supplies from the former Soviet Union. The reality is quite different.

The fate of Ukrainian gas pipelines has long been an object of concern for followers of the gas industry in Europe. Ninety percent of Russian exports to Europe must go through them, and Ukraine has been regularly accused of siphoning this gas. Yet this accusation has been true in only three well publicized incidents, in 1992 and 1993.

What happened back then was very simple: Russia tried to cut off its gas deliveries to Ukraine, which were not being paid for, and Ukraine retaliated by reducing deliveries on the export lines to Europe. This situation lasted only a few days; in each instance, Western buyers immediately panicked, then Russia backed off and resumed supplies to Ukraine. But deliveries to Europe have not been interrupted a single time since 1993.

Gazprom understands very well that the reliability of its supplies is essential in its relationship with European purchasers, and it took the decision then to deliver to Ukraine whatever was necessary to get the exports out on the other side. Indeed, this situation was really no worse than what was happening elsewhere in the region, with gas delivered and not paid for -- except that no other customer of Gazprom held a stranglehold on the company quite like the Ukrainians did.

Luckily for Gazprom, no other customer was also quite so bumbling. The only thing that the Ukrainians managed to achieve in return for controlling absolutely 25% of Russian exports was a dwindling supply of gas, which was wasted with the same abandon as in the Soviet period. No reforms were engaged to reduce consumption, or to try to grab the export market from Gazprom by buying the gas from them and on-selling it to Europe. Instead, the Ukrainians let Gazprom slowly take over their industry.

Corruption in the Ukrainian gas industry meant that certain officials took advantage of Gazprom's inability to enforce payment in order to enrich themselves. As in Russia , the final consumers in Ukraine quite often paid for their gas, but the bill collector chose not to pass on these revenues to Gazprom (in Russia for political reasons, and in Ukraine thanks to control over the export routes).

Gazprom's brilliant solution was to have Russian gas delivered by someone else, a private entity not affiliated to Gazprom which could cut off supplies to Ukraine without risking retaliation like Gazprom: Itera. Itera found accomplices among Ukrainian factions able to take control of the gas distribution business, and it sold directly to such private entities and not to Kiev's state gas company.

Gas was procured by Itera from Turkmenistan to build the fiction that it was not Russian gas being delivered (a scheme made all the easier because Turkmenistan was in such a weak bargaining position, with all its pipelines going straight to Russia ). The revenues collected in Ukraine from distribution of non-Gazprom gas -- whether in the form of money, goods or ownership of local production assets -- were shared between the new Ukrainians, Itera and its partners in Russia and Turkmenistan.

The fact that Itera, and Itera alone, was able to ship large volumes of gas through Gazprom's pipeline network between Central Asia and Ukraine strongly suggested to observers that it had close relations with Gazprom's top management, although this has always been denied by both Gazprom and Itera and never has been conclusively proven by outsiders. In any case, such a sort of arrangement seemed to make sense: It reduced Gazprom's deliveries to Ukraine and extracted some revenue for Gazprom from that country (whatever was paid by Itera for gas transport which would have taken place anyway) and it was a perfect opportunity for well-connected individuals to benefit. This led to massive corruption and nasty political battles inside Ukraine, to take part in this juicy business, with the population, as usual, the main victim.

Meanwhile, as Itera officials stepped in with its deliveries, Gazprom's deliveries were quickly reduced to a volume of 25-30 billion cubic meters per year, which is the volume where Gazprom loses no money in Ukraine, because the value of that gas roughly corresponds to a reasonable transit tariff payable to Ukraine for all the volumes exported to Europe through Ukraine, which is some 120 bcm a year. Ukrainians still do not pay for that gas, but they do not incur new debts (the $1.4 billion debt figure quoted all the time is essentially the debt incurred in 1992-93 which is rescheduled every other year.) Gazprom does not get cash but gets value for its gas. This can be accounted at production cost or at any equivalent transit tariff value, depending on the reporting requirements of the day -- the difference between the two extreme options can represent an extra $2 billion per year in Gazprom's declared revenues and profits.

Today, Ukraine receives 50 bcm of gas per year from, or, in the case of Turkmen gas, through Russia (compared to close to 100 bcm in 1990). Half of it is delivered by Gazprom directly, the other half by Itera or other similar "independent" traders. Gazprom's exports flow to Europe unhindered, with plenty of spare capacity (thanks to deliveries to Ukraine having fallen overall faster than Gazprom's exports to Europe have grown), and its deliveries to Ukraine bring it a decent level of revenue.

So, why would Gazprom want to bother now taking over the assets? The simple explanation is that it represents a great opportunity to make the European purchasers pay for the maintenance of the Ukrainian pipelines. Gazprom has a long history of making its clients pay, willingly or not, for its investments. For instance, Ruhrgas purchased shares in Gazprom at a time when nobody wanted to invest in Russia , in exchange for the shelving of Gazprom's expansion plans in Germany (via its Wingas venture with BASF). The Italian energy company ENI invested in the Blue Stream pipeline, which significantly increases Gazprom's export capacity to Turkey, at the same time that Gazprom's plans to develop in Italy with Edison were abandoned.

This time, the idea is to build on the bad reputation earned by the Ukrainians (since "thieves" wouldn't bother to maintain their pipeline network) to once again get the likes of Ruhrgas, ENI and Gaz de France to pay for new Gazprom investments. After all, even if they pay for truly needed work in Ukraine, it frees Gazprom resources for other projects.

In sum, while the "Russian-Ukrainian condominium" name may make it sound like a collective venture for the good of Europe, it really is closer to highway robbery. But the Western companies can't do much about it. The share of Russian gas is bound to increase inexorably in Europe in the coming 20 years as demand grows and all buyers need to renew their contracts and safeguard their supplies. Still, it would be ironic if, by agreeing to pay Gazprom to maintain its transportation infrastructure and reduce its dependency on (supposedly unreliable) Ukrainian partners, Western European companies end up strengthening Gazprom's overall control over the European gas market by way of its iron grip on the main transport routes.

Gas is essentially an infrastructure business, and Gazprom understands this better than most and has been building up and nurturing its access to the European market steadily over the past 30 years, as the Ukrainian saga attests once more. Other gas companies, beware; before it is too late.