U.S. Threatens to Punish Russia with Economic Sanctions for Violating Arms Treaty

On December 10th, at a Congressional hearing, Undersecretary for Arms Control and International Security, Rose Gottemoeller said that Russia was in violation of the Intermediate-Range Nuclear Forces (INF) Treaty and the Treaty on Conventional Armed Forces in Europe (CFE). The State Department undersecretary told the panel that current US countermeasures include both military actions (such as missile defense systems) and the so-called “three-pronged approach” involving diplomacy and even possible economic sanctions. In retaliation for the treaty’s violation, the Pentagon might consider re-deployment of nuclear cruise missiles in Europe as well. “We don’t have ground-launched cruise missiles in Europe now obviously because they’re prohibited by the treaty,” said Brian P. McKeon, Deputy Undersecretary of Defense for Policy, at the hearing, “but that would obviously be one option to explore.”

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In light of the tensions over the Ukrainian crisis, Russia’s reckless behavior in the Baltic, its continuous support of the Assad regime in Syria, its disproportionately large defense budget, and now its new military doctrine, U.S. concerns should be taken quite seriously.

Russia and U.S. have accused each other of cheating on arms control agreements for years now. As early as 2008, Washington first raised its concerns surrounding Russia’s testing of its R500 cruise missile, which has a range long enough to violate the 1987 Intermediate Nuclear Force (INF) treaty. In May 2013, the Obama administration officially voiced its concerns with the Russians. In late July 2014, the administration finally provided its official finding that Russia was “in violation of its obligations under the INF Treaty not to possess, produce, or flight-test a ground-launched cruise missile (GLCM) with a range capability of 500 km to 5,500 km, or to possess or produce launchers of such missiles.”

Russian officials, however, responded with their own allegations; claiming that Aegis Missile Defense System sites being deployed by Americans in Romania and Poland breach prior treaty obligations. Although their purported purpose is to intercept Iranian missiles, Russia worries that they are actually designed to intercept Russian missiles. Meanwhile, according to Sergei Lavrov, the Russian Foreign Ministry never received a clear answer to Russian questions, nor was it provided with any evidence that such a deployment was permitted.

“As far as we know”, says Greg Thielmann, Senior Fellow at the Arms Control Association, in his email to the IMR, “Russia has not begun the deployment of the ground-launched cruise missile tested. And even if it did, it is difficult to understand why this would be a militarily significant enhancement of Russia’s capabilities, considering the hundreds of nuclear-tipped warheads it can already deliver at INF ranges from its strategic missile arsenal.” Hans Kristensen, director of the Nuclear Information Project at the Federation of American Scientists, adds that “punitive actions are mainly something being pushed by the hardliners in Congress.”

It is also fair to assume that given the current situation of economic slowdown, currency crisis, Western pressure and diplomatic isolation, President Putin feels entrapped – a miserable situation that the headstrong leader has never felt before. Placed under such circumstances, he may believe that Russia is in no shape to compete with the Western democracies economically, however, in military terms, Russia is still a nation to feared and respected. «Putin is a ‘He-man’ under the squeeze”, comments Mr.Kristensen in his email to IMR, “and some of his defense plans will have to be scaled back, so he’s perhaps trying to be more dramatic than he actually is.” Given Putin’s unpredictability, this creates a dangerous situation. Therefore, it is in the United States’ interests to make sure that Russia stays in compliance with major treaties and does not cross any red lines.

By its strident warnings, the United States is seeking to bring Russia to the negotiations table, rather than fomenting a military snafu. “I believe the Obama administration would be very reluctant to deploy new weapons banned by the treaty and most potential host-nations even more so,” notes Mr. Thielmann. “Instead,” he continues, “the administration is likely to continue efforts to persuade Moscow to cease prohibited activities and avoid giving it an excuse to back out of the INF Treaty.”

Gottemoeller said President Obama has written a letter to Russian President Putin about the treaty violation. However, she did not specify how long the United States would wait before taking action in response to the alleged violation. One way or another, without resolution of the issue soon, “it could eventually lead to enhancements of U.S. military capabilities — but more for political rather than military reasons”, says Mr. Theilmann.

Russia bans food imports

On August 6th, Russia adopted a retaliatory package of sanctions against the West. Namely, they ban imports of food coming from the US, European Union, Norway, Canada, Japan, and Australia. In theory, the initiators of the restrictions have sought to hobble Western economies by hitting their exports to Russia. In fact, Russian authorities seem to have done much more damage to Russia’s own economy instead. The total volume of food exports from the EU to Russia was 126 billion euros in 2012. However, that number represents only 9% of the EU’s food exports, a noticeable decline, yet not fatal. Nevertheless, Europe’s #1food importer is still the USA, not Russia. Russia has occupied second or third place in European trade. Meanwhile, China, India, Saudi Arabia are each rapidly rising economies with growing population and thus growing demand for food. As a result, it won’t take long for Europe to divert its food exports to these regions thereby ameliorating the eccentricities of its rowdy eastern neighbor.

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The new measures will be detrimental for the Russian market and ordinary Russian citizens. First, it is important to consider that before the restrictions so-called “domestically-produced” products were made partially with imported ingredients. Russia’s hot dog and sausage industry relies on imported ferments and fillers. Russian chocolate also depends on foreign ingredients. To make a chocolate bar, Russian confectioners add local ingredients like sugar to cacao solids brought from abroad.
Second, to maintain the variety and quality of home-made goods the market needs to be open and conducive for small and medium business. The companies, in their turn, need to be competitive. Russia’s current situation is the opposite. A few monopolists dominate the market. Shelf space is literally purchased, rather than won on the basis of price or quality. In such an environment, there is little chance that the isolated Russian food market will be able to offer a large assortment of goods at similar to Western quality.

Third, barring Western brands from Russian market won’t really stop the flow of goods from the West. Belarus and Kazakhstan haven’t adopted any restrictions on foreign food items, plus both are in the Customs Union with Russia, which acts as a free trade zone. Thus, Belarus and Kazakhstan will become essentially the gateway for foreign food to enter Russia’s market. Replacing foreign stickers with “Made in Russia” is a well-known trick practiced in Belarus. So, little will change from the exporters’ perspective; however, people who work along its path will get a lot richer. In Russia, instead of the anticipated deficit of foreign foods, there will be a giant black market controlled by gangsters, who will charge outlandish prices. The situation will be analogous to that of Venezuela, which implemented currency controls, resulted in nothing more than a thriving black market for foreign currency.

Who will pay for a social experiment with entirely predictable consequences? Obviously, Russia’s ordinary people will.. For how long? For at least a year, as Putin made it clear. Bearing in mind recent attempts to protest in the streets over the past two years, it’s highly doubtful that the Russian people will be eager to tolerate such a denial of their basic rights. It is also doubtful that after such a retaliation against Western pressure and sanctions, Putin will still be enjoying his current 85% approval rating. Prohibition of food imports from the West is a draconian measure primarily directed against Russia’s own people and yet is just a mosquito bite for the targeted countries. In this regard, tension in Russian society will increase. Russian indignation with their decision-makers should spill over to other social clusters and including both the older generation and low-income groups, giving it the potential to become massive. In the best case scenario, Putin will soon realize that and change their policy trajectory. In a worst case scenario, the peoples’ resentment might soon grow to a revolutionary fervor.

How great is the chance that Iran goes nuclear any time soon?

I think the chances are much lower now than Autumn 2012. There is a two-fold reason for this. First, Iran has been severely hampered by stiff economic sanctions imposed by the West, so now it is desperately seeking to get some relief and restore its people’s living standards. Second, after Russia annexed Crimea and its relations with the United States and Europe became challenged, the West turned to Iran with more than just a non-proliferation agenda. Geographically, Iranian gas is located much closer to Europe than Russian gas delivered to Europe from the remote gas facilities in the Yamal Peninsula. It is estimated that over the course of 10 years Iranian gas could replace Russian gas in the European market. In fact, today, Iranian gas can be transported through a gas pipeline in Georgia, that is built but not yet in use.

Hence, the West is taking incremental steps to rebuild its relations with Iran. Thus, for instance, Great Britain opened its Embassy in Tehran, and the US has suspended certain sanctions. Iran, in exchange for relief from painful restrictions, has allowed the International Atomic Energy Agency (IAEA) to have daily access to its nuclear sites and enrichment facilities. In compliance with an interim agreement between Iran and the P5+1 (US, China, France, Russia and the United Kingdom plus Germany) from last November, Iran has stopped producing 20%-enriched uranium (HEU) and converted almost a half of its stockpile to low-enriched uranium (LEU) with concentration of 5%. During the latest talks in June between the P5+1 and their Iranian counterparts, Kerry said substantial gaps still exist between what Iran’s negotiators say they are willing to do and what they must do.
Even though the negotiations are still far from a final resolution to the Iranian nuclear program, hypothetically, once the West removes the embargo on Iranian exports, Iran will immediately start selling its oil and gas to Europe and Asia. This uptick in supply will help eventually bring down the world prices for hydrocarbons, which, in the long run, would be catastrophic for Russia.

South Stream pipeline and the EU double standards

Naftogaz, Ukraine’s gas company, owes its Russian-owned counterpart, Gazprom, an estimated $4.46 billion for previous deliveries of gas. Gazprom demands prepayment for future supplies to Ukraine now and files an arbitration claim in Stockholm. On June 16, Naftogaz missed a deadline to pay part of that debt (about $2 billion), which entails three consequences. First, even though the new president was elected, Ukraine has yet rendered to be an unreliable client who fails to pay bills and thereby prompts another cut-off. Second, Ukraine has repeatedly proved to be unable to provide a reliable transit for Russian gas to Europe. Third, the need for diversification of gas supplies has become even more obvious and relevant.

No wonder, Russia has become even more bullish about South Stream, a pipe-line project designed to pipe 63 billion cubic metres of gas per year from Russia to Central and South Europe bypassing Ukraine. The pipeline will go across the Black Sea bottom from Russia to Southern Europe. Its length will be 900 km. The project is being implemented by South Stream Transport, of which Gazprom owns 50%, Italian ENI 20%, French EDF and German Wintershall 15% each. To build the land part of the pipeline, Russia has stricken agreements with the governments of Bulgaria, Serbia, Hungary, Greece, Slovenia, Croatia, and Austria.
Thus, the project will cement Russia’s hold on the European gas market and diversify the gas supplies. However, the European Union seeks to diversify the gas suppliers (in other words, to give other gas suppliers access to the pipeline), not the methods of its supply. As a result, the European Commission postpones the final approval of the pipeline and applies pressure on the key-members of the South Stream chain. With solely a political purpose – to punish Russia.

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On the one hand, Brussels sharing its part responsibility for the ongoing events in Ukraine (namely, the so called Euro-Maidan was inspired by hopes to join the Economic Association with Europe), cannot let the situation be taken over by Russia. Once the situation is under Russia’s control, Ukraine (who is physically unable to pay the debt back, because its economy is gruesomely broke) is no longer the gas-transit country, Ukraine is no longer Russia’s client at all. Russia will build a new gas pipeline bypassing Ukraine, and leave the country in oblivion. That being said, why does not the EU bail out Ukraine and helps it redeem the debt to Russia? Once the debt issue is settled, there is a chance for a new round of talks regarding further cooperation in gas supplies between Ukraine and Russia, between Putin and Poroshenko, who have numerously demonstrated their eagerness to diplomatically solve the conflict.

The European Union is not so much interested in bailing out Ukraine and even less so in its admission to the Union. It would entail further subsidies, humanitarian and financial aid, all that burden that the German taxpayers have already been pissed off by dragging Greece, Spain, and Portugal out of their debts. The problem is that there are actually two Europes: the European Union as a huge bureaucratic machine, and Europe as a conglomerate of nations. Those two Europes appear to be different. What’s more, those two Europes appear to be pursuing different interests and goals, if not conflicting goals. The European Commission is acting from a position of a universal judge who seeks to pursue justice and punish the hot-headed game-breakers. The European Commission is a “stronghold” of morality that cannot allow its members to do business with someone who violates international norms and neglects other country’s sovereignty. Fair enough. Such an approach is quite understandable from the rule of law and the world-system perspective. But the reality is more complex. The reality is that Europe is still (whether it likes it or not) highly dependent on import of hydrocarbons. The price it pays for these imports matters too – now even more than ever, given the stagnation in the eurozone. Thus, the cheapest and the most reliable gas supplier to Europe is still Russia. In fact, Russia has never let Europe down since the 1960s in terms of the energy supplies. Again, 2006 and 2009 were the transit zone blackouts. The Middle East could potentially be accounted too, but at the moment it’s major client is Asia and it’s undergoing another wave of terrorist coups and civil war turmoils. EU countries get about 30% of their gas from Gazprom, and half of that is piped through Ukraine. If Europe had alternative energy suppliers such as LNG from Qatar, Algeria, and the U.S available right now (by “available” I mean ready-installed refineries, de-liquification facilities, special storages, the money, after all, to pay for the gas shipments across the Atlantic), or if Europe had alternative energy resources (wind, solar power, water energy, etc) that could easily replace natural gas, the Brussels talks would make more sense. Sadly, the fact of the matter is that Europe does not have those alternatives handy as of yet. Nor is it going to have them available in the next two-three years. Thus, no matter how unlawful and rogue Russia’s bahavior is, Europe is nowhere near ready to wean itself from Gazprom. To sum it up, Brussels acts from its supranational, hyper-idealistic perspective and makes decisions based on the same premises that drives the EU committees to set cucumber shape regulations or obligations to put a sticker on non-GMO food-items. Meanwhile, individual European states, being guided by sheer energy security interests, have to think pragmatically and act individualistically. They need to make sure that the gas supplies are guaranteed and there is no such a situation when their citizens have to burn woods to keep their homes warm on cold winter days (as it used to be the case in 2009).

Thus, Italy’s Saipem, for instance, signed a contract worth 2 billion euros with Gazprom regarding the construction of the first submarine section of South Stream and is now ready to start the work. Right at the rise of the Ukrainian crisis, in April, Austria and its biggest energy firm OMV enthusiastically supported the South Stream project. Hungary, another land route of South Stream, is also teaming up with Russian state companies for a €10 billion deal involving the construction of two nuclear reactors.
Serbia finds itself caught between its ambitions to join the EU, with which it has started accession talks, and historical ties with Russia. Nevertheless, Ivica Dacic, Serbian Foreign minister confirmed that the South Stream project is in their best national interests. After all, whether Serbia shifts to the EU or not, does not really matter. Serbia is not the key player in the project. What does matter though is Bulgaria. The gas pipeline goes through its territory, thus its approval of the project and commitment to it are crucial for the entire venture. The European Commission figured it really quickly and started pressing Bulgaria. In the very beginning, since 2010 (long before the Ukrainian crisis, by the way) the Bulgarian part of the South Stream has been criticized by the European Commission. The latter was skeptical about the transparency of the tender. Meanwhile, the tender was won by the Bulgarian Gasproject Yug and Gennady Timchenko’s Stroytransgas. Timchenko is already on the sanctions list after Russia took over Crimea in February 2014.
In April and May, the situation in Ukraine deteriorated which only strengthened Brussels’ stiff position against Russia and elevated its desire to punish it. The Bulgarian socialist government (very loyal to Russia) was holding a staunch resentment against the EU threats – until the EU reminded Bulgaria of the 15 billion euro it promised in subsidies for the Bulgarian agricultural sector and infrastructure. On June 8, Bulgarian Prime Minister Plamen Oresharski announced the suspension of the project till matters with the EU clears up. The Bulgarian head of government made his decision shortly after meeting a US troika delegation – John McCain, Ron Johnson and Christopher Murphy. The meeting came after a public statement on the 6th of June by American Ambassador in Sofia Marcie Ries, warning that Bulgarian companies participating in South Stream maybe part of US sanctions against them due to their collaboration with the Russian Stroytransgaz. This caused the Bulgarian government to split into pro- and anti-Russian factions, and they announced early elections scheduled for September this year. Boiko Borisov, who leads the centre-right Citizens for European Development of Bulgaria (GERB) party, is the most likely prime minister to be, given that his party scored the largest number of seats (representing Bulgaria) in the European Parliament elections in May.

It is fair to say that Russia tries to manipulate Ukraine and tells it what to do. It is also fair to say that Russia wants Europe play by its rules and buy its oil and gas the way Russia offers them. Paradoxically, criticizing and punishing such misdeeds, the European Union acts by exactly same token. It disregards national interests of its individuals members and uses threats and blackmails to force them to do what the EU deems appropriate. Abusing the weak points of other states (such as bad economies or chances for future membership in the EU), Brussels is actually playing by the same rules it’s been fiercely opposing.

Why has Europe had difficulty imposing sanctions on Russia?

Annexation of Crimea, Russian military posturing along the border with Ukraine, demonstrations in Eastern Ukrainian cities, Donetsk’s declaration of its independence – all these sweeping revolutionary metamorphoses in Ukraine prompted the West to respond with a series of economic sanctions against Russia. The sanctions banned around 33 Russian and Ukrainian top officials and businessmen from traveling to Europe and the US, froze their foreign bank assets, and disabled processing Bank Rossiya and SMP Bank Visa and MasterCard transactions, and expelled Russia from G-8. Despite such pressure, so far, the Kremlin continues to dismiss the sanctions as inappropriate and shows no sign of giving in under pressure.

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On the contrary, Moscow increased its pressure on the interim Kiev government, which it views as illegitimate. Meanwhile, Russia’s major power – its energy resources and ability to export them – still remains untouched. Targeting this economic sector would seriously, if not fatally, hurt Russia, since 60% of its state revenue comes from oil and gas exports and constitutes more than a half of its federal budget. But would the gas export ban be only fatal for Russia?

Europe remains dependent on Russian energy
Russia is, by far, the largest supplier of energy to Europe. According to the Energy Information Administration (EIA), European countries import 84% of Russia’s oil exports, and about 76% of its natural gas. The degree of energy dependency on Russia varies across European countries. The Baltic States and Finland are 100% dependent on Gazprom, Bulgaria, Slovakia and Hungary– 80%, Slovenia, Austria, Poland, Turkey, the Czech Republic and Greece –50%. Obama suggests replacing Russian gas in Europe with Liquified Natural Gas (LNG) imports from North America, Australia and/or Papua New Guinea. So far, this idea is but an amusing fantasy for at least two reasons: first, neither European countries nor Ukraine are able to use American LNG because they lack essential terminals to regasify LNG. It might take at ten years or more to technically prepare European terminals to fully utilize American gas, including installation of new pumping systems and other expensive facilities to decompress and store gas. Second, the cost of the LNG gas will be markedly higher than traditional gas piped from Russia – accounting for both its transatlantic shipment and associated infrastructure. The project per se is plausible but unrealistic in the near-term. Given the size and scale of these projects, it will to take years before LNG begins moving from the Gulf coast in substantial volumes. Additionally, the United States is not ready to export sufficient amount of gas to Europe yet – largely accounting for its own needs. In 2013, the US used 736 billion cubic meters of gas (98% of its total) on its domestic consumption, whereas Russia domestically consumed only 456 billion cubic meters (68%). The domestic consumption level inevitably impacts the amount of gas slated for export. Over the past year, Russia exported 190 billion cubic meters of gas, while the US only 44 billion.

 

Europe is looking forward to breaking free from Russia’s dependence on fuel supplies and has enthusiastically started to explore its own potential shale gas reserves. Poland is estimated to possess 346-768 billion cubic meters of shale gas, Bulgaria may host 481 billion cubic meters, Germany has technically recoverable shale gas reserves of 481 billion cubic meters. According to U.S. EIA estimates, Europe could have as much as 13 trillion cubic meters of recoverable shale gas. However, due to regulations on fracking and the generally high cost of European Shale, by 2020, the total annual production of shale gas in Europe is only expected to be 4 billion cubic meters, according to energy consultancy IHS. Regardless of how optimistic or pessimistic one views Europe’s potential production in 2020,  2020 is still 6 years away. Where will Europe get gas to keep its houses warm and lit this coming winter? Another impediment with fracking gas in Europe is its possible impact on the local environment. Probe shafts drilled in Poland have suggested that Europe’s ground structure differs from that of America, making it harder to cost-effectively extract natural gas. Also, political pressure from environmental groups in countries like France and Bulgaria has resulted in the imposition of outright bans on fracking. As a result, Europe is unlikely to experience the sort of “shale gas revolution” that is transpiring in North America.

 

Another energy source that will replace some Russian gas is coal. The US has plenty of excessive reserves of coal and its producers are looking for foreign customers. Because of the low demand over the past three years, the prices on coal have fallen – from $130/ton in 2011 to $75/ton today. In 2014, America is expected to send 100 million tonnes of coal abroad, mainly to the EU. By 2015, Eni predicts, Germany will shut its gas stations that cumulatively produce 10 gigawatts and open coal stations with 7 gigawatts power. According to the EIA, to produce 1 gigawatt hour (GWh) of energy needs 225,000 cubic meters of gas or 490 tonnes of coal. By contrast, for 650 terawatts produced from Russian gas, Europe pays Gazprom $60 billion a year. The equivalent amount of coal (around 340 million tonnes) would cost Europe half as much- $30 billion. On the other hand, a coal plant is still a coal plant, producing roughly twice the CO2 emissions of a natural gas plant, regardless of how much is invested in its emissions control system. WWF estimates the new coal plant planned in Greifswald, Germany, will produce 6.9m tonnes of carbon emissions a year, an amount equivalent to the entire emissions of the country of Tanzania. Coal is not the environmentally-friendly energy source of the future.

Europe could step up imports of Middle Eastern energy, however, this is fraught with issues as well. First, Europe has never fully entrusted its energy security to the Middle East and has no plans to start now. Second, although increasing oil tanker shipments is straightforward, importing Middle Eastern and Caspian Zone natural gas would require construction of thousands of miles of additional natural gas infrastructure. Currently, many of the European refineries in Czech Republic, Poland, Slovakia and Germany still get their crude oil via the Soviet-era pipeline network “Drouzhba” running through Ukraine and Belarus to Europe. In the event of an embargo, those refineries wouldn’t be able function until the logistics are adjusted. Third, OPEC could potentially leverage Europe’s situation to gouge it on pricing. Obama is currently trying to manipulate world oil prices. He has paid visits to Saudi Arabia, to speak with its 80-year-old king about the development of Saudi facilities to extract gas and deliver it to Europe in exchange for reduced oil prices. The idea that jawboning Saudi Arabia into reducing prices will have any lasting impact on the world market is a complete farce.

The most draconian policy Europe could impose would be an embargo on imports of Russia’s oil and gas. However, even with such a policy, the embargo is not going to destroy Russia. There could be cuts (say, by 20% or by 50 million tons) in volume of oil imports by European states. In that case, Russia’s loss would be $35-40 billion a year. At the same time, once Europe introduces the embargo, Russia would look for new customers. Fortunately, there are many potential oil-importers out there – notably, Central Asia and China and oil itself is fungible. Russia will refocus both economically and strategically towards Asia, thereby strengthening China – obviously, to no great thrill to the West.

All of these facts indicate that Europe can’t simply ignore its energy relations with Russia and cut itself from Russian supplies. Energy security in Europe is quite a sensitive matter, which requires a delicate approach to its resolution; in an attempt to screw Russia over, Europe could be shooting itself in the foot.

How could Russia and Europe solve the dilemma?

Europe fears the repetition of the gas supply disruptions in 2006 and 2009 when Russia simply switched the gas flow off in response to Ukraine’s fail to pay its gas bills. Who was to blame in that – Russia’s supply or Ukrainian transit? European governments were collectively blaming Russia and its aggressive rulers, whereas German, Italian, and French leading energy firms were in agreement that it was primarily Ukrainian transit crisis. Who to trust? Well, governments do politics and employ much rhetoric to justify their deeds as well as to attract more votes, whereas companies do business. The current situation in Ukraine has put European countries under the threat again, and has repeatedly shown who has been the major hurdle on the road.
When then pro-Russian president of Ukraine Victor Yanukovich chose not to sign the association agreement with the EU, Putin graciously offered him a $15 billion package of loans plus a generous discount on gas supplies. Now, when Yanukovich fled the country and the new interim government (whose legitimacy Russian authorities refuse to recognize) is assertively anti-Russian and explicitly leaning toward the EU, Russia does no longer feel obliged to provide Ukraine with any subsidies. What’s more, Russia claims Ukraine has not settled its previous gas debts. Naftogaz, Ukrainian national gas company, still owes Russia its unpaid gas bills for March, thereby totaling the debt to $2.2 billion. If Russia suspends the gas supply, Ukraine will need to turn to Europe for loans to pay off its debt in order to continue the transit of gas from Russia to Europe. In other words, Europe will have to take care of Ukraine’s debt, which Ukraine herself can’t reimburse. “Russia is not obliged and no longer going to bail out the Ukrainian economy through discounts and gas and forgiving debts, and through the subsidies to pay off Ukraine’s trade deficit with the EU countries,” said Putin in his letter to the 18 European leaders on April 10. “According to the current contract, Gazprom will have to switch to the system of preliminary payments for gas supplies and in the event of violation of the payment obligations, will have the right to fully or partly suspend the supply of gas. In other words, Russia will provide gas as longas Ukraine pays a month ahead.”
Earlier in March, Alexey Miller, head of Russia’s Gazprom, announced that starting from April 1st, the gas price for Ukraine would be $385.50 per 1,000 cubic meters in the second quarter of 2014 as the conditions of payment had been violated. On April 3, Russia announced the raise of the gas price as high as $485 due to the cancellation of the discount that was included in an old agreement concerning the deployment of the Russian fleet in the Black Sea. To compare, the initial price Ukraine used to pay for Russia’s gas was $268.50 for 1,000 cubic meters of gas (as of December 2013). In addition, during an April 3rd meeting with Mr. Miller, prime minister Dmitry Medvedev announced the cancellation of the so called “zero tariff” on gas for Ukraine. The “zero tariff” was adopted after the signature of the 2010 Kharkiv agreements in exchange for the permit to keep Russia’s Black Sea fleet in Sevastopol after 2017. The agreement implied that if the gas market price is $333 and beyond per 1,000 cubic meters Ukraine is granted a discount of $100, if the price is below $333 – Ukraine gets 30% of that level. Russia authorized this discount through the “zero tariff” on the amounts of 40 billion of cubic meters a year in 2011-2019, which the prime minister has cancelled now after the annexation of Crimea and denunciation of the Kharkiv agreements. The Kremlin now is planning to charge Ukraine for the missing incomes from the exploitation of the “zero tariff”.
Whether Ukraine pays its debt off and buys Russia’s gas at the reviewed prices or it doesn’t, Russia is committed to its European relationships and long-term contract obligations to provide Europe with gas. So far, Russia can’t bypass Ukraine in terms of gas delivery to Europe. However, it is under Gazprom’s control to decide who are his clients. Once Ukraine refuses to pay the full price, Gazprom cuts it off from the gas supply. The way out of such a troublesome situation Ukraine sees in reverse gas supplies from Hungary and Poland. The European pipe-line system can potentially be upgraded so that it can stream gas in the opposite direction – from the West to the East. According to the Slovak gas-transmission operator Eustream, the pipeline will allow “the supply of gas to Ukraine in reverse flow mode already in October of this year, with a volume of 3.2 billion m3 a year. Later on, in March 2015, this capacity could be increased to as much as 8-10 billion cubic meters a year.”
To reverse gas flow from Europe to Ukraine the pipeline needs an interconnection that would connect the pipe in Slovakia with the one that Eustream and Ukrtransgaz are planning to set in reverse mode – in Ukraine. Thus, the gas should physically cross the border with Slovakia, otherwise Gazprom may legally appeal because during the pumping of gas in Ukraine Gazprom is still the owner of that gas and any manipulation with it can’t be done without Gazprom’s permission. Eustream suggests that Ukraine build this technical solution because in addition to its functional effectiveness it will also legitimize the reverse supply of gas. The cost of the project is expected to be €20 million. The construction can be finished by the beginning of this winter. However, the Ukrainian authorities criticize this project as overly time consuming and insist on immediate revers supplies, notwithstanding the warnings from the Eustream that such a deal could violate the contract with Gazprom.

Gazprom to renegotiate the prices

It is not only Ukraine and Europe who have found themselves in an uneasy situation with Russia, Gazprom too has to reconsider its policy in response to the changing gas market reality. European market has been in stagnation since the 2008 crisis and the demand for gas has been relatively low. Hans-Peter Floren of the Austria’s OMV AG board of directors is speaking about oversupply of natural gas in Europe for the next couple of years. He expects the demand on gas in Europe to stagnate till 2020, thus, he suggests the provisions of the long-term contracts should be reviewed, the gas-suppliers should cut the price in order to restore the competitiveness of gas in the energy market. Energy Information Agency (EIA) says that the demand in Europe fell by 7.5% in 2010, and by 3.5% more in 2012.
Despite the tensions and hostile political environment between Russia and the West, European companies still view Russia as their business partner, particularly with regard to its energy sector. In the past two months alone, three major energy deals have been negotiated or signed between European and Russian companies. On April 1st, Hungary signed a 10 billion Euro credit agreement with Russia for an upgrade of its nuclear plant in Paks.
Russia’s Lukoil holds talks with France’s Total regarding the exploration of shale gas in Russia. Italy’s Saipem has signed a $2.8 billion contract to build Gazprom’s new South Stream pipeline. In March, Germany’s RWE sold its oil and gas exploration and production unit to Russian oligarchs for $7.1 billion.
Gazprom now is in a position when it can literally save the situation from rolling further downhill and maintain trust and good partnership with the West. For that it needs to become more flexible and willing to renegotiate its long-term contracts with European clients. Gazprom’s long-term contracts’ price formation mechanism is based on oil indexation. According to Sergei Komlev of Gazprom Export, such a mechanism lays down fair trading conditions in which neither supplier nor costumer can manipulate the price. The gas price is determined by the energy market. Another reason Gazprom does not want to abandon its long-term contract system is that it guarantees minimum annual purchase of gas (“take-or-pay” contract) by a client given the falling demand for energy due to the crisis in the Eurozone. However, being known for its legendary sturdiness, Gazprom has actually started reconsidering its policy: the long-term contracts are no longer unchangeable throughout decades, they are reviewed every 2-3 years and as a result have become framework agreements rather than a decade-long contracts. Eventually, Gazprom has brought its gas prices close to spot prices. If we look at a chart drafted by Thierry Bros of Societe Generale, we will see that in early 2013 the Gazprom prices were different from the NBP (gas hub in the UK, with the highest liquidity in Europe) prices by no more than 5-6%.Moving Gazprom towards market-based pricing and contract terms has served to depoliticize, to an extent, Russian-European energy trading.

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Energy-supply routes diversification

Given that this is not the first time when relations between Ukraine and Russia achieve a boiling point, Russia is seeking to avoid Ukrainian transit in its energy supplies to Europe by all means. The most feasible way out of this conundrum for Russia would be to move gas westwards using routes bypassing Ukraine, whereas for Europe it is both to diversify the pipeline routes and its energy sources.
In 2003, then-President Putin signed an agreement with the German government to construct the Nord Stream pipeline. The two pipelines of the project run almost parallel to one another through the Baltic Sea and provide Russian natural gas to Germany – from Russia’s Vyborg to German port at Greifswald. The lines were completed and set online in 2011. While the construction of a pipeline along the seabed is over three times as expensive as the construction of a similar overland pipeline, Russia benefits immensely from its investment, as Nord Stream bypasses Ukraine, Belarus, and Poland, reducing transit costs and consolidating Russian control over the energy supply to Germany and the center of Europe.

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In 2007, the Kremlin and the Italian government signed a memorandum of understanding regarding the construction of a Russian pipeline to supply natural gas to Italy. South Stream, scheduled to begin transport of gas in 2015, will travel from Russia across the Black Sea, Bulgaria, Serbia, Hungary, Slovenia, and finally to Italy. Its capacity is estimated to be 63 billion cubic meters. It is over 930 km long and 2 km deep. The pipeline is in its early phase of construction as Gazprom is laying down pipe in Russia, Bulgaria, and Serbia. The European Parliament is looking to use the South Stream as a tool to put pressure on Russia and freezes talks on its further construction. This is clearly rhetoric, yet who knows how far this rhetoric might go. Once the Nabucco project turned a failure, Europe might also want to make stake on Azerbaijan’s Southern Gas Corridor, which is underway and designed to pump gas via Georgia and Turkey to the Balkans. Once its construction is completed, the 1,250-mile pipeline will supply gas to Bulgaria, Montenegro, Bosnia and Herzegovina, Croatia, and Albania. As a result, it will make this part of Europe far less dependent on Russia.

Bottom line

No matter how desperately Europe would like to punish Russia for its truculent actions in Ukraine, European countries are to varying degrees dependent on Russia’s energy supplies. Thus, sooner or later, Europe will have to get back to the negotiating table. The interdependence between Russia and the European Union means that crippling economic measures against Russia’s key sectors may turn out a double-edged sword – strongly impacting both Russia and Europe.  Even before the outbreak with Ukraine, the Kremlin’s energy policy in Europe was aggressive and ruthless rather than cooperative and respectful of its costumers. Throughout the years Russia has systematically acquired a significant amount of influence over the countries of Eurasia and the European Union, benefiting from their dependence on Russian natural gas. As a result, it has been hard to find economic sanctions that would harm Russia without hurting other states’ economies. For example, Cutting off European imports of natural gas from Russia would leave them scrambling for other resources. Now, however, the Western states’ desperate eagerness to switch to non-Russian sources of energy strongly suggests that Russia’s energy hegemony won’t last much longer. If Russia remains in a political confrontation with Europe, Europeans will diversify their energy supply away from Russian fossil fuels, either by switching fuel sources (e.g. coal) or by country of origin (e.g. U.S. LNG)  rendering Russia’s most potent source of leverage impotent. Taking a long-term perspective, European states will need to reconsider their energy security priorities and develop them into a more coherent and harmonized policy, which will reduce Europe’s vulnerability in the event of a broken relationship with Russia.

Some remarks on “Historical Justice”

One of the driving forces behind Putin’s determination to annex Crimea was a mission to restore so-called “historical justice,” as I mentioned in the previous post. What is “historical justice?” one can contemplate the term as far as  his/her awareness of history, education, etc. stretches. Why would it be “historically just” to attach Crimea back to Russia and not to Greece or Turkey? Crimea was a Greek colony for over 400 years and then part of the Ottoman Empire for 300 years. Neither Greece, nor Turkey, today claim their territorial rights for the peninsula. By and large, revision of borders over disputable territories looks redundant and nonsensical in the modern world. Rivers of blood are spilled for only to move a border a few meters further. Thus, to restore the infamous “historical justice,” Putin could have come up with better idea how to do it in the 21st century. Meantime, what Putin just did was a surreptitious theft of Ukrainian territory  in the midst of revolutionary turmoil. Putin pragmatically seized the momentum and grabbed a piece of another sovereign state. In other words, rather than any basis in fact, “historical justice” is merely an emotional and relative category, used by politicians as a rhetorical device.

Putin and Ukraine: Small gains at the price of irrevocable loss

Here in America, people often ask me to comment on the situation in Ukraine, Russia’s military occupation of Crimea, Euro-Maidan, and Putin. Some are even curious if I, as well as other Russians, believe that Putin is somewhat psychologically or mentally deviant. I’m not a psychiatrist, so I can’t confidently set a diagnosis. Nonetheless, I believe such outrageous comparisons of Putin to Hitler or Saddam Hussein are unacceptable. There is a good article by Aaron David Miller in which he also criticizes such hyperbolic statements.

By and large, to my great disappointment, the Western media appears disturbingly hostile towards Russia and Putin. I understand the healthy nature of criticism and exquisite reproach, but what I see in the American press is just a torrent of blind hatred with the ultimate and the only aim to defeat and, rather than an attempt to try objectively analyzing Putin’s decision-making process. People got particularly excited about Angela Merkel’s remarks on Putin such as her claim that Putin was “in another world” and not really in touch with reality.
Now, let us try to look at the situation from Putin’s perspective, the perspective of a leader who is power-hungry, who has been driven by imperialistic ambitions, who desires to restore Russia’s former glory, and who wishes to halt Western meddling within its sphere of influence. As a reminder, he once declared the fall of the Soviet Union, “the greatest geopolitical catastrophe of the century.” A strong and powerful Russia is his ideology. To me, that a leader feels so strongly about his state is quite reasonable. Especially, keeping in mind that we are speaking of an autocratic leader who is used to making critical decisions on his own, who does not act inline with the commitments his country has with a variety of international organizations and councils. Putin keeps entertaining the idea that the former Soviet states are still under Russia’s umbrella, and Moscow may do whatever it wishes to do there. This is how Putin is programmed. We should take this framework as a given and use it to understand Russia’s state of affairs in and the mind of its leader. Whether or not it is a democratic, internationally legitimate, or strategically far-sighted policy is another question. I will elaborate on those ideas further in the text.

On the one hand, it would be fair to say that any state’s leader’s mission is to protect the interests of his nation and to struggle to the bitter end in any conflict or crisis situation that could potentially threaten the security of his state. And that is exactly what Putin does. What is insane about it? In situation with Ukraine, Putin’s political steps are pretty rational – again, from the authoritarian leader’s perspective. The main reason Russia is so concerned about Ukraine is NATO, the Cold War military alliance. NATO was formed to defeat an enemy – the Soviet Union, or to be more precise – the Eastern European members of the Warsaw Pact. It is first and foremost a military alliance. Although, its members claim its purpose is now merely political, as opposed to military, the evidence proves the opposite. Both Putin and the average Russian believe that the only reason for NATO to exist is the existence of an enemy. With the collapse of the Soviet Union, the Alliance found itself in a situation with no potential threat to the existence of its member-states. However, the Alliance does not want to disband. Or rather – the US (essentially it’s CEO) doesn’t want to shut the Organization down. Thus, NATO will simply invent enemies out of whole cloth to justify maintaining large military forces and adding new members. Russia is one of those mythical enemies. Thus, NATO is adamant in its desire to move anti-ballistic missile systems closer and closer to Russia’s borders, under the guise of targeting Iran and North Korea. From 1999 to 2009, NATO added 12 new member states, most of whom were former Warsaw Pact members, and is widely believed to have further expansion in mind. By “further” I mean as far as to “the Black Sea” – a region with enormous strategic value to Russia. Thus, Russia’s calculation is pretty simple: first, Ukraine joins the EU, then NATO, then NATO deploys forces to Sevastopol, blocking Russia’s sole southern seaport. Such a situation would be a strategic disaster for Russia. Thus, Putin was eager to pay any cost to keep Ukraine away from any kind of association with EU. Speaking of the currently deployed Russian troops in Crimea and the annexation of the Peninsula, Putin realized that with the abdication of Yanukovich – a pro-Kremlin leader – Putin lost his last grip on the country. At the same time, he can’t yield a strategically important region of Crimea which the feckless Khrushchev willingly gave to the Soviet Socialist Republic of Ukraine in 1954. As if the strategic rationale was not a strong enough justification, 60% of Crimea’s population are ethnic Russians bolstering Russia’s territorial claims.

Given internal consistency of Putin’s actions thus far, why would prominent Westerners aggressively parrot Merkel’s rumor? Putin’s behavior towards his neighbors is essentially identical to US actions worldwide, yet few called Bush or Obama insane when America invaded and bombed Yugoslavia and Iraq. Where were the calls to levy international sanctions against America back then? Why was there no world-wide hysteria as we are witnessing now? Why can America interfere in any part of the world and act as the world’s policeman, while at the same time Putin is expected to remain passive in the face of unfolding chaos right next to Russia’s immediate border? In other words, why are the West allowed to effectuate change whatever, whenever, and wherever they want and Russia is not? The questions are an attempt to picture reality the way Putin sees it. To this point, I want to remind readers that in the 20th century the borders of most Middle East states were drawn by the West in the ways the Western powers deemed it most convenient for them to operate in the region. Saudi Arabia, Jordan, Lebanon – all these states were created at the discretion of Western powers. In the 1940’s, during World War 2, these territories were not yet dominated by nationalists but rather were under the dominion of Axis and Allied armies.

On the other hand, had Putin acted more pragmatically, being internationally minded and strategically far-sighted, he would have had to assess the entire situation (even before Yanukovich fled Kyiv) with a strong consideration of number of problems piled up. These include declining Russian demographics, technological backwardness, insecurity of its southern borders, complex relations with China, etc. Considering all these long-term systemic issues Russia needs to maintain good relations with the West – US and EU – based on mutual trust and stability. The stabilization in Ukraine could have been achieved by different methods – acting collaboratively with other states within the Security Council, where Russia is a permanent member. Unilaterally intruding with military forces Russia violated all its previously established doctrines and international agreements (including the Budapest agreement) regarding sovereignty of other states. Thus far, Russia has not only damaged its relations with Ukraine, but also with the US and EU. Had Ukraine signed a major treaty with EU, it would have probably started moving towards EU membership. Accession to the EU, however, was never certain (look at Turkey), no doubt because it is in Ukraine’s interest to keep a balanced relationship with Russia. By abruptly disregarding international law and its commitments to various agreements, Russia has strengthened NATO’s hand, as Poland, Czech Republic, Lithuania will now feel very insecure and thus call on NATO to fortify their borders with Russia.

It remains unclear what Russia seeks to gain by absorbing Crimea. To protect Russian speaking population there? From whom? The Russians form a majority there and have never been oppressed by ethnic Ukrainians. To get more territory? Russia is a vast country – the largest in the world. An access to the Black Sea and its fleet there? Russia has been allowed to keep its naval forces in the Sevastopol harbor according to the agreement with Kyiv, and renewal of that agreement has never been in doubt. Despite the preceding, under Russian supervision, Crimeans held a referendum to secede from Ukraine and join Russia on March 16th, 2014. Although the official results are not ready, initial results suggest an overwhelming victory for joining Russia. Looking merely at the referendum misses the point. On the surface this appears to be a Wilsonian expression of self-determination, the Crimeans wanted to re-unite with Russia and the Russian government has favorably responded to their will and allowed a referendum. This is reminiscent of traditions from the Middle Ages when the Polyans and Drevlyans of ancient Russia invited the Varangians to come and rule them. Today’s rules are clearly different. We have certain norms and legislation that regulate territorial issues. Russian legislation clearly outlines the procedure of absorbing new territories. Russia may annex a state if that state sincerely asks to join Russia, note the term “state,” not “portion of a state.” Although autonomous, Crimea is still a part of Ukraine. Russia, therefore, cannot legally annex Crimea. The Ukrainian Constitution does not allow secession either. If Russia nevertheless obtains Crimea, in the long run, it will bring nothing but constant confrontations with Ukraine and the international community. Crimea will neither be recognized as either a new state, should it wish to follow in the footsteps of South Ossetia and Abkhazia, nor as a part of Russia. Furthermore, Crimea is a very poor region, with an average salary of $500 a month. Thus, Russia will gain just another dependency, again similar to South Ossetia and Abkhazia.

How can the West respond to Putin’s occupation of Ukraine? It could respond with economic sanctions, introducing bans on financial assets of certain people involved into the crisis, it could impose travel restrictions, and cooperation with Russia overall could be curtailed. Realistically speaking, however, I don’t think the West will impose draconian economic and financial sanctions on Russia. Europe, to a certain extent, is still dependent on Russian energy supplies. Russian gas accounts for 30% of Europe’s imports. Obviously, European states cannot suddenly give up on a key input to their economies. The biggest risks that Russia faces are not a momentary sanctions but rather the long-term threat of international ostracization. Such disengagement does not simply imply that the EU will leave Russia alone and ignore it. The consequences of such isolation and lack of respect and international recognition could be, in fact, catastrophic for Russia. The combined GDP of the Western countries (EU, USA, Canada, but not including Japan, Australia, and New Zealand) is 17 times bigger than Russia’s. Thus, simply by the massive economic superiority the West will start rendering Russia less and less competitive in the global market. While Russia’s energy resources are still essential, it is not the only supplier any more. Europe will gradually diversify its gas and oil imports towards liquefied natural gas (LNG) from the US and Qatar. Even Yanukovich, when he was still in power, declared that Ukraine was going to end dependency on Russia’s gas supplies by 2020, while together with Chevron they are starting shale gas exploration this year. Over the past five years, Ukraine’s gas imports from Russia have fallen by half. In addition, the West can facilitate the fall of oil and gas prices similarly to what President Reagan did after the military intrusion in Afghanistan, namely encouraging an increase in crude oil production both in the US and abroad. Thus Reagan explicitly demonstrated how a petrostate whose leader claims he is great, can wake up one beautiful morning and realize that it has confused superior leadership with high oil prices. At the same time, with the fracking proposed in Ukraine, and Poland, Russia risks losing its comfortable position in the European gas market as well.

Putin pursues policies unpopular in the West to prevent possible spillover effects from Ukraine’s revolution on Russia, to restore the so-called “historical justice” (i.e. reuniting with Crimea since it was always a part of Russia), and to restore his approval rating among the Russian population. These measures will benefit three groups in the short run: Putin and his closest oligarchs, the ethnic Russians in Crimea, and the new government of Ukraine (which can expect to be showered in Western aid money). Yes, looking a few years out, although Putin may well retain the reputation of a great leader who defended the Russian minority in Ukraine, who restored the “historical justice”, who secured access to the Black Sea, and who was able to stand up for Russian sovereignty. This glory will be short-lived. Looking forward, out years and decades, Russia loses Ukraine as a strategic partner and neighbor (a country whom Kissinger called a bridge between Russia and Europe), Russia loses trust and respect from the West, Russia becomes less resilient to China’s challenge in the Far East, and finally Russia becomes even more isolated and exposed to political disintegration.