Ukraine Not So Weak, and Why Gazprom Is Losing the Game

Ukraine Not So Weak, and Why Gazprom Is Losing the Game

Ahead of the European Union summit in Vilnius this November, Russia is stepping up pressure to prevent participating Eastern European states from signing on to an Association Agreement that will bring countries like Moldova and Ukraine closer to the European Union. Moscow has already successfully wrangled a promise from Yerevan to not sign on to this agreement by threatening to sell arms to Azerbaijan, a nation Armenia has been in conflict with since the dissolution of the Soviet Union.

It is hard diplomacy that will weigh heavily on Russia's reputation and a haphazard enticement by the Kremlin to get the former Soviet space on board the 3-nation Customs Union that promises so much less than the EU's 28-member state free trade zone.

Kiev stands up and makes way for new opportunities
Similarly, Moscow has been liberally using economic levers against Ukraine, not so subtly blocking the export of chocolate, agricultural goods, and meat products on unclear sanitary grounds alongside steel pipes and other heavy industrial products. Kiev, however, has yet to budge. In fact, it is openly defying Moscow by committing to establish closer ties with the EU.

Russia has not yet deployed its most effective whip, Gazprom and its natural gas supply to Ukraine, but the recent decision by the energy giant to speed up the designing of the Slovenian section of the South Stream gas pipeline, which will deliver natural gas to Western Europe while bypassing Ukraine, indicates that the Kremlin is taking the challenge seriously. At the same time, shots across the bow for another round of gas disputes have already been fired as Moscow responded to Kiev's demand for revision of the contract between Ukraine's Naftogaz and Gazprom with threats of sanctions.

But Ukraine is also taking measures to bolster its energy security. In pursuit of this objective, Kiev has opened up new opportunities for energy giants hoping to tap into Western Ukraine's shale gas reserves, estimated to be third largest in Europe, and hydrocarbon resources in the Black Sea.

Liquefied Natural Gas (LNG) is the name of the game
Big name companies are on the scene. Chevron is supposedly only weeks away from singing a production sharing agreement with the Ukrainian government. But the most lucrative venture right now is Royal Dutch Shell and ExxonMobil , which lead a consortium selected by Kiev to develop the Skifska gas field in the Black Sea. The field's reserve is estimated to be between 200 and 250 billion cubic meters and is expected to produce 5 billion cubic meters a year.

Shell and Exxon are both well positioned for the project in the Black Sea because of their extensive investment in researching new methods of delivering LNG. In particular, both companies have been developing floating LNG plants for offshore gas fields. Whereas conventional method had to bring the gas onshore to cool it to minus 162 degrees for shipping, the new process could take care of the liquefaction process offshore, facilitating the expansion of the gas delivery capacity, especially for a country like Ukraine where the onshore pipeline infrastructure has already been established.

In addition to the technology they bring to expand Ukraine's energy potential, the complementary benefits of the Association Agreement, which will make capital and technology transfers to Ukraine easier for not only the European Union but also the United States, further bolster the position of Shell and Exxon in Ukraine.

Gazprom left out in the cold
Meanwhile, Russia's decade-old diplomatic weapon, Gazprom , is becoming dulled. The new LNG terminal in the the Polish port of Swinoujscie, expected to begin operating next year, and China's direct negotiations with energy producing countries in Central Asia threaten Gazprom's position across the Eurasian landmass.

Recent success with Gazprom's independent offshore project near the Sakhalin has raised hopes for further expansion of production in the Arctic Ocean to supply Western Europe. However, the Arctic's Shtokman field is 550 kilometers offshore and 320 meters below surface, still an unassailable task for a company that has just achieved exploring 28 kilometers from shore at 90 meters depth.

Gazprom is banking on negotiating a long-term natural gas deal with China as pollution from coal plants and rising LNG prices in Asia make the offer more lucrative for Beijing. However, the deal has yet to be completed because China rightly holds reservations. Russia is living off the Soviet legacy and companies like Gazprom, cushioned by the export monopoly, are falling behind in developing high-tech extraction methods.

Meanwhile, the US is set to surpass Russia as the world's leading oil and gas producer because its companies have continued to invest in new extraction technology (ex. the floating LNG plant). Furthermore, The Peterson Institute for International Economics in Washington estimated that Gazprom loses $40 billion a year, equivalent to nearly 40 percent of its total revenues, to corruption and waste.

Now to top it all off, Moscow has alienated Ukraine, Europe's single largest natural gas consumer, from the Russian gas supply. Since the Ukrainian public is largely aware of the long-term benefits that the Association Agreement will bring to the country, Kiev is set on continuing the current path, and Gazprom will pay the price for being used as Moscow's geopolitical weapon over the years. At the same time, for Shell and Exxon, the conflict between these two countries was just what they needed to expand their grip on Europe's energy market.

Bottom line, expect the Vilnius Summit to bring good news to Western energy companies and turn on the warning lights for Gazprom.

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