The Orange Meltdown – Tragedy and farce

The Western alliance has made much of its “success” in splitting Ukraine from Russia – inviting a country which has been part of greater Russia for the past 1000 years to adopt a pro-Western position, joining NATO and distancing itself from Russia. Unfortunately, there is a cost – and this is a cost which neither the Americans nor the Europeans have any intentions of footing. Both apparently expect to win a victory on the cheap and appear to be caught flat-footed by the recent turn of event.

Having succeeded in getting their candidate elected, the Western countries congratulated themselves on a job well done and pulled away – the Americans have provided the most trivial amounts of aid. With more than enough on its plate already, the European Union has made clear that it has no conceivable intention of spending the tens of billions which would be required for Ukrainian convergence. Quite amazingly, until this month both the Americans and the EU appeared to sincerely expect that Russia – the loosing side in this skirmish – would actually fund the transformation, continuing to subsidize the Ukrainian economy with the annual supply of several billion dollars worth of cheap gas. Even more incomprehensibly, the Ukrainians have stupidly fallen into the trap – with potentially devastating results for what remains of their economy.

Bitter Oranges

Long time readers of Truth and Beauty (and Russian Finance) will remember our extreme scepticism as regards the Orange revolution. Russian attempts to influence the elections were typically clumsy, misguided, and counterproductive – while the American-Polish manipulation was skilful in the extreme. This does not mean that the substitution of one crooked and incompetent government with another was cause for rejoicing. Transparently, the real reason for the widespread celebration of this “triumph of democracy” was simply the fact that it left the Russians firmly on the backfoot.

The Western press was literally gushing about this new, pro-Western government – conveniently glossing over the fact that Julia is Ukraine’s surgically enhanced version of Viktor Chernomyrdin – corrupt down to the very marrow of her bones. A billionaire, who made her fortune pillaging Ukraine’s notoriously-corrupt United Energy Systems (her old crony – Lazarenko, jailed in the US on charges of having laundered bribe money from her, was apparently a rare case of a bribe taker without a bribe giver – Julia was never charged!). Indeed, some of our usually-insightful Moscow peers were incapable of realizing to what extent they were being manipulated, giving way to virtual paroxysms of joy at “yet another young country throwing off the bonds of its past and emerging into a shinning new…” – but you’ve heard it before! .Like Poe’s Raven, T&B intoned “Nervermore”.

Yushchenko’s firing of the notoriously-corrupt Timoshenko and her thieving cohorts, replacing her with the technocrat Yekhanurov, born in the Russian republic of Buryatia and has no known political ambitions seemed a very positive sign. In the event, while the new team is far less corrupt than the previous ones, it also appears to be substantially less competent. Ukrainian GDP has collapsed from an annual growth rate >12% to 2.2%, and is expected to sink in recession this year. Inflation has gone ballistic. Thus far, rather surprisingly, Ukrainian financial markets have held up decently on the back of the extremely positive trend in the EMEA…but for how long?

The Ukrainian industrial structure is post-Soviet unreformed. The extraordinary growth seen early in this decade was almost entirely piggy-backed upon Russian growth – and massively subsidized Russian gas. The Eastern-Ukrainian industrial complex saw little if any new investment. Cheap energy made it unnecessary – open hearth pits were kept open, steel was rolled into pipe, and the pipe re-exported to Russia to compete with domestic production. Similarly, the chemical industry, in particular the producers of nitrogen fertilizers, can function profitably only with subsidized gas.

Mittal Steel’s historic purchase of Kryvorizhstal for $4.8bn now looks a blunder of huge proportions. We do not know who did their due diligence, but they seemed to have missed one vital detail: the energy-inefficient Kryvorizhstal complex can be profitable only with very cheap energy supplies! While with substantial investments they could substantially decrease their energy consumption by moving to continuous casting and especially, by using far larger quantities of coke in the steel-making process, this would be equally expensive. As for gas, while only 25-30% of Ukraine’s gas is supplied by Russia, another 35% - supplied by Turkmenistan at prices less than a third of world levels, is delivered to them by Gazprom. On the other hand, Gazprom depends upon Ukraine for transport of about 80% of its gas supplies to Europe, theoretically making them susceptible to the threat of interruption of their export routes.

In fact, throughout the 1990s Ukraine simply “diverted” whatever gas it needed, siphoning it off from the pipeline. Oddly enough, while this theft was widely known, it resulted in nothing more than the occasional scolding from the then-management of Gazprom, followed by solemn pledges by the Ukrainians that they wouldn’t do it again…given the well-known transparency of the Chernomyrdin- and Vyakhirev-led Gazprom, one can safely assume that they turned a blind eye because there was something for them in the deal – and that the Kremlin had no desire to destabilize Kuchma.

As Gazprom evolved into a for-profit commercial entity, the nature of the deal was revised to a barter system whereby Ukraine was paid in gas for transporting Russian production West to the EU and the Eastern Europeans. This deal was subject to annual revision, and this time, the Russian side has decided that it intends to pay for transport in cash, at (European) market prices, and intends to bill for its own gas in hard cash too. While in theory the Ukrainians would have the option of increasing transit costs to Russia, this might leave them open to worse problems, as Gazprom could charge them the same amount for transporting Turkmen gas. While there was a possibility that Ukraine would simply divert Russian gas intended for the European Union, they have received some very firm warnings from several of the major EU countries regarding the effects that this would have on their relations with the bloc. Europe is disinclined to freeze in the dark in support of Ukraine’s right to subsidized Russian gas!

Methodless Madness?

At first glance, the recent events could lead one to enquire not just about Yushchenko’s intelligence, but indeed, about his sanity. Leaving aside the rights and the wrongs of the situation – Ukraine has found itself facing exceedingly difficult negotiations with Russia as regards gas prices – negotiations which bear a very real threat of total devastation of the Ukrainian economy. Yet, amazingly, during the count-down to the New Year’s day deadline, Yushchenko could find nothing better to do than to announce the establishment of a committee to smooth Ukraine’s entry into NATO! Certainly, his timing could not have been worse. But his strategy leave us somewhat bewildered.

First of all – the issue is irrelevant. Ukraine will shift to a parliamentary regime after the 26 March elections, and with Yushchenko in third place behind both Yanukovich and Timoshenko [1], he will no longer be in a position to negotiate Ukraine’s joining the Boy-scouts! But even if he were, what possible advantage could he expect from poking a finger into Putin’s eye just now?

There are at least three possible explanations of Yushchenko’s strategy:

-The most likely is that, faced with an election campaign he seems destined to lose, and having failed in his attempts to change the constitution to save himself from defeat, he is looking to create a major crisis with Russia – and to attempt to rally the Ukrainian people against the foreign threat. This is likely to prove a losing strategy, since Yanukovich (and, mark our words, in all probability Julia as well) will simply claim that this demonstrates his utter incompetence – provoking an unnecessary fight with Ukraine’s largest trading partner.

-A second explanation, not incompatible with the first, was offered by Yanukovich. While Mr. Yanukovich’ credibility is very limited, that does not mean that everything he says is untrue (self-serving truths are not unheard of…) and he claims that the gas dispute worsened following a meeting between Yushchenko and CIA chief Porter Goss in Crimea. Certainly, it is in the interests of the CIA that Ukraine falls out with Russia. With less than three months before the elections, and their candidate seemingly out of the running, the US administration has little to lose by fostering a crisis.

-Stupidity and arrogance – the least interesting of the three – cannot be entirely ruled out. Perhaps the Ukrainian side simply painted itself into a corner, assuming that Gazprom would flinch under Western pressure. Similar mistakes have been made before.

Western opinion has been caught a bit over a barrel on this one. Having browbeaten the Russia to begin using market pricing in its exchanges, it is somewhat difficult to now complain that they are doing so. While the allegation that Russia is still providing subsidized gas to Byelorussia, and somewhat cheaper gas to Georgia and Armenia, is true, it is of limited relevance. Byelorussia is seen as part of the Russian Federation (if only Lukashenko would disappear!) and Russia has the God-given right to sell its gas at whatever price it chooses – if the offtaker does not like the price, they are welcome to shop elsewhere.

Unhelpfully, the Russian side disingenuously claims this to be a purely economic issue – without any political overtones… i.e. the Kremlin communications strategy is typically dire! In fact, they should simply point out that any country in Russia’s old sphere of influence adopting an overtly hostile policy and threatening to join NATO is exercising its sovereign rights – but should expect no further economic subsidies! We are unaware of any law which prohibits selective subsidies to friendly countries. The United States provides billions of dollars a year in aid to Egypt, and not a penny to its neighbour, Syria. Not coincidentally, Egyptian policy is rather pro-American, Syrian policy very much otherwise. Syria is hardly about to take America to court to demand equal subsidies.

The Endgame

-For Ukraine

In fact, there may be rather less here than meet the eye. Conveniently, Ukraine has about 4 months of gas supply (in fact, the gas is owned by Gazprom, but then, possession is 95% of the law!) in underground storage. That four months conveniently takes us through the upcoming Ukrainian parliamentary elections. One would assume that the first priority for the next Ukrainian government will be to negotiate some sort of a deal with Gazprom. It seems a safe bet that the difficulty of those negotiations will be very much a function of what the next Ukrainian government looks like, and what its policy orientation will be

-For Gazprom

Gazprom is an odd hybrid. On the one hand, it is clearly an effect organ for the Russian government. On the other hand, it is an increasingly profitable hydrocarbons company run for the economic benefit of its shareholders – including the Federal Property Ministry. Thus, while some of its tariffs in the neighbourhood (Georgia, Armenia, Turkey, Baltics) are a better bargain for the buyer than for the seller, not all of the buyers could take gas at international prices, and at least the tariffs received are moving towards some sort of a vaguely market basis. On the other hand, domestic tariffs (and that includes Byelorussia) are going to remain subsidized for a long time to come. This is a political reality, and needs to be factored into the prices of the stock. Gazprom export routes will remain dangerously exposed to political pressure until the commissioning of the Baltic sea pipeline sometime in 2010.

[1] Julia has prudently cut a deal with the Kremlin. Shortly after being fired, the crusader for transparent, pro-Western governance rushed to Moscow where she was facing criminal charges for bribery. By the time she left the prosecutor’s office she had been miraculously reclassified as a “witness” in the probe of alleged bribery by herself! Most recently, she was again named as a suspect – however since it was simultaneously discovered that the charges against her were covered by the statute of limitations – she is now free to come and go as she likes (and how do you spell “Kremlin” in Ukrainian?). In any event, Julia was recently spotted having drinks at the birthday celebration of a prominent siloviki, also attended by President Putin!. Ici, tout se rиgle en famille!

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