Is Russia Preparing a Gas Nuclear Option?
By University of Houston Energy Fellows
Vladimir Putin is noted for taking surprise action, which confronts his victims with a fait accompli. They must then either accept the new unfavorable status quo or react in a way that they would consider too risky. Putin has employed this playbook in Georgia, Crimea, East Ukraine, Syria, on Ukrainian naval vessels in the Black Sea and to prop up the Maduro regime in Venezuela.
Putin’s potential targets should put themselves inside Putin’s head to anticipate his next hostile move in order to avoid again being caught off guard with few good options.
Putin loves the unexpected; so beware. On paper, this would be the worst time for Russia to act up in its European gas market. Russia’s Gazprom just narrowly saved its key project – the undersea Nord Stream 2 pipeline directly to Germany – despite almost universal opposition in Europe. Gazprom faces new unfavorable (unacceptable) regulations: On April 5, 2019, The European Parliament and European Commission adopted a new gas directive that requires Gazprom to unbundle delivery from production. Moreover, Germany’s Angela Merkel has promised Ukraine that, Nord Stream 2 or not, Russian gas will continue to flow through Ukraine. That’s not all: With the threat of competition from American LNG, Russia would strive to emphasize the reliability of its deliveries to its massive European market. Finally, LNG competition would surely constrain Putin from taking hostile action that jeopardizes Russia’s European gas revenues.
We can add one more factor that should temper Gazprom’s behavior with respect to its European gas market: According to Gazprom’s own reports, the Nord Stream 2 pipeline will not be completed as planned by the start of 2020. Denmark has not issued construction permits and has requested that Nord Stream change its route. According to European authorities, the delays could be substantial.
With Nord Stream 2 delayed (its capacity is 85 percent of Ukraine’s transmission capacity into Europe), Russia would seem to have no choice but to make substantial use of Ukraine’s pipeline.
Despite these factors, Ukraine’s gas company, Naftogaz, worries that Putin is preparing to launch what amounts to a “nuclear gas option” that will push Ukraine into recession and create gas shortages throughout Europe. Russia’s move, they think, will take place on or around Jan. 1, 2020.
Here is how it would work:
Ukraine gas experts point with some alarm to Gazprom’s accumulation of gas in European storage facilities. As they fill up, Gazprom leases more storage facilities. The gas in storage, the Ukrainians think, is being accumulated to meet Russia’s minimum contractual deliveries to Europe while bypassing Ukraine’s pipelines in total.
If Gazprom were not planning to bypass Ukraine, it would be negotiating a transit contract with Naftogaz, but Ukraine sees no move by Russia in this direction. In fact, Ukraine has yet to receive the relatively small volume of Russian gas for which it prepaid. Russia’s Gazprom, in addition, continues to refuse to pay Ukraine a $2.6 billion fine levied by Stockholm arbitration.
Consider the effects of such a nuclear option: With no gas coming through Ukraine, Gazprom will only be able to meet its minimum contracts to Europe, even with the gas in storage. Gas prices, in such a scarcity situation, will increase, compensating Gazprom in part for the smaller volumes of sales. Ukraine, which has been buying Russian gas from Europe, will literally be left out in the cold. Europe will not have enough gas supply to back flow it into Ukraine. With a struggling economy and Azov seaports quasi-blockaded by the Russian navy, Ukraine would lose the $3 billion in transit revenues, which constitutes some 3% of its GDP. Deprived of these revenues, Ukraine could slip into a recession, in new President Volodymir Zelensky’s first year in office. Russia could hope the besieged Zelensky will cave and seek accommodation with Russia on Crimea and East Ukraine.
Whether or not Putin deploys the nuclear option depends on his calculation of short and long-run costs and benefits. In the short run, the nuclear option could destabilize the Ukrainian economy, a top priority for Putin. He would deprive Ukraine of essential transmission fees and create gas shortages during Ukraine’s bitter winter. He might be able to convince Ukraine’s new political leadership to play ball with their powerful neighbor. With a general shortage of gas in Europe, Putin might be able to split Europe by playing favorites and punishing enemies. Maybe he could even force those countries that are delaying Nord Stream 2, either through permits or gas directives, to get behind completion of the project.
Clearly, a nuclear option would risk long-term damage to Russia’s gas business with Europe. It would promote the construction of LNG terminals throughout Europe and drive European buyers into the clutches of American LNG. Europe could not afford to gamble with Russia’s unreliability as a supplier of such a key resource. But the nuclear option carries with it tempting short-run gains. It would remove Ukraine from the gas delivery business. Russia could destabilize the new administration of a young and popular president. Russia could again play king of the hill and split Eastern Europe from Western Europe, not only with cyber-attacks but with the more potent weapon of energy.
Let’s wait for Putin’s move.
Paul Gregory is a research fellow at the Hoover Institution. He is Cullen Professor Emeritus in the Department of Economics at the University of Houston, is a research fellow at the German Institute for Economic Research in Berlin, and is emeritus chair of the International Advisory Board of the Kiev School of Economics. Gregory has held visiting teaching appointments at Moscow State University and the Free University of Berlin.
Gregory was the director of the Russian Petroleum Legislation Project of the University of Houston Law Center from 1992 to 1997 and has written broadly on Russian energy.
The holder of a PhD in economics from Harvard University, he is the author or coauthor of twelve books and more than one hundred articles on economic history, the Soviet economy, transition economies, comparative economics, and economic demography. His most recent books are Women of the Gulag: Portraits of Five Remarkable Lives (Hoover Institution Press, 2013), Politics, Murder, and Love in Stalin’s Kremlin: The Story of Nikolai Bukharin and Anna Larina (Hoover Institution Press, 2010), Lenin’s Brain and Other Tales from the Secret Soviet Archives (Hoover Institution Press, 2008), Terror by Quota (Yale, 2009), and The Political Economy of Stalinism (Cambridge, 2004), which won the Hewett Prize. He co-edited The Lost Transcripts of the Politburo (Yale, 2008). His archival work is summarized in “Allocation under Dictatorship: Research in Stalin’s Archive” (Journal of Economic Literature.) Gregory is the producer working with director Marianna Yarovskaya of the documentary film Women of the Gulag, short listed in the 2019 Oscar competition.
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