Do I Smell…Gas?

Well, the Great Gas War of 2006 seems to be over before it started. The Russians and Ukrainians composed their differences and now, it’s back to sleep at the back. What on earth was up?

The first thing to remember was that, whatever the Russians said after they announced the crisis, almost all the gas the Ukraine gets from Russia is free. Rather, it’s a payment in kind for Gazprom’s use of the pipeline from Russia to the Hungarian border. So, whatever the “market price” was, the delivery of gas from Russia to the Ukraine is chiefly set by the terms under which Russian gas transits the Ukraine en route to Germany. The first blogger to mention this – in fact, the first media source of any kind, I think – was Jérome of European Tribune fame. He was also the first to predict that settlement would be swift and not necessarily in Russian interests. Why was this important?

Well, Russia is a near-monopoly supplier of natural gas to much of Europe. They have no choice but to buy gas from Russia. This would seem to mean that the Russians have a very strong position. However, Russia has very little choice but to sell gas to much of Europe. The infrastructure constrains who they sell it too, and the economy constrains them to sell it. Rather than the relation of a monopolist to many customers, then, we have the relationship of a monopolist to a monopsonist, or sole buyer. This is exactly like the position between a dominant employer and a single trade union that represents the whole workforce. Historically, such relations tend towards stability – an extreme case of the well-known phenomenon of price stability among oligopolists.

To improve its bargaining position, Russia needs to prevent the customer states acting as a monopsony – to put it another way, to divide them. Now, remember those transit fees. Obviously, it is in Gazprom’s (and Russia’s) interest to ship gas as cheaply as possible. But there is a problem with simply demanding this – there are no good substitutes for the Ukrainian pipeline, so there is little leverage. If the gas is cut off entirely, there will be political crisis of the first water, and an immediate end to payments into Russia. The monopolist and the monopsonist are stalemated.

What if we could cut off just the Ukrainians? They would be forced to negotiate from weakness, and our notion of using gas as a deterrent would be demonstrated as credible. Further, there would be a division between those who wanted to tough it out and those who wanted to keep quiet so long as the gas kept coming. Great! There was only one problem; cutting off the Ukrainian take and still pumping the rest would be just as much a theft (of services) as them still keeping their gas would be a theft (of gas), and nothing could stop them from doing so. Turning down the taps even more would have meant not exporting the European gas…and that would have been the failure of the strategy.

In essence, it was a little like the peering dispute between ISPs Cogent and Level 3 last year. Under peering, also known as settlement-free interconnection, two ISPs agree to carry each other’s traffic on a basis of reciprocity, without billing each other. Cogent’s policy is to sell cheap bandwidth to webhosting businesses that send a lot of traffic – porn sites, essentially. Under the standard Internet procedure of hot-potato routing, traffic to another network is handed over at the earliest point of interconnection, so traffic from a Cogent user in Los Angeles might be routed onto Level 3’s wires on the edge of town, taken to New England by L3, then delivered over Cogent’s local wires. L3 thought Cogent were exploiting the arrangement. Hence the dispute.

Two things come to mind; for a start, the underlying dynamic was for settlement. Neither firm could long offer its customers a service that went to the Internet but not some of it, and in fact it was customer outrage that pressed them to compromise. Similarly, over time no party in the gas row could afford not to settle. Another is that the escalation strategy for Russia was deeply unfavourable (just an extension of the first one, really).

The Russians could have turned off the tap completely, triggering all hell breaking loose. As detailed above this was not in their interest. The Europeans, though, could have made a countermove that would have been very unfavourable for Russia. Gas exported to central Europe is paid for when it passes the old western border of the Soviet Union. Therefore, it’s Russia’s gas until that point. Therefore, Gazprom is responsible for it that far. One counteroffer could be to suggest that the gas be charged for at the Russian-Ukrainian frontier. That would mean that the transit charges through the Ukraine would be the problem of the customer, and that the responsibility would lie with them too. Now, the Ukrainians would now be a customer state like the Germans, Hungarians, Austrians etc…which doesn’t sound good until you realise that the lost transit charge would be reflected in the price chargeable by Gazprom to the Europeans, and then by the payment for use of the pipeline by the Europeans to the Ukrainians. Essentially, the gas would be cold-potato routed after Russia, the Europeans taking over the cost, but also the control.

The result would be that it would no longer be possible to switch-off one state on the pipe: only the lot. Ukraine would be part of the EU for gas purposes, and the policy of offering cheap gas (rather like the old colonial one of handing out rations to keep the natives dependent) as a form of political control, bankrupt (as least as far as the central and eastern Europeans go).

Regarding the Turkmen gas and the mystery Austrian firm…well, you’d better read the link above, because that out-weirds even me.

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