Gas talks stall as Russia pushes for EU guarantees on Ukrainian gas payments

Update 11.50 30/10/14:
Reuters is reporting that an EU spokesperson has said a deal is "very close" and talks will continue today, as we note below. As we also say below, a deal is still doable and likely, the question remains whether any form of EU payment guarantee will be needed and if this can get sufficient support within the broader EU member states.

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Despite another round of talks between Ukraine, Russia and the EU which ran late into the night yesterday the negotiations seem to have reached somewhat of a stalemate.

Earlier in the year the halting of gas supply between Russia and Ukraine (for Ukraine’s own use at least) was not seen as too big of an issue and it was hoped Ukraine would be able to leverage the combination of economic pain from sanctions and the Russian government’s reliance on commodities exports for funding to secure a relatively favourable deal. However, on the cusp of the harsh Ukrainian winter the power balance has steadily shifted and Russia has continued to hold firm and even broadened its demands.

What has been agreed so far?
Quite significant progress has actually been made compared to the starting point:

• Ukraine has agreed to pay for previous gas supply at a price of $268.5 per thousand cubic metres. This means $1.45bn will be paid by the end of October and $1.65bn ($3.1bn total) by the end of the year. Ukraine’s Naftogaz has set aside $3.2bn in an escrow account to pay for this.
• Going forward Ukraine will prepay on a monthly basis for its gas this winter at a price of $385 per thousand cubic metres. Russia has agreed to pay transit costs.

Russia has clearly shifted from its original price demand (at least with regards to back dated payments), but Ukraine has also compromised by agreeing to prepay and pay off existing debts.

What are the key sticking points?
There is really only one, but it’s a biggie. While Ukraine has proven that it can afford to pay off its existing debts there is much less certainty about its ability to prepay going forward.

We have noted before the significant downward spiral in the Ukrainian economy. While the fighting has calmed down to an extent, things are still far from normal, not least because the conflict has become frozen in the East with part of the country still de facto cut off.

Ukraine is now totally reliant on external funding from the EU and IMF. As we have seen in the Eurozone crisis the release of such funding is often more complicated than expected and creates a staggered cash flow linked to economic reforms. Such reforms should pick up following the election but remain tricky to implement in a country caught in the proverbial no man’s land in the sanctions war between Russia and the EU.

For these reasons Russia has continued to demand some form of explicit guarantee from the EU that Ukraine will be able to pay for the supplies over the winter – they are expected to cost around $1.6bn, though this could increase if the winter is particularly harsh.

Is a deal likely?
It’s looking difficult as this meeting was earmarked as the most likely one for a deal. Russia seems to be using this arena to flex its muscles given that it believes it has the upper hand. That said, the economic costs of sanctions and a falling oil price are creating problems for the Russian economy, though it’s not always clear whether economic logic is sufficient to alter Russian President Vladimir Putin’s position.

Getting explicit EU support for around $2bn to guarantee prepayment would be difficult. But, so far, the EU has been fairly supportive of Ukraine and may be willing to offer a more tacit agreement to provide further funding rather than outright underwriting of the payments. Furthermore, without a deal there will be a huge temptation for Ukraine to siphon off gas which it is transiting from Russia to Europe. This could cause Russia to halt all gas flow through Russia, something Europe is keen to avoid to say the least.

Talks are set to resume later today according to RIA Novosti. With all this in mind, and the fact that a deal remains in all sides' interests, we would think one could still be struck.

What are the lessons here?
Ultimately, this dispute is teasing out a key question for the EU in the wake of this crisis. It is becoming increasingly clear that Ukraine is economically devastated in the wake of the war and the sanctions. The offer of opening up markets in the EU is unlikely to be sufficient and the EU and IMF will have to face up to the fact that in the short and medium term they will probably have to offer significant amounts of cash to Ukraine to help stabilise its economy, currency and energy supply.

Putin is aware of how politically sensitive this is for the EU – it has just gone through a series of its own bailouts in the Eurozone crisis and now countries are being asked to stump up cash for a country which is not even a member (and is unlikely to be one for the foreseeable future, if ever). As with the sanctions, this narrative is likely to expose dividing lines within the EU and set the tone for the negotiations over the future of Ukraine.

Russia suspends gas flow to Ukraine as talks fail to yield compromise

As has long been feared, negotiations between Russia, Ukraine and the EU over Russian gas supplies to Ukraine have ground to a halt.

Despite last ditch negotiations over the weekend a deal did not materialise and the two sides remain some way from reaching a deal. Ukraine is willing to pay a price of $326 per 1,000 cubic metres, however Russia continues to demand $385. Russia also insists that Ukraine owes debts of $4.5bn, of which it wants $1.95bn paid immediately. Reports over the weekend suggested Ukraine (pushed by the EU) was willing to offer a $1bn payment immediately – an offer which was swiftly rejected.

What does this mean for Ukraine?

• Reports suggest that Ukraine has sensibly built up sizeable gas reserves – around 14 billion cubic metres, enough to last the country until December. This reduces the immediate pressure on the negotiations.
• However, both sides are now playing hardball and have filed lawsuits at the Stockholm international commercial arbitration court. Russia is also refusing to countenance any further talks until a sizeable chunk of the outstanding debt is paid. The hope of a quick solution then seems to be fading

What does this mean for the EU?

• So far, the direct impact will be limited. Russia has said it will continue to transit gas through Ukraine to the rest of Europe and Ukraine is obliged to ensure all gas is delivered. This is vital given that Europe receives just over 30% of its gas from Russia, 16% of which comes through Ukraine (according to the EIA).

• That said, this assumes Ukraine will not siphon off any gas for itself (although as pointed out above it does have sufficient reserves), as it did back in 2009 when a similar situation arose. That time Ukraine's decision was driven by mostly by simple economic necessity. Even though it has sufficient reserves this time around it does not guarantee it will not adopt a similar approach. Any disruption in supply to Europe would force the EU to become more involved, possibly to the benefit of Ukraine – clearly, if the situation continues to worsen there may be an incentive for such action (although of course the political fallout in Europe would not be positive).
• In the longer term the indirect impact could be that this because another area of Ukraine where the EU has to become more involved. At the very least, future bailout funds could be primarily earmarked to prepay for Russian gas, something Russia seems intent on enforcing. This could either increase the cost or reduce the impact of the bailout.

In the end, despite the current intransigence of both sides, it remains in their interests to strike a deal. Russia seems to have the upper hand at the moment but equally Ukraine remains an important market for it and pushing the country further away may only exacerbate the original issue it took exception to – Ukraine moving closer to the EU.

However, this state of affairs only holds as long as the gas continues to flow through Ukraine. If this stops, then the volatility of the situation would increase significantly and the incentives would shift radically (as we have said before, neither side would want a breakdown in energy relations between the EU and Russia). This is the key point to watch in coming days and months.

Will EU leaders agree on sanctions for Russia?

EU leaders have arrived in Brussels to discuss the situation in Ukraine, the details of the €11bn aid package announced by Barroso yesterday and how to respond to the Russian occupation of Crimea. At PMQs yesterday, Cameron said that the EU should "display a unity of purpose" and "speak with a clear voice". So what are the prospects for that? We look at the positions adopted by the key players below:

UK: Although it appeared that the UK was ruling out taking supporting strong economic sanctions on the basis of a leaked memo on Monday, since then both Nick Clegg and David Cameron have all said that no economic and diplomatic measures would be off the table. Foreign Minister William Hague indicated yesterday today that "we can’t make progress on that, then of course there will be costs and consequences [for Russia]". Interestingly, he added:

"I think the UK and France are very closely aligned. The Prime Minister has held discussions with President Hollande and with Chancellor Merkel over the last couple of days by telephone."

Germany: As ever the one to watch. The government has hinted that sanctions could be on the table but Foreign Minister Frank-Walter Steinmeier has stated his preference for a political solution and warned against "adding even more fuel to the fire." There is a lot of resistance to sanctions in Germany, and not just in the SPD which has traditionally been seen as favourably disposed towards Moscow. Senior CSU MP Peter Gauweiler, said that:

“If Germany and Russia had a good relationship, then that would be good for Europe. We are looking for a partnership with Kiev, but just as much with Moscow too." 

The German Chambers of Commerce and Industry (DIHK) has warned against sanctions on Russia, saying they “could significantly harm Germany”. Germany's relatively strong dependence on Russian energy sources (30% of its gas and 35% of its oil) as well as its strong exports to Russia (€76.5bn of trade between the two countries annually) give it a strong incentive to avoid wide-reaching economic sanctions.

France: President Hollande has said that, “Russia has taken the risk of a dangerous escalation” – and spoke of the possibility of sanctions, but did not specify what kind, although Foreign Minister Laurent Fabius said they could be "significant".

Italy: Italian Foreign Minister Federica Mogherini has said “the option of a military solution doesn't exist”, but the government's official position is that violations of Ukraine’s sovereignty and territorial integrity “would be totally unacceptable for Italy”. In principle, Italy would back targeted sanctions on Russia. Similar to Germany, though, the approach is more doveish due to higher dependency on Russian gas.

Spain: Spanish Foreign Minister José Manuel García-Margallo said today that Spain would support targeted sanctions, given that it endorsed the conclusions of the meeting of EU foreign ministers on Monday. Then he added, “I said and I say that we wish that the situation calms down and the de-escalation happens” – so the EU is not obliged to resort to sanctions.

Poland: Along with Sweden, Poland has taken the toughest stance on the Ukraine issue. Speaking in parliament yesterday afternoon, Prime Minister Tusk did not pull his punches; he demanded that the EU uses all the tools it has at its disposal, in effect calling for wide-ranging sanctions on Russia, adding that Poland was prepared for this eventuality having stockpiled significant gas reserves. He also made a pointed reference to Europe's "catastrophic" experiences with appeasement in the past.

Tusk: EU needs to be determined and use all its available tools not in order to escalate the situation but in order to de-escalate it
— Pawel Swidlicki (@pswidlicki) March 5, 2014

It now appears likely that some measures will be taken against Russia, the question is how wide ranging these will be. We assess the likelihood of a number of options in the table below:

What is clear so far is that there remains several different views among EU governments on how large a stick they should wield. The upshot is that the US will probably be forced to take the lead role in confronting Russia.

EU sanctions on Russia: Who would they hurt most?

EU sanctions on Russia: Who holds the key?

EU foreign ministers are meeting today to decide what pressure to put on Russia. However, although trade and economic sanctions have been discussed in the US, the EU is less than enthusiastic. Under the EU treaties trade sanctions are decided unanimously, so all EU states will have a say - and for those wishing to take a harder line, the EU does not hold all the cards.

On paper the EU has a strong hand with Russia. Russia is the third largest trading partner of the EU and the EU is the largest trading partner of Russia and runs a large deficit.


Germany accounts for a large proportion
of the EU's trade with Russia (Eurostat 2013)

Of this EU/Russia trade, Germany is the most important accounting for 30% of the EU's exports to Russia. In addition, there are some states such as Finland who for historical and geographical reasons conduct a large proportion of their trade with Russia, making them vulnerable to an East/West showdown. Through their banking systems, Cyprus and the UK also have important financial and investment links with Russia and Russian individuals.

However, there is another important factor that counts against the EU. For although the EU is a large trading partner, 80% of the EU's imports from Russia are energy. This dependancy is particulay acute for gas - as you can see from the chart below, the Baltic States, the Finns, Czechs, Slovaks and Bulgarians are, according to Eurostat, 100% dependant on Russian gas. A mild winter and a relatively large European stockpile of gas means this risk is perhaps less critical than it might have been in previous years, but it could still cause them severe problems if this dispute were to escalate.

Eurostat (Oct 2012)

So will we see trade sanctions? Well probably not for the practical reasons above, but other sanctions are possible, arms embaragoes are not decided en masse so could be implemented swiftly by the UK, France and Germany. Targeted economic sanctions on individuals are also possible.

So on sanctions, an EU-US good cop/bad cop routine has an element of European self-interest to it.