Ken Silverstein EnergyBiz Insider Editor-in-Chief

Russia has taken over the chair of the G8, which are the industrialized countries of the world. And with such prestige comes responsibility. If Russia is to be viewed as a dependable partner, then it must demonstrate it can supply oil and gas at reasonable prices -- especially because it is no longer a military powerhouse. While its dispute with Ukraine may be a temporary setback, all of Europe felt the effects. And, the United States, which expects to buy liquefied natural gas from Russia, also waited to see how the matter would be resolved.

About one-third of the natural gas Ukraine consumes comes from Russia at prices well below market values. In fact, Ukraine pays $50 per 1,000 cubic meters. That's compared to the $220 per 1,000 cubic meters the rest of the world pays. As such, Russia was demanding a four-fold price increase from Ukraine -- something that would have outstripped Ukrainians' disposable incomes and crippled Ukraine's economy.

Moreover, Ukraine says that the move is purely political, as it has formed ties with the West while countries such as Belarus, which is close with Russia, still receive subsidized natural gas. Belarus pays about $47 per 1,000 cubic meters.

Russia's attempt to raise prices on Ukraine caused the country to "withhold" gas supplies, which some peg at 100 million cubic meters valued at $25 million. That's had an effect on Europe, which gets about half its gas from Gazprom with 80 percent of that being piped through Ukraine -- at transit fees that Ukraine notes are at below-market rates. When Russia cut off supplies to Ukraine, France reported a 25 percent drop in Russian supplies while Austria, Italy, Poland and Hungary said they experienced declines.

Ukraine does not oppose the concept of liberalization or the paying of market-based natural gas rates. But, it says that any increases ought to be phased in over five years. If increases are sudden, the country says it would create a 5 percent decline in its fledgling gross domestic product. The combination of this reality and the black eye that Russia has gotten in the international community caused the two sides to reach a complex compromise regarding pricing structure.

"On the surface, Gazprom would seem to have achieved its preliminary objective of moving pricing arrangements with Ukraine from a post-Soviet, preferential pricing arrangement to a market-based one," says Zach Allen, president of Pan Eurasian Enterprises. "But, we also believe Gazprom has paid a very high price to achieve these benefits."

Russia's Credibility

Russia hopes to emerge as the world's pre-eminent energy supplier. While its lucrative oil industry was sold to private investors in the 1990s, its natural gas business is still largely state-owned and reform has proven difficult.

The government there has said that Gazprom ought to functionally separate its production and transportation units in an effort to become financially transparent. Along those lines, Russian lawmakers have debated how to give foreigners more latitude when it comes to owning shares of Gazprom. While shares are freely traded in Moscow, foreigners pay a huge premium when compared to local shares.

That may change but it is highly unlikely that Gazprom would become a private entity. The state controls the entire natural gas pipeline infrastructure along with every compressing station. The monopoly is also the largest producer of gas in Russia. Specifically, Gazprom controls nearly all of Russia's natural gas while it owns a quarter of the world's gas reserves. Gazprom is an outgrowth of the old Soviet Union and today, the Russian government owns 51 percent of the conglomerate.

"Russia's natural gas sector has been stunted primarily due to aging fields, state regulation, Gazprom's monopolistic control over the industry, and insufficient export pipelines," says the U.S. Energy Information Administration in its 2005 report on the Russian gas industry. To become an energy leader, the agency says that between $173 billion and $203 billion must be invested in Russia's gas sector by 2020.

Clearly, Gazprom can't supply the needed capital by itself. More reform that would make it easier for foreigners to own shares in the company may help. Like the Russian government, investors also want to know that Russia can get market rates for the gas it sells in such a way that it would minimize disruptions to the former Soviet states.

That's not an easy task as shown by Russia's dispute with Ukraine, which may have damaged Russia's credibility in world financial markets. It's particularly noteworthy given that the European Union now requires its members to open their pipeline and distribution lines to third parties, which will allow consumers to choose from among a variety of suppliers.

Russia's Status

Opportunities for alternative suppliers in Western Europe are rising. Natural gas usage can only increase, given its environmental status. Moreover, new pipeline construction is enabling the fuel easier passage between producers and suppliers, which could bring prices down. In fact, Gazprom has just named former German Chancellor Gerhard Schroeder to chair a subsidiary that is building the first pipeline that would directly connect Russia with Western Europe. While Gazprom has the majority of shares, Germany energy multinationals BASF and E.On hold nearly 24.5 percent each.

The so-called Yamal-Europe line is estimated to cost $40 billion and is projected to be finished in 2010. The project foresees gas field development and pipeline construction across Russia, Poland and into Germany before heading into Hungary and Italy. Just recently, Russia opened an undersea pipeline that will deliver gas to Turkey and southern Europe. Meanwhile, a Finnish-Russian joint venture announced in 1999 it would build a pipeline to carry Russian gas via Finland and into Western Europe.

Developing Russia's gas pipeline network may be years off, but new pipelines are linking the Caspian Sea, Middle East and North Africa with Continental Europe. Algeria, for example, is increasing the capacity of its export routes that carry gas into Italy and efforts are also underway to do the same for routes into France and Germany. Meanwhile, Turkmenistan, Iran and Turkey are performing feasibility studies to deliver gas into Central Europe.

All that may be good news to European consumers. But Russia still supplies 25 percent of its natural gas and the flare up between it and Ukraine should give world markets some concern. The matter only highlights the need for reform of Russia's gas sector and specifically Gazprom. It's about making it more palatable for foreigners to invest and to provide the billions needed to upgrade the country's aging infrastructure. It's also about ensuring Russia's place in the world as a reliable energy provider.

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