Petrostate: Putin, Power, and the New Russia

POWER OUT OF A PIPELINE

While its petroleum exports have generated the cash blizzard that has made Russia rich and allowed it to repay most of its foreign state debt, its natural gas and monopoly control of the gas pipelines that transport the gas to the West have transformed Russia from an anemic and essentially bankrupt charity case into a robust energy superpower with restored political muscle.

Initially it seemed like such a sensible idea. Determined to reduce their over-dependence on energy from the problematic Middle East, European leaders in the mid- 1980s, especially Helmut Kohl and later Gerhard Schroeder in Germany in 1998, concluded that Germany should diversify its sources of supply. One way to do this would be to support efforts to tap into energy exports from the USSR and its most important successor state, Russia.¹

This required some rethinking by the major Seven Sister oil companies. Historically, they have worked to prevent the sale of Soviet discounted crude oil so that it would not undercut market prices in the capitalist world. This began to change in 1973. Following the lead of Eni (Ente Nazionale Idrocarburi) of Italy, which began to buy Soviet crude oil as early as 1931, Western petroleum companies began to view imports of petroleum from the USSR in a more positive light. This coincided with their need to diversify their sources of supply. The 1973 Arab petroleum embargo that accompanied the Yom Kippur War taught the West that manipulation of energy supplies not only could have important financial repercussions but could also be a powerful political tool.

In their effort to diversify, European leaders also decided to broaden energy use in Europe to reduce their overreliance on coal and petroleum. In France this took the form of an ambitious expansion of nuclear energy. By 2004, nuclear energy accounted for 78 percent of France’s electricity. For environmental reasons, the Germans were more hesitant about nuclear energy, but for a time even they used nuclear energy to generate 30 percent of their electricity. But having decided to phase out nuclear energy, German leaders needed to find additional sources of power. Because of their physical proximity to the USSR, they agreed to supplement the natural gas they were beginning to use from the North Sea with natural gas delivered by pipeline from the USSR. Soviet gas would allow Germany to reduce its overreliance on petroleum, the risk of a nuclear accident, its exposure to turmoil in the Middle East, and the need to ship tankers through the Persian Gulf and other potentially dangerous open sea routes. In addition, manufacturing the pipe and the compressors needed to move the gas would generate jobs throughout Europe. The downside of the Soviet gas pipeline option was that it would put Germany at the mercy of a Cold War adversary. Most Germans still remembered the Berlin Blockade of 1948.

For those who had forgotten the Berlin Blockade or were too young to have experienced it, Ronald Reagan, when he subsequently became U.S. president, did all he could to remind them of how vulnerable they could become. Reagan understood the geopolitical risks that such a pipeline would create. He was very concerned that by building such a pipeline, Germany might some day find itself held hostage to Soviet demands. Given the German determination to diversify their sources and types of energy, however, the Germans regarded Reagan’s arguments as unduly ideological and, even if it meant misleading Reagan as to their intentions, went ahead with the pipeline construction.²

Adding muscle to his rhetoric, Reagan banned the export of General Electric compressors and pumps, the preferred technology used in most of the world’s gas pipelines. When the pipeline contractors sought out non-U.S. manufacturers, Reagan followed suit by ordering that similar bans would also apply to any non-U.S. manufacturers that utilized U.S. technology or parts in their products. This created a rift with his otherwise ideological soul mate, Prime Minister Margaret Thatcher of England.³ Close as she was to Reagan, her first allegiance was to the British public. She wanted the jobs that would come from building the pipeline compressors that would go to the British company John Brown. It could easily fill in if GE could not. In the end, she ignored the U.S. demand that England impose export restrictions and instead allowed John Brown to build and export the necessary compressors.

The Europeans were not unaware of the risks that would come with relying on Russian gas. For that reason they agreed to seek, develop, and promote alternative sources of supply, particularly those from Norway in the North and the Barents Sea off Norway.⁴ They also agreed that they would limit their use of Soviet gas to 30 percent of overall consumption, a promise they soon forgot. Not that he could do much about it, Reagan understood that with time all such initial caution would probably fade from memory and both European homeowners and industrial consumers would become more and more comfortable accepting gas imports from the USSR.

No matter what kinds of precautions are taken, a halt in the flow of natural gas exports that lasts more than a few days inevitably is disruptive. As a consequence, once manufacturers and households begin to incorporate imported natural gas into their daily work and living routines they are at the mercy of the exporter. That is almost certain to have political ramifications. Western leaders would have to think twice before resisting the political demands of the supplier.

Moreover, because natural gas pipelines, including the proposed Bratsvo (“Brotherhood”) pipeline from the USSR that Reagan was trying to halt, are so expensive to build, it is simply not feasible to build a standby pipeline for emergency use. Since all but a small proportion of natural gas sold in the world comes via pipeline, should the flow through a part of one of those pipelines be disrupted—whether because of the weather, human mistakes, or political mischief—the pipeline-dependent consumer becomes particularly vulnerable.

One of the few possible alternatives to pipeline-delivered gas is LNG (liquified natural gas), but this, too, is very expensive and generally not a suitable standby for emergency use. Building the processing units needed to liquefy the gas at the exporting site and reconverting it at the importing site is very expensive. So are the specially built tankers that transport the gas. Building the combined LNG processing plant package often costs almost as much as building a pipeline. Consequently, such LNG systems are normally constructed only if the exporter and importer are willing to commit to long-term contracts similar to those signed by the parties utilizing a pipeline. That explains why, unlike the way petroleum is bought and sold on spot markets, there is still only limited use of a spot market for LNG. The result is that once a gas pipeline is built, it acts, as we said, like an umbilical cord. Severing it is bound to be disruptive.

PUTIN REINS IN GAZPROM

It was good luck that his rise to power coincided with a tightening in world energy markets; but in retrospect it seems clear that Putin understood as early as 1997 that with its oil and gas reserves and pipelines, Russia was well situated to take advantage of this new dynamic.⁵ While Saudi Arabia has the world’s largest reserves of crude oil, Russia, not Saudi Arabia, has the world’s largest reserves of natural gas. Most experts agree that Russia holds 27–28 percent of the world’s natural gas reserves.⁶ With a little more than half of what Russia has, Iran with 15 percent of the world’s reserves ranks second in size of natural gas reserves. Qatar is close with 14 percent. Even though Canada is a major supplier of natural gas to the United States, it has only 1 percent of the world’s reserves. Since no other country but the United States, Saudi Arabia, and the United Arab Emirates has even as much as 3 percent of the world’s natural gas, Russia is in a dominant position.⁷ Its reserves and its pipelines, if strategically utilized, have the potential to provide Russia with a powerful political and economic weapon. To his credit, Putin understood this potential and has been skillful in utilizing it.

Building on his concept of “national champions,” as we saw, Putin’s first priority was to purge the self-dealers and asset-strippers from Gazprom. He seems instinctively to have recognized that Gazprom would make an ideal flagship, on the assumption, of course, that he could find managers who would place the interests of the state above their own. That is why almost immediately after his election as president, Putin sought to put managers in place who would no longer strip off producing assets into their privately held empires. To take on the task, Putin began to appoint comrades he considered loyal and trustworthy, almost all of whom were FOP (Friends of Putin) from St. Petersburg. He knew them from his days either in the KGB or in the mayor’s office when Putin headed the office of International Affairs under Mayor Anatoly Sobchak.

Not everyone in Moscow was happy with these “provincials” from Russia’s second city taking charge of what had been the political center for eighty years. We saw in Chapter 5 how Putin began by removing Chernomyrdin in June 2000 from his post as chairman of the Gazprom board. He replaced him with Dmitri Medvedev, who also took on the job as head of the Kremlin administration. (In 2007 Putin chose Medvedev again, this time as his successor for president of Russia.) Medvedev had previously worked in the St. Petersburg mayor’s office alongside Putin. The following year Putin replaced Rem Vyakhirev as Gazprom CEO with Alexei Miller, who had also worked for the St. Petersburg mayor.

From the outside, the transition within Gazprom appeared to be rather straightforward and routine. Both Chernomyrdin and Vyakhirev left without too much fuss. Chernomyrdin went on to become Russia’s ambassador to Ukraine. But while it may have seemed routine, it was anything but. With all their spoils and patronage to protect, Vyakhirev in particular had fought ferociously against previous attempts to oust him. Those opposed to his tenure had much to criticize. Among other charges, some members of Gazprom’s board of directors complained that the company had paid little in either taxes or dividends. In 1995 and 1996, despite having generated earnings of almost $2 billion, Gazprom paid only $3.5 million in dividends to the state.⁸ Even stranger, the state at the time held 38.4 percent of the company’s stock.

Stingy as they were with dividends and taxes, the managers were overly extravagant in using company funds to pay bonuses to themselves and build resorts for the exclusive use of the staff. Others complained about what they considered the waste of money spent in building the company’s Taj Mahal–like corporate headquarters⁹ (see Introduction). This was all in addition to the asset stripping.

There were also suspicions that the company’s accounting statements did not reflect the true financial situation. In 1999, for example, based on Russian accounting standards, Gazprom reported a profit of $1.3 billion. However, when calculated according to Western accounting practices, Gazprom had a loss of $3.2 billion.¹⁰

Putin ultimately succeeded in changing Gazprom’s senior management, but others had tried earlier and failed. The difficulty is illustrated by what happened when Boris Fedorov tried to convince his fellow members of the board of directors to join him in bringing about a change in management. Before he became a member of Gazprom’s board of directors, Fedorov had been Russia’s Minister of Finance and for a time the director of the Russian Tax Office. Now as an investor in Gazprom, he sought to clean up the company. One of his goals was to bring in a new auditor. He wanted such an auditor to come up with a “second opinion” on the relationship between ITERA, that Florida-based company that at one point was Russia’s second largest producer of natural gas, and Gazprom. Most important, Fedorov began to call openly for Vyakhirev’s immediate removal as CEO before his term expired.

Vyakhirev did not take kindly to Fedorov’s effort. Fedorov told me that he began to fear for his life, particularly after he was visited by representatives of the Russian mafia. Then as if it were all a scene from the movie The Godfather, someone poisoned Fedorov’s dog!¹¹ If there were any doubts as to what was happening, more than fifty newspaper articles in the Moscow press suddenly and simultaneously appeared with vicious attacks on him. Only when Vyakhirev was fired by Putin in July 2001 did the attacks abruptly came to an end. Intrigued by what seemed to be the obvious orchestration of this effort, Fedorov subsequently canvassed each newspaper to see what had precipitated this sudden campaign. As if they were normal events, each paper explained that such attacks were a common occurrence, a normal part of the for-hire nature of Russian journalism. He managed to compile a price list indicating how much each paper charged for these attacks. Reflecting the market, the higher quality newspapers such as Vedomosti, which is jointly owned by the parent companies of both the Wall Street Journal and the Financial Times, charged the highest rate: $6,000 for each of the four articles they published.

No one knows what might have happened if Vyakhirev had been able to continue his campaign against Fedorov. Fortunately for Fedorov, he and Putin had similar agendas. Putin was just as eager as Fedorov to put an end to the asset stripping, the self-indulgent extravagance, and failure to compensate the state and other stockholders for their investment. But unlike Fedorov, Putin had the power to implement it. Yet Putin also had a supplemental and—in his view—equally important agenda. He wanted Gazprom to become the first of what he had hoped would be those “national champions.”

Once in charge, one of Medvedev’s and Miller’s first assignments was not only to bring a halt to any further asset stripping but to reclaim assets that had been stripped earlier. This was not easy to do, but Miller moved aggressively. One of his first targets was ITERA. From the mid-1990s, ITERA had operated as a middleman between a bunch of countries such as Ukraine, some of the Caucasus countries, and Central Asian producers. In the process, ITERA earned a handsome profit for that Florida-based corporation whose trustees were mostly associated in one way or another with Gazprom management. To persuade it to cooperate, Miller denied it access to the Gazprom pipeline, a step that by 2004 all but forced ITERA into bankruptcy.¹² In 2006, faced with an offer they could no longer refuse, ITERA’s managers agreed to resell their 51 percent interest in Sibneftegaz back to Gazprombank for the bargain price of $130 million.¹³

Despite Miller’s success with ITERA, Gazprom would not become a transparent corporation overnight. As we shall see shortly, Gazprom’s dealings and interactions with the state and other companies remained almost as opaque as before.

GAZPROM, THE HOLY OF HOLIES

Repeatedly, Putin has signaled how central Gazprom is to him and the role it must play in Russia’s emergence as an energy superpower. He has referred to it elsewhere as this “holy of holies.”¹⁴ Given Gazprom’s role in his thinking, it is not surprising that in his May 2006 state of the nation speech, Putin took time to boast that Gazprom had just become the world’s third largest corporation as measured by the total value of its stock. At the time, only Exxon-Mobil and General Electric were larger. (Microsoft subsequently increased in value to push Gazprom to fourth place, and it in turn and even Exxon-Mobil were displaced by a set of Chinese corporations when an index of Chinese stocks more than doubled in 2007–2008.) Admittedly, such information would be of interest primarily to readers of business newspapers, but it is unlikely that many other world leaders (except those fighting an inferiority complex) would choose to emphasize such a fact in their state of the nation speech. By including it in his presentation, Putin signaled its importance to him. Yet Putin and those around him have even higher ambitions. Putin’s ultimate goal is to see Gazprom overtake and surpass (Nikita Khrushchev’s favorite way of comparing the USSR and the USA) Exxon-Mobil to become the corporation with the largest capitalized value in the world. Moreover, as he has put it, he sees no reason why some day the value of Gazprom’s stock should not rise from $300 billion to $1 trillion, overtaking Exxon-Mobil along the way.

In Putin’s mind, Gazprom’s emergence as a dominant international corporate player was no accident. In that same 2006 state of the nation speech, he went so far as to claim this was “the result of a carefully planned action by the state.”¹⁵ While patting himself on the back for bringing to life this national champion, Putin somehow ignored that perhaps the post-1998 increase in world energy prices might have had a little to do with that surge in the price of Gazprom stock. Putin is not the only Russian official who associates the turnaround in Russia’s fortunes with whether Gazprom is thriving. As we noted in the Introduction, Alexander Medvedev, deputy CEO of Gazprom and general director of Gazexport, its export affiliate, frequently seeks to reassure foreign audiences by insisting that what is good for “a strong Gazprom is good for the world.”¹⁶

Given the symbiosis between Gazprom and Russia, Putin and his colleagues do not take kindly to those who question how Gazprom is run. William Browder, the grandson of the long-time head of the U.S. Communist Party, Earl Browder, is a good example. As the founder and director of the $4 billion Hermitage Capital Management investment fund, Browder the younger has been an outspoken advocate of investing in Russia. However, Browder has criticized not only the original Gazprom executives but Putin’s subsequent appointees. Browder concedes that such Putin initiatives enhance the glory of Russia, but they are not in the best interests of the company’s stockholders and a higher return on their investment. Browder soon discovered that while it may be okay for Putin to criticize Gazprom’s previous management, Putin and his subordinates in the Kremlin are not eager to have others, especially foreigners, do the same. To register its displeasure with Browder and alert others that there are limits to criticism of this “holy of holies,” the Russian government canceled Browder’s Russian visa and prevented him from returning to his home in Moscow when he left Russia in 2006.

As the Browder incident illustrates, it is hard to tell where Putin begins and Gazprom ends. Alexander Medvedev, deputy chairman of Gazprom’s management committee, insisted in a presentation in St. Petersburg on June 21, 2007, that to the contrary, Gazprom operates free of interference from the Kremlin. As he put it, “We don’t get hourly calls from the Kremlin. We get none at all.” That would seem to overlook not only Putin’s assertion about his successes with Gazprom and some of the other national champions but also Putin’s actions and unwavering advocacy and support for Gazprom’s initiatives. As the wags have it, Russia or “Gazpromistan” is run by its president and spiritual leader, Gazputin, an obvious play on the gas-rich countries of Central Asia, as well as Rasputin, the mad monk favorite of the last czar’s wife, Czarina Alexandra.¹⁷

Putin’s new appointees, Chairman Dmitri Medvedev and particularly Alexei Miller, moved quickly to stop the asset stripping. It was not easy to repair all the damage, but as a minimum, they put an end to further dismantlement.

The next step was more controversial and most likely another example of a Putin-initiated action. For many years, Gazprom, like the Ministry of Gas before it, intentionally held down the price of natural gas it sold within the boundaries of the former USSR, far below comparable market prices in the West. This was done to facilitate Soviet industrialization. But it also had the effect of encouraging the wasteful overuse of all raw materials, particularly oil and gas. Because the price was so cheap and because there always seemed to be more oil and gas available, there was no need to worry about conservation. This policy continued for several years after the breakup of the USSR. Prices were kept below world prices not only within Russia but also in the other republics that made up the USSR.

UKRAINE IS TOLD TO PAY THE MARKET PRICE

It was easy to ignore these hidden subsidies that came from being a part of the USSR, but they were substantial. Shortly after assuming the role of president of Ukraine in January 2005, Victor Yushchenko adopted a noticeably cooler attitude toward Russia. At the same time, he drew closer to the West, including the United States. In reaction, pushed by Putin, Gazprom began to warn that a looser alliance would lead to an end to gas export subsidies. If Yushchenko wanted a closer relationship with the West, he should also be prepared to pay prices closer to those paid by Western customers. As Putin told a group of us in September 2004, Yushchenko was welcome to seek a closer alliance with the West and turn his back on Russia, but he should understand that if he did so, Russia was under no obligation to continue to subsidize its energy exports to Ukraine. Ukraine was paying as little as $50 per 1,000 cubic meters while the market price in the West at the time was $150 per 1,000 cubic meters, so paying the higher price would cost Ukraine $3–5 billion a year. Since the United States was providing Ukraine only about $150 million in aid at the time, turning its back on Russia would be costly. So in Putin’s words, “Ukraine should think twice about any such embrace of the West.” By contrast, Belarus, which was then a close Russian ally, was charged less than $50 per 1,000 cubic meters for its deliveries, not much different from what users within Russia itself had to pay in 2006.

Warning that it was prepared to take extreme measures, on January 1, 2006, Gazprom demanded that Ukraine pay $150 per 1,000 cubic meters, a threefold increase from the earlier charge. Refusing to be intimidated, Ukraine insisted on paying the lower fee, arguing that this lower price had been agreed to during previous contracts. Any reduction or cessation of gas deliveries through the pipeline by Gazprom would be a contract violation. In response, Gazprom insisted that the contract had expired and proceeded to reduce the flow of gas, sending through just enough to meet its contract obligations to its customers in Western Europe. Ukraine, however, continued to withdraw the same amount of gas from the pipeline that it had prior to December 31, 2005. Like Belarus, it felt entitled to pay for those deliveries at the lower price. The Russians then reduced the flow to Ukraine. Claiming Gazprom had broken its contract, Ukraine provided first for its own needs and only then sent what gas was left on through the pipeline to the West.

Gazprom and Putin, however, used an economist’s arguments, pointing out that Russia was only asking Ukraine to adhere to market practices and prices. In the long run, this would be good for Ukraine. Gazprom was only helping Ukraine wean itself away from distorting subsidies. Isn’t that what the United States and the West Europeans had been urging Russia to do? Accordingly, when the flow of gas was reduced, Gazprom spokesmen repeatedly insisted that none of this pressure on Ukraine was political. The flow of gas would be resumed once the Ukrainians agreed to pay the market price, with the emphasis on market price. To the contrary, it was not Russia that was at fault but Ukraine. By diverting the gas intended for Western Europe to itself, the Ukrainians were simply stealing Europe’s gas.

THE USE OF INTERMEDIARIES—WHO IS THE REAL OWNER?

To Russia’s surprise, however, most Europeans turned out to be more sympathetic to Ukraine than to Russia. It was January, after all, and cold, and turning off the gas was not a nice thing to do. Moreover, there was widespread suspicion that executives of the gas companies in both Ukraine and Russia were using the crisis to stuff their own pockets with kickbacks. These suspicions arose because the final agreement did not involve a direct and transparent contract between GazpromExport (Gazprom’s export division) and its Ukrainian counterpart. Instead, GazpromExport agreed to deliver gas from Russia and Turkmenistan to a mysterious company called RosUkrEnergo (RUE), which in turn sold it to UkrGaz-Energo, the Ukrainian utility that delivers it to Naftogaz, which ultimately delivers the gas to the actual Ukrainian consumers.¹⁸ Setting up these different entities was designed to confuse outsiders and, as we shall see, those in charge succeeded brilliantly.

RUE first began to supply UkrGaz-Energo in 2005. The use of intermediaries, however, dates back to the 1990s when ITERA, that opaque Florida-based company, stepped in to deliver gas from Turkmenistan to Ukraine. ITERA was created by Igor Makarov. A native of Turkmenistan, Makarov was a poor boy who became a world-class bicycle racer, bringing glory to Turkmenistan and becoming a local hero. As a result he was befriended by the Turkmen president, the President for Life or Turkmenbashi, as he called himself, Saparmurat Niyazov. (Except that he was president of Turkmenistan and not Kazakhstan, Niyazov could have served as a model for the movie Borat.) After the collapse of the Soviet Union, Turkmenistan found itself with almost no convertible currency and as a result, in serious need of basic consumer goods. Through his friendship with Niyazov, Makarov was given access to Turkmenistan’s natural gas, which Makarov was then allowed to use to barter for food and other consumer goods. To do all of this, of course, Makarov also had to convince Rem Vyakhirev of Gazprom to grant him access to Gazprom’s pipeline network. Gazprom was not interested in bringing gas into Russia to compete in its own domestic market but it was willing to transport Turkmen gas to Ukraine, which it did beginning in 1994. This earned ITERA a handsome profit (and who knows what for Vyakhirev), at least until the financial collapse of August 1998. The market collapse, while bad for most businesses, including Gazprom, provided ITERA with a great opportunity to buy up some distressed Gazprom properties at an auction. Since auctions in Russia are not noted for their transparency, especially those associated with the Loans for Shares privatization of 1995–1996, it is hard to dispel the suspicion that with Vyakhirev’s blessings, ITERA ended up with valuable Gazprom assets at a cost that was low even compared with the distressed prices that prevailed in 1998. In any case, after Putin removed Vyakhirev as CEO of Gazprom, Alexei Miller, Vyakhirev’s successor, moved rapidly to repossess as much as two-thirds of the property that ITERA had acquired from Gazprom.

It may have been coincidence, but once Vyakhirev was no longer in charge of Gazprom, ITERA lost one of its main protectors. Not only did ITERA have to return some of its assets to Gazprom but it was also squeezed out of the Turkmenistan-Ukraine trade in 2002 by a company controlled by Dmytro Firtash called Eural Trans Gas.

Eural Trans Gas in turn held on to the franchise until 2005 when RUE took it over.

All of these companies were opaque and regarded with suspicion.

Ostensibly, while the companies were different, it seems that many of the principal owners of the various companies remained the same.¹⁹ Thus, Dmytro Firtash, a Ukrainian businessman who had been bartering consumer goods to buyers in Ukraine, Turkmenistan, and Russia, joined a company called Highrock Holding in 2001. Firtash insists that one of his partners in Highrock Holding was Igor Makarov, president of ITERA. Subsequently, ITERA was superseded in Turkmenistan-Ukraine trade in 2002 by Firtash’s Eural Trans Gas. According to the Financial Times, Makarov subsequently denied he ever had an economic interest in Highrock Holding.²⁰

That is of interest because it reflects the murkiness associated with importing natural gas and the unsavoriness of the parties involved. When Putin moved to clean up Gazprom, the new Gazprom management in turn began to apply pressure on ITERA, not only to return assets to Gazprom (as we saw) but to force it out of the transit business between Turkmenistan and Ukraine. That opened the way for Eural Trans Gas, which hardly seemed much of an improvement.²¹

The U.S. Department of Justice and the FBI have been investigating whether Russian and Ukrainian mafia members have also been involved with these companies. After it became known that the FBI was investigating Highrock, its principal owner Dmytro Firtash acknowledged that he and his junior partner, Ivan Fursin, owned Centragas Holding, which owns 50 percent of RUE.²² The other 50 percent was owned by Arosgas Holding, Gazprom’s Austrian affiliate. Without meaning to deprecate Ukrainian and Austrian skills at obfuscation, this is almost but not quite as complicated as trying to ascertain who owned what of the Enron Company in Texas before it went bankrupt. Gazprom demanded part ownership in RUE for the obvious reason that its monopoly control of the gas pipelines in Russia gave it the exclusive rights to ship the gas from Turkmenistan and its neighbors through Russia to Ukraine.²³

Firtash’s role was news because for some time his involvement had been shielded from public view by Raiffeisen Investment AG, the investment arm of the Raiffeisen Bank of Austria. Raiffeisen Investment AG acted as trustee for what was thought to be the true owners. It should be noted that the Raiffeisen Bank itself has had a long history of dealing in Eastern Europe and the Soviet Union, which almost guarantees that many of its transactions will not be transparent.

For Gazprom, a Russian company, to be involved in such convoluted corporate juggling within Ukraine is troubling enough, but what drew the attention of the FBI was the possible evidence that another “Ukrainian businessman,” Semion Mogilevich—or at least his wife— had also been involved in these machinations as a partner with Firtash in Highrock Holdings.²⁴ Mogilevich has, as they say, been a person of interest to the FBI since 2003. Although he was found not guilty of criminal activity in one trial, he has been on the FBI’s Most Wanted List, regarded as “one of the world’s most sophisticated international criminals.”²⁵ In January 2008, after considerable international pressure, Russian authorities finally arrested him. Among other crimes, the FBI wanted to question him about his alleged involvement in prostitution, drug trafficking, and stock fraud.²⁶

The shenanigans of Highrock, RUE, ITERA, Eural Trans Gas, and Gazprom illustrate the skill with which veterans of the black market in the Soviet era have learned to manipulate the market system and obfuscate their operations from even sophisticated investors. How they learned to build such a web of false fronts and hidden assets for themselves despite having grown up in a system of relatively simple central planning remains a mystery. Where did they learn such sophisticated schemes? It was not taught to them in Soviet institutions of higher learning or in Gosplan, the state central planning agency.

Such shadowy entities linking up Russia and Ukraine cast doubt on the integrity and the transparency of the economic interactions between Russia and Ukraine. The Russians’ argument that Ukraine deserved to pay the market price for gas was weakened when it became known that at least 60 percent of the gas supplied to Ukraine actually came from Turkmenistan, not Russia. Nor did Gazprom win sympathy for itself when it was learned that at the time Gazprom refused to pay Turkmenistan more than $46 per 1,000 cubic meters while selling the same gas to RUE and Ukraine for $95 per 1,000 cubic meters. Only in February 2006 did Gazprom agree to pay a comparable amount for its Turkmenistan purchases. Gazprom control of the pipeline linking Turkmenistan with the West, a legacy of the Soviet era, allowed Gazprom to squeeze Turkmenistan this way. Gazprom agreed to raise the price to $130 in 2008, but that remained for below the $354 Gazprom expected to collect from its sales to Europe.

What does seem odd is that Turkmenistan agreed to extend a PSA (production sharing agreement) to Russian companies engaged in energy development there. Russia has been invalidating similar PSAs it made earlier with Western companies such as Shell, Exxon-Mobil, and Total. While Russian companies have opposed extending PSAs to foreign companies working within Russia, evidently that has not prevented Russian companies from signing up for similar concessions for themselves in other supplicant states.

What all this illustrates is that Gazprom control over the pipeline network of the one-time USSR Ministry of Gas has been one of Russia’s most valuable and strategic assets. For the time being, the only way Central Asian countries can export their gas to Europe is through Gazprom’s pipeline.

SEEKING A WAY AROUND GAZPROM PIPELINES

Efforts are afoot by the United States and some members of the European Union to build an alternate gas pipeline under the Caspian Sea from Central Asia to Baku. U.S. Vice President Dick Cheney made a visit to Kazakhstan in the spring of 2006 to seek support for such a bypass. That gas pipeline would then parallel the recently completed private petroleum pipeline from Baku, Azerbaijan, through Tbilisi, Georgia, which then terminates in Ceyhan, Turkey, on the Mediterranean Sea. There is some uncertainty, however, as to whether such a gas pipeline will be financially viable. To ensure that it would not be, Putin moved immediately to neutralize Cheney’s effort by making a follow-up visit to dissuade Kazakhstan from such a move.

As we saw in the Introduction, the Russians, along with the Italian company, Eni, are doing everything they can to ensure that a bypass and diversionary pipeline is not built. Putin is doing this by trying to dissuade not only potential suppliers but customers from using such a pipeline. Toward that end, Russia and Putin have reached at least a tentative agreement with Turkmenistan to tie up much of its natural gas exports for twenty-five years so little would be available for an alternative routing.²⁷ Unless the U.S. government and other promoters of such a pipeline can assure themselves and prospective users and investors that the volume of gas carried by the pipeline will be large enough, they will not put up the money needed to build it.

As for Georgia, given its crucial role as the connecting link between Baku and Ceyhan, Russia has done its best to destabilize the region and keep Georgia from operating the pipeline in an orderly and reliable way. If Georgia collapses in turmoil, investors will not put up the money for a bypass pipeline and Russia will be able to maintain its pipeline monopoly. That, at least in part, explains why the Russian government has provided rather open support for South Ossetia and Abkhazia, two regions that seek to separate from Georgia and align themselves instead with Russia.

That is not all Russia has done. In 2006, after Georgia arrested and then expelled some Russian embassy officials on charges of espionage, Russia declared an embargo on imports of Georgian wine and mineral water as well as its fruits and vegetables—its most important export earners. At almost the same time, Russia shut down transport and postal service to Georgia, thereby severing its most important link to the outside world.²⁸ To underline its hostility, Russia also expelled Georgians living and trading in Russia, not only those without legal documentation but also those who had proper permission. In addition, there were disruptions in the flow of electricity from Russia. At about the same time in January 2006, the gas pipeline passing through North Ossetia from Russia to Georgia mysteriously exploded.²⁹ This coincided with the campaign against Ukraine and the application of similar pressure on Moldova. As with Ukraine, the Russians demanded that Georgia and Moldova agree to pay the much higher Western European market price for gas.

It has not been an easy time for either Georgia or Moldova. In the fall of 2007, for example, opposition groups in Georgia began to call for the resignation of Mikhail Saakashvili’s pro-Western government. Saakashvili called out the troops and put down the demonstration in a rather heavy-handed way, insisting that these protests were provocations organized by Moscow in an effort to regain control of the area, an accusation Moscow disputes.

Upping the ante, Gazprom began to demand that it be given ownership of Georgia’s and Moldova’s domestic pipelines. In 2007, the two agreed to pay more for gas—in Georgia’s case, a price of $235 per 1,000 cubic meters, about the same as Europe—but Georgia refused to yield to Gazprom demands that it sell off its domestic pipelines. But Moldova, along with Armenia, both succumbed and agreed to sell Gazprom a controlling share in their gas distribution networks.³⁰

Undoubtedly such pressure on relatively small countries hurts. But despite the harassment, the Georgian economy, in particular, has enjoyed an unprecedented economic boom. It may have been an effort to make Russia and Putin look foolish, but President Mikhail Saakashvili attributed the country’s astounding 10 percent annual growth to the embargo itself. As he explained, the embargo unexpectedly led to an increase in foreign direct investment from Kazakhstan and the United Arab Emirates.³¹ (By investing this way Kazakhstan seemed to be doing what it could to undermine Russia’s policy. However in May 2007, after a series of visits by Putin, Kazakhstan appeared to become more supportive of Russia.)³² It also helped that President Saakashvili’s government began to implement a vigorous program of economic reform that included the adoption of a 12 percent flat tax (1 percent lower than a similar flat tax in Russia), the slashing of red tape, and the introduction of a new customs code. Moreover, the cutoff of gas from Russia caused only temporary hardship. Almost immediately the Georgians were able to arrange for substitute deliveries, primarily from Azerbaijan. By 2007, Georgia had managed to shift more than 80 percent of its natural gas imports to non-Russian sources.³³

While Russian intimidation of Georgia may have backfired, the Russians continued to harass Ukraine, and in 2007, even their heretofore cooperative ally, Belarus. Much to the disbelief of Alexander Lukashenko, president of Belarus, in January 2007 Russia began to apply the same type of pressure on Belarus that it had on Ukraine a year earlier. This was quite a surprise. Lukashenko, a one-time collective farm manager and what some have called the last dictator in Europe, has used his powers to tie Belarus almost blindly to Russia. It was a shock therefore when Belarus was told it too would have to pay more for its gas. At first the Russians demanded $200 per 1,000 cubic meters. Ultimately, they consented to a price of $100 per 1,000 cubic meters. But even $100 meant a doubling of prices from 2006. Belarus was also asked to pay $180 for each ton of petroleum sold to Belarus as a form of export duty.³⁴ Reluctantly, Lukashenko agreed to the $100 per 1,000 cubic meter price for gas. But to Lukashenko, this was much more than an unfriendly gesture from what he had frequently boasted was a supportive partner. Belarus depended on these highly subsidized and therefore cheap petroleum imports from Russia and their subsequent re-export to Western Europe at considerably higher world prices. The difference between what it paid and what it charged provided Belarus with a substiantial profit, which is used to underpin its otherwise shaky economy.

In response to the imposition of the $180 Russian export duty, Belarus then imposed a $45 a ton transit fee on the petroleum the Russians were sending on to Western Europe. Since about half of all Russian petroleum sold to Western Europe is shipped through Belarus, this was a significant countermeasure.³⁵ After almost a week and a half of nasty words and an occasional halt in the flow of gas and oil to Belarus, the two sides reached a compromise. Russia agreed to lower its export duty on petroleum from $180 a ton to $53, and, in turn, Belarus agreed to abolish its transit fee.³⁶ But even though Lukashenko agreed to the higher prices, Belarus fell behind in its payments so that by mid-2007, it was $456 million in arrears. Once again Russia threatened to cut off deliveries. After apparently turning for help to Hugo Chavez, president of Venezuela, Belarus paid its bill and the flow of gas was no longer interrupted.³⁷

THE PIPELINE POKER GAME

While most of the outside world’s attention was on whether Belarus, like Ukraine the year before, would agree to pay a higher price, at the same time there was an even more significant effort by Russia to expand its control of the pipeline network linking Russia to its European consumers. After the collapse of the USSR, almost all of Gazprom’s customers in the CIS, the Commonwealth of Independent States (the former Soviet republics), found themselves with significant bills they could not pay for the gas they had already imported. In what became a standardized routine, Gazprom would then offer to cancel the debt or charge a lower price if the Ukrainians, Armenians, Moldavans, or Georgians would give Gazprom an equity stake in their domestic pipeline network (see Table 6.1). In Belarus, Gazprom offered $2.5 billion for a 50 percent stake in Beltransgaz, which owned the gas export pipeline.³⁸ While Belarus agreed, some of the others have held back. The Financial Times for example, reported that in Ukraine, President Viktor Yushchenko had publicly criticized Naftogaz for offering Russia a measure of control over its gas transit system. Yushchenko and his allies feared that if Gazprom gained an equity interest in their pipelines, Russia would demand an ever larger say in their economic and political affairs.³⁹

There was particular concern that if Russia or Gazprom were allowed to buy up local gas distribution systems used by its customers to maintain their monopoly control and economic rent, the Russian operators would do all they could to exclude other potential suppliers. In fact, gaining control over pipeline access to other producers of gas as well as to Gazprom customers has been a major goal of Gazprom and Russia. It is not only the foreign consumers of Russian natural gas who worry that Russia will some day control gas pipelines within their territory; non-Russian producers of natural gas operating in what used to be the USSR are also very much concerned. They are indeed vulnerable. As long as there is no other way for the Central Asian countries—or for that matter Russian petroleum companies—to transport their gas to Europe except through Gazprom-controlled pipe-lines, the only alternative for the Central Asians is to find customers in Asia or accept a Gazprom-dictated price for their gas. That explains why until 2006 Turkmenistan was forced to sell its gas to Russia for as little as $46 per 1,000 cubic meters. Ironically, at that price, when the Russians were the sellers and Ukraine, Belarus, Georgia, and Moldova were the buyers, Russia complained that the price was too low. It also explains why landlocked Turkmenistan, as well as its neighbors Kazakhstan and Uzbekistan, express interest now and then in a proposal to build a pipeline under the Caspian Sea from Kazakhstan to Azerbaijan and from there overland through Georgia and Turkey and on to Europe. This was the proposal promoted by U.S. Vice President Dick Cheney when he went to Kazakhstan in the summer of 2006.⁴⁰

For the time being, Nursultan Nazarbayev, the Kazakhstani president, has indicated he would keep his options open.⁴¹ Most of the petroleum from Kazakhstan continues to move west overland to Russia through the pipeline of the Caspian Pipeline Consortium (of which the Russian pipeline monopoly Transneft owns 24 percent) to Novorossiysk on the Black Sea. But Kazakh petroleum is also flowing through the Baku-Tbilisi-Ceyhan route, thereby bypassing Russian territory and also the dangerous and overcrowded Bosporus Straits (see Figure 2, page 8).⁴²

PREVENT A SOUTHERN ROUTE

To Putin, all of this is like a giant chess match. Every move by a rival must be met by Putin with an even more attractive offer. He was confronted with such a challenge in December 2006 when a consortium led by BP began construction of a South Caucasus pipeline designed to transport natural gas from the Shah Deniz field in the Caspian Sea, as well as gas from Turkmenistan, Uzbekistan, and Kazakhstan, through Azerbaijan and Georgia to Ceyhan, the Turkish port on the Mediterranean Sea. From there, the gas would be shipped to the Balkans and ultimately to the European Union.⁴³ The route would parallel the already built Baku-Tbilisi-Ceyhan petroleum pipeline. Because it passes through Georgia, this gas pipeline would also make gas available for Georgia. But the pipeline’s main purpose would be to free countries in Europe from being so dependent on Gazprom. From Turkey, the gas would be shipped through the NABUCCO pipeline, which is scheduled to be finished by 2011. NABUCCO would carry gas through Bulgaria, Romania, Hungary, and Austria, and from there to the West.⁴⁴ The main transit and storage hub would be built in Austria by OMV, the lead promoter of the project.

Turkey has also proposed to work with Iran to ship its gas overland by pipeline through Turkey and on to Europe. If it is eventually built, such a pipeline might also be used to transit gas from Turkmenistan. Some gas from Turkmenistan is already shipped to northern Iran, for now the only outlet for Turkmen gas that does not flow through Russia.⁴⁵

The big challenge for BP, the NABUCCO partners, and Turkey is to see whether they can sign up enough customers to make the effort profitable. Eager to see that they did not, Gazprom moved simultaneously to increase deliveries of gas to Turkey via its Blue Stream pipeline under the Black Sea. Blue Stream was officially inaugurated in November 2005. From Turkey the Russian gas will be piped on to Western Europe via Gazprom’s South European Gas Pipeline (SEGP). A Gazprom delegation, headed as usual by Putin, went to Budapest in 2006 in an effort to convince the Hungarians that using Gazprom gas, not BP’s from the Caspian, was a better deal for Hungary. Since the market would probably not be large enough to support both pipelines, Gazprom and Putin hoped in this way to preempt the NABUCCO effort.

To make the offer more appealing than the NABUCCO route, Gazprom proposed to offer its gas sooner and cheaper. It also sought to persuade Hungary, an essential NABUCCO partner, that it should support Gazprom’s South European Gas Pipeline for Russian gas (SEGP) instead. To make it worth their while, Gazprom offered to provide Hungary with an attractive long-term supply contract, and to make the offer even harder to resist, Gazprom promised that under its proposal, Hungary rather than Austria would become the European hub.

Political grandmaster that he is, Putin’s tactics appeared, at least initially, to have worked. On March 12, 2007, the Hungarian prime minister Ferenc Gyurcsany announced that Hungary would support Gazprom’s Blue Stream pipeline rather than NABUCCO.⁴⁶ As he put it, NABUCCO is “a long dream and old plan. But we don’t need dreams, we need gas.” No doubt the fact that Hungary, not Austria, would be the hub for the Blue Stream project was also a factor. The Hungarian prime minister explained that because the European Union had yet to agree on a common energy policy, it was dangerous for Hungary to wait when it had the option of making a favorable bilateral deal with Gazprom and in so doing solve its immediate energy problems.⁴⁷ Gazprom already had available the gas that Hungary needed. The NABUCCO pipeline, however, had yet to be proven. At best it would not be available until some time in the future. Eager to support the NABUCCO alternative, the European Union argued otherwise. Azerbaijan already had enough gas available and Kazakhstan was in the process of adding more.

After Gyurcsany announced that Hungary had opted for the Russian Blue Stream variant, which ran through the Black Sea from Russia to Turkey, he and his government evidently had some second thoughts. Perhaps, he suggested, they should keep their options open at least a little longer. Showing that the Hungarians are good chess players as well, a spokesman for the Hungarian government told a press conference the next day that Hungary was still willing to work with the NABUCCO consortium. After all, NABUCCO was strongly supported by the European Union and, as a new member, Hungary could not disregard its wishes, at least in the early planning stages and especially since there were still uncertainties in both projects.⁴⁸ As Prime Minister Gyurcsany explained after meeting with President Putin, “Why shouldn’t we receive half from one source and [half] from the other?”⁴⁹ The prospects for NABUCCO also improved when Germany’s second-largest gas company, RWE, decided to join in as a sponsor.

Putin clearly seemed determined to prevent the construction of the NABUCCO pipeline. To add to the competition from the Blue Stream and SEGP gas pipelines, in the summer of 2007 Putin along with the Italian company Eni proposed the construction of what they called the South Stream pipeline. This would be yet another gas pipeline from Russia running under the Black Sea to Bulgaria and then on to Italy.⁵⁰ As if all these proposals and negotiations were not complicated enough, in July 2007 OMV, the partly state-owned Austrian energy company, tried to take over MOL, the recently privatized Hungarian national energy company. While OMV earlier had initiated the NABUCCO project, as NABUCCO appeared to flounder, OMV reversed course and agreed instead to a deal with Gazprom that would make Vienna a gas hub. In effect this would mean that Gazprom would be dropping MOL as its main partner and eliminating Hungary as the hub. The Hungarians were opposed to OMV for other reasons as well. In 2006 they had gone to the trouble of fully privatizing MOL. If the partially state-owned OMV were allowed to buy it up, the Hungarian MOL would again become a state company, only this time the state would be Austria. There was also concern that if Gazprom should some day acquire OMV then Gazprom would own gas distribution facilities not only in Austria but also in Hungary.⁵¹

BUILDING A BALTIC SEA BYPASS

The Caspian Sea pipelines via Turkey and the pipelines in the south of Eastern Europe are not the only instances of rivalry between Gazprom and Western companies and governments or where Putin has taken it upon himself to represent Gazprom. Even though Ukraine, Belarus, and Poland have complained that they were victimized by Gazprom, one of Gazprom’s biggest concerns has been to find a way to protect itself from Ukraine and Belarus. As Gazprom sees it, both countries have at times blackmailed Russia, either cutting off or threatening to cut off the flow of oil or gas to Western Europe. That is the primary reason that Gazprom and Putin have worked with Germany and particularly Chancellor Gerhard Schroeder to support the construction of a gas pipeline under the Baltic Sea directly from Russia to Germany. Now called the “Nord Stream” pipeline, Gazprom has a 51 percent share in the consortium that is building and operating the pipeline. Two German companies, E.ON and Wintershall, a wholly owned subsidy of BASF, each initially had 24.5 percent of the remainder.⁵²

This pipeline has been surrounded by controversy, both within Germany and in Eastern Europe. For the Germans, it was embarrassing to discover that Gerhard Schroeder, after having been so outspoken in support of building this bypass Nord Stream pipeline while chancellor, became the chairman of its board immediately upon being voted out of office. (At the time it was called the North European Gas Pipeline Company [NEGP].)⁵³ The embarrassing part was that for this relatively cushy, figurehead job, Schroeder was to be paid an annual salary of $300,000.⁵⁴ Moreover, not only had he been the main sponsor of such a pipeline within Germany but days before he left office, the German government offered to act as a guarantor for a 1 billion euro loan which a consortium of German banks was prepared to offer to finance the project.⁵⁵ This would make such a loan more attractive to the banks and thus result in a lower interest rate.

Critics questioned why Gazprom, one of the world’s wealthiest corporations, needed such a guarantee. In the words of Guido Westerwelle, a German opposition party leader, “This affair stinks terribly.”⁵⁶ Many Germans saw Schroeder’s appointment as chairman of the pipeline consortium not only as a blatant conflict of interest but also as outright prostitution. They called for Schroeder’s resignation from the chairmanship. Schroeder denied that he even knew such a loan guarantee had been offered and Gazprom insisted that it did not need a loan, much less a loan guarantee.⁵⁷ Schroeder refused to resign but the incident did little to improve either his or Gazprom’s image, much less its transparency.

Schroeder’s role in this was not a black and white matter. It certainly made sense to argue—as he did—that Germany should diversify its sources of energy supply so that it would be less dependent on the Middle East. Moreover, with the continuing unrest in the Middle East, supplies coming overland by pipeline from a continental neighbor seemed a safer bet than supplies shipped from the Persian Gulf and through the Suez Canal.

From the environmentalists’ point of view, there was also something to be said on behalf of such a pipeline, at least in part. Once he was assured of supplies of natural gas from Russia, Schroeder ordered all of Germany’s nuclear energy plants to be closed down by 2021.⁵⁸ In 2004 nuclear reactors generated 30 percent of Germany’s electricity, so to do away with nuclear energy would mean that Germany would have to generate significant quantities of electricity with other fuels.

The downside of these otherwise praiseworthy initiatives was that this pipeline would increase Germany’s dependency on Russia. Would Russia adhere to its contracts, even if there should be a future political disagreement? Because the Soviet Union had held to its contract commitments with Germany and others in Western Europe even during tense periods of the Cold War era, those favoring such dependence on Russia felt the risk was worth taking.⁵⁹

From the American point of view, however, concerns were raised by the knowledge that both the Soviet Union and Russia had a history of ignoring contractual agreements with a number of non-West European countries. Of course, halting the flow of gas to Germany would be a much more momentous matter than cutting off the flow to Ukraine, but if there were a serious enough dispute, the Russians might do just that. While some U.S. as well as European policy makers began to worry that the showdown with Ukraine in January 2006 was a forerunner of many more such incidents, the German public was much more titillated by the scandal that centered on their prime minister. It stemmed from Schroeder’s appointment as head of the Nord Stream Pipeline and Schroeder’s brazen efforts subsequently to obtain a gag order from a Hamburg court halting criticism of his backing of the project. Nor were skeptics reassured in August 2007 when Gazprom acknowledged that the cost of building the pipeline would be 50 percent higher than initial promises. Moreover, there was also a strong likelihood that there would be yet other costs in the future.⁶⁰

Adding to the notion that the pipeline project had become a honey-pot for payoffs and a form of apparatchik nepotism, Matthias Warnig was appointed managing director of Nord Stream, the company that would build and operate the pipeline.⁶¹ Warnig, who at the time was board chairman of the Russian branch of Dresdner Bank, had worked with Putin in East Germany during the 1980s when both were intelligence agents: Warnig a captain in the Stasi, the East German Secret Police (or the East German Ministry of Foreign Trade, as his official biography describes it), and Putin a lieutenant colonel in the KGB.⁶² Their paths crossed again in St. Petersburg when Putin was put in charge of the mayor’s office for foreign economic relations. Warnig negotiated with Putin for an operating license in St. Petersburg for Dresdner Bank, and it became the first foreign bank to receive such permission to operate in St. Petersburg.

Having friends in the U.S. White House is not that much different, but clearly, friendship with Putin does pay. Schroeder and Warnig are the best examples. Before he became managing director of Nord Stream, Warnig was also nominated to Gazprom’s board of directors. It did not hurt the Putin-Warnig relationship that in 1993 Warnig stepped in to pay for an emergency private plane flight to a German hospital for Putin’s wife after she had a serious auto accident.⁶³ Warnig also helped finance the living expenses for Putin’s two daughters while they were studying in Germany.

While the Germans favored the Nord Stream project, the East Europeans—particularly Ukraine, Belarus, and Poland—opposed it. They were not only worried that Nord Stream would eliminate their chokehold on such shipments, but they were also concerned that they would lose substantial transit fees. Besides, there were legitimate fears that the construction of such a pipeline would cause further damage to the ecology of the Baltic Sea, which was already seriously polluted. Incidentally, other neighboring states, including Latvia, Estonia, and Lithuania, worried that any underwater construction might trigger the explosion of the numerous mustard gas containers the Germans had dumped into the Baltic at the end of World War II.⁶⁴ Such concerns ultimately have forced a review by Nord Stream of the pipeline’s environmental impact. Sweden insists that Nord Stream must have the approval of all the countries whose territory will be traversed by the pipeline. For that reason, Estonia has extended its claim to sovereignty over the territorial waters from three to twelve nautical miles, which means that the Russians will now also need Estonia’s permission. However, Estonia has rejected Nord Stream’s request to conduct a survey of the Baltic seabed in Estonia’s offshore economic zone. With such complications, construction has been postponed for at least one year.⁶⁵

The Poles had their own fears. Given their history, some saw the pipeline agreement as a conspiracy by Germany and Russia to gang up on their immediate neighbor. For a time it seemed to be a replay of the Rapallo Pact of 1922, which some argue helped Germany re-arm after World War I. However, after Donald Tusk became prime minister in late 2007, he and German chancellor Angela Merkel worked to reassure Poland, and Ms. Merkel also offered to divert gas to Poland from the German pipeline should there be a need to do so.⁶⁶

As if all this were not enough to cloud the project, knowledgeable specialists from Sweden have told me that the Swedes are also opposed to such a Baltic Sea pipeline. Their opposition goes beyond the environmental concerns of their Baltic neighbors. The Swedes are worried that the Russians will use such a pipeline to install underwater listening and eavesdropping equipment.⁶⁷ This would allow the Russians to monitor the commercial traffic as well as Swedish military communications, just as the Swedes presently use similar equipment to monitor communication within Russia. Officially Sweden is neutral and not a member of the NATO pact, but whether a member or not, Sweden nonetheless maintains close intelligence connections with NATO headquarters. Officially, Sweden argues that its permission is needed for such a pipeline because it will be built within what Sweden considers its exclusive economic zone.⁶⁸ Its ostensible concern is that because the Baltic is such a shallow sea, the pipeline will serve as a barrier to existing poor water circulation and thereby increase pollution within the already vulnerable seabed. Should the Russians go ahead with the pipeline’s construction, some Swedes have told me that the Swedish military have drawn up plans and are fully prepared to sabotage the pipeline if and when it is built.⁶⁹

OPPOSING CASPIAN OIL AND GAS ALTERNATIVES

While Russia has had to fight off efforts by countries bordering the Baltic Sea who want to prevent the building of a direct Russian-German gas pipeline, there has been a somewhat similar struggle over a Caspian Sea pipeline, only this time Russia seeks to outmaneuver and discourage efforts by Western companies, Central Asian producers, the European Union, and the United States. As we saw, they seek to build a non-Russian alternate undersea route for both gas and petroleum pipelines from producers operating within the Caspian Sea basin. This gas pipeline would be built under the Caspian Sea, and depending on the particular proposal, link up with either or both Turkmenistan and Kazakhstan. The pipeline would then come ashore in Baku and flow through to Ceyhan, Turkey, on the shore of the Mediterranean Sea. The Russians have warned that they would oppose such an underground gas pipeline until “the legal status of the Caspian Sea” is resolved. After the breakup of the USSR, three new countries— Azerbaijan, Kazakhstan, and Turkmenistan—all began to claim underwater rights, some of which had previously been held by either Iran or the USSR (until 1991 the only two countries with Caspian Sea shoreline).⁷⁰ Not surprisingly, Russia evidenced no such concerns as it sought to build its own gas pipeline under the Baltic Sea.

Because the petroleum pipeline did not involve construction under the Caspian Sea, there was no petroleum pipeline proposal for the Russians to oppose. The Trans-Caucasian petroleum pipeline was all overland and on non-Russian land. As we saw, prompted by the United States, BP and some other producers in the region constructed a petroleum pipeline from Baku in Azerbaijan through Tbilisi, Georgia, on to Ceyhan, Turkey, on the Mediterranean Sea. This petroleum pipeline satisfied three needs. First, it provided an outlet to the Mediterranean and on to Europe for non-Russian petroleum producers so their petroleum shipments did not have to pass through the narrow and therefore dangerous nineteen-mile long Bosporus Strait in Istanbul. Second, it also offered an alternative to the Caspian Pipeline Consortium (CPC) that transports petroleum from Kazakhstan—a country with huge production potential—to Novorossiysk in Russia on the Black Sea. Finally, it also provided a right of way for the parallel natural gas pipeline that opened in December 2006 and is intended to link up with the NABUCCO gas pipeline further to the west, which, as stated, was also designed to provide an alternative to the Gazprom pipeline monopoly.

To ensure that the Baku-Tbilisi-Ceyhan oil pipeline will not be profitable, Putin has done his best to provide cheaper alternatives through overland Russian routes. For that reason, in March 2007 he agreed to promote the construction of the Trans-Balkan Oil Pipeline from Burgas, Bulgaria, on the Black Sea, to Alexandroupolis, Greece, on the Aegean Sea, which would also bypass the Bosporous. To guarantee that this new Trans-Balkan Oil Pipeline will attract enough volume, Russia consented to the expansion of the semi-privately owned Caspian Pipeline Consortium (CPC) from Kazakhstan, which the oil companies need badly; however, there was a condition: in exchange for allowing the expansion of the CPC pipeline, the companies must also agree to use this proposed Trans-Balkan Oil Pipeline—which of course will reduce the supplies available to ship through the BP-backed pipeline alternative through Azerbaijan and Georgia. In what seems to be an effort to intimidate them into supporting these Russian projects, the CPC members have been charged with failing to pay $290 million in back taxes to Russia.⁷¹ When built, this Burgas-Alexandroupolis pipeline will be the first pipeline within the European Union itself that will be controlled by a Russian state agency. Expanding into Europe, Russia will hold a 51 percent share and Bulgaria and Greece each 24.5 percent. These moves are designed to counter the EU’s efforts to reduce its dependency on Russian oil.⁷² Even though construction will not be completed before 2011 at the earliest, use of the Burgas-Alexandroupolis route will help frustrate Western efforts to send petroleum from the Caspian region on through Georgia across the Black Sea and then to the Odessa-Brody pipeline in Western Ukraine. The Odessa-Brody pipeline, built in 2001, was designed to take Caspian oil from Odessa north to Poland and the EU. Because the volume and shipments were too low to make this profitable, the Russians instead arranged to reverse the flow and send petroleum south from Brody to Odessa and on to Burgas, Bulgaria. While efforts continue to find enough petroleum to make it possible to send non-Russian petroleum north, for a time at least the Russians seem to have prevented Western companies from bypassing a Russian chokehold.⁷³

PIPELINES IN ASIA

Russia’s pipeline diplomacy is not limited to Europe. Asia’s dynamic economies are also important markets for Russian energy exports. Russia has enormous potential for oil and gas development off the island of Sakhalin and for gas at Kovykta in East Siberia. Japan, South Korea, China, possibly India, and even the United States are all potential customers. On a 2006 visit to China, Putin indicated that Russia would build two gas pipelines to China, one from East Siberia and one from West Siberia. As a measure of how important Asia is expected to become to Russia, at a September 2006 meeting, Putin told a group of us that Russia’s energy exports to Asia would increase from 3 percent of the country’s total energy exports in 2006 to 30 percent by 2012. He did not indicate where, if at all, its energy exports would be cut back, but the implication is that at least the share of energy exports—if not the actual volume—destined for Europe would be smaller.

The sale of so much petroleum and natural gas is predicated on the assumption that the parties can agree on prices (China is a particularly tough negotiator) and that an agreement can be reached as to who will build and operate the pipeline. The latter should be a simple matter, but nothing is simple in these dealings. In the case of Kovykta, for example, Gazprom insists that TNK-BP, which has developed the field, cannot build its own pipeline. Rather, it can only transport its gas through the Gazprom pipeline, and Gazprom will do that only when Gazprom is allowed to have a major equity share of the project. As we saw, Gazprom also muscled out Royal Dutch Shell from dominant control in the Sakhalin II project in much the same way. (We will see that when the sides were reversed, the Russians were quite unhappy when the EU proposed that as a producer of natural gas, Gazprom should be precluded from owning and controlling the gas distribution pipelines as well.)

Given the distances involved, constructing a pipeline to China is a major engineering challenge. But Kazmunai, the Kazakh state oil company, has already completed a 970-kilometer petroleum pipeline from Central Kazakhstan to Xinjiang in northwest China, which it opened in May 2006.⁷⁴ Both countries have agreed to extend the pipeline to western Kazakhstan near the Caspian Sea oil fields. The CITIC group of China, along with the China National Petroleum Corporation, has spent over $6 billion to buy up shares in Kazakh oil fields.⁷⁵ The Russians are engaged in similar pipeline construction efforts, including one project that would involve transporting Russian oil via the Kazakh pipeline on to China.

Shipping petroleum or gas to China is also an important part of Gazprom strategy. Whenever Europeans try to reassure themselves that they need not fear that the Russians will use energy to bully them because the Russians need Europe to buy its gas as much as Europe needs to buy the gas, Putin runs off to Asia with promises that even though it will be very costly, Russia will ship gas from fields the Europeans assumed had been set aside for their use.⁷⁶ And if China refuses to pay Russia’s prices, Putin knows there are customers in Japan and South Korea who will. Moreover, once it does start to accept Russian gas, China is as likely to become as dependent on it over time as the Europeans and to find itself becoming as vulnerable as Europe to the possibility of political pressure and on occasion blackmail.⁷⁷

Of course, the Russians insist they will never, ever, allow political disagreements to interfere with contractual agreements. According to Alexander Medvedev, deputy CEO of Gazprom, “For us contracts are like a Holy Bible.”⁷⁸ He has been echoed by Igor Shuvalov, the economic adviser to President Putin, who told the Financial Times that Russia “did not like” the fact that the European Union felt it necessary to diversify its energy suppliers. “We’ve always said the same thing; we are the most reliable supplier, in any circumstances, for the European market. The most reliable. Like it or not, even if people question it. Europe will never have a more reliable supplier of energy than Russia.”⁷⁹ In much the same spirit, Sergei Karaganov, chairman of the Russian Council on Foreign and Defense Policy, criticized U.S. Senator Richard Lugar for referring “to Russia as an unstable country in talking about NATO’s energy security…. Indeed, Russia has now a reputation over several years as a reliable partner for the West in terms of supplying energy resources.”⁸⁰ Putin himself has also stressed Russia’s reliability. At a press conference on February 1, 2007, Putin charged, “We are constantly being fed the argument that Russia is using its current and emerging economic levers to achieve its foreign policy goals.” He insisted, “This is not the case. The Russian Federation has always abided by all of its obligations fully and completely, and it will continue to do so.”⁸¹

Were it only so. Admittedly, the Soviets held to their supply contracts with NATO countries, like Germany and Italy, through the worst of the Cold War. But ironically, other countries, some of which were one-time Soviet allies or part of the USSR itself, were not so lucky. Although Putin and his associates may not find it in either their Soviet or Russian history books, as we saw earlier in Chapter 2, there have been almost a dozen instances when both petroleum and gas deliveries were suspended for political or economic reasons in mid-contract by both Soviet and Russian energy exporters. Behavior like this, and the denials that such things ever happened, should make those dependent on Russian gas deliveries very nervous.⁸²

OGEC

For a time, in 2006–2007, there was debate as to whether Russia would be able to create a gas counterpart to OPEC. Putin visited all the usual suspects. He discussed such an arrangement with leaders of Iran, Algeria, and Qatar, the most likely participants in such an organization. Even earlier in 2002, Putin had proposed that Russia and the Central Asian gas producers explore the possibility of creating an “alliance” to coordinate the transportation of their natural gas, a trial balloon he soon dropped.⁸³

But the gas market is different from the petroleum market so that an OPEC-like organization, an OGEC (Organization for Gas Exporting Countries), would not make sense. Unlike petroleum producers, gas producers cannot easily shift their deliveries around to other countries. To the extent it is effective, OPEC must be able to induce restraint among producers of petroleum from doing just that. This generally means reducing the supply of petroleum on the market so that at existing prices there will be more demand for petroleum than producers are willing or able to supply. But for such a tactic to be effective, each OPEC member must limit its daily production so as to hold down competitive pressures and price cutting. This tightens the market and frequently leads to an increase in crude oil prices. By contrast, since most natural gas is delivered to its customers by pipeline, there is usually no other viable or affordable source of supply available. Some say that LNG could serve that purpose, but producing and delivering it is very expensive—so much so that producing and selling LNG is viable only when the parties are also willing to sign long-term contracts. This explains why there is as yet only a limited international spot market for LNG, which contrasts with the petroleum spot market where many last-minute purchases can easily be arranged.

Because of spot market pricing in the buying and selling of petroleum and the absence of anything similar to the natural gas market, oil prices, unlike gas prices, tend to be uniform around the world. According to a study by Richard J. Anderson at the George C. Marshall Center in Garmisch, Germany, because there is no such flexibility or ability to substitute suppliers in the natural gas market, prices for natural gas will vary as much as 31 percent from place to place on any given day. In the vocabulary of economists, there is very little room for arbitrage in world gas markets.

While Putin’s discussions with Algeria, Iran, and Qatar are unlikely to result in the actual formation of an OPEC-like organization, the Gas Exporting Countries’ Forum (GECF), which was formed in 2001 and has met only sporadically, may attempt to increase the sharing of information on prices and technology, but not much more. Russia has refused to join OPEC because it did not want to feel constrained by the decisions of such a coordinating group in the way it sells its petroleum. Unless it can work out an arrangement assuring that it will always be able to dictate GECF policy, it seems unlikely that Russia would be willing to accept decisions about how and when it can sell its natural gas.⁸⁴ In actual fact, given the difference in the way gas is delivered, a gas supplier is less likely to need an OPEC to exercise economic and political leverage. Unlike the petroleum markets, which need coordinated behavior among a substantial number of producers to control price and supply, a supplier of natural gas is more likely to have a monopoly relationship with its customers. This is the kind of market OPEC tries to create, but to be effective, it must mobilize a concerted effort by more than a dozen producers. By contrast, because it already is the sole supplier of gas to many of its customers, Russia is effectively a one-country OGEC: an Organization of a Gas Exporting Country, in the singular.

Of course, Russia is not the only source of Europe’s natural gas. Norway and Algeria are major suppliers, and the United Kingdom and the Netherlands can supplement output. But reserves in all these countries are being depleted. While they are all connected to the pipeline network, by 2006 there was very little excess capacity available if Russia, as the major supplier, were suddenly to suspend its deliveries to its customers.

Table 6.2 shows just how important Russian gas is to Europe. Over a quarter of all the gas consumed there comes by pipeline from Russia. In the extreme case, Finland and the Baltic countries depend on Russia for 100 percent of their gas. But Germany, which buys a larger volume of natural gas from Russia than from any other country, depends on Russia for more than 42 percent of its imports. Russia provides 38 percent of its overall gas consumption. This is despite initial promises to limit dependence on Russian gas to 30 percent of overall consumption. As the reserves of the other suppliers are drawn down, dependence on Russia is expected to increase. If there should be any break in the flow, neither Norway nor Algeria can do much to make up the difference. Although they are at the other end of the pipeline, even Italy and France each depend on Russia for more than 30 percent of their imports. This heavy dependency partly explains why Gazprom was able to convince the French and their gas company, Gaz de France, to allow Gazprom to take over the internal pipeline delivery of three billion cubic meters of gas directly to individual French households. (See Table 6.1.) This of course gives Gazprom even more power. The Italian company Eni, a long-time trading partner of Gazprom and Enel, has also agreed that by 2010, Gazprom can sell up to 3 billion cubic meters directly to Italian households and factories.⁸⁵ In exchange, Eni was allowed to buy gas-producing assets within Russia. The Italians have sought to acquire Gazprom’s 19 percent share of ownership in Novatek, which is now Russia’s second largest producer of gas.

Since Gazprom exports so much gas to Germany, it has made a special effort to integrate itself into Germany’s domestic distribution system. It has become closely connected to Germany’s three major gas supply companies, E.ON, Wingas, and Wintershall. The latter is a wholly owned subsidiary of BASF, a major multinational chemical corporation, which is involved in a maze of interlocking directorates. For example, Wintershall and Gazprom are partners in Wingas (Win and Gas), in which Gazprom has a 50 percent equity less one share. Beyond that, Gazprom, Wintershall, and E.ON have created another joint venture to develop the YuzhnoRusskoye gas field in Russia. In this joint venture, E.ON and Wintershall each have one share less than a 25 percent equity. As for Wingas, it originally had a 49 percent interest in Nord Stream, the proposed Baltic gas pipeline. In this case Gazprom has the majority 51 percent portion. Wingas will tie in Nord Stream to the internal German gas grid. E.ON, which was created in June 2000 as a joint venture by the German companies VEBA and VIAG, was allowed to acquire 24 percent of the Nord Stream project from Wingas and BASF.

While Gazprom continues to hold 51 percent of Nord Stream, the German companies have had to spin off some of their shares to Gasunie, a Dutch company. In November 2007, Putin and Dutch premier Peter Balkenende announced that Gasunie had acquired a 9 percent share in the pipeline. This forced both E.ON and BASF/Winstershall to reduce their equity from 24.5 percent each to 20 percent each. Gazprom kept its 51 percent share. Equally important for Gazprom, part of this partnership arrangement includes an option for Gazprom to purchase 9 percent of the Balggand-Bacton pipeline that connects the Netherlands to Great Britain, an access Gazprom has long sought.⁸⁶

If this were not confusing enough, Gazprom in turn can purchase up to 25 percent in E.ON. The German firm Ruhrgas, which in 2003 was bought up by E.ON, owns 6.5 percent of Gazprom. So here is how things stand. E.ON owns Ruhrgas which in turn owns part of Gazprom, and Gazprom can buy up part of E.ON. This is like a dog trying to grab hold of its tail. To top it off, Bergmann Bruckhard, chairman of the Management Committee of Ruhrgas, is one of the few foreigners who is on the Gazprom Board of Directors.⁸⁷

All of this is very reminiscent of the way Soviet authorities designed their overseas trading and banking networks during the Soviet era. Each Soviet overseas corporation owned shares in almost all their fellow overseas corporations. This was done to mask responsibility while creating the appearance that the Soviet corporation had private shareholders and owners like other corporations.⁸⁸ In sum, although who owns whom is convoluted and as hard to follow as the pea in a sidewalk shell game, the Germans are very much involved with Gazprom, and Gazprom, in turn, has become an important player in Germany.

Direct access to the French, German, and Italian consumers allows Gazprom to earn a higher margin on its sales. It also gives it greater control over the source of the gas sold within these countries and again is a way of excluding other suppliers. The effort to gain dominant control is part of Gazprom’s long-term strategy. In addition to France, Italy, and Germany, Gazprom has either already succeeded or is trying to gain control of internal gas pipelines and distribution systems in Belarus, Ukraine, Georgia, Moldova, Switzerland, Austria, Finland, Turkey, Hungary, Greece, Latvia, and Lithuania, where Gazprom now owns 34 percent of Lithuania’s pipeline grid company, Lietuvos Dujos.⁸⁹

THE RUSSIANS ARE COMING

Alert to the strategic control Gazprom would gain from internal pipelines and distribution systems, some gas distributors have become wary of allowing Gazprom to make such inroads. After Gazprom began to explore the possibility of buying up Centrica, Great Britain’s largest gas distributor, the Financial Times published an editorial entitled, “Your Local Gazprom,” warning British consumers that they might find themselves subject to Kremlin control. It could have added that Gazprom has also attempted to gain control of some British electricity-generating facilities as part of a swap arrangement with the German company, Ruhrgas.⁹⁰ The paper acknowledged that foreign companies from the United States, Germany, and France were also taking control of energy assets in the United Kingdom, but given Russia’s past record it was concerned that the possibility of Russian control brought with it other negative “geopolitical factors to which unfortunately Gazprom is inherently prone.”

Such concerns go beyond Great Britain and the European continent. Alexander Medvedev, deputy CEO of Gazprom, for example, has implied that some day Gazprom might create a joint venture that would distribute gas in China’s domestic market.⁹¹ For that matter, there is nothing to prevent Gazprom from making a similar investment in U.S. gas companies. LUKoil’s purchase of Getty Oil’s filling station network is a precedent. In addition, several Russian metallurgical companies have already acquired a variety of U.S. steel and nonferrous metal companies, including the only U.S. producer of platinum and palladium.

Not surprisingly, the Russians do not take kindly to suggestions that Europeans should be wary of allowing Russian companies to expand beyond their borders. After Alan Johnson, British minister of Trade and Industry, insisted that England would block Gazprom from taking over Centrica, the parent company of British Gas, Alexei Miller, Gazprom’s CEO, warned that “attempts to limit Gazprom’s activities in the European market and politicize questions of gas supply, which in fact are of an entirely economic nature, will not lead to good results.”⁹² His response not only conveys Russia’s sensitivity over efforts to exclude it; it also reveals his insensitivity. Miller angrily chastised the British and Europeans for acting for political reasons while he apparently failed to realize that to Western observers, it is the Russians, even more than Western governments, who place political considerations ahead of commercial and economic considerations.