HUDSON WHITE PAPER INSTITUTE Energy

Security: Zeyno Baran & Emmet Tuohy

Ukraine’s CENTER FOR EURASIAN Existential POLICY

Challenge JULY 2006

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Hudson Institute is a non-partisan policy research organization dedicated to innovative research and analysis. Energy Security: ’s Existential Challenge

By Zeyno Baran and Emmet Tuohy Center for Eurasian Policy, Hudson Institute

ISBN 1-55813-152-3

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The authors are grateful for the support of interns Benjamin Fidler (who contributed editing, research, and writing) and Diana Marongiu (who provided research assistance). Table of Contents

Authors’ Note ...... 3

Introductory Note ...... 3

Political and Economic Review ...... 4

Foreign Policy ...... 8

Energy ...... 10

Gas: The New “Political Weapon” ...... 11

Oil Production, Refining, and Transportation ...... 18

Key Players ...... 27

Conclusions and Recommendations ...... 27

Endnotes ...... 34 Authors’ Note

On July 11, as we went to press, Speaker of Parliament officially submitted the nomination of to become the next Prime Minister of Ukraine. This nomination came after a tumultuous series of events that saw the collapse of the projected Orange coalition and the formation of a new alliance between the Socialist Party, the , and the Com- munist Party. At the time of writing, it is possible that this new coalition itself may not survive; sev- eral alternate possibilities still remain. One thing remains certain, however: if a new Yanukovych-led government comes to power, the chances of Ukraine achieving meaningful energy independence are slim. We remain confident that only an Orange coalition has the ability and will to implement the necessary reforms to Ukraine’s economic and political system. Regardless of the final outcome, the recommendations in this paper are certainly still applicable.

Introductory Note

ver the last year and a half, Ukraine has lost election, followed by the Our Ukraine bloc of President —and continues to lose—valuable time in ; the two parties were expected to O which to develop a comprehensive energy form a solid Orange-Blue coalition, and continue bus- security strategy. More than three months after the iness as usual. When Tymoshenko’s party took second March 2006 parliamentary elections, Ukrainian politi- place, such an arrangement was no longer possible. cal parties have struggled to reach agreement on a new While Our Ukraine showed great reluctance to once governing coalition. The nature and the future of the again enter into a coalition with Tymoshenko, and may government and of Ukraine itself will depend to a large still choose to partner with the PR, the new Orange degree on the decisions reached in the coming months coalition represents the best possible outcome for the in the energy sector, especially concerning natural gas. country—especially for its energy security. The cutoff of gas supplies to Ukraine by on This paper builds on Zeyno Baran’s March 2005 New Year’s Day in 2006 came as a major wake-up call study, entitled “Energy Reform in Ukraine: Issues and to the West—and a major rallying point for large num- Recommendations”.1 bers of , who had previously been relatively It consists first of a review of recent political and complacent about their country’s energy dependence economic developments, followed by a discussion of on its northern neighbor. In March, large numbers of key issues in the oil and gas sectors. It does not focus these voters cast their ballots for former Prime Min- on other important energy sources, such as hydroelec- ister , who was the leading oppo- tricity and coal, as the primary purpose of this paper is nent of the non-transparent January and February gas to address the critical interplay between energy and agreements reached with Russia. Many had previously domestic and international politics. The third and last assumed that the Party of Regions (PR) led by Viktor section is made up of recommendations to the new Yanukovych would finish first in the parliamentary government as well as the EU and the .

HUDSON INSTITUTE 1 Center for Eurasian Policy Political and Economic Review

s he pledged to “defend the unity of Ukraine” ters were such parties as Our Ukraine, the Yulia Tymo- at his inauguration in January 2005, Viktor shenko Bloc, PORA/Party of Reforms and Order, the AYushchenko basked in the applause2 of the Socialist Party, and the Party of Kostenko and Plyushch. hundreds of thousands of supporters gathered to cele- Meanwhile, the so-called “Blue” parties included the brate the success of the . Shortly Party of Regions, the Natalia Vitrenko Bloc, Ne Tak, thereafter, eager for the cheers to continue, Yushchen- and the Communist Party. Most pundits concluded that ko sought to capitalize on the momentum of his his- despite the proliferation of choices, voters would toric victory by seeking adulation abroad. In this choose to continue supporting the parties best associat- respect, the West was happy to oblige; Yushchenko ed with the 2004 presidential candidates. graced the covers of newspapers and magazines, re- The morning after the election, it became clear that ceived a variety of honorary degrees and awards3, and this prediction was only half true. The Party of the most of all, was loudly cheered by Western legislators. Regions vanquished almost all of its competitors (ex- During Yushchenko’s address to a joint session of the cept for the Communists, which due to the dogged sup- US Congress, legislators chanted his name, while Euro- port of pensioners from the south and east, was able to pean Parliament members waved orange scarves dur- squeak past the 3% threshold), thus establishing itself ing his later visit to Brussels. as the leading opposition party in Ukraine. It is impor- Yet back home—in a country still reeling from the tant to note, however, that the PR’s claims to have bitterly-fought election—Yushchenko would soon be “won” the election are exaggerated, as the total “Blue” hearing no cheers at all. Despite the best intentions and share of the vote remained roughly constant from 2004 efforts of the new president, the end of his first year in to 2006. The most salient aspect of the election was the office revealed him unable to even “defend the unity” extraordinary performance of the Yulia Tymoshenko of his own political supporters, let alone the entire Bloc—which showed itself by a significant margin to nation. Soon enough, the cheers of foreign crowds also be the leading Orange party, winning all but three of died away, as investors lost confidence in the Ukrainian the oblasts that had voted for Yushchenko in 2004. economy and as doubts increased about the govern- Thanks to this performance, Yulia Tymoshenko is ment’s true commitment to political reform, especially perhaps now best positioned to provide the needed the fight against corruption. Now, over eighteen months leadership—even though she faces major challenges later, Ukraine has clearly fallen short of its potential, both at home and abroad. Indeed, she is considered to and remains a divided country—one in continuing be populist and unpredictable, was derided in Russia need of strong leadership that can consolidate the as a “criminal” (due to outstanding arrest warrants gains made by the Orange Revolution. during her term as premier, she was unable to enter the Consolidation seemed furthest from the minds of country for the first months of her premiership)4, and Ukraine’s political elite during the divisive March 2006 is criticized in Western capitals as an “oligarch”. parliamentary election, which bewildered voters with She is also the country’s most charismatic leader, one an array of 45 registered parties appearing on ballots. who worked hard to be seen as trying to fill the de- Rather than targeting the entire electorate, most of these mands made by the Ukrainians on ’s Maidan Nez- factions competed only within the broader “color” alezhnosti (Independence Square) during the Orange groupings. Striving for the votes of “Orange” suppor- Revolution in 2004.

HUDSON INSTITUTE 2 Center for Eurasian Policy As prime minister and subsequently as an opposition the killers of journalist Heorhiy Gongadze (allegedly candidate, Tymoshenko tried to do so in three ways: murdered on the orders of high-ranking officials in the first, by seeking to establish the economy on sound previous regime, including Kuchma himself) within footing; second, by adopting a fierce stance against cor- two months of his inauguration. However, due to a ruption; and third, by strongly supporting long-term deliberate leak from within the prosecutor-general’s economic growth and economic independence, specifi- office, the senior figure directly responsible for the cally from Russia. assassination escaped arrest in Israel; meanwhile, other First, she recognized that the high ideals of a peace- former officials were found dead in suspicious suicides ful revolution cannot be achieved without a sound eco- shortly before their scheduled testimony. By the middle nomic foundation. Accordingly, her budget framework, of 2005, it seemed clear that Yushchenko was content which was overwhelmingly approved by the Verkhovna to trumpet the arrest of the low-ranking policemen Rada (Parliament) in March 2005, raised wages, pen- who had actually carried out the murder, and leave the sions, and social spending (on groups such as orphans, true extent of the scandal largely untouched. Worse yet, mothers, and the handicapped) while slashing the gov- the president seemed unwilling even to hold account- ernment’s budget deficit to below 2% of GDP. Inflation able the perpetrators of perhaps the highest-profile continued to increase, however. In order to limit the crime of the Kuchma era: his own poisoning. Through- impact on lower- and middle-class Ukrainians, Tymo- out this period, however, Tymoshenko continued to shenko decided to introduce limits on the prices of two maintain a hard line against corruption. important commodities: gasoline and meat. Both meas- The Orange team was further distracted from its ures provoked fierce criticism abroad (Anders Åslund, goals by the spread of corruption allegations against then of the Carnegie Endowment in Washington, officials close to Yushchenko himself—allegations that labeled the prime minister’s move “wild intervention”). sprang up almost immediately after the term in office This criticism was valid, as both petrol and food short- began. Justice Minister almost re- ages soon resulted. Yet, seen as a whole, Tymoshenko’s signed two weeks into his term, because Tymoshenko’s economic policies proved largely beneficial. As Åslund proposed February 16 ban on re-exporting imported later acknowledged, state revenues doubled and red oil prevented a company linked to Zvarych’s wife from tape was removed in order to improve the business cli- meeting previous contract obligations. Yushchenko in- mate. By September 2005, signs of positive economic tervened, but even he could not save Zvarych after growth had returned to Ukraine—because of, not investigative journalism revealed that the American- despite, the actions of the prime minister. born minister had dramatically falsified his CV (claim- Second, Tymoshenko was able to capture and retain ing, for example, to hold a PhD from Columbia Uni- the hearts of the Orange camp due to her fidelity to the versity). Allegations hit even closer to home when, in anti-corruption ideals of the Revolution. A key prom- July 2005, a journalist from Ukrayinska pub- ise made by the opposition at the time was that the lished an expose entitled “Son of God” on the lavish “bandits” and “crooks” then in government would be lifestyle of Andriy Yushchenko. The younger Yush- held accountable for their actions. However, the Yush- chenko had been seen driving a $160,000 BMW, talk- chenko government had difficulty implementing this ing on a $40,000 cell phone, and drinking $1,000 bot- promise—in part because many such individuals tles of champagne—items which not even his father remained in their positions after the change in power could afford to purchase. The scandal only deepened (notably the holdover Prosecutor-General Svyatoslav when the president responded by labeling the journal- Piskun, who was charged with many of the investiga- ist a “hired killer” at a press conference. tions). Yushchenko had specifically promised to find Yet, both of these scandals paled in comparison to

HUDSON INSTITUTE 3 Center for Eurasian Policy the civil war within the government that broke out in economic policies, the third pillar of Tymoshenko’s September 2005. Oleksandr Zinchenko, state secretary future electoral success. While correctly pointing out to Yushchenko, resigned at a public news conference in that economic growth had slowed considerably from which he alleged that “corruption and bribe-taking are the figures of the previous year, Yanukovych and other growing in force,” singling out National Security and critics missed the key story behind the numbers. First, Defense Council chair for particular part of the “decline” in GDP was due to fraudulent fig- criticism. Poroshenko subsequently resigned, though ures created by the previous government. Second, the promising to cooperate fully in an investigation to Yanukovych government saddled Tymoshenko with a clear his name. Yushchenko’s response was to dismiss budget deficit equal to 10% of GDP, due to its efforts the entire government, including Tymoshenko, arguing to spend its way to victory in the presidential election that interpersonal tensions had become so great that (pensions were doubled, and salaries for government they were preventing the state from functioning; a workers dramatically increased). When combined with “fresh start” was therefore needed.5 other exogenous factors, such as the decline in world demand for Ukraine’s exports, particularly metal prod- n order to avoid a choice between the “factions” ucts, and the considerable increase in natural gas prices Iwithin the government, Yushchenko announced the paid by Ukrainian industries 6, some economic correc- selection of loyal technocrat , then tion was inevitable. governor of , as candidate for The government does bear responsibility for econo- prime minister. However, the president made two mic setbacks in three other areas: foreign direct invest- critical mistakes: first, he assumed that his choice ment (FDI), tax policy, and integration with the world would be approved, and thus continued with preexist- economy. ing plans to travel to the United States—thereby miss- First, foreign investment never reached the level ing a valuable opportunity to secure the necessary votes hoped for either in Kyiv or in Western capitals at the for Yekhanurov’s confirmation. Second, he underesti- start of the new government’s term. In part, this dis- mated the speed with which Tymoshenko would shift appointment was due to heavily-publicized disagree- into opposition. Yekhanurov was accordingly rejected ments between Yushchenko and Tymoshenko over by the Rada on a first attempt. Only after Yushchenko reprivatizations of former state-owned firms that had made significant concessions to Yanukovych and the been fraudulently sold to well-connected investors dur- Party of the Regions in a “Memorandum of Under- ing the Kuchma era. While the difference between the standing”—including a guarantee of amnesty for those president and former prime minister have been greatly who had falsified the first two rounds of the 2004 elec- exaggerated (Tymoshenko never directly proposed tion, and an end to reprivatization—was the new 3,000 reprivatizations; she was merely describing the prime minister approved. While permitting an end to extent of the previous fraudulent transactions, and soon the political crisis, this act was seen by many settled with Yushchenko on a figure of approximately Yushchenko supporters as a betrayal of the promises of 12), the issue remained a sticking point for the majori- the Orange Revolution. With his former chief opponent ty of the Orange government’s first year in office. thus compromised, Yanukovych and the PR were able According to the State Statistics Committee, FDI to gradually increase confidence and reemerge into the flows reached the dramatic total of $7.3 billion in public eye, abandoning the former policy of political 2005, a nearly five-fold increase over the previous obstructionism. year’s figure of $1.7 billion. However, this figure Before that point, however, the Party of the Regions masked a continuing trend towards low investor confi- had led a firestorm of criticism against the government’s dence in Ukraine among members of the Western busi-

HUDSON INSTITUTE 4 Center for Eurasian Policy ness community. The increase was due almost entirely bership to be a major component of Ukraine’s Euro- to the repeat privatization of the Kryvorizhstal steel Atlantic integration. However, despite the steadfast mill, sold to a German subsidiary of Mittal Steel (for a support of both Our Ukraine and the Yulia Tymoshen- purchase price of $4.8 billion), and by the acquisition ko Bloc, the government was forced repeatedly to of a controlling stake in Aval Bank by the Austrian postpone its projected accession date—hampered once group Raiffeisen for $1.1 billion. Moreover, many of more by domestic political considerations. The Social- the leading countries investing in Ukraine, such as ist Party, though members of the government coalition, Cyprus (second in the FDI source rankings), and the nevertheless joined the opposition in blocking key leg- British Virgin Islands (fourth), are not necessarily pro- islation necessary for WTO membership. While the viding “new money” to the country; instead, they opportunity presented by the December biannual serve as offshore shelters for Ukrainian companies and WTO conference has passed, the government’s efforts individuals seeking to escape the country’s complicat- have brought it closer to membership. After being ed and often unfair taxation system. granted “market economy” status by the US and EU, and after signing the necessary bilateral access agree- oon after entering office, Yushchenko made it a pri- ments with many states (including the US), Ukraine Sority to reform that system, in which the payment now stands ahead of Russia in the WTO queue—and of taxes was often seen as more or less optional. Eager may very well join by the end of 2006. to begin ensuring compliance, the government enacted a new code in March 2005, which allowed citizens to ltimately, Ukraine’s decidedly mixed economic pay a flat 200 hryvnia ($38) in income tax per month. Urecord in 2005 is due to the absence of govern- Employers were generally exempted from social contri- ment leadership in resolving conflicts, both with the butions, under a scheme in which nearly all employees opposition and within the government itself. In the were considered “private entrepreneurs,” thus avoiding former case, as demonstrated above, the failure to ade- social security taxation altogether. However, as part of quately punish those responsible for the previous his efforts to close the budget deficit inherited from the regime’s misdeeds led to what some have labeled the previous administration, Yushchenko soon announced “impotence of authority.” This “impotence” also a new 13% income tax; with a punitive 40% social extended to the government itself; since the threat security levy to be paid by employers. The business posed by the opposition was still considerable, community reacted with anger and confusion, issuing Yushchenko turned a blind eye to corruption, dissent, dire warnings of the economic consequences, particu- and obstruction within his own side. larly to small businesses, of what the labeled Though much opportunity was missed to erase the an “arbitrary shift.” This “shift” was not the final one, legacy of political and economic mismanagement left however; while trying to calm fears of an economic dis- by Ukraine’s first two presidents, it is certainly true that aster, Yushchenko suggested that the tax code would be some progress has been made. A consensus on the need modified once more, this time by adopting a flat-tax for greater economic transparency and integration into regime similar to that in place in neighboring countries the world economy is gradually emerging within such as Russia and Slovakia. However, concrete steps Ukrainian politics (with the notable exceptions of the toward such a system have not yet been taken. Communists, the Vitrenko bloc, and the remnants of Concrete steps were taken toward accession to the the authoritarian hard-left within the Party of the WTO—a key policy priority for the Yushchenko gov- Regions). Yet much still needs to be done before “the ernment. Early on, the president declared WTO mem- greater unity” of Ukraine can be brought about.

HUDSON INSTITUTE 5 Center for Eurasian Policy Foreign Policy

ndoubtedly, foreign policy was a clear early to work very hard, I think, to meet the criteria” for priority of the Yushchenko administration; NATO membership. Ufrom Central Asia to Russia to Europe and Yet, at the recent Vilnius conference on “Common the United States, Yushchenko sought to spread the Vision for a Common Neighborhood” Vice President message that Ukraine was a country open for business, Dick Cheney offered verbal encouragement for open to reform, and open to closer relations with all Ukraine’s eventual membership while harshly criticiz- nations. Yet, despite the president’s significant empha- ing Russian interference in the affairs of post-Soviet re- sis on diplomatic efforts—by April, the year’s consider- publics. Furthermore, at the highest levels, NATO has able travel budget had already been spent—he hinted that it may offer Ukraine a clear path to mem- achieved only partial success. bership at the Riga summit in November. At Sofia, Sec- First, despite the initial warm reception in Europe, retary-General de Hoop Scheffer stated that “I have no and the continuing advocacy of Ukraine’s candidacy by doubt that in Riga, countries aspiring to membership countries such as Poland and Lithuania, the EU has will want a signal. When they are ready, NATO is ready largely rebuffed Ukraine’s efforts to secure a commit- …There will be a signal at Riga.” Clearly, these state- ment to talks leading to accession. For now, the future ments would no longer hold if the Party of Regions of Ukraine seems locked in the European Neigh- enters government. borhood Policy. Meanwhile, after many months of positive “signals,” Accordingly, NATO is now the main hope for concrete advances have finally been made in the sphere Ukrainians desiring a secure Western path to Ukraine. of US-Ukraine relations. Despite the fanfare and celebra- The government has repeatedly made clear that this tion that accompanied President Yushchenko’s two vis- is an extremely important priority; most recently, as its to the United States—including the signing of what Foreign Minister declared at the was labeled a landmark Strategic Partnership Agree- NATO summit in Sofia, “Ukraine’s strategy towards ment—these visits produced little in the way of tangible joining NATO is irreversible.” Yet, however certain achievement. Ukraine lifted the visa requirement for US this desire, the combination of popular opposition and citizens in June, but it was not until after many months technical difficulties may make accession to NATO a of lobbying that such steps as the recognition of Ukraine difficult task for the next government. Polls have indi- as a market economy and the permanent repeal of the cated that up to two-thirds of Ukrainians oppose mem- Jackson-Vanik amendment were taken. bership. While hardly representative of national senti- ment, the recent protests in Crimea, which led to the n terms of regional relations, Ukraine has main- abandonment of planned exercises with the US and Itained and deepened close ties to neighbors such as Britain, have rallied anti-NATO sentiment in southern Poland, Slovakia, and Romania, along with nearby and eastern Ukraine, and raised doubts in alliance cap- nations such as the Baltic republics and Georgia. itals about the eventual possibility of Ukrainian acces- Ukraine has been a leader in regional groupings such sion. Similarly, modernizing Ukraine’s decaying mili- as GUAM and the new Community of Democratic tary infrastructure to meet NATO standards will be Choice (formed in December 2005), and has also difficult and expensive; in sum, as US Secretary of State taken a belated lead in the search for a final settlement Condoleezza Rice noted at Sofia, “[Ukraine] will have of the crisis in Transnistria. Yet, in this sphere as well,

HUDSON INSTITUTE 6 Center for Eurasian Policy much concrete advancement remains to be made; Yet, due to domestic political considerations and its visions of establishing GUAM or the CDC as alterna- already low level of ties to the grouping, Ukraine is not tives to Russian influence in the region remain outside willing to quit the CIS outright. Furthermore, some the realm of reality. officials—especially within the presidential administra- In the end, as has so often been the case throughout tion—hold out hope that the economic and other Ukrainian history, Ukraine’s foreign relations hinge on cooperation agreements made within the CIS frame- the Russian question. Before his flurry of trips to the work may yet prove effective. However, the president West, Yushchenko paid his respects to Moscow by himself recently expressed doubt in even this moder- choosing it as the destination for his first state visit, ately hopeful proposition. In an interview with the during which he labeled Russia “our strategic partner.” Polish daily Gazeta Wyborcza, Yushchenko labeled the The ensuing months saw Moscow attempt to “win CIS as “above all, a political club whose members meet back” Ukraine. In February 2005, Russian Foreign regularly, but whose effectiveness in economic affairs is Minister Lavrov called for the two countries to “take a very limited—and all its members know it.”8 Although fresh look” at their relations, acknowledging that Uk- his government “believes that dialogue…is still pos- raine was no longer part of Russia’s “near abroad.” sible,” “cooperation requires a new policy…[which] Russia also attempted to accommodate Ukraine’s eco- doesn’t exist.” nomic interests as part of its plans for an EU-alterna- Moscow is currently making little effort to assuage tive “Single Economic Space.” these concerns. Indeed, for some time now Russia has shifted its approach away from this “fresh look,” seek- hile entertaining this Russian outreach effort, ing instead to discredit the Orange parties and thus WYushchenko never wavered from his emphasis strengthen the Yanukovych-led opposition. This policy on Euro-Atlantic integration; for example, he acknowl- was made clear by the blockade of certain Ukrainian edged the possibility of SES membership only if it imports, uncooperativeness on the Transnistria border “would not block or come into conflict with the princi- issue, and intransigence on the matter of the Black Sea ples of our policy towards the .” More Fleet in Crimea—the location, more recently, of incen- recently, Ukraine has been increasing its criticism of the diary speeches by Duma members during the recent Commonwealth of Independent States (CIS), with an anti-NATO protests. The series of events that became eye towards leaving the organization entirely. After the known as the “gas crisis” must be understood within April ministerial conference in Moscow, at which CIS this bilateral context. By discrediting Ukraine as a reli- members (led by Russia) refused to consider a resolu- able transit country, and by highlighting mismanage- tion condemning the Holodomor 7, Tarasyuk con- ment and corruption in the country’s energy sector, demned the CIS as “not a normal international organi- Moscow sought to undermine Ukraine’s image in West- zation” that is “without a future.” Several weeks later, ern capitals, thereby paving the way for the achieve- First Deputy Foreign Minister Volodymyr Ohryzko dis- ment of its ultimate goal: a takeover of Ukraine’s ener- missed the CIS as a “talk shop” and an “empty shell.” gy transport infrastructure.

HUDSON INSTITUTE 7 Center for Eurasian Policy Energy

ussia is (and almost certainly will remain) southeastern -Donets basin. These fields, which Ukraine’s primary source of energy; it supplies are partly located beneath existing shallower fields R up to 80 percent of Ukraine’s oil and 75 per- already in production, are located inside an area of cent of its gas needs. This concentration in supply is due more than 31,000 square kilometers—and are believed mainly to inherited Soviet infrastructure that made to contain “significant” reserves, according to Shell. Russia the hub of Eurasian oil, gas and electricity sys- Ukraine also has rich gas reserves; the total is esti- tems. In addition, Russia itself has subsequently become mated to be 1.12 trillion cubic meters. Onshore gas one of the world’s leading oil and gas producers. fields are located primarily in central Ukraine (Dnipro- Ukraine is a major oil and gas transit country, Basin), though smaller deposits can be found though it does not yet take full advantage of its strate- in western Ukraine’s Carpathian region. Additionally, gic position. It re-exports over 90 percent of its gas im- offshore reserves in the Black Sea and the Sea of Azov ports from Russia and to European mar- are estimated at approximately 73 billion cubic meters kets. While Russia has several options by which it can (bcm). Gas production, however, has been relatively export its oil, it currently sends some 80 percent of its low—Ukraine produces less than 25 percent of its gas exports to Europe via Ukraine. Even though Russia is needs domestically and imports the balance. On top of actively considering alternative export routes, for now all this, Ukrainian economy is notoriously energy-inef- Ukraine retains potential leverage against Russia that ficient9; Ukraine uses 76 bcm of gas per year, while can be utilized with the adoption of the right strategy. next door, Poland achieves roughly the same GDP with Ukraine is believed to have significant domestic oil only 13.7 bcm of gas annually. and gas reserves. In total, the country is estimated to In the past, these oil and gas reserves have been poor- possess over 1 trillion cubic meters of discovered ly developed—leaving the country largely dependent on onshore reserves. If undersea reserves are taken into Russia for its energy needs. Under the Kuchma regime account, the total may be as high as 5 trillion. In order —especially during its last year, when the leadership to fully exploit these resources, Ukraine needs foreign wanted Russian support for the Yanukovych candida- investment and Western technology to improve pro- cy—Ukraine was rumored to have signed long-term duction efficiency and increase penetration into reser- agreements with Moscow that promised increased de- voirs. The most significant potential source of oil is off- pendence on Russian oil and gas supplies for years to shore, in the Black Sea; there may also be significant come. Instead of correcting these mistakes, the Yush- coal-bed methane reserves. Recently, in early June, chenko government has made the situation worse— Royal Dutch Shell agreed to a joint exploration agree- especially by signing the January and February agree- ment with Naftohaz Ukrayiny in eight fields in the ments with Moscow, as described in detail below.

HUDSON INSTITUTE 8 Center for Eurasian Policy Gas: The New “Political Weapon”

ver the past year, natural gas has become “widespread corruption” in Ukraine’s energy sector. established as the key political and energy Unfortunately for Ukraine, such allegations of cor- O security issue in Ukraine. The January 4 ruption were not unfounded. Indeed, ever since inde- Ukrainian-Russian gas agreement directly led to the pendence, the energy sector—particularly gas—has parliament’s vote of no confidence in the Yekhanurov been the most corrupt segment of the Ukrainian econ- government and definitively impacted the March par- omy. As in Russia, the economic chaos11 caused by liamentary elections. And as information emerged post-independence mismanagement opened up ample about the role of the intermediary firm RosUkrEnergo, economic opportunities—that is, for vested interests. the deal has become a critical factor in discussions Even after 1994, when President Kuchma took office about the formation of a new government. In large trumpeting his new plans for economic reform, the part, the success both of Ukraine’s domestic reform politically well-connected were able to exploit the pro- programs and of its efforts to integrate more closely cesses of privatization and economic liberalization for with European and Euro-Atlantic institutions depends their own ends. Unlike their counterparts in Russia or on how this issue is resolved. Central Asia, however, who were able to build their Ukraine is the largest gas importer of the former fortunes upon rich reserves of natural resources, Soviet countries, due largely to inefficient industries Ukraine’s nascent oligarchs were largely left only with that have flourished thanks to the availability until the uncompetitive assets—inefficient collective farms recently, of Russian-supplied gas at below-world- and outmoded factories—of the communist era.12 Yet market prices. Russia supplies Ukraine with about 25 even though Ukraine lacked the energy reserves of its bcm of gas annually: 17 bcm of which is received as an fellow former Soviet republics, its oligarchs nonethe- in-kind payment for transit of Russian gas through less took advantage of the country’s critical location Ukraine to Europe, and 8 bcm of which is purchased. and large domestic market to enrich themselves as mid- Ukraine also imports gas from Kazakhstan and dlemen and distributors. Uzbekistan (via the network). However, in the past few years, Turkmenistan has become n 1996, after the appointment of Ukraine’s largest source of natural gas though long- Ias prime minister (an appointment made unilateral- term contracts: Ukraine imports approximately 37 ly by President Kuchma), “corruption seemed to enter bcm from Turkmenistan (via Russia) annually. a new dimension.”13 For now, Ukraine does have some leverage over While manipulating numerous fields of the econo- Russia as over 80% of Russian gas exports to Europe my, Lazarenko’s true gains were in energy. His spon- cross Ukrainian territory. However, Russia has been sorship (allegedly secured at a cost of 50% of profits) making a steady and concerted effort to bypass its enabled United Energy Systems (UES) to secure a mon- “unreliable” Ukrainian partner by promoting new opoly on the resale of gas in Ukraine. As a result, the pipelines under the Baltic and Black Seas. Rather than firm’s yearly earnings dramatically increased from $1.5 acknowledging the inherent geopolitical implications of million to $3 billion—though it paid a mere $11,000 this effort, Moscow has insisted that this shift in supply in taxes. As Lazarenko’s political power grew in tan- routes is being done purely to “increase Europe’s ener- dem with his Swiss bank balances—at the time estima- gy security”10, and to avoid the problems caused by ted at over $70 million—Kuchma saw him as too

HUDSON INSTITUTE 9 Center for Eurasian Policy much a threat to remain in office, and quickly acted to Kuchma was forced to look elsewhere for help—and eliminate the prime minister and his political allies found a willing partner in a Russian government wary through a campaign that included arrests, public de- of the new Ukrainian opposition’s pro-Western orienta- nunciations, and “private” lawsuits. (Lazarenko him- tion. The “unholy alliance” that the president and his self was arrested in on money-laundering oligarchic allies formed with Moscow became an effec- charges a year after being permitted to resign; he later tive source of support for the president and his regime fled to the United States, where he failed to win politi- —and a lucrative source of revenue for his partners. cal asylum and was ultimately convicted of various corruption charges.) n June 21, 2002, Naftohaz Ukrayiny and Gaz- Meanwhile, through her position as president of Oprom signed an energy supply contract scheduled UES, Dnipropetrovsk-born parliamentary deputy Yulia to expire in 2013. Under this contract, the payment for Tymoshenko rose to prominence, earning the derisive the transit of Russian natural gas through the Ukrain- title “Gas Princess” from her critics. Blessed with solid ian pipeline system was made in the form of barter political instincts, however, she reached an accommo- exchange—up to 15 percent of gas pumped through dation with Kuchma, avoiding the fallout that contam- Ukrainian territory was kept by Ukraine as payment. inated most of her energy-sector colleagues after the Originally, the amount of gas to be shipped as in-kind purge of Lazarenko and his associates. Tymoshenko payment of transit fees was supposed to be negotiated also survived a second, more serious attempt to ruin her every year, and fixed by intergovernmental protocols. political fortunes after she was arrested in February However, in order to boost the political popularity of 2001 on charges of smuggling gas while UES president; Kuchma’s chosen successor Viktor Yanukovych in the she was released and cleared several weeks later. 2004 presidential campaign, Naftohaz and Gazprom According to Tymoshenko, the charges were “fabricat- signed an addendum to the contract in August 2004. ed” by oligarchs threatened by her efforts to “root out Accordingly, Ukraine would receive gas barter pay- corruption and institute market-based reforms.” ment for transit of 110-120 bcm of Russian gas to Europe. The price of natural gas delivered to Ukraine espite Lazarenko’s dramatic departure from the was lowered to $50 per thousand cubic meters (tcm), Dscene, the gas sector continued to operate largely while the basis price for calculating the amount of gas as before, as a lucrative monopoly run by another given as payment for transit fees was changed to $1.09 politically well-connected group. This time, it was led per tcm per 100 km. The price was not subject to any by Ihor Bakai, who directed the successor companies changes until the end of 2009. Interhaz and Naftohaz Ukrayiny. He was in turn Yet, after the political defeat of Yanukovych in the linked to long-term Kuchma adviser and media mag- Orange Revolution, these calculations changed. There nate Oleksandr Volkov, who had been the center of were also uncertainties regarding the reliability of the numerous corruption allegations. Naftohaz subse- Turkmen supplies. In March 2005, Gazprom demand- quently played a key role in Kuchma’s 1998 reelection ed that Ukraine start paying $160 per tcm starting campaign. January 2006—a price far closer to that charged in Throughout this period, public dissatisfaction with Western Europe than in Ukraine’s neighbors. Ukraine’s political and economic elite grew, finding Acknowledging that a fully independent and sovereign expression in the 2000 “Ukraine without Kuchma” Ukraine would no longer be subsidized by Russia, street protests and culminating in the first-place perfor- President Yushchenko agreed to this increase—but mance in the 2002 parliamentary election of Viktor Yu- asked Russia for the price hike to be introduced over a shchenko’s embryonic Our Ukraine bloc. Accordingly, period of five years, thus avoiding massive shock to the

HUDSON INSTITUTE 10 Center for Eurasian Policy country’s economy. However, Russia repeatedly reject- With no agreement reached, Gazprom cut off gas ed this request. supplies in an extravagantly televised ceremony on January 1—the day Russia assumed the chair of the s the critical winter period approached, no reso- G8. Assuming that Kyiv would simply siphon off its Alution was in sight. A crisis point was reached needed supplies from the pipelines to Western Europe, when on December 14th Gazprom announced it Moscow confidently predicted that subsequent would more than quadruple the price of gas to $230 European pressure would force Ukraine to agree to the per tcm. According to Alexander Medvedev, deputy Russian demands. This miscalculation was in part due chairman of Gazprom, the company was simply apply- to Russia’s expectation that Ukraine would be con- ing market principles to Ukraine: “Since the EU has strained by its adherence to the Energy Charter, and applied a market economy status to Ukraine, then would be punished for violating it—ironically, consid- Ukraine should live up to that.” However, the very ering that Russia itself is able to prevent freedom of term “market price” was ambiguous when applied to transit in its pipelines to Central Asia thanks precisely Russian pricing policy, whose basis often bears little to its lack of adherence to ratify the Charter! resemblance to market principles. President Yushchen- A Russian Ministry of Foreign Affairs statement of ko rightly questioned Russia’s pricing policy: “Why do January 1 publicly clarified this thinking: Baltic countries pay $120 while Belarus pays $46.68? Ukraine is located closer to Russia than any of these We consider that the Ukrainian side, in full accor- countries. So natural gas from Russia has to be trans- dance with the international obligations specified ported a shorter distance. So why should Ukraine pay in particular in the Energy Charter, guarantees $230?” The president made clear that he believed unimpeded transit of natural gas across its terri- Moscow was once again trying to use natural gas prices tory to the countries of the European Union and to influence Ukrainian politics: “I think this issue is will take all necessary measures to prevent unlaw- clearly connected with the upcoming elections.” ful taking of natural gas in transit, and also gas in In contrast, Russia’s defenders argued that the coun- underground storage in Ukraine. If this does not try was not obligated to continue to subsidize the price happen, all responsibility for possible complica- of gas to Ukraine, citing a clause in the previous agree- tions in Russian-Ukrainian gas relations for prob- ment that linked that price to Ukraine’s participation in lems affecting the countries of Europe caused by the SES. Expanding on Medvedev’s statement, these the actions of Kyiv will lie on the Ukrainian side.15 critics contended that the logical corollary of Ukraine’s freedom to choose its allies was Russia’s freedom to Of course, this argument was completely fallacious; decline to subsidize “political changes it views as dam- as a signatory (even one that has not ratified the char- aging to its vital interests.”14 In response to Yushchen- ter) Russia is obliged to uphold all provisions that do ko’s argument, Russian critics noted that Belarus only not explicitly contradict existing Russian law—includ- secured a price of $46.68 after agreeing to surrender ing the obligation not to interrupt supplies without control of its pipeline infrastructure to Gazprom. With first resorting to mediation. Gazprom has consistently the New Year’s Day deadline rapidly approaching, denied that it is under any such obligation; as deputy Russia offered a $3.6 billion loan to help Ukraine board chairman Alexander Medvedev argued, the fact make payments at the new market price—perhaps, as that “we heard no comment from the Energy Charter some have noted, with the expectation that Kyiv secretariat” about the “illegal” actions of Ukraine only would default, forcing it to repay the loans by selling “proves that the document was stillborn,” and hence its transport assets to Gazprom. not a concern of the Russian side.

HUDSON INSTITUTE 11 Center for Eurasian Policy Despite its public relations campaign, these Russian $1.09, withholding the rest as payment for Ukraine’s arguments did not hold sway within the EU. Indeed, outstanding cash debt of $1.25 billion. after the cutoff, the reaction in Western capitals was As predicted, Gazprom declared that the gas price precisely the reverse of Russia’s expectations; rather would be lowered only if Ukraine would agree to cre- than acknowledging that “all responsibility” lies “on ate a “consortium” with Russia for joint control over the Ukrainian side,” Europe (along with the rest of the the Ukrainian gas pipeline network. Yushchenko con- industrialized world) strongly condemned Moscow’s tinued to claim publicly that Ukraine would never sur- aggressive behavior—while continuing to insist on render ownership of the nation’s infrastructure. Yet, Russian adherence to the Charter. Anxious to preserve events behind the scenes continued to lead in that its reputation as a reliable supplier, Russia desired a direction. quicker settlement of the issue, which it achieved directly with Ukraine (avoiding the Charter mecha- n February 2, as provided for in the January nism) in less than three days. Oagreement, Naftohaz and RUE signed an accord The deal was signed on January 4 by Naftohaz head creating a joint venture to sell gas in Ukraine. The joint Oleksiy Ivchenko and Gazprom CEO Alexei Miller. venture, UkrGazEnergo (UGE), was established with According to the agreement, Gazprom was to sell 25 charter capital of 5 million UAH ($1 million) provided bcm of Russian gas to RosUkrEnergo (RUE) for $230 equally by its founders. Naftohaz assured Ukrainians per tcm. Gazprom would also transport 35 bcm of that neither gas-storage facilities nor gas pipelines in Turkmen and other Central Asian gas to Ukraine at a Ukraine would be included in UGE’s charter fund, but price of between $50 and $60 per tcm. RUE would encountered a skeptical reaction. Naftohaz also then combine the two flows, and sell the combined claimed that RUE and UGE had signed a five-year con- stream to Ukraine at a price of $95 per tcm. The tract on gas supplies to Ukraine, whereby Ukraine is to transit fee to be paid by Russia was also raised to $1.60 receive 34 bcm of gas in 2006 and 60 bcm annually in per tcm per 100km—a low price by regional, let alone 2007-10, all at the $95 price. However, as the texts of European standards. (For example, charges the originally-secret agreements themselves make clear, Russia $2.50 per tcm per 100km).16 this was never the case. From the beginning, the Ukrainian government was Furthermore, although officials in Kyiv claimed that on the defensive against domestic and international UGE was a 75% Ukrainian enterprise (since Naftohaz criticism. It claimed that it had secured the price of $95 is a state-owned firm, and RUE is a 50-50 joint venture for the full five-year contract term, even as the Russian between Gazprom and the Centragas holding company side confirmed that it was only valid for six months. owned by Ukrainian investors), the documents reveal On 30 January, RUE executive director Oleg Palchikov that Ukrainian control of UGE is at best highly limited. admitted that the price of $95 per 1,000 cubic meters RUE will be represented by board member Alexander of gas for Ukraine will remain unchanged only for the Ryazanov, who happens to be vice-chairman of first half of 2006. Gazprom. His counterpart on the Naftohaz side is Vice- It soon became clear—as previously feared—that Chairman Ihor Voronin, who “is believed to have links Gazprom would be able to increase the gas price after with RUE, and was listed as a member of its board in July 1, possibly to $230, according to Medvedev, who 2004.”17 As will be discussed shortly, RUE’s true own- in April again cited this figure as the “market price”. ership structure remains highly questionable. At the same time, he also confirmed that the transit tar- The agreements did not pass unnoticed by domestic iff of $1.60 would remain until 2011. Furthermore, politicians. Even before the February agreement had Gazprom would effectively pay a transit fee only of been signed, domestic political tension resulted in a

HUDSON INSTITUTE 12 Center for Eurasian Policy parliamentary vote to dismiss Yekhanurov’s govern- RUE remained murky. Registered in Zug, Switzerland, ment; the parliamentary resolution accused the govern- it is owned jointly on an equal basis by Gazprom and ment of creating a “threat to national security” by by the Centragas holding company, an umbrella corpo- signing the January 4 agreement. Expressing the senti- ration run by Austria’s Raiffeisen bank on behalf of a ment of the anti-agreement faction, which included the group of Ukrainian investors that it refused to identify , former deputy foreign minis- despite pressure from Western officials. Officials in ter Oleksandr Chalyy described the agreement as “the Russia and Ukraine had repeatedly accused one anoth- Ukrainian diplomatic service’s Pearl Harbor.” The day er of ownership in the company while themselves after the agreement, Tymoshenko had vociferously denying any participation. attacked the deal, calling for a criminal investigation of Despite these denials, the participation of high-level Naftohaz and of the Ministry of Energy. She argued Russian and Ukrainian officials in RUE’s operations that $230 was the “fixed price in the agreement” and cannot be doubted. Aleksandr Medvedev, the director cited the gas deal as the best example of the corruption of Gazprom’s export arm, is one of eight members of and untrustworthiness of the Yushchenko regime— the board of RUE. Konstantin Chuychenko, the head and of its failure to uphold the ideals of the Orange of Gazprom’s legal department and a longtime associ- Revolution. ate of Putin, is a co-director of RUE, while Gazprom Accordingly, Tymoshenko ran on this message in banking subsidiary chairman Andrei Akimov also sits the parliamentary election campaign, finishing in sec- on the board. ond place despite all expectations. Subsequently, in the post-election negotiation period, Tymoshenko insisted n a March 2006 press conference, Yushchenko dec- on a renegotiation of the January 4 agreement after the Ilared that he had no knowledge of RUE’s true own- formation of a new government. ership. However, after his resignation, former State Sec- urity Service (SBU) chief said that the government had ordered him to investigate the RosUkrEnergo company—before Yushchenko ordered him to aban- don the inquiry last summer. Turchynov declared that he history of RosUkrEnergo (RUE) dates to July his investigation had uncovered the involvement of the T 2004, when it replaced EuralTransGas as the offi- known organized criminal Semyon Mogilevich, the for- cial importer of gas to Ukraine. EuralTransGas had mer president , and the then little itself in 2002 replaced Itera, an “equally opaque”18 known businessman Dmytro Firtash. There are also trading company that had played a similar intermedi- reported links to the Russian FSB. In response, current ary role between Turkmenistan and Ukraine. 19 SBU chief Ihor Drizhchany denied that his organization In 2005, Naftohaz Ukrayiny secured 36 bcm of had ever undertaken any criminal investigation into Turkmen gas from RUE in a barter deal that gave the RUE. intermediary firm some 37.5% of the Turkmen flow. Information soon started to flow even more quick- RUE sold this gas in turn to EU countries, providing ly. The Wall Street Journal reported on April 23 that the vast majority of its $3 billion in sales and $500 mil- investigations into RUE were under way. On April 24, lion in profit. As noted above, the January 4 agreement Global Witness (a nonpartisan, multinational NGO) only increased RUE’s role. It also yielded the firm a 50 released a devastating report entitled “It’s a Gas: Funny percent share in the new UGE venture that will supply Business in the Turkmen-Ukraine Gas Trade.”20 In gas to Ukrainian domestic industries. addition to its criticism of the practices of President Until May 2006, the ownership and operations of Niyazov and Gazprom, the report detailed the involve-

HUDSON INSTITUTE 13 Center for Eurasian Policy ment of “top Ukrainian public officials” in RUE, and Turkmenistan-Russia-Ukraine heavily criticized the opaque ownership structure of the company. Gas Triangle Finally, on April 26, Gazprom-owned newspaper Izvestia announced that Dmytro Firtash and Ivan azprom’s basic strategy towards the countries of Fursin, two Ukrainian businessmen, are the owners of G the Black Sea region is to reach gas supply and RosUkrEnergo. Holding company Centragas con- transit arrangements with them that satisfy the compa- firmed Izvestia’s report in a statement, saying Firtash ny’s goals: keeping Central Asian gas prices at below- owned a 90 percent stake in Centragas, and Ivan Fur- world-market rates, channeling Central Asian gas to sin a 10 percent stake. Firtash is director of the Cyprus- lower-paying Russian customers, and protecting its based investment company Highrock Holdings, as well lucrative European markets by freezing out Central as board chairman of Estonian fertilizer factory Asian suppliers. In short, Gazprom seeks to strengthen Nitrofert, according to Global Witness. Fursin owns an its monopoly power, which in turn will strengthen its Odesa bank and a movie theater, and, as the Russian leverage (and that of the Russian government) over newspaper Izvestia reported, is also president of a European gas consumers. branch of Highrock Holdings. The newspaper also Turkmenistan has been the key to Gazprom’s strate- reported that Highrock was owned by Mogilevich.21 gy for European markets. Gazprom has long been able to buy supplies at below-market prices in Turkmenistan n a parliamentary debate earlier this year it was to be sold at low prices on the Russian domestic mar- Ialleged that Mogilevich, a reputed organized crime ket. Russian domestic production is then sold to Europe boss who is on the FBI’s “most wanted” list on charges at a price three to four times higher. In this way, Gaz- of being involved in a stock fraud, was involved in the prom has been able to make billions of dollars of prof- company. Firtash was previously involved in two other it, and avoided having to undertake expensive corpo- gas trading firms with Zeev Gordon, an Israeli lawyer rate restructuring and technology improvements to who also represents Mogilevich. Mogilevich denied increase its domestic production. To meet its supply any involvement in RUE; Gordon said he had not met commitments to Europe, Gazprom needs Turkmenistan Firtash through Mogilevich; finally, Firtash insists to continue to sell its gas at below-world-market prices while he met with Mogilevich, he never had any busi- —which can only be done if Turkmenistan has no other ness dealings with him. Firtash’s background was outlet but the Russian pipeline network. probed by Austria’s Raiffeisen Bank, which subse- This unhealthy dynamic has existed for over a quently cleared him of wrongdoing. However, this ver- decade. In the early 1990s, Turkmenistan already began dict was not quite as important as that of the court of trying to use the Soviet-era transit pipeline from Cen- public opinion, in which numerous doubts still remain. tral Asia to Russia in order to directly export gas to The opaque nature of RUE’s operations and owner- hard-currency markets in Europe, but even then Gaz- ship structure would raise questions in any country. In prom had no desire for Turkmen competition. Turk- a nation such as Ukraine, which is eager to join the menistan cut off gas supplies to Russia in 1997 over WTO and to demonstrate its ability to abide by accept- transit and price issues; Gazprom then declared that it ed business practices and international commercial would never allow Central Asian producers to use its standards, the continued role of RUE is simply unac- pipeline system for exports to Europe. ceptable. If it continues in its present form, RUE will Recognizing the broader geopolitical implications of not only endanger Ukraine’s energy future, but likely this dynamic, in the late 1990s the US supported a pro- its Euro-Atlantic aspirations as well. posal to transport Turkmen gas to European markets

HUDSON INSTITUTE 14 Center for Eurasian Policy via a Trans-Caspian gas pipeline. However, the project buy 30 bcm from Turkmenistan at $65/tcm this year, failed for commercial and political reasons. Turkmen- including 15 bcm in the first quarter. (Last year, it istan does have one non-Russian outlet, however: a bought 10 bcm). small pipeline that transports a small amount of gas to Gazprom’s clear strategy is to fill the pipelines from Turkey via Iran. Turkmenistan to capacity and to prevent Turkmenistan During her previous time in government, Tymo- from supplying gas to Ukraine under a separate deal. shenko attempted to obtain supplies of Turkmen gas Most recently, at the end of June Gazprom’s Miller via the Caucasus, thus avoiding the Gazprom system; went to Ashgabat to finalize an agreement to purchase however, this project was also found to be economical- 25 bcm at the second half of 2006, and 70 bcm in 2007. ly unworkable. Yet, in recent weeks the issue has been The Turkmen side demanded $100/tcm for 25 bcm and reopened, and cannot be ruled out in the medium-term 50 bcm in 2007 again at the same price, and underlined future. At the same time, all the same commercial and that this is in line with the 2003 agreement. The Turk- political challenges remain, and Turkmenistan (as well men side also said that its agreement to supply 30 bcm as Kazakhstan and Uzbekistan) is only more depend- of gas to Gazprom would end in September. It also stat- ent on Gazprom for export. ed that if no new agreement is reached, the Turkmen Turkmenistan locked itself into a 25-year supply deal government will once again cut off supplies. with Russia’s Gazprom in April 2003. With pressure It is very clear that, since the 2003 agreement, Gaz- from Russia and no other option to get its gas to prom wanted to prevent an independent arrangement European markets, Turkmenistan reluctantly agreed to between Ukraine and Turkmenistan. So far, it has suc- the arrangement, which designated EuralTransGas as ceeded. The recent position of the Turkmen side indi- the intermediary for the shipment of the gas to Ukraine cates that it too now understands the unfavorable and western markets. A trilateral agreement established nature of the status quo—in which it sells gas at below- a 50-50 cash barter system for payments by Ukraine; world-market prices while being subject to the near- the deal also provided for an increase in Russian pur- total transport monopoly of another country—and chases of Turkmen gas from 6 bcm in 2005 to 10 bcm may be willing to explore alternatives. in 2006, eventually reaching 80 bcm in 2009. While Turkmenistan’s internal dynamics have been In December 2004, Turkmenistan once again halted problematic, driving away potential Western involve- gas supplies to Russia and Ukraine. Ashgabat report- ment, President Saparmurat Niyazov (also known as edly demanded $60/tcm, but Russia’s Gazprom de- Turkmenbashi, “the father of all Turkmen”) needs to clined to increase the price. In April 2005, Russia and be supported now in his effort to once and for all end Turkmenistan finally clinched a deal to end the price Gazprom’s control over his country’s energy future. dispute. It was agreed that Gazprom would make all This support would not of course be intended to prop payments in cash at $44/tcm, thus terminating the ear- up Niyazov’s authoritarian regime—instead, it would lier barter arrangements. be designed to help Ukraine and the EU achieve lasting In October 2005 Turkmenistan reportedly request- energy independence. If high-level Western support is ed an increase in the price of natural gas supplied to not forthcoming, Niyazov may once again give in to Russia. On December 30, 2005, Gazprom agreed to Russian pressure for lack of an alternative.

HUDSON INSTITUTE 15 Center for Eurasian Policy Oil Production, Refining and Transportation

of its success in attracting foreign investment. In a Offshore Exploration media interview, Prime Minister Yekhanurov declared that “We simply do not realize now what important kraine currently produces about 85,000 event occurred yesterday,” adding that the tender “is barrels per day (b/d) of oil, which accounts evidence that very important people are coming to U for approximately 20 percent of domestic de- Ukraine.” mand. Its proven oil reserves, located primarily in the Vanco’s successful bid to obtain Ukraine’s first deep- eastern Donbas region and underneath the Black Sea, water license (and the first production sharing agree- amount to approximately 395 million barrels. Yet ment for hydrocarbons) is reflective of the company’s despite these significant reserves, the level of produc- comparative advantage—previously, small and inde- tion has remained essentially constant since independ- pendent oil companies have proven themselves more ence. This failure to increase production is due largely efficient at deepwater explorations of the kind required to a lack of modern equipment and technological in the Kerch zone. Indeed, Vanco has already developed expertise; although there has also been resistance from a reputation for bold and successful deepwater explo- Ukrainian oligarchs who wish to keep the country ration projects in Africa, where it is the largest deepwa- dependent upon Russian imports. While it is imposs- ter exploration license holder. Vanco was joined in its ible for Ukraine to end this state of dependence over- bid by the UK-based JNR Easter Investments Limited (a night, due to the degree of its reliance on Russia—a Rothschild family company), and the two firms expect country that supplies 80% of Ukraine’s oil—it can to invest a minimum of $60 million in exploring the begin to remedy the situation by increasing domestic Prykerchensky fields over the next eight years. If initial production. In December 2005, Ukraine finally took exploration is successful, their investment will increase some concrete steps to open its Black Sea shelf to ex- to about $400 million, and could attract other FDI in loration and drilling by international oil companies by the amount of $1.5 to $2 billion. announcing a tender for international bidding. Bidders Before Vanco’s involvement, the only major compa- on the tender included Hunt Oil (which, in February nies with oil exploration and production rights in 2005, had signed a production-sharing agreement with Ukraine were Hunt Oil, Cardinal Resources (formerly ChornomorNaftoHaz targeting the Black Sea shelf), Carpatsky Petroleum) and Shell. Hunt, in addition to along with Ukrnafta, Vanco International, and the its February 2005 agreement, had already struck a pre- joint bids of Shell and ExxonMobil and of TPAO and vious Black Sea exploration deal in 2004. In 2005, Alsa One Ltd. On April 19, 2006, Vanco was Shell followed suit, pledging $100 million in invest- announced as the winner, giving the US-based oil com- ments in Black Sea exploration. However, to date pany the right to conclude a production-sharing agree- neither company has begun to exercise these rights. ment in the Prykerchensky oil and gas fields, located However, other firms may yet move into the region. off the coast at the Crimean city of Kerch. This agree- According to US officials, Halliburton has been mak- ment was trumpeted by the government as an example ing plans to lend technological assistance to Ukrainian

HUDSON INSTITUTE 16 Center for Eurasian Policy deep-water exploration. The company estimates that gish domestic demand, but to the lack of investment its efforts would increase production from these wells in existing refineries, ineffective government policies, by a factor of ten. and the poorly-functioning regulatory sector. The government has opened its refining sector to Refining foreign ownership as part of an effort to secure more crude supplies for refining; however, to date only Rus- kraine has six crude oil refineries with a com- sians have been seriously interested due to unwelcom- U bined capacity of 1 million barrels per day. Yet, ing domestic business conditions, such as the lack of since domestic demand is only about 300,000 b/d, transparency. As a result, up to 80 percent of Ukrain- these refineries are significantly underutilized. Ulti- ian refining is under Russian control; four out of six mately, however, this overcapacity is due not to slug- refineries are owned by Russian companies.

OWNER REFINERY MARKET SHARE22

Alliance Group & Kazmunaigaz (Kazakhstan) Kherson 7%

TNK/BP Lysychansk/Lynos 31%

Lukoil Odesa 10%

Tatneft (UkrTatNafta) & Pryvat Group Kremenchuk 30%

Pryvat Group Nadvirna/Zakarpattya 8%

Pryvat Group & Lutsk Kontininum Halychyna/Drohobych 10%

Pryvat Group Naftokhimik Prykarparttya 5%

Pryvat Group/Ukrnafta reportedly has expressed inter- er, as discussed in more detail below, these efforts failed est in increasing its control over the country’s refining due to strong parliamentary opposition.In order to capability. The Kuchma government initially planned improve its position in the oil sector, Ukraine is inter- to create a national, vertically-integrated oil and gas ested in developing its own independent capacity to company (VIOC) by combining the remaining state- refine Caspian oil. This desire took a step toward real- owned energy assets, including refineries and retail ity in October 2005, when a memorandum was signed operations, under Ukrnafta. A September 2004 presi- between Naftohaz Ukrayiny and the local government dential decree indicated that the new company would of Lviv. The agreement provided for a new refinery to instead be created under Naftohaz Ukrayiny, ensuring be built in Brody, located in Lviv oblast near Ukraine’s more direct state control. Strenuous effort to create a border with the European Union. The refinery’s capac- VIOC continued after the Orange Revolution; howev- ity is projected at 8 million tons.

HUDSON INSTITUTE 17 Center for Eurasian Policy Reportedly, the refinery—which is projected to cost duction remains constant or shrinks. In this context, approximately $3 billion—will include a facility that demand for Caspian supplies has increased, even would use byproducts of the refining process to manu- among refiners who were previously uninterested— facture lubricants, plastics and oil-based asphalt cover- thus increasing Ukraine’s potential as a transit country ings. With a view towards reducing prices for petrole- for non-Russian oil. um products, pipelines will also be laid to nearby termi- nals. The project’s second stage provides for the con- struction of an electric power plant and of additional Odesa-Brody-Plock facilities to process agricultural products, additions Oil Pipeline which will cost about $500 million. Two US-based companies, ComOxy LLC and Bortex Enterprises, he increased European interest in Caspian crude is along with the Ukrainian enterprises Agrolid and Stek, Tpart of a general European desire to diversify its oil are as of today the primary investors. These companies imports away from Russia. This desire results not only are expected to create a consortium, to be called Brod- from geopolitical and strategic factors; since Russia’s AgroOil, which would finance and build the refinery. internal consumption is steadily increasing, the supply available for export is correspondingly decreasing. At hile there is some cause for doubt about this the same time, Ukraine faces the problem of declining Wproject—for example, its location is a signifi- oil transit. Currently, 32 tons transit the country per cant distance from Ukraine’s ports—if implemented, it year, of which 7 are exported by Kazmunaigas through would be one of the largest investment projects ever the Kremenchuk-Odesa pipeline to the old Odesa ter- undertaken in Ukraine. It could also play a significant minal. There is an active railway that can be used for role in diversifying the country’s energy supplies, as the the shipment of petroleum, but the rising costs of rail oil refinery would be the first in Ukraine—and one of transit have made this route increasingly expensive. the first in the region—technically capable of processing Currently, the price is set at $190 per ton, leaving Caspian crude. This would allow Ukraine to receive oil Russian supplies as the cheaper alternative—though the through the Odesa-Brody pipeline, and then process price of the latter is increasing.The reversal of the and transport the refined products to the Czech Odesa-Brody pipeline, using it to transport Caspian oil Republic, Poland, Slovakia, Hungary, and other to Europe rather than Russian oil to the Black Sea European nations. would address both the problem of declining transit The proposed refinery would also remove a signifi- volumes through Ukraine as well as the problem of cant obstacle to the effectiveness of a reversed Odesa- increased European dependence on Russian oil. More- Brody pipeline: currently, Polish refineries are set up to over, the reversal would reduce the amount of oil that is handle Ural, not Caspian, crude oil. However, the transported via tankers from the Black Sea through the Polish company Orlen has expressed an interest in dangerously narrow, over-trafficked Turkish Straits to obtaining 100,000 tons of Caspian oil this year—an the Aegean and the Mediterranean. amount equal to 20% of its supply. This interest is due Ukraine is legally able to switch the pipeline’s direc- largely to Orlen’s experience with unstable Russian oil tion once more—but only after giving three months’ supplies last winter, during which the company had to notice to TNK-BP, the Russian/British consortium that make up for the Russian shortfall by obtaining oil is currently shipping Russian crude from Brody to from elsewhere via tanker—at very high prices. The Odesa. To this end, there have been multiple rounds of case of Orlen is indicative of the situation elsewhere in negotiations aimed at achieving the participation of Europe, where demand is growing while Russian pro- international actors and of linking the existing pipeline

HUDSON INSTITUTE 18 Center for Eurasian Policy more directly to Europe. One example is the project commercial justification, it will only reinforce the im- extending the pipeline to the Polish city of Plock. The pression that the pipeline is a political project. cost of this extension is estimated at $500 million. Potential shippers will justifiably hesitate to commit Financing efforts are incomplete, as funds are still volumes, because they will recognize that there is an being sought from the EBRD, the EU, and members of abundant risk that, at some point in the not-too-dis- a potential consortium. Officials are hopeful that a full, tant future, the line will be re-re-reversed at a political “bankable” business plan will be ready by the end of whim. UkrTransNafta has failed thus far to help the this year. market understand what obligations TNK/BP has— There has been a flurry of political activities to make and which obligations it has failed to meet, especially the Odesa-Brody reversal work. President Yushchenko its throughput commitments. If this argument can be met with President Nursultan Nazarbayev of Kazakh- successfully made, international oil companies will be stan in May 2005 to discuss the possibility of extending more comfortable participating in the re-reversal, as the pipeline beyond Plock to Gdansk, thus providing an such a move would be based on commercial realities. outlet to the Baltic Sea. Yushchenko and Nazarbayev also began the early stages of planning for the con- urrently, the consortium behind the Brody-Plock struction of a 52-km pipeline from Dnipropetrovsk to Cproject is comprised of Polish Druzhba, a Polish Ukraine’s Pivdenny terminal. In February 2006, Polish technical operator, and the Ukrainian oil company Deputy Economy Minister Piotr Naimski reasserted Po- Ukrtransnafta. The commercial operator is Sarmatia, a land’s desire to extend Odesa-Brody, though cautioning joint Polish-Ukrainian venture. A key recognized area that it was likely to be extended only to Plock, and for improvement is in the scope of this consortium, warning that Poland’s level of participation in the which needs to be widened to include both producers, project would be contingent on internal political devel- such as Kazmunaigas and Chevron, as well as refiners opments within Ukraine. This initiative was cemented elsewhere in Europe. Recent developments in this area later that month when Prime Ministers Marcinkiewicz have been encouraging; despite outward Russian oppo- and Yekhanurov signed a joint declaration on govern- sition, Kazakhstan, Azerbaijan, and Slovakia have all ment assistance to the scaled-back Odesa-Brody-Plock expressed interest in the project in recent months. project. For his part, Marcinkiewicz stressed that the Kazakhstan’s interest, first articulated in May 2005, has pipeline would play an important role in Poland’s ener- not diminished; Ukrtransnafta head Oleksandr Todiy- gy security strategy. This declaration was followed at chuk has reported that ongoing talks are being held the presidential level on February 28, when Yushchen- with producers in Kazakhstan, including ExxonMobil, ko and Kaczynski called for progress on the stalled proj- Conoco, Chevron, and Dragon Oil. Kazakhstan had ect, expressing their view that Odesa-Brody is “central also been interested in utilizing the Mazeikiai refinery in to Europe’s energy independence.” Most recently, Lithuania, which also offers a possibility of rail ship- Ukraine, Poland, and the EU reached a general agree- ment; however, with Orlen’s recent purchase of this ment on a draft proposal for the Plock extension on facility, finalized with the Lithuanian government on May 19. June 12, Kazakhstan’s calculations may have changed. Of course, the success of a reversed Odesa-Brody Part of the new Odesa-Brody plan will include rail tran- pipeline depends above all on securing throughput sit until the pipeline to Plock is completed. Kazakhstan from oil-producing companies, and not political state- is also in the process of developing the Pivdenny oil ter- ments that do not have the volumes. There is a distinct minal, and jointly agreed with Ukraine to build anoth- risk that, if the new government reverses Odesa-Brody er pipeline linking Pivdenny to Odesa. without a solid, logical, and well-articulated legal and Azerbaijan’s interest was first noted by then-secre-

HUDSON INSTITUTE 19 Center for Eurasian Policy tary of the National Security and Defense Council the Druzhba pipeline that links Russia, Ukraine, (NSDC) in March. The momentum Slovakia, and the Czech Republic. Ultimately, an esti- behind Azerbaijani involvement only increased after mated 3 million tons of oil are expected to flow President Ilham Aliyev’s Washington meetings with through Slovak pipelines each year. President Bush in early May. This momentum has con- Russian remains strongly opposed to the Odesa- tinued to the present, as evidenced by the topic’s inclu- Brody re-reversal and for Ukraine to succeed, support sion in the agenda of the May 23 GUAM talks. That from the US and the EU will be essential. As an April said, Aliyev’s statements have yet to translate into the 16 report by the Ukrainian TV network “1+1” commitment of oil volumes from the petroleum com- revealed, a Polish oil company executive suggested that panies active in Azerbaijan. Russian intelligence agents had lobbied to prevent the After Russian attempts to gain control of the Slovak extension of the Odesa-Brody pipeline to Plock. The company Transpetrol were defeated, Slovakia finally report also concluded that in 2004 Russia induced became an official partner in the Odesa-Brody-Plock Ukraine to start using the Odesa-Brody pipeline in the project in late April 2006. Slovakia’s involvement will reverse of its original direction, a direction, which has allow oil to be transported to Czech refineries through caused a financial loss to Ukraine.

Key Players

lent lifestyle.23 Amidst a storm of controversy, Ivchenko Naftohaz Ukrayiny stepped down from his post on May 11, 2006. While corruption allegations were damaging, he was ulti- kraine’s largest company in the energy sector mately brought down due to his central role in negoti- is the state oil and gas holding company, ating the controversial January 4 gas agreement with U Naftohaz Ukrayiny, which has a market cap- Russia. Ostensibly, Ivchenko resigned for the purpose italization of $9.5 billion. This company accounts for of taking a seat in Parliament that he won in March’s fully 15 percent of Ukraine’s GDP and for almost 20 elections. This may indeed have been a wise move for percent of government revenues. Ivchenko, as it will give him parliamentary immunity Through its subsidiaries, ChornomorNaftohaz, Ukr- from criminal investigations into his tenure as TransNafta and UkrTransHaz, Naftohaz Ukrayiny Naftohaz head—investigations that the Prosecutor controls an extensive oil and gas pipeline network. Ukr- General’s Office (PGO) is likely to undertake. TransNafta transports oil through two further sub- Meanwhile, Naftohaz Ukrayiny and Ukrtransnafta sidiaries: Pridniprovsky, in the southeast of the country, face the conflicting tasks of addressing financial diffi- and Druzhba, in the northwest (which includes the culties while simultaneously pushing to overhaul Odesa-Brody pipeline). Ukraine’s oil processing and transportation system. Oleksiy Ivchenko, a Yushchenko protégé, was Two other Naftohaz subsidiaries, Ukrnafta and appointed CEO of Naftohaz and first deputy fuel and UkrHazVydobuvannya (Ukrainian Gas Extraction), energy minister in March 2005. Ivchenko soon became are in charge of oil and gas exploration and develop- the subject of strong criticism due to his mismanage- ment, including offshore work in the Black Sea and ment of the company. Naftohaz engaged in numerous the Sea of Azov. Ukrnafta was established in 1994 and wasteful spending projects, not least on its CEO’s opu- is the largest oil and gas production company in

HUDSON INSTITUTE 20 Center for Eurasian Policy Ukraine. It is responsible for 93 percent of the coun- the state was handing over control to private owners try’s total oil production, 40 percent of its gas conden- precisely when it should have been consolidating gov- sate, and 18 percent of its natural gas. It operates ernment control over oil-processing industries—which approximately one hundred oil and gas fields in the fueled suspicions that the decision was heavily influ- Carpathian and Dnipro-Donetsk regions of Ukraine. enced by lobbying from the Pryvat Group. Several days It also owns three gas processing plants and a network later, the Ukrainian newspaper Invest-Gazeta reported of filling stations. that the planned privatization would give the Pryvat Due to the firm’s central position and numerous sub- Group even more access to state oil assets, lending fur- sidies, any serious reform of Ukraine’s energy sector ther credence to these criticisms. would necessitate a restructuring of Naftohaz Ukray- Ukrnafta continued to be the focus of news reports iny. Such a complex task would be fraught with eco- following a June 2005 shareholders’ meeting. At the nomic, political, and technical difficulties, and some of meeting, Ihor Palytsa, a representative of Pryvat Group, its subsidiaries, such as UkrTransNafta, need to remain was appointed chief executive of Ukrnafta. However, under state control for national security reasons. in a complex maneuver, a group of rival businessmen However, there is no such obstacle to the privatization close to President Yushchenko was given a controlling of firms such as Ukrnafta and ChornomorNaftohaz. stake in the company. This was accomplished by shift- Nonetheless, a critical, ongoing challenge of privatiza- ing control of the company to its supervisory council, tion is that only Russian companies have shown them- a group comprised of six representatives from the selves prepared to acquire these assets. Additionally, state, and a minority of five representatives from restructuring Naftohaz Ukrayiny may also put the state Pryvat. These state representatives included business- at odds with the powerful business interests whose man and prominent Yushchenko aide Oleksandr influence remained largely unchanged by the Orange Tretyakov. As a result, Pryvat’s power was diminished Revolution. However, as described below in the while those close to Yushchenko increased their influ- Recommendations section, the company’s significant ence. This move may have been driven by the govern- indebtedness imperils its continued existence. ment’s desire to create a vertically integrated oil com- pany, in the pattern of the Putin administration and Gazprom. Ukrnafta A legislative battle between Yushchenko and parlia- ment subsequently emerged over the issue. On October n the domestic oil sector, Ukrnafta is the leading 4, the passed a law banning the pri- Icompany, controlling over 90 percent of Ukraine’s vatization of the government stake in Ukrnafta—legis- oil production (along with 40 percent of gas conden- lation that was promptly vetoed by the president. In sate and 17 per cent of natural gas production.) A plu- conjunction with a court decision striking down a July rality of the company’s shares, 43 percent, is held by 2004 presidential decree transferring the government’s the Ukrainian government, with Pryvat Group owning share in two Ukrainian refineries to Naftohaz Ukray- a 42 percent stake. iny from the State Property Fund, this veto left the state On May 20, 2005, President Yushchenko ordered unable to vertically integrate its oil operations. Prime Minister Yulia Tymoshenko to ensure Ukrnaf- The issue was not dropped at that point, however. ta’s privatization, in order to promote efficiency in the In an attempt to override the presidential veto, the Ra- country’s oil and oil-product market. This decision da passed a new ban on February 23, disallowing echoed a previous but ineffectual decree of former once more the privatization of the state’s shares of President Kuchma. At the time, opponents argued that Ukrnafta for the period 2006-2007. Once again,

HUDSON INSTITUTE 21 Center for Eurasian Policy Yushchenko vetoed the legislation. This sparked a fur- ery, with the rest owned by the Ukrainian government ther exchange between parliament and the president: (with 26 percent) and by various domestic gasoline the Rada this time passed a ban on privatization for traders. After modernization of the refinery is complet- the period 2006-2008 on April 4; Yushchenko vetoed ed later this year, its capacity will increase from 2.6 mil- this final bill on April 25, after the final session of the lion metric tons to 4.3 million metric tons, more than outgoing parliament. enough to handle the increased supply from the Looking ahead, Palytsa has spoken of plans to Zhulino-Nadvirna pipeline (see page 25). Much of the increase oil production and introduce modern tech- product from this refinery is sold at the 700 retail gas nologies to open up new oil fields, possibly with the stations owned by Pryvat. assistance of the American firm Halliburton. Palytsa Public controversies involving Pryvat have not been said that the increase in Ukrainian oil production could limited to the issue of Ukrnafta. On February 18, compensate for the rise in energy prices for low-income 2006, the Kiyevskiy Telegraf reported that two Ukrain- households. These plans, however, are overshadowed ian companies had been allowed to export oil, despite by the continuing privatization controversy, as well as probable future domestic shortages. The first company, by the general financial problems that continue to Prylutskyy Naftonalyv, received permission to export plague Naftohaz Ukrayiny and its subsidiaries. 60,000 tons, including 15,000 tons in the first quarter of 2006. The second, Naftokhimik Prykarpattya, is allowed to export 120,000 tons. Both companies have Pryvat Group close ties to Kolomoysky. Despite the frequent negative publicity, Pryvat’s oil ryvat Group (hereafter Pryvat) is a Dnipropet- maneuverings have only continued: on March 7, Provsk-based business empire that has been a very Invest-Gazeta reported that the group had taken con- active player in the Ukrainian energy sector. Formed in trol of the Halychyna oil refinery, located in north- 1992, it has performed very well in the metallurgy, western Ukraine. Pryvat reportedly had further plans banking and oil sectors. Pryvat’s leaders are: Ihor Kolo- to complement the Halychyna sale and expand its moyskyy, the head and co-owner of group (reportedly petroleum operations by purchasing the Illichivsk fuel based in Geneva); Hennadiy Boholyubov, the founder terminal, which would allow it to export oil deriva- and co-owner (reportedly based in Germany); and tives. The increased complexity of the group’s petrole- Oleksiy Martynov. um operations has stirred speculation as to whether The net value of Pryvat’s companies is estimated at the creation of a coordinating management company $1.5 billion. Pryvatbank is the largest bank in Ukraine, will be needed. with assets of over 14.8 million hryvnia (approximate- ly US$2.8 million) as of 1 September 2004. Along with Pryvatbank’s shares in Naftohaz Ukrayiny, Pryvat’s pri- Viktor Pinchuk mary energy-related holdings have focused on refine- ries. Pryvat is the sole owner of the Nadvirna/Zakar- inchuk, son-in-law of former president Leonid pattya refiner, and it partners with Tatneft and Lutsk PKuchma, once again came into the news spotlight Kontininum to control the Kremenchuk and Halychy- in April 2006, when reports emerged that the na/Drohobych refineries, respectively. Prosecutor General’s Office had launched a criminal The Naftokhimik Prykarpattya refinery, Ukraine’s investigation into the privatization of two important sixth-largest refining facility, is also a Pryvat subsidiary. Ukrainian assets that he had acquired in 2004. Despite The group owns approximately 48 percent of the refin- higher offers from other bidders, a company controlled

HUDSON INSTITUTE 22 Center for Eurasian Policy by Pinchuk bought a majority stake in Nikopol her first term as prime minister. Although a Ukrainian Ferroalloy Plant in 2003-04 for about $80 million. court ruled in September 2005 that a controlling stake Later on, a consortium controlled by Pinchuk and in Nikopol had to be returned to the government, the Donetsk mogul Rinat Akhmetov (Ukraine’s richest renationalization process stalled after Tymoshenko’s man) also acquired the steel mill Kryvorizhstal in 2004 government was ousted. Thus, the Nikopol factory— for $800 million. An Interior Ministry statement on and its tens of millions of dollars in monthly revenue— April 22 explaining the case estimated the total loss to is thus still managed by Pinchuk’s companies, which the state to be $5 billion. These losses were blamed on have maintained control due to legal technicalities. the “abuse of office by State Property Fund officials” of Government officials are still considering the reprivati- the previous regime, which was responsible for con- zation of the firm, a sale that could net as much as $1 ducting the tenders. billion. The factories were sold under controversial terms, A spokesperson for the PGO stated that specific allegedly conducted in favor of Pinchuk and Akh- individuals are not yet being blamed for the alleged metov. Both men have ties to the previous administra- crimes committed during the Kryvorizhstal and tion, as Pinchuk is the son-in-law of the former presi- Nikopol privatization tenders and added that the case, dent, and Akhmetov is actively involved in Party of the first launched by prosecutors only in February, remains Regions (he is believed to be the key financier of the PR ongoing and has not yet been sent to the courts. The in the March parliamentary elections). During his spokesman declined to say whether blame could fall 2004 presidential election campaign, Yushchenko con- upon Pinchuk, Kuchma or Mykhailo Chechetov, who sciously distanced himself from the so-called “shad- was the head of Ukraine’s State Property Fund at the owy” sales, pledging to reverse them if elected. His time the tenders were conducted. Bringing Chechetov administration did manage to reverse the Kryvorizhstal to justice could prove difficult should he be found sale in mid-2005 and resold the controlling stake in the guilty of wrongdoing, as he now benefits from parlia- fall to Mittal Steel, the world’s largest steel company in mentary immunity from prosecution; he was elected to the world, for an impressive $4.8 billion. However, the Rada in March 2006 on the Party of Regions list. there have since been problems reportedly resulting However, Pinchuk remains a target, having lost immu- from contractual obligations, and Mittal Steel may end nity on April 26; he did not stand for reelection. up losing its stake. If Mittal does not soon fulfill its Kuchma, who has held no official state post following obligations, the government will have the right to hold the end of his presidential term in early 2005, will also an auction to resell Kryvorizhstal (now renamed Mittal be a legitimate target for prosecution. Steel Kryvyy Rih). On May 25, Mittal had reached an agreement with the local labor union to increase wages and comply with the terms of the initial tender. While Ukrtransnafta Mittal has stated that it is in full compliance with all obligations, union officials disagree and intend to push krtransnafta, Ukraine’s national oil pipeline oper- for a new auction. If the plant is eventually resold, the Uator, is fully controlled by Naftohaz Ukrayiny. State Property Fund could receive as much as $6 billion On August 9, 2005, Oleksiy Ivchenko was elected from potential investors—some of whom have already chairman of Ukrtransnafta’s supervisory board. Olek- expressed interest. sandr Todiychuk, who had been the company’s acting Court proceedings concerning the return of the director-general for two months, was appointed CEO. Nikopol plant have stretched into 2006, after having The firm’s recent activities have centered largely on been initiated last year by Yulia Tymoshenko during expanding Ukraine’s existing oil pipelines, notably the

HUDSON INSTITUTE 23 Center for Eurasian Policy aforementioned Odesa-Brody pipeline project. meters in length and is capable of transporting some 4.3 Ukrtransnafta is particularly interested in expanding million metric tons per year. The pipeline will provide its operations in cooperation with the Kazakh energy the Nadvirna-based refinery, which had been relying on company Kazmunaigaz. To this end, on September 16 railroad tank shipments, with a steady supply of crude Ukrtransnafta and Kazmunaigaz agreed to construct a oil. This in turn was expected to boost oil deliveries to 52-kilometer pipeline link in Ukraine which would at least 2.5 million metric tons in 2005, up from 1.86 connect the Prydniprovsky pipeline with the Pivdenny million in 2004. terminal near Odesa on the Black Sea. The pipeline Despite these productive developments, Ukrtran- would run parallel to an existing pipeline being used to snafta experienced fiscal difficulties in 2005, as net carry Russian crude to Pivdenny, allowing Ukraine to profits declined to UAH 8.5 million, 2.3 times less than transport both Kazakh and Russian oil to the Black Sea in 2004. Net revenues in 2005 fell as well, dropping without mixing the two streams. The new pipeline 5.5 percent from 2004 to end at UAH 1.03 billion. would also play an important role in the Odesa-Brody- Declining profits have caused a number of problems Plock project, as it would allow Ukraine to divert for Ukrtransnafta. Smaller profit margins reduce the Russian oil away from Odesa-Brody when it switches firm’s ability to conduct further upgrades and recon- to Caspian oil. The new link is expected to cost $150 struction of the pipe system, and hamper its potential million to build, and is being financed by a joint to pursue projects aimed at increasing the overall tran- Ukrainian-Kazakh venture called Transmunai. Con- sit capability of the oil transportation system. Ukr- struction on the project, which will take an estimated transnafta’s leadership offered a number of explana- 18 months to complete, was scheduled to begin in the tions for the company’s recent fiscal decline. Some of first quarter of 2006, but has not yet taken place. the most important factors were the temporary closure Aside from attracting foreign participation, Ukr- of the Odesa and Kherson refineries (which were shut transnafta has also been actively involved in individual for 4 months in order to install upgrades) along with a development projects aimed at expanding Ukraine’s ca- more general decline in refinery processing—due first pacity for oil production and transportation. On Sept- to Russia’s emphasis on supplying its own refineries ember 7, 2005, Ukrtransnafta launched a pipeline link- and transit networks, second to an increase in the ing Naftokhimik Prykarpattya with the Druzhba pipe- world price of oil, and third to a significant increase in line. The pipeline, called Zhulino-Nadvirna, is 85 kilo- required tax payments (up to 40 percent of revenue).

HUDSON INSTITUTE 24 Center for Eurasian Policy Conclusions and Recommendations

s argued above, the issue of energy security efforts to develop its membership prospects in advance has had a decisive influence on the perform- of the November summit at Riga. The PR is further- A ance of past Ukrainian governments in the more opposed to WTO membership without Russian spheres of both domestic and foreign policy. Ukraine accession, and would block moves (such as an expan- has lost critical time between the March parliamentary sion or deepening of GUAM) to bring Ukraine closer elections and still has no united position on what needs to the European community of democracies. to be done. With a Tymoshenko government, there is Of course, this is not to say that the Orange coali- potential to resolve the difficulties inherent in Ukraine’s tion would govern without difficulty. The Socialists, current energy situation. This potential can only be for example, are almost as opposed to market liberal- reached if such a government can overcome the chal- ization and WTO/NATO membership as the PR. lenges posed by the current international environment Moreover, a coalition agreement would not magically —from Russian aggression to Western skepticism— erase the conflicts between the Yulia Tymoshenko Bloc and by significant domestic players opposed to reform. and Our Ukraine. Tymoshenko may choose to attack To surmount these obstacles, the government must the president and position herself for a 2009 presiden- demonstrate the serious will to address the endemic tial election victory even while governing—though, in and persistent problems of corruption, dependence, seeking to establish a durable24 working relationship inefficiency, and mismanagement. with the president, she seems to have learned from the While there is a distinct risk that the divisions with- experience of 2005. in an Orange coalition would prevent effective reform However, the president (and, more importantly, his of the energy sector, the chances for progress under a advisors) has yet to show a full willingness to recipro- Tymoshenko government are certainly higher than an cate. It is a known secret that the Our Ukraine leader- Orange-Blue one. In the months since the March elec- ship has been supporting an Orange-Blue coalition that tion, many argued that only an Orange-Blue “grand would leave out Tymoshenko; in fact, some have sug- coalition” would be able to unite the country and con- gested that party apologists had already prepared the tinue its path to development. However, such a govern- groundwork for such a move. Many analysts now sus- ment would have such opposing interests that it would pect that the President may have supported the forma- not be able to undertake serious reforms—not only in tion of the second Orange coalition solely in order to the energy sector, but also in other much-needed areas. give Tymoshenko the opportunity to fail. Others argue It is important not to understate the key policy differ- that it is only a faction within the party, led by would- ences between the Party of Regions and the two main be PM Petro Poroshenko, which is outwardly seeking Orange parties. In light of the PR’s vocal support of the to undermine Tymoshenko. Despite his ignominious recent defiance of central government authority in sev- departure from Naftohaz Ukrayiny, Oleksandr Ivchen- eral southeastern oblasts (on language and defense ko is said also to be a part of this faction—thus present- issues), it is hard to imagine that the party would sud- ing a potential challenge to energy-sector restructuring denly abandon these positions and betray its electoral efforts. Even if Yushchenko is not personally involved base if it entered into government. Moreover, even if it in these factional squabbles, the public rhetoric used by were ever to make such concessions, the PR remains the Our Ukraine party during the coalition negotiations staunchly anti-NATO—and would hamper Ukraine’s (in which Tymoshenko was sometimes harshly criti-

HUDSON INSTITUTE 25 Center for Eurasian Policy cized) can only serve the interests of both domestic and itive, albeit hollow, first steps were taken on March 15, foreign parties opposed to Orange policies. when the Cabinet adopted an official energy strategy, Thus, considering both the strength of the opposi- covering the period until 2030.25 The new strategy set tion within and outside Ukraine, as well as the urgent three key long-term priorities: shifting to energy-saving nature of the challenges facing their country, the technologies, reducing dependence on fuel imports, Orange leaders need to put aside their personal differ- and ensuring reliable energy supplies to consumers. ences in order to avoid sacrificing the gains of the The strategy envisages an increase in electricity genera- Revolution. They should take advantage of Ukraine’s tion by boosting the output of the nuclear and thermal electoral calendar, which has provided for a three-year power plants that use domestically-mined raw materi- break in campaigning before the next presidential elec- als (uranium and coal, respectively). Through increas- tion, in order to place the country’s priorities first— es in efficiency, it also aims to cut the consumption of though this, of course, is easier said than done. While natural gas to approximately 50 bcm per year, down President Yushchenko and his team are concerned that from the current 76 bcm, and to triple annual domes- an overly powerful Prime Minister Tymoshenko may tic gas production to 30 bcm by 2030. Though these challenge and overshadow him—especially given the goals are noble, the strategy document itself is largely new powers granted to the prime minister by the recent devoid of internal consistency—let alone concrete steps constitutional changes—the alternatives (whether an toward implementation. The new government must Orange-Blue coalition or a vocal Tymoshenko-led immediately develop plans to make reasonable opposition) would be far worse not just for Yushchen- progress toward making the lofty goals of the strategy ko’s political prospects, but also for the future of the a reality—while recognizing that this will be a long- country. For if Ukraine does not take decisive action term endeavor. now—action that will require the partnership of the However, there are several ways in which Ukraine international community—it risks losing its pipeline can jump-start this process—notably, by developing network, abandoning the possibility of obtaining alter- backup capacities and energy supply alternatives in the native supplies from the Caspian, and becoming forev- event of another Russian cutoff. Some of these steps er dependent on Russia. can be taken unilaterally, while others will require the assistance of foreign partners. First, Ukraine should increase its underground gas Recommendations storage, which would allow it to withstand a further interruption in Russian gas supplies without compro- for Ukraine mising its transit commitments to Europe. Currently, the country’s storage tanks can hold between 32 and ssuming that the leaders of the Orange 35 bcm—roughly 40% of domestic consumption. Yet, ARevolution will be able to resolve these differ- Ukraine has reportedly not set aside enough gas to fill ences for the greater benefit of Ukraine, the new gov- these storage facilities, which could lead to a decrease ernment’s first task must be to develop a comprehen- in European supplies in the event of another gas cut- sive and feasible energy security strategy. This strategy off—a decrease that would severely damage Ukraine’s should be designed and implemented in concert with a reputation as a reliable gas transit country. A preemp- broader effort to eliminate corruption and reduce the tive effort to attack that reputation was recently made extent of the “shadow economy”, thus establishing the by Gazprom spokesman Sergei Kupriyanov, who noted rule of law in all spheres of economic and political life. that Naftohaz had not been pumping sufficient vol- Despite the chaotic political environment, some pos- umes into the facilities and suggesting that “This may

HUDSON INSTITUTE 26 Center for Eurasian Policy lead to problems in the winter in supplying the needs tensive commercial and political support if it is to of the domestic market, as well as in fulfilling contracts become a reality. on gas transit [to Europe], when gas will be in high Most of all, the new Ukrainian government should demand both in Ukraine and Europe”. In order to increase domestic oil and gas production. As noted meet it consumption demand and supply requirements, above, there are encouraging signs that foreign invest- it is estimated that Ukraine requires an additional 10.7 ment is returning to the country’s gas and oil sector. bcm throughout the second half of 2006. Gazprom The new government must do everything it can to and RUE have offered to sell the missing quantity at overcome attempts by state-owned firms to resist com- the price set in the January agreement—although since petition, and to ensure that the regulatory environment that agreement applies only to a limited quantity of promotes transparency and efficiency. Given the op- gas, much of the remainder will have to be purchased portunity to invest in a way that allowed for coopera- at the extraordinary rate of $230/tcm of Russian gas. tive relationships with Ukrnafta and Naftohaz, other In order to demonstrate its reliability, and to devel- companies such as Cardinal, Hunt, Shell, and Vanco op further redundancies in its energy system, Ukraine would improve Ukraine’s FDI totals while significantly should seek a connection to the European electricity increasing domestic production in the medium term. grid. The Baltic States, which are currently seeking The most immediate responsibility of the new such a connection, should share their experiences with Ukrainian government is to restructure the energy rela- Ukraine in this important area. To connect to the grid, tionship with Russia. First and foremost, it must can- Ukraine must abide by the detailed EU energy regula- cel the January and February agreements and renegoti- tions as provided for in the Athens Treaty. Imple- ate a new gas supply deal—this time, directly with menting these regulations, which require the extensive Gazprom and not through non-transparent intermedi- restructuring of the electricity market, will require con- aries. There is no reason to use intermediaries at all— siderable political will from the new government. and certainly no reason to continue to do business with Next, with the assistance of the EU, Ukraine should RosUkrEnergo, since the identity and motives of the build metering stations on its borders. The EU’s techni- firm’s true beneficiaries remain unclear, and since the cal assistance was instrumental in constructing the government has little recourse against the firm in the existing station at the Ukraine-Moldova border; event that its obligations are not met. As discussed however, such stations should also be built at crossing below, however, Ukraine will require the support of the points to EU member states. This will allow Ukraine to international community if it is to succeed in renegoti- demonstrate its fulfillment of its obligations to Russia ating the agreements. and its Western neighbors, and further improve its rep- utation for reliability. n its public rhetoric, designed for the Western capi- While the Ukrainian government has expressed Ital markets, Russia has consistently declared that it desire to develop a liquefied natural gas (LNG) termi- wants to charge “market prices” for gas supplies to nal on the Black Sea coast, it would be better both Ukraine. However, in the Russian understanding of the strategically and commercially to focus on a direct term, these prices are determined not by a “market,” undersea pipeline connection from Georgia. The pro- but by the Kremlin. The new Ukrainian government posed GUEU (Georgia-Ukraine-European Union) must clearly and consistently insist on market princi- pipeline would take gas from Azerbaijan, and later ples—according to which the price will be determined Central Asia, and transport gas via Georgia directly to transparently, in cooperation with the relevant produc- the Ukrainian gas network and on to Eastern and ing, transit, and consuming countries. Central Europe. However, this project will require ex- Before focusing on the diplomatic challenge of

HUDSON INSTITUTE 27 Center for Eurasian Policy ensuring such cooperation, the new government must sectors, it was doubtful that Naftohaz would make any first build a domestic consensus—most of all, within profit at all. Without profit, Naftohaz will become un- the coalition itself—that the agreements must be re- able to make the infrastructure investments that are pealed. Considering the clear threat posed to Ukraine’s necessary to maintain Ukraine’s transit capacity. national interests by the agreements, such a consensus There has been some belated recognition that a can be easily formed in theory, though difficult to broader effort is necessary to avert the complete bank- implement in practice. The new government must take ruptcy of the company. Many have now advocated the active steps to renounce the secretiveness and lack of establishment of direct commercial relations with transparency that have characterized energy policy in Gazprom, which would bring sorely-needed efficiency the past, in particular by clearly stating the reasons and transparency to Naftohaz operations. More signif- why the old agreements must be abandoned. icantly, Tymoshenko has recently called for the audit- It is now apparent that even the most basic defense ing of Naftohaz by a major Western accounting firm as of the agreements—that they prevented dramatic price part of her new government’s initiative to foster greater increases to Ukraine—is without merit. Despite fixing confidence among foreign investors. the tariff Russia will pay for gas transport across However, some fear that it may be already too late Ukraine for five years, it froze the price Ukraine must for Naftohaz. In the intervening months, the company’s pay for gas for only six months. While Russia is not finances unraveled. The influential political weekly likely to raise the price before the July 15 G8 summit, Dzerkalo Tyzhnya (Weekly Mirror) recently cited a a subsequent price increase is not out of the question; State Security Service audit showing that Naftohaz had indeed, a new crisis is likely to occur in the second half accumulated a debt of over $6 billion in loans in the of 2006. past two years—including, as other sources have noted, over $700 million in debt to RUE for gas supplies this ltimately, especially judging from the previous his- year alone. The accumulation of this debt had been Utory of Gazprom in other Soviet successor states, facilitated by Gazprom’s decision not to charge Naf- it seems clear that the January 4 agreement is designed tohaz for imported gas from January until May, a deci- to force a debt-for-equity exchange. In other words, sion made with the knowledge that the Ukrainian firm Russia plans to force the Ukrainian side into accruing would be unable to pay for six months of supplies at so much debt that it will have no choice but to sell its one time. The credit rating agency Fitch recently low- pipeline infrastructure to Gazprom—effectively ending ered its evaluation of Naftohaz by an entire grade, cit- Ukrainian economic independence. While for some ing significant concerns about the company’s finances. time Moscow has quietly signaled that this outcome is In light of this rating, the possibility of Western “res- Moscow’s ultimate intention, it became even clearer in cue” investment in the company seems remote. February 2006 with the creation of the UkrGasEnergo The scene is thus set for a future Russian takeover joint venture between RUE and Naftohaz Ukrayiny. of Ukraine’s energy infrastructure. Ukraine need not Drawing on leaked documents, Vladimir Socor con- guess at Russia’s intentions: if precedent and prepara- cluded that “the UGE deal…is a scheme for RUE to tion did not make them clear enough, then a recent take over a large share of Ukraine’s internal distribution statement by Gazprom CEO Aleksander Medvedev market from Naftohaz Ukrayiny.”26 Under the agree- certainly does: he suggested that the company “could ment, UGE became the exclusive supplier to the lucra- offer a lower price” to Ukraine if “it relinquishes con- tive industrial market, leaving Naftohaz to supply trol of its pipeline network”. Yet, even if Ukraine made households and municipal utilities. Due to the low prof- such a concession—which is certainly possible, in light it margins and unreliable income streams of the latter of widespread public outrage at domestic price hikes

HUDSON INSTITUTE 28 Center for Eurasian Policy that have already been made27—it would provide no Ukraine must be prepared to accept that the price protection against subsequent Russian demands, as will be inevitably higher. Ukraine will either stick to the Belarus has recently discovered. Despite surrendering RUE deal or reach a separate agreement with Turk- control of its European pipelines to Gazprom (after its menistan. The latter is a clearly superior alternative, own supplies were cut off), the Lukashenka govern- but requires high-level international support in order ment is struggling with the prospect of a fourfold price to be successfully implemented. increase this fall. Under the RUE agreement, Ukraine in 2005 import- Even as it is presented with the prospect of losing its ed about 60 bcm of gas, of which approximately 24 transit infrastructure to Russia as a bargaining chip, bcm came from Russia, and 36 from Turkmenistan. To Ukraine faces another threat: the bypassing of its tran- reach the $95 figure promised by Gazprom, Ukraine in sit infrastructure altogether. The North European Gas 2006 would need to import 41 bcm from Turkmen- Pipeline (NEGP), scheduled to be finished in 2010, will istan and only 15 from Russia. However, Turkmen- permit Russia to directly transport the majority of its istan simply does not have 45 bcm to sell to Ukraine: gas exports directly to EU consumers, dramatically Russia has already a contract to buy 30 bcm of the 65 reducing Kyiv’s leverage vis-à-vis Moscow in future bcm to be produced in Turkmenistan in 2006. Turk- negotiations—and reducing Western European interest menistan itself consumes approximately 15 bcm, ex- in any future Russian supply cutoff to Ukraine. porting 5 bcm to or via Iran. This leaves only 15 bcm In this dire context, Ukraine must deepen its inter- for Ukraine. 28 national partnerships. In particular, it must engage the Ukraine has tried to reach a direct agreement with Baltic States and Poland in two ways. First, they must Turkmenistan, but Ashgabat’s options are limited due be approached as potential Ukrainian partners in their to its contract with Russia. Even if additional volumes own right—as sources of assistance for projects such as were available, Russia could simply refuse to deliver the Odesa-Brody pipeline, and as models of successful them via its pipeline network. political and economic reform. Second, they should be In Turkmenistan, gas prices are set at the border. engaged as members of the EU, an essential source of Thus, even if Ukraine is able to secure the same price support for Ukraine’s broader reform efforts. Only paid for Turkmen gas by Russia, it would still need to after these steps are taken can Ukraine then ask for pay transit fees. In this respect, Ukraine needs to engage help directly from Washington and Brussels, since only with the G8 in order to ensure that Russia makes its concrete action will ensure that such requests are taken pipelines available for fair, market-rate transit. seriously. Most importantly, Ukraine must seek direct gas pur- chase agreements with other former Soviet states, par- Recommendations ticularly Turkmenistan. A window of opportunity has opened up, through which both Turkmenistan and for the EU Ukraine can achieve energy independence. In March 2006, Ukraine finally reached agreement with Turk- f Gazprom is serious about its long-term interest in menistan on clearing its 2003-2005 debts for natural Isupplying EU markets, it will agree to a renegotia- gas shipments, and also made a prepayment on 2006 tion. However, the new Ukrainian government will purchases. The next head of Naftohaz Ukrayiny require strong diplomatic support, particularly from should follow up on negotiations begun by a Ukrain- the European Union, in order for a new agreement to ian delegation to Ashgabat in May, which raised the be successful. In its diplomatic outreach efforts, the EU possibility of resuming direct purchases. must stress that it is in the mutual interest of both

HUDSON INSTITUTE 29 Center for Eurasian Policy Russia and Europe for the issue of Ukraine’s energy cutoff. Second, Russia has begun to incorporate future to be resolved in a clear and transparent fashion. European companies and governments into its own Some EU players, notably the newer members and the energy empire—often without making these partners European Commission, have continued to insist that aware of its long-term strategic agenda. The NEGP32 is such resolution be undertaken transparently and with- being built in partnership with Germany’s two largest in the framework of the Energy Charter treaty—which energy companies, BASF and E.ON Ruhrgas, thus pro- commits its signatories (Russia has signed, but refuses viding Berlin with a strong interest in the commercial to ratify, the treaty) to liberalize pipeline access and to success of the project. prohibit the unilateral halting of supplies to any coun- Yet, however reliable a supplier Moscow may have try. Objectively, such a resolution would be in the been in the past, and however lucrative to European broader29 foreign policy interests of both Brussels and countries such joint ventures may prove in the near Moscow. As former US ambassador to Ukraine Carlos future, trust in Russia’s good faith will lead to only one Pascual has noted, the EU “cannot afford to be pas- end for Europe: the loss of its energy security. This is sive,” since one-third of its gas supply transits Ukraine already happening. Taking advantage of the reliable en route from Russia.30 reputation of its Soviet-era predecessor, Gazprom has Conversely, Russia itself cannot in the short term been able to secure lucrative infrastructure and trade afford to end its energy relationship with Ukraine: sim- agreements with countries such as Germany, Italy and ply put, Russia cannot export gas to Europe without even Hungary. Even Britain is now backtracking on access to Ukraine’s pipeline infrastructure. Further- initial attempts to exclude Gazprom from its market. more, as Pascual has pointed out, “Russia needs nei- Once Gazprom gains direct access to Western Europe ther an irate European customer nor a fight with diplo- via the NEGP, it will be able to lock its European part- matic partners seeking to prevent an Iranian nuclear ners into long-term, exclusive gas contracts before the bomb.” EU is able to open up energy markets to competition. It is simply fallacious to assume that Russia’s past reli- et, despite this confluence of interests, Russia has ability as a supplier will continue once it is granted Ybeen openly using its political and economic such considerable leverage. might to disrupt and discredit any Ukrainian reform efforts, including the plans of the new Orange govern- better guide to potential Russian action is its ment. Thanks to its skillful media manipulation cam- Abehavior in situations in which it possesses similar paign, Moscow has been able to alter the perceptions power. In such contexts, Moscow has acted without of many EU policymakers.31 They now see Tymosh- regard for contracts—for example, when it cut the flow enko’s renegotiation plans as threatening to the overall of the North Druzhba pipeline to the Latvian Ventspils energy security of the EU—while ignoring or playing refinery without any warning whatsoever. There is no down the very real dangers of Russian energy policy. reason to expect that this precedent would not be This collective blindness to the Russian threat is sus- applied to Western Europe—especially considering the tained by two additional factors. First, until the recent veiled threats issued by Gazprom in response to the change in its political calculus, the Kremlin had long release of a relatively mild EU Green Paper that dis- placed a premium on maintaining its perception as a cussed the need to diversify the European energy mar- reliable supplier in Western capitals. Even at the height ket. Alexei Miller ominously declared that “attempts to of the Cold War, Moscow avoided taking any action to limit Gazprom’s activities in the European market…will compromise its reputation in this regard—a reputation not lead to good results.” Despite its binding supply that has not been erased despite reaction to the January commitments to the EU, Gazprom has emphatically

HUDSON INSTITUTE 30 Center for Eurasian Policy declared that it has “other alternatives in terms of gas Caspian oil shipments, ending years of political and sales,” adding that “if the European Union wants our diplomatic inertia. But the countries of Central Asia gas, it has to consider our interests as well.”33 and the Caucasus, and even Turkey and , will There are, however, existing projects that have the need to see continued engagement by the US as Russia potential to limit Russia’s influence and promote ener- will inevitably continue its top level gas diplomacy. gy security in Ukraine and the EU. To this end, the EU The upcoming G8 summit in St. Petersburg presents (along with the United States) should support Ukrain- a perfect opportunity to craft high-level solution to this ian efforts to improve the use of the Odesa-Brody pipe- issue—especially before the situation in Ukraine is fur- line. Current developments, such as the progress ther exacerbated by price increases during the winter toward using the pipeline in its original direction to season. At the summit, transport Caspian crude instead of Russian oil, the extension of the pipeline to Plock, and the involvement • The US should suggest facilitating negotia- of other Eurasian producing and consuming countries, tions between Russia and Ukraine based on deserve and require active EU support. sound market principles. To help Ukraine In order to ensure its own future security, the EU meet its obligations and live within its means, must cooperate with Ukraine in developing a concrete Washington) should commit to supporting and comprehensive plan to avert Russian dominance Ukrainian efforts to reduce gas consumption of the continent’s energy supply and transport sys- and strengthen barriers against corruption. tem—before it becomes too late. • The US should explain to Russia why it should welcome such moves as being in Recommendations Russia’s own long-term interest, since they would eliminate unpredictability and help it to for the US maximize benefits from its natural resources.

t the “Common Vision for a Common Neigh- Although the opportunity provided by the summit is Aborhood” conference at Vilnius in May 2006, a significant one, since Russian intransigence on the Vice President Dick Cheney eloquently and forcefully issues related to Ukraine and energy security is highly set forth the position of the US government: likely, no real progress can be made without alienating “Actions by the Russian government have been the Kremlin—something that President Bush is unlike- counterproductive, and could begin to affect relations ly to do to his hosts. Ultimately, real progress must with other countries. No legitimate interest is served happen after the summit, so that the US can demon- when oil and gas become tools of intimidation or strate that Vilnius was not a fluke. blackmail, either by supply manipulation or attempts Ultimately, the US and the EU must urge Moscow to to monopolize transportation. And no one can justify abide by commonly-accepted commercial norms by actions that undermine the territorial integrity of a signing the Energy Charter Treaty—or face the conse- neighbor, or interfere with democratic movements.” quences. As Russia continues to benefit from exposure Naturally, the Vice President’s remarks must be fol- to foreign investment and integration into the world lowed up with action. A first step was taken by Cheney economy, WTO membership has become yet more himself just a few days later, when he traveled to important to the country. If necessary, then, the West Kazakhstan. His personal engagement was critical in must take advantage of this leverage and reject Russia’s providing the impetus for an agreement on trans- application for now.

HUDSON INSTITUTE 31 Center for Eurasian Policy Endnotes

1 Currently Senior Fellow and Director of the Center for Eurasian Policy at Hudson Institute, Zeyno Baran published this study at The Nixon Center, where she directed the International Security and Energy Programs until April 2006. The study is available athttp://www.nixoncenter.org/ukraine-energy.pdf

2 In an indication of future political trends, the crowd’s chants of “Yulia for Prime Minister!” and “Tymoshenko!” were significantly louder. See for example Olga Nuzhinskaya, “Tymoshenko tapped as prime minister”, Ukrainian Weekly, January 30, 2005.

3 These awards included the inaugural Chatham House Prize, personally awarded by Queen Elizabeth II, and the Profiles in Courage Award of the John F. Kennedy Library.

4 Tymoshenko was cleared only in September 2005; Russian authorities dropped the charges after Tymoshenko agreed “voluntarily” to appear for questioning in the future.

5 There is speculation that Poroshenko resigned only after he was assured that Tymoshenko would be dismissed as well.

6 In the short term, the increases in gas prices are likely to continue to cause significant economic disruption, though growth is still possible (it reached 4.0% in 2005 despite the difficulties outlined in this section.) See Transition Report Update 2006, published by the European Bank for Reconstruction and Development (EBRD)

7 An artificially-induced famine in the 1930s that killed one-fourth of Ukraine’s population.

8 Waclaw Radziwinowicz, “Viktor Yushchenko: Let us shake hands,” Gazeta Wyborcza, May 12, 2006; available in Ukrainian at http://www.bbc.co.uk/ukrainian/pressreview/story/2006/05/060512_yuschenko_wyborcza_oh.shtml

9 In the long term, this is likely to change, as increased natural gas prices will inevitably act as a catalyst for the restruc- turing of the industrial sector and the promotion of energy-efficient practices and technologies. See Transition Report Update 2006, EBRD.

10 http://news.bbc.co.uk/1/hi/world/europe/4512472.stm

11 For example, inflation reached 10,200 % in 1993, while GDP declined by half from 1991 to 1996.

12 Metals are an exception; Ukraine has the world’s largest supply of titanium, and the third-largest of iron ore. This sector was also marked by the same endemic problems as the gas sector, to which it has been linked; for example, Kuc- hma’s son-in-law Viktor Pinchuk, head of Interpipe, inherited much of Pavlo Lazarenko’s empire.

13 Wilson, Andrew, The Ukrainians: Unexpected Nation (New Haven, CT: Yale University Press, 2002), p. 197

14 Simes, Dimitri, “The Facts on Moscow’s Side”, Los Angeles Times, January 14, 2006

15 This argument is exceedingly ironic in light of Russia’s own failure to allow “unimpeded transit” (or, for that mat- ter, any transit) of Kazakh and Turkmen gas to Ukraine via its pipeline network.

16 Socor, Vladimir, “Russia-Ukraine Gas Truce: More Questions than Answers”, Eurasia Daily Monitor, Vol.3, Issue 3, January 5, 2006

17 Socor, “UkrGasEnergo: A New Russian-Ukrainian Venture”

HUDSON INSTITUTE 32 Center for Eurasian Policy 18 Vladimir Socor, “New Gas Trader to Boost Turkmenistan-Ukraine Transit,” Jamestown Daily Monitor Volume 1, No. 64 (August 2, 2004).

19 Yulia Tymoshenko has been closely linked to Itera since before entering public office; in May 2006, Yushchenko accused her of seeking to reestablish the firm once more in its intermediary role. See Catherine Belton, “Gas Trader Emerges from the Shadows,” Moscow Times, May 3, 2006.

20 Available in full at http://www.globalwitness.org/reports/show.php/en.00088.html.

21 Vladimir Berezhnoy, “Kto Vladeyet Ukrainskim Gazom” (Who Owns Ukrainian Gas?), Izvestia, April 26, 2006; available in Russian at http://www.izvestia.ru/economic/article3092391/

22 Approximate figures, which do not equal 100% due to rounding

23 Yushchenko was forced to publicly criticize Ivchenko after the latter’s habit of purchasing luxury cars with state funds was the subject of an exposé by . When asked to defend his acquisition of a $215,000 Mercedes Benz, Ivchenko responded that “I think that a director of such an enterprise [Naftohaz] should ride around in the most decent and most expensive car,” adding that “the cost is a drop in the ocean” to the company.

24 She has made the symbolic step of publicly pledging not to run for the presidency in the next election, though clear- ly this is a pledge that can be rescinded.

25 “Enerhetychna stratehiya Ukrayiny na period do 2030 roku” (“Energy Strategy of Ukraine in the Period up to 2030”), available at http://mpe.kmu.gov.ua/control/uk/archive/docview?typeId=36172

26 Vladimir Socor, “Ukrgasenergo: A New Russian-Ukrainian Venture to Dominate Ukraine’s Gas Market,” Eurasia Daily Monitor, Volume 3, Issue 33, February 16, 2006.

27 In May, private consumers saw gas prices jump 25 percent, with a further increase from 220 hryvnias to 414 hryv- nias per tcm (88 percent) declared on July 1.

28 PVM Oil Associates, “Russian-Ukrainian Gas Row Leaves a Bad Smell,” CIS/FSU Oil Report. January 5, 2006.

29 It would not be in the interest of Gazprom, which estimates that accession to the charter would cost it $4.5-$5 bil- lion in annual losses, owing to price adjustments. This money, however, is being earned at the expense of Central Asian countries.

30 Carlos Pascual, “Chernobyl’s Lesson,” special to Washingtonpost.com, June 2, 2006

31 The EC has remained a notable exception to this trend. On April 20, it issued a firm message emphasizing the need to diversify energy sources away from Russia, and reminding Gazprom that the company was expected to deliver fully on all its contractual obligations.

32 It is also being promoted by former Chancellor Gerhard Schröder, who signed the agreement creating the pipeline just a few weeks before leaving office; he is now chairman of the NEGP consortium shareholder’s committee.

33 Sergei Kupriyanov, quoted in Peggy Hollinger, “Gazprom Threat Adds to EU Fears on Supply,” Financial Times, April 20, 2006, p. 1

HUDSON INSTITUTE 33 Center for Eurasian Policy