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People walk past a currency exchange office in downtown Moscow, Russia, Monday, March 3, 2014. Russia's markets have dropped about 10 percent and its currency has fallen to its lowest point ever against the dollar and the euro because of the crisis in neighboring Ukraine. (Alexander Zemlianichenko/AP Photo)
People walk past a currency exchange office in downtown Moscow, Russia, Monday, March 3, 2014. Russia's markets have dropped about 10 percent and its currency has fallen to its lowest point ever against the dollar and the euro because of the crisis in neighboring Ukraine. (Alexander Zemlianichenko/AP Photo)

Russia’s Putin holds a pipeline trump card over struggling Ukraine Add to ...

For Russian President Vladimir Putin, the pipeline may be mightier than the sword.

Russia’s main export to the 28-country European Union and Ukraine is neither cars nor grain: It is natural gas, and lots of it. About a quarter of all the gas consumed in the EU – worth almost $100-million (U.S.) a day – and half the gas in Ukraine comes from Russia. Most of the EU-bound gas travels through pipelines that criss-cross Ukraine.

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The near stranglehold on gas supplies to the EU and Ukraine gives Mr. Putin considerable geopolitical power. If Russia were to turn off the taps, lights and furnaces would go out, putting pressure on an already-fragile European economy.

Will Russia use that leverage to pressure Kiev to meet its demands, or persuade the EU to back off on any sanctions threats?

It already has with Ukraine. Russia has turned off, or constricted, gas supplies to Ukraine several times in the past decade, ostensibly over contract disputes. On at least one occasion, the choked-off gas reduced supplies to Eastern Europe, sending utilities in that region scrambling for replacement fuel.

Besides pushing up energy prices, those episodes made the EU and Ukraine well aware of Russia’s potential power to use fuel exports, or lack thereof, to apply economic or political pressure on captive customers.

“If you supply roughly a quarter of Europe’s gas, that gives you a card you can play extremely effectively and Russia has already played that card,” said Nicholas Spiro, managing director of Spiro Sovereign Strategy, a London debt investment consultancy. “But obviously that’s a double-edged sword.”

Mr. Spiro means that it appears unlikely that Mr. Putin would instruct Gazprom, the state-controlled company that dominates Russia’s gas exports, to restrict supplies to the EU if Europe, with American backing, were to hit Russia with punitive sanctions. Energy exports – Russia also delivers six millions barrels of crude oil to Europe every day – are the lifeblood of the Russian economy and its biggest export earner, accounting for 50 per cent of state revenue. Cutting energy supplies to Europe would damage Gazprom’s earnings and the government’s ability to balance its budgets as its social and military costs rise.

Julian Jessop, chief global economist at Capital Economics, said in a research note that a “disruption to energy trade would be in neither side’s interest, especially as it would simply encourage EU customers to seek more secure supplies elsewhere. We suspect that any Western sanctions will only target individuals and political and cultural links, rather than trade.”

Gazprom is already reeling from the Ukraine crisis. On the Russian market Monday, its shares finished down 9.3 per cent, and lost 17 per cent at one point, as investors took the view that the crisis, if it were to expand beyond Crimea, could hurt Gazprom’s exports. A shooting war in mainland Ukraine could easily result in the damage or sabotage of Gazprom’s pipelines.

But using Russian gas as a geopolitical tool in Ukraine is entirely possible. It has happened in the past and seems to be happening now as the Kremlin puts pressure on the interim government, led by Arseniy Yatsenyuk, who on Monday vowed to protect Crimea even it was under full Russian military control. “No one will give up Crimea to anyone,” he said.

Over the weekend, Gazprom said it may raise prices for Ukraine in the next few months because the country’s unpaid debts to the energy giant – reportedly $1.5-billion – meant that it “may not keep the current discount on gas.” The threat came three months after Ukraine was given a big discount on gas supplies as part of a $20-billion bailout package. (Only about $3-billion has been paid out so far.) The discount, however, has to be renegotiated every three months.

Keeping the discount intact is crucial to Ukraine’s financial viability. The country is running out of money as its foreign exchange reserves dwindle and investors ditch its currency and sovereign bonds. Failure to keep the gas discount might make Kiev’s effort to borrow $15-billion or more in emergency funds from the International Monetary Fund harder to achieve yet more crucial.

In essence, Mr. Putin, through Gazprom, has the ability to make or break the Ukrainian economy. If it eliminates the gas discount and withholds the rest of the bailout funds it offered in December, Ukraine could slip off the economic precipice unless the IMF were to come to the rescue in a hurry with conditional loans. (IMF officials are in Kiev this week to examine the government’s financing needs).

If Gazprom were to keep the discount intact and Russia to pay out the rest of the bailout funds, Ukraine might be saved from financial collapse. But what would Mr. Putin demand in return? Certainly, it appears that playing the energy card could buy Mr. Putin considerable political sway as the interim government runs out of financial options. “Ukraine is an economy that is highly dependent on Russian gas and essentially bankrupt,” Mr. Spiro said.

Follow on Twitter: @ereguly

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