Graham Stack in Kyiv for Business New Europe (www.businessneweurope.eu)

“Ukraine will move to European prices for gas in 2010, we are sure of this,” says John Greer, CEO of AIM-listed gas producer Regal Petroleum, tells bne. “Ukraine has enjoyed a fuel discount for a long time thanks to its Northern neighbour. But now it’s time to get off the hydrocarbon hook. If no one else does, then the IMF will make sure of this. And this is good news for Ukraine and for us.”

“The shift to European prices in 2010 marks the beginning of a new beginning for Ukraine’s gas production,” confirms Harry Verkuil, Regal Petroleum’s Chief Operating Officer. “We are confident the country has the potential to attain self-sufficiency in hydrocarbons.”

Since independence, Ukraine has been hooked on cheap gas supplied more and more reluctantly by Russia. Ukraine has the dubious honour of being the world’s most energy intensive economy, consuming as much gas annually as Germany, whose population and economy are vastly greater.

This forces Ukraine to import most of its energy needs. But it is often overlooked that Ukraine produces around 30% of the gas it consumes, placing it just behind UK, Venezuela and Kazakhstan on the list of gas-producing countries.

Since 2005, Russia has been clawing back the discount on Ukraine’s gas. The price Ukraine pays for imports has increased almost 5x over five years, from 50$ per thousand cubic metres in 2005 to what will be nearing $300 in 2010. When at the end of 2009, a remaining 20% price rebate for 2009 ends, Ukraine will finally be off the cheap gas hook, a process the COMECON countries all successfully absolved over fifteen years ago.

For the handful of independent producers such as AIM-listed Regal Petroleum, the price surge suddenly makes gas production in Ukraine a profitable business. And with the government keen to reduce dependency on Russian gas, there is political support for foreign investors in the energy sector.

Technology upgrade

The move to European pricing is crucial to unlocking slumbering potential in Ukraine’s Dniepro-Donetsk basin that accounts for 90% of Ukraine’s gas and oil production. After half a century of production has depleted fields, Ukraine’s remaining gas lies deep, and is expensive and technically challenging to get at.

“We have great respect for Ukraine’s drillers,” says Verkuil, “but they are working with outdated Soviet-era technology. They can drill down to 5000m, but it takes them two years. It takes us six months, and then we go even deeper.”

90% of Ukraine’s gas is extracted by state-owned companies lacking market stimulus and capital for investment.

Regal, on the other hand, has imported two state-of-the-art-rigs from the US that drill four times as fast as Soviet-era rigs and also incorporate state of the art evaluation technologies unique in Ukraine. Regal also sees huge potential for working over depleted fields using new drilling techniques such as horizontal drilling and fracturing to tap residual gas.

“The Ukrainian companies are interested in what we are doing, and whether it’s successful,” says Verkuil. “They’re watching us and consulting with us, and we hope to convince them of the benefits, because if they adopt such technologies as well, it will lower our overheads for servicing and logistics.”

Pioneering new technologies is a time-consuming and bureaucratic process in Ukraine, where it involves importing all new machinery and spare parts and diverging from standard approved practices. The lack of any servicing infrastructure in the country is another drawback.

Regal invested $48m in the first half of 2009 aiming to boost gas production 156% in the second half to over 3,000 barrels of oil equivalent per day. Even when complete, this will only comprise two wells online, with a third currently being drilled. This is very small beer, but the longterm plan is to spend $1.6bn and drill 95 wells over the next decade, raising output to a plateau of 40k boepd by 2017. This would make Regal the country’s third largest gas producer.

There has been a chequered record of foreign investment in hydrocarbon exploration and production in Ukraine, with a number of scandals and false dawns. But with the framework conditions now more reasonable. Regal sees itself in the vanguard of what will be a stream of transparent and professional private investors.

This is exemplified in Regal’s ability to raise the finance it needs. “We need $400m, and have raised $300m in equity over the last two years,” says CEO Greer. “Things weren’t looking good for debt earlier this year when the world was on its head, so we went for a share issue instead. But things have changed significantly since then, so that we now hope to raise the additional $100m in debt. And even this does not happen, we will carry on regardless, turning cash positive in 2011.”

Graham Stack in Bucharest for Business New Europe (www.businessneweurope.eu)

With the third tranche of IMF funding for Romania on hold until a new government is in place and willing to meet IMF criteria, Romania will have to turn to the domestic market to fund outstanding expenditure in 2009. Analysts anticipate a resulting liquidity drain that will stall recovery.

As anticipated, the collapse of Romania’s grand coalition government October 13 in the run-up to tightly-contested presidential elections November 22 has made it impossible for the IMF to disburse the third, 1.5bn euro tranche of a 20bn euro stand-by loan agreed in April. An additional 1bn euro tranche of financial support from the EC was also tied in to IMF approval.

“(I)n the current political environment crucial components of the policy package cannot yet be implemented. Most important, the interim government cannot legally submit the 2010 budget to parliament, nor can it undertake the actions needed to trim the 2010 deficit to the 5.9 percent of GDP deficit target. The Fiscal Responsibility Law and Pension Reform cannot yet be agreed and approved by parliament,” was the IMF’s official description of the situation November 6.

With the budget deficit likely to hit over 8% of GDP by year end, adviser to Central Bank governor Adrian Vasilescu was quoted by media as saying that the government needs 5bn euros by year end.

This puts Romania in a catch-22 situation. With the presidential elections likely to go into a second round December 6, no party is going to take responsibility for the cuts needed to downsize the budget. But the failure to countenance these cuts means that the main anticipated source of funding spending – IMF et al – has been lost. And the only alternative –expensive government borrowing on the domestic market – will drain liquidity that should be restarting the economy, thus prolonging the recession.

“Printing money is out of the question without a foreign exchange cover,” says Melania Hancila, chief economist at Volksbank Romania, “therefore the only financing resource remains for the moment the domestic market, however the cost of borrowing will be significantly higher, probably double, inducing an extra burden on Romania’s debt service. The public sector will drain up the excess liquidity in the banking system, leaving scarce financing available for the private sector, further delaying the recovery of the real economy.”

“Even if we got the money from IMF/EU, says Nicolaie Alexandru, chief economist at ING Romania, “it would have been still difficult to finance the budget deficit as those amounts were unlikely to cover liquidity needs during these two months.”

“It is going to be a tough job,” Alexandru predicts, agreeing with the figure of 5bn euros funding requirements for November and December. “It might be that the Ministry of Finance pays more than a maximum of 10% for RON securities before the end of this year, but even this would not suffice. The rest of the spending is likely to be delayed with arrears and the pressure on the 2010 budget is to increase.”

“Clearly pressure on yields will grow, as issuance needs rise, says Pasquale Diana of Morgen Stanley. “Also, there will be pressures on the RON to weaken, the NBR will be active in the foreign exchange market, market rates will go up and the easing cycle will stall indefinitely.”

Killing with kindness?

As the crisis struck Eastern Europe, and the IMF re-entered the scene like a blast from the past, the institution was keen to reassure populations and show that it had taken on board criticism of policies in the 1990s. Notoriously, former World Bank deputy head and Nobel Prize holder Joseph Stiglitz lashed the IMF for imposing too harsh austerity measures on borrowers during the Asian crisis 1997, thus prolonging the crisis and provoking political instability.

This time round, the IMF has done the opposite: directly financing budget deficits, despite its articles limiting its remit to balance of payment crises. One third of Romania’s IMF money is assigned to finance the deficit.

Critics are now arguing the IMF could have got more reform for its money.

With IMF programmes going off-track in both Romania and Ukraine, where wide-open presidential races are fuelling populist politics, accusations are being made that the IMF has encouraged moral hazard in the form of expansionist budgets that will prolong the recession as surely as sweeping austerity measures.

“The IMF has not been tough on Romania, quite the opposite,” argues Morgan Stanley’s Diana.

“The institution increased moral hazard here,” says Alexandru, “and it is likely to face very strong opposition to any harsh measures it may try to impose on Romania early next year – as these unsympathetic measures are unavoidable given no real reform measures were implemented so far and the fiscal imbalance is growing in Romania.”

The argument for both Romania and Ukraine is that governments when applying for IMF aid were ready to make more commitments than the IMF demanded from them. When the IMF went for conditionality–lite, and as elections dates approach, local politicians lost their fear of the institution, and thought they could take it for a ride, reneging on budget deficit targets and other reform measures promised. In both Ukraine and Romania, the IMF has now quit the game, but not before the damage has been done – in anticipation of IMF funding, budgets deficits are huge, and will lead to downwards pressure on the currency, drying up of domestic liquidity and payment arrears, in the worst case printing money.

This is also of course linked to the specifics of the political process in both Romania and Ukraine. In both countries, there is no majority in parliament, and both countries are going into presidential elections – Romania in November, Ukraine in January, – that polls show are wide open. Because no top politician in either country can be sure of being in office a few months from now, there is no reason to take responsibility for the situation. But whoever gets in, is going to have to deal with the mess, and cuts will then be harsher than if they had been implemented earlier.

“Therefore, the recession is likely to be longer than we expected and tighter fiscal policies might have a bigger negative impact on growth for three to four years from now. If there is no recovery in 2010, things could become even more complicated,” concludes Alexandru gloomily.

Graham Stack in Bucharest for business new europe (www.businessneweurope.eu)

Romanian democracy may not be beautiful, but it works. As the world celebrates 20 years of the fall of the wall, memories of Romania’s bloody 1989 revolution serve in Bucharest for electioneering mud-slinging rather than serious reflection. But this just points to yet another neck-and-neck presidential race: no Romanian president has yet won reelection for a successive term, and this time round may be no exception.

Even the joyous celebrations in Berlin November 9th to mark 20 years since the fall of the wall were occasion for mudslinging rather than national consolidation in Romania’s hard-fought presidential elections, the first round of which will take place November 22. Incumbent president Traian Basescu, a centre-right candidate backed by the Liberal Democrat Party (PDL), traveled to Berlin to take part in the festivities, accompanied by a 20 year old student whose mother had been killed by state security forces during Romania’s violent overthrow of the Nicolae Ceausescu regime six weeks after the fall of the wall 1989.

For all the celebrations, it is often overlooked that the consolidation of democracy in Eastern Europe paradoxically owes a lot to the successor parties of the former national Communist Parties. In most countries, the “former Communist Party”, turned into social democrats, has frequently governed, and when not in government, has been a powerful opposition. Despite the horrors of Ceausescu’s regime, as evoked by this year’s literature Nobel Prize winner Herta Müller, for ten out of Romania’s twenty years of democracy, the president was Ion Iliescu, a former top ranking Communist party official under Ceausescu whose role in the violence December 1989, and the summary execution of has never been properly cleared. It was however former Communist top dog Iliescu, with the support of his Communist-successor Party of Democratic Socialism, who took Romania into NATO and paved the way for EU membership.

Iliescu was removed from the leadership of the Communist-succesor party Party of Democratic Socialism (PSD) in 2004, but still acts as its elder statesman.

So when Basescu reminded in Berlin that Romanian leaders immediately following Ceasescu’s execution – meaning none other than Iliescu – had used violence against protestors they defamed as terrorists, resulting in total loss of life of 1600, everyone understood this to be simply an electioneering dig, rather than a call for real investigation of what happened twenty years ago. Iliescu simply responded as good as he got, calling Basescu a profiteer of the old regime and of the new one, someone who had not even participated in the revolution, whereas Iliescu claimed to have taken both risks and responsibility.

And underlying how the PSD has, at least superficially, morphed into a social democratic party, its presidential candidate this time round, Mircea Geoana, is a cosmopolitan former diplomat with degrees from Paris National School of Administration and Harvard Business School, and became Romania’s ambassador to US in 1997 at the age of 39. In 2005 he ousted Iliescu from the leadership of the PSD in a surprise vote.

This means that the PSD presidential candidate this time round suddenly looking more modern and European than former ship’s captain Basescu. And attempts to use the memory of the bloodshed twenty years ago won’t cut ice with Romanian voters.

“The 1989 “Revolution” is still a controversial topic in Romania. Twenty years after the collapse of Ceausescu’s regime, Romanians’ agenda is filled with issues related to the current economic crisis – unemployment, wages, pensions etc; the events from December 1989, unfortunately, are not a major concern for most Romanians,” Catalin Augustin Stoica, pollster and director of the Centre of Urban and Regional Sociology (CURS) tells bne. “I personally do not think that the topic will play a major role in this campaign.”

“The PSD is today treated just as any other political party,” agrees Professor Adrian Pop of Romania’s National School of Political and Administrative Studies.

Neck and neck

Before the current economic crisis broke over Romania, President Basescu was looking a dead cert to win reelection, possibly even at the first round with over 50% of the votes. But with the crisis set to reduce Romania’s GDP by a whopping 8% this year, and Geoana a plausible anti-crisis candidate, the opposition is fast making gains. Now a second round of voting looks certain for December 6, with Basescu and Geoana going through ahead of Crin Antonescu of the National Liberal Party (PNL). Opinion polls for the first round put Basescu at 30-35%, Geoana at 25-30% and Antonescu at 20-25%.

What happens then is anyone’s guess. Polls show the second round to be neck and neck, with Basescu and Geoana both hovering around 50%.

“Answers to poll questions about the second round should be taken with a grain of salt,” says Stoica. “Against the backdrop of a tense and
controversial campaign, it is too early to predict how voters will react
in the runoff election. I expect that the campaign for the second round will be very tough, with tons of innuendo, false accusations, rumors, personal attacks.”

Among the complicating factors is that the media are generally believed to have a bias against Basescu as a result of historic ties between some of Romania’s TV moguls, such as Adrian Sarbu and Dan Voiculescu, and the PSD. On the other hand, according to Dan Sultanescu of infopolitic, Basescu’s image has always been that of the lone outsider taking on the powers that be, so media opposition could also work to his advantage.

Moreover, Basescu has incorporated a referendum on abolition of the upper house of parliament and reduction of lower house MPs into the first round of voting November 22. The parliament is the institution Romanians trust least, suspecting it not without cause it to be a pit of sleaze and pork-barreling, and the move against it is popular, supported by 75% of voters. The referendum is not binding, but it will highlight again Basescu’s image as fighter against deep-rooted corruption and cronyism, compared to Geoana who is chairman of the upper house.

“The referendum on a unicameral parliament could affect the elections by favoring Basescu,” believes Pop. “Basesecu is in favor of a presidential republic; Geoana and Antonescu prefer a parliamentary republic.”

The combination of a close-run race and mutual smearing means that Romania’s electoral system could be in for its toughest time yet. “The Romanian electoral system is pretty fair, but a more or less disputed election can’t be ruled out,” says Pop.

“I do not think that the Romanian electoral system is strong enough to
avoid controversy,” agrees Stoica. “PNL and PSD have already started accusing PDL of attempting to “steal” the elections. One can only imagine what would happen after the first round.”

Graham Stack for Russia Profile (www.russiaprofile.org)

Ukraine’s youthful Presidential Candidate Arseny Yatsenyuk is tailor-made to be a pro-Western leader, but his stagnating ratings show how weak this political constituency has become in Ukraine. Instead, all three leading contenders in the presidential election campaign that kicked off this week are making pro-Russian statements.

History repeats itself as farce, Karl Marx apparently said. The Ukrainian presidential hopeful, 35-year-old Arseny Yatsenyuk’s great historical moment may have come and gone on June 7, 2009. During a week boiling with rumors it seemed that the two largest parties in Ukraine’s unicameral parliament, the Rada, were preparing a grand coalition to achieve a constitutional majority and transform Ukraine into a parliamentary republic, abolishing direct presidential elections. The trigger: Yatsenyuk’s meteoric rise in opinion polls, from zero to over ten percent in the course of months. Extrapolating, neither leader of the two largest parliamentary parties, Prime Minister Yulia Tymoshenko of the Yulia Tymoshenko Bloc or the former Prime Minister Viktor Yanukovych of the Party of Regions, could be sure of winning the presidential elections  January 2010. So they had apparently simply decided to call off the elections altogether, and divvy up power between them.

Yatsenyuk sprang into action. Talking to this correspondent, he called on the West to beware of the imminent creation of a Russian-backed “junta.” “If the coalition’s plans go ahead, Ukraine will return to the sphere of influence of a certain big country,” he warned, “and Ukraine will turn into a banana republic.” Calling the nascent coalition’s plans “an anti-constitutional conspiracy,” he said he would lead people out on the streets to fight them. Asked if there would be a second Orange Revolution, Yatsenyuk replied “you will see it.”

By Sunday, June 7, however, it was all over. The “putsch attempt” has been debunked as just another Ukrainian political stunt. Viktor Yanukovych suddenly backed out of the negotiations, saying that he was alarmed by the anti-democratic nature of Tymoshenko’s suggestions. The episode left Yanukovych looking wily, and even a little democratic, Tymoshenko looking like she would stop at nothing to stay in power, and Yatsenyuk like a callow wannabe popular hero.

Yatsenyuk, with his perfect English, baby-face looks, superb credentials and squeaky clean image, is tailor-made to fit the role of a “pro-Western democratic candidate.” But it is a sign of the times that there is no demand for such in Ukraine today, making Yatsenyuk seem like a rebel without a cause.

From Ukraine’s Obama to Ukraine’s Medvedev

Launching his unofficial campaign in late 2008, Yatsenyuk tried to tap into the buzz surrounding the new U.S. President Barack Obama. The media picked up the “Ukraine’s Obama” jingle, and Yatsenyuk’s spinmeisters playfully disclaimed it, pointing out “significant differences:” “Obama uses a Blackberry, but Arseny prefers an iPhone.”

This strategy paid off in the first half of 2009, as Yatsenyuk’s ratings rose meteorically to around 13 percent, fractionally behind prime minister Tymoshenko. Yatsenyuk’s advance, however, was at the expense of democratic President Viktor Yushchenko, as he was winning over the latter’s residual pro-Orange constituency. As a result, Yushchenko’s own rating fell below the margin of error, with Gallup declaring him to be the most unpopular president in the history of polling. Conversely, as Yushchenko’s rating tended to zero, Yatsenyuk hit his ceiling of around 13 percent, which was still less than Tymoshenko at around 15%, and way behind Yanukovych’s mid 20s.

Realizing that the post-Orange constituency was too small to get in the second round of the elections, let alone win it, Yatsenyuk was forced to change his tune and follow in Tymoshenko’s footsteps. The latter, formerly an iconic figure of the Orange Revolution, had already jettisoned her Orange ballast in 2008. In the course of months in 2008, she spectacularly morphed from an anti-Russian, pro-NATO firebrand into a moderately pro-Russian politician. By September she was  under investigation by the Ukrainian Security Service for acting against Ukraine’s national interest for the benefit of Russia. Not least, she refused to support Georgia in the August 2008 war with Russia over South Ossetia.

To compete with Tymoshenko, Yatsenyuk then likewise discarded the “Ukraine’s Obama” mask. Instead, he donned what Andrew Wilson of the European Council of Foreign Relations called the image of “Putin-lite,” to capitalize on the Russian prime minister’s sky-high approval ratings in Ukraine. Instead of railing Orange-style against juntas and authoritarianism, Yatsenyuk switched to declaring war on corruption, using hard-man talk of filling the jails and cutting off hands. He also showed himself happy to speak Russian in public, supported the Russian stance over gas transport, and praised Putin as “having saved his country.” “Putin-lite” is also reminiscent of Dmitry Medvedev, who enjoys a high level of approval in Ukraine, has declared war on corruption, is young and has a background in law, like Yatsenyuk.

But Yatsenyuk is not the only one trying to tap into the buzz surrounding Putin and Medvedev. The polls’ frontrunner, Viktor Yanukovych, has the best pro-Russian credentials, although he is hardly a Putinesque figure. Yulia Tymoshenko can match Putin for charisma, and has been hard at it, with Putin/Medvedev-like phrases, such as “dictatorship of the law” and “legal nihilism” tripping off her tongue, along with Putin-style promises to restore Ukraine’s Soviet-era high-tech aerospace and ship-building sectors. Tymoshenko’s enthusiasm for Putin apparently even caused the latter to postpone a meeting with her in October, lest it seem he was favouring her in the elections.

This means that switching to “Ukraine’s Medvedev” has not brought Yatsenyuk the anticipated breakthrough in the polls. The latest ratings have seen him fall back to around ten percent, and his chances of getting into the second round of elections ahead of Tymoshenko are fading. Meanwhile, Yanukovych is for the first time looking likely to beat Tymoshenko in a second round run-off.

But the remarkable result of Yatsenyuk’s switch to “Putin-lite” is that the leading three candidates in Ukraine’s crucial presidential elections are now all actively campaigning on their lack of hostility toward Russia, and their current order in the ratings corresponds to the respective plausibility of this platform

Graham Stack, Berlin / Kyiv

According to Ukraine’s ambassador to Germany, Natalia Zarudna, new foreign minister Petro Poroshenko will not oversee trade negotiations with the EU, despite being tasked by President Viktor Yushchenko with achieving an associate membership agreement with the EU as soon as possible.

“Petro Poroshenko will not oversee negotiations on the free trade part of the Ukraine-EU associate membership agreement,” Zarudna told this correspondent in an interview. “This will be done separately by ministry trade experts, with Poroshenko overseeing only the political component of the agreement.”

Zarudna says this rules out any conflict of interest with Poroshenko’s business dealings: Poroshenko is not only a close associate of President Viktor Yushchenko and political high-flyer. He is also a top businessman, and his assets are held to include Ukraine’s second largest car producer Bohdan Corporation, although he does not officially acknowledge ownership of the car maker.

“Poroshenko may be a shareholder in Bohdan, but he is not involved in operational control of the company, since this would contradict Ukrainian legislation,” explains Zarudna.

The issue is pertinent, because Bohdan Corporation is one of the principle victims of Ukraine’s economic crisis, with its revenues down 87.4% in the first half of 2009, and losses totaling $27.1m.  Analysts are questioning whether the company can continue servicing its debt, after having come close to default in August.

In an interview with this correspondent earlier in the year, Bohdan Corporation CEO Oleg Svinarchuk demanded a government U-turn on trade policy, with a shift from free trade to protectionist tariffs to save Ukraine’s car industry. Svinarchuk also bitterly criticized the terms of Ukraine’s accession to the World Trade Organisation.

This indicates Poroshenko’s ties to Bohdan Corporation could clash with his duties as foreign minister – in particular concerning trade negotiations, where higher import tariffs on cars would directly benefit Bohdan Corporation.

There are already signs Poroshenko’s appointment will benefit the company. Immediately following his appointment, the government announced a raft of measures to help Poroshenko’s automotive holdings. Prime Minister Yulia Tymoshenko called Bohdan “a strategic partner in bus production,” and announced a government order for 750 school buses worth UAH 150m, and orders for Euro 2012. There is also talk of a government credit line to modernize bus production facilities, according to sources at Bohdan.

Tymoshenko’s generosity contrasts with previous animosity between herself and Poroshenko, whom she openly accused of corruption in 2005, days before Yushchenko ended her first spell as prime minister. However, considering that votes from Tymoshenko’s party Bloc Yulia Tymoshenko were crucial for Poroshenko’s confirmation by Ukraine’s parliament, the Rada, it is likely that some wider deal is in place, believes Yelena Biberman, Ukraine foreign policy expert at Brown University.

“It could involve Poroshenko buying into Tymoshenko’s more pro-Russian foreign policy line,” says Biberman. Biberman points out that among Poroshenko’s first actions as foreign minister was to reject US radars in Ukraine as part of the US anti-missile defence system. Poroshenko said such plans, aired by U.S. Deputy Defense Secretary Alexander Vershbow, would “contradict the constitution.”

According to Zarudna, however, Poroshenko’s appointment does not signify any shift in Ukraine’s foreign pro-NATO policy. “But because of the crisis, foreign policy may be temporarily more oriented to trade and aid,” she concedes.

Meanwhile, the foreign ministry itself is pinning its hopes on Poroshenko to secure more budget funds. “The foreign ministry suffered disproportionately from budget cuts in 2008, compared to ministries more loyal to the prime minister,” complains Zarudna. “We think that Poroshenko will use his ‘special diplomatic skills’ to get more funds for the ministry.”

According to Zarudna, Ukraine’s foreign representations have had funding cut to 40% of 2008, with budget funding down 20% and hryvnia devaluation doing the rest. “We are being inventive and attracting sponsors to help with our functions,” Zarudna says.

Graham Stack for Russia Profile (www.russiaprofile.org)

Russian Prime Minister Vladimir Putin’s last visit to China, when he attended the opening of the Beijing Olympics in August of 2008, went badly wrong when Georgia opportunistically attacked South Ossetia, and the resulting war damaged relations between Russia and the West. Putin could now continue Russia’s eastward shift on his upcoming visit to China, by signing long-term gas supply agreements between Gazprom and the China National Petroleum Corporation.

Speculation is mounting that a long-term gas supply agreement might finally be signed between the Russian gas giant Gazprom and China National Petroleum Corporation (CNPC). The plan, outlined in a number of memorandums signed by the Russian and Chinese sides, but since bogged down in negotiations over price, envisages new gas pipelines from Western and Eastern Siberia to China and the development of virgin East Siberian gas fields.

As president, Putin was closely involved in the negotiation process during his previous visits to China, and may feel that it’s now time to go the final mile. The last Memorandum of Understanding on the issue was signed in 2006: it specifies a pipeline running from West Siberia with a 30 billion cubic meters capacity, and another from East Siberia with a capacity of 38 billion cubic meters, with work due to start in 2011. That date is now clearly unrealistic, but still, for most analysts, it is just a question of time.

“We have long taken for granted that Gazprom will sell significant amounts of gas to China,” said Alfa Bank energy analyst and Head of Research Ron Smith. “The resource base of East Siberia and Russia’s Far East is very large, including two untapped world-class gas fields in Chayanda and Kovykta that are very well situated for pipeline exports to China, not to mention the Sakhalin reserves that are already being tapped.” So analysts perceive Putin’s hastily arranged visit to China as indicative of the fact that a long-term deal has been finalized for signing.

Negotiations to date have been shrouded in secrecy, but the main problem holding up implementation of the project has been arguing over the price mechanism. Russia is rooting for the same price mechanism applied to Gazprom’s European Union customers. China has pushed for a discount price previously paid by former Soviet countries, such as Ukraine. “Since then, however, the discounted deal with Ukraine ended in a very high-profile manner, and Russia is also paying full price for gas purchases from Central Asia,” said Chris Weafer, an analyst at UralSib brokerage. “Hence the rationale for China’s discounted price demand is eliminated.”

But the Chinese may instead want a gas price linked to coal prices and not to oil prices, as is the case for European customers. Since there is no global market price for gas, gas prices are linked to the cost of the fuel gas substitutes for, which in Europe is crude oil and heating oil. In China, however, gas will substitute mainly coal used in power generation. “We are not sure whether the Chinese prefer a coal-linked price, as that fuel generates the bulk of the country’s power, or whether it is a matter of a simpler argument about the absolute level of prices,” said Smith.

“Linking the price of gas to the one of oil is an anachronism,” argued Mikhail Korchemkin of East European Gas Analysis. “There is an oversupply of inexpensive gas in the world, and the market prices of oil and of gas often move in opposite directions.”

Coal prices are currently very low following the economic crash, while oil prices have soared back up to 2007 levels, making it harder to reach a compromise. However, according to a source quoted by the Russian business daily RBK, in the absence of final agreement on a long-term price mechanism, Gazprom and CPNC could still provisionally agree on fixed prices for short-term delivery volumes.

But the Chinese have some trumps that could induce Gazprom to bring the prices down from the European levels. Firstly, China is flirting not only with Russia, but also with Central Asian countries. The 7,000-kilometer-long Central Asia-China pipeline is set to take Central Asian gas to China, particularly from Turkmenistan, which has contracted to supply 40 billion cubic meters of gas annually for 30 years. Korchemkin believes that Turkmenistan probably agreed to prices around 50 percent lower than Gazprom’s European price. “Moscow will be keen not to lose the opportunity to be a direct gas supplier to China, especially with a lot more uncertainty over future gas export volumes to Europe,” said Weafer.

Secondly and most importantly, with the economic crisis having raised the cost of borrowing even for Russian giants such as Gazprom, Chinese state companies can offer cheap credits unavailable elsewhere. The summer has seen a slew of Chinese credits granted to Russian companies in telecommunications, cement and energy. According to Kingsmill Bond of Troika Dialog brokerage, “China provides cheap financing and equipment for the development of Russian infrastructure. As the head of the Russian cement association poignantly said, ‘we can’t borrow from Russian banks at less than 20 percent, but from China we can borrow at under ten percent.’”

In June of 2009, China provided Turkmenistan with a $4 billion loan to develop its massive South Yolotan field. But the mother of all such deals was signed between Russia and China in February of 2009, with CNPC and the China Development Bank offering a $25 billion loan to Russian oil pipeline operator Transneft and state-owned oil company Rosneft, as part of an agreement for Russia to supply 15 million tons of oil annually for 20 years. The credit, at an unbeatable estimated interest rate of 5.7 percent, will finance oilfield development and pipeline construction from East Siberia to China.

“If that deal were to be replicated in the gas sector, we could see a timeline agreed not only for the pipelines, but also for the development of the giant Kovykta gas deposit, as that is the logical source of gas sales to China,” said Weafer.

Graham Stack for Russia Profile (October 5)

It’s official Russian policy to push oil companies to acquire downstream assets outside of Russia, and with a wave of M&A set to sweep European refineries, opportunities are looming. But European governments are not enthusiastic – and neither are many Russian companies.

Igor Sechin, chief “silovik” in former president Vladimir Putin’s Kremlin, now deputy prime minister for the energy sector in Putin’s government, revealed his dream to the Wall Street Journal earlier this year – a rather modest plan for the man who is believed to have masterminded the dismantling of Mikhail Khodorkovsky’s Yukos. “My dream is for Russian oil to be refined in Russia or by assets controlled by Russian companies,” he confided.

Sechin’s plan might be close to realization, as analysts agree the European oil product market is facing a wave of M&A. According to Jürgen Doetsch, co-owner of German oil trader Erich Doetsch, “the European downstream market is facing a structural shift,” as margins shrink due to falling demand and rising oil prices. “The golden decade when refineries in Europe earned big money is ending, and refineries could return to being loss-makers as they were for 25 years before the turn of the century,” says Doetsch.

The shift is marked by big 6 supermajors such as British-Dutch Shell, French Total S.A and U.S. ConocoPhilips divesting or mulling divesting refineries. Shell is looking to sell one UK and two north German refineries, and ConocoPhilips uncertain about the future of its Wilmershaven refinery in Germany.

Total S.A CEO Christophe de Margerie specified September 22 that Russian companies could be among the buyers: “they have a market to develop in Europe and may be interested to buy when we are interested to sell,” he told  Bloomberg. His statement followed hot on the heels of Total’s sale of a 45 percent stake in its Dutch Vlissingen refinery to Russia’s Lukoil in June for $725 million.

The selling is not just limited to the multinationals. Polish petrochemical national champion PKN Orlen, owner of Europe’s largest chain of filling stations, is said to be looking to divest a 63% stake in strategically significant Czech Unipetrol and an 87% stake in Lithuania’s Mazeikiu Nafta, in order to pay down $3.2bn worth of debt.

Governments are also getting in on the act. Specifically, Belarus government is mulling privatization of its strategically significant Naftan-Polymir refinery complex, the country’s largest, supplied by the Druzhba pipeline. Belarus has been in talks with Russian majors Rosneft and Lukoil over a sale, but is dragging its heels. “If you have money and willingness, then please come. I am ready to support the programme of privatizing the Belarusian oil refining association,” Alexander Lukashenko said September 16, evaluating the total complex at nearly $3bn.

Another dark horse is Venezuelan president Hugo Chaves and the Venezuelan national oil company PDVSA. PDVSA owns stakes in a number of German refineries as partner in a joint venture with BP, Ruhr Oel that controls around a quarter of German refinery capacity. Ever since coming to power in 1999, Chavez has said he will divest PDVSA’s overseas assets and in 2003 PDVSA was in talks to sell to Russia’s Alfa Group, co-owner of oil company TNK-BP, but these talks came to nothing.

September, however, also saw the signing of an upstream tie-up between a consortium of Russian oil companies and PDVSA to prospect and extract in Venezuala’s Orinoco regions. The partnership could reasonably also entail asset swaps seeing transfer of Venezuela’s downstream stakes in Europe to Russian companies.

Pipeline pressure

Russian companies however face considerable political resistance to plans to buy into European refineries, especially of strategic significance. Analysts thus expect the ongoing M&A wave to trigger a number of political spats between Russia and individual European countries, and also bring pipeline politics to the fore.

Leonid Fedun, vice president of Lukoil, Russia’s second biggest oil company and most active acquirer of foreign assets, complained to the Financial Times in April 2009 that, “some countries in eastern Europe have an extreme level of political antagonism towards Russian investments.” In the same month Russia’s President Dmitry Medvedev complained of “idiotic” fears in Spain of Russian investment in the energy sector.

Fedun’s comments come a week after privately-owned Russian oil company Surgutneftegaz Mol in a surprise move acquire 21% in strategically important Hungarian energy group MOL. Hungarian politicians reacted with fury and responded in dramatic fashion: the Hungarian courts allowed MOL to delay registering the new shareholder until poison pills had been adopted in the company’s charter that left decision-making power with the government-backed board of directors at the expense of shareholders.

Poland watched the MOL episode with equal consternation. Despite owning only a 27% stake in petrochemical giant Orlen, the government forced through similar poison pill changes to Orlen’s charter in July, “removing all chances of PKN becoming a takeover target in the future,” according to Wood analysts.

Such tactics may however cause the Kremlin to up the ante rather than back off. Russia has gained bargaining power vis-a-vis the Central European refining sector supplied by the Druzhba pipeline, following the start of construction in August 2009 of the Baltic Transport System-2. BTS-2 will reroute Russian oil from Druzhba around Belarus to Russia’s new Baltic port of Ust-Luga in Leningrad Region, and thus increase flexibility of export routes. Refiners remember that Lithuanian refinery Mazeikiu has its oil supply shut off by Russian pipeline operator Transneft after it fell to Polish hands instead of Russian in 2007.

The East Central European countries for their part put their hopes on the Odesa-Brody pipeline running through Ukraine from the Black Sea, planning to extend it to the Polish refinery of Plock, Orlen’s biggest plant. The pipeline would then ship Azeri oil to Central Europe. However the feasibility of the plan is not yet established, and the pipeline is continues to be used in reverse mode to ship Russian oil to the Black Sea.

Reluctant imperialists

The weak link in the Kremlin’s strategy could be the Russian oil companies themselves. With the noticeable exception of Lukoil, they have shown little interest in expensive acquisitions in Europe’s downstream sector.

Lukoil is open about pursuing downstream expansion, with major acquisitions in Italy in 2008 along with the Dutch acquisition from Total this year. However, Lukoil’s ambitions predate Igor Sechin’s watch over Russia’s energy sector. In fact the fully private company, in which US major ConocoPhilips holds a 20% stake, counts as one of the most free from Kremlin influence. And the company’s strategy of overseas downstream expansion was evident as early as the 1990s, when it purchased a chain of filling stations in the USA.

On the other hand, state-owned Rosneft, Russia’s largest oil company, has still to make a large foreign acquisition, and is focused on capital-intensive upstream expansion in the Arctic and Pacific shelf, with little resources left for acquisition abroad. At the most Rosneft might acquire the Belarus refineries. Gazpromneft, the oil division of state-controlled gas giant Gazprom “doesn’t really have the scale for European acquisitions to make much sense,” according to Ron Smith, head of research at Alfa Capital.

Surgutnefegaz, the transparency-challenged private oil company named by Igor Sechin “Russia’s best privately-run oil company” would seem the most likely acquirer of European assets. The company is believed to be sitting on a cash pile and potential war chest of $20bn, and in April this year bought 21% of Hungary’s energy company MOL for $1.4bn from Austria’s OMV, causing outrage in Hungary.

At the time, however, many commentators believed the move was requested by the Kremlin for political reasons, namely to stymie the Nabucco gas pipeline project in which MOL is a participant, rather than being part of Surgutneftegaz strategy. “They are very tight and unambitious with their massive pile of money, the MOL thing notwithstanding. It would be completely out of character,” according to Smith. In addition, Surgutneftegaz are more focused on downstream investment in Russia, with large investments in the Kirishi refinery in Leningrad Oblast

Finally, TNK-BP held talks with PDSVA on acquiring the Venezuelan companies refinery stakes in 2003, but the talks ended without any results. Analysts say TNK-BP is very focused on adding value, and the returns on European refining are not sufficiently compelling. TNK-BP is more focused on Russian downstream, having just overhauled its Ryazan refinery, one of the largest in Russia.

This means leaves Lukoil with a clear field in making acquisitions downstream in Europe, as far as governments allow, and, in conjunction with the ConocoPhilips 20% stake, well on its way to becoming a true oil multinational.

The South Ossetian conflict flaring up in late 1989 started the break up of Georgia. The conflict of 2008 might well have sealed it.

Four months after Slobodan Milosevic’s speech on the Kosovo Field June 1989 symbolised the start of the Yugloslavia conflict, Georgia’s nationalist leader Zviad Gamsakhurdia, backed by over 20,000 supporters including paramilitaries, rolled towards the South Ossetian capital Tskhinvali, to assert ethnic Georgian rule over the entire territory of the republic. Ossetian groups duly blocked Gamsakhurdia’s entry to the town, and violence broke out. Andrei Sakharov, not long before his death, commented gloomily on the creation of “minor empires” in the former Soviet republics.

The standoff escalated through 1990. In April 1990, the Supreme Soviet in Moscow ruled that the ethnic autonomous territories of any republic seceding from the Soviet Union retained the right to remain in the Soviet Union. Then it was Tbilisi’s turn to pour fuel on the fire. In August 1990, the Georgian Soviet adopted a law prohibiting regional parties from participating in Georgian elections. Excluded from the political process in Georgia, South Ossetia boycotted parliamentary elections in October 1990, instead holding elections to their parliament in December 1990.

In response to the South Ossetian elections, the newly-elected Georgian parliament abolished the autonomy status of South Ossetia, declared a state of emergency in the region and in late December, imposed an economic blockade on the region that was to last to July 1992.

The conflict finally escalated into war the following month. In the first days of 1991, the Supreme Council of Georgia passed a law on the formation of the National Guard of Georgia. Then on January 5th, at the time of the Orthodox Christmas festivities, several thousand Georgian troops, police and paramilitaries entered Tskhinvali and carried out violent reprisals and atrocities against the population, ostensibly in search of arms.

The weekend war

The initial fighting took place mainly in and around Tskhinvali, around the Georgian villages, and north along the road to North Ossetia, the lifeline of the South Ossetians in the face of the Georgian blockade.

According to Nikola Cvetkovski of Caucasus Links, who has written a history of the South Ossetia conflict, the fighting in Tskhinvali initially divided the town into an Ossetian-controlled western sections and a Georgian-controlled east. But fierce resistance from Ossetian irregulars meant that already by the end of January, 1990, Georgian forces withdrew to take up positions on the heights around the city. From there they enforced a blockade that lasted almost one and a half years, and aimed at cutting the town off from heat, electricity, water and food.

Actual fighting was low intensity, deploying mostly light arms. Fighting however peaked regularly at weekends, as the so-called ‘weekend warriors’ of paramilitary formations arrived from Georgia proper. The ‘weekend warriors’ were themselves more interested in looting than fighting. As a result, military fatalities stayed low, but of the roughly 1000 Ossetians killed in the conflict, only around 100 are regarded to have been militia members: the remaining 900 were civilians. In addition, according to Alexei Zverev, ethnic conflict expert at Vrije University of Brussels, 93 villages (mostly Ossetian) were completely burned down.

Even the newly-formed Georgian national guard, intended to become the core of a new Georgian army, was recruited and financed “almost exclusively by private individuals, especially successful black-market entrepreneurs,” according to Swiss security expert Christoph Zuercher, who has written the classic account of the Georgian crisis in “The Post-Soviet Wars”.

Georgia’s second main (para)military formation prosecuting the war, the Mkhedrioni (Georgian for medieval knights), was, according to Zuercher, “created in 1989 by Jaba Ioseliani, a former patron of the Soviet underworld, and funded its activities from criminal dealings, including extortion and racketeering,” and constituted “a private army at the service of the state when it was waging war against secessionist minorities.”

“The Georgian militias—the Mkhedrioni and the National Guard—were to a very significant extent driven by the presence of private entrepreneurs of violence, undisciplined weekend warriors, who conducted frequent attacks on the civilian population and took hostages,” Zuercher continues. “But in the case of the Ossetian and Abkhazian fighters, the use of military force was not mainly motivated by private profit, but by the perceived threat to the status quo posed by an independent and nationalistic Georgia. (…). Once the Georgian militias entered their territories, Ossetians and Abkhazians saw their fears confirmed, and organized violence ceased to be an option and became a necessity,” adds Zuercher in his seminal study.

Russia appears on the scene

Until then, the Soviet Centre, in its death throes, had remained largely on the sidelines in the conflict. The Soviet leadership had apparently latterly struck a deal with Tbilisi, allowing Gamsakhurdia a free hand in South Ossetia in return for accepting Soviet supremacy. This deal was shown up during the Moscow Putsch in August 1991, when supposedly nationalist Gamsakhurdia – in sharp contrast to events in Moscow and Leningrad – meekly accepted the authority of the Provisional Committee established by the putsch, and subordinated his armed units to the Soviet Interior Ministry.

The failure of the putsch, however, destroyed Gamsakhurdia’s authority: On December 22, 1991, in the last days of the Soviet Union, approximately 500 National Guard soldiers entered Tbilisi and drove Gamsakhurdia out, marking the start of the Georgian civil war. The new interim authorities—Ioseliani (leader of the Mkhedrioni) and Kitovani (head of the National Guard), then called Eduard Shevardnadze, former Soviet foreign minister, back from Moscow to head Georgia.

The struggle for power in Tiblisi now hugely exacerbated the ongoing ethnic conflicts, as the deposed president mounted military resistance from his home region in western Georgia against the new authorities in Tbilisi – and thus triggered the Abkhasian conflict, flaring up in spring 1992 and turning to war by the summer.

The conflict constellation now also changed due to the appearance of an entirely new actor: Boris Yeltsin’s Russia. Yeltsin’s new Russia, born of the idealism of the Perestroika liberal movement, and riding high on the wave of enthusiasm following the defeat of the Putsch, was more concerned about the rights of minorities in neighbouring states than the Soviet leadership had been. Russia was also sensitive to the concerns of the North Ossetian leadership, who were inundated with refugees from the South Ossetian conflict and feared further destabilisation.

According to Alexei Zverev, this new conflict constellation made Russian intervention on the side of the South Ossetians look increasingly probable. In mid-April 1992, Georgian artillery resumed daily missile attacks on the residential quarters of Tskhinvali. Then, in 20 May 1992, unidentified gunmen, whom the Ossetians claimed were Georgians, massacred a busload of Ossetian refugees fleeing Tskhinvali.

The massacre prompted North Ossetia to cut the gas pipeline to Georgia, and elicited furious statements from Russian politicians, including chief reformer Yegor Gaidar. By June 1992, Boris Yeltsin’s administration seemed to be on the brink of intervening to protect South Ossetia.

The situation was ironically saved only by a further escalation of Georgia’s own civil war between Shevardnadze and Gamsakhurdia in Western Georgia, which was simultaneously making conflict between Tbilisi and separatist Abkhazia look imminent. In the face of this extraordinarily dangerous situation, Shevardnadze could not possibly afford to fall out with the Russians.

On 22 June 1992, Yeltsin and Shevardnadze duly met with North and South Ossetian representatives in Sochi and signed a ceasefire agreement. The agreement envisaged the deployment of joint Russian, Georgian and Ossetian peacekeeping forces. The peacekeepers moved into the region on 14 July, 1992.

In view of the civil war raging at the time in Georgia and the start of the Abkhazian conflict, no one initially gave the South Ossetian ceasefire much chance. But it held 16 years… until August 7 2008.

Graham Stack for Russia Profile (www.russiaprofile.org)

Despite the rhetoric, Germany’s likely new coalition may slowdown nuclear power phase-out, but will not cut back on Russian gas.

If, as is likely, Germany’s September 27 national elections result in a new governing coalition between incumbent chancellor Angela Merkel’s Christian Democratic Union (CDU) and the small liberal Free Democratic Party (FDP), the planned phase-out of nuclear power in Germany will be slowed indefinitely, ostensibly to reduce dependency on Russian gas. However, analysts say the shift will make no significant longterm impact on German demand for Russian gas. Moreover, FDP head Guido Westerwelle as probable foreign minister is likely to be as Russia-friendly as his social democrat predecessor Frank-Walter Steinmeier, the loser of the election.

The man almost certain to be Germany’s new foreign minister did not mince his words when drawing conclusions from the Russian-Ukrainian ‘gas war’ January 2009, which saw supplies to Europe halted for a number of days.  “We Europeans have to do everything to free ourselves from dependency on a single supplier of energy,” Guido Westerwelle told Poland’s Gazeta Wyborcza in March, referring to Russia. “In Germany the government has made the mistake of phasing out nuclear power for ideological reasons. That makes us vulnerable to foreign energy suppliers. Germany should do what most of our European neighbors are already doing: achieve a reasonable energy mix, with renewable energy such as solar and wind power, fossil fuels such as oil, coal and gas, but also nuclear power.”

Westerwelle’s call to postpone nuclear power phase-out to reduce dependency on Russian gas found an echo in one of the minor scandals that livened up an otherwise lethargic election campaign in September: a detailed election-campaign PR strategy apparently commissioned by Germany’s large energy concern E.ON, subsequently leaked to the press, advised lobbyists to actively harp on the population’s “historically rooted fears of Russia.” “E.ON can draw on these fears for its own benefit,” read the leaked PR plan.

With Chancellor Angela Merkel’s CDU also in favour of slowing nuclear power phase-out, this coming shift in German energy policy might seem to be one of the immediate implications for Russia to come out of yesterday’s elections.

Russia currently supplies 37% of German gas imports. Germany relies on gas for 12% of electricity production and around 25% of total energy needs. Nuclear power, originally to be phased out by 2022 and replaced by renewable sources, counts for around 25% of power generation and 12% of total energy requirements. These figures give rise to fears that renewables will not be able to fill the space left by decommissioned nuclear plants, leading to even greater reliance on Russian gas.

However, analysts claim that much of the anti-Russian rhetoric is merely a political strategy to make slowing the phase-out more acceptable to voters, while it will in fact hardly impact on projected Russian gas deliveries to Germany.

“I do not think that a possible postponement of the envisaged nuclear phase-out is related to fears of increasing dependency on Russian gas,” argues Marcel Viëtor, Head of Foreign Energy Policy Program at the German Council on Foreign Relations. “Rather this fear is being developed by the atomic lobby to argue for the postponement. Fear of dependency on Russian gas imports is rhetoric but not factual since the Russian companies are mutually dependent on European gas markets,” says Viëtor.

Pierre Noel of the European Council on Foreign Relations also argues that the real reasons behind the coming policy shift is lobbying from German energy companies, who earn good money with nuclear power, together with growing electricity demand in Germany and carbon emissions reduction goals.

Furthermore, Russian analysts doubt that the move will even impact significantly on the projected volume of gas supplied to Germany from Russia.

According to VTB Capital’s gas analyst Lev Snykov, “such a move would not impact my long-term forecasts for Gazprom’s exports to Germany. Long-term Russian gas exports to Germany will grow at a low single-digit rate, although the market share may deteriorate due to a strong push towards LNG.” Similarly, energy analyst at Renaissance Capital, Alexander Burgansky, believes that, “German demand for gas may not now grow as fast as some people had expected, but Gazprom’s supplies are anyway protected by the minimum off-take commitments under the long-term contracts.”

Analysts also point out that Germany’s largest energy companies such as E.ON, although lobbying domestically for a suspension of nuclear power phase-out, are also heavily involved in Russia’s gas sector. EON’s CEO Wulf Bernotat is in fact a member of the Gazprom’s Board of Directors, as the company holds a 6.5% in the gas giant. E.ON and German chemicals giant BASF are also taking stakes in the major Siberian Yuzhnoe-Russkoe gas field.

Thus it was logical that Thursday September 24 EON was among a group of the world’s largest energy companies addressed by Russia’s ex-president, now prime minister, Vladimir Putin, in the town of Salekhard on Russia’s Yamal peninsula. Putin called on the international companies to invest in gas production in the region, destined to become Russia’s main production region in the long term, as older fields decline. Gazprom estimates total investment needed at $100bn.

Germany has particular interest in the massive Yamal development, according to UralSib energy analyst Viktor Mishnyakov. “Yamal is of strategic importance for the Russian government and for Gazprom as this gas will be the source for the Nord Stream pipeline project.”

Nordstream pipeline is a controversial Gazprom-led project to bring Russian gas directly to Germany via the Baltic Sea bypassing transit countries such as the Baltic countries and Poland.

There has been vociferous opposition from Poland and Baltic states to the pipeline. But, according to Marcel Viëtor, this is one energy policy that definitely won’t be changed under a CDU-FDP coalition.

“The CDU has shown different, more critical rhetoric on Russian domestic
issues than SPD did – but it has supported NordStream and German companies
cooperating with Russian companies, investing in Russia, just like SPD did,” says Viëtor. ”In a CDU-FDP-coalition this attitude is most likely to be continued.”

Russia – “Europe’s natural partner”

Apart from adjusting energy policy, the new German government’s Russia policy is likely to remain pragmatic and constructive, including disavowing Ukraine and Georgia’s bid to join NATO. With Westerwelle almost certain to become new foreign minister, the influence of SPD elder statesman Gerhard Schroeder in shaping Germany’s Russia policy will cede to the influence of FDP elder statesman Hans-Dieter Genscher, the Federal Republic of Germany’s legendary foreign minister from 1974 to 1992.

With 20 years marked since the fall of the Berlin Wall this autumn, events in which Genscher played a crucial role, an FDP-led foreign ministry will be especially minded to take a pragmatic and measured policy towards Russia, considering Moscow’s support for German reunification 1989-1990. Awareness of the Kremlin’s constructive role towards unification twenty years ago has even been heightened in recent weeks by archival revelations of how bitterly European leaders such as then British Prime Minister Margaret Thatcher and French President Francois Mitterand were initially opposed to the idea.

Outside of energy policy, the FDP regards Russia, in Genscher’s words, as “Europe’s natural ally, not natural enemy.” Added to this is the generational factor: 47-year old Westerwelle sees himself as one of a new generation of politicians that includes US president Barack Obama and Russian president Dmitry Medvedev. Westerwelle is thus an enthusiastic supporter of Obama’s “reset” policy of improving relations and cooperation with Russia. “If President Medvedev emphasizes he is a moderate politician and wants to reform his country and pursue disarmament, we should take him at his word,” he told Gazeta Wyborcza. “He is a young politician, and together with the US president, who is also young, he will have the chance to go down in history in a positive fashion.”

Graham Stack for Russia Profile (www.russiaprofile.org)

Rumours of imminent growth may be exaggerated by sketchy inventory statistics. A chorus of analysts are attributing Russia’s 10% GDP contraction this year to companies selling down inventories rather than producing, and are gung ho about growth restarting as soon as inventories empty. But others are warn against drawing strong conclusions from Russia’s sketchy national statistics on inventory levels.

Alexei Moiseev, macroeconomic analyst at Renaissance Capital, speaks for a number of analysts arguing that Russia’s astonishing GDP collapse of 10.2% – in the first half of 2009 was the result of huge selling down of inventories by industrial enterprises rather than demand collapse.

“Very expensive money resulted in massive de-stocking in fourth quarter 2008,” he argues. “The trend intensified in the first quarter of 2009, with the negative contribution to GDP in this quarter exceeding 7 percentage points of a total decline of 9.8%.” 

Similarly, Anton Nikitin of UralSib argues, “the fall of GDP and slowdown in industrial production was mostly driven by the huge disposal of inventories” which started late 2008 and continued into early 2009. Citibank’s Elina Ryvbakova also estimates that at least one third of the collapse in production in the first half of this year resulted from destocking.

Since GDP is a pure production statistic, it plummets when enterprises en masse stall production lines to sell down inventory, even if turnover stays steady. And the harder they come, the harder they fall: overheated growth in 2008 brought about unprecedented stockpiling due to anticipated future demand. “Spiraling costs of raw materials 2007-2008 also caused companies to massively build up their inventories,” says Rybakova. Moisseev speaks of “a crisis of overproduction” starting in the first quarter of 2008, with inventories at 150% of their 2007 value.

If destocking rather than demand collapse was so much to blame for the economic disaster this year, then logically when inventories are empty stalled production will start up again. According to Moisseev, “some of the damage done to the economy has resulted from overheating in 1H08, and some of the damage will be easy to recover. Unfortunately, inventory statistics come with a significant delay, so we have no way of knowing what has been happening since, but historical experience suggests de-stocking cannot last for longer than two-to-three quarters”

Shadowy statistics

As Moiseev admits, the catch with betting on emptying inventories to kickstart growth is that no one knows very much about them. The problem is that Russian Federal State Statistics (Rosstat) reports inventory statistics only sketchily, on a quarterly basis and aggregated across the economy. The next figures won’t appear until October, meaning that forecasting growth on their basis is very speculative.

“The question of inventories has advanced to be the one of the key questions, especially because the economy ministry has focused on it,” explains Vladimir Sal’nikov of the Centre of Macroeconomic Analysis. “But the problem is that inventories are not counted directly and there is a high level of statistical error involved. It is very difficult to separate the real inventory level from the margin of error.”

According to VTB Capital analyst Aleksandra Evtifyeva, “Rosstat only provides quarterly aggregate inventory figures that don’t allow close analysis. The Economy Ministry has a wider base of statistics available and said in August that inventories were drying up. However we don’t know for instance if oil companies are included in their statistics or not.”

Business daily Kommersant has reported that Bank of Moscow analysts report that inventories have remained stable over the last three quarters, and that as a proportion of turnover inventory has grown by a third compared to 2006-2008. If true, this would point to demand collapse that Sal’nikov also feels has been underestimated. “It seems to us to be the case that markets have contracted more strongly than is reflected in statistics,” he says.

Citi’s Rybakova admits that the quality of inventory statistics provided by Rosstat is very poor. However, she says  “the magnitude of the production collapse in the first quartern 2009 is hard to explain by any other factor. It was more severe than in 1998.”

“Restocking however won’t be a panacea to cure the economy,” she adds. “Instead, we are seeing an adjustment down to a new production level, meaning inventory will never return to pre-crisis levels.” Rybakova believes restocking could add 1-3% to annual GDP growth, but not before 2010. Instead, she believes that consumer demand will pull Russia back up, if it strengthens. Sal’nikov also prefers demand as a growth factor – but tips deferred demand for investment goods instead of consumers.

With the government still holding out for growth driven by an end to destocking, skeptical voices are growing stronger. The Finance Ministry forecast for August was for 1.5% growth, but the result disappointed at 0%. Electricity consumption statistics, a proxy for industry, show demand still contracting.

Timothy Ash of Royal Bank of Scotland is consequently dismissive about the talk of growth. “Brokers seems to be jumping over themselves at the moment to talk up the Russia story, that recovery has begun, and that Russia will bounce back quickly. While favourable base period effects should come into play in the final few months of the year, the data flow is far from convincing,” he says.