World Economy
Weaponizing Energy: The Pandora’s Box Is Wide Open

Energy trade has been the backbone of the overall economic relationship between Russia and the West. This is especially true of Europe, which has been the main export market for Russian energy. But now it appears that this era is ending abruptly. The conflict in Ukraine has turned a long and carefully planned separation between Russia and Europe that both sides were contemplating for quite some time into a hasty and ugly divorce in which ex-partners  are trying to hurt each other as much as possible regardless of consequences and collateral damage. 

Since Russian oil, refined products, coal, and gas export flows have been constituting Russia’s relevance in international trade and have been forming the lion’s share of Russia’s export revenues and a significant part of Russia’s overall budget it is not surprising that they are now at the center of the controversy. Some European politicians has been using the mere fact of importing large quantities of hydrocarbons from Russia as a reason to accuse it of using the ‘energy weapon’.  Russia was assumed to be guilty by default when it had to take measures to make its counterparts to pay the contractual prices that from time to time would be inconveniently high for the buyers.  The fact that during 2020 when gas prices declined to rock-bottom levels Gazprom was supplying gas to Europe at a loss for itself was quickly forgotten. It is true that the energy crunch in Europe has resulted in unprecedented spikes in energy prices, concerns about energy security and fears of energy poverty in 2021 and 2022. At the same time, Russia’s export revenues skyrocketed, propelled by the price windfall.
But the energy crisis has been global in nature and blaming Russia for the business cycle fluctuations is hardly justifiable.

And yet the Western decision-makers are extremely unhappy about the price windfall working in Russia’s favour as they do not want to give the Kremlin the means to finance its military program and diversification efforts away from Europe via ‘Pivoting East’. So, they weaponize energy, introducing plans of energy sanctions, trade embargos, and asset freezes.

Additionally, as the monetary estimates of the damages incurred by Ukraine as a result of the military conflict grow,  so do the concerns by the West about the future liabilities and the sources to cover them. What happens when the conflict is over, but Russia refuses to pay the reparations that Ukraine has been demanding? Will the US and the EU have to finance the reconstruction of Ukraine without much hope for getting their money back? Amid these concerns the plans to confiscate Russia’s export earnings have emerged.  

The freezing of about $300 billion of Russia’s hard currency reserves in western banks was the first act but there will be others. One such plan is to introduce an import tariff on the Russian energy exports.  

Another is the idea to pay for the Russian hydrocarbon exports to escrow accounts in the Western banks and only allow Russia access to the funds on a limited and conditioned basis. 

To make Russia bend under pressure and accept the West’s terms, the increasingly tougher restrictive trade measures have been introduced as the European Commission announced that it would stop importing Russian energy as soon as possible. 

Firstly, the EU countries introduced an embargo on imports of Russian coal, to take effect on August 10, 2022. 

The volumes of Russian coal exports would go down in the near term because of the logistical problems related to re-directing supplies to other markets but the record price of coal in 2022  would result in Russia getting much more revenues than from the previous three years combined even by exporting less coal this year. 

Secondly, the EU wants to introduce an oil embargo against Russia  but runs the risk of hurting its own economies much more than Russia’s because of spikes in crude oil prices  and possible physical shortages of diesel fuel that is critical for moving goods across Europe. 

Thirdly, the EU announced its plans to gradually wean itself of Russian gas, boasting the targets (reducing Russian gas exports by two-thirds in 2022 and freeing itself of Russian gas by 2030 altogether) that require miracles to occur on both supply and demand sides if this ambition is to be realized.   

Even more importantly, in contrast with the situation with coal and oil, Gazprom and the European companies have in place long-term gas contracts with take-or-pay obligations some of which extend well into the 2040s. If Gazprom’s counterparties do not take the amounts of gas stipulated under the contract, they still must pay for it (the take-or-pay is usually 80% of the average contract quantity with some grace period that allows to carry forward the obligation for a few years).  A unilateral breach of the long-term contracts incurs heavy fines, so the political directives by the EU regarding the abrupt termination of the Russian gas supplies put the European companies on a collision course with Gazprom and open up the Pandora’s box of litigation and wealth destruction.
Russia’s response to the trade restrictions and the threat of confiscation of its export earnings by the EU has been very pragmatic.

The energy interdependency between Russia and Europe cannot be eliminated by decree.  Energy supply and demand are inelastic in the short term, and any attempts to mess up with the economic realities can only result in price spikes. Russia is under extreme urgency to re-direct its energy exports to India and China but cannot do it in a flash. As to the West’s attempts to control Russia’s hydrocarbon export revenues, the response was swift and resulted in the Presidential Decree 172 (the so-called ‘gas for rubles’ scheme).

Any move in a strategic game combines offense, defense, and pre-emption.  While the elements of offense (a warning shot to the holders of global reserve currencies) and defense (shielding from sanctions Gazprombank, the authorized entity to conduct settlements for Russian gas), it appears that the pre-emption was the key concern behind Putin’s decree: the introduction of a regulatory requirement to switch to the new payment mechanism under which the buyers’ obligation to pay is recognized only when the payment is transferred to Gazprom’s ruble account in Russia blocks any potential attempts to arrest Gazprom’s export revenues in the EU.  A failure to pay in accordance with the new scheme would mean a failure to pay for the supplied gas, which would force Gazprom to halt the deliveries immediately because it must abide with the Russian legislation. Possible plans by the EU to arrest the payments by the European buyers to Gazprom’s euro accounts in the European banks and continue to demand uninterrupted supplies while the matter could be in arbitration for years have been blocked. Now the European companies that do not pay for the supplied gas face the risk of immediate cutoffs. 
 
In the end of April Polish PGNiG and Bulgarian Bulgargaz, two European companies whose long-term contracts with Gazprom are to expire in the end of 2022, decided to test Gazprom’s resolve and refused to pay in accordance with the new scheme saying it was not in accordance with their contracts.  On April 27th Gazprom said it had stopped gas supplies to Poland and Bulgaria.   

Last week Gazprom said that according to its information Poland and Bulgaria started taking volumes from the transit flow of Russian gas using the increased nominations by French and Italian companies (who apparently were demonstrating their solidarity by allowing PGNiG and Bulgargaz to take gas from the volumes contracted for France and Italy) and employing the so-called ‘virtual reverse’ mechanism

During May the big-ticket buyers of Russian gas from Germany, France and Italy have their deadlines to switch to the ‘gas for rubles’ scheme.  There is little doubt that their failure to pay will also result in gas cutoffs by Gazprom but with no ‘back door’ options.  The result of the possible escalation will be the interrupted program of refilling the European gas storage facilities during this summer, further spikes of gas prices and a real and present danger that the European gas-intensive industries come to a halt while the European citizens risk freezing in the dark during the winter of 2022/23.

There is little doubt that an oil embargo against Russia that the EU is discussing and/or a halt of gas flows as a result of the disputes over the ‘gas for rubles’ scheme could cause a set of extreme calamities.  Russia would be hurt, but so would be Europe.  What is most troubling is that the politicians are raising the stakes in an energy game they poorly understand, and which can easily spin out of control.
 
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