Putin's 'Last and Best Weapon' Against Europe: Gas

Russia's President Vladimir Putin signs on the first segment of pipeline during a ceremony marking the start of construction of "Power of Siberia" pipeline at the village of Us Khatyn, September 1, 2014. Alexei Nikolsky/RIA Novosti/Kremlin/Reuters

In the cornfields of the Donbass, the war between the Ukrainian army and Moscow-backed rebels has sputtered to an uneasy stalemate. But as winter approaches, a new battle­front in Moscow's proxy struggle with the West is opening up – and though it will not be as bloody, it could be no less politically dramatic than the recent shooting war.

On the face of it, the battle lines are clear enough. Russia needs the West for loans, financial services, foodstuffs, and technical expertise – all of which are being choked off by economic sanctions over the Kremlin's intervention in Ukraine. Europe, for its part, relies on Russia's majority-state-owned gas giant Gazprom for up to a third of its gas – and about half of that is piped through Ukraine. Should the Kremlin decide to use its gas supply to hit back against European sanctions, the stage is set for a serious gas war.

The Kremlin "firmly believes that [gas] is our last and our best weapon, the one Europe fears the most", says one Kremlin pool reporter, citing private conversations he has had over recent weeks with top officials. "They say: just wait till the first snows fall and we'll see what Europe says about sanctions then."

Superficially, Russia does indeed seem to be holding all the trumps. Support for President Vladimir Putin's rule still rides high at over 80% despite Western sanctions that have crashed the ruble, sent inflation soaring, and cut off crucial funding to many of Russia's main industries and banks. Even sanctions from the Russian side, banning imports of all European and US foodstuffs, ­haven't dented Russian patriotic fervour.

Europe is a different story. A sustained gas cutoff would have an immediate and dramatic effect. "People in democracies notice their energy bills. They will not tolerate power cuts. Clearly, [Western] politicians have to take account of this," says a senior Western diplomat with knowledge of the European Union's internal debates on sanctions. "This is why, for the time being, we do not touch Gazprom." Whereas almost all Russian state-owned oil companies and major banks have been cut off from borrowing money on international capital markets, Gazprom has been, so far, exempt from sanctions.

While the Kremlin may consider leaving Europe shivering – its trump strategic card in negotiations with Europe – it's a weapon which could actually damage Russia just as much as its newfound adversaries in the EU.

The first reason is technical. A gas well is like a pressurised bubble deep in the surface of the earth, usually trapped under a dome of impervious rock and under huge pressure. Drill down into it and the gas emerges on its own – indeed one of the main challenges of opening new gas fields is controlling the enormous pressure of the escaping gas. In other words, says former Gazprom consultant Lev Smirnov, "you can't just shut off a gas well without inflicting serious damage." You can get rid of some gas by just flaring it off at source. "But even disregarding the environmental consequences even the smallest wells still produce far too much gas to safely flare it all," says Smirnov. Nor can significant volumes of gas be easily stored. Over recent years Gazprom has built a variety of underground storage facilities in salt caverns, in so-called "water bearing structures" that trap the gas in natural domes of rock, and in depleted gas wells. But at best all that storage capacity – which essentially entails expensively pumping the gas back into the ground – can hold only a few days of Gazprom's production.

But Gazprom's biggest vulnerability is financial. In theory, the company is still one of the few Russian majors with access to international finance. In practice, says oil and gas project-­finance consultant Bruce James, "lenders are very nervous about Tier Three" – a threatened next round of sanctions – "and Gazprom is find ing it almost as hard as the other [sanctioned] Russian companies to raise capital." That matters a lot, because Gazprom's overheads are a massive $25bn a year, including investment needed to maintain current output levels from flagging fields. The company also needs to service $50bn current debt, as well as pay for the development of new Arctic fields, build new pipelines and gas liquefaction plants in the Pacific and the Baltic, and construct a giant new pipeline to China due to come on line in 2019. Without international bank loans, the company only has its day-to-day cash-flow to rely on – 60% of which, or $65bn, comes from sales to Europe. True, in May Putin inked a major agreement with Beijing in May to supply $400bn-worth of gas over the next 30 years. But an agreed pre-payment from China for $25bn has not yet materialised. For the foreseeable future, says the Western diplomat, "Gazprom needs its European customers just as much as, if not more than, we need Gazprom".

So for the time being, a truce, just as fragile than the one in place on the ground in Ukraine, obtains between Gazprom and its European customers. "They're trying to pretend that it's business as usual," says Smirnov.

The wild card, though, is Ukraine itself.

All previous Russian gas cutoffs – and there have been four since 1995 – have centered on an ongoing dispute over gas prices and transit fees paid by Kiev, and pitted Gazprom against various Ukrainian governments controlled by see-­sawing pro- and anti-Moscow factions. Now, after this year's war which left over 3,000 dead and saw Crimea annexed by Russia, the electoral arithmetic of Ukraine has changed for ever. Without the Russian-speaking population of Crimea, a pro-Moscow administration will never be elected in Kiev. And, more importantly, the war has fostered such powerful anti-Russian – and by extension anti-Gazprom – sentiments that the chances of Kiev paying up the more than $5bn in arrears that Gazprom claims in full are clearly nil.

As a result, Gazprom already technically suspended gas shipments to Ukraine in June – but continued pumping gas through Ukrainian pipes for European customers downstream. Few in the energy industry doubt that the Ukrainians have been helping themselves to gas from that Europe-bound supply, despite Russian protests that millions of dollars are being illegally siphoned off into the Ukrainian system. The situation is complicated even further by the fact that some Gazprom customers sympathetic to Ukraine – notably Poland and Slovakia – are actually officially pumping some Russian gas back into Ukraine at knockdown pric es to support their beleaguered ally.

That arrangement leaves Gazprom in a hostage to unscrupulous politicians in Kiev. As temp­eratures fall, Ukraine could choose to siphon off yet more gas – thereby depriving Central Europe – but Gazprom will get the blame. The annexation of Crimea has also made Moscow a hostage to Kiev in another, quite novel, way. The Crimean peninsula has no land bridge to Russian and gets 80% of its electricity and most of its water from Ukraine. Suddenly Ukraine has water taps and electric switches of its own – and could start a complicated barter game swapping Crimea's electricity for Russia's gas.

Gazprom, for its part, has invested at least $20bn over the past five years in an attempt to bypass troublesome Ukraine altogether. To the north, the Nord Stream pipeline, laid along the seabed of the Baltic in 2011, now supplies Germany and Denmark. But a similar project to lay a giant pipe across the bottom of the Black Sea linking Russia directly to Bulgaria, Central Europe, Greece and Italy – known as South Stream – has been halted, temporarily at least, by a nervous European Commission concerned at increasing Europe's dependence on Russian gas. Russia and the EU are now arguing the matter out in the World Trade Organization.

But regardless of the verdict on South Stream, Russia's actions in Crimea and covert support for rebels in Eastern Ukraine has transformed the EU's once-tentative support for Ukraine into a firm pledge of partnership and assistance.

And Europe itself has changed. Once divided between anti-Putin hawks like the UK and what the Germans call "Putin-understanders" (who were mostly also big Putin business partners, mostly in Germany and Italy) the war and particularly the tragedy of the downing of MH17 by Russian-backed rebels have united Europe against Russia to an unprecedented extent. In other words, a prolonged slow-down of gas supplies – either as a result of a deliberate Gazprom shutdown or because of Ukrainian siphoning – now immediately becomes a serious showdown with all of Europe, risking even more crippling sanctions.

The EU hopes those newly-high stakes will persuade the Kremlin to cease and desist from its years-old habit of using gas supplies as a geopolitical tool. For years, Moscow has rewarded allies like loyal Belarus with cheap energy and punished wayward former vassals like Ukraine by slapping on high prices. "Energy supplies are important in the run-up to winter," Russia's deputy prime minster Dmitry Rogozin told Moldova's president last September. "I hope you won't freeze."

It was a thinly-veiled warning to stop Moldova from signing a partnership with the European Union. Moscow also rewarded former Ukrainian president Viktor Yanukoyvch for refusing to sign up to Brussels' trade deal with a promise of cheap gas back in December. Both ploys failed. Moldova eventually signed Europe's cooperation document in June, and Ukraine in early ­September.

The strange truth of the Gazprom bogeyman is that both producer and buyer are locked in a relationship of mutual dependence. An all-out gas war between Europe and Russia would be the economic equivalent, says the Western diplomat "of the old Mad thinking" – Mad being the Cold War Acronym for the Mutually Assured Destruction that would follow a nuclear strike. Brussels is betting that Putin may be dangerous – but not suicidal.