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Russia strikes while the iron is hot

May 24, 2010 - Following the Kiev-Moscow rapprochement, Russian gas giant Gazprom wants to stitch back together the Ukraine-Russia gas pipeline system, but is keen still on South Stream. But the two goals are mutually exclusive.

Russia appears to be losing the politically fraught battle to bring together its pipeline network with that of Ukraine. How the remerger would work in the first place has exercised analysts, given the vast difference between the companies' sizes and Ukraine's enthusiasm only for a merger of equals.

The merger, as initially outlined, extended to the two companies in their entirety, not just the pipelines; and Gazprom dwarfs Naftogaz Ukrainy. But Gazprom itself appears undecided what the rationale for the merger is, since European security of gas supply would be met just as well by South Stream as by the merger, and it has never questioned that South Stream would be built.

The CEO of Gazprom, Alexei Miller met Ukraine's energy minister Yuri Boiko in Moscow on May 13 to discuss the proposal that Russia's president Vladimir Putin raised in late April.

In a press release Miller spoke of the benefits a merger would bring to EU supply and how it would at the same time repair the damage done to the gas industry by the break-up of the Soviet Union.

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"The merger of Gazprom and Naftogaz Ukrainy is an absolutely pragmatic decision. This idea arises from the common history of the development of the gas sectors of our two countries and in particular the single gas transport complex which was built during the time of the Soviet Union. So it is natural that modernizing Ukraine's gas transport system should be closely linked to the development of Russia's unified system of gas supply," Miller said.

"Ukraine's gas transport system was originally designed to ship Russian gas to Europe. But, as is well known, any pipe is a valuable asset only while it is filled with gas," he said. Miller, a member of Medvedev's team for talks with Ukraine, said May 17 that Gazprom would be willing to pay for the modernization of Ukraine's gas pipelines -- a key asset of Naftogaz -- in the event of the merger.

But he also said Gazprom was determined to build South Stream for the same reason: to promote security of supply in Europe. And iff South Stream were full, the new company would have written off Ukraine's pipelines.

With Nord Stream's 55 billion cubic meters/year from 2012 and South Stream's possible 63 Bcm/year, not much gas would be left to flow through Ukraine by 2015, whereas transit capacity there could actually be increased to almost 200 Bcm/year.

This expansion would likely be a much easier option, financially, technically and politically, than would a line under the Black Sea.

The group's executive committee met late April 18 and a source said they had reached a consensus to act to raise gas prices but that a mechanism for doing so had yet to be decided.

But Russia is unlikely to shelve the costly project just because relations with that country have improved, the analysts said. The political situation in Ukraine is unstable and only time will show if Ukraine is to fulfil already reached agreements, they said.

The former prime minister, Yulia Tymoshenko, is not letting the issue of these agreements lie and a large body of opinion in Ukraine takes a dim view of the new government's friendly stance towards Russia. it sees the extension of the lease of the Sebastopol port as unpatriotic.

Analysts say that a tri-lateral consortium with European companies and Gazprom equally with Ukraine operating the transit gas network is a more realistic option than a full-blown merger.

Ukraine's president Viktor Yanukovych said he was ready to accept Russia's proposal to merge Naftogaz and Gazprom if it were made on a parity basis. "If I had been there, I would have given my hand to Putin and said: 'I agree – on a 50:50 [basis]'," Yanukovych said in an interview with Russia's Ekho Moskvy radio station.

This was later described as an attempt at humor. But in any case this is not on the cards, analysts say. "Merging the two companies seems to be an unrealistic scenario in any proportion," said Moscow-based Metropol investment company's Alexander Nazarov.

Naftogaz is valued at around $10 billion, taking into account its large debt burden, implying that a direct merger and share swap with Gazprom would give the Ukrainian side just 7% of a merged company, as Gazprom is valued at around $130 billion, said Alfa Bank's Pavel Sorokin

In addition, both companies are monopolists in certain spheres in their countries, so the merger would require significant changes in the legislation of the two countries, said Nazarov.

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