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Analysis & Opinion
04.05.10 Love’s Limits
By Tai Adelaja

As Mark Twain once said, familiarity breeds contempt and children. This could well sum up the possible economic and political fallout from the newly forged marriage of convenience between Russia and Ukraine. In the last few weeks, Moscow’s new romance with Kiev has produced cheaper gas deals and a lease extension through 2042 for a Russian naval base in the city of Sevastopol in Ukraine's Crimea. But cheaper gas and lease extensions could be as far as “children” go.

In an apparent effort to keep momentum gained through improved relations, Prime Minister Vladimir Putin emerged from an April 30 meeting in the Black Sea resort of Sochi with a proposal to merge Russian gas monopoly Gazprom and Naftogaz Ukrainy, Ukraine's troubled national energy company.

“We spoke about integration in the nuclear area, and we are ready to do the same in the gas area, that is, to unify Gazprom and Naftogaz Ukrainy,” Putin told journalists after the meeting of intergovernmental commission attended by Mykola Azarov, the Ukrainian prime minister.

Putin’s proposal appeared to have caught everyone off guard.

Vitaly Lukyanenko, spokesman for Mykola Azarov, said the issue of a possible merger of Naftogaz and Gazprom was neither discussed nor even raised at the meeting. "The idea expressed by the Russian prime minister was impromptu. So, we will discuss impromptu proposals and look into concrete proposals," Lukyanenko quoted the prime minister as saying.

However, Gazprom's CEO Alexei Miller, who appeared to have foreknowledge of the far-reaching proposal, said consultations and negotiations on the proposal will begin immediately after the May celebrations in Moscow. “We are willing to consider swapping assets with Naftogaz in business segments ranging from exploration to sales. In reality, that's the question of a merger of the two companies,” Miller said. "Gazprom does have experience in implementation of transactions on the basis of dispensing assets with German and Italian partners," he added, saying that such work will be carried out along the chain from exploration to end-user.

Russian government spokesman Dmitry Peskov said in a telephone interview that while the proposal might have come at the end of the leaders’ meeting, it was nonetheless well thought out. "Of course, we understand that the Ukrainian side will need time to think things through but this is a highly advantageous offer for both countries, and it will have a long-term perspective," Peskov said. The proposal, he said, will not affect efforts by Russia to build the South Stream gas pipeline bypassing Ukrainian territory. The form of a possible merger with Naftogaz can only be determined after negotiations, he said.

State-owned Naftogaz Ukrainy is the exclusive importer of Russian gas into Ukraine and about 20 percent of the European Union's gas needs flow through its pipelines. In recent years, the company has been a big drain on the country's budget as it sells gas to utilities at home for less than it pays. Last year, the IMF estimated Naftogaz’s operational deficit at just under $3 billion and treated it as part of the broader fiscal deficit. Experts and industry executives are skeptical that a merger - which would have combined Gazprom and the heavily-taxed national oil and gas company into one legal entity - is possible.

Jonathan Stern, director of gas research, at the Oxford Institute for Energy Studies, said the proposed merger deal, though smart, is going to be politically impossible in Ukraine. "When Ukraine extended the lease, the understanding was that the gas issue had been resolved for good," Stern said. "The Ukrainians regard their gas industry as the crown jewel of their economy, the symbol of their national sovereignty and pride. This is why they have been completely unwilling to give Gazprom or anyone else any stake in any part of the industry."

Chris Weafer, chief strategist at UralSib, said an outright merger of both companies seems very unlikely, if not impossible. “What we are looking at is more likely the creation of a joint venture to control the gas transmission system in Ukraine or, some other asset swap between the two companies that would allow Gazprom to gain an equity interest in the pipeline.” From a strategic perspective, a full merger of the two companies would be negative for Gazprom’s share price, while an asset swap that allows Gazprom to gain an interest in the pipeline would be a net positive, he said. Weafer said Naftogaz would end up with only a small equity interest in the combined entity, making it seem like a complete takeover of Naftogaz by Russia. “That would be completely unpalatable in Kiev and president Yanukovich would risk a considerable political backlash if he supported that move,” he said.

Russia’s reluctance to loosen its grip over the national gas monopoly will also scuttle plans for a complete merger as Russia would not allow its holding in Gazprom to drop below a 50-percent-plus-one controlling stake. That means that any merger deal would create equity problems for the state as it tries to keep its controlling stake intact.

Analysts have also pointed out that a potential merger deal would face valuation issues, as Gazprom is a listed company with a market value while Naftogaz is not. The implication is that any valuation used in a merger would have to be calculated rather than derived from the stock market. "A valuation that was perceived as too low would raise the political pressure on Yanukovich, while too high a valuation would prompt accusations of discrimination against Gazprom minorities," Weafer said.

Russia, he said, might be willing to clinch a deal that gives it a 50 percent equity interest in the pipeline system that takes Russian gas to its European customers similar to the one it already had with Belarus. “The gas deal with Belarus involved Gazprom acquiring a 50 percent interest in the pipeline that transits Belarus. The objective with Ukraine is clearly similar. If such a deal is broadly replicated, both Gazprom and Naftogaz would remain independent with both having, for example, a 50 percent stake in a company that operated and controlled the pipeline,” Weafer said.

Putin’s surprise merger proposal has caused widespread indignation and streams of criticism from within the rank-and-file of Ukraine’s fiery opposition. Ukraine's former Prime Minister and opposition leader Yulia Tymoshenko denounced the proposal as part of "a plan to destroy Ukraine." "It is not a merger based on partnership but Russia's push to fully take over Ukraine," Tymoshenko said in a statement posted on her party's Web site. "The Crimea was just the beginning." Tymoshenko also threatened to call people out onto the streets from May 11 to depose Yanukovich and suggested that a committee be set up “to save Ukraine.”

Alexander Hudyma, Tymoshenko’s former adviser on energy issues, said Putin's proposal was a threat not only for the opposition but also for Yanukovich's inner business circle. "Members of Yanukovich’s inner circle including the Fuel and Energy Minister Yury Boiko and billionaire Dmitry Firtash currently control the entire energy market and a joint venture with Gazprom will surely put their business interests in peril,” Hudyma said. “If Gazprom controls more than 80 percent of the gas market, nothing will be left of the Ukrainian national energy industry."

Ukraine’s former President Viktor Yushchenko also derided the plan saying it was an imperial ambition directed against the territorial integrity of his country. “It's almost self-evident that Gazprom's engineers and technicians arriving at the gas transit units across our entire country would be accompanied by Russian military garrisons for the so-called defense of Russian citizens and property on Ukrainian territory,” Yushchenko said in a statement Monday.

But whatever the drawbacks, analysts said a joint venture between Gazprom and Naftogaz would not only allow Moscow to control its gas transit route through Ukraine to Europe, but also benefit Naftogaz considerably. Naftogaz would reap benefits from an asset swap as it would allow the company to obtain equity in upstream gas production in Russia which would enable it to diversify its operations and move away from being just a gas utility, Weafer said. Involving Naftogaz in a very long-term production project would allow for greater “valuation flexibility," he said.

A joint venture with Gazprom will also help Naftogaz upgrade its rickety pipeline by sharing the cost with the Russian gas-export monopoly. In addition to eliminating the gas wars that left Europe shivering in 2006 and 2009, asset swaps could trigger a change in Russia's attitude to the planned modernization of Ukraine's transit system.

"If Gazprom was an equal equity partner in the Ukraine gas pipeline, Moscow could then reverse its objections to the proposal to upgrade the Ukraine transit system to take Caspian and Central Asian gas to Europe," Weafer said. "If Russia supported the proposal to upgrade the Ukraine pipeline and the Caspian and Central Asia producers agreed to supply gas across the Black Sea (transiting across Georgia) then Nabucco would be a dead project. It would have no access to a gas supply."
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