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Two seemingly disparate stories involving Russia are linked to a subject I’ve written about a few times at SWP.

The first story is the Tymoshenko trial. Let me start out by stating the the trial is a travesty, an example of the corrosive effects of criminalizing political disputes. I would also add that the irony is thick enough to cut with a dull knife. The firebrand of the (allegedly) anti-Russian Orange Revolution being hauled into the dock by the man who was widely believed to be a pro-Russian toady, with the Russians criticizing the trial and its outcome as anti-Russian. You could not make up this stuff.

Now to the linkage with the SWP subject. The issue of the trial was the gas contract Tymoshenko negotiated with Gazprom (OTCQX:GZPFY) and Russia in 2009. It was like a subprime mortgage: a low teaser price, combined with a floating price in out years. Specifically, Ukraine negotiated a low price for 2010, but the price was indexed to oil for the remaining 9 years.

With the rise in oil prices in 2011, this hit Ukraine hard. Prices for the Q4, which are linked to prices of oil in Q3, will likely reach $400/mcm, in contrast to the $230 in Q1. In other words, to get a political boost in the impending election 2010, Tymoshenko traded a widely-trumpeted short term price cut for a millstone that will hang around Ukraine’s neck for a decade. Like a subprime borrower, the end of the teaser rate and the kick-in of the indexed price is driving Ukraine to the brink. Again, the punishment for this should have been purely political, not legal. But it does not redound to Tymoshenko’s credit.

Oil-indexed contracts are also the (somewhat hidden) centerpiece of the second story. Putin traveled to China this week; the primary immediate purpose of this trip was to finalize agreement on a gas deal that Russia and China have been hammering out since 2006. They’ve agreed on everything! Um, except the price.

Russia/Gazprom insists on the oil linkage formula. China refuses. After numerous statements that a deal was imminent, it wasn’t. Proving, yet again, that you should discount heavily any representation about Gazprom’s coming contractual coups. How do you know a Gazprom spokesman is lying? His lips are moving.

The oil linkage mechanism is under pressure from the West and the East. Gazprom clings to it desperately because it likely–and realistically–perceives that the market price of gas will fall relative to the price of oil in coming years. Shale and LNG and the development of deeper spot markets will tend to keep gas prices down, but there is no corresponding bright spot on the horizon for oil. Indeed, the likely peaking of oil production in Russia puts upward pressure on the price, which redounds to Gazprom’s benefit. Thus, oil linkage is a hedge against the financial impact of long term declines in Russian oil output.

Gazprom obviously sees this, but so do those to whom it wants to sell. They realize that the good deal for Gazprom is a bad deal for them. The Chinese can afford to be patient. Customers in Europe, especially in Germany (finally!) are not willing to fall into Gazprom’s long-term contract trap. The weak or politically driven (like Ukraine) may succumb, but others are pushing back.

Thus, it is increasingly likely that Gazprom will not be able to operate under the oil price umbrella, and exploit the fact that future expansions of oil supplies will be much harder to come by than future gas production increases.

This hits Russia hard in many ways. First, it will limit a huge source of money flowing to connected parties in Russia. Second, as pahoben pointed out in the comments, Gazprom is a notoriously inefficient company, with far more employees and far more capital employed to produce an MCM of gas than Western companies. It can survive under the oil price umbrella, but its prospects are far less favorable if it actually has to, you know, actually compete on price in the gas market. Third, Gazprom subsidizes Russian gas consumers, and provides considerable sums for the budget. A less profitable Gazprom produces domestic political problems, and creates fiscal challenges.

Gas contracting practices may seem to be a very arcane subject. But they are a matter of freedom–literally–in Ukraine, and a matter of huge financial import in Russia, both nationally, and in the bank accounts of its "corruptocracy." Look for this issue to be a source of increasing conflict and controversy going forward, in Asia and in Europe. If you had to choose one leading indicator of Russia’s future economic and political course, you could do worse than to focus on how it fares in gas contract negotiations. Every compromise on oil linkage, every customer that walks away from an oil linked deal (as Turkey did, and as China has just done), is a thorn in Putin’s vitals.

In other words, Gazputin’s fate depends on his ability to browbeat buyers of gas into entering into oil-linked contracts. He may be able to beat up on countries like Ukraine, but my sense is that he will have a much tougher row to hoe in Germany, and especially in China. Again, music to my ears.

Source: Gazprom, China Fight Over Oil Price Linkage