But all this occurs while viable political candidates opposed to Putin are being disqualified over petty formalities, and an overwhelmingly pro-Kremlin majority in the Duma is adopting laws with little or no debate. Even Kremlin officials admit that corruption has grown rampant. Meanwhile, the state-owned mass media, steered by Vladislav Surkov, Putin’s deputy chief of staff, continues to produce stories lauding life under Putin.

So what, exactly, is going on in Russia? With this article, we review last year’s events, offer a perspective on the current state of Russian politics, and provide our take on the country’s most important and most strategic entity, Gazprom.

As we at ET have said many times, control of the energy industry is central to Putin’s power. The re-nationalization campaign that started in 2005 with the destruction of Yukos continued and matured in 2006 with Rosneft’s IPO, a deal that capitalized on the production unit that it had usurped from Yukos. Half-destroyed Yukos was about to reschedule or even pay off its remaining debts, but that scenario ran counter to the government’s plans. So, in August, the company was officially declared bankrupt and its remaining assets slated for sale in 2007. Despite this blatant government-sponsored theft, the nation remains positive about the re-nationalization campaign. Polls show that some 60 percent of the public approves of Putin’s energy power plays. It appears that Russians still yearn for a strong man, a boss, and that the country’s perception of its self-worth still requires assertions of central power, Soviet-style – by hook or by crook, mostly by crook.

The beginning of 2006 was marked with viciously cold temperatures, unusual even by Russian standards, which revealed the country’s natural gas deficit and the ongoing deterioration of its infrastructure. Despite the emerging energy crisis Russia continued to assert its power, both to the business sector (read Yukos) and to its foreign customers. That power play was manifested by threatening to curtail gas supply unless buyers agreed to price hikes of 100 or even 200 percent.

The end of the year was marred when Georgia accused Russia of espionage and demanded that it vacate its military bases in Georgia. That embroglio followed Russia’s diplomatic and energy war on pro-western Georgian president Mikhail Saakashvili. In spite of this, the United States agreed to admit Russia to the World Trade Organization.

But Russia’s international boorishness belied internal conditions that were even worse. Several murders in Moscow shocked the world, raising freedom of speech and citizen security issues. In September, the progressive deputy chairman of the central bank, Andrey Kozlov, was gunned down. He had been running a “cleaning program” and was canceling the licenses of suspiciously operating banks. In October, unknown assassins killed journalist Anna Politkovskaya, who was among Putin’s most ardent critics. Another victim: ex-KGB officer Alexander Litvinenko, who was poisoned in London, presumably by his former Russian colleagues, with the radioactive element polonium-210. “It is the state of the nation that brought about their deaths, and it is Putin who is responsible for the creation of such [a] climate,” declared Vladimir Ryzhkov, the co-chair of the opposition Republican Party.

According to Ryzhkov, Putin’s regime is heavily laden with former agents of the special services, including the KGB. At least one survey showed that about 80 percent of Russia’s leading politicians are former intelligence agents. “The danger is their entrenched mentality – antidemocratic, anti-liberal, anti-western,” said Ryzhkov. “In recent years their power expanded even more, but parliamentary control over them was non-existent.” These former intelligence operatives have seized the Russian energy industry, and in doing so gained control of Russia’s single most powerful company, Gazprom.

Gazprom in 2006

Over the past 14 months or so, Gazprom has revealed the real face of the Russian government, openly using natural gas for geopolitical purposes. In the first days of 2006, the company cut off gas supplies to Ukraine after it balked at seeing their gas prices go from $65 to $230 per 1,000 cubic meters. The gas shortages in Ukraine triggered gas deficits in a freezing Europe, the major consumer of Russian gas piped across Ukraine.

Eventually, that crisis was defused and the parties reached a convoluted and uneasy settlement. Ukraine’s gas price was fixed at $90 per 1,000 cubic meters. Gazprom said it would sell gas to an intermediary in Ukraine at $230 per 1,000 cubic meters. Further complicating the deal, Gazprom announced that just 30 percent of the gas shipped to Ukraine would be from Russia, with the rest from Central Asian countries. But something did not add up. Assuming those percentages and prices (30 percent of $230, the amount and cost of Russian gas shipped, equals $69, out of Ukraine’s fixed price of $90), the remaining 70 percent of gas from Central Asia would have to cost less than $30 – actually, $21 or less – per 1,000 cubic meters (equivalent to $0.85 per Mcf). At that rate, the cost of transporting the gas was likely to exceed the cost of the gas itself!

But Gazprom didn’t stop with Ukraine. During 2006 it delivered knock-down blows to other former Soviet republics without bothering to distinguish between friend or foe. The tripling of gas prices was portrayed in the Russian media as a political threat to Kremlin-unfriendly Ukrainian president Viktor Yushchenko. But that political threat theory proved incorrect after Belarus, run by Kremlin darling Aleksandr Lukashenko, was also told to accept a tripling of gas prices. The end of 2006 saw yet another gas war with Belarus, which successfully ended just barely before 2007 began.

Belarus will pay double what it used to, starting in 2007. Gazprom received a 50 percent equity stake in its local gas transportation company, Beltransgaz. In return, Belarus will double its gas transportation tariffs. Armenia accepted a supply contract for 25 years at double the previous price, with a potential price change in 2009. All these events destroyed the Gazprom-Kremlin conspiracy theory that was seen as punishing enemies and rewarding friends. All these countries have been targets for increasing Gazprom’s revenues.

To help Gazprom even further, Russia has been receiving a fairly high discount on gas from Turkmenistan. This was a quite attractive situation for Gazprom: it spared Russian gas resources, enabling their sale outside the country, while Turkmeni gas could be used for Russia’s internal consumption. Moreover, the two countries signed a 25-year gas contract which calls for Turkmenistan to dramatically increase its gas supplies to Russia, going from 0.17 Tcf to 2.3 Tcf per year. Is this a coincidence? Hardly. That 2.3 Tcf is the exact amount that Gazprom has agreed to sell to China, beginning in 2010. With the recent death of Turkmeni president Saparmurat Niyazov, it is unclear whether the new government will continue to sell gas at such a rock-bottom discount. Without this gas Gazprom would be unable to satisfy the overall demand, both domestic and foreign.

So, is there enough gas in Russia to meet the demand over the next few years? The short answer is no, particularly if one accounts for the growth in domestic demand and the amount of pledged exports. Russia’s own gas production can no longer satisfy the existing requirements of domestic and foreign markets. Gazprom is strengthening its positions in Turkmenistan, Uzbekistan, and Kazakhstan with constantly increasing gas production, to feed the former Soviet republics as well as to satisfy domestic demand. A gas consumption forecast approved by Gazprom shows that through 2008, the difference between the volume of gas produced by the company and that used in domestic and foreign markets will be augmented with imports from former Soviet republics. The most likely supplier, of course, is Turkmenistan, thanks to the existing gas pipeline network. (That includes the Central Asian pipeline, which carries about 45 billion cubic meters of gas per year, and the Bukhara-Urals pipeline, with an annual capacity of 14 billion cubic meters. These two pipelines will be expanded over the next few years, and will eventually carry a combined annual total of about 100 billion cubic meters.)

However, those pipes won’t supply enough to stem the looming gas shortage. According to calculations by the Institute of the Problems of Natural Monopolies (IPEM), Russia’s annual gas deficit may reach 120 billion cubic meters by 2010, and 343 billion cubic meters by 2020. (Other studies put the shortfall at 100 billion cubic meters by 2010.)

Despite the looming shortfall, Gazprom has agreed to double the amount of its gas exports to Europe and China. Meanwhile, gas production is flat and the development of new gas fields has stalled. Among the biggest projects now stuck in neutral is the giant Shtokman gas condensate field in the Barents Sea, which the Russian government recently announced won’t be developed until 2012. The same is true for the huge Kovykta gas condensate field in eastern Siberia. The development license for that field belongs to TNK-BP. But Gazprom has engineered a myriad of roadblocks for TNK-BP that have effectively prevented Kovykta from progressing. Thus, it’s become clear that Gazprom wants to gain control of Kovykta in the same way it gained a bigger share of the Sakhalin projects.

Indeed, the politics of Sakhalin show just how tough Gazprom will be on foreign companies. According to the recently signed agreement with Shell, Gazprom obtained a 51 percent stake in the Sakhalin 2 project for $7.45 billion. By any measure, it looks like Gazprom took Shell to the cleaners.

Sakhalin’s Evolution

Shell’s capitulation on Sakhalin was only part of the story for 2006. According to Putin’s doctrine for strategic energy assets, the foreign share in Russian energy assets should not exceed 50 percent. This doctrine became law in 2006 and since then, production sharing agreements (PSAs) have been under attack. According to sources in the Russian government, the Sakhalin PSAs were among the biggest mistakes of the Yeltsin regime, and Putin and his cronies want to renegotiate the deals so that Russian companies get a larger equity stake.

Despite the billions spent on the Sakhalin projects, the massive energy fields’ development is falling behind the license commitments, and the projects expect cost escalations far beyond their original budgets. As part of a Kremlin-orchestrated campaign, Russian environmental inspectors found hundreds of alleged violations of ecological norms and regulations at Sakhalin, committed by Sakhalin Energy Investments, the Sakhalin 2 operator. The environmental agency recommended that the state prosecutor suspend the license and oblige the operator to pay anywhere from $10 billion to $50 billion.

The partners on the Sakhalin 2 project, Shell, Mitsui, and Mitsubishi, realizing that Russian prosecutors are quite good at exacting penalties, decided to agree to Gazprom’s terms. They recognized that if they wanted to keep any part of the project, they had to agree to sell 51 percent at a large discount and continue investing in it. Sakhalin 1 will likely follow a samilar path.

Geopolitics

In 2006, Russian energy companies continued to expand their overseas businesses as part of the Kremlin’s plans to increase Russia’s presence abroad and keep domestic energy resources under state control. The results: Gazprom bought some European gas supply networks. Lukoil began investing in South America, the Middle East, and North Africa, and also tried to buy refineries in Europe. And Rosneft has been declaring its intentions to expand its refining capacities beyond Russian borders.

Gazprom also began getting into the gas distribution business in Europe, signing agreements with Italy’s ENI and France’s Gaz de France for direct gas supplies. Similar agreements were signed with Austria’s OMV and Germany’s E.ON, which exchanged 25 percent in the Yuzhno Russkoe field for its shares in Hungarian supply networks.

The Russian government’s growing political ambitions provoked an escalation of tension between it and its neighbors. Georgian president Mikhail Saakashvili won his presidential elections with support from the West. His election was remarkably similar to Ukrainian president Yushenko’s. Saakashvili’s election was an insult to the Russian government, a clear sign that Russia was losing control over yet another former Soviet state. Rather than accept the change in Georgia, Russia openly supported the opposition – the breakaway state of Abkhazia, whose leader Saakashvili considered a terrorist.

Adding to the tension: Georgian police arrested four Russian military officers, and Saakashvili publicly accused them of being spies. The Kremlin’s reaction was quick and brutal: transportation, communication, and money transfers between Russia and Georgia were blocked. Georgian citizens staying in Russia were forced to leave the country within 24 hours. And while some of the furor has died down over the past few weeks, the scent of hostility remains strong.

Meanwhile, Russia is building close ties with China – its nearest and biggest energy customer. Prior to 2006, the Chinese had tried to penetrate the Russian energy market, but Putin’s 51 percent Russian ownership rule applied to all foreigners, and the Chinese were no exception. Chinese bidders failed to win any of the tenders issued by Russia. But thanks to Putin’s March 2006 visit to China, that is likely to change. Hu Jintao and Putin signed a long memorandum of understanding that should open the Russian market for Chinese companies.

The biggest Sino-Soviet energy deal of 2006 was Sinopec’s purchase of TNK-BP’s non-core unit Udmurtneft, which produces over 7 million barrels a year. Sinopec’s acquisition would have been simple had it not been for some special conditions. According to the terms of the deal, Rosneft got 51 percent of the asset without paying a penny for the acquisition. Sinopec will provide all of the funding but will get only a 49 percent share. On the other hand, Rosneft inaugurated a new office in Beijing and announced its plans to launch some joint ventures in China. As part of the deal Russia committed to build a big refinery plant and more than 300 filling stations.

The growing number of deals with China helps both countries. China gets reliable supplies from a nearby source. Russia – facing contentious relations with many of its other neighbors and a growing dependence on the European market – gets to hedge its bets and gain entry to one of the fastest-growing energy markets on the planet.

Relations with the U.S.

Further, Russian politicians are criticizing America’s military interventions in the Middle East. They believe that the United States has been looking for a reason to open a new war for oil in the Middle East, a war that’s dictated by America’s unsatisfied ambitions for global energy dominance.

Conclusion

Of course, Putin and Gazprom haven’t been forced to choose – not yet. But when they do, we think that the Russian bear might not be as fearsome as many people now believe it to be.