by Nicholas Watt

Almost exactly one year ago in the southern Russian city of Anapa, Vladimir Putin, in an auditorium filled with energy company executives and high-ranking international government officials, launched construction of the South Stream pipeline. Projected onto a giant screen directly behind the Russian president was live footage of the welding of the first two pipes of the project that will cost about $20 billion. South Stream will carry Russian gas under the Black Sea, through Bulgaria and Serbia, and on up through central Europe. Though this launch ceremony was more symbolic than anything, now – a year later – is an appropriate time to revisit the reasons this costly project was set in motion. South Stream is often portrayed only as a means by which Russia can enhance its geopolitical position. This interpretation is provocative and attracts readers, but is over-simplistic because it overlooks the pipeline’s economic basis. Gazprom’s economic rationale behind this costly pipeline may not be compelling, but it is logical. This article strives to illustrate this logic.

Some may understand South Stream as some kind of political bludgeon that Putin will be able to wield over Yanukovych’s head whenever the Ukrainian president acts out of line. While it is true that South Stream will run contrary to Ukrainian national interests, its primary purpose is to sell Russian gas to Europe – a novel but important point given the hysteria surrounding the protests in Ukraine. Currently, about 50% of all of Russia’s gas travels through a pipeline system controlled by Ukrtransgaz, a Ukrainian state-owned Naftogaz subsidiary, before it reaches European customers. South Stream will bypass Ukraine, and if running at full capacity, could, in principle, decrease this figure to zero, thereby depriving the former Soviet region of significant transit revenue and a key geopolitical lever over Russia. At the time of the infamous 2009 gas crisis, 80% of European-bound gas went through the Ukrainian controlled system, highlighting the importance of a good (and if not good, then workable) relationship between Russia and Ukraine.

Gazprom’s economic rationale behind South Stream may not be compelling, but it is logical.

This importance is amplified when you consider the kinds of gas contracts Russia’s Gazprom has with its European customers west of Ukraine. If you take, for example, the gas supply contract between Gazprom and Poland’s PGNiG, the gas delivery point is not at the border between Russia and Ukraine, but at the border of Ukraine and Poland. What this means is that if Ukraine chooses to disrupt the flow of gas to Poland, then Russia’s Gazprom is legally liable. Continued transit of Russian gas through Ukraine, therefore, relies in large part on trust between the leaderships of the two countries.

Such a delicate trust is untenable when the stakes are so high; Russian gas sales provide significant revenue to the Russian state – roughly 7% of the state budget. Ukrainian control over the transit of much of this lucrative commodity poses a serious risk and the Russian state will do what it can to protect these sales and reduce that risk. South Stream should not be seen as the optimal choice of doing so, however. Another cheaper and more reasonable option would have been for Gazprom to take over the Ukrainian transit system. Negotiations over Russian acquisition of this system have been underway since the 1990s – long before discussion of South Stream, which was conceived in 2007. Ukraine is and has been understandably reluctant to part with what may be its most valuable economic asset and its most valuable geopolitical lever over Russia. Once South Stream comes online, however, the value of Ukraine’s system will be greatly diminished.

Part of successfully selling gas to a particular region is making sure that others do not do so before you. South Stream has served this purpose by beating out the initial Nabucco project.

Russia acted quickly to mitigate the risk following the 2009 crisis, and as Ukrainian transit pipeline negotiations bore little fruit, South Stream gained momentum. As the crisis was the most significant impetus for this new momentum, understanding the 2009 crisis is key to understanding South Stream. The gas cutoff is often perceived as Putin punishing Ukraine for its western leanings, such as supporting Georgia in the 2008 war or adopting more pro-NATO and -EU stances on issues. The economic reasons are sometimes forgotten or added only as a side note. On the eve of the crisis, no supply contract had been signed to provide Russian gas to Ukrainian markets, and this gas was cut off. Russian gas to European markets through Ukraine continued for a few days, until Russia stopped all flow, accusing Ukraine of stealing some of this gas meant for Europe. Naftogaz’s consistently delinquent gas bills, which by the time leading up to the cutoff amounted to $2 billion outstanding, for already below market-priced gas could explain much of Russia’s uncompromising attitude.

Just because South Stream is hostile to Ukrainian interests does not mean that it is being implemented with the specifically designed purpose to hurt Ukraine. A $20 billion investment for the sake of punishment does not make sense. South Stream is being built to sell gas to southeastern Europe. For all of the natural gas that Russia has, it has not been very successful at selling it, except in Europe – the primary export destination for Russian gas since the late 1960s. Russia is painfully behind other countries in LNG development, a method of transport that would give Russia greater market options, and Gazprom’s negotiations with China have been embarrassingly slow and fruitless. Selling piped gas to European markets is Gazprom’s bread-and-butter and South Stream’s construction keeps with this trend.

Part of successfully selling gas to a particular region is making sure that others do not do so before you. South Stream has served this purpose as well by beating out the initial Nabucco project, which was conceived in 2002 and had the support of both the EU and the US. From 2007, when South Stream was conceived, until the summer of 2013, when Nabucco West lost out to the TAP pipeline, Nabucco and South Stream were competing for roughly the same southeastern European markets. The coexistence of two huge pipelines feeding roughly the same markets was a financial impossibility, and as South Stream progressed forward, support for Nabucco waned as the EU-sponsored pipeline struggled to find suppliers and its investors were unwilling to take on the financial risk of supporting what would have been a redundant pipeline.

Another question is not about risk or competition, but about numbers. South Stream’s 63 bcm capacity eclipses demand for the markets it is slated to supply. One trunk, instead of four, would be roughly 16 bcm and would more closely reflect regional demand. Alexander Medvedev, chief of Gazprom Export, at an investors meeting in 2012, admitted the possibility of sizing the project down a line or two. The official figure of 63 bcm may stay there just because it will be easier to size down later by delaying construction of one line than to start at a lower negotiating point and scaling up. Additionally, a 63 bcm pipeline may have been more effective in squashing Nabucco than a 15 bcm or 30 bcm pipeline would have been.

One can be reasonably confident that South Stream will be realized in one form or another with Forbes 2013 world’s most powerful man in Vladimir Putin serving as its biggest cheerleader.

There is much legal uncertainty surrounding South Stream at the moment. There are two provisions of a 2009 piece of EU legislation called the Third Energy Package that particularly threaten Gazprom’s business model: “ownership unbundling” – that transmission and supply be controlled by separate entities – and “third party access” – that other gas suppliers be given access to pipeline infrastructure. Just last week, the European Commission ordered all of Gazprom’s bilateral deals with EU member countries regarding South Stream to be redone; Gazprom has no intention of following this order. The European Commission will continue to battle to make sure that South Stream fits into the framework of the Third Energy Package and Gazprom will continue to resist. One can be reasonably confident, however, that South Stream will be realized in one form or another with Forbes 2013 world’s most powerful man in Vladimir Putin serving as its biggest cheerleader.

South Stream should be viewed primarily in the context of Russia’s natural gas strategy of maximizing export revenue for both the present and the future. Whether or not this strategy is being executed successfully is debatable. Indeed, South Stream has been maligned as too big, too expensive, too politically charged, and too technically difficult to be justified. The sorry state of current Russian-Ukrainian relations has played a central role in causing Russia to favor construction of this controversial pipeline over the pursuit of a compromise with Ukraine that could have seen continued or even increased transit of Russian gas through Ukraine on mutually acceptable terms. As Ukrainian leadership is flirting with signing an Associated Agreement deal with the EU, it remains to be seen what gas concessions Russia is willing to give up to sway its western neighbor. Perhaps, we will see Ukraine paying a lower gas price if the country continues to reject the Association Agreement, but cancellation of South Stream is likely off the negotiation table. Vladimir Putin has already thrown too much weight behind the project to back down and unless something drastically changes with Russian-Ukrainian relations, the risk that South Stream was designed to reduce will still be present.

Nicholas Watt is an alumnus of the ENERPO program and the editor-in-chief of the ENERPO Journal.