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And the Winner in Ukraine Is . . . China


Just before turning up at the St. Petersburg International Economic Forum, Putin sealed a massive deal with China for natural gas exports. Was Gazprom taken to the cleaners?

After three months of low-intensity but highly impassioned conflict between Ukraine and Russia since the Maidan Revolution overthrew President Viktor Yanukovych in February, both sides seem to be losing.  Ukraine is losing for the obvious reason that large swathes of its territory are annexed or ungovernable, and Moscow is turning the screws on gas prices when Ukraine can least afford it. Russia is losing because it is flirting with pariah nation status and enduring a self-inflicted recession for the dubious reward of Crimea, whose lack of land border with Russia proper will cost it a fortune, and Eastern Ukrainian chaos that Vladimir Putin seems as weary of as his counterparts in Kiev.

But last week a clear winner did emerge from the Ukraine debacle: China. What does China have to do with masked men waving Kalashnikovs in the half-ruined Donetsk coal basin?  It happens that Beijing has spent the last 10 years haggling with Moscow over natural gas imports -- very large-scale natural gas imports, for which it will pay in the neighborhood of $400 billion over the next 30 years.

The reason the two sides took so long to agree is the one you would expect, price. Before Ukraine blew up, analysts saw a wide gap, the Russians demanding $14 per million British thermal units (mmbtu) while the Chinese held out for $10.  Locked in a glowering match with his core customers in Europe, Putin had a new incentive to get to Yes during a state visit to Shanghai last week. He particularly needed a deal not to return empty-handed to the annual St. Petersburg Economic Forum, Russia's premiere annual investor event, which was already embarrassingly diminished by cancellations from Western CEOs and government types.

The Chinese, predictably, did not make things easy for Putin. The first day of his visit came and went with no gas pact. Negotiators clung to the table until 4 am on the second day, with the Russian president's jet back home all but revving on the runway. The price they finally agreed on was .... Well, actually all parties refused to disclose the price, even though Russian state giant Gazprom (OTCMKTS:OGZPY), which will execute the megacontract, is 49%-owned by mostly foreign private investors who might have a right to know. But as hints leaked out over the following days, it was clearly a lot closer to the Chinese position.

The best boast that Gazprom boss Alexei Miller could muster at St. Petersburg was that the price would be more than $350 per thousand cubic meters, which converts to $9.75 per mmbtu. That is to say, better than what China had been hoping for and even less than Gazprom gets from current European customers, which averages a little less than $11 per mmbtu. Then too Gazprom will have to spend maybe $30 billion building new pipelines from its West Siberian heartland and/or drilling for new supplies closer to China in East Siberia. "New capex will likely cause free cash flow to turn negative in the medium term," an analyst from Renaissance Capital in Moscow told Bloomberg, financial wonk language for Gazprom got taken to the cleaners. Gazprom shares stayed more or less flat on the news, while those of Chinese gas distributors like China Gas Holdings (HKG:0384) and Beijing Enterprise Holdings (HKG:0392) took a jump.

The political math that Putin cares most about looks somewhat better for Russia. The European Union, which currently gobbles about two-thirds of Gazprom's exports, is due to issue a new long-term strategy on energy security next month, and Russia's role in it may well be pared back given the confrontation over Ukraine.  Aside from diversification at a stroke, the China accord will act as a long-running stimulus package for Russia's sputtering domestic economy.  Putin, who turned up to present the keynote in St. Petersburg, estimated the contract would spur $55 billion in spending and create "the largest construction site in the world."

But locking Russia into what looks like a money-losing proposition for the next generation is hardly the ideal underpinning for its economy. China, which is choking on coal-fired pollution and was looking at buying liquefied natural gas at a 40-50% premium to Gazprom's tariffs, catches a nice break. Beijing will be only too happy to keep providing Moscow with a counter-balance to its troublesome Western customers, for the right price.    
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