How the EU Will Sanction Moscow Over the Ukrainian Crisis

by | published March 6th, 2014

For some time now, I have been telling you the real impact on the energy sector is global. Well, what has transpired over the past week in Ukraine is a clear testimony to that fact.

Now the focus of the Ukrainian crisis will shift from Paris – where negotiations have begun (however furtively) between the U.S. and Russia – to Brussels and what the European Union (EU) can accomplish in the way of sanctions.

Of course, the sanctions are only possible with U.S. support, and America has no direct seat at the EU table.

But the past few days here in London have once again reminded me of how little the West can usually accomplish without direction from Washington, D.C.

Everybody I am talking to, including representatives of Russian interests, recognizes the change in terrain regarding European responses.

There has been resolute oratory and posturing. But London can no longer lead; Berlin is already balancing its economic interests against the situation in Crimea; while the rest of Europe is worried about sanctions resulting in higher energy prices and the threat that Russia will reduce natural gas supplies moving west.

The emergence of such a possible split in European resolve is certainly among the calculations currently going on in the Kremlin.

And all of this presents an obvious question for energy investors…

It’s simple really: What will the nature of these sanctions be and how will they impact the energy markets?

The Eight Brewing Sanctions Against Russia

Since this is a two-part question, today I’m going to address the likely nature of the sanctions. And on Tuesday, I’ll suggest the best strategies for dealing with their impact.

Now assuming that Putin does not blink on Crimea (my initial expectation at least), a series of moves are certain to come from the West. That process begins in earnest today with the EU convening an emergency session at its headquarters in the Belgian capital.

But addressing the nature of sanctions today starts with a dose of reality. Despite widespread European criticism, bordering on outright condemnation of the Russian move into Crimea, this is not likely to be another “Charge of the Light Brigade.”

I’m referring to the fateful British cavalry attack against an entrenched Russian artillery position in October 1854. It took place during the Battle of Balaclava in the Crimean War and is immortalized in Tennyson’s poem. It remains one of the best examples of military valor resulting from a profound miscalculation.

In this case, the economic response to our current “Crisis in Crimea” will certainly be far more tempered. There will be an initial telegraphing of intent from the EU, one that will require a full sign off from the U.S. and approval from a beleaguered interim government in Kiev.

That’s why both U.S. Secretary of State John Kerry and Andrii Deshchytsia, Ukraine’s acting foreign minister, first traveled to Paris yesterday and then to Brussels last evening for today’s EU session.

But make no mistake: The sanctions will increase in severity the longer Russia attempts to increase its presence. That makes the sanctions regime an expanding one.

These are the eight elements I expect to be in the first expression of a combined EU-US response:

  1. A more formal commitment for an aid package to Ukraine; $15 billion has already been pledged by the EU to go along with $1 billion in loan guarantees from the U.S.;
  2. Suspension of joint military activities with Russia;
  3. Suspension of the G8 meeting scheduled for Sochi (the site of the recently completed Olympics in Russia);
  4. A freeze of designated Ukrainian bank accounts in Europe;
  5. A demand that Russian natural gas deliveries to Europe across all transport venues remains uninterrupted — some 60% of those imports move by the Ukrainian throughput pipeline system; this would be combined with a demand that Russian deliveries to Ukraine remain unaffected;
  6. An increased difficulty in — or outright prohibition of — visa approvals for travel to Europe and America by Russian officials;
  7. Threats to freeze Russian assets abroad — especially those controlled by Russian energy companies like Gazprom, Rosneft, and even LUKoil;
  8. Threats to limit Russian access to hard currency banking.

The Detail Behind The Possible Sanctions

Now matters may become more acute from there, should the crisis become more pronounced.

The EU-Russian formal mechanism for dialogue has to remain in place; otherwise, there would be no ongoing means to continue diplomacy. Ad hoc approaches are always less desirable as tensions increase.

The first five sanctions are of immediate need. First, Ukraine cannot survive without quick financial support. A collapsing financial picture there merely plays into the hands of a surgical Russian move into Crimea and perhaps Eastern Ukraine (also heavily populated by Russian-ethnic and Russian-speaking Ukrainians).

After all, the increasingly difficult economic situation in the country was the key reason Viktor Yanukovych, a Moscow-leaning president, was elected by Ukrainians the last time out in free and open balloting.

The next two merely reflect what either the U.S. has done already (suspend joint military activities) or has been expressed by several EU foreign ministers (suspending the next G8). Remember, the G8 used to be the G7 and comprises the principal industrial global powers. The initial seven countries brought Russia into the fraternity; they can always kick it out.

Number four may not be initially obvious, but is a very important statement to struggling Ukrainians. Corruption has been the main problem since independence. To allow the escaping former president and his cronies to profit sends the wrong message to the population they callously left behind.

The next is the major concern throughout Europe. Russia could suspend gas flows, as it did in two previous disagreements with Ukraine. As it happens, spring is hitting nicely these days in the UK, with warm weather. But that gas is essential to industry throughout Europe and that remains basic to employment, markets, and a weak economic recovery.

Now the only grounds Moscow would have to suspend gas deliveries is the failure of Ukraine to pay and claims that Kiev is syphoning off volume meant for transport to Europe. After all, that was the charge last time the flow was interrupted.

Given these problems in the past, Kiev agreed to pay in advance for gas consignments from Russian Gazprom. The pricing in these long-term contracts is determined by a basket of crude oil and oil products. They also have a take-or-pay provision.

The pricing means the gas costs more as crude oil prices increase. The second requires that Ukraine buy a minimum amount each month (usually 70% to 75% of the contracted amount) or pay as if they had. Kiev has been regularly avoiding this latter element and Gazprom has not made an issue of it. Now, of course, all bets are off. Moscow will be taking a hard line.

In addition to everything else, providing immediate financial assistance to Ukraine guarantees that contracted Russian gas consignments will continue. And that is as necessary for the European countries meeting today in Brussels as it is for the government in Kiev.

The sixth, restricting travel to Europe and the U.S. for Russian officials can be rapidly introduced, since visas are required and those can be coordinated and controlled by the governments.

Of course, that will be reciprocated by Moscow and more broadly than simply public officials. If the crisis persists, you should probably delay any vacations in Mother Russia. The visa hoops you would have to negotiate will become more than an inconvenience.

The last two comprise the real teeth of any economic sanctions and would signal a serious confrontation with Russia. Freezing corporate assets would certainly constitute a noticeable ratcheting up of the conflict with Moscow doing the same on their side.

The net damage, however, would be worse for Russia. And it would be a decided negative for foreign stockholders in Russian energy companies. Gazprom and Rosneft, the Russian-state controlled natural gas and crude oil companies, are available via depository receipts abroad. LUKoil is the largest privately-held oil company in Russia and is widely held by foreign investors.

A likely Kremlin response would be to freeze or even confiscate foreign holdings in Russia. This will have a bigger impact in Europe, where joint ventures between corporations and Russian companies are more pronounced. But there will be a more limited effect on selected American entities as well.

The Most Serious Sanction of Them All

It is the final sanction on my suggested list that is the most serious. The Russian budget has been under pressure for some time. It requires foreign sales of oil and gas because those sales provide the largest chunk of export revenues.

Virtually all of the exports are dollar-denominated, as are almost all oil and gas trade worldwide. Restricted access to foreign banking makes currency transfers more difficult and increases the cost of doing an essential business for Russia.

Moscow has claimed that it can set up alternative arrangements with trading partners using other currencies. While possible, this significantly increases costs and reduces revenues. It is inconvenient and places a new transfer expense into the calculation of prices and return.

Don’t assume this will bring Russia to its knees anytime soon. Heavy capital access sanctions have long been imposed on Iran’s far weaker economy, and the government has not collapsed, nor has civil war erupted.

Then there are the political developments inside Ukraine itself. Kiev has promised new elections to legitimize a post-Yanukovych government. That would make the transfer of power democratic.

Yet, using the same logic, the Russian position will be enhanced… and soon. There is a referendum scheduled for Crimea later this month. The heavily Russian-ethnic Crimean people will certainly choose more autonomy and a closer relationship with Moscow. And that will also be a democratic statement of popular intent.

Such developments will probably mean the current situation will be “resolved” by an evolving Ukrainian federalism, one in which Crimea will have more independence and Russia more leverage moving forward. There will be the reality of a permanent presence of the Russian Black Sea Fleet on Crimean territory.

That guarantees the underlying crisis continues without Russia having to formally annex any territory. And what happens in Crimea may portend similar developments in other Russian leaning areas of Eastern Ukraine.

What we need to do now is insulate our energy investments from these waves of geopolitics. That will be the topic in the next issue of OEI.

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  1. March 6th, 2014 at 15:29 | #1

    You excuse me, but you did not learned the lessons of history? Napoleon, Hitler tried to overwhelm Russia by force and fail miserably. Seriously believes that its proposed sanctions may have some effect in this geopolitical conflict?
    I think that you makes a serious error of appreciation and would ask you to do a deeper analysis of the problem not only facing EU and USA, but also to the south and east

  2. Sailor Jo
    March 7th, 2014 at 00:57 | #2

    Nobody would seriously entertain the idea of using military force against Russia. Their military may be a shadow of the former power only but still strong enough to cause heavy damage. Diplomacy and financial pressure is what may have some impact. We must not forget that the world is bigger than the US (there is no country America, no matter how often it is repeated), the EU and Russia. Russia can always count on China and others who despise the US for her aggressive actions.
    So Putin will get what he wants, more money through higher energy prices and more power as a result.
    The Europeans don’t like the idea of fracking for good reasons. So they continue on their path of renewable energy. Raw materials become less and less important because of recycling. Germany recycles 90% of the aluminium (I use UK English) being used. Germany also uses since decades cleaned gas from “land fills” to power city buses. So there are alternate sources of energy though they do not represent international investment opportunities. For that we better listen to Dr. Moors.

  3. Alexandru, Romania
    March 9th, 2014 at 01:05 | #3

    Just a little hint that popped in my mind: What will Russia do with the $43 billion gas reserves? Sell it to North Korea, to China?
    How about Israeli interests in Russia? Remember, 70 % of the Russian oligarchs are Russian-Israeli. Regarding the economic sanctions: Let’s put in balance EU/ US assets in Russia vs the Russian ones in the whole West.

  4. Jeff P. from Canada
    March 10th, 2014 at 07:10 | #4

    Crimea is lost to Russia. In the end there is little that the rest of the world can do to prevent that, short of direct military action. As when Russia invaded Georgia, there will be a period of turmoil and then it will all settle in to a general acceptance of the situation. If that happens, then it is only a matter of time until Russia picks another target to expand into. The only way that this expansionism will be halted is if the west puts a serious military threat in Ukraine, either a U.S. base or an EU military base. That would drive Russia nuts but they have to understand that there will be further consequences for their expansionistic efforts.
    And I am still wondering if Gasprom found a large oil or gas reserve in or around Crimea, prior to the invasion, and this whole invasion is all about seizing those assets and denying Ukraine those same assets. If there is a large, as yet undisclosed gas or oil reserve in or around Crimea, and if that reserve was to be developed by Ukraine, then it would cause a huge loss of power to Russia because they would no longer have a strangle hold on Ukraine and Ukraine could be selling those reserves to the West which would further reduce Russia’s economic power. It will be interesting to see if, two years down the road, Crimea all of a sudden becomes a major exporter of gas or oil.

  5. yngso
    March 11th, 2014 at 08:52 | #5

    ThereĀ“s the noise and real signals. I still believe that too much deoends on things more or less staying the same. Aexandru has a very interesting point about the huge undeveloped natgas resources in Ukraine…

  6. TRex
    March 17th, 2014 at 22:38 | #6

    Jeff P., Crimea is far from lost. It is, by Russian and international treaty a Ukrainian province. Persons born there are Ukrainians unless they choose to be Russians (and Russia wants them, and they don’t). Exactly the same thing happened in Lithuania, and ethnic and actual Russians were required to have visas, at which time they were given 30 days to return to Russia. Russia could not accommodate and borrowed millions from the US to build housing. In the mean time they made concessions to Lithuania to allow Russian citizens to stay (until housing was built). Some returned, the smarter ones became Lithuanian citizens. Ukraine has international treaties and principle on it’s side. Russia has Ras-Putin, the half-mad ex-KGB thug. There is NO reason for Ukraine to capitulate to terror. Ras-Putin, like a rabbit through the Russian python, will all so pass in several years into the cesspool of Russian history.

  7. March 20th, 2014 at 14:53 | #7

    We should resurrect General Patton. He wanted to kick the Ruskies back to Moscow when we had the muscle to do it. We can’t keep letting Russia expand its territory. It’s time for Putin to be Putout.

  8. March 20th, 2014 at 17:17 | #8

    hope they would solve this diplomatic saction without hurting the economy…….. Aloha….

  9. April 5th, 2014 at 13:44 | #9

    OK, now that Crimea seceded from Ukraine and returned to Russia, where it was from 1783 to 1954, where do we stand? The leader of Right Sektor was killed in a tussle with Ukrainian cops, but it and Svoboda still have 4 ministries in the Kiev government, which was installed through a putsch by neo-Nazi stormtroopers – the real kind, with swastikas, Nazi salutes, and the rest.

    Now let’s consider the American response if the Russians or Chinese arranged a coup d’etat in Canada that brought to power a pro-Chinese government extremely hostile to the United States which contained a number of ministers allied to al-Qae’da. Would the United States sit still for that?

    So Russia, which clearly understands and believes the stated American intention to bring NATO military bases up to the Russian border and to bring Russia under American domination as in Yeltsin’s days, is simply not going to put up with that. And the United States does have a minor problem. It is a large net importer of petroleum that is in no position to do anything to supply European needs, whose fracking bubble is already peaking, and RAussia doesn’t have that problem.

    The United States, contrary to the dreams of “Fuck the EU” Victoria Nuland, will not be able to turn Ukraine into an American client, and even the western Ukrainians who supported the coup may lose their taste for NATO and the EU as the begin to get the Greek treatment this summer.

    And we may be confident that the Russians will not gobble up the rest of Ukraine, being content to protect the east from the militias of the Kiev government. As the US learned in Vietnam, and the Soviet Union learned in Afghanistan, taking responsibility for incompetent client states can be a big and expensive mistake, which Russia will be pleased to allow the US and EU to make.

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