Russia’s cutoff of gas supplies to Ukraine Tuesday caused alarm in Western Europe, much of which is dependent on Russia for gas, but was quickly resolved. However a Russian state that controls important natural resources and that operates by nationalist whim rather than by market demands potentially imposes huge costs on Western economies. The “peace dividend” of the 1990s may yet have to be repaid.

Gas is supplied from Russia to Ukraine and Western Europe by the Russian state controlled gas company Gazprom through a collection of pipelines, the largest of which run through Ukraine (the Yamal pipeline runs through Belarus to the north, the new Blue Stream pipeline from the Caspian fields runs directly under the Black Sea to Turkey and there is also a small pipeline through Moldova.) Ukrainians had been foremost in the development of the Soviet gas industry in the 1920s, and Ukraine also has the advantage of containing most of the gas storage capacity of the former Soviet Union as well as its only producer of gas pipe of more than 1 meter in diameter, necessary for large volume international deliveries.

During the period when Ukraine remained closely aligned with Russia gas negotiations between the two countries had been fairly friendly – in one negotiation in 1993, the Russian negotiators spoke Ukrainian, but the Ukraine team were all ethnically Russian, and did not do so! Russia had typically supplied gas to its satellites at subsidized prices during the Soviet period, and in the case of Ukraine continued to do so after 1991, although Ukraine’s own foreign exchange shortages meant that payment was often made very late or by delivery of goods such as tractors in compensation. From time to time, Russia would attempt to cut off Ukraine in order to enforce payment for the gas, but Ukraine in turn would reduce deliveries through the pipeline system to Europe by an equivalent amount. Russia’s only recourse in such cases was to make deliveries to Europe from gas companies other than Gazprom, or by routes that did not pass through Ukraine.

In 2004, in the run-up to the crucial Ukrainian election in December of that year, Gazprom signed a 5 year supply agreement with Ukraine at a price of $50 per 1000 cubic meters. After the “bad guys” (from Russia’s point of view) won the Ukrainian election, Russia demanded a renegotiation of that agreement to a world price of around $235. Wednesday’s settlement of the dispute allowed for Gazprom to sell gas to RozUkrEnergo AG, a Swiss-based joint venture between Gazprom and the Austrian Raiffeisenbank, at $230 per 1000 cubic meters after which RozUkrEnergo will sell it to Ukraine at $90 per 1000 cubic meters. This enabled the Moscow Times to trumpet that Gazprom was to receive $230 for its gas, while the Ukrainian press and most of the Western media announced that Ukraine was to pay only $90. Raiffeisenbank presumably not being willing to subsidize its joint venture to the extent of $140 per 1000 cubic meters, this looks like a typical post-Soviet negotiation in which the only solid reality will be that all the officials involved will get nice fat rake-offs!

As a reality check (to the extent that any such thing exists in Russian-Ukrainian negotiations) the spot price of natural gas from the U.S. Henry source Wednesday was $9.25 per 1000 cubic feet, equivalent to $327 per 1000 cubic meters. The average U.S. wellhead price paid in 2004 was equivalent to $194 per 1000 cubic meters, but natural gas prices have risen since that point in line with oil prices. In other words, $230 per 1000 cubic meters is likely to be closer than $90 to a true market price, and the RozUkrEnergo structure would appear to be a mechanism for the Ukrainian government to pull the wool over voters’ eyes in the run-up to the Ukrainian parliamentary elections due March 26.

This would be an unimportant spat between two impoverished political primitives were it not for the new Gazprom-controlled Northern European Gas Pipeline to be built across the floor of the Baltic Sea, bypassing Poland and the Baltic states, of which former German Chancellor Gerhard Schroeder has accepted the Chairmanship. By supplying gas to western European customers through NEGP, Russia will be able to blockade Ukraine, the Baltic States and Poland, thus exerting economic pressure on those countries that could potentially become severe.

Putin’s willingness to use every means of pressure available to him and the Russian government’s priority for political over economic realities cannot be in doubt. In turn, these preferences make Russia both a politically dangerous supplier of essential commodities and one whose long term performance cannot be relied on.

In the oil sector, where Russia is the world’s second largest supplier after Saudi Arabia, Russian production in the early years of this decade ramped up rapidly, from 6.48 million barrels per day in 2000 to 6.92 million in 2001 (+6.8 percent) to 7.41 million in 2002 (+7.0 percent) to 8.13 billion in 2003 (+9.7 percent). The rise in world oil prices which began in 2002 appeared to be having an effect in increasing Russian production, as in a free market it should. Then in late 2003 Putin arrested Vladimir Khodorkovsky, Chief Executive of Yukos, at that time Russia’s second largest oil company, from which point property rights in the Russian oil sector came seriously into question. In spite of the very rapid rise in world oil prices in 2004-05, to levels undreamed of only 3 years earlier, the growth in Russian production began to slow; to 8.81 million barrels per day in 2004 (+8.4 percent, a lower increase than in 2003) then to only 9.01 million barrels per day in the first 10 months of 2005, an increase of 2.3 percent on 2004’s production, or 2.7 percent annualized to a full year.

The Russian oil sector is now predominantly state owned, and the private portion of it is controlled by corrupt Putin cronies; it’s not surprising that the rapid increase in production in 2000-03 has slowed sharply. This was not expected by outsiders; official forecasts had been for an increase of 5.7 percent in Russian oil production in 2005, compared to the 2.7 percent actually achieved, and official growth forecasts for 2006 are around 2 percent. Since oil prices are currently around double their level in 2002-03, when Russia was enjoying record production increases, it is clear what effect the country’s corruption and economic obscurantism is having.

In 2000-02, it had been hoped that Russia would provide both a reliable source of hydrocarbons, and one whose output would rapidly increase to meet the expected surge in demand, especially from rapidly growing emerging markets such as China and India. This has not happened, and the outlook for world oil supplies must accordingly be considerably more clouded than had been thought to be the case, with higher prices likely.

Russia’s political changes in the past few years have been well aired in the Western media; their overall effect is likely to be a perpetuation of the corrupt and authoritarian Putin regime after Putin’s own presidential term ends in 2008. Property rights will be violated wherever convenient, Russia’s political goals will be emphasized over economic realities, productive sectors of the Russian economy will remain inefficient and unreliable, and foreign policy adventurism will be attempted wherever it seems attractive to Russia’s overall goal of rebuilding the Soviet Empire.

Thus (i) Western Europe cannot rely on Russia for gas supplies but must diversify its sources elsewhere, doubtless at increased cost (ii) Russia is not a reliable counterweight to OPEC in the oil market, but a rogue producer, possibly aligned with OPEC radicals in a crisis, whose output is unlikely to increase and cannot be relied upon and (iii) the military and security expenditures which the United States and Western Europe benefited from winding down in the 1990s need to be to a considerable extent rebuilt.

George W. Bush’s fatuous declaration in June 2001 that he had “looked in Putin’s eyes and got a sense of his soul” now seems an appalling misjudgment, as does the Bush administration’s monomaniacal concentration on the threat from a fringe group of extremist Islamic terrorists. Security expenditures must be correspondingly increased to address both the continuing terrorist threat and the increasing danger from an aggressive and revanchist Russia, her military machine fueled by high oil prices.

The total cost to the United States and the EU from Russia’s increasing authoritarianism can only be guessed at, but can hardly be less than 2-3 percent of U.S. and EU Gross Domestic Product. The cost to the West of Russia’s turn to the Dark Side is thus likely to be considerably greater than the GDP of Russia itself.

As the Russian commissars have always known, Russia is far more important as a threat than it ever could be as a business partner.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.