The dispute between Ukraine and Russia over natural gas primarily revolves around the issue of pricing. In 2010, Russia agreed to give Ukraine a discount of $100 per thousand cubic meters of natural gas for extending the lease of Russia's Black Sea Fleet in Crimea. But the two countries' most recent energy contract, signed in 2009, partially tied future natural gas rates to the price of oil, leading to rate hikes from the mid-$200s per thousand cubic meters in 2010 to more than $425 per thousand cubic meters currently.

The increase has strained Ukraine's budget. Depending on the season, Kiev now pays roughly $1 billion for natural gas imports per month. In response, Ukraine has called on Russia to lower its rates. Moscow said it would comply but only in exchange for major concessions. These concessions include Ukraine's joining the Russia-led Customs Union and merging Ukrainian state energy firm Naftogaz, which controls the country's pipeline system and storage tanks, with Russia's Gazprom. On Oct. 9, Ukrainian Prime Minister Nikolai Azarov said Russia had offered to lower prices to $160 per thousand cubic meters if Ukraine joined the Customs Union. Moscow has neither confirmed nor denied Azarov's statement.

For Ukraine, joining the Customs Union or agreeing to a Naftogaz-Gazprom merger would amount to a major cession of sovereignty, so Kiev has thus far firmly resisted both conditions. As a result, the two countries have been jockeying for leverage in negotiations over the past several months.

Competing for Leverage

Russia's primary strategy has been to build natural gas pipelines that circumvent Ukraine. These pipelines, such as the Nord Stream pipeline, which came online in November 2011, undermine the leverage Ukraine has as a transit state for Europe-bound natural gas. On Oct. 8, a second line of the Nord Stream pipeline opened, doubling the capacity of the pipeline to 55 billion cubic meters. By the end of 2012, Russia is set to begin construction on the South Stream pipeline, which will run under the Black Sea and through the Balkans to deliver natural gas to southwestern Europe. Notably, that project is facing political complications from key transit states, such as Bulgaria. Given its position as an energy supplier and its insulation from the negative economic impacts of high energy prices, Russia is in a preferable negotiating position.

To prepare for its diminished role as an energy transit state and to limit its vulnerabilities as an energy importer, Ukraine has been steadily reducing its dependence on Russian natural gas. In 2010 and 2011, the country imported roughly 40 billion cubic meters of natural gas from its eastern neighbor. By comparison, Ukraine is on track to import 27 billion cubic meters from Russia in 2012 and, in September, submitted a bid to Gazprom to import just 24.5 billion cubic meters in 2013. 

To reduce its imports of Russian natural gas, Ukraine has expanded domestic energy production while lowering consumption and attempting to increase energy efficiency. Kiev recently struck a $3.5 billion deal with China to design and build coal gasification plants in Ukraine beginning in 2013, putting to use the country's nearly 34 billion metric tons of coal reserves. Kiev has also been in talks with German energy firm RWE to make use of "reverse-flow technology," which would enable Ukraine to import natural gas from Europe, making energy procurement cheaper and more efficient. Ukraine is also hoping to diversify through shale gas exploration (with assistance from Western energy companies), hydrocarbon projects off the Black Sea shelf and a planned nuclear power plant.

Political Considerations

With these projects in mind, Kiev has set a lofty goal of reducing imports of Russian natural gas to 12 billion cubic meters per year by 2017. Still, political and economic hurdles remain. For example, Russia prefers "take-or-pay" contracts, which obligate Ukraine to pay for supplies regardless of how much the country consumes. Moreover, Ukraine's poor investment climate and regulatory environment have made it difficult to attract foreign energy firms.

Ukraine's domestic political situation is another complicating factor. The previous government of Ukrainian President Viktor Yushchenko, which came to power in the pro-Western Orange Revolution of 2005, was frequently at odds with the Kremlin, leading to tense energy relations and two major natural gas cutoffs. The Yushchenko government was also beset with internal conflicts, most notably the personal rivalry between Yushchenko and former Ukrainian Prime Minister Yulia Timoshenko, making it difficult for the Kremlin to negotiate with Kiev. This environment produced the contentious energy agreement reached between Putin and Timoshenko in 2009 that is at the heart of the current dispute.

Since being elected in 2010, Yanukovich has consolidated political power, giving Moscow a unified political camp to deal with. But this has also made the president less willing to capitulate to Russia's demands. Yanukovich's grip on power will be tested in the upcoming elections, with the Ukrainian opposition unifying in hopes of eroding the ruling Party of Regions' hold on parliament. However, reducing dependence on Russian energy has broad public support, and the principle of maintaining sovereignty is one that transcends partisan politics.

Ultimately, the prospects of a deal will depend on economics as much as politics. Ukraine's ability to offset higher Russian prices by lowering its demand for imports has helped the economy stay afloat; gross domestic product is projected to grow by 2 percent this year and 3 percent in 2013. But a major increase in oil prices or a significant weakening or collapse of the Ukrainian economy could change the situation and force Ukraine into a deal. Barring such developments, Ukraine will likely continue to prolong negotiations to maximize its concessions — regardless of which party wins the elections.