The biggest story of the day is Russia’s decision to cut off the supply of natural gas to the Ukraine.

It’s a story best covered by Jerome a Paris, but I will give it a shot.

The state-controlled Russian energy giant Gazprom cut off the supply of natural gas to Ukraine on Sunday after weeks of intense negotiations, including a last-minute intervention by Russian President Vladimir Putin, failed to resolve a dispute over pricing.

The dispute is ostensibly centered on Gazprom’s desire to move immediately to market pricing and Ukraine’s willingness to accept only a phased transition to the kind of prices paid in Western Europe. But the stand-off has a fraught political backdrop and could also have potentially far-reaching implications for Europe, which is increasingly dependent on Russia for critical supplies of natural gas.

Europe is concerned because they rely on Russian gas for about 25% of their supply, and 80% of that gas traverses the Ukraine. Russia has promised that European supply will not be affected (technically, they haven’t cut off the supply, but lowered the pumping pressure so that less gas is fed through the system). But the Ukraine insists they are entitled to 15% of the gas as a transit fee. There are reports that the Ukraine is already siphoning off gas, and that could cause shortages in Europe.

Despite Russia’s claims that this move is necessary to move to market pricing, it is clear that the Ukraine is being punished for the decision to align themselves with the West.

After months of negotiations, Gazprom announced late last month that it intended to raise prices for Ukraine from $50 to $230 per 35,300 cubic feet of gas — an increase that would have a severe impact on Ukraine’s economic growth. Some of the country’s key industries, including steel and chemicals, are heavily dependent on gas for energy.

Ukrainian officials rejected an offer from Putin to freeze prices at 2005 levels for three months and then shift to the $230 price. The Ukrainian government wants a much slower transition to higher prices, and Yushchenko suggested a price of $80 for 2006.

Under new pricing accords, Armenia, Georgia and the Baltic States pay $110 per 35,300 cubic feet. And Belarus, an increasingly authoritarian country closely aligned with Russia, pays $47. Gazprom officials say that Belarus has provided the company with a stake in the pipeline that crosses its country, allowing the company to continue to provide subsidized gas.

Ukraine has rejected any compromise based on giving Gazprom a stake in its state-owned pipeline network.

The dispute is a tangled mess, involving a mixture of capitalist impulses towards free markets versus state-owned energy companies. Russia is clearly throwing their weight around. They have used subsidized energy to maintain influence in the former socialist republics. Now, they are cutting new deals based on the degree to which their interests are respected, rewarding friends and punishing the recalcitrant.

Jerome says: “Russia CANNOT afford to cut off gas and be seen by Europe as an unreliable partner in the energy sphere, the only one where it is a serious player.” Yet, that is exactly what they have just done.

If this cutoff lasts very long, Europe will start to make difficult choices precisely because they will no longer see Russia as a reliable partner.

Wars have been fought over much less, and we should expect some turbulence in the region if this dispute isn’t quickly resolved.

For background on the more local issues (corruption) that may be at play, see Jerome’s Making sense of the Russian-Ukrainian gas spat.