Are higher gas prices raising the 'pressure' on Ukraine's gas transit system?

The price Ukraine pays

Currently, Ukrainian Naftogaz covers around 80% of its gas demand with imports from Russia. In 2010, Ukraine consumed around 52 BCM. The price for gas it buys from Russia is based on a ten year oil indexed contract from 2009, signed by then Prime Minister Yuliya Timoshenko. However, in April of 2010, the Russian state provided a 30% 'discount' on the gas price for Ukraine by freeing Gazprom of paying export duties on its sales to Ukraine with a maximum 'discount' of $ 100 per 1,000 CM. Ukraine was only granted the 'discount' after it agreed to prolong the stay of Russia's Black Sea Fleet in the Ukrainian port of Sevastopol for another 25 years after 2017.

But as the Ukrainian leadership has been making clear, the price for Russian gas remains too high. As the Ukrainian Deputy-Prime Minister, Sergey Tihipko, put it in a recent interview, "the gas price for Ukraine cannot increase in light of a lower gas price in European countries". Some suggest that Ukraine could again have difficulties with its gas payments to Gazprom. The state budget for 2011 does not foresee a gas price as high as was recently forecasted by Gazprom. According to a recent forecast, the gas price for Ukraine is to hit $ 400 / 1, 000 CM (including the 'discount') in the 4th quarter, from $ 350 in the 3rd quarter. As to illustrate the price increase, in the 1st quarter Ukraine paid $ 263 / 1,000 CM.

Gas talks

In the past months there have been several rounds of gas talks between the two and it continues to dominate Russian - Ukrainian relations. In the run up to a meeting with Russian Prime Minster Vladimir Putin on 7 June, where a revision of the gas contract was be discussed, the Ukrainian Prime Minister, Mykola Azarov, expressed hopes that Ukraine would be able to convince Russia to revise the price formula. However, at the meeting Prime Minister Putin agreed to set up joint working groups that would look deeper into the matter, but no further promises were made. Next day, the clearly disappointed Azarov stated that Ukraine would make maximum efforts to diversify its gas supplies. 

Russia, on its turn, is willing to consider a revision of the gas price under certain conditions. The main condition is that Naftogaz merges with Gazprom or that the two form a joint venture (JV) under which Ukraine's GTS can be operated. Gazprom prefers such a solution, because it would provide it with a higher degree of transit security through Ukraine. Already in February 2011, Gazprom CEO, Alexey Miller, stated that his company was interested in such a solution. More recently, he has made clear that this remains the main condition. During a meeting, on 21 June, between Naftogaz and Gazprom, the proposal was again put forward, Kommersant-Ukraina reported on 22 June. Under such a scenario gas prices for Ukraine would reportedly be 40% below European prices, according to an anonymous source from the Ukrainian Energy Ministry familiar with the talks. At Gazprom's annual shareholders meeting, on 30 June, Miller again stressed that Gazprom would be prepared to revise the gas price for Ukraine, but only after signing an agreement on the merger of Naftogaz and Ukraine.

Merger plans

The idea of merging the two companies is not new and was at first proposed by Russian Prime Minister Vladimir Putin in April 2010.  The merger would give Ukraine access to lower gas prices and, possibly, gas production in Russia as well. This idea did not receive a warm reception in Ukraine, mainly because of fears that state company Naftogaz would be 'dissolved' in gigantic Gazprom, leaving Naftogaz without a voice in the merged company. Judging by some of the most recent statements, Ukraine might have revised its position or at least does no longer exclude the idea of JV between Gazprom and Naftogaz.

In mid April, Prime Minister Azarov confirmed his country's interest in a JV with Gazprom. But in an interview with Russia Today stressed that a JV should be mutually beneficial. A JV between the two whereby Naftogaz' share would, for example, make up 3,5%, would not be mutually beneficial, according to Azarov. Another option that is being considered by the Ukrainian leadership, is the partial sale of Naftogaz shares, as suggested by Ukraine's Energy Minister, Yuri Boyko. In a statement earlier this year, Boyko said that up to 25% of Naftogaz' shares might be put for sale in the course of 2012-2013. The shares could reportedly bring in between $ 5-6 bln. However, it must be stressed that Ukraine wishes to see both Russia and the EU as shareholders and not just one single party.

Modernisation of the Ukrainian GTS

Ukraine has made several attempts to involve both Russia and the EU in the modernisation of its GTS. It believes that Russian and EU participation would be a way to share the costs for modernising its GTS, costs that Ukraine cannot cover on its own. Moreover, EU and Russian participation would serve as a guarantee for future transit volumes through Ukraine's GTS, which is an important source of revenue for the state budget. With the construction of the Russian backed South Stream, Ukraine fears that it might lose this important source of revenue.

Until now, Ukraine has not succeeded in involving both the EU and Russia. Nevertheless, Naftogaz has announced that, despite the high costs, it will start the modernisation on its own. However, whether this entails a full scale modernisation remains to be seen. A spokesperson of the Ukrainian Energy Ministry described the modernisation as a group of projects different in size and cost, but admitted that a modernisation, as referred to in the 'Brussels declaration', would require international assistance. For the time being it seems that the future of Ukraine's GTS lays in the hands of those outside Ukraine.

Meanwhile Ukraine's ruling Party of the Regions is opening up the way in parliament for the privatisation of the GTS. This latest development suggests that Ukraine is creating the legal basis for Russian and EU parties to become shareholders. The existing legislation imposes a moratorium on the sale of Naftogaz and any of its subsidiaries or affiliated companies. If Russian Gazprom seems to be interested in such a plan, Brussels appears to be prepared to allot funds only in return for political reforms in Ukraine.

The Dolyna Compressor station, in Ukrainian Ivano-Frankivsk region, is part of the Ukrainian GTS. Ukraine has announced it will start modernising its GTS, but nevertheless would require international assistance for a full scale modernisation.

Ukraine finds new energy partner in China?

In order to convince Russia to offer it a lower gas price, Ukraine realises that it has to make concessions, but at the same time it is on the look out for new energy partners. In late May of this year, the Ukrainian state nuclear company Energoatom, which operates all of Ukraine's nuclear power plants (NPP), signed an MoU with its Chinese counterpart CNNC. Several weeks, later another MoU on energy cooperation was signed with China during a state visit of the Chinese President, Hu Jintao, to Ukraine. When meeting with Hu Jintao, Ukrainian President Viktor Yanukovich did not forget to mention Ukraine's interest in participating in the construction of the Russian-China Altay gas pipeline.

Some experts seem to believe that Ukraine's 'sudden' interest in energy cooperation with China is mainly motivated by the desire to prove to Russia that it is capable of forging new partnerships with major world powers and in this way wishes to gain more leverage in talks with Russia. Ukraine's nuclear industry has traditionally only cooperated with Russia.

Ukrainian LNG terminal

In order to diversify its gas supplies Ukraine has also announced plans for the construction of an LNG terminal on its Black Sea coast at an estimated cost of $ 1.5 bln. The Ukrainian state would allegedly hold 25% of the shares, while the remainder would be offered to private investors. Reportedly, an investor is to be found before the end of the year. Western companies, such as, ExxonMobil, Chevron and Shell have showed interest in participating in the project.

According to the plans, initial volumes would be 2 BCM / year, already in 2013, and could reach as much as 10 BCM by 2020. LNG could come from Azerbaijan with whom Ukraine has reached a preliminary agreement. A precondition would of course be the construction of an LNG plant in Georgia. This still seems something of the distant future. Therefore some experts believe it is just another way of trying to gain more leverage in gas talks with Russia.

Is the EU worried?

With the gas crisis of January 2009 still in mind, Brussels seems to be carefully watching the revived discourse between Russia and Ukraine. This led the European Commission (EC), in early June, to demand from Ukraine additional guarantees for the transit of Russian gas through Ukraine, guarantees it did not receive. Ukrainian First Deputy Prime Minister, Andrey Klyuyev, told press on 2 June, that Ukraine agreed with the EU that there would be no financial sanctions for Ukraine in case of interruptions of gas transit to European countries. According to Klyuyev, Ukraine had convinced the EU that there would be no disruption of transit, as Ukraine was not linking the price and transit issues.

Although Ukraine has succeeded in reassuring the EC that the there would be no such thing as a disruption of transit, Azarov's statements of mid June on Ukraine's Channel One could be interpreted as ominous. Azarov warned that Ukraine's gas agreement with Russia was not for ever, "The time will come when we will breakup the agreement, it is therefore better to, sooner or later, reach a normal composition of this contract." In what way such a contract break up would proceed remains unclear, but possibly could follow the path of arbitration. Ukrainian weekly Zerkalo Nedely reported on 14 June that the Ukrainian Energy Ministry was considering to take the case to Stockholm's Court of Arbitration and was, in this respect, already consulting Swedish lawyers.

A new deal?

A new round of gas talks is scheduled for mid July, but talks could easily stretch out for more months to come. As the gas price continues to increase, Ukraine's negotiation position grows weaker and with it the pressure to offer concessions. Meanwhile, however, another issue is causing growing tension between Russia and Ukraine and could directly affect the outcome of gas talks. With Ukraine striving to reach a Deep and Comprehensive Free Trade Agreement (DCFTA) with the EU, the Russian-led Customs Union (CU) has taken protective measures against Ukrainian metal exports to CU members Belarus, Kazakhstan and Russia. The metal industry is an important industry in Ukraine and such protective measures would make themselves felt.

Russia would much rather see Ukraine join the CU in stead of the DCFTA. In case Ukraine reaches a DCFTA with the EU, CU-membership is no longer possible and chances for a revision of the gas price in Ukraine's favour could be marginalised. Most likely, a revision of the gas price would occur in the style of the Kharkov addendum from April 2010. It will be tied to an important Ukrainian asset or interest, for example Naftogaz or the CU, and as usually is the case, it will come unexpectedly.