Ukraine hopes for economic stimulus from gas transit system overhaul

By bne IntelliNews May 12, 2009

Graham Stack in Kyiv -

The Russian-Ukraine gas dispute in January set alarm bells ringing about the condition of the Ukrainian gas transit system (GTS) that transports 80% of Russia's gas to Europe. Its organizational and technological backwardness meant it wasn't possible to verify the conflicting Russian and Ukrainian claims about gas flows through the system. Another point of contention was the amount of "technical gas" that Ukraine needed to pump gas through the system, due to outdated compressor stations.

And as if the January dispute wasn't enough, in April a major Ukraine-Bulgaria gas pipeline exploded in Moldova, causing supplies to Bulgaria to fall by 70%. The pipeline, it transpired, was over 40 years old. One week later, on April 9, the same thing happened to a Soviet-era pipeline in Turkmenistan. This confirmed dire warnings by Ukrainian experts in 2008 that the former Soviet Union's over 40-year-old GTS was already living on borrowed time. And that Ukraine, at the heart of the system, was most threatened.

So the EU-Ukraine declaration of March 23 that committed Ukraine to revamp its GTS in return for billions of EU and international investment was long overdue. "We have been aware of the potential need for investments to modernize the GTS and of its importance as an economic asset for Ukraine for some time," Martin Raiser, head of the World Bank mission to Belarus, Ukraine and Moldova, and one of the signatories to the EU-Ukraine Declaration tells bne. "With rising gas import prices and the move to more transparent gas trading relations between Russia and Ukraine, there is now an opportunity to realize this potential."

Engineering a boost

Soviet Ukraine was not only at the heart of the gas transport system. The main engineering companies building and equipping this system were also located in Ukraine, which is why Gazprom still sources approximately 75% of its engineering needs from Ukraine. This means that any investment in the modernization of the GTS could have knock-on effects for Ukraine's crisis-stricken engineering industry.

"Ukrainian companies are standing ready to participate in the GTS modernization, including Sumy Machinery Plant, Motor Sich, Khartzysk Pipe Plant, and Novomoskovsk Pipe Plants," says Alfa Capital Ukraine analyst Denis Shauruk. "If Ukrainian producers will supply the modernization project with domestic equipment, the economic impact from such modernisation may range from 0.5% to 3% of GDP contribution annually, depending on the amount of investment in any particular year."

Ukraine's master plan for the modernization of the GTS, incorporated in the EU-Ukraine declaration, envisages a first phase of modernizing the existing transport and storage infrastructure, requiring $3.5bn over seven years, before a second phase sees new pipelines being built. Half of the sum for the first phase would to go to new compressor stations, with the rest divided between improvement of pipelines, underground storage facilities, and gas measuring stations at entry and exit points. This first phase holds most promise for machinery producers such as Sumy Machinery Plant, Gazprom's supplier of choice, and turbine manufacturer Motor Sich, which can supply high quality gas compressor stations and gas pumping aggregates.

Ukraine's authorities have apparently been quick to seize on the beckoning opportunities for local manufacturers. Ukrainian media reported in early April that Ukraine's Fuel and Energy Ministry had taken steps to prioritise local companies in awarding contracts. According to Kommersant Ukraine, immediately following the EU-Ukraine declaration, a memorandum was signed by the Fuel and Energy Ministry, Ukraine's pipeline operator Ukrtransgaz, state gas planners Urkgazproect, the Ukrainian Oil and Gas Institute, and engineering companies Zorya-Mashproect and Sumy Machinery Plant. The memorandum ascertains that the Ukrainian companies are "capable of satisfying all the needs of Ukraine's GTS," says the newspaper, and that pipeline operator Ukrtransgaz has named them as its "most likely suppliers" due to their positive collaborative history to date.

However, Ukraine's authorities might not find it that easy to channel GTS modernization orders to Ukrainian companies. The memorandum in fact contradicts the sixth point of the EU-Ukraine declaration, which specifies the observation by Ukrtransgas of "best practice international procurement rules," ie. competitive international tenders. Raiser emphasizes that the World Bank, as well as the European Bank of Reconstruction and Development (EBRD) and the European Investment Bank (EIB), prescribe procurement rules ensuring competitive and open tendering of goods and services. But this need not be to the detriment of Ukrainian companies. "Our rules do allow for some preferences for domestic manufacturers, and our experience shows that Ukrainian suppliers can often win under competitive tenders, particularly in civil works," says Raiser.

However, funds provided directly by the EU or national governments are likely to be tied to procurement sourced in those countries. "Ukrainian manufacturers can supply both high-quality pipe and compressor equipment, but the major share of any EU loan is likely to be spent on imports of goods and services from the EU. This is a normal condition of governmental loans," believes Mikhail Korchemkin, director of East European Gas Analysis.

Germany and Japan, both of which have shown interest in financing the GTS modernisation, have advanced engineering companies specialized in the natural gas sector, namely Man Turbo and Mitsubishi respectively.

Moreover, Prime Minister Yulia Tymoshenko agreed on April 29 with her Russian counterpart Vladimir Putin that Russian companies will also be involved in the work, possibly in exchange for Russian funding. This means that Ukrainian engineering companies could find that their slice of the action is less than they initially hoped. "The impact of the GTS modernisation plan on the Ukrainian economy may differ, depending on the degree of participation of Ukrainian companies, in the modernization contracts," says Alfa's Shauruk. "If a consortium of international banks will provide financing for modernisation of GTS and these funds will be channelled to purchasing imported equipment, the impact on the Ukrainian economy will be short term and negligible."

But World Bank's Raiser points out that Ukraine's GTS is a priceless asset in and of itself. "The benefit is not just the linkages that investment spending has on domestic producers, but also the maintenance of a critical asset, earning several billions of dollars in revenues a year," he says.

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