Winter freeze looms as “transit-less” Ukraine scrabbles for Russian gas

By bne IntelliNews September 14, 2015

Sergei Kuznetsov in Kyiv -


With the approach of winter, the government in Kyiv is trying to muster funds to stockpile Russian natural gas ahead of the heating season and secure an affordable gas purchase price under a new "winter package".

Meanwhile, one of its chief bargaining chips and money-earners seems to have been snatched from its hand: Kyiv is incensed by the recent decision of European energy companies to sign a shareholders' agreement with Russia’s Gazprom about the planned Nord Stream-2 gas pipeline.

"What does the construction of Nord Stream-2 mean for Ukraine? First, it absolutely excludes Ukraine from transit supplies to the EU," the country's prime minister, Arseny Yatsenyuk, told journalists in Bratislava on September 10. Consequently, Ukraine will lose the opportunity to pump around 140bn cubic metres a year (cm/y) of Russian gas to Europe, which would mean losing $2bn in revenue per year, Yatsenyuk added.

Gazprom currently supplies around a third of EU energy needs, and approximately half of the gas imported by the EU is piped through Ukraine’s territory. The Russian company on September 4 announced that it had formed a consortium for the €9.9bn project with E.ON, BASF/Wintershall, OMV, ENGIE and Royal Dutch Shell.

Nord Stream-2, which will transport 55bn cm/y via two new pipelines running alongside the existing two pipelines of Nord Stream, which runs from northern Russia under the Baltic Sea to Germany,  is due to start operations by the end of 2019.

As a result, the new route will not only put a hole in Kyiv’s pocket, but remove a potential pressure point in its economic and political negotiations with the Kremlin. This is especially significant given the current conflict between Ukraine and Russia over the 2014 annexation of Crimea and Russia’s support for rebels in the Donbas, Ukraine’s industrial heartland.

Other gas transit countries also Poland and Slovakia condemned the deal, with Slovakian Prime Minister Robert Fico branding it a "betrayal" that would cost his country and Ukraine billions of euros, and which ran against Europe’s official position on Ukraine.

Pragmatic shift

"The European side is showing the determination of EU companies to  normalise or even strengthen their relations with Gazprom," Agata Loskot-Strachota, chief expert in Russian oil and gas at the Warsaw-based Centre for Eastern Studies (OSW), tells bne IntelliNews“They [European companies] share a common problem with Gazprom related to the situation on the EU gas market, specifically: low gas demand. They also have a history of fruitful cooperation and lots of infrastructure in place.”

The move also indicates that the European energy companies don't seem to expect any lasting solution to the Ukrainian gas transit issue to be achieved in the near future, the expert adds, and that the complexity of EU-Ukraine-Russia negotiations over the past year strengthens this view. "Western companies seem also to understand that Russia is determined to find a solution that enables Gazprom to fully bypass Ukraine, and so they prefer to co-shape this solution and make it profitable for themselves. Nord Stream-2 seems to be such a solution that enables gains for both sides," Loskot-Strachota says.

Unless there is "strong and effective opposition" to the deal, it could reinforce Shell's role in the EU and global gas markets, whilst providing a chance for Austria's OMV to develop its Central European Gas Hub (CEGH) after the failure of the EU-backed Nabucco gas project and against the background of constant gas tensions over Ukraine.

Just after the North Stream-2 deal was signed, US energy envoy Amos Hochstein criticised the move, saying that it was more about politics than economics, just like Russia's previous plan for the South Stream pipeline that was abandoned by the Kremlin in late 2014. "It carries the risk of allowing Gazprom to cut off Ukraine," Hochstein said in an interview with Reuters, adding that this would be "devastating for Ukraine and damaging to European energy security as a whole, but particularly for Eastern and Central Europe".

Victor Logatskiy at the Kyiv-based Razumkov Centre think-tank believes that the US "evaluates the situation and potential of Ukraine" better than the EU. "The EU has difficulties in developing a common policy, because decisions are taken there on the basis of consensus between the member states. Therefore, the EU’s position towards Ukraine is more amorphous," the expert tells bne IntelliNews, adding that this shows again that Ukraine should rely on its own resources.

Still not last word for Ukraine route

Loskot-Strachota agrees that losing payments for Russian gas transit would be "devastating" for Ukraine. "At the same time, the possibility to earn big money by acting as an intermediary in the sale of Russian gas to the EU was one of the sources of corruption in Ukraine, and has always been one of Russia’s leverages in bilateral relations," she adds.

Nord Stream-2 would potentially allow Gazprom to almost fully bypass Ukraine in its exports to Europe. But it is not clear that, once built, it would be used to reroute 100% of the gas currently going through Ukraine. “Maybe it will be used as leverage - as was the case when Gazprom gained control over the Belarusian gas network by using the first line of Nord Stream," the expert says, noting that Belarus sold its gas pipelines system to Gazprom for $5bn in 2007-2011 under Russian political pressure.

Disappointing progress in Russia’s efforts so far to boost gas exports to its new best friend China, as well as agree export terms via new routes under construction, also cast doubt on Russia’s ability to completely forego the Ukraine route in the coming years.

Logatskiy also notes that Gazprom's interest in gas transit through Ukraine could partially remain for the time being, in part due to the functioning of the Kyiv-based Gastransit joint venture. Established in 1997, the company is responsible for gas transit to the Balkans and Turkey. "That is why some volumes of gas transit, at least in the southern direction, should remain," the expert says.

According to Gastransit's website, Gazprom and Ukraine's state gas company Naftogaz each control a 40.2% stake, while the Turkey-registered Turusgaz (Gazprom controls a 45% share of the firm) holds a 19.6% stake. Logatskiy says that all stakeholders have invested up to $250mn in the company, where Gazprom holds directly and indirectly a 49% stake.

Bring on the  'winter package'

On September 11, the European Commission announced that it had held "constructive" talks in Vienna on winter Russian gas supplies to Ukraine and gas transit to the EU with Russian Energy Minister Alexander Novak and Gazprom CEO Alexei Miller. Russia, Ukraine and the European Commission will finalise a new "winter package" in the near future, the sides said.

Meanwhile, to prepare for a possible harsh winter, Ukraine needs to increase its gas stockpiles by around 4bn cm from the existing reserves of around 15bn cm. The country needs more than $1bn to buy 5bn-6bn cm, and the Kyiv government is mainly relying on financial support from international financial institutions.

Western backers have not rushed forward to provide additional financial support to Ukraine for this purpose. The governor of the National Bank of Ukraine (NBU), Valeriya Gontareva, has said that the European Bank for Reconstruction and Development (EBRD) and the International Finance Corporation (IFC) will only be able to allocate up to $500mn to Naftogaz to buy gas in the upcoming heating season.

However, Miller said on September 11 that the EU might provide Kyiv with $500mn for gas purchases of about 2bn cm. According to the Russian side, the trilateral meeting at which this question might be discussed could take place within a few days. Ukraine and the European Commission did not comment on the issue.

Ukraine suspended its Russian gas purchases in early July, citing its inability to secure a heavily discounted price from Gazprom for the third quarter of the year. According to Volodymyr Demchyshyn, Ukraine's minister for the energy and coal industry, the cost of Russian gas for the fourth quarter could be around $250 per 1,000 cm, but Kyiv will try to secure a significant discount. Currently, Ukraine imports natural gas from Russian clients in Europe, like Slovakia and Poland, by reverse flow, and with a mark-up, according to the Russians.

"It is common knowledge that the reverse gas they [Ukraine] receive from several European countries costs $20-30 more [per 1,000 cm] to consumers," Prime Minister Dmitry Medvedev said earlier in September, adding that this means paying $270-280 per 1,000 cm.

Brinkmanship continues

Other analysts said Kyiv is already treading a thin line on the issue, having rejected a 14% discount while pushing for the up to 30% reduction it had enjoyed since 2010. "On the one hand, the price of Russian gas for [the fourth quarter], even without a discount, will be the lowest in the last five years," analyst Alexander Paraschiy of the Kyiv-based Concorde Capital investment house wrote in a note to clients. "On the other, Ukraine will create a dangerous precedent by agreeing for the first time on a smaller-than-ever discount." 

Kyiv also still has some useful supply leverage in the talks. The analyst Logatskiy notes that the EU and Russia know that if they want to have normal supplies during the winter, they should provide funding to Ukraine for obtaining Russian gas that will be pumped to underground gas storage facilities. "Ukraine has enough gas stockpiles for its own consumption during the winter season. If the winter is warm, it will be sufficient to have 16bn-17bn cm of gas; if the winter is cold, it will need 18bn-19bn cm," he says, adding that volumes above these levels are necessary to secure stable supplies of Russian gas to European countries. "As an option, European countries could buy Russian gas using their own funds and pump it into our storage facilities."

Winter freeze looms as “transit-less” Ukraine scrabbles for Russian gas

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