Alan Riley - Stockholm Bombshell: The Implications of the Gazprom v. Naftogaz Arbitration
It is clear even from the first ruling that Naftogaz and Ukraine have been substantially strengthened and Gazprom Weakened.
Dr. Alan Riley, Senior Fellow, Institute for Statecraft, Temple Place, London*.
Almost all gas contract disputes between Gazprom and its customers have ended up with an amicable settlement between the parties. German, French or Hungarian customers may push Gazprom on the pricing, Gazprom then pushes back and ultimately everyone settles on a number they can live with-and each side claims victory. Rarely does either side actually intend to seek a final ruling from an arbitrator.
However, when Gazprom launched its case against Naftogaz in the summer of 2014 the Russian aim was to push the case to a final arbitration ruling, and with that ruling cripple the Ukrainian company. Gazprom claimed the huge sum of $35 billion plus interest, amounting in mid-2017 to $40 billion, half Ukraine’s current GDP. The claim revolved around the take or pay clauses from the 2009 supply contract agreed in the shadow of the 2009 Ukraine-Russia gas crisis. Gazprom was confident that it would prevail.
Much to the Russian company’s shock on the 31st May the Stockholm arbitration tribunal sided with Naftogaz and ruled that the take or pay clause was unenforceable.
Although the tribunal has to yet rule on other parts of the Gazprom v. Naftogaz dispute, this central Gazprom claim has been struck out. With limited rights to appeal the ruling Gazprom has few possibilities to reverse the decision. By pushing the case to a final ruling Gazprom has forfeited all leverage over Naftogaz, strengthened the economy of Ukraine and undermined its own financial prospects.
The case against Naftogaz was launched by Gazprom in June 2014. The main claim involved the alleged unlawful failure of Naftogaz to pay for natural gas under the terms of the take or pay clause of the 2009 supply contract. A take or pay clause requires the customer to either use the gas contracted for or pay for it if not used. This clause usually limits the ‘pay for in all cases’ element of the clause to a specific percentage of the total amount contracted. In this contract it was 80% of the 52 bcm that Gazprom agreed to supply Naftogaz. Naftogaz never took the full amount of gas it was required to under the contract. At first sight the Gazprom claim appeared to be quite strong.
While as yet we do not know the details of the arbitration ruling we do know that the 2009 contract was agreed under circumstances where Ukraine and Naftogaz were put under considerable pressure to come to a final agreement with Gazprom. In addition, the contract included a destination clause which meant that Naftogaz could not onsell the gas to third parties. In addition, the pricing mechanism resulted in Ukraine paying a far higher price for gas than EU states, remarkably including those in Western Europe, despite the significant additional transit costs to bring gas to France, the Netherlands and Germany. A further factor was that the natural gas price in the contract bore no relation to the prices on the gas hubs in the EU states, now increasingly the bench mark for European natural gas prices.
All of these factors clearly fed into the ruling of the Stockholm tribunal. In its first end of May ruling it held that the take or pay clause on which Gazprom’s $35 billion claim rested was unenforceable. It then also held that the destination clause was unenforceable and that the pricing mechanism in future must reflect the pricing on the main European hubs.
Potentially for the harm caused by the application of the destination clause and the existing pricing mechanism Gazprom may be facing a damages award against it of up to $18 billion (which will be decided later on in the proceedings).
However, the most immediate significant issue is the striking out of the take or pay claim. This is an enormous relief for Naftogaz and Ukraine. At a stroke a $35 billion ($40 billion with interest) claim is struck out, removing a huge potential liability over the company.
The removal of the shadow of this substantial Gazprom liability hanging over Naftogaz also strengthens Ukraine’s overall financial position, reducing the perception of sovereign risk and increasing the appetite of the capital markets for Ukrainian debt.
The next significant stage of the arbitration case is the Naftogaz claim against Gazprom for approximately $12 billion. This claim was brought by Naftogaz following the June 2014 claim against it by Gazprom and is being dealt by the same tribunal panel. This claim surrounds the scale of fees that Gazprom should pay for transit of gas across Ukraine. The claim involves two principal elements. First, a claim that the transit price is too low. The second claim is that Gazprom was obliged under what are known as a ‘ship or pay’ clause to ship a certain amount of gas through the Ukrainian pipeline system. Under a ship or pay clause a failure to ship the full amount still results in a requirement to make a full contractual payment.
A further key element of the second case is Naftogaz’s demand that Gazprom comply fully with its EU modelled national regulatory rules. These are the EU style liberalisation rules which require tariffs are set by regulators, and users of infrastructure such as Gazprom being required to provide transit information such as shipping codes; permit virtual flows and not block reverse flows. Success on these issues will force Gazprom to operate on European liberalisation principles in Ukraine. Ukrainian success here would make it much more difficult for Gazprom to lever its market power in Ukraine and in the states of Central and Eastern Europe.
From a financial perspective, if Naftogaz were to win this second claim it would further enhance Naftogaz and Ukrainian state finances. A substantial success in this claim would also impose significant financial damage on Gazprom, undermine its financial stability and make it much more difficult for the company to raise capital.
However, even if the tribunal does not rule wholly in Naftogaz’s favour in respect of the subsequent claims Gazprom is in some trouble itself even from this initial ruling. The damage to Gazprom can be seen in the immediate fall in its share price following the announcement of the ruling. The prospect that none of the take or pay claim is recoverable will damage the company’s financing standing as major source of revenue has just evaporated. This fear of evaporating revenue will be reinforced by the prospect that defeat on the take or pay clause issue in the Naftogaz case may well encourage other companies across Central and Eastern Europe and Turkey who have substantial take or pay debts with will now rely on the Naftogaz precedent to seek to challenge the legality of their own debts.
For Naftogaz, and Ukraine any significant awards will help improve both the corporate and state financial position, permitting a much more rapid advance to a more liberalised European style gas market. It very much appears to be the case that Gazprom by pushing the case into a tribunal and forcing a ruling has done much to liberalise the Ukrainian gas market on the European model, improve Ukrainian state finances, and ensure a far greater degree of Ukrainian independence and autonomy.
*Dr. Riley is an adviser to Naftogaz but has not participated in the arbitration case.