Russia-Ukraine Tensions Could Hit EU Gas Prospects: Pirani

A new paper – published November 29 by the Oxford Institute of Energy Studies and written by Simon Pirani – points out that Russia and Ukraine need to agree new contractual arrangements next year, ahead of the expiry of their gas transit contract.

But these terms are being negotiated "in an atmosphere of unprecedented friction," he says. Failure to agree could mean interruptions to gas supplies westwards, which would be bad news for certain countries in central Europe; plus a major setback for the gas industry’s efforts "to raise its status as part of Europe’s energy supply future".

More or less difficult ever since the end of the Soviet Union, relations between the two states have worsened sharply since the Russian annexation of Crimea in 2014. The following year, Ukraine stopped buying gas from Gazprom, taking the deliveries in reverse flow from Germany and elsewhere. Then in February 2018 the Stockholm arbitration court ruled after a lengthy hearing that Gazprom had to pay $2.6bn more for under-used transit capacity than Ukraine had to pay Gazprom for not taking gas.

Gazprom CEO Alexei Miller immediately termed this "asymmetrical" as the cause of each breach was similar: a catastrophic drop in gas demand beyond the control of either. He has refused to pay any of the money; and Naftogaz has been taking in lieu money that ordinarily it would have returned to Gazprom as monthly overpayments for transit.

Pirani says therefore: "This conflict cannot be understood only on a corporate level: it is part of a breakdown of political, diplomatic and economic relationships between Russia and Ukraine, which is as grave as it could be short of a declaration of war. This stems from the removal of the Yanukovich government in Ukraine in February 2014 and includes: Russian annexation of Crimea in March 2014; the military conflict in eastern Ukraine, which has resulted in 10,000 deaths, the internal displacement of 1.8mn people in Ukraine and the migration of 430,000 refugees to Russia; Russian economic, political and (in a manner and on a scale that are disputed) military support for the separatist "republics" in eastern Ukraine; and the collapse of Russian-Ukrainian trade." The latest clashes over Ukrainian access to its ports on the Azov Sea only underline the gravity of the situation.

Fearful that the Ukrainian economy would collapse further without the few billion dollars it receives from transit services, the European Commission is pressing for a guarantee from Russia of a minimum volume of transit through Ukraine for an unspecified period of time after 2020. Pirani says: "It has been implied, but not stated openly, that, in exchange for such a guarantee, the EC and leading European governments would ensure the removal of regulatory obstacles to the construction of Nord Stream 2." 

However, next October sees the appointment of a new commission which will reduce its capacity for brokering deals. "The Ukraine transit negotiations would inevitably be disrupted by the handover process. Therefore, if no agreement has been made by that point, the risk of no agreement being made at all will increase significantly," he says.

German chancellor Angela Merkel has also tied support to Nord Stream to Gazprom committing to sending a certain amount of gas through Ukraine, although European demand for Russian gas, as the author argues, will depend to an extent of the price of alternative sources. This will be chiefly liquefied natural gas, most of which has normally headed to the highest priced market, Asia, he says. The less that comes to Europe, and this is unknowable, the greater will be the demand for pipeline gas from Russia.

Naftogaz Ukrainy is seeking a minimum of 40bn m³/yr in transit, Pirani says, also citing sources saying that Russia might accede to that if all other claims against it, notably the "asymmetrical" Stockholm arbitration ruling, are dropped. That would be a big increase on the planned 15-20bn m³/yr that Miller has mentioned in the past. But Pirani says Ukraine would not drop its financial claims. On the other hand, Gazprom's gas production base is moving further north to Yamal as its supergiants fade, making Nord Stream the quicker route to market. Pirani's view is that the Ukrainian transit system will be substantially scaled down and parts of it decommissioned as Nord Stream and TurkStream ramp up. Investment funds are likely to be available for this only when the planned unbundling makes progress, he says.

Ukraine too has problems that need to be fixed before it can expect largesse from external funders, Pirani says; notable is the “unviable business model” of heat suppliers and distribution companies, which are deeply indebted to the government, in addition to being a prime site of corrupt misappropriation of gas. The World Bank’s estimate of the economic cost to the Ukrainian state is $1.7bn/year; the Energy Community secretariat’s is in the same range, he says. Ukraine also has presidential elections in March 2019 and parliamentary elections in October, the run-up to both of which may influence the Ukrainian government’s attitude to the negotiations.

In the period 2020-25 as a whole, demand for Ukrainian transit capacity will fall steeply if and when the transit diversification pipelines are completed, which is the most likely course of events. However, under scenarios in which total gross imports of Russian gas to Europe exceed about 190bn m³/year, some Ukrainian transit capacity would certainly be necessary – but, bearing in mind the limitations to the system at peak times, Ukrainian transit may still be needed at lower levels of total gross imports than that, he says. This and other uncertainties mean that a series of short-term agreements may have to suffice even when Nord Stream 2 and TurkStream 2 are functioning.

The full paper may be read here.