Natural gas still plays an outsized role in Ukraine’s energy mix – and it will continue to do so for many decades to come, writes Jakub Kucera, economic analyst at RSJ, a Prague-based investment company. Kucera explains the many formidable challenges Ukraine is facing in the gas sector and their profound impact on the European energy market. He concludes that Ukraine has made admirable progress in cleaning up the gas sector. Unfortunately, success still hangs on the goodwill of Ukrainian politicians in combination with pressure from Ukraine´s Western allies.

The fate of the Ukrainian energy industry is intimately tied up to the troubled international situation Ukraine is in. A complicating factor is that the country is finally (and let’s hope definitely) awakening from the morass of the post-Soviet period. In a letter to the Director of Energy Community Secretariat from 19^th March 2018, civil society representatives described the Ukrainian energy sector as “heavily monopolized, poorly regulated and deeply corrupt”. The country has definitely made great progress in reforming the sector, but the ultimate success of the reforms is still dependent on political will.

Natural gas is important and will stay that way

Within the energy sector it is natural gas that is playing the key role. Although gas does not dominate the Ukrainian energy mix (gas and coal are both good for 30% of the primary energy consumption), its importance and media appeal are, however, enhanced by three factors.

Firstly, domestic gas production cannot cover domestic demand so Ukraine relies on imports, the volume of which have been very large. As recently as in 2006 Ukrainian consumption was approaching the level of 80 bcm which is approximately equal to Germany, the largest EU economy and gas consumer. Around 60 bcm had to be imported. Even though import volume has declined since then, imports still are a major security issue, as almost half of the gas Ukraine uses is still imported. And although the gas now comes from EU trading companies, the country of origin is still the same – Russia.

Secondly, Ukraine is still the most important route for Russian gas to Europe. Around half of the Russian gas imported to Europe and Turkey is shipped through Ukraine.

Thirdly, natural gas is the main fuel for heat generation and in this capacity it is hard to replace. All these factors make natural gas a much bigger political issues than the crude energy statistics suggest. Few people in Europe should be surprised by this remembering the Ukrainian-Russian gas crises of 2006 and 2009 when gas supplies to EU customers were interrupted despite fierce winter conditions.

The Energy Strategy of Ukraine till 2035, approved by the Ukrainian Cabinet of Ministers in August 2017, foresees an undiminished role for natural gas. Its share in primary energy supply will, in contrast to other traditional energy sources, remain constant. Consumption was 32 bcm in 2017, 14 bcm of which was imported.

Ukraine has an ace up its sleeve. It possesses the largest gas storage facilities in Europe of up to 31 bcm

It has already been mentioned that natural gas is the dominant fuel in heat generation be it as fuel for district heating systems or in the form of gas being sold to the households. In 2016 this sector accounted for 60% of overall gas consumption, i.e. 20 bcm. Over a third was consumed by industry. Meanwhile, natural gas is marginal in power generation. It is estimated that only 3% is consumed there.

The Ukrainian natural gas sector now faces a range of difficulties. Some of them are of an internal nature, others are external. One of the most important domestic issues is the reform of the gas market and of Naftohaz, the state gas giant. But let us have a look at the external issues first, as these are doubtless more interesting to gas consumers in the EU. In this field, the transit of Russian gas to Europe and Turkey is key. The gas imported for Ukrainian consumers is also an issue. Incidentally, according to Naftohaz Ukraine was the first country to export gas abroad. In 1945 Ukrainian gas was delivered to Poland.

Thus Spoke Stockholm

The two recent arbitration cases between Naftohaz and Gazprom got a lot of attention in the media. Both disputes were connected to the gas agreements concluded in 2009. One contract dealt with Russian gas supplied for Ukrainian consumption. The other one regulated the transit of Russian gas through Ukrainian pipelines. On the whole the outcome has been favourable to Ukraine.

The Arbitration Institute of the Stockholm Chamber of Commerce lifted Naftohaz’s obligation to buy 41.6 bcm of Russian gas annually as minimum (take-or-pay clause), although it stipulated Naftohaz has to buy a minimum amount of 4 bcm in 2019 and 2020. There is also no fine for Naftohaz as a result of failing to buy a minimum amount of gas in previous years. The overall size of this claim was reported as $56 bn, which was a staggering 60% of Ukraine’s GDP in 2016.

On the other hand, Naftohaz has to pay $2 bn to Gazprom as the price for gas actually purchased. This is, however, no victory for Russia as the Ukrainians did not dispute the duty to pay but the amount of money they owed. The arbitration court took their side in this matter and derived the price from German market prices lowering the bill by approximately $1 bn. All potential deliveries in the future should be handled the same way. The old price formula from 2009 was nullified definitely.

The arbiters refused to use the German prices for determining the purchase price for Naftohaz before Naftohaz filed the claim against Gazprom in April 2014. On these grounds, Naftohaz’s demand that Gazprom return some of the money received was dismissed. This defeat can be, in Ukrainian eyes, balanced out by the fact that the arbitration court clearly stipulated that Naftohaz does not have any obligation as to gas delivered by Gazprom to the territories which are not under Kyiv’s control. Moreover, should the Ukrainians buy any Russian gas again, they can resell it at their pleasure.

Chart 1 – Ukraine’s consumption, export from Russia and the EU as well as price of and expenditure on gas imports

source: State Statistics Service of Ukraine, Naftohaz, author’s own calculations

In the parallel dispute over gas transit, the court reached to some degree an opposite conclusion. Naftohaz will not get any compensation for supposedly too low transit fees from Gazprom. Naftohaz had claimed up to $18 bn. But, the arbiters did award $4.6 bn to Naftohaz, ruling that there is indeed a de facto ship-or-pay clause in the 2009 transit agreement. Thus, Gazprom is obligated to ship at least 110 bcm through the Ukrainian transit system a year. If it fails to do so, it has to pay.

Gazprom objected to the seeming paradox that the court, while holding up this ship-or-pay clause, dropped the take-or-pay obligation for Naftohaz. The explanation lies in the different nature of the causes why Naftohaz, respectively Gazprom, did not fulfil their respective volume obligations in terms of bought or shipped gas. One might argue that Ukraine was buying less Russian gas because, based on objective facts such as a decrease in gas consumption, it did not need any. On the other hand, Gazprom shipped less gas via Ukraine because it decided to do so. In a way, the Russian success in creating transit corridors outside Ukraine, e.g. Nord Stream went online in 2011 and 2012, has hurt Gazprom like a boomerang.

Grr, grr, complains the unhappy bear

Some Ukrainians could be dissatisfied with the outcome that Naftohaz has to buy gas from Russia again. It has not bought any since November 2015. However, it is estimated that Naftohaz would actually save some money doing so as Gazprom’s gas is cheaper than that bought in the EU. But it was Gazprom itself who cut such speculation short as it refused to supply Ukraine. It returned the down payment with the excuse that some accompanying documents were missing. Naftohaz denies this.

This was such a surprise that Naftohaz had to organize a supply of gas from the EU hastily. Some universities, schools and kindergartens were forced to close for a couple of days making headlines chillingly reminiscent of the gas crises of 2006 and 2009. The situation was solved in a matter of days, however, clearly demonstrating that times have changed.

Apart from causing this minor trouble to Naftohaz, it is far from easy how to interpret this move by Gazprom. The Ukrainians were made to buy Russian gas so Gazprom’s refusal will hardly make them sad.  The Russian company could try to lay the blame on Naftohaz for ignoring the Stockholm ruling but it is unlikely this strategy can pay off. It is probably just a knee-jerk attempt to save its face by doing something.

Whither Ukrainian energy sector?

The energy sector and the gas sector especially are fields in which the Ukrainians have indisputably made the greatest progress in recent years.

Three factors have contributed to this.

Firstly, the gas sector is arguably the industry sector most essential to Ukraine´s energy security as well as its economy.

Secondly, as Ukraine is a major transit country, for the country’s western allies, the health of its gas sector is of key importance.

Thirdly, it has somewhat paradoxically helped that the gas sector is a state monopoly. In itself this is not a good thing, and the establishment of a liberalized competitive market environment is a clear goal for the coming years. But if the state genuinely wants to introduce changes, it can do so quite easily in the gas sector, unlike for example in the coal industry, where a private monopoly has been created and the state has to take into account the interests of private owners.

Apart from establishing a properly functioning market, Ukrainian politicians need to anchor the independence of important institutions and their representatives (such as the Naftohaz leadership and the energy regulator). As for the gas sector itself, there is still room for improvement, although in the light of the upcoming elections, Western institutions could consider postponing their pressure to increase prices for households.

It would probably be much better if the focus of reforms, sustained by Western pressure, shifted to strengthening the rule of law and stamping out corruption, e.g. by establishing special anti-corruption courts. If the local authorities have more money at their disposal, they could fund energy-savings measures more easily or attract more foreign donors, who would not have to fear their money will disappear. The same applies to private foreign investors who are very sensitive to the overall state of the rule of law in a country. As a result of better business environment, more money would be left in the pockets of Ukrainian ordinary citizens, enhancing support for market-oriented reforms and a pro-Western regime.

It is possible in Ukraine to have very favourable economic conditions for energy or gas saving projects with very short pay-back periods. However, if legal protection of investment is weak, investors will stay away. Admittedly, such nation-wide reform is much harder to pull off than reforming a couple of state companies, no matter how big they are.

Similarly, Gazprom announced it wished to significantly alter or even to terminate the contracts with Naftohaz. Yet again, this does not make much sense, especially in the case of the supply agreement. Nobody in Ukraine wants to buy Russian gas. As for the transit contract, it is unclear whether Gazprom can avoid any further fines stemming from the ship-or-pay clause. Ukraine is highly unlikely to forgo this income and without its concession any change will hardly happen. Above all, Russia cannot dispense with the Ukrainian corridor right now as there are simply no alternatives (see below).

The Stockholm cases are not the only disputes between Ukraine and Russia in the gas industry. Earlier, a Ukrainian court of appeals confirmed that Gazprom has to cough up another €5.5 bn (172 bn UAH, to be precise) as a fine for abusing its market power in the Ukrainian gas market. Due to this case, Gazprom has already lost some assets in Ukraine. The Ukrainians are now looking into what else could be seized. In the end, they will have to look beyond Ukrainian borders which could have some serious repercussions.

And there is also a dispute over the gas assets taken over by Russia in the aftermath of the occupation of Crimea, including the gas illegally produced there and in the continental shelf since the illegal annexation. If the Permanent Court of Arbitration in The Hague takes the Ukrainian’s side, they could get another $5 to $7 bn.

Scramble for pipes

To European customers, the most interesting issues concerning the Ukrainian gas industry are the transit routes for Russian gas to Europe. Will Gazprom accomplish its quest for avoiding the Ukrainian transit system? And if not, what volume will be still shipped through Ukraine and under what conditions?

The transit gas to the EU brings Ukraine two advantages. It may serve as a lever in disputes with its Eastern neighbour and it generates handsome revenues for Naftohaz. In 2016 the transit fees brought in $3 bn and the same sum is expected for 2018 and 2019. It is actually fairly unimportant how Gazprom’s newest wish to terminate the current agreement turns out since the contract will be history by the end of 2019 anyway. What happens afterwards, that is the question.

Russia has announced many times its aim to abandon the Ukrainian route altogether or keep the shipped volume to a minimum at least. In spite of the major setback with the South Stream pipeline, running through the Black Sea from Russia to Bulgaria, it may succeed in the end, at least partially. Firstly, there is a replacement project, TurkStream, going from Russia to Turkey. The first string could deprive Ukraine of gas for Turkey. A second string would siphon off some gas for European customers, although this depends on the following connection to the Balkans.

The main threat for Ukrainians comes from the North, though. An expansion of the Nord Stream pipeline (through the Baltic Sea) could deprive the Ukrainian corridor of 55 bcm. Even here, nothing is clear. In April, German chancellor Merkel, who had supported the project so far, or at least had not opposed it actively, said in the presence of Ukrainian president Poroshenko that Nord Stream also has a political dimension. It was surprising since it was Merkel who had been stressing the economic nature of the new pipeline and asserting it is no threat to the EU’s energy security.  Similar concerns were aired by the chancellor at a meeting with Russian President Putin in May.

Chart 2 – Russian gas exports to Europe

For 2020, Nord Stream 2 and both the strings of TurkStream are expected to go online here.

source: Naftohaz, Gazprom

Even if Russia builds Nord Stream 2 eventually, it will hardly be in place by the end of 2019 when the transit contract with Ukraine expires. Realistically, only the first string of TurkStream will be built. Gazprom and Naftohaz will have to agree on a new contract that will cover still significant amounts of gas. It will be less than 110 bcm, but it will not be as little as 10-15 bcm. This number was mentioned by Gazprom’s boss Miller in April. This volume is too optimistic and it corresponds to the probable transit amount after completion of Nord Stream 2 and both the strings of TurkStream.

And all this is only true provided Russian does not sell more gas to Europe. Gazprom plans on increasing supplies to Europe, though.

We must keep in mind that even gas bought from the EU is still actually gas produced in Russia

To sum up, Russia cannot totally forgo the Ukrainian corridor. This was admitted by Putin at the May meeting with Angela Merkel.

Some analysts warn that the negotiations over the new transit agreement may prove hard and contentious. Gazprom could even try to provoke another gas crisis in order to discredit Ukraine in the eyes of its EU partners. On the other hand, more meddling in Ukrainian affairs could provide more ammunition for critics of cooperation with Russia in the energy sector, including Nord Stream 2.

Another interesting point in the great game over pipelines is the transit agreements Gazprom concluded with the pipelines operators in Bulgaria and Slovakia. They expire as late as 2028 and 2030, respectively. Also supply agreements between Gazprom and European utilities could be an issue as they also include points of delivery, now in Ukraine.

Table 1 – Russian pipelines to Europe and Turkey

Smaller pipelines to Finland and the Baltics are excluded.

Keep in mind, Russia is now exporting about 200 bcm outside the former USSR.

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source: Naftohaz, Annual Report 2016; other sources

Is Ukraine manoeuvring itself out of the game?

Many experts point out that the Ukrainians themselves are partially to blame for the preference of some Europeans for Nord Stream 2 over the Ukrainian pipelines. After all, half the funding for Nord Stream 2 will be provided by European gas companies.

First of all, the Ukrainian transit fees are higher than those envisaged for the new Baltic route. Moreover, the Ukrainian tariff policy is neither transparent nor predictable.

Another issue is the conflicts between Naftohaz and the Ukrainian government that hinder badly needed reforms. One of the major issues is the transformation of Ukrtranshaz, currently Naftohaz’s daughter company, into an independent operator of the transit pipelines. In 2016, in violation of an agreement between the Energy Community and the EBRD on the one side and Ukraine on the other, the government wanted to place Ukrtranshaz under the control of the Ministry of Economic Development and Trade.

Only after the threat of interrupting financial aid to Ukraine did the Ukrainian government back off. It does not help either that the energy market regulator is highly politicised and dysfunctional from time to time.

However, there is some hope for improvement. President Poroshenko has announced that many respected companies are taking part in the tender for management of the transit pipelines. Another positive piece of news was the definitive appointment of Paweł Stańczak as head of Ukrtranshaz. Stańczak was responsible for the reform of Poland’s gas monopoly PGNiG and creation of the independent pipeline operator Gaz-System in 2003-2004. If Ukraine can demonstrate that it has an independent operator in place who lays down a transparent and coherent framework for gas transit, the country could blunt calls from Western Europe for alternative shipping routes.

The Ukrainian corridor may, however, succumb to two other shortcomings. One of them is of an economic nature. There has been little or no investment in the pipelines making it a cash cow for Naftohaz. The reconstruction of the pipelines is estimated to cost €10 bn – almost as much as the price tag for Nord Stream 2. Who will put such money into a network, the future of which is very uncertain? And if the transit continues, how much will it generate given lower volumes are transported? The Ukrainians themselves warn that too low an amount of shipped gas would make the corridor economically unfeasible.

Here, Ukraine has an ace up its sleeve, however. It possesses the largest gas storage facilities in Europe of up to 31 bcm (followed by Germany and Italy with 22 and 18.5 bcm respectively). That is something no other transit route to Europe can boast. The storage volume could also be used to balance the EU gas market.

The other problem posed by Ukraine as a transit country for Russian gas is purely geographic. The centre of Russian gas production is slowly moving northwards with new fields being opened in the Barents Sea and on the Yamal Peninsula. Rather than shipping this gas via Ukraine, it could make more sense to use the Baltic corridor, or the Yamal-Europe pipeline through Poland or even liquefy the fuel and ship it in LNG tankers.

Chart 3 – Russian export pipelines

– 1 = Yamal-Europe; 2 = Nord Stream; 3 = Urengoj-Pomary-Uzgorod; 4 = Soyuz; 5 = Progress; 6 = Trans-Balkan; 7 = Blue Stream; 8 = Nord Stream 2; 9 = TurkStream; 10 = Power of Siberia

source: Gazprom Export, Annual Report 2016

Focus shifts to domestic issues

As for Ukrainian gas imports, the domestic consumption-production balance is now more important than the relations with Russia. In 2017, Ukraine needed 32 bcm of gas, 14 bcm of which were imported.

Two questions about the future development arise here. In the first place, whether domestic production can be increased and if so by how much. The attempts of the government to do so have been pretty futile so far. Initially it made some mistakes such as raising the profit tax for producers. In the end, a more benign regulatory and tax environment for gas producers was established.

There is also a new budgetary rule giving a higher share in the tax income to municipalities. This step could ease the concerns of local populations, which populist politicians are trying to exploit. According to BP, there are 600 bcm of proved reserves in Ukraine covering 20 years at current production levels. Other resources are believed to be hidden in shale formations and offshore.

Secondly, it will be interesting to observe how the economic recovery will impact domestic demand for gas. The dramatic decline in consumption, which helped Ukraine a lot during the hot phase of the conflict with Russia in 2014 and 2015, can only be partly seen as a result of savings measures. The economic crisis and the loss of industrial centres in the East played a major role, too. Any increase in gas consumption will lower the chances of some Ukrainian politicians’ dream of total gas independence coming true (the dream may be unrealistic anyway).

Without pressure from Western institutions the Ukrainian gas sector would probably slip back into the dark ages of corruption, stealth and inefficiency

We must keep in mind that even gas bought from the EU is still actually gas produced in Russia. An increase in gas consumption can still be counteracted by further price liberalization (Ukrainian households are still subsidised, albeit to a lesser extent than previously) and higher efficiency, e.g. better measuring equipment.

A better insight into the financial flow in the sector is urgently needed. It is all but unbelievable that until recently the only way for Ukrainian households to regulate the inside temperature was by opening windows. According to some sources, up to 80% of them paid for heat according based on floor area.

The Ukrainians themselves concede there is a lot of room for improvement. Higher efficiency and a switch from gas to other fuels such as biomass are supposed to bring down gas demand in the heating sector from 18 bcm last year to 13 bcm in 2022.

Was King Augean in charge of Ukraine’s gas sector?

The most pressing domestic issue is currently the reform of state behemoth Naftohaz. It is still responsible for all aspects of the gas and oil sector, including exploration and production, transport, storage and distribution and sales. Unbundling of the various functions and more transparency as well as higher efficiency are called for. The country’s Western partners (EU, IMF, EBRD and World Bank to name a few) insist on far-reaching reform.

On the other hand, it would be grossly unfair to say there has been no progress since the Maydan revolution. On the contrary. As recently as four years ago, when corruption was rampart, the company made tremendous losses and an unbelievable quarter of the state budget went towards Naftohaz and various subsidies for end customers. Naftohaz was a piggy bank, always ready to be robbed by Ukrainian politicians to finance their electoral promises. George Soros did not hesitate to label Naftohaz “a black hole in the budget and a major source of corruption”.

At present, Naftohaz is responsible for almost a seventh of state revenues and the subsidies to households, now paid directly from the state budget, are on the decline. In 2017 Naftohaz generated €3 bn in the form of taxes and dividends. Subsidies for households were approximately half of this sum. These successes are closely connected to higher transparency in the sector and household prices levelling up to import prices. In 2014 the difference was almost nine-fold ($39 versus $339/1000m³). 

The gas used for heating households is still cheaper but the difference has been narrowing continuously. The Ukrainian government shirks from the last final step, though, although it is one of the conditions the IMF imposes on financial aid. There will be parliamentary and presidential elections next year and the politicians, understandably, do not want to anger the voters before they go to the polls.

A major problem with the current reforms is that they fully depend on the will of the politicians. Just a little resistance would be enough to stop or even reverse them. The position of key figures is not anchored in the law and they can be dismissed easily. Naftohaz CEO Kobolev is aware of this and has resorted to extraordinary measures such as openly criticizing the government for its lack of will to make more reforms.

On a similar note, three independent members of Naftohaz Supervisory Board resigned on grounds of political meddling in the company’s affairs. By “independent” we mean foreign experts who had been hired to reform the gas sector. The Western partners had to revert to the stick-and-carrot strategy of last resort – they threatened to stop financial aid to Naftohaz and in the worst case to Ukraine as a whole. Only after this did the government appoint a new Supervisory Board, in which there are four independent members out of seven. Without pressure from Western institutions the Ukrainian gas sector would probably slip back into the dark ages of corruption, stealth and inefficiency.

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