Ukraine wrestles with the consequences of higher gas prices

by Simon Pirani

Both Ukrainian and Russian politicians and gas industry officials pushed for an end to the traditional barter arrangements for the payment for Russian gas and Ukrainian transit. Now that they have got it, the Ukrainians are finding that there are several unwelcome consequences, including the exposure of its internal gas users to international gas prices. And, if anything, there seems to be even less clarity about the contractual relationships between Russia, Ukraine, and Central Asian suppliers than there was before the notorious negotiations and “agreements” of the last three months. Industrial users in Ukraine are paying one-third more than a year ago. And the long-term outlook remains hazy: prices have yet to be agreed for the second half of the year, and protests over the involvement of opaque supplier Rosukrenergo are growing in advance of parliamentary elections on 27 March.

Ukrainian industrial gas customers in the unregulated market have experienced large increases this year. The maximum price for industrial users, set by the National Energy Regulatory Commission (NERC), rose to 548 hryvna ($108)/Mcm for March, net of VAT. Trades were reported at above $100, compared to $75-80 in the middle of last year, $65-70 at the end of 2004 and $55-60 at the end of 2003. At the Ukrainian agricultural exchange’s regular auction on February 28 Ukrnafta, the state-owned oil and gas producer, sold 695 Mcm of gas for $106/Mcm, net of VAT, on a starting price of $83/Mcm, and up from a sale price of $74/Mcm at the last auction, on November 11 last year.

Naftogaz Ukrainy’s regulated prices have not yet changed, a spokesman told Gas Matters: they remain at $75/Mcm for industry, £52/Mcm for power generators and $37/Mcm for residential users. The delay in the inevitable increases to this sector is partly due to the furore that surrounded the licensing of Ukrgazenergo, the Naftogaz-Rosukrenergo joint venture set up under the Russo-Ukrainian agreement of 4 January with which the new year “gas crisis” culminated.

Ukrainian politicians had urged the government and regulators not to licence Ukrgazenergo to sell gas into the internal Ukrainian market until Rosukrenergo declared the identities of its beneficial owners. The calls were not heeded: on March 6 the government approved Ukrgazenergo’s licence application and the paperwork was expected to be completed by mid-March. On 9 March, NERC licenced Ukrgazenergo to sell 5.04 bcm of gas at unregulated prices, leaving unresolved the issue of how the bulk of the Ukrainian market would be supplied, and whether the provision of the 4 January agreement, that Ukrgazenergo sell 34 bcm into the domestic market, would be implemented. Some Ukrainian media reported NERC sources saying that Ukrgazenergo would be limited to a total of 24 bcm of sales. Parliamentarian Mikhail Volynets, a member of the committee on fuel and energy, was quoted as saying that NERC’s decision was made under pressure from those in Naftogaz Ukrainy desperate to hang on to the industrial segment of the domestic market. NERC would only rule further on market access after the elections, he said.

The implications of the price rises for the Ukrainian economy are difficult to calculate until the price of imported Russian and central Asian gas for the second half of the year becomes clear. Economics minister Arsenii Iatseniuk urged parliament to limit tariffs to $110/Mcm (including VAT and transport), i.e. lower than the level set by NERC. Even at that level, he said, electrical energy prices would rise by 10%, rail freight charges by 15% and the steel sector would lose $20 million, wiping out its profitability. Iatseniuk had asked ministry experts to prepare forecasts on the basis of $110 gas in the first half of the year and $230 in the second half. Such prices would “completely destroy” the steel industry’s economic viability, he said.

Industry and banking sources in Kiev are more sanguine about the steel industry’s problems. They say the chemicals and fertiliser producers will bear the brunt of the immediate effect, and that the long-term impact on economic growth is also of concern.

When Ukrgazenergo was set up on February 2, after heated negotiations between Russian and Ukrainian politicians and gas executives, its founders announced that it would buy gas from Rosukrenergo for $95/Mcm for five years – an apparent improvement for Ukrainian gas consumers on the January 4 agreement, which had specified that price for the first six months of this year only. But the durability of the five-year fixed price – which was set against a background of loud accusations by former Ukrainian prime minister Iuliia Timoshenko, and others, that the January 4 agreement was a betrayal of national interests – has already been questioned by Russian minister of industry and energy, Viktor Khristenko.

The January 4 agreement “put an end to barter and split European transit from Ukrainian deliveries”, Khristenko said on March 6 in an interview with Vedomosti newspaper. The interviewer suggested that, with Rosukrenergo committed to buying central Asian gas from Gazexport (Gazprom’s export sales subsidiary) and delivering it to Ukraine at $95/Mcm, future price rises in central Asia would mean selling at a loss in Ukraine, with Gazprom bearing much of the impact. Khristenko acknowledged that central Asian sales prices were fixed only to the end of this year, and said the issue required further discussion. “It’s possible to reject an agreement with fixed gas prices and use formula prices. Here there’s a real choice.” He added that, if the Ukrainian government wanted to subsidise consumers, it could choose various methods of doing it, but “to impose a price policy on a commercial structure [i.e.UkrgazEnergo] is absolutely wrong”.

So, many crucial details not ironed out on January 4, including prices after the end of June, remain unresolved. A protocol detailing volumes of Russian gas deliveries to Ukraine, and of transit via Ukraine to Europe, also remains unsigned. On February 22 Ukrainian foreign minister Boris Tarasiuk said that it would be signed soon, but as we went to press there had been no further announcement.

Another area in which Russo-Ukrainian battles may be revived is gas storage. On February 13 Ukrainian prime minister Yuri Ekhanurov asked the economics ministry to prepare paperwork to increase storage prices charged to Gazprom from $2.25/Mcm to $6.75/Mcm – reported by the business newspaper Delovaia Stolitsa as a “counter attack” to Russian price rises. Anatoly Kinakh, head of Ukraine’s national security council, told a conference in Warsaw on February 20 that leasing storage capacity was also a possibility. Either path should lead to a more market-oriented management of storage, as should increases in transport tariffs, but only if these numbers are given some economic substance.

Further echoes of last year’s “gas wars” were also heard in February during Ukrainian-Turkmen negotiations on the price of gas that Ukraine will buy directly from Turkmenistan, i.e. volumes covered by a bilateral deal signed in December and not by the Rusukrenergo buy-sell arrangements made on January 4.

Naftogaz had agreed to buy from Turkmenistan 40 Bcm/year, with the price set at $50/Mcm in the first half of this year and $60/Mcm in the second half. But in mid February, Ukraine’s prime minister Ekhanurov claimed to have “operational information” that Turkmenistan was planning to hike prices to $100/Mcm. On February 20 Turkmen president Saparmurat Niyazov fired back a demand for payment of $158.9 million outstanding on past barter deals; Ekhanurov responded that Ukraine was $11 million ahead rather than $158.9 million behind, and was ready to go to the international arbitration court at Stockholm to prove it.

On 12 March, though, the Turkmen foreign ministry said that Ukraine had just paid $59.6 million outstanding in cash, and agreed that $28.7 million in cash and $67.3 million in goods was outstanding. A delegation to Ashgabat headed by Naftogaz Ukrainy commercial director Anatoliy Popadiuk had agreed to clear a further $55.1 million by deliveries of 1020 mm steel pipes, the ministry said in a statement to the pro-government web site Opaque barter arrangements under which Ukraine delivers building services and goods to Turkmenistan remain part of the problem, and statements from Kiev on the subject are contradictory. President Viktor Yushchenko in February again demanded the immediate abolition of barter, and denounced “lobbying” by barter profiteers, while Naftogaz chief executive Aleksei Ivchenko referred to abolition as an option to be taken up by Ashgabat if it wishes.

While many energy economists would argue that rising world oil and gas prices are the pivot on which Ukraine’s gas crisis turns, most Kiev politicians will tell you that it’s Rosukrenergo. The identity of its Ukrainian owners – who will earn very substantial sums from the buy-sell arrangement under which most of Ukraine’s gas will be supplied, and who, via UkrgazEnergo, will have a dominant hand in the internal market – remains at the centre of a political row that has spread to Moscow and beyond.

“It’s a fantasmagoria […] Neither Russia nor Ukraine know who they are paying these billions in commission to, but neither do they want to reject their services”, commented Russia’s leading business newspaper, Vedomosti, on March 2, after presidents Putin and Yushchenko had both told journalists they could not find out who controlled the Ukrainian half of Rosukrenergo. Gazprom originally owned 50% of Swiss-registered Rosukrenergo through a holding company, and in February shifted this asset from Gazprombank to its own balance sheet for a nominal sum, €2.3 million. The other 50% is held by Raiffeisen International, a subsidiary of Raiffeisen Bank of Austria, for unnamed Ukrainian interests.

The presumption that the beneficiaries were close to former Ukrainian president Leonid Kuchma was reinforced in late January when Zerkalo Nedeli (Mirror Weekly), Ukraine’s leading political weekly, published what appeared to be a facsimile of minutes of a Rosukrenergo shareholders’ meeting in 2004. Co-ordinating committee members appointed by the Ukrainian shareholders included Yuri Boiko, then Naftogaz CEO, and his deputy Igor Voronin, who has remained in post after the “Orange revolution”.

Accusations that Rosukrenergo’s owners were making substantial profits from the transit business redoubled when financial information released by Gazprom showed that, in the first nine months of 2005, Rosukrenergo had made 14.3 billion rubles ($520 million) profit on a turnover of 83.4 billion rubles.

The most consistent critic of the 4 January agreement, former prime minister Timoshenko, told president Yushchenko in an open letter in mid February that he should take Russia to international arbitration, arguing that the Rosukrenrgo deal breached contractual obligations under previous Russo-Ukrainian gas agreements.

Other high-level political opponents of the deal include finance minister Viktor Pinzenik, who says that Ukraine must scrap the deal and “return to [negotiating from] a blank page”. He warned during an on-line question and answer session that Rosukrenergo had no legal obligation to deliver gas, that no volumes are specified in the January 4 agreement, and that transit tariffs are fixed for the first two years and may only be reviewed twice before 2030.

The parliamentary elections on March 27 are unlikely to quieten political dissatisfaction with the Russo-Ukrainian deal. No party is expected to win an outright majority: the Party of Regions headed by last year’s defeated presidential candidate Viktor Yanukovich, and Yushchenko’s Our Ukraine, have been tipped to gain first and second place respectively. Horse-trading to form a coalition is expected, and this year’s constitutional shift, which gives parliament extra power at the president’s expense, adds to its importance. The electoral bloc headed by Timoshenko is unlikely to win enough votes to wield much influence in coalition talks – but an articulate, populist campaign by the former premier from the back benches would make it harder for a fragile coalition to manage the impact of higher gas prices, let alone win acceptance for the Rosukrenergo arrangement.

However strong the criticisms in Kiev political circles of the transit arrangements, no-one seriously argues that gas price increases can be avoided. Indeed president Yushchenko was the first to propose, after coming to power against Russian-backed opposition last year, that the two countries’ gas relations should move to market principles. Now the reality of higher prices has arrived, Kiev is being forced to think more seriously about energy strategy. On February 7, Yushchenko set up a working group on diversification of energy sources and gas supplies, headed by security council chief Kinakh, a former prime minister with a background in industry and industrial policy-making.

A spokesman for the ministry of fuel and energy told Gas Matters that a national energy strategy now under discussion envisages imported gas, which now accounts for 30.1% of Ukraine’s energy balance, falling to 4.1% by 2030. The strategy provides for massive increases in domestic atomic energy production (from 12.6% of the balance to 32.6%) and coal production (from 18.9% to 31.3%). But such fundamental changes are not only a long way off but probably wholly unrealistic in relation to the capital investment requirements. Indeed the fate of Kinakh’s commission beyond the elections must be uncertain. What has to be tackled as a matter of urgency are the gas issues of this year, next year and the next five years. At present, the only positive development may be that much higher prices will provide incentives for Ukrainian industry to wean itself off excessive and inefficient consumption of gas.

$1 (US) = 5.06 Ukrainian hryvna = 28.06 Russian rubles

A version of this article appeared in Gas Matters, March 2006.
Posted June 2006; © 2006 Simon Pirani

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