Ukraine’s gas travails

Published in Gas Matters, April 2011

Ukraine’s share of Russian gas transit to Europe remains under threat mid- to long-term, despite a promise by Gazprom to raise transit volumes via Ukraine to 112 bcm/year for five years. Ukraine’s talks about the transit network’s future,  with Russia on one hand and European institutions on the other, are dragging on inconclusively. Meanwhile efforts to raise domestic production, and streamline consumption, move forward slowly.

 Transit

 Gazprom’s commitment to increase transit volumes through Ukraine “to 112 bcm from the 100 bcm envisaged in the gas contract”was confirmed in a government memorandum to the International Monetary Fund (IMF) published on 25 February, after Ukrainian energy minister Yuri Boiko announced it in December.

The deal is seen by some in Kiev as reassurance that Gazprom will not reduce Ukrainian transit volumes immediately when the Nord Stream pipeline is commissioned later this year.

 But there must be doubt about the strength of the arrangement – firstly, because Gazprom only transited 98.7 bcm through Ukraine to Europe last year, up from 92.8 bcm in 2009, but far short of the 116.9 bcm transited in 2008. The recovery of transit to that level is only as certain as Gazprom’s recovery of its share of the European market.

 Secondly, the transit contract signed in January 2009 in the wake of the “gas war” stipulates transit volumes of 110 bcm/year; when and how this fell to 100 bcm/year is unclear. Thirdly, there is no indication that the 112 bcm/year volumes are written into the contract, the ship-or-pay provisions in which are anyway exceptionally lenient.

The bottom line is that the commissioning of Nord Stream, which should start by the end of this year and within two years could approach its 55 bcm/year capacity, will give Gazprom additional transit options as opposed to Ukraine and Belarus.

 In the case of 11-12 bcm/year that Gazprom used to transport through Ukraine to southern Russian provinces, once a non-Ukraine route was completed, in 2006, the volumes were diverted permanently. Although Russo-Ukrainian relationships vastly improved after last year’s presidential election, a future deterioration could see substantial cuts in transit volumes.

 It therefore remains likely that, mid- to long-term, Ukrainian transit to Europe will remain substantial, but will not increase … and could fall. The doubts over the scale of future transit volumes are compounded by continuing uncertainty over how the network will be managed and investment found to upgrade it.

 Talks on one side on a Gazprom-Naftogaz joint venture (that could include a resurrected consortium to manage transit), and on the other about loans to upgrade the system, from the European Bank for Reconstruction and Development (EBRD) or other international financial institutions, are ongoing but inconclusive.

 The only firm step taken towards financing arrangements from the European side is the commissioning of an engineers’ audit of the transit network.

 Politically, Ukraine has committed to integrate her energy networks, including gas networks, with those in Europe, as part of accession to the European Energy Community, which includes non-EU countries in the Balkans and aims to harmonise their energy legal regimes with those of the EU. Ukraine joined the community on 1 February, after approval from its parliament.

 Meanwhile, Rosukrenergo (RUE), the Swiss trader owned jointly by Gazprom and the Ukrainian billionaire Dmitry Firtash, has regained a foothold in the gas transit business as a result of settling an arbitration case with Naftogaz Ukrainy, the national Ukrainian oil and gas company.

 Under the settlement terms, 12.1 bcm of RUE gas appropriated from Ukrainian storage by Naftogaz in January 2009 will be returned to RUE. The first 3.471 bcm was returned in January this year.

 Gazprom Export will buy the 12.1 bcm and resell it in Europe, Russian newspapers have reported. Gazprom Export has paid an advance (undisclosed but reported at $2.6 billion), from which RUE paid $450 million in outstanding storage fees and $810 million in old debts to Gazprom. This still left RUE with spare cash, $550 million of which has been loaned to Gazprom at a 3.5% interest rate.

 The peace deal between the companies also provide for RUE to return to Naftogaz the $1.7 billion it paid for the confiscated gas, minus a $200 million penalty, and for Gazprom to advance $1.5 billion in transit fees to Naftogaz to purchase the extra gas to return to RUE.

 The Ukrainian government also included details of that deal in its memorandum to the IMF, which is effectively underwriting Ukraine’s consolidated budget deficit – which includes Naftogaz’s $1 billion-plus operating deficit. The Fund has accepted that Naftogaz will not get out of the red until next year at the earliest.

 Consumption

It is widely accepted in political circles in Kiev that Ukrainian energy policy needs to focus on increasing energy efficiency, and reducing import volumes and thereby import dependence.

 The economic crisis has made this difficult, slashing consumption by industrial customers – who pay higher prices, and pay more reliably, than those in the public and residential sectors – and exacerbating Naftogaz Ukrainy’s payments gap. (The sharply lower consumption in industry since the recession is shown in the graph.)

 Nevertheless, in 2010, a partial recovery in demand combined with the effect of higher import prices meant that – despite the 30% discount provided by the Russian government from April, in return for an extended lease on the Black Sea naval base – Ukraine’s import bill was the highest ever, at around $9.2 billion (see table, The Russia-Ukraine Gas Trade).

 The epicentre of Naftogaz’s financial problem is the district heating sector, which consumes up to 10 bcm/year of expensive imported gas and has built up substantial arrears: about 3.6 billion hryvna ($500 million) for the 2010-11 heating season, during which their payment rate fell to 41%, and 1.8 billion hryvna ($250 million) left over from the 2009-10 season.

 One piece of good news is that Kyivenergo, which consumed 2.72 bcm of gas in 2010, announced on 2 March that it is in talks with the capital’s adminstration about leasing its heat networks and jointly with the EBRD investing up to $2 billion in upgrades, to provide a pioneering example of energy efficiency gains.

 Kyivenergo, which runs the city’s two big combined heat and power plants and numerous district boilers, is 40% owned by DTEK, the power company controlled by Rinat Akhmetov, Ukraine’s richest man. The management has been calling for heat tariffs to be raised to cost-recovery levels as part of municipal services reforms.    

 Another group of consumers undergoing change is the chemical fertiliser sector, which buy 7-8 bcm/year. Dmitry Firtash has strengthened his position here too: his Group DF holding company announced on 2 March that it has bought the Azot Cherkassy fertiliser plant, raising its share of world capacity in ammonia-based fertilisers to 2.44%. Group DF, which had already purchased Stirol in September last year and Severodonetsky Azot in February, now has a near-monopoly on the Ukrainian fertiliser market.

A discount on gas sales to chemical plants was removed by government a year ago, but it would be logical for Group DF to seek cut-price gas inputs. One starting-point could be a government decree that has lain dormant since being issued in April 2009, allowing chemical fertiliser producers to buy gas directly from Russian companies, outside the Naftogaz import monopoly.

 Production

 Ukraine also faces a battle to raise domestic production, which runs historically at 20-21 bcm/year. Energy policy specialists point out that it could realistically be raised to 25-30 bcm/year this decade – a level at which, combined with energy-saving policies, it could make a serious dent in Ukraine’s import bill.

 But a stark warning was sounded this month by Naftogaz subsidiary Ukrgazvydobuvannya, the largest producer, that with Shebelinka and other producing fields now in accelerating natural decline, the most urgent issue is to invest in booster compressor stations, the rig fleet and other infrastructure.

 Ukrgazvydobuvannya deputy ceo Oleksiy Nesterenko told the Adam Smith Conferences Ukraine oil and gas conference in Kiev on 2 March that the company’s output could fall from 15 bcm/year to 8-9 bcm/year by 2015 without 2 billion hryvna ($250 million) investment in infrastructure.

 On a longer time scale, there are some reasons for optimism on production. ExxonMobil, which has unconventional gas licences in neighbouring Poland, on 18 February signed a memorandum to cooperate with Naftogaz to explore similar resources in western Ukraine.

 TNK-BP and Gazprom have also made agreements with Naftogaz on unconventional resources. In addition to shale gas in western provinces, part of the same geological formations as afford potential to Poland, Ukraine has coal bed methane in the eastern part of the country. 3P International, a small Canadian company, is producing CBM commercially in Donetsk.

 International oil companies are lobbying the Ukrainian government to move rapidly to implement the gas market law passed in April last year, and strengthen the licence regime, to provide a framework for investment.

 Industrial customers in Ukraine already pay essentially European netback prices, warming the hearts of managers of IOCs working in Ukraine. But the IOCs say that robust third-party access rules, a continuing improvement to upstream licencing rules and the establishment of a strong regulator free of political influence are all essential for large-scale investment.

 Government has set, and president Yanukovich published on his web site, a set of deadlines for the promulgation of normative acts and other measures that will be needed to put this into practice. Ukraine is also applying for membership of the Extractive Industries Transparency Initiative, the international agreement on oil and gas revenue transparency, in a bid to show that it means what it says on improving the investment environment.

 An optimistic view is that by the end of the decade, Ukraine could be producing up to 30 bcm/year of gas and will have left behind its cycle of disputes with Russia over transit and import. Pessimists argue that renewed friction with Russia will lead to a substantial reduction in transit volumes and fees, while sight will be lost of energy efficiency strategies and that import dependence will frustrate Ukraine’s economic recovery. Right now, the country could go either way.

THE RUSSIA-UKRAINE GAS TRADE
 

2005

2006

2007

2008

2009

2010

Imports
Volume imported, bcm

55.8

53.3

50.1

48

26.8

35.8

Average price ($/mcm) 44-80

95

130

179.5

232.54

257

Value of imports, $ billion

3.2

5.1

6.5

8.6

6.24

9.23

 
Transit
Volume transited to Europe, bcm

121.5

113.8

112.1

116.9

92.8

98.7

Volume transited to CIS, bcm

14.9

14.7

3.1

2.7

3

3

Cost of transit ($/mcm/100km)

1.09

1.6

1.6

1.7

1.7

2.83

Value of transit services, $ bn (OIES est.)

1.5

2.2

2.1

2.34

1.88

3.31

 
Source: energy ministry statistics, company announcements, OIES estimates
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