Moscow-Kyiv gas contract tensions rise

Published in Gas Matters, September 2011

The war of words between Moscow and Kiev over gas prices intensified last week, adding to fears that they will remain at loggerheads through the winter – with the possibility of supply disruptions to Europe.

Even if the dispute drags on, disruption is less likely than two years ago – and would probably not be on the same scale, due to the Nord Stream pipeline starting up, sluggish European demand, and improvements in interconnection and storage in central Europe.

On 2 September Ukrainian prime minister Mykola Azarov said that the 11-year import and transit contracts signed in January 2009 between Naftogaz Ukrainy, the national oil and gas company, and Gazprom, would be nullified as a result of the planned break-up of the Ukrainian entity. President Viktor Yanukovich’s office announced a timetable for the break-up into production, transport and distribution divisions, which is required by the gas reform law passed last year.

Gazprom chief executive Aleksei Miller quickly pointed out that the contracts require any legal successor to Naftogaz to fulfil its terms. If the company’s assets were returned to the Ukrainian state, its 100% owner, the contractual obligations would go the same way.

Ukrainian ministers are also warning of a unilateral decision to cut imports. Azarov said on 31 August that gas imports from Russia would be reduced to 27 bcm in 2012 (from 40 bcm this year), since Moscow has rejected pleas to renegotiate prices. Gazprom’s Miller responded that, however much gas Ukraine actually imports, “take or pay” terms require that 33 bcm/year be paid for.

Kyiv has all year been urging that the contracts be renegotiated – and Moscow has consistently responded that it would only do so in exchange for commercial concessions, e.g. the merging of Naftogaz Ukrainy with Gazprom.

On 5 August, Ukrainian prime minister Nikolai Azarov said Ukraine was preparing legal action in Stockholm to annul the import contract.  On 6 September, Ukrainian president Viktor Yanukovich said in a newspaper interview that the contract breaches the 2001 intergovernmental agreements that require gas prices to be renegotiated annually. He argued that Ukraine should pay the average German price minus $70/mcm for imported gas.

On 24 August Russian president Dmitry Medvedev said that if Ukraine entered the Belarus-Russia-Kazakhstan customs union, prices could be heavily discounted. But customs union membership is incompatible with Ukraine’s hopes of signing a free trade agreement with Europe, which Yanukovich reiterated on 25 August is a priority.

Medvedev cited the example of Belarus, which on 15 August agreed to raise Gazprom’s stake in its transit network from 50% to 100%, in return for a further discount on gas prices from next year. Belarus was paying $223/mcm earlier this year; the size of the 2012 discount will be negotiated at corporate level.

The demands for Ukraine’s contract to be renegotiated have a political aspect. The former prime minister Yulia Timoshenko, who led negotiations on the January 2009 contract, is on trial for “exceeding statutory powers”, on the grounds that she did not seek Cabinet approval for the deal. The EU and Russia have criticised Timoshenko’s arrest as politically motivated.

Former Naftogaz chief executive Igor Didenko and former customs chief Anatoly Makarenko were also charged in connection with the 2009 deal, on the grounds that the sequestration of 11 bcm of gas belong to Rosukrenergo, as agreed by the parties, was unlawful. On 5 September Didenko was convicted and given a three-year conditional jail sentence.

The oil-linked prices under Ukraine’s contract have risen steeply this year: Naftogaz announced that, even after the $100/mcm discount agreed last year, it is paying $355/mcm in the third quarter of this year, up from $263/mcm in the first quarter and $296/mcm in the second. Fourth-quarter prices could reach $388/mcm, Azarov has said. (Transit tariffs paid by Russia also rose in the third quarter, to $2.89/mcm/100 km, from $2.84, energy minister Yuri Boiko stated.)

High gas prices clearly have a negative impact on Ukraine economically – and on 5 August the tariff regulator announced that prices for residential and district heating customers would not be increased further this year, despite the government’s agreement with the International Monetary Fund to do so. Sergei Arbuzov, head of the Ukrainian central bank, said in a newspaper interview that raising tariffs would be “political suicide” for the government.

The IMF counts the Naftogaz deficit as part of the consolidated budget deficit. Fund officials estimated in February that Naftogaz’s losses this year would total 5 billion hryvna ($625 million). After the tariff freeze was announced, analysts at SigmaBleyzer investment company, who follow Ukrainian fiscal issues closely, said Naftogaz’s losses will likely be three times that size, i.e. 15 billion hryvna ($1.87 billion).

Ukraine’s 31 August announcement that it would reduce imports was accompanied by the revelation of extremely optimistic plans to diversify away from gas in the next five years. Energy minister Boiko said that Russian imports – which were 37.2 bcm last year and are projected at 40 bcm this year – could fall to 12 bcm by 2017.

Energy ministry officials, quoted by Kommersant newspaper, said that conventional gas production on the Black Sea shelf could rise by about 7 bcm/year (from about 20 bcm/year); shale gas production and coal-bed methane could replace 5 and 4 bcm/year respectively; and LNG imports to a proposed regasification terminal on the Black Sea 5 bcm/year.

Substitution of gas by domestically-produced coal in the power and steel sectors – probably the lowest-cost and easiest to implement of the proposals – could cut gas demand by 8 bcm/year, the officials suggested.

One significant development came on 1 September: Shell and Ukrgazvydobuvannya, Naftogaz’s production subsidiary, signed an agreement to explore shale gas deposits in north-eastern Ukraine, according to agency reports. Shell had not issued an official statement, and details were sparse, but Reuters reported plans to drill up to 1000 wells and quoted ceo Peter Voser as saying that up to $800 million could be invested.

The Shell deal, and ENI’s recent purchase of a stake in Cadogan, a small production company active in Ukraine, are rare examples of commitments to invest – and even these may not deliver significant volumes in the five-year time frame. Furthermore, until there are more deals and investment decisions, the government’s proposals – some of which are more ambitious and capital-intensive than others – may remain on paper.

Kommersant reported that ministry officials are also looking at energy-saving measures – which, if investments were carefully planned, could bring substantial results – but put no numbers on those.

Even if Ukraine succeeds in making unprecedented improvements, it is bound by the January 2009 contract to buy 33 bcm of gas, as Miller of Gazprom intimated. The annual contract quantity (ACQ) is 52 bcm, and there is a provision for this to be reduced by up to one-fifth, i.e. to 41.6 bcm, if six months’ notice is given. The “take or pay” clauses require that 80% is paid for, so even after such notification payment on 33 bcm/year is due up to 2019.

The 20th anniversary of Ukraine’s declaration of independence from the Soviet Union, marked last week, afforded an opportunity to reflect on what has and has not been achieved. From an energy policy standpoint, the lack of progress in diversifying away from Russian gas imports – especially by means of energy saving – stands out as a negative. Continuing as before, which has been the default position, is not a sustainable option for another two decades, or even one.

Published in Gas Matters, September 2011

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