Ukraine's quiet energy revolution
Ukraine, which in Russian translates as 'on the border', is sitting on the fence in more than one way. The country is now in the news after its president single-handedly put the Association Agreement with the EU "on pause", in favor of a Eurasian customs union with Russia and regional allies. In dealing with Ukraine, the EU through its AA, proposed a Most Favored Nation trading partner status[1]; this falls short of a customs union, not to mention, a commitment to EU integration, but it was worth striving for. In comparison, Russia proposed what on the face of it looks like a better deal, an integration in its customs union by 2015, and Russia accounts for 25% of Ukraine's exports trade[2]. Russia also explicitly threatened Ukraine with trade retaliation if it signed the AA. Natural gas is one leverage Russia has used in 2006 and 2009, when it cut its supplies to Ukraine. The disruption of supplies to countries downstream of Ukraine backfired on Gazprom, which had prided itself in being a reliable supplier to Europe. Gazprom is unlikely to cut gas supplies to Ukraine in the future. However the selling price of gas continues to act as a barometer for the Kremlin's appreciation of successive Ukrainian governments. The price of gas at the Russian-Ukrainian border stands at a high $430 / kcm (thousand cubic meters) or $13.8 / MMBTU. For comparison, NBP benchmark price of $10.2 / MMBTU for Jan-14[3], and Ukraine ought to benefit from a lower price owing to its proximity to Russia. It does not, because the Ukrainian gas price is not an oil-indexed one, as is the case with most of the gas Gazprom sells to Europe. It is a politically negotiated one. Paradoxically, this price has increased from $234 / kcm since Viktor Yanukovich became Ukraine's president in February 2010, and he was thought to be Moscow's candidate. This is despite the fact that his government signed in March 2010 a deal to extend beyond 2017 Russia's lease on the Sebastopol naval base in Crimea, Ukraine. The price of gas at the Russian-Ukrainian border may or may not fall as a result of Ukraine's shift eastward, but the price at which Ukraine imports its gas remains the country's Achilles' heel. For one, gas is being sold to the population at a ridiculously low price of $156 / kcm [4]; this is to be compared with an average residential price of roughly $730 in the EU. Even if Ukraine's own gas production pretty much covers the 18 bcm the population consumes, the high price of gas imports affects the competitiveness of Ukraine's heavy industry. This social price has over the years deepened the debt of the state-owned oil and gas company NAK Naftogas Ukrainy before Russia.
Neither the border price of gas, nor the internal social price of gas are sustainable on the long term. Several factors are reducing Ukraine's economic dependence on Russian gas, and will continue to do so in the future:
1) Falling gas demand. As in Western Europe, the economic crisis has depressed the demand for gas in Ukraine. Demand fell from 70 bcm in 2007[5] to 54 in 2012[6], and this trend is likely to continue. In the meantime, domestic production is stable and is likely to grow as unconventional gas resources are developed. Ukrainian gas imports from Russia and from Turkmenistan (via Russia) will therefore decrease to an expected 27 bcm in 2013[7], down from 42 bcm in 2009. Ukraine is actually subject to a take-or-pay clause in its Gazprom supply contract. The amount Ukraine should import, and the tariff Gazprom should pay for using Ukraine's transit pipelines and storage facilities in Western Ukraine are the subject of endless arguments between the two. There used to be an explicit link between the price of Russian gas for Ukraine, and the tariff for transiting and storing this gas West of Ukraine. Ukraine thus had a leverage in its dealing with Russia. With the commissioning of the North Stream pipeline in 2010, Russia became able to sell gas directly to Germany in volumes of up to 55 bcm / year. Possibly as a result (this is conjecture), the price of gas at the Russia-Ukraine border became unlinked from the transit and storage that NaftoGaz Ukrainy charges to Gazprom. This could have allowed the price of gas to rise uncontrollably.
2) New sources of imports. Ukraine is Europe's second-largest gas importer after Germany. Unsurprisingly, the gas importers have wielded much economic power, thanks to near-monopoly import rights from Russia or Turkmenistan[a]. This state of affairs changed with a law passed in 2010[b] but actually enacted in late 2012 setting in motion the process of gas market liberalization. Currently large consumers can choose their gas supplier, and this freedom will be extended to all consumers by January 1st 2015. This change in legislation, for which the EU had long lobbied, has had its intended effect: there are now gas trading new entrants who can book pipeline capacity, import at the expense of the incumbent player. Gas importers are developing creative dispatching strategies to arbitrage out the regional gas price differences, thus circumventing the destination clauses in Gazprom's supply contracts to European utilities. Since September 2013, NaftoGaz Ukrainy and independent traders have been importing small volumes via Poland and Hungary. Potentially 20 mcm / d could be imported from Slovakia in reverse flow, once upgrades to an unused stretch of pipeline is completed[8]. The price discount versus Russian gas has been over the order of $2 / kcm[9]. This arbitrage opportunity may disappear in the Winter months, as the price of gas delivered to Central Europe increases, under newly flexible Gazprom supply terms. Further down the road, Ukraine could become a LNG importer, perhaps even the first one on the shores of the Black Sea. Shipping authorizations relating to the passage of LNG carriers through the congested Bosphorus have apparently been settled. A Floating Storage & Regasification Unit -in effect a converted LNG carrier- is being connected to the Yuzhnyi terminal, near Odessa[10]. According to official announcements 5 bcm of gasified LNG could be flowing as early by the end of 2016, going up to 10 bcm by 2018 when on-shore cryogenic tanks are built. This should come with caveats, however[11]: firstly, the Ukrainian State Investment Fund is the only investor in this $1b initial project at this time, after it was revealed that a foreign "investor" was an impostor[12]; secondly, no LNG suppliers have been announced, so far. This is unsurprising, given Ukraine's volatile politics, and the project's marginal profitability, which depends on sustained high import prices. Still, Ukraine's Black Sea shore could one day allow diversification of supply. The saga of the Odessa-Brody crude oil pipeline shows how politically sensitive infrastructure projects can be. The Odessa-Brody line was conceived in newly-independent Ukraine to provide an alternative to Russian crude delivered by the Soviet-era Druzhba pipeline, and has been entirely state-financed. Ironically, this line has exported Russian crude via Odessa since it became operational in 2004. For the last decade, there has been wishful talk in Ukrainian government circles of reversing the pipeline's flow to supply refineries in Belarus and, once an extension is built, to the port of Gdansk, Poland.
3) Increased domestic production. In January 2013, Shell[13] announced investments of "at least" $10b to develop shale gas in Eastern Ukraine and is already producing at time of writing; in November 2013 Chevron announced investments of "up to" $10b, to develop shale gas in Western Ukraine[14]. The precedent of Poland's shale gas should inspire caution, however. The country started its shale gas revolution in 2011 with an estimated 5.3 trillion cubic meters (tcm) of shale gas, according to the EIA[15]. This figure was downgraded to 4.2 tcm in 2013. Several O&G companies have discontinued operations in Poland, either as a result of anti-fracking activism, in the case of Chevron, or because flow rates from exploration wells were disappointing, in the case of ExxonMobil[16]. Beyond shale gas, Ukraine has other gas resources to develop. Offshore from Crimea, ExxonMobil and OMV, on one hand, and EDF, ENI and Ukrainian partners on the other are in discussions to develop blocks in the Black Sea and the Azov Sea, as part of Production Sharing Agreements[17]. According to the state-owned offshore E&P company Chernomorneftegaz, potential reserves amount to 1.9 tcm of gas and 434 mt of oil.
4) Ukraine as a trading hub?Geography and infrastructure in place could make Ukraine a major gas trading hub. Starting with the obvious, Ukraine shares borders with 7 countries, on par with Hungary and more than any other European country. In addition Ukraine has access to the Black and Azov Seas. Its gas transportation infrastructure is connected to all its neighbors, first and foremost to Slovakia, with a 90 bcm / yr westward capacity. Ukraine's storage capacity West of Ukraine is second to none, with a 32 bcm capacity. In spite of this favorable situation, several factors stand in the way of Ukraine's making an entry in Europe's crowded club of gas hubs. The first obstacle is that Gazprom has booked Ukraine's transit and storage assets for its own exports to Europe. Naturally, allows neither the physical nor the virtual reversal of flows on the segments it controls. Secondly, the underground gas storage facilities are depleted gas fields, which are exploited strictly as seasonal storage with withdrawals occurring only during the gas year's winter. Finally, gas hubs can only thrive in jurisdictions where third party access is seen to work and, more generally, where contracts are backed by efficient and independent courts. Ukraine has a long way to go before Europe's gas companies will purchase their Russian gas supplies at the Russia-Ukrainian border. An encouraging first step in this direction is greater disclosure on flows and inventories from Naftogas and the government's statistics agency.
[a] Under President Leonid Kuchma (1994-2005), the gas import monopolist were Itera Energy, founded by Igor Makarov, a figure close to Turkmenistan's late leader and to Gazprom's former president. He was pushed aside by InterGas, founded by Igor Bakai, who also set up NaftoGas Ukrainy. Under the premiership of notoriously corrupt Pavlo Lazarenko, United Energy Systems prospered under now-imprisoned Yulia Timoschenko. Under President Viktor Yuschenko, it was the turn of Dmytro Firtash's RosUkrEnergo to prosper.
[b] «Об основах функционирования рынка природного газа», voted July 8th 2010.
[1] http://en.wikipedia.org/wiki/Ukraine-European_Union_relations#Deep_and_Comprehensive_Free_Trade_Agreement_.28DCFTA.29
[2] http://www.economist.com/news/europe/21583998-trade-war-sputters-tussle-over-ukraines-future-intensifies-trading-insults
[3] http://en.wikipedia.org/wiki/2010_Ukrainian-Russian_Naval_Base_for_Natural_Gas_treaty
[4] 1300 UAH, http://en.for-ua.com/news/2013/11/11/102936.html
[5] Elusive potential: natural gas consumption in the CIS and the quest for efficiency, Oxford Energy Institute, NG53, July 2011
[6] http://en.interfax.com.ua/news/economic/172342.html
[7] http://eurodialogue.org/energy-security/Ukrain-%20to-Keep-Cutting-Russian-Gas-Import-in-2013
[8] ICISL MOU near on physical gas reverse flow from Slovakia to Ukraine, 19/11/2013
[9] ICIS Poland tests gas exports to Ukraine, 20/11/2013
[10] http://zn.ua/article/print/ECONOMICS/pervyy-gaz-na-lng-terminal-mozhet-priyti-uzhe-osenyu-2014-goda-122546_.html
http://worldmaritimenews.com/archives/82400/global-fsru-leader-signs-up-for-ukraines-lng-terminal-project/
[11] http://zn.ua/article/print/ECONOMICS/vedomstvo-kaskiva-podpisalo-novyy-dogovor-po-lng-terminalu-121284_.html
[12] http://blogs.ft.com/beyond-brics/2012/11/27/ukraine-the-gas-deal-that-never-was/?#axzz2mD0GFUyH
[13] http://www.nytimes.com/2013/01/25/business/global/ukraine-signs-drilling-deal-with-shell-for-shale-gas.html?_r=0
[14] http://uk.reuters.com/article/2013/11/05/uk-ukraine-chevron-idUKBRE9A40FE20131105
[15] http://www.eia.gov/countries/country-data.cfm?fips=PL
[16] http://www.krakowpost.com/article/7256
[17] Financial Times, 14/11/2013, Ukraine's shale gas lures western companies
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