Ukraine and Russian Gas – The Never Ending Crisis

Ukraine and Russia have had a stormy relationship over gas supply and gas transit for two decades. Periodically their disputes spill over to affect gas supply of their European neighbors, usually in the dead of winter, most recently in January of 2006 and 2009. Just as regularly the two sides declare that they have solved their problems, only for another crisis to appear a few years later. During Vladimir Putin’s time in power as either Russian president or prime minister, long-term agreements were signed with Ukrainian governments under President Yushchenko in 2006, Prime Minister Tymoshenko in 2009, and President Yanukovych in 2010. Soon afterward one side (often both) would complain about unfair pricing or unreliable performance by the other side. Yanukovych and his Prime Minister Mykola Azarov set a post-Soviet record by objecting to unreasonably high gas prices within months of signing agreements in Kharkiv in April 2010.

So how is a neutral observer supposed to judge the stability of this latest deal, signed during Yanukovych’s meeting with Putin on December 17 in Moscow? Permit me to provide a short primer.

Here’s what we know, which is very little:

  • Mr. Putin called this agreement temporary and said discussions will continue on gas supply to Ukraine and gas transit to Europe.
  • Russia will cut the gas price to Ukraine from well over $400 to $268.50 per thousand cubic meters.
  • Russia will buy $15 billion in Ukrainian government bonds (paid out of Russia’s National Welfare Fund) to save Ukraine from financial default.

Here’s what we don’t know, which is a lot:

  • How was Ukraine’s ongoing gas debt to Russia of around $2 billion resolved? Ukraine has been borrowing money from Russian banks to pay for gas it purchased from Russia.
  • Was Ukraine’s failure to meet its purchase volume commitments under the Kharkiv agreement discussed and resolved? In January this year, on the day after Ukraine signed a shale gas exploration agreement with a major international energy company, Russia’s Gazprom handed its Ukrainian counterpart Naftogaz a $7 billion bill for volumes it committed contractually to buy but did not take. The overdue bill would be a lot higher now, since Ukraine bought even less Russian gas in 2013 than it did in 2012.
  • What is the pricing formula that led to the new price of $268.50? Is this the new base price or a temporary price and for how long? What is the price escalation clause?
  • Has Ukraine’s purchase volume commitment been adjusted downward from the unrealistically high level set in April 2010?
  • Did Russia make gas transit volume commitments to Ukraine, which was conspicuously missing from the fatally flawed Kharkiv agreement? How long is it for?
  • What does that do to Gazprom’s plan to build the expensive South Stream pipeline? Or has Gazprom secured under this deal control of Ukraine’s gas transit system, through which more than 50 percent of Russian gas exports to Europe still flow, including important gas storage facilities? Did Russia pledge to abandon South Stream, which this Ukrainian government has demanded since 2010?
  • What role, if any, do middlemen companies (the traditional vehicle of choice for murky Russian-Ukrainian gas deals) play in this agreement, particularly since one of these Ukrainian gas intermediaries was permitted earlier this year to purchase Russian gas at a much lower price than the official price that Gazprom sold to Naftogaz?

Even larger questions loom if none of the issues mentioned above has been resolved on a sound long-term basis. These questions would leave the Sword of Democles that is Russian gas trade hanging over Ukraine and President Yanukovych’s head:

  • Does the much lower Russian gas import price allow his government to finally proceed with much-delayed and urgently needed gas pricing reform, which is a major demand of the IMF? Without an IMF agreement, Ukraine stands no chance of stabilizing its precarious fiscal and balance of payments situation. Or is this a temporary fix designed for Yanukovych to avoid any reforms before the 2015 presidential election?
  • Will Ukraine now free wellhead gas prices to the same level as the import price? Currently domestically produced gas is regulated at one-fifth the price of the new Russian gas price or one-eighth the previous higher price?
  • Controlling gas prices at below market-clearing levels at both the burner tip and wellhead has the perverse effect of depressing domestic production, encouraging wasteful consumption, limiting energy efficiency gains, and subsidizing higher-priced imports. Yet it promotes a gray market in gas trading, privileged access and corruption in the gas sector, favorite pastimes for Ukrainian politicians for twenty years.
  • What does a much lower price for Ukraine mean for Gazprom’s recently adjusted European contracts? Will they have to be renegotiated again? Gazprom was forced to lower prices for all its major gas buyers in the last couple of years because of lower European demand, greater competition from liquefied natural gas (LNG) indirectly due to the American shale gas revolution, and rigid contract gas prices that escalate with oil prices.
  • As fellow members of the World Trade Organization (WTO), how do Russia and Ukraine defend the disparity in Russian gas prices between Ukraine and other European countries, beyond what can be attributed to lower gas transportation costs?

This recent gas agreement between Russia and Ukraine raises more questions than provides answers, which is a pattern we have seen before. Partly this is because negotiations are always held behind closed doors and the terms of agreements are rarely, if ever, revealed. This is justified in the case of legitimate commercial secrets. However, in negotiations between governments and government owned and controlled companies, the public and their elected representatives have the right to know about critical terms that affect the public interest. Perhaps more details will emerge in the coming weeks. Nevertheless, the protesters in EuroMaidan the last four weeks are in large part reacting strongly to such secretive, seemingly capricious, decision making on matters critical to Ukraine’s national interest.

Mr. Putin has now jumped with both feet into the volatile Ukrainian political situation in spite of his unhappy experience during the 2004 Orange Revolution and against the advice of many Russian commentators. How confident is he that he will get his way this time without some future Ukrainian leader overturning any deal? We may be able to tell by how expeditiously Gazprom now proceeds with its ambitious South Stream pipeline project, which would finally remove all of Ukraine’s gas transit leverage over Russia. And, of course, bond buying can stop at any time (only $3billion of the promised $15 billion purchases will be made immediately) and this does not fundamentally address Ukraine’s serious fiscal and payments imbalance. It merely kicks the can down the road, while increasing the total amount Kyiv owes Moscow.

Finally, to the extent that Ukraine has been addicted to cheap gas, which has blocked the modernization of its industry, economy and politics, this is a temporary fix, which only prolongs and aggravates the agony. The European alternative would require immediate and painful reforms for a faster and more robust recovery, a choice Mr. Yanukovych rejected.

In February 2012, I testified before the U.S. Senate Foreign Relations Committee that, on current trajectory with its government ignoring longstanding energy challenges, Ukraine will become an energy appendage of Russia. I’m afraid my prediction may come true. Is anyone in America and Europe paying sufficient attention or do we care? History suggests paying attention to the systemically problematic details of agreements long before the moment of crisis may be a good place to start. Luckily with Ukraine, nothing is irreversible. EuroMaidan protestors certainly believe so.

Edward C. Chow is a senior fellow with the Energy and National Security Program at the Center for Strategic and International Studies in Washington, D.C.

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Edward C. Chow
Senior Associate (Non-resident), Energy Security and Climate Change Program