Ukraine’s Gas Dilemma: Two steps forward, two steps back

Ukraine is finally taking serious strides towards energy independence, its biggest geopolitical headache. New deals should boost production from unconvential energy resources, alternative sources are being explored and local consumption is being reduced.

Yet Russian Gazprom's single biggest client is not out of the woods just yet. A recent seven billion dollar bill for unpurchased gas in 2012 suggests Moscow will try to keep pressure on Ukraine high, while a rising campaign against shale gas could cause additional problems at home. Moreover, government policy does not always seem to have the nation's best interests at heart.

Seeking independence

If there is one consistent positive theme to the Ukrainian government's actions over the past couple of months, energy independence would be it.

Last month, the authorities signed a ground-breaking ten billion dollar production sharing agreement with Shell to drill the Yuzivska Shale Gas Field in Eastern Ukraine. In 2012, major steps were made on other sources of unconventional gas, including shale deposits in the country's west and offshore drilling in the Black Sea. Despite intial problems, involving the signature of a one billion dollar deal with an unknown Spaniard, plans for a liquified natural gas terminal are moving forward, providing a further alternative to the up to 1.2 trillion cubic metres of shale gas that Ukraine potentially has.

In addition to bringing in billions of dollars in investments to the recession-hit economy (assuming no major legislative or administrative hurdles emerge), these developments will help Ukraine reduce its dependence on Russian gas.

In 2011, the state gas behemoth Naftogaz imported 40 billion cubic metres of Russian gas. In 2012, however, this level was just 25 billion, although Ostchem, which is controlled by billionaire Dmytro Firtash, made up for 8 billion cubic metres worth of slack. This year, the plan is for Naftogaz to buy just 18 billion cubic metres.

Repurchasing gas from Europe, through somewhat counterintuitive physical supplies, will further cut Russian imports. In 2012, this amounted to a relatively small 52 million cubic metres, but is set to grow to 5 billion cubic metres next year.

Ukraine is also actively looking further afield for new suppliers, such as Azerbaijan or Turkmenistan. President Viktor Yanukovych has been particularly fond of visiting the Central Asian dictatorship, with a visit in each of the past three years, resulting in a tentative gas deal signed earlier this month to resume imports, which stood at 36 billion cubic metres annually until 2006.

Further integration into European networks is also possible. In an op-ed for the Kyiv Post published on February 22nd, European Commissioner for Energy Guenther Oettinger highlighted the possibility of turning Ukraine into a European storage hub (Ukraine has 31 billion cubic metres of gas storage space, compared to 91 for the European Union in total), as well as diversifying supplies.

“The EU is willing to explore the possibility of establishing a 'gas corridor' to bring more long-term diversification options for Ukraine using, inter alia, existing pipelines in Western Ukraine that link to Romania, Hungary, Slovakia and Poland,” the commissioner wrote.

Gazprom weaker, but not defeated

Ukraine's surge toward energy independence comes at a time of existential crisis for Vladimir Putin's main geopolitical tool. After several years of record profits, Gazprom's star has begun to wane, driven by a shale gas revolution in the United States which has freed up supply of liquified natural gas from the Arab states. This, in turn, has allowed the spot market to develop, introducing more competition on the European arena. Meanwhile, an EU commission probe has encouraged Central European governments, including Poland and Lithuania, to revise their contracts or challenge Gazprom in court.

Nonetheless, the Russian gas giant took the offensive on January 24th, just hours before the Shell deal was signed, slapping Ukraine with a seven billion dollar bill for allegedly violating a take-or-pay clause in the bilaterlal agreement. Given that Ukraine only imported 25 billion cubic metres in 2012 (not including the 8 billion for Ostchem), Moscow argued, it should cover the shortfall between the 52 billion cubic metres foreseen in the 2009 contract.

According to some analysts, one result of Gazprom's weakness is that Russia has opted for indirect pressure on Ukraine rather than resorting to the previous habit of launching a “gas war”, i.e. cutting supplies in the middle of winter. Indeed, according to former Naftogaz spokesperson Ukraine's authorities have so far remained unfazed. In a “conversation with the nation” on February 22nd, Yanukovych restated the position that Ukraine has no intention of paying the seven billion dollar bill. So far, it remains unclear whether anything will come of it, as neither side seems particularly eager to seek judicial intervention.

Yet this doesn't mean the tango is over, with the latest twist coming in the form of a Stockholm resolution on a dispute between Ukraine's Naftogaz and Italy's Italia Ukraina Gas. Reported last week by business daily Kommersant, the dispute involves a 10-year contract requiring that Naftogaz re-export 1.3 billion cubic metres of Turkmen gas to the Italian company. As a result, the paper argued, Stockholm had required Ukraine to provide the gas at 2003 prices, which would cost the country around four billion dollars.

Yet according to the Warsaw-based Centre for Eastern Studies, the Gazprom-controlled daily lied about the case (it has since published a correction, although without an explanation). Naftogaz has indeed dismissed the charges, saying that the arbitration court merely demanded that it cover the shortfall experienced between September 2008 and December 2010, and pay a fee of under 13 million dollars.

The Ukrainian authorities have so far shown little inclination towards making good on the decision. A clause in the contract, as in most of Ukraine's international deals, stipulates that acknowledgement by a local court is required for the deal to be valid. It seems unlikely to be forthcoming. Nonetheless, the dismissal of the Stockholm verdict on the eve of a potentially bigger case involving Gazprom and Naftogaz, could prove extremely inconvenient.

Unclear energy politics

Ukraine's participation in the European Energy Community and the implications for negotiations with Russia raise many eyebrows. During his recent televised appearance, Yanukovych said the signature of the Energy Charter treaty and accession to the Energy Community has produced no positive results for Ukraine.

“When we got the seven billion dollar bill from Russia, there was no reaction [on behalf of the European Energy Community]. We don’t feel the effect we were counting on from our membership in the European Energy Community,” Yanukovych complained. While there is some validity to this grievance, EU officials also point to a lack of initiative on Ukraine's behalf.

According to analysts at the Kyiv-based investment bank Dragon Capital, the president's statements are possibly setting up the basis for a joint venture with Gazprom to manage transit. Rejecting the charter is a likely precondition for Russia, the analysts argue, and the creation of a joint venture would allow to bypass legal restrictions on selling what is a key national security asset.

Yet most experts agree that this is not unavoidable. Among others, the precendent set by RWE Transgas, which won a comparable case in Stockholm, suggest that Ukraine, too, could take its chances at a trial. Indeed, the country's situation has changed considerably since the 2009 contract was signed, and the agreement was inked under duress, when supplies were cut in the middle of winter.

Despite the potential merits of such a solution, as well as the time and energy that has gone into barren negotiations with Moscow, Ukraine's authorities seem loathe to take judicial action. Equally puzzling are the president's statements about the fact that there will be no increases in gas prices for both households and industrial consumers. Alhough the latter currently pay a price that fully covers import costs, households have been receiving a de facto subsidy that is causing the nation to lose 500 million dollars per month, according to Yanukovych himself.

More importantly, removing the costly subsidy is a key precondition for renewed cooperation with the International Monetary Fund, whose mission just ended talks in Kyiv in early February. Despite noting some progress, the mission highlighted significant differences that would have to be resolved before any further programme could be launched.

A previous programme had been aborted in 2011, over the same issues. This year, however, Ukraine faces 10.5 billion dollars in public debt redemptions, much of it to the IMF. With the economy already in recession and international currency reserves below the safety level of three months of imports, one would expect the government be more ammenable to the lender's demands.

So far, however, Ukraine's position has barely budged an inch. It seems some parts of energy and economic policy are moving in the right direction. But on other, equally critical aspects, there is no progress to be seen.

Jakub Parusinski is an editor at the English-language weekly Kyiv Post and a contributor to New Eastern Europe's Unravelling Ukraine column.