April 17, 2015

More competition, less expensive Russian gas in Ukraine’s market

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Part I

On April 1, on President Vladimir Putin’s instructions (Kremlin.ru, March 31; Interfax, April 1), Prime Minister Dmitry Medvedev prolonged the validity of the existing agreement on Russian natural gas supplies to Ukraine until June 30, effective immediately.

Originally signed by Russian Gazprom and Naftohaz Ukrainy last October, the agreement was in force from November 1, 2014, through March 31 of this year (the winter heating season) with a price discount. That “winter package” agreement (see Eurasia Daily Monitor, March 18) has now been prolonged, including that discount, until the end of the second quarter of 2015, as part of a “summer package.” This looks likely to be carried over into the third quarter. The European Commission is mediating these negotiations at each stage.

While Russia persists with full-spectrum conflict operations against Ukraine, there is overlapping interest on both sides to insulate the Russia-Ukraine gas trade and the gas transit to Europe from the impact of the ongoing conflict. The European Union encourages this understanding of the overlapping interest.

Although the agreement’s prolongation looks like a short-term measure, it reflects far-reaching changes on the energy markets in Europe and Ukraine. Those changes are increasingly neutralizing Russia’s ability to pressure Ukraine and Europe through manipulation of gas supplies and transit. As long as Ukraine carries a major portion of Russian gas exports to Europe, the Kremlin can no longer impose extortionate gas prices on Ukraine or threaten it with supply cutoffs, as in previous years. For Moscow to do so in the currently evolving market conditions (see below) would be to risk defaulting on Russia’s supply commitments to Europe and losing markets there.

Thanks to EU market liberalization and Central Europe interconnections, European energy companies are themselves gaining market share against Gazprom in Ukraine. No longer bound by Gazprom’s bans on re-export to third countries, European companies resell gas of Russian and other origins in growing volumes to Ukraine. Ongoing expansion of reverse-flow pipeline capacities, particularly through Slovakia, makes this possible. This means differentiation of the gas suppliers and routes to Ukraine. The Ukrainian gas market is becoming a competitive market with alternative import options.

In the bilateral Russia-Ukraine gas trade, the Ukrainian market seems about to begin turning from a seller’s into a buyer’s market. While Ukraine gains access to non-Gazprom alternatives, the country’s overall natural gas demand is down as a result of war and recession. Planned energy conservation measures promise to cap that demand after recovery from recession. Gazprom’s sales to Ukraine have declined both in market share and in quantitative terms, with correspondingly shrinking revenues. In this situation Gazprom, and behind it the Kremlin, have little choice but to keep selling gas to Ukraine and be flexible on prices, even amid the Kremlin-led war on Ukraine.

Moscow could not seriously prevaricate at this time in the gas negotiations with Ukraine. The EU-mediated negotiation to prolong the agreement proceeded relatively smoothly.

On pricing, the “summer package” carries over the wintertime price discount for Ukraine. On volume, the agreement’s prolongation should enable Ukraine to begin storing sufficient Russian gas for subsequent delivery to Europe, in anticipation of next winter’s heating season.

Under Mr. Medvedev’s April 1 governmental decision (postanovlenie), Gazprom continues granting the price discount to Ukraine on the same terms as during the winter just past. The discount is relative to the fluctuating price of the gas at any given time. At a sale price exceeding $333 per 1,000 cubic meters, a discount of $100 applies. At a sale price below $333 per 1,000 cubic meters, a discount of 30 percent applies in correlation with that price. The financial mechanism of applying the discount operates by deducting Russia’s gas export duty from the price charged to Ukraine. The Russian state budget absorbs that loss (RIA Novosti, April 1).

This discount’s value and methodology are based on the inter-state agreement of 2010 (gas price discount to Ukraine in return for long-term Russian naval basing rights in Crimea). Russia, however, repudiated that agreement shortly after annexing Crimea from Ukraine in March 2014. At that time Moscow cited (inter alia) Ukrainian debts for past supplies of gas.

The “winter [2014-2015] package” marked the resumption of Russian gas sales to Ukraine. The winter agreement introduced, and the summer 2015 agreement maintains, pre-payment by Ukraine for Russian gas supplies. Ukraine has recently been pre-paying in small installments, for a few days’ worth of gas supplies at a time. Ukrainian pre-payments covered Russian gas delivered until March 31, on which date Gazprom halted its deliveries (Gazprom press release, March 31).

According to Ukrainian Energy Minister Volodymyr Demchyshyn, Kyiv’s decisions on whether to procure gas from Gazprom, and in what volume, would partly depend on comparing the prices offered by Gazprom and European companies (Interfax-Ukraine, April 1). It is an opening gambit for negotiation, made possible by diversified options newly available to Ukraine.

The Ukrainian government had initially sought prolongation of the expired “winter package” until the end of the next winter’s heating season, October 2015-March 2016. Moscow, however, insisted on a three-month solution, hoping for a subsequent rise in world oil prices, to which the Russian natural gas price for Ukraine is pegged. The European Commission advised Kyiv to seize Moscow’s offer at this time and continue negotiations in the tripartite format – Russia, Ukraine, the EU – to bring forward an agreement for next winter’s entire heating season. European Commission Vice-President Maros Sefcovic, who is responsible for the Energy Union, mediates these negotiations (EurActiv, April 2).

Part II

On April 2, Russian Gazprom and Naftohaz Ukrainy signed an agreement on natural gas sales-and-purchases to cover the next three months. Russian President Putin authorized his government, which in turn instructed Gazprom, to sign this agreement, with a substantial price discount for the “Ukrainian partners” (Kremlin.ru, March 31). Valid until June 30, as part of a putative “summer package,” this agreement represents the continuation of the “winter package” gas supply agreement, which was signed last October for the period November 1, 2014, through March 31, 2015 (see Part 1).

Under the agreement just signed, Naftohaz’s purchase price for Russian gas drops to $248 per 1,000 cubic meters, valid until the end of the second quarter of 2015. Gazprom has arrived at this price by applying a discount of $100 per 1,000 cubic meters on the “contractual price,” which is set at $348 for this year’s second quarter (Interfax, April 2).

The “contractual price” refers to the 2009 Russian-Ukrainian inter-governmental agreement on gas supplies, negotiated by then–Prime Ministers Putin and Yulia Tymoshenko, and deemed valid until 2019. The $100 discount stems, in turn, from the 2010 inter-state agreement negotiated by Mr. Putin with then-President Viktor Yanukovych, whereby Russia received long-term naval basing rights in Ukraine’s Crimea in return for the gas price discount. Russia tore up the 2010 agreement by annexing Crimea in March 2014. But it reinstated the gas price discount in the Gazprom-Naftohaz agreements of October 2014 and April 2, 2015.

Gazprom is dramatically losing market share to European energy companies in Ukraine. During the first quarter of 2015, for the first time ever, gas supplies to Ukraine from Europe exceeded those from Russia. The volumes delivered were 3.6 billion cubic meters (bcm) versus 2.2 bcm during the period of January 1 through March 31. European energy companies re-sell gas mostly of Russian provenance to Ukraine. Their sale prices averaged from $270 to $280 per 1,000 cubic meters during this period (Ukrinform, UNIAN, April 2).

Gazprom’s discounted price at $248 seems designed to outbid European competitors in Ukraine. Rebuilding its market share would also mean rebuilding Russian leverage and influence in the country. Conversely, a defeated and shrunken Gazprom in Ukraine would severely embarrass the Kremlin, and Mr. Putin personally.

Russia’s state budget, not Gazprom, will bear the costs of Gazprom’s price cut. The $100 difference between the contractual price and the discounted price (per 1,000 cubic meters) results from the waiving of Russia’s gas export tax on the volumes to be delivered to Ukraine.

Under the April 2 agreement, delivery volumes will be determined on a daily basis, depending on Naftohaz’s requests. The volumes can range from 0 (zero) up to 114 million cubic meters (mcm) per day, by prior request and based on Ukrainian pre-payment in each case. The agreement signed in October 2014 introduced the pre-payment requirement, and the prolongation agreement just signed maintains it. For a quantitative comparison, Ukraine currently imports some 55 mcm per day from all external suppliers, via Naftohaz (Interfax-Ukraine, April 1).

The April 2 agreement brings back the issue of “take-or-pay” into the argument. This is related to the Gazprom versus Naftohaz litigation, ongoing in the Stockholm Arbitration Institute and due for a resolution in 2016. Gazprom claims some $20 billion in penalties from Naftohaz and/or Ukraine, for what Gazprom describes as non-compliance with the take-or-pay clauses of the 2009 agreement. The follow-up agreement of October 2014 did not include take-or-pay clauses (Interfax, April 1). The unpublished April 2 agreement (itself a continuation of the October document) apparently includes some reference to the 2009 take-or-pay clauses.

Russian officials’ public statements show some discrepancies on this issue. Gazprom CEO Aleksei Miller disclaims intentions to enforce take-or-pay under the April 2 agreement. Mr. Miller, however, claims that Gazprom needs this reference in the new document for consistency with its take-or-pay case in the Stockholm arbitration (see above). For his part, Russian Energy Minister Aleksandr Novak insists that the take-or-pay clauses from 2009 remain in force, along with that whole agreement; but Gazprom would, “as a goodwill gesture,” delay a decision on the possible imposition of penalties (Vedomosti, Interfax, April 2; RIA Novosti, April 4).

Ukraine maintains that take-or-pay does not apply to current Gazprom-Naftohaz relations; and attempting to apply it retroactively would amount to discrimination against Ukraine, since Gazprom has renounced those clauses or at least their application in a number of cases in recent years (UNIAN, April 2). The April 2 agreement is based strictly on Ukrainian pre-payment, which should render take-or-pay moot.

Apart from claims and counterclaims in the Stockholm arbitration, Naftohaz has fully repaid its debts for Russian gas consumed in 2013-2014. The October 2014 agreement “on gas supply resumption and debt repayment” had linked the two issues. Naftohaz repaid $1.45 billion in November 2014 and another $1.65 billion in December 2014, extinguishing its arrears to Gazprom (UNIAN, April 2). Gazprom, in turn, resumed gas deliveries to Ukraine, though strictly on a pre-payment basis.

The article above is reprinted from Eurasia Daily Monitor with permission from its publisher, the Jamestown Foundation, www.jamestown.org. 

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