THE NEW GAS DEAL: THREATS AND RISKS FOR UKRAINE

Katja Malyhina

The harshest dispute in the history of the “gas wars” between Russia and Ukraine is over. On January 19, in Moscow, the Ukrainian energy supplier “Naftogaz Ukrainy” and its Russian counterpart “Gazprom” signed a new gas deal for 2009-2019. According to the agreement, Ukraine received a 20% discount on the negotiated gas price in 2009, which corresponds to the average European level. The fee for gas transit paid by Russia remained, however, unchanged from 2008 at US $1.7 cubic meters per 100 kilometers.

Introduction

Are there really any winners in this war? Ukraine’s sagging economy has become even more weakened due to the gas dispute with its neighbor. A number of large industrial companies, including the Odessa port plant and the chemical group “Stirol”, were shut down because Russia suspended its gas supplies to Ukraine. However, Russia has also suffered some damages. According to some estimates, Gazprom has endured financial losses of up to $1.5-2 billion. Limitation of Gazprom’s foreign exchange gains has strengthened devaluation tendencies in Russia. On January 20, the Russian ruble dropped to its lowest value in a decade (RUR32.2 to US$1). A number of European gas companies are seeking reimbursements from Gazprom for the halt in gas supplies. The most important consequence, however, is that the gas conflict essentially undermined the images of both Russia and Ukraine in the eyes of the European community. The President of the EU Commission Jose Manuel Barroso recently questioned the reliability of the both countries as energy suppliers to the EU.

Because of huge financial losses and Ukraine’s lack of compliance Moscow took a very tough position concerning future gas relations with Ukraine. The signed agreement has already tightened the prolonged political conflict in Kiev. President Viktor Yushchenko heavily criticized the contracts that were negotiated by Premier Minister Yulia Tymoshenko. Meanwhile, Tymoshenko called the conditions “unique.” But what makes new agreements really “unique”, and what impact will they have on Ukraine?

“Unique” Conditions

According to Tymoshenko, the gas contracts are unique because for the first time they were signed directly between the energy companies Gazprom and Naftogaz without any intermediary. Also, another precedent, the gas deal will regulate gas relations between Russia and Ukraine for the long term instead of annual negotiations. Finally, the gas prices for Ukraine are now tied to oil prices, following the example of European countries. Undoubtedly, the elimination of the dubious intermediary “RosUkrEnergo” (RUE) from the gas trade is a positive result for Ukraine. However, the result should not be solely attributed to the active endeavors of Tymoshenko. Gazprom was also interested in this decision. With the aim to reduce the profitability of the Nabucco project, Russia increased prices for gas from Central Asia, which made any intermediary services unprofitable.

The removal of the intermediary seems to be the only positive outcome for Ukraine from the new gas deal. The increase of gas prices to market levels from 1 January 2009 is a very unfavorable result. The gas price will be calculated quarterly according to a formula with the basic price of $450 per 1,000 cubic meters. Tymoshenko assured the public that the base price corresponds to the average European gas price for the first quarter of 2009. But if one compares quarterly prices for Ukraine announced recently by Naftogaz with the would-be European quarter average (that is without the 20% discount), then the annual average price for Europe would amount to $316 per 1,000 cubic meters. Gazprom, however, declared recently, that the average gas price for its European customers in 2009 would be $280. As a result, natural gas for Ukraine will be even more expensive than in Europe in the future. Moreover, with the high base price of $450 for Ukraine, Russia can offset the costs of expensive Central Asian gas and profitably sell it to Ukraine. In any case, Russia has done everything to get the utmost benefits from the negotiations.

Nevertheless, Prime Minister Tymoshenko did succeed in obtaining relatively low gas prices for the current year. According to Tymoshenko, the annual average price for Ukraine would be $228.8 per 1,000 cubic meters in 2009. The 20% discount granted by Gazprom will not be the only source of low average gas prices for this year. Naftogaz Ukrainy announced that it would buy the lowest amount of gas in the first quarter of 2009, when the gas price for Ukraine will be the highest (only 5 billion cubic meters at a price of $360 per 1,000 cubic meters). Naftogaz also lays claim to 11 bcm of RUE gas stored in Ukraine. RUE owed $1.7 billion to Gazprom for this gas, which was paid off by a complex maneuver: Gazprom made an advance payment for the same amount in lieu of transit fees, which Naftogaz then returned to pay off RUE’s debts. However, the Ukrainian energy company has faced problems with the transfer of ownership rights from RUE in its own country. If the transaction is successfully completed, the price for 11 billion cubic meters of gas would be only $154 per 1,000 cubic meters, which is $25 less than last year.

With all the discounts added together, Ukraine will pay about $9 billion for imported gas this year, while it will get only about $0.6 billion from Russia for gas transit through its territory. The actual amount of about $2.3 billion should be reduced by the aforementioned $1.7 billion, which Gazprom “paid” Naftogaz via RUE’s debt assignment. Leaving the transit rates at the same level as in 2008 and switching to the gas prices formula re-calculation illustrate the asymmetry of the contracts. It turns out that a 20% discount on gas prices comes together with a discount in around 60% on transit fees. Such a discrepancy will also remain over the next year, when the transit rate will be calculated according to the aforementioned formula. Gazprom has already announced that the price for transit will be about $2.66 per 1,000 cubic meters per 100 kilometers in 2010. For comparison, the average transit fees in Europe are around $4. According to the Ukrainian experts’ estimates, transit rates should be increased to US $5.11, in order to cover costs of the pipeline system. As a result, Ukraine subsidizes the transit of Russian gas.

The asymmetry of the contracts has also been emphasized by the Secretariat of the President. On the one hand, Ukraine is obliged to continue the transit of Russian gas even in the case of bilateral dispute, while Russia has the right to stop its supplies if needed. On the other hand, Ukraine will cooperate with Russia on the principle “take-or-pay”. This means that Ukraine is obliged to pay for the entire amount of gas specified in the contract, regardless of the amount actually consumed. At the same time, Russia may alter the volumes of gas transit and, consequently, their payment as it wishes. So another principle works here: “We pay only for actually transited gas”. Another positive development for Russia is the increased presence of Gazprom at the Ukrainian gas market. Founded in the spring of 2008, a subsidiary of Gazprom, “Gazprom sbyt Ukraina”, will get 25% of the Ukrainian gas market, equivalent to about 13.5 billion cubic meters. In 2008 the company was allowed to sell only 7.5 billion cubic meters of natural gas.

If Ukraine fails to pay on time, it will be immediately transferred to a 100% advance payment. According to the Secretariat of the President, Russia has developed such a scheme especially for Ukraine, as there is no other European country where such a clause exists. Overall, the asymmetry in the contracts shows that the political component still plays an important role in gas relations between Russia and Ukraine. Relations between two business parties are built according to the mutually beneficial conditions.

Impact on the Economy

Ukraine has thus signed long-term contracts on very disadvantageous conditions, which will adversely affect the already deplorable state of the Ukrainian economy. Taking into account the increased prices for imported gas, Naftogaz Ukrainy will have to increase prices for all consumer groups in the domestic market. Ukrainian industrial companies already paid a price of $300-330 per 1,000 cubic meters of natural gas in 2008, owing to various surcharges. However, 2008 was also a record year in terms of prices on Ukrainian products. Ukrainian companies, after all, were able to pay high gas prices and even get profits. But if gas prices for this year stay at least at the level of the previous year, the Ukrainian economy might encounter enormous problems of maintaining competitiveness. To prevent this scenario, Ukrainian politicians will need to continue subsidizing Naftogaz Ukrainy from the state budget. The budget for 2009 provides support for Naftogaz in the amount of about $0.9 billion in comparison with more than $1 billion used for this purpose in 2008. Under changing circumstances, this amount is likely to be increased again. The amount of state subsidy to Naftogaz will increase alone due to the fact that consumer gas prices were tied to the official exchange rate by the end of the year. While Naftogaz buys gas from Russia in U.S. dollars, it sells the fuel in Ukrainian hryvnya (UAH) on the domestic market. Devaluation of the UAH consequently leads to a further increase in subsidies. All this will provide an additional fiscal burden.

In future, it will be very difficult for Ukraine to pay for the imported gas on time. Last year Naftogaz was able to pay back its debt to Gazprom only because the company received loans from state-owned banks. The exchange rate broke down the day after Naftogaz bought in one transaction almost $1 billion from the National Bank of Ukraine at the end of 2008. Thus, if such practices are repeated, the further devaluation of the UAH and rising debt of the public funds are not excluded. Moreover, a threat of advance payment means that Ukraine would have to provide a significant part of its state budget for the payments to Gazprom, before it is taken up by taxes and customs.

The difficult financial situation of Naftogaz also complicates the problem of timely payment for gas bills. Naftogaz has been constantly on the verge of bankruptcy in recent years. The hope to improve the financial situation of the company by eliminating the intermediary is not justified. Even after the exclusion of RUE, Naftogaz may increase its presence on the gas market in the best case from 50% to 75% (25% is reserved for “Gazprom Sbyt Ukrainy”) and thus its revenue would be increased only by a quarter. But even this modest increase in revenue could be relinquished by decreasing demand for gas from industrial enterprises, which plan to buy only 24 billion cubic meters of natural gas instead of the usual 30 billion. It therefore seems quite unlikely that Naftogaz will be able to raise its income above last year’s $7 billion. In addition, many non-industrial consumers pay their gas bills with delays. Their common obligations to Naftogaz for the years 1998 – 2008 amount to approximately $0.8 billion. The debt of Naftogaz itself amounts to $9 billion, while about $2 billion has to be repaid this year. That is why one might expect a huge budget deficit of Naftogaz by the end of the year.

The one positive note for the economy of Ukraine might be the following. Because of the high gas prices, Ukraine will likely be forced to take appropriate energy saving measures. The Ukrainian economy is in general 2-2.5 times more energy-intensive than industries in Europe. In response to the crisis, some steel companies have already begun to replace natural gas with coke in their production. If Ukraine manages to reduce its energy needs, it could sell its own produced gas to Europe. Russian gas does not come into question because the re-export of this gas is prohibited. All these trends confirm the gloomy forecasts for the economic situation in Ukraine, which leads the world in the fall of industrial production, inflation, devaluation of national currency, and the decline of stock indices. Therefore, there is a high probability of default in Ukraine, according to the new UN report on the global economic situation.

New Gas Conflict Possible

A possible reason why the gas war between Ukraine and Russia was so intense in January 2009 is that Russia tried to realize the so-called “Belarusian scenario” in Ukraine. Two years ago, Belarus and Russia signed a five-year contract for the supply and transit of gas. Under the agreement Belarus switches to EU pricing levels in 2011. Until that time a discount system operates. In return for price concessions, Gazprom acquires a 50% share of the Belarusian pipeline system “Beltransgaz” by the 2010. Currently, Gazprom owns 25% of this company.

For Ukraine, too, a gradual transition to European gas prices within three years was initially foreseen. This was reflected in the memorandum signed in October 2008 between Putin and Tymoshenko. It is not excluded that Putin once again called for the Ukrainian pipeline system to be privatized or rent for a long term during the negotiations on the new gas contract this winter. However, according to Ukrainian legislation, the privatization of the pipeline system is prohibited. In addition, the system has great significance for national security of Ukraine. Indeed, Gazprom could become a monopolist over gas supply to Europe in every respect with the Ukrainian pipelines as Gazprom controls, or will control in the near future, all other transit routes of Russian gas to the EU. That is why Ukraine wants neither to sell nor to rent Russia its pipelines. Even the gas war at the beginning of this year did not force the Ukrainian authorities to surrender to Gazprom. Although Putin again appealed to the Europeans for an international gas consortium on common control of Ukraine’s pipeline system, Ukraine refused this proposal.

It is possible that, unlike Belarus, Ukraine agreed to the accelerated transition to the European market prices precisely for these reasons. Thus, “the Belarusian scenario” lost its relevance and the Kremlin has now to search for a new strategy. But what the “energy weapon” could not achieve could be perhaps attained through Ukraine’s falling deep into debt. The world economic crisis arrived just at the right time for the application of this tactic.

Disadvantageous conditions resulting from new gas contracts and the threat of economic collapse of Ukraine increase the likelihood of a renewed gas dispute. This could happen in two different ways.

1) Under the terms of the treaty, Russia has the right to halt its gas supplies to Ukraine if the latter does not pay on time. This step, however, could lead to technical problems with gas transit to Europe. In that case, the events at the beginning of 2009 would be repeated. The only difference would be that all the blame for delivery failure and responsibility for the resulting problems would be laid on Ukraine. In this way, Ukraine gets entrapped by the signed contract.

2) Russia would not halt gas supplies, but rather allow debts and fines to accumulate. Then Ukraine would probably be unable to refinance its gas debts. At some point Gazprom would try to acquire the Ukrainian pipeline system in exchange for debt forgiveness. There is already such a precedent: in the late 1990s Russia exchanged Ukraine’s gas debt for the long-term lease of Sevastopol naval base to the Russian Black Sea Fleet. To avoid such pressure from the Russian side, Ukraine could declare default. However, together with its inability to pay back debts, Ukraine might face difficulties in meeting its obligations on gas transit to Europe. In this case, Putin would set the question of the gas consortium high on the agenda again.

In conclusion, no matter how the situation develops, Russia has gained a position of strong advantage.

First published at “Ukraine-Analysen №50”, p. 5-9.