Is Another Gas War Brewing Between Russia and Ukraine?

A Painful Transition

Reports are already circulating that both Russia and Ukraine are interested in renegotiating the gas supply and transit deal they signed only last month. The 5 December deal, increasing gas prices to Ukraine by 38.1% year-on-year to US$179.5 per 1,000 cm, was negotiated and completed by the outgoing Ukrainian government, and Yulia Tymoshenko, the former opposition leader who became prime minister last month, has vowed to get rid of intermediaries in the deal she has inherited. Thankfully for European energy security, Tymoshenko refrained from trying to scrap it altogether as soon as she took office, as that very well might have jeopardised Ukraine's gas supplies from 1 January and, in turn, Russian gas exports to Europe via Ukraine.

So fears of another "New Year's gas war" between Russia and a neighbour have passed, but this does not necessarily mean that all is well with Gazprom and its customers in the ex-Soviet states. Tymoshenko has accepted the deal but this does not mean she is content with it. Scrutiny of the deal was one of the first tasks for her government, but this was quickly superseded by the discovery that Naftogaz Ukrainy, the state-owned oil and gas holding, was on the verge of bankruptcy. Naftogaz has seen its finances eroded over the past three years, being forced to pay substantially more for gas imports while its ability to cover these costs was limited by the previous government keeping a lid on the prices at which gas is supplied to the domestic market.

Although Ukraine's economy has weathered the storm caused by the price of gas imports—which account for 75% of the country's consumption needs—rising from an implied price of US$50 per 1,000 cm in 2005 to US$130 last year, Naftogaz has clearly suffered. The new nearly 40% hike in prices for 2008 is offset only partly by an increase in the transit rate for Russian gas via Ukrainian territory, which rose to US$1.70 per 1,000 cm per 100 km, up from a rate of US$1.60 last year. In theory at least, the 6.25% increase was limited as a result of an October 2007 deal under which an advance payment by Gazprom to Ukraine for gas transit services for this year was then returned to Gazprom to pay off the remainder of the estimated US$1.3-billion debt that Ukrainian firms had accrued (see "Related Articles"). This limited Ukraine's scope for negotiating a higher transit price under the 2008 supply deal, while also denying Naftogaz some much-needed revenues.

Desperation in Ukraine?

It could be said that what started all this was the original January 2006 deal ending the brief Russia-Ukraine "gas war". This introduced RosUkrEnergo, the joint venture (JV) between Gazprom (50%) and two Ukrainian businessmen (50%), as the key middleman in the delivery of Russian and Central Asian gas to Ukraine, and also resulted in the formation of UkrGazEnergo, a second 50:50 JV comprised of Naftogaz and RosUkrEnergo, to distribute this imported gas to the Ukrainian domestic market.

Indeed, in the eyes of Tymoshenko and her cohorts in government, Naftogaz's current financial woes can be traced back to that seminal deal, and the creation of those intermediaries. It raised the need for the gas price and transit deal (covering Central Asian supplies to Ukraine in 2007) in October that year, which then led to the debt deal the following October, and on to last month's new gas supply and transit deal. In order to put Naftogaz back on sound financial footing, therefore, it is necessary to get rid of both UkrGazEnergo and RosUkrEnergo as middlemen. The government recently restricted UkrGazEnergo's operations, limiting the JV to selling just 5 bcm of Ukraine's gas imports on the domestic market, in a move decried by UkrGazEnergo but promoted by the government as a means to increase competition in the retail gas market. Now, with Tymoshenko scheduled to head to the Russian capital, Moscow, on 23 January for her first ever visit to Russia as prime minister, it appears that she is poised to lobby Russian officials on the need to get rid of RosUkrEnergo in its intermediary role as monopoly importer of gas to Ukraine.

Tymoshenko recently said that she is interested in resuming the direct supply of Turkmen gas to Ukraine, but this appears unlikely, given Gazprom's own import deal with the Central Asian country. Furthermore, any "direct" deal would be something of a misnomer, considering that this gas would necessarily have to transit Russian territory, and Ukraine would thus still have to pay an added transit price. Essentially, this is already the case. Gazprom agreed to pay Turkmenistan US$130 per 1,000 cm for gas supplies in the first half of 2008 (rising to US$150 per 1,000 cm in the second half), so by having Ukraine import only Central Asian gas at a price of US$179.5 per 1,000 cm, the Russian gas giant is effectively marking up the price on the Ukrainian border. The only difference is the inclusion of the intermediaries, with Gazprom selling the gas to RosUkrEnergo, which in turn sells it to UkrGazEnergo, which in turn sells it to Naftogaz.

In returning to a potential "direct" gas supply deal, Ukraine would need to buy its gas straight from Gazprom. Moreover, Gazprom's import deal with Turkmenistan means that Gazprom would be selling Central Asian gas to Ukraine in any case, meaning the only real "direct" deal for Ukraine would be to buy Russian gas from Gazprom itself. Russian officials have warned that such a scenario would see Ukraine face an even higher price for its gas imports.

Outlook and Implications

Although a new gas war between Russia and Ukraine seems unlikely at this point, the conditions are ripening for a potential worsening of relations in the lead-up to Tymoshenko's Moscow visit. Ukrainian First Deputy Prime Minister Alexander Turchinov said that Naftogaz's new chief executive officer (CEO), Oleh Dubyna, is expected to meet with Gazprom officials in the next few days to discuss "a range of issues" in gas supply including transit rates. More than 80% of Russian gas exports to Europe transit Ukraine, and Russian daily Kommersant reports that Ukrainian officials are seeking to increase the transit rate fivefold, to US$9.72 per 1,000 cm per 100 km. Russian officials were largely silent on this, but RosUkrEnergo CEO and Gazprom board member Konstantin Chuichenko replied that Gazprom could hike prices to Ukraine in turn, since the Russian gas giant is now having to supplement Central Asian gas supplies destined for Ukraine, which have fallen due to a cold snap and resultant demand spike in the region, with more expensive Russian gas.

With a gas price and transit deal in place between Russia and Ukraine for 2008, the potential for a disruption in Russian gas supplies to Europe via Ukraine in the event of a disagreement has been minimised. Indeed, even as Central Asian gas supplies to Russia have been reduced, Gazprom has kept to its word and ensured steady gas supplies to Ukraine thus far this year. Ukrainian officials are increasingly desperate to rescue Naftogaz from its precarious financial position, but a unilateral decision to increase gas transit rates fivefold is unlikely. Gazprom could well seek to charge Ukraine more for the Russian gas that the firm has been delivering so far this year, but Chuichenko's comments seem designed instead to remind Ukraine about its own supply situation and to persuade it not to hike gas transit rates.

In the final analysis, however, that may very well be what Tymoshenko chooses to do, although if this arrangement is going to have any chance of pulling Naftogaz out of the financial abyss, Ukraine must negotiate a new deal that sees transit rates increase by a greater percentage than gas import prices. Moreover, the deal will have to rid Ukraine of the intermediaries that have clouded Naftogaz's finances—precisely what Tymoshenko has vowed to do. Finally, the Ukrainian government must then allow Naftogaz to pass these higher gas import costs on to consumers in the household and industrial sectors. This last point could prove political suicide, however, particularly if it has a substantially negative impact on the country's economy. Tymoshenko, who is believed to be interested in challenging President Viktor Yushchenko in the next presidential election, could then be forced to choose which is more important for her to save: Naftogaz, or the Ukrainian economy…and her political future.

Related Articles

CIS: 14 January 2008: PM Says Ukraine Wants to Resume Direct Deliveries of Turkmen Gas; Transit Volumes in 2007 Down 1.5%

Ukraine: 3 January 2008: Naftogaz in Technical Default; New Ukrainian PM Says State Energy Firm on Verge of Bankruptcy

Ukraine: 28 December 2007: Government Hikes Gas Ceiling for Ukrainian Industrial Sector on Higher Import Prices

Ukraine: 24 December 2007: New Ukrainian Government Starts Scrutiny of Russian Gas Contract

Ukraine: 6 December 2007: Gazprom Officially Signs Contract with Ukraine for Gas Supplies in 2008; Ukrainian PM Unhappy with Price Agreement

CIS: 5 December 2007: Russia, Ukraine Agree on Gas Price Deal for 2008, Averting Potential Supply Disruption

CIS: 28 November 2007: Gazprom Consents to Increased Turkmen Gas Prices; Ukraine to Face Higher Prices in Turn

Ukraine: 19 October 2007: End Appears Closer for RosUkrEnergo as Russian President Suggests Direct Gas Sales to Ukraine

Ukraine: 3 October 2007: Gazprom Threatens to Cut Gas Supplies to Ukraine Unless US$1.3-bil. Debt Paid

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