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Is Ukraine’s Embattled Energy Sector A Lost Cause?

Is Ukraine’s Embattled Energy Sector A Lost Cause?

The back and forth, the ebb and flow, or business as usual continues in Eastern Europe. As another interim gas deal approaches its deadline, Ukraine will temporarily halt natural gas purchases from Russia – at least until a new deal is signed. Thus far, Ukraine has quite successfully demonstrated the limitations of short-term solutions for long-term problems.

Its goals, while limited in scope, remain attainable, but a restive business class and marginal change under President Petro Poroshenko place success just beyond reach.

The ‘winter package’ agreed upon in October saw Russian gas return to Ukraine after a near six-month hiatus. The agreement, which expires April 1, included prepayment provisions and even a neighborly discount. It is worth noting that Russia’s immediate neighbors to the west – excluding Belarus – pay nearly 10 percent more for their natural gas deliveries than the rest of Europe. Ukraine paid in advance and, for a time, fears of another gas stoppage were assuaged. Related: Oil Prices Will Recover: Market Fundamentals Are Working

As spring settles in, it’s back to the drawing board, though the particulars are largely the same. According to Russia, Ukraine is still very much in debt – a claim that Ukraine denies and will challenge in court. A resolution is not expected until at least 2016. In the meantime, Ukraine wants cheaper gas, and the EU just wants gas, period.

Another short-term agreement will indeed come to pass – certainly with prepayments, though the figure will likely be closer to $250 per thousand cubic meters than the $378 originally agreed upon in the ‘winter package. Still, the long-term goal is energy independence – at least from Russia. It’s a goal that president Poroshenko believes is attainable in two years. The Kremlin isn’t worried however, and you can’t blame them.

Far from the conflict zone in the Donbass, widespread infighting and high-level corruption dominate the domestic business and political climate. Most recently, the actions of banking oligarch and regional governor Igor Kolomoisky have taken center stage. Related: Is US Oil Production Finally About To Fall?

Kolomoisky, together with a band of armed men, occupied the main offices of the state-owned oil pipeline company UkrTransNafta on March 20. The raid came in response to Poroshenko’s sacking of company chairman and Kolomoisky ally Oleksander Lazorko. A new law granting Kiev greater – and much needed – control over state-owned joint stock companies, notably oil and gas extractor UkrNafta, also didn’t help. UkrNafta gas production has dropped nearly 50 percent since 2005, all under Kolomoisky’s de facto control.

In the early morning of March 25 Poroshenko dismissed Kolomoisky from his post as governor, replacing him with someone from his own circle. The oligarchs’ open confrontation, while publically settled, is far from over and Poroshenko will surely step on more toes in his fight against corruption. However, Poroshenko will have to do more to demonstrate his consolidation of power is not a thinly veiled attempt at more of the same. Clan-like structures still rule Ukraine, and power transfers to Poroshenko do not necessarily guarantee a better, or more transparent, outcome.

His continuing work on the ailing energy industry will serve as good a barometer as any. Specifically, the mess that is Naftogaz. The breakup of the state-owned oil and gas company into three smaller units remains one of the centerpieces of his reform plans. The split should improve the lumbering company's efficiency, but boosting production and ultimately government revenues will require greater determination. Related: 100,000 Layoffs And Counting: Is This The New Normal?

Naftogaz has long supplied gas to its customers at a loss – its mandated selling prices are roughly 10 times less than what it needs to ensure future investment and development. Gas production fell by 8 percent last year and plans to raise domestic gas prices 5-fold will only move the government subsidy from the company to the consumer. Adding to the headache are the departures of western majors Chevron and Shell as well as the loss of its industrial supply monopoly.

Private companies have fared better – their gas production was up 18 percent in 2014. But, their gains may slow in 2015 as the government ups their production tax to fill budget holes.

Forget production, residential energy efficiency improvements alone could reduce gas imports by up to 10 billion cubic meters. Sizeable renewable potential offers similar savings. To that end, USAID has already spent approximately $175 million toward energy efficiency projects and Chinese companies have targeted solar development.

Poroshenko appears game for reform, but outside lendors should give pause to his early advances.

By Colin Chilcoat of Oilprice.com

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  • Nik on March 27 2015 said:
    When you speak - "the Ukraine has quite successfully demonstrated the limitations of short-term solutions for long-term problems", do you take into account the info that Ukraine's industrial output fell 10.7 percent in 2014 compared with the previous year?
  • Colin Chilcoat on March 27 2015 said:

    Certainly. Nearly every economic indicator is down compared with last year, and even looking back further to 2008. Reverse flows from the EU and hard-head haggling with Russia won't turn those around.

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