How The Worsening Ukraine-Russia Crisis Will Affect Energy Markets

The confrontation between Ukraine and Russia has entered a potentially dangerous new phase that could increase the likelihood of a dispute over energy supplies.

On Aug. 15, Ukrainian authorities reported that they destroyed a convoy of armored vehicles that had pushed into Ukraine from Russia. The details were murky, but armored vehicles apparently entered Ukraine from Russian territory close to where a convoy of Russian aid trucks was located.

Tensions over Russia’s attempt to send aid to eastern Ukraine had been brewing for days, as Ukraine suspected it was a cover for a shipment of military supplies to pro-Russian rebels. Ukrainian officials said artillery was used to destroy Russian armored vehicles, forcing the standoff to a dangerous low point.

European diplomats tried to calm tensions, but the incursion indicates that the conflict is not going away anytime soon. And that’s going to affect the energy trade in Europe and Asia in several ways.

First, the prospect of an interruption of natural gas flows from Russia to Europe has just gone up; European foreign ministers have said they are prepared to take additional measures against Russia due to its ongoing support for rebels in eastern Ukraine and Ukraine approved a law on Aug. 14 that allows it to impose sanctions on Russia. Both moves could lead to supply disruptions.

Second, relations between Russia and Europe are so low that the South Stream pipeline is probably doomed in the near-to-medium term. Intended to bypass Ukraine – a key Russian objective – South Stream would connect Russian natural gas to Europe via the Black Sea, arriving on EU soil in Bulgaria. South Stream is an important strategic project for Russia, and for that reason, European officials will likely keep it on ice.

As a result, European support for South Stream’s competitor project, the Trans-Adriatic Pipeline (TAP), will likely receive a boost. The TAP project will bring natural gas from Azerbaijan to Italy, diminishing Russia’s role as an energy supplier to Europe. TAP recently signed up former British Prime Minister Tony Blair to advocate on behalf of the pipeline. The pipeline is still facing environmental opposition in Italy, but the more Russia meddles in Ukraine, the more likely European politicians are to try and make TAP a reality.

Another effect of the worsening tensions in Ukraine is Russia’s decision to shift its priorities towards the east. Russian oil exports to Asia have already accelerated as relations with Europe deteriorate. Russia now exports 1.3 million barrels per day – about one-third of its total exports – to Asia, the highest share ever recorded. At the same time, Russian is pairing back its oil exports to Europe, dropping from 3.72 million barrels per day in 2012 down to 3 million barrels per day in July 2014. This trend will continue.

That means Russia will need to lean more heavily on the Chinese market for its energy exports, which is not necessarily a good thing for Moscow. This past spring, Russia largely gave in to Chinese demands on the terms of a $400 billion natural gas agreement that could see 38 billion cubic meters of Russian natural gas flow to China. As Russia loses more and more friends, it risks becoming too dependent on China.  

Finally, with Russia becoming an international pariah, oil companies operating in Russia will face increasing risks to their investments. This is bad news for ExxonMobil, BP, and Shell, but potentially good news for Chinese firms. Chinese banks and Chinese companies building offshore oil rigs, and other oil field service companies, could pick up the slack.

The next phase of conflict between Ukraine and Russia may be unclear, but one thing is already clear: European and Asian energy markets are in for a bumpy ride.

By Nick Cunningham of Oilprice.com