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Viktor Katona

Viktor Katona

Viktor Katona is an Group Physical Trader at MOL Group and Expert at the Russian International Affairs Council, currently based in Budapest. Disclaimer: views set…

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Ukraine’s Natural Gas Transit Woes May Be Easing

Despite significantly weakened interest towards internal political dealings in Ukraine itself, the issue of Ukraine’s gas transit remains a much-debated issue of the European energy community (understandably, since European countries want to make sure a viable solution is found for Russian pipeline gas supplies).

Ukraine’s gas transit was even on the tapis during the recent Putin-Trump talks in Helsinki, where the Russian president assured his counterpart that Moscow would keep the transit route even after 2019, when the current 10-year contract runs out. Analysts have long argued that such an outcome would be highly expedient and recent Brussels-induced developments point to a potential consensus-based solution brewing already.

Russia, Ukraine and the Energy Directorate of the European Commission held three-party talks June 17 on ways to solve the Ukraine gas transit limbo. The back story was pretty daunting – Russia has had to backtrack on its previous pledge to completely annul Ukrainian gas transit by 2020 and is now identifying 10-15 BCm/year as the optimal transit volume (even though it will most likely need 20-30 BCm/year even after Nord Stream 2 and TurkStream are commissioned).

Ukraine’s political leadership, too, finds itself in a difficult position because it has invested way too much political capital in depicting Russia as the ultimate cause of all of Ukraine’s evils, yet it desperately needs the transit revenues to finance its ailing budget.

Related: Saudi Arabia's Solution To Rising U.S. Gas Prices

The first results of the trilateral negotiations are overwhelmingly positive – it genuinely seems that by taking on the political responsibility in case the talks fail, Brussels has managed to solve one of the key deficiencies of Russo-Ukranian relations lately, namely, that everything is used as an argument in a perennial blame game.

Also, it seems that the EU is intent on seeing through the end Ukraine’s implementation of EU energy regulations, which, regarding tariff-setting and operator unbundling, are a positive development. The sides have agreed that it will not be Naftogaz, the traditional partner, that will be included in the final gas transit setup, but a new system operator, unbundled from it for the specific purposes of gas transportation.

Ukraine’s long-delayed attempts at unbundling the gas transmission system operator can be characterized as nothing but chaos-ridden. Following several years’ wait, the Ukrainian government postulated June 2017 that the current gas transportation grid assets be transferred to PJSC Trunk Gas Pipelines of Ukraine (Mahistralni Gazoprovody Ukrainy, MGU), yet the current operator Naftogaz is bent staying in the transmission business one way or another and has been delaying the implementation for quite some time already. Naftogaz even spun out a new entity within its umbrella, the Ukrainian Gas Transmission System Operator, thus creating a situation in which there are two potential grid operators vying for their place in the sun.

Naftogaz has been trying to peg the unbundling process with the Stockholm Arbitration Decision on the Gazprom transit contract, despite significant pressure from the European Commission to pursue the path that had been charted. It is important to remember that a total of $1 billion was granted to Kiev on the condition that it reforms its gas transmission system and creates an independent grid operator.

The Ukrainian government, too, is trying to obfuscate the situation – even though it has created a new entity, MGU, it is by no means willing to privatize it. The ensuing mess is understandable in a way, since gas transiting was traditionally the only profit-making segment of Naftogaz’s activities and was used for many years as a cross-subsidy to keep the company afloat.

Despite many difficulties ahead, the results of the talks seem to signal a palpable shift in attitudes. Naftogaz suggested lowering the transit fee, for years a taboo, to increase the competitiveness of the Ukrainian transit conduit, from $2.50/MCm/100km to $2.17/MCm/100km.

The proposal comes with several caveats, most importantly the Ukrainian side wants to establish a volume peg to the given formula. Ukraine’s expectations in this respect are somewhat quixotic as their considerations are built on the assumption that annual transit flows would amount to 141 BCm/year, meaning that  they do not see the 55 BCmpa Nord Stream 2 being built. Moreover, Ukraine is betting on Moscow ending Gazprom’s export monopoly (after NOVATEK was assigned the role of Russia’s leading LNG exporter, definitely not going to happen) and letting Central Asian gas suppliers in, which is very ambitious indeed.

Related: Yamal LNG Is Conquering China

In view of the above, the upcoming task is fairly straightforward, that is to find a volume threshold that would be acceptable to both parties. Something within the range of 40 and 50 BCm per year might be a consensual number – the 93.5 BCm transited in 2017 will inevitably decrease after Nord Stream 2 is brought online. However, several BCm of Nord Stream volumes will cover demand that was not previously included in Gazprom’s export allocation, either compensating falling Dutch output or increasing German demand.

The Russian Energy Minister A. Novak estimates that European gas demand will increase by 17-25 BCm in the next five years, hence even after Nord Stream 2 eats away half of the current Ukrainian gas transit, there will be sufficient demand for the remaining volumes. 

Russia needs Ukraine as a backup gas conduit, but similarly to Ukraine does not want to risk a face-losing settlement. As things stand now, sooner or later Gazprom will have to accept the Stockholm Arbitration ruling and pay, if not the $2.6 billion adjudicated this February, a part of the sum (as a result of their appeal mitigating some factors).

It is also imaginable that Moscow’s suggesting of reaching an out-of-court settlement will materialize at some point. All in all, by moving the judicial foundations of the next transit contract to Brussels and imbuing it with current EU regulative approaches, both sides stand to benefit. Now both Moscow and Kiev have to see the negotiation process through so that one of Europe’s greatest energy logjams can be finally cleared.

By Viktor Katona for Oilprice.com

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