Few expected such a dramatic turn of events in the long-ongoing Russo-Ukrainian gas dispute. Before the February 28 decision of the Stockholm Arbitration Court, most observers expected a court ruling that would largely cancel out the claims of Gazprom and Naftogaz, the national companies of the two nations. Yet the court awarded Naftogaz with $4.63 billion with regard to Gazprom’s under-deliveries as per the valid transit contract, bringing the total decision to a $2.56 billion arrears for Gazprom (it previously decided on a $2.02 billion compensation due to Ukraine’s underpayment of gas in 2014). This has propelled Gazprom to move forward with the cancellation of the Russo-Ukrainian supply and transit contract, a move, which according to some, might bring about a new 2009 style gas war.
Due to the (highly explosive) political background of the issue, gas relations between Russia and Ukraine have grown into one of the most difficult energy controversies of our days. Therefore, disentangling the Gordian knot takes a lot of steps, just as its analysis should be done little by little. It is very unlikely that a Gas War will take place – gas supplies to Europe continue uninterrupted and it will take at least one and a half year until the appeal court decides on the contract annulment. Let’s look into the thick of the Court decision to understand what has elicited such a seemingly radical response.
The February 28 court ruling postulates that Gazprom did not meet the minimum transport volume criterion – the long-term gas supply contract from 2009 states that the annual transit volume should be “no less than 110 BCm”. Throughout 2009-2017, Gazprom could not meet this level, due to the commissioning of new transportation infrastructure (NordStream) and the deterioration in bilateral relations between Moscow and Kiev. The $4.63 billion arrears reflect this shortfall on Gazprom’s part, moreover, were Gazprom to miss the 110 BCm/year target this and next year, too, it would be obliged to pay again. Given that pipeline capacity has been already booked for 2018, the Russian gas giant is sure to miss it (and, consequently, pay the fine again).
This disagreeable necessity was deemed too high a price to pay and Gazprom proceeded to annul all of its Ukraine-related contracts (both the supply and transit one). Naftogaz was caught completely unawares by the above developments, it had counted upon the restart of Russian gas supplies as soon as March. Despite the lack of prospect for the normalization of Russo-Ukrainian political ties, the rationale behind it was straightforward – Naftogaz has had enough of overpaying for “reverse gas” (Russian gas supplied to Ukraine indirectly, via Slovakia, Hungary and Poland). The difference between Gazprom’s average monthly European gas price and that of Ukraine’s “reverse gas” purchases for February 2018 was a hefty $53/MCm.
Naftogaz was anticipating the resumption of gas deliveries based on the Stockholm Court’s ruling that Gazprom be obliged to supply at least 4 BCm/year in 2018-2019, with prices tied to Germany’s NetConnect levels. As stated before, this, too, was appealed by Gazprom – it would be unfeasible to keep the supply contract whilst cancelling the transit one. It should be noted that by lodging an appeal against the Arbitration Court’s decision and annulling all Ukraine-related contracts (here it is again resorting to Stockholm arbitration), the Russian company is sticking to the contract so there are no contract breaches here. However, by disagreeing to resume deliveries, Gazprom not only delayed the moment when it has to pay (it is most likely the reviewed verdict would alter the sum payable only slightly), it also sort of forced Ukraine into paying the higher reverse gas price.
After the Ukrainian GDP fell by 49 percent in U.S. dollar terms in 2013-2016, Kiev still finds its economy in a shattered state. Indicative of its weakness is the fact that the $2.56 billion determined by the Stockholm Arbitration Court represents 2.3 percent of the nation’s GDP. Similarly, Ukraine gets roughly 3 percent of its GDP from Europe-bound gas transit. As we have previously established, Ukraine’s reverse gas purchases are highly ineffective – in 2017 alone, Kiev overpaid $0.5 billion when comparing its factual prices to the average Gazprom European price (the average annual). This piercing loss of money explains Kiev’s sensitive reaction. Confronted with a situation it did not expect, Ukraine has moved to seize all of Gazprom’s assets on Ukrainian territory. Gazprom was precautious enough not to leave any valuables in Ukraine – the aggregate value of assets seized is $3.1 million.
Despite some European fatigue with Naftogaz’s antics, Gazprom’s sudden cancellation of its supply contract makes the Russian firm susceptible to reputational damage. Countries which oppose the construction of NordStream (because it will make them lose out on transit revenues) will inevitably lament that Gazprom uses the “energy weapon” to achieve its aims. This stance is largely incorrect, as Gazprom has no plans whatsoever with Ukraine and were its relations with Kiev to normalize, it would still prefer to finish NordStream-II because it would earn the company several billion USD in transit fees. However, it is notable that Gazprom was caught off-guard by the Arbitration Court decision – it expected the 10-year supply contract to simply run out, it seemed all it takes is to wait.
Despite everything seemingly pointing to the inevitability of a terminal breakup, Gazprom will most likely keep transiting some volumes of gas through Ukraine. Transit via Ukraine currently oscillates in the 80-95 BCm per year interval. Even after the 55 BCm/year NordStream-II and the 16 BCm/year second line of TurkStream attain full throughput capacity (i.e. mid-2020s) and reach Gazprom’s European customers, the company would still have 10-20 BCm/year of remaining supplies to deliver. Moreover, given that gas infrastructure for TurkStream volumes to reach Central and Southeastern European markets is far from ready and its construction might run into delays, it would be realistic to assume that Ukrainian gas transit would be kept at an average of 20-30 BCm/year throughout the 2020s.
It is not only Gazprom that needs the continuation of Ukrainian gas transit – the Ukrainian economy would suffer greatly were it to lose such a substantial chunk of income. With the current gas supply contract running out December 31, 2019, there is still time and room for a potential policy change from both sides (all the more so as Ukraine will hold parliamentary elections in the autumn of 2019). Gazprom’s appeals are unlikely to alter the situation significantly, therefore after the judicial dust settles it would be politic for Gazprom to pay the compensation or to pump an equivalent volume of gas to Ukraine and only then proceed to the scaling down of its Ukraine ties.
Disclaimer: views set out in this article are solely those of the author in his private capacity.
By Viktor Katona for Oilprice.com
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