Business
Russian Natural Gas Exports to Europe
By Simon Pirani and Roland Götz, Center for Security Studies (CSS), 25/6/18
Jul 1, 2018 - 9:13:46 AM

The Russia–Ukraine gas trade is being reduced to a shadow of its former self, as the data in Table 1 at the end of the text indicates (p. 6). Contracts between Gazprom and Naftogaz Ukrainy—for the import of Russian gas to Ukraine and the transit of Russian gas across Ukraine to European customers, in 2009–19— remain in place, but have been broken by both sides. The breaches were the subject of one of the largest ever commercial arbitration disputes, initiated at the Stockholm Chamber of Commerce in April 2014 after the overthrow of Viktor Yanukovich’s government and the outbreak of war in eastern Ukraine. The arbitral tribunal’s final ruling, on the transit contract, was issued on 28 February and was immediately denounced by Gazprom. Commerce has been unable to disentangle itself from politics. Post-2019 arrangements will be worked out with political relationships between Russia, Ukraine and Europe at an all-time low. Russian gas imports by Ukraine will probably stop all together, and transit be reduced to a bare minimum.

Arbitral Tribunal’s Final Ruling

The arbitral tribunal’s most important decisions were:

That Naftogaz had been overcharged for imports between April 2014 and November 2015, but that retrospective claims relating to 2009–14 were outside its jurisdiction; that the oil-linked price formula in the contract should be replaced by prices linked to those in the German gas market (at the NCG trading point).

• That the “take-or-pay” requirement on Naftogaz in the sales contract should be drastically reduced, from 41.6 bcm/year to 4 bcm/year.
• That the clause preventing resale of Russian gas is null and void; and that gas delivered to separatistcontrolled areas could not be invoiced to Naftogaz.
• That Gazprom had defaulted on its obligation to transport minimum volumes under the transit contract in 2009–17. Gazprom was required to pay $4.63 billion to Naftogaz for this, from which was subtracted $2.02 billion owed by Naftogaz for unpaid invoices in 2014, plus interest. The net payment required from Gazprom was $2.56 billion.
• That Naftogaz’s claim, that new transport tariffs introduced by the Ukrainian regulator in 2016 should be applied, be rejected. (For further detail, see Pirani 2018)

Reactions

Gazprom managers denounced the arbiters’ decision on the transit contract as “asymmetrical,” and took three actions in protest against it.

First, on 1 March, immediately following the arbiters’ decision, they cancelled a planned resumption of direct gas exports to Ukraine. The resumption had been expected, in line with the tribunal’s ruling on the supply contract, after an interruption of more than two years. Gazprom managers cancelled it and returned prepayments made by Naftogaz. The change came as a surprise to Naftogaz, which stated on 3 March that it had had to take emergency action to ensure customers were supplied with alternative volumes. Gazprom management did not present the cancellation as related to the arbiters’ decision; on the contrary, Aleksandr Medvedev, deputy CEO, said that additional agreements that needed to be in place prior to delivery had not been made. No substantial sticking-point holding up such agreements was reported, however.

Second, Gazprom wrote to Naftogaz on 3 March to initiate termination of both contracts. There is provision in the contracts for disputes, including those leading to termination, to be resolved via Stockholm arbitration. It has been reported that this issue is under discussion by the two companies; it may be superceded by their negotiations on post-2020 arrangements for transit.

Third, Gazprom lodged an appeal with the Stockholm arbitration court against the decision on the supply contract, and stated that it will lodge a similar appeal regarding the transit contract. Vladimir Chizhov, Russian ambassador to the EU, has stated that hearing these appeals is expected to take at least six months.

During these additional arbitration and appeal processes, the current contracts remain in place. They both expire on 31 December 2019. This is presumably the basis of the assurance given by Aleksandr Novak, Russian energy minister, on 6 March—in response to expressions of concern by Maroš Šefčovič, EU vice president for the energy union, on 2 March—that Russian gas deliveries to EU customers remain reliable, notwithstanding Gazprom’s statements in response to the arbiters’ decision.

There has been no noticeable concern expressed about these events by the European companies that purchase Russian gas, since there has been no physical interruption in supplies to Europe, and none is expected. In European political circles, though, these events may redouble concerns about the level of dependence on Russian gas.

Outlook

In the medium and long term, given the opening-up of the Yamal gas fields, Russian gas exports to Europe could not only be maintained at their current level (179 bcm in 2016 and 194 bcm in 2017), but increased. Russia’s reserve base will continue to provide the lowest-cost gas for export to Europe through the 2020s. The limits on Russian exports are likely to be set not by supply constraints, but by the European Commission and European governments, which are anxious to minimise dependence on Russian gas, for both strictly commercial, and political, reasons. These broader debates and negotiations form the background to the settling of important questions about arrangements for gas transit across Ukraine after 2019. Russia is determined to reduce its reliance on Ukrainian transit, and the European Commission believes it is strategically important to retain it.

The ultimate aim of Gazprom’s transit diversification strategy, to reduce gas transit across Ukraine to zero, cannot be achieved by 2020, and probably not for some years afterwards. Gazprom will certainly require transit across Ukraine immediately after the current contracts expire (in 2020–21), and might need some level of residual transit even if and when the first two major transit diversification pipelines, Nord Stream 2 and TurkStream, are completed.

Nord Stream 2 retains its target of being operational by the end of 2019, but this is unlikely to be met, due to outstanding regulatory issues raised by the European Commission and the Danish parliament. TurkStream is under construction, and the first line, which will transport Russian gas to western Turkey, is due to be completed by the end of 2019. The second line, to carry Russian gas to Turkey for further transport to south-eastern Europe, could also be completed in a comparable time frame, but it is not clear which of several alternatives (a proposed pipeline from Greece to Italy, expansion of the Trans Adriatic Pipeline, or a Bulgaria–Turkey interconnector) will be used for onward transport of gas to European destinations.

A number of scenarios, depending on whether, and on which time scales, new pipelines are constructed, were discussed in an OIES publication in 2016 (Pirani and Yafimava, Russian Gas Transit Across Ukraine Post-2019 (NG105)). The scenario that now seems certain to apply in early 2020 is that no new pipelines will be built, but the capacity cap on the OPAL pipeline will be lifted (albeit partially rather than completely). In this case, Gazprom would, without Ukrainian transit, be able to serve the Czech republic, Slovakia, Austrian and Hungary at 2014 export levels and above, but be unable to meet a significant part of Italian demand, and be unable to make some deliveries to south eastern European countries and Turkey.

By the mid-2020s, a scenario in which two strings of TurkStream and two strings of Nord Stream 2 are built may well apply. In this scenario, even at a high level of exports totalling 180 bcm, Gazprom would be able to serve all its European markets, and Turkey, without using Ukrainian transit. The caveat that now needs to be added is that, potentially, demand for Russian gas to Europe could exceed that level. Gazprom would not realistically, therefore, be able to close the door on Ukrainian transit completely.

So in 2020–21, Gazprom will require 40–75 bcm/ year of transit capacity across Ukraine. If and when Nord Stream 2 and TurkStream are fully operational, the capacity required could decline, theoretically to zero, but in reality Gazprom would prefer to retain the option of transporting residual volumes across Ukraine. Ukraine and the European Union, for both political and commercial reasons, favour the continuation of transit. There are three possible frameworks for this:

1. The conclusion of a medium-term (3 to 5 years) and more flexible transit contract between Gazprom and the Ukrainian Transmission System Operator (TSO), for example, for 30 bcm/year of capacity. It is possible that, now Ukraine has adopted EU-compatible market rules, Naftogaz could buy capacity from the TSO and sell it to Gazprom.

2. A series of shorter-term contracts for smaller volumes. This is likely if efforts to put in place a more robust arrangement fail.

3. The shifting of the delivery point in Gazprom’s current long-term sales contracts from Ukraine’s western border, and other European sales points, to the border of Russia and Ukraine. This approach, long supported by the Ukrainian government and European politicians, has no obvious commercial rationale from Gazprom’s point of view. First, the company would need to reopen negotiations on its long-term contracts with major European purchasers. Second, selling gas on the Russian border would set a precedent with unpredictable and potentially undesirable consequences. Gazprom’s major European customers have also been lukewarm to this proposal, which implies a big upheaval in trading arrangements. And finally, the political context, of Russia’s relations with Ukraine and European countries at a low ebb, is not conducive to a move in this direction. All these things considered, it is unlikely.

These three possibilities apply up to the mid-2020s. Thereafter, it is possible, assuming no thawing of political relations, that only residual volumes that cannot be transported by other routes will be transited across Ukraine. This could imply zero transit in some periods.

Direct Russian exports of gas to Ukraine, which ceased in November 2015, seem unlikely to resume, without a political sea-change. Ukraine’s gas consumption has fallen sharply due to military conflict, economic crisis and some energy saving—and is now supplied from domestic production and imports from EU countries.

The Ukrainian Transport Business

One crucial element that will shape gas transit across Ukraine after 2019 is the reform of Ukrtransgaz, the Naftogaz subsidiary that operates Ukrainian gas pipelines and storage facilities. Ukrainian energy law provides for these assets to be unbundled, i.e. to be separated- out from Naftogaz’s other businesses (oil and gas production, supply, etc) within 30 days of the completion of the Stockholm arbitration. Nevertheless, major obstacles remain.

• First, the government and Naftogaz management have different views of how unbundling should be implemented. A government decree (no. 496, July 2016), required that Ukrtransgaz’s transmission assets be transferred to a new state-owned entity, Main Gas Pipelines of Ukraine, after the arbitration hearings, and that storage assets be unbundled subsequently. Naftogaz managers, by contrast, have set up a new subsidiary, Ukraine Gas Transmission System Operator, to manage the transmission system but not the storage assets; they argue that the holding company should retain control of the whole system while unbundling proceeds. The question of whether the storage assets should be unbundled together with the pipelines, or separately, is complicated by legal cases, brought by oligarchical industrial groups, in respect of stored gas.
• Second, both government and Naftogaz agree that European partners should be brought in, but the form of cooperation is not yet clear. There are prospects for involving European TSOs as partners, with political support from the EU. Under a Memorandum of Understanding signed in April 2017 with Naftogaz and Ukrtransgaz, Snam of Italy and Eustream of Slovakia have produced proposals for unbundling. Naftogaz management is also in talks with other European TSOs.
• Third, Naftogaz has long cross-subsidised the supply of cheap gas to households and district heating companies, and the burden of non-payment especially from the latter, with revenue from sales to industrial customers and from transit services. Since 2014, market reform has reduced Naftogaz’s sales to industrial customers substantially; without transit revenues, the cross-subsidy scheme would be in danger of collapsing. While all sides agree that the crosssubsidy needs to be phased out, that is tricky socially and politically—especially with a presidential election approaching in March 2019—and this affects the timing and manner of unbundling.

The biggest unknown in the unbundling puzzle, though, is the post-2019 size and shape of the transit business. Perhaps only when this becomes clearer will this aspect of market reform move forward.

Conclusions

Hopes that the conclusion of the arbitration case would allow the companies involved to draw a line under the past, and negotiate commercial arrangements for post- 2019 transit, appear not to have been borne out. Gazprom’s appeal against the decision is unlikely to produce a substantially different result, and its proceedings for termination of the current contracts is irrelevant to the arbiters’ decision. However, these actions will overshadow possible negotiations on post-2019 arrangements.

Moreover, during this year and next, while the arbitration appeal is in progress, other crucial issues for Russia’s gas trade with Europe will also be in the process of being negotiated, including the final outcome of the EU Director General of Competition (DG Comp) investigation into Gazprom pricing, and the legal and regulatory obstacles to the Nord Stream 2 and Turk- Stream pipelines.

Gazprom’s reactions to the tribunal’s decision appeared to be a form of protest rather than a way of pursuing a business strategy. Its major European customers may not be unduly concerned. But the appearance given, that it was ready both to suspend gas deliveries to Ukraine that were paid for and expected, and to terminate both supply and transit contracts without anything to put in their place, will reinforce political rhetoric in Europe about reducing dependence on Russian gas supplies.

The European Commission after 2014 brokered the arrangement of “winter packages” that enabled transit and gas supply to Ukraine to continue, despite the political tensions. It may again feel motivated to intervene— although there is a time constraint, in that the current European Commission’s term of office ends on 31 October 2019.

The decline of the Russo–Ukrainian gas relationship will continue. From 2020, transit of Russian gas across Ukraine will continue, but at much lower volumes. Direct sales probably will not. By the mid-2020s, all transit could cease. The only realistic possibilities of change depend on an improvement of political relationships, which in turn probably depend on a significant shift in the situation in eastern Ukraine.