Questions about Ukrainian energy policy

I participated in a discussion in London yesterday (9 December) on “Is Ukraine ready to face the winter freeze: focus on diversification of energy supplies and embracing energy efficiency”. I made my comments in the form of questions and answers, as follows:

Q. Can Ukraine reduce gas demand further in 2015-20?

A. In the mid 2000s, Ukraine’s gas consumption was 75 bcm/year. It was 50 bcm in 2013 and will be about 42 bcm in 2014. That’s a 40%+ reduction, due to:

■ economic recession (which has reduced industrial demand, and naturally it is hoped that much of this will be restored);

■ high prices which have encouraged diversification to coal;

■ and some energy saving measures, also due to high prices.

Gas demand has already been reduced where it is easy to do so. But, assuming (i) a modest economic recovery, (ii) continued diversification to coal (and other fuels), and (iii) continued energy saving measures, it

is realistic to suppose it could be reduced further. It’s possible to imagine, in the next few years, consumption falling to 35 bcm/year (20 bcm of own production, 15 bcm of imports).

Q. Is there anything to stop Ukraine ceasing purchases of Russian gas?

A. Yes.

The contract signed in 2009 implied very large volumes of imports (52 bcm Annual Contract Quantity). Under the Brussels agreement (31 October 2014), Gazprom made substantial concessions on price and on volume. But there is surely a point at which Gazprom will try to recoup losses. Further reductions in purchases would surely result in a decision against Ukraine at arbitration, which would be expensive.

 “Reverse flow” purchases are often depicted in the Ukrainian media as non-Russian gas. But in fact the molecules originate in Russia, and this will remain the case for almost all gas consumed in eastern and central Europe for the foreseeable future.

Ukraine can purchase more gas on “reverse flow” terms, and while it might be cheaper than contract gas (because of the differential between hubs and oil-linked prices) it will not be fundamentally cheaper than other Russian-origin gas over the long term.

Because of Ukraine’s geographical position, non-Russian gas is unlikely ever to be cheaper than Russian gas. Therefore if the aim is to diversify from Russian gas, then domestic gas production, coal, hydro and energy saving measures – and possibly nuclear and biofuels – are the more logical alternatives. 

Q. Can Ukraine develop its own gas production?

A. Yes, but it will not be easy, given the setbacks to the largest projects in which foreign companies are involved, as a result of the military conflict.

An outstanding question is that the level of investment in Naftogaz’s own conventional production is insufficient. This is what we hear each year at the Ukraine energy conference from the company’s own upstream people.

It is a decision to be made by government, whether to prioritise investment in Naftogaz’s upstream assets.

Q. What is the point of Ukraine’s transit business?

A. Until 2013, Ukraine was earning an estimated $2.5-3 bn/year from its transit business, while its expenditure on imported gas rose to about $14 bn/year.

Since (a) the transit system is designed to transport Russian gas to Europe; (b) Russia and Ukraine now have the worst political relationship they have had since the break up of the Soviet Union; and (c) the disputes over transit have been, and will probably remain, highly political … it seems logical to ask: why build up the transit business? Why not see it as a business in decline, and concentrate on other activities?

Cancellation of South Stream may delay the decline of Ukrainian transit, but a new Turkish pipeline would have a similar effect.

Naftogaz has stated that it wishes to move the sales point for Russian gas to European customers to the eastern border. The problem is that neither Gazprom nor its European customers are likely to favour such an idea. As far as we know, their contracts provide for sale of gas on Ukraine’s western border.

European companies are reluctant to take on Ukrainian transit risk. (Note that when I say “Ukrainian transit risk”, that implies only that transiting gas through Ukraine is seen as a problem. It is not a comment on how that problem has been caused.) The companies’ attitude is sharply at odds with that of European politicians, who speak very optimistically about the prospect of moving the sales point – but it is the companies, not the politicians, who have to take the commercial decisions.

Q. Could Ukraine’s gas storage capacity be integrated into the European system?

A. The system has very great potential, because of its size and the proximity of much gas storage capacity to the western border. However, the only realistic way for this to happen in the short to medium term is if Ukraine’s market rules are integrated with those in Europe (i.e. the third energy package).

Experience shows that, even in countries whose governments have consistently pushed ahead with market reforms, integration into the European market system takes time. Once Ukraine starts implementing market reform along the lines envisaged in the gas law of 2010 (i.e. transparent trading, separated-out transport business, third party access, etc), it will become clearer how long such integration might take.

The emergency this winter has led to the adoption of regulations – including, specifically, the compulsory sale of gas by private producers to Naftogaz, and the compulsory purchase of gas from Naftogaz by industrial firms – that move further away from such market reform, not nearer to it.

Conclusions

■ There are no magic bullets.

■ Ukraine can obviously reduce gas consumption further, but what gas it imports will inevitably be Russian in origin.

■ I believe that it would be welcome if the military/political crisis prompted a rethink of energy policy priorities, and specifically the extent to which further diversification from gas is possible and desirable. I think it is both.

■ The transit business is often portrayed as Ukraine’s strong point. I would suggest that it may be Ukraine’s weak point.

This discussion – in which the other participants included Naftogaz Ukrainy chairman Andriy Kobolev and representatives of JKX, Misen and Burisma (private Ukrainian gas producers) – was held at a conference on investment in Ukraine, organised by the Adam Smith Institute.