Is There a Solution?

The Beginning of the Conflict

In the first years after the collapse of the USSR, the former Soviet republics purchased gas at Russian domestic prices, but in 2005 (after the Orange Revolution in Ukraine and the Rose Revolution in Georgia) the situation began to change—Russia announced its desire to gradually transition to gas prices closer to the ones in Europe. Simultaneously, Ukraine announced its intention to raise the tariff for pumping gas through its territory. The two sides’ inability to reach an agreement led to the “first gas war” during the first days of January 2006, when Gazprom stopped supplying natural gas to Ukraine, but continued to export gas through Ukrainian territory. The “war” lasted four days and concluded with the signing of a five-year contract between Gazprom and Naftogaz (until January 1, 2010) with terms (price and volume) to be fixed every year. Additionally, an intermediary company, Rosukrenergo ², was created to provide a lower price on gas for Naftogaz by obtaining from Gazprom the right to purchase gas from Turkmenistan, which was significantly cheaper.

In the autumn of 2008, a conflict between President Victor Yushchenko and Prime Minister Yulia Tymoshenko came out into the open in Ukraine, blocking the signing of Russian gas provision terms for 2009. As a result, from January 1, 2009 Gazprom halted the flow of gas to Ukraine, from January 5 the gas flow to European consumers decreased, and from January 7 the transit of Russian gas through the territory of Ukraine stopped completely. Gas supplies to Ukraine and transit to Europe resumed on January 20th after the signing of a new 11-year agreement ³ on gas provision, which proved highly disadvantageous to Ukraine. Ukraine agreed to the following conditions:

• An annual gas supply of 52 billion cubic meters (40 billion in 2009) with the possibility of annual adjustments in either direction of no more than 20 percent.
   
• “Take-or-pay” in the amount of no less than 80 percent of the fixed volumes stipulated in the agreement.
   
• A base price of 450 dollars tied to the price dynamics for fuel, oil, and diesel fuel over the previous nine months. The price was fixed on the basis of high prices during the “reference period” of April-December 2008 and, obviously, had been overstated for Ukraine. The compromise found by the negotiating parties was clearly of a temporary nature, and it seems both sides thought that it would allow them to further improve their position in the future.

Incidentally, these supply volumes were clearly excessive for Ukraine. While Ukraine had low gas prices for Russian gas, it’s chemical industry consumed a lot of gas to produce fertilizers for export using old equipment with high costs. But as the price started to grow, costs became non-competitive, export declined, and the gas consumption in this country rapidly decreased in 2005-2008. Moreover, during this period, Ukraine  implemented a set of energy saving measures that allowed it to reduce gas consumption as well. According to estimates, the Ukrainian economy’s gas needs during 2010-2012 amounted to 57-62 billion cubic meters in addition to Ukraine’s own production of gas at a volume of 22 billion cubic meters. Thus, no more than 30 billion cubic meters of Russian gas were needed.

As this contract was being signed, another contract was signed for gas transit through the territory of Ukraine by Naftogaz. The terms of this contract proposed:

• Yearly pumping of no less than 110 billion cubic meters of gas.
   
• The price in 2009 was 1.7 dollars (per 1000 cubic meters pumped 100 kilometers), but a lower price (1.094 dollars) was partially used in payment of debt from a 250 million dollars advance previously issued by Gazprom.
   
• Since 2010, the PRICE of transit has been calculated based on a formula, the main component of which is the base PRICE for all 10 years (2.04 dollars), which is indexed to the rate of inflation in the euro area, plus a premium to the price based on the price of gas supplies to Ukraine.

Membership Has Its Privileges

However, in February 2010, the political situation in Ukraine changed. Yulia Tymoshenko lost the presidential election to Victor Yanukovych. Russian politicians judged Yanukovych to be a pro-Russian candidate whom they were ready to support financially. On April 21 2010, Russia and Ukraine signed the so-called Kharkiv Pact, which significantly adjusted the conditions of the gas contract in favor of Ukraine:

• The sanctions against Ukraine for not fulfilling its Russian gas consumption obligations were abolished (in reality, this meant the cancellation of “take-or-pay” conditions),
   
• As payment for the lease of Sevastopol as the base for Russia’s Black Sea Fleet, Ukraine received a discount on the price of gas at a rate of 30 percent, but not more than 100 dollars,
   
• Further opportunity was provided for the reduction of gas prices for Ukraine through the lowering of customs duties on gas by decision of the Russian government.

Figure 1. Price of Russian gas for Ukraine, Germany, and the Baltic States ($/MmBTU)

 

ZEE-BELG Day-Ahead price for Zeebrugge, Belgium
HH-USA  Henry Hub price, USA
RUS-GER Price of Russian gas at the German border (WGI estimation)
RUS-UKR Price of Russian gas at the Ukrainian border (long-term contract)
RUS-BALT The average price of Russian gas exported to Estonia, Latvia and Lithuania

Source: www.eegas.com

As a result, in 2010 and the beginning of 2011, the price of gas (taking into account the discounts and the dynamic of oil prices in 2009-2010) for Ukraine was on the level of 320-330 dollars per 1000 cubic meters, which was acceptable to both sides. However, the increase in oil prices at the beginning of 2011 to more than 100 dollars per barrel led to an increase of both the base and the contract gas prices for Ukraine. Soon it became clear to everyone that the base gas price agreed to in 2009 was much too high. According to experts’ estimates, even with all the discounts, Ukraine’s price for Russian gas was higher than the gas price for Germany (excluding additional transport costs).

Ukraine has made numerous attempts to revise the price on gas, but, since the start of 2010, the Russian side has clearly articulated its positions: a discount on gas is only possible if Ukraine joins the Customs Union. According to the managers of Gazprom, the discount would have been 200 dollars.

Yet, even before the Orange Revolution, Ukraine had reached a consensus in favor of European integration. Some politicians—Viktor Medvedchuk for example—argued in favor of integration with Russia, but they had little popular support. In these circumstances, Yanukovych could ill afford to the Customs Union, and Ukraine gradually moved toward signing the Association Agreement (AA) with the EU. Russia and Putin personally continued to pressure Yanukovych to convince him of the inevitable large-scale economic losses for Ukraine in the event that he signed the AA. At the very end of November 2013, at the EU-Ukraine Summit in Vilnius, where this agreement was supposed to be signed, Russian pressure paid off and Yanukovych refused to sign the AA, citing the need to study them further ⁴.

 

In return, Russia offered Ukraine 15 billion dollars in credits (the first tranche of 3 billion dollars was delivered in December 2013) and a sharply lower (by 30 percent) gas price at 268.50 dollars per bcm. Additionally, it immediately became clear that Russia had put Yanukovych on a short leash—the gas price agreement stated that this discount would be reviewed on a quarterly basis: failure to meet the relevant conditions by the 10th day of the first month of each quarter would lead to the cancellation of discount for that quarter.

In this situation, it is not surprising that following the overthrow of the Yanukovych regime and the formation of a pro-European government, Russia did not extend the agreement on gas price discounts. Moreover, on April 2, 2014, after the annexation of Crimea, Russia unilaterally terminated the Kharkiv Pact on the Black Sea Float, having annulled the earlier 100 dollars discount associated with that agreement. As a result, the price of gas for Ukraine in the second quarter of 2014 should have been 485 dollars per bcm based on 2009 agreement.

The Crisis Reaches Its Peak

Such a sharp increase in gas prices has certainly been very negatively received in Ukraine, whose government refused to recognize this price and to pay for Russian gas on the basis of this. The situation was aggravated by the fact that Naftogaz of Ukraine had stopped paying for Russian gas from November 2013 until the end of April. Ukraine’s accumulated gas debt amounted to approximately 3.5 billion dollars (of which 1.45 billion dollars represent the debt from November-December 2013).

Looking for a Solution

The negotiations began. In the course of a month, from mid-May until the mid-June, there were seven rounds of talks, but the sides could not agree on a solution. By the end of May, Ukraine’s debt had grown to 4.45 billion dollars , and, in the middle of June, Gazprom announced that it would transition to a prepayment system for gas supplies to Ukraine. Simultaneously, Gazprom filed a lawsuit in the Stockholm arbitration court, demanding the recovery of 4.45 billion dollars from Naftogaz for previous gas deliveries. Naftogaz, in turn, filed a counterclaim in the Stockholm arbitration court, demanding the recovery from Gazprom of 6 billion dollars spent purchasing Russian fuel at allegedly inflated prices.  In addition, Naftogaz demanded the revision of the gas contract’s conditions and the tariff on the transport of Russian gas to Europe.

If Gazprom’s position before the May 25 Ukrainian presidential elections was openly aimed at escalating the confrontation, after the election the Russian side assumed a more constructive position. This enabled both parties to formulate their positions clearly.

Russia’s Position

• Ukraine’s repayment of its debt for gas supplied by Russia is the main issue of negotiations. The amount of the debt reached 5.3 billion dollars (2.9 percent of Gazprom’s annual revenues or 13.5 percent of annual profit) by mid-June when the prepayment system has been enacted.
   
• Russia is ready to lower the price of gas. According to its stated proposals, the price could decrease (in relation to the price fixed in the agreement) by 100-120 dollar per bcm. But Russia proposes decreasing the price by lowering the export duty on gas, which could be implemented by a government decree. Simultaneously, Russia is ready to guarantee that the given price discount will be valid for the entire period of the contract.
   
• Gazprom’s final proposal:

- Total payment of debt for November-December 2013 at the contract prince (1.45 billion dollars), which Ukraine does not dispute.
- Payment of 500 million dollars as partial repayment of debt from April and May 2014 without specifying the amount paid, that is without determining the price at which Ukraine is paying for the gas.
- The continuation of negotiations and deliveries of gas to Ukraine without prepayment.

Because of the economic sanctions imposed on Russia for annexing Crimea the terms of borrowing for Russian companies have deteriorated sharply, affecting their overall financial position. As a result, the loss of 13.5 percent of the after-tax profit gained new significance for Gazprom. In 2014, Gazprom will have to repay (and refinance) foreign-denominated loans in the amount of approximately 10 billion dollar. In 2013, Gazprom’s long-term debt increased by 17 percent; in 2014, it will need to increase its long-term loans to develop the East Siberian gas fields, in order to meet its commitments under the contract with China. What’s more, under Russian law Gazprom has paid 1.8 billion dollars of profit tax for gas supplied to Ukraine regardless of non-payment (accrual method).

Ukraine’s Position

• The purpose of the negotiations is to reconcile all issues related to the gas contract.  Debt repayment would mean recognition of the price of gas used by Gazprom in April-May; therefore debt repayment will be contingent upon reaching an agreement on all other issues.
   
• Ukraine does not agree with the price of gas that Gazprom is using to calculate the debt for April-May 2014 (485 dollars per bcm). The price from the first quarter of 2014 (268.5 dollar per bcm) should have been in effect during this period.
   
• Ukraine insists on lowering the base price (the price from the first quarter of 2014 is called the “fair market price”); the new price should be fixed taking into account the new, lower Russian export duty on gas and no further price changes are  to be introduced unilaterally.
   
• Ukraine’s final proposal:

- Temporary price of 326 dollars per bcm (the average of 268.5 dollar per bcm demanded by Ukraine and the 384.5 dollar per bcm proposed by Gazprom) for the period of April-July 2014;
- Naftogaz repays its debts on the basis of the temporary price;
- An agreement about a new price will be reached either through negotiations or through legal proceedings in Stockholm; and debts will be settled on the basis of that agreement;
- Ukraine will provide a sovereign guarantee for Naftogaz’s debt.

Bound Together

Comparing the positions of the two parties, one can easily see that the number of disagreements between them is not great. Both sides recognize that they will not be able to reach a long-term agreement quickly. Both are ready to accept interim solutions. Both realize the need to compromise: Ukraine will need Russian gas for years to come; and, until the “South Stream” pipeline is built, Russia cannot meet its gas supply commitments to Europe without using the Ukrainian gas transport system.

Moreover, the European factor is important for both sides: Ukraine is signing the Association Agreement with the EU and wants to be perceived as a “normal European country;” for Gazprom, Europe will remain the most important market for many years; it is critical for Gazprom to preserve its reputation as a reliable supplier. As a result, it is a good bet that a solution—even if only a temporary one—to supply the European gas market will be reached before the onset of cold weather.

That said, the dynamic of the overall Russian-Ukrainian relationship will affect the course of the gas negotiation in the coming months. But there is clearly room for a compromise between the two sides that will protect their economic interests and preserve their legal positions.

As to the long-term contract, both sides have demonstrated their full commitment to take the matter to court. At the same time, it’s worth remembering that in recent years Gazprom has repeatedly faced the problem of revising existing contracts with European consumers. The main demands of the European companies were:  changing the price formula, usually to link the price of a part of the consumed gas to the spot price; and abandoning the “take-or-pay” clause. Having lost in courts repeatedly and having to pay significant compensation retroactively, Gazprom has frequently attempted to reach pre-trial settlements in such disputes.  This improves the odds of a similar settlement with Ukraine eventually.

Ukraine appears likely to reach an out-of-court settlement, as Gazprom’s demand of repayment for gas seems quite clear. Even if the court rules in favor of a 30 percent cut in the price of the gas Ukraine consumed but did not pay for in April-May 2014, this will reduce the total amount of Ukraine’s payments on the claim by less than 10 percent. Considering the legal costs and accrual of interest for Gazprom, Ukraine’s “savings” will be even smaller.

Naftogaz’s chief complaint is that the price of Russian gas for Ukraine was higher than for other European countries. As a result, Naftogaz will probably ask to lower the starting price in the contract. The likelihood that this claim against Gazprom will be met is very low.

If the two sides reach an interim agreement on price and partial debt repayment, the chances of an out-of-court settlement on the fate of the long-term contract will increase. However, even in the case of a temporary solution, the decisive factor that will help or hinder a compromise will be the dynamic of the Russian-Ukrainian political dialogue.

However, the mutual dependence between two countries (gas import vs transit) may result in new conflicts in the future. Both Russia and Ukraine are looking to reduce their dependence on each other. Russia is looking to build another pipeline (South Stream) that will allow it to supply gas to all European countries without passing Ukrainian territory even though it will be a generously expensive project. Ukraine is looking to increase its own gas production (possibly including shale gas) and  LNG imports that may enable it to cancel or significantly reduce imports from Russia. If both sides fulfill their plans (5-7 years from now) the gas conflict will disappear forever.

Sergei Aleksashenko, the former deputy chairman of the Russian Central Bank, is a visiting fellow at Georgetown University.

Notes

¹ Ukraine, Belarus, Moldova, Georgia, Armenia.

² Fifty percent of the capital of the company belonged with Gazprom, and 50 percent—to the Ukrainian businessman Dmytro Firtash. According to the rumors circulating in Moscow, Firtash had to share the profits from the company with the top managers of Gazprom and the reputed organized crime boss Semion Mogilevich. Rusukrenergo’s profit during its existence (after taxes) exceeded 2 billion Swiss francs.

³ Simultaneously, Russia and Ukraine agreed to the removal of Rosukrenergo from the gas provision scheme.

⁴ Here and below, this price is for 1000 cubic meters (100 dollars for 1000 cubic meters = 35.3 dollar/MmBTU).