The European gas market is about to enter the final stages of a major reorganization that will change its structure from the foundations up. Ukraine must respond appropriately to these tectonic changes.
Going after the monopolist
On April 22, the European Commission accused Gazprom of interfering in the formation of a consolidated market and establishing fair prices for all consumers. The ultimate fine could be as much as 10% of the Russian gas monopolist’s annual income, which, based on the company’s own figures, was €9.3 billion in 2013. Preparations to form an Energy Union among the EU’s 28 member countries continue, with the purpose of putting an end to their fragmentation in relations with external suppliers of natural gas, starting with Gazprom. And this should make the EU’s position stronger than that of certain individual countries today. Above all, the idea is to put an end to politically motivated pricing and to establish universal principles for all consumers.
Gazprom President Alexei Miller has already admitted that the fulfillment of the Third Energy Package and new initiatives from the European Commission are causing mayhem with the gas giant’s traditional operating strategy on the European market. He warned that any efforts to establish a single import price for gas would lead to its becoming more expensive for many EU countries, adding that the company was prepared to simply stop deliveries. “We can always take a break, if necessary, and we will maintain it if someone forces our hand,” Miller threatened.
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The ire of the Russian monopolist is easy to understand in the face of not only losing opportunities to carry out its plan to subordinate the European gas market and being relegated to the position of a mere resource supplier, as is being proposed. A revolution on the global gas market brought about by the expansion of shale gas extraction, growing supplies of liquefied gas extracted in more traditional ways, and last year’s drop in oil prices have left Gazprom with sharply shrinking profits.
In particular, Gazprom’s latest financial report shows that the considerable devaluation of the ruble in QIV 2014 still left the company’s gross income from gas sales in rubles at 2011 levels, while pre-tax profits fell from RUB 1.49 trillion in 2013 and RUR 1.14tn in 2011 to RUB 0.31tn in 2014 as costs mounted. Although less than half of Gazprom’s production goes for export—207.5bn cu m vs 232.4bn cu m sold to domestic consumers in 2014—, the lion’s share of income—RUB 2.15tn vs RUB 0.82tn—comes from it. Domestic sales amounted to only 27.3%, while in 2015 the relative value will likely be even worse due to the devaluation of the ruble, as in 2014 it only began to be felt in QIII.
Realigning networks
Year-end results show that Gazprom exports to the EU shrank by 13.8%, to 121.3bn cu m. This volume was almost equivalent to deliveries to EU countries from Norway’s Statoil. Meanwhile, Statoil has expanded right to the borders of the Eurasian Union and has entered not only the Polish market, but also the Ukrainian and Lithuanian ones. In addition, an LNG terminal went on line in Lithuania in December 2014 that has a capacity of 4bn cu m. Since Lithuania only used 2.54bn cu m last year, this offers another opportunity to cover demand in neighboring Latvia and Estonia, whose combined consumption was 1.4bn cu m in 2014. At the moment, its contract with Statoil is only for 0.54bn cu m of natural gas per year.
From the southern flank, alternative sources besides Russia will include Caspian gas in another 3-4 years, which will go to the Balkans through the Azeri-Turkish TANAP pipeline whose construction began on March 17, 2014 and is planned to be complete by 2018. Initial capacity will be 16bn cu m per year with the option of expanding it based on demand for Caspian fuels and specifically demand for it in Europe. Today, Bulgaria is dependent on Russia for 80% of its supplies but is preparing to receive at least 1bn cu m through TANAP, which will replace 35-40% of the volume imported from Russia in recent years.
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But this is not all. Not long ago, energy ministers from Greece, Bulgaria and Romania signed an agreement to build links among their countries’ gas transport systems, a kind of vertical gas corridor whose construction will start in March 2016 and be completed by the end of 2018. The purpose is to set up opportunities to transfer 3-5bn cu m of natural gas from the TANAP pipeline and the LNG terminal that could be build across northern Greece to Bulgaria, Romania, Hungary and Moldova. The capacity of this vertical gas corridor can be expanded to include the pipeline currently being used in Ukraine to transport Russian deliveries. The necessary conditions for this could emerge should Gazprom make good its managements threat to stop shipping via Ukraine starting in 2019.
In a recent interview with Reuters, European Commission Vice President Maros Sefcovic announced that the European Union was counting on bringing in gas through Azerbaijan and Turkey and from Turkmenistan by 2019. “The political decision has been made that Turkmenistan is part of this project and will be supplying in the direction of Europe,” he noted. Turkmenistan has been feeling the pain of lost markets as Gazprom’s purchases collapsed from 11bn cu m to 4bn cu m. Even if political issues arise with the uncertain status of the Caspian Sea and it proves impossible to build a pipeline along its bottom, it will still be possible to move 5-10bn cu m either through Iran or by building LNG terminals in Turkmenistan and Azerbaijan.
Meanwhile, the Russian Federation is also actively working to shift its center of trade in gas from the EU to the Balkans. Its “special relations” are helping in this, including the newly friendly relationship between the new government in Greece and the Kremlin. Greek shares a marine border with the biggest consumer of Russian gas after Germany, Italy. In addition, it can receive gas through the “Turkish Stream, across the bottom of the Black Sea and the territory of Turkey, which is also one of the biggest consumers of Russian natural gas.
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Gazprom boss Alexei Miller told Greek Premier Alexis Tsipras in recent talks that the Russian side could guarantee 47bn cu m gas transit across Greek territory annually and noted the benefits of investing in the Greek portion of the pipeline.
This clearly shows that the structure of the European gas market is in the process of being reorganized and will be fundamentally different by 2020 from what it was prior to 2010. Gazprom’s monopolist position on Central and Eastern European markets and its dominance in such major national consumers of gas like Germany, Italy and Turkey will be challenged by a much higher level of diversification. Options for transferring huge volumes of fuel among individual countries in Europe will multiply, especially among CEE countries. The transit role of Turkey will grow, and likely Greece, although in the case of the latter, this will be reversed somewhat by regulations governing its transit gas facilities through EU energy legislation.
The cloud: declining volumes
Whatever way the gas market goes, it’s clear that Ukraine will ultimately and irreversibly lose its status as the main transit network supplying the EU with Russian gas. Ukraine’s Energy Minister Volodymyr Demchyshyn recently announced that Gazprom realistically would not have the option of stopping gas deliveries through Ukraine in 2019. Still, the throughput capacity of Ukraine’s GTS is 142.5bn cu m. In 2008, it handled 116.9bn cu m and Ukraine’s 2009 contract with Russia obligates Gazprom to pump at least 110bn cu m through Ukraine’s pipelines annually. In actual fact, volumes have been falling steadily and were down to 84.3bn cu m in 2012 and 62.2bn cu m in 2014. Given that Gazprom export deliveries to European countries was 126bn cu m in 2014, Ukraine’s share of this transit has declined by 49% already.
In 2015, volumes of Russian gas transiting through Ukraine’s GTS are expected to shrink further, to a maximum of 50bn cu m. Over January-March 2015, for instance, compared to the same period of 2014, volumes fell by 31.4%. Over January-February, even though this was the winter heating season, Ukraine’s GTS transported only 26.2% of Russia’s exported gas or 7.22bn out of 27.5bn cu m. And nearly a third of that returned to Ukraine as reverse gas from Slovakia.
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In short, should the situation with Gazprom go into conflict mode, Ukraine could find its GTS running empty next heating season as Gazprom can turn off the taps without a catastrophic collapse in its export revenues. Meanwhile, only 14% of the natural gas consumed in the EU in 2014 went through Ukraine’s system. Of the six biggest gas markets in the Union—Germany, Great Britain, Italy, the Netherlands, France, and Spain—, only Italy imported more than 15% of its gas via this pipeline last year. Right now, it serves mostly minor gas markets in the EU: Bulgaria, Hungary and Slovakia. Even those countries that are 100% dependent on Russian gas coming via Ukraine’s pipelines—Moldova, Bulgaria, Greece, Macedonia, Serbia, Hungary, and Slovakia—only bought 18.6bn cu m of it. Italy, Slovenia and Austria, which also depend on Russian gas coming exclusively from Ukraine but to a lesser degree, bought an additional 26.1bn cu m.
Cologne University’s Energiewirtschaftliches Institut, an energy research institute, published a study on March 19 that showed that the EU is now much better prepared for disruptions in Russian gas transit via Ukraine than during the 2009 gas crisis. It will survive even a months-long interruption in supplies relatively painlessly. A simulation carried out by energy specialists showed that even if supplies are stopped during the cold season for as long as six months, only one country in the EU will face serious problems, and that’s Bulgaria. Of course, Ukraine itself will sharply feel the sudden lack of natural gas. Should heavy frosts accompany this situation, Greece and Italy are also likely to find themselves unable to satisfy domestic demand fully. The remaining EU members are capable of providing themselves with enough natural gas to cover temporary disruptions.
The silver lining: independence
Without any doubt, the reorganization of the European gas market presents challenges to Ukraine, but it also offers some obvious advantages. The apparent interdependence between Ukraine and Russia, with one completely dependent on the supply of gas and the other on its transit, was an anachronism inherited from soviet times with their “single economic complex.” In all the years that Ukraine has been independent, this atavism got in the way of Ukraine’s economic and energy emancipation from Russian influence, of a complete cutting of the colonial umbilicus to the one-time soviet metropole. Ukraine’s GTS and gas market were never seen outside the context of Russia, let alone in the context of a single European energy market.
The same can be seen in the trade and economic sphere, especially in the cooperation between the two countries in the military-industrial-complex and in heavy industry in general: a complete break is necessary for Ukraine to become truly independent and to leave Moscow’s orbit. Russia should have diversified its transit networks and reduced—if not completely lost—interest in Ukraine’s GTS, while Ukraine should have diversified its suppliers and lost any incentives to agree to political and economic concessions in exchange for price breaks. Right now, the important point is for Ukraine prepared to abandon Russian gas imports or to reduce them to less significant levels, say 10-20% of annual consumption, by 2020, when the Russian Federation will be entirely able to abandon Ukraine’s gas transit network. Otherwise, the interdependence of old threatens to transform itself into completely unilateral dependence on Moscow.
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Still, there are reasons to be concerned. At first glance, it seems that Ukraine has almost reached this goal already. Of the 1.48bn cu m of gas Ukraine imported in April, 1.18bn cu m came from the EU and only 0.30bn cu m from Russia. Unfortunately, at this time, all of Ukraine’s diversification is oriented towards re-exports of natural gas. Existing infrastructure makes it possible to ensure the delivery of up to 50mn cu m of gas daily from EU countries, that is, over 18bn cu m per year. For comparison, in 2014, Ukraine only needed to import 19.9bn cu m, including for the occupied areas of Donbas, where industries functioned normally the first six months and household rates had not yet been increased.
Should Russia stop transporting gas through Ukraine’s system, serious problems could arise with reverse transit. This problem can only be resolved if European consumers and Gazprom can pressured to move the points of sale of Russian gas to the eastern border of Ukraine, not the western one, as it is now. Whether this can be achieved is not clear yet. If the Turkish Stream is completed, Balkan and Italian consumers will genuinely find it more convenient to buy gas at the border between Turkey and Greece. At that point, the Ukrainian network will offer a clear advantage only to Hungary, Slovakia and Austria.
Considering all options
Naftogaz Ukrainy meantime is counting on a significant increase in domestic extraction of traditional gas, with the potential to reach 27-29bn cu m by 2020. But this means a sharp increase in investment capital and this also means raising prices for domestic natural gas to import levels, while keeping the tax burden for its extraction at a reasonable level. So far, this is all a bit problematic and populist politicians continue to insist on maintaining below-market household rates that would be detrimental to domestic production.
Building interconnectors between Ukraine and those countries that will be receiving large volumes from alternative sources by 2020 could reduce the negative impact of a possible stop in the transit of Russian gas through Ukraine’s GTS and the inevitable shortage in volumes available in the GTSs of Slovakia and Hungary. In particular, this can already be seen in Ukraine’s cooperation with the Polish GTS operator Gas-System regarding an increase in throughput capacity along the Polish branch feeding Ukraine from the current 1bn cu m to 8-9bn cu m per year. Talks have also renewed with Romania to supply Ukraine with natural gas from the Balkans, where it is likely to be delivered by the TANAP pipeline or via an LNG terminal that might be built in northern Greece.
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Still, Ukraine needs to take the initiative to build an LNG terminal itself, most likely on its own Black Sea coast. The overall capacity of LNG terminals in Northern Africa—Egypt and Algeria—alone is 44.1bn cu m. Deliveries from these countries have gone down in recent years. Should there be difficulties with supplies through Black Sea streams, an LNG terminal to handle gas from Azerbaijan or Turkmenistan can be built on the Georgian coast and financed by independently by Ukraine. If geopolitical problems arise with this as well, another option is to build a Polish-Ukrainian LNG terminal on Poland’s Baltic coast, given that this country is a reliable, consistent ally of Ukraine in holding back Russia’s geopolitical and energy expansionism in the region, and to then transport gas from it to Ukraine through Poland’s GTS.
Backtracking?
When the article was sent to press, it became known that Ukraine almost halved the amount of gas imported from the EU while increasing the amount bought from Russia. Over January-April 2015, only 2.45bn cu m (33.8%) of the 7.24bn cu m of imported gas was bought from Russia, and 4.79bn cu m (66.2%) – from the EU. Over May 1-4, the share of Russian gas in total import grew to 46.4% (86.3mn cu m), while that of the EU shrank to 53.6% (86.3mn cu m). If Ukraine chases the discount for Russian gas, it risks getting a reputation of an unreliable partner that can play against the EU in the long run in the eyes of European suppliers and transit operators
