Since the recent escalation in the gas confrontation between Ukraine and Russia, the Russian media has started buzzing about a looming gas war, while the EU has expressed the hope that this would not hamper the gas supply to European consumers as it did in 2009. After the construction of South Stream was formally launched in December 2012, in January Gazprom decided to build the subsequent branches of Nord Stream. On January 14, the GAZELLE pipeline began to operate, going from Northern to Southern Czech Republic and binding the German OPAL (Nord Stream branch) with MEGAL, the pipeline used to transit Russian gas through Ukraine and Austria to Southern Germany and France. Its potential capacity is now up to 30bn cu m of gas annually. In response to Gazprom’s strategy to bypass Ukraine in transiting gas to Europe and keep gas prices high, Ukraine’s Nadra Yuzivska signed a deal with Shell Exploration and Production Ukraine Investment BV in Davos on 24 January regarding the distribution of the shale gas extracted at the Yuzivka field in Kharkiv and Donetsk Oblasts. Shortly thereafter, Gazprom billed Naftogaz of Ukraine for the gas it had not used under previously signed contracts.
The stance of the Russian side is clear: Moscow is playing with Yanukovych, pressuring him into capitulation – handing over Ukraine’s gas transit system or entering the Customs Union. Obviously, Ukrainian authorities are not guided by the intent to decrease Ukraine’s energy dependence on Russia. On the contrary, government officials say openly that they are willing to see Ukraine’s energy and economic dependence on Russia grow, providing it offers benefits for the businesses that are close to them. Meanwhile, Gazprom’s future looks more bleak. Russia is implementing a long-term plan to raise domestic gas prices annually until they meet world levels. According to earlier predictions, this should have happened by 2015-2016, yet much will not change if the plan is completed a few years later. Moreover, gas prices have been changing on both sides lately, those in the US already lower than domestic gas prices in Russia, while the growing NLG imports push gas prices in Europe down as well. The continuation of the so-called shale revolution could drive the domestic price of Russian gas to match that on the European market much earlier than expected. This could completely wipe out any discounts for Ukraine within two or three years, even if Ukraine joins the Customs Union or sets up a joint Russian-Ukrainian venture to run the Ukrainian gas transit system.
Given the latest developments, the interests of the key players in the conglomerate in power, particularly the Family, are ever more related to expanding their own profitable projects, rather than knocking down the price of Russian gas.
The Family is counting on domestic gas extraction, as signaled by the contract with Shell and the scandal with NaftoGazVydobuvannia, the Oil and Gas Extraction Company owned by Nestor Shufrych and Mykola Rudkovsky, which until recently, controlled nearly a third of all gas extraction by private-owned companies in Ukraine. According to information that surfaced in the media thanks to MP Oleksandr Bryhynets, the company should have transferred nearly 30% of its shares to entities linked to the Family as a reward for the extension of its extraction license. Given its total control over the Ministry of Natural Resources and the Ministry of Energy, supervised by the loyal Eduard Stavytsky, the Family has extensive opportunities to increase its share in other gas extraction-related projects. Rumour has it that the Family even has a share in the joint project with Shell. It is supposedly represented by the little-known SPK GeoService which already owns 10% of Nadra Yuzivska but there is no guarantee that its share will not increase to a controlling stake at any time.
It is therefore not surprising that the joint venture for shale gas extraction has ended up with a privileged environment in which to operate (see Overprotected below). The important aspect of the deal is that Shell is supposed to make large purchases from Ukrainian suppliers, so entities close to the government that have previously been involved in many public procurement scams, will try to take advantage of the opportunities that open doors to investments which are initially worth hundreds of millions of dollars, and tens of billions if the industrial extraction of shale gas is confirmed and launched.
THE OLIGARCHS’ STRATEGY
Both the Family and Rinat Akhmetov’s DTEK have expressed interest in coal extraction and processing, while expensive gas makes the business ever more profitable and opens new prospects for coal bed gas extraction. DTEK is not only concentrating its coal mining assets in Ukraine, but is also increasing coal extraction in Eastern (Russian) Donbas in the Rostov Oblast. In 2013 alone, DTEK is supposed to extract 1.8mn t which is 4.6 times more than in 2012. After all, the myth about the problems that high gas prices cause to Akhmetov’s steelworks is also exaggerated. Before the 2008-2009 crisis, Ukrainian steelworks consumed 9-10bn cu m of gas annually. In 2011, consumption fell to 5.5bn cu m and below 3.9bn cu m in 2012. The companies that are part of Akhmetov’s SCM holding consume almost half of this amount, while the scheduled – and slowly implemented by MetInvest – technology that uses pulverized coal fuel should ultimately decrease gas consumption by his steelworks to 1bn cu m per year. This is an amount that he can easily extract in Ukraine. And it is only for the better, if his competitors have troubles with gas supply or are forced to buy overpriced fuel.
Meanwhile, Akhmetov’s entities are showing interest in the extraction of gas on the Black Sea shelf (Vanco Prykerchenska) as well as of unconventional gas that could bring maximum profits in view of existing expensive imported fuels. Thus, DTEK and Linc Energy, an Australian company that has been involved in underground coal gasification (UCG) in Australia for 12 years, signed a memorandum of understanding and a contract to draft a feasibility study on syngas production through UCG in Ukraine. DTEK’s CEO, Maksym Tymchenko, stated that the company expects to launch syngas extraction in 2014, its estimated original cost lower than that of shale gas and close to that of domestically extracted natural gas.
The biggest industrial consumer of natural gas in Ukraine is still Dmytro Firtash’s Ostchem Holding. However, having the opportunity to import gas directly from abroad, bypassing Naftogaz (and at spot prices) for the third year now, the oligarch can not only to provide his companies with gas at affordable prices, but also take advantage of Russia’s high gas price for Naftogaz to increase his own share on the market as a supplier of fuel for industrial consumers. It is Firtash’s entities that could become key players in various schemes to purchase gas from the EU market.
The media has already reported that a new company called Ostchem Gas Trading AG was registered in Switzerland in December 2012. It is headed by the CEO of RosUkrEnergo AG, which is also one of Firtash’s companies. A week later, Yevhen Bakulin, the Chairman of the Board at Naftogaz, who is close to Firtash’s group, said that industrial consumers should buy gas from alternative traders because it is cheaper. According to Bakulin, it makes sense to leave Naftogaz to supply gas to individual consumers and utility companies.
In 2013, Ostchem Gas Trading plans to import over 8bn cu m of gas, and sell nearly 25% of it to industrial consumers that are not linked to Firtash. In the near future, the oligarch is prepared to increase gas supplies to Ukraine by at least 150%. Eventually, in addition to importing gas from “alternative sources”, Firtash may also take part in the privatization of gas extraction facilities in Ukraine, since he has long shown interest in UkrGasVydobuvannia, a gas extraction company that is currently part of Naftogaz.
In this context, expensive Russian gas plays into the hands of the major groups of influence in the Ukrainian conglomerate in power, while the burden of overpriced gas remains a useful argument in lobbying various privileges for oligarch-controlled companies, overpricing the original cost of their production, and using various tax optimization schemes. Therefore, their real interest is to cut the extra gas imports provided for by the 2009 deals and subsequent addenda thereto, rather than persuade Russia to reduce its gas price, while cheap fuel can only be of interest if it allows them to arrange schemes to resell it for their own benefit.
Under the contract between Shell and Nadra Yuzivska, the two companies are exempted from most taxes and fees applicable in oil and gas extraction. They will only pay income tax, VAT and taxes for subsoil use. Regardless of changes in Ukrainian legislation, the income tax rate for project investors will only be 16% as of 2014. The government could be fined for late VAT reimbursement. Project investors are not subject to any Ukrainian central or local authority laws if they limit the rights of the investors. The Shell and Nadra Yuzivska operation is going to be inspected by only one authority, no more than once every three years, and each inspection should take no more than 10 days.