Ukraine on the Back Foot in New Gas Dispute

Outflanked on two fronts in its gas dispute with Russia, Ukraine is facing another bleak winter. Compared to previous ‘gas wars’, Russia now holds far more cards and looks set to dictate terms.

Almost every new year since 2006, Moscow and Kiev have engaged in down-to-the-wire arguments about the cost and volume of Russian gas exports to Ukraine, as well as the contract terms for Russian gas transiting to Europe.

2009’s gas contract between Vladimir Putin and Ukraine’s then-Prime Minister Yulia Tymoshenko, which was intended to avoid these perennial disputes: it commits Ukraine to paying incrementally more for its gas each year (starting from a low point) over a ten-year period.

With Tymoshenko now languishing in prison on charges of abuse of office whilst brokering that deal, nominally pro-Russian President Viktor Yanukovych is struggling to renegotiate the terms. The price of gas imports is putting a heavy burden on Ukraine's fragile economy: the country is expected to pay $415/tcf for the coming quarter’s gas, and is looking to cut this down to $250/tcf.

Apparently aware that it is losing the battle on price, Kiev is also trying to reduce the amount of gas it buys off Russia. Ukraine insists that it only needs 27bcm this year but the 2009 agreement stipulates that Kiev must buy at least 33.3bcm or face harsh penalties under a strict take-or-pay regime. Ukraine’s Naftogaz insists that it sent letters informing Gazprom about the reduction well in advance; Gazprom responded by saying that “the terms of gas delivery are determined only by contract, and cannot be changed unilaterally by this or that letter”.

Neither side appears willing to budge on the contract. Russia has offered to buy up a major stake in the Ukrainian pipeline network but Kiev has rejected this, viewing it as a violation of sovereignty. More pragmatically, Ukraine is aware that this would remove one of its only points of leverage against Russian gas transiting to Europe. Gazprom recently acquired total control of Belarus’s pipeline network in exchange for reduced prices, cementing its influence over gas supplies to Europe.

Ukraine’s pipeline network is estimated to be worth around $20 billion, and Kiev is seeking a price discount on gas imports worth $9 billion in exchange for a stake in it: Russia would also probably have to foot the bill for modernising the ageing infrastructure.

Kiev is now very much on the back foot. The opening of the Nord Stream pipeline from Russia to Germany under the Baltic Sea in November last year has allowed Moscow to circumvent Ukrainian soil with up to 55bcm of gas. Ukraine still has advantages – its pipeline network has more capacity than Nord Stream and sends gas to central Europe, which Nord Stream does not. But with progress now being made on South Stream, across Turkish waters under the Black Sea, Kiev’s position as a gateway for Russian gas to Europe is being slowly undermined.

This has broader implications. Naftogaz is a millstone around the neck of Ukraine’s economy, with subsidies to the inefficient energy company helping to strangle the state budget. The IMF has insisted upon reforming the country’s sclerotic energy sector as one precondition of a $15 billion loan. A failure to win concessions from Moscow on price or contract volumes would unbalance Naftogaz and the economy even further.

Talks resumed on 15th January and it seems likely that Russia will prevail. The EU, which has a vested interest in maintaining stable energy supplies from Russia via Ukraine, has mostly stood on the sidelines. Energy Commissioner Gunther Oettinger reiterated on 13th January that Brussels was ready to help modernise Ukraine’s gas network and to help mediate transit talks, but its involvement has been minimal. Some analysts suggest that Brussels is less concerned about this year’s stand-off because growing LNG and shale supplies can help to make up the difference in the event of a protracted wrangle between Kiev and Moscow.

However this is of precious little comfort to the Ukrainian government, which is probably going to resign itself to giving up a stake in its pipeline network, and thus its main leverage against Russia. Ukrainian Prime Minister Mykola Azarov has said that there will be no new gas war between the two: but this sounds like an admission of defeat, rather than reassurance.

Alex Jackson is a political risk analyst at Menas Associates in London, focusing on the Caspian region. He also writes independently on politics, security and energy in the wider Caspian region.