Ukraine and Russia: Another Gas War?

Relations between the Kremlin and Kyiv are at a new low after serious gas shortages in Europe this winter. In a Q&A, Olga Shumylo-Tapiola examines energy relations between Russia and Ukraine, the potential for this latest conflict to escalate, and the implications for EU-Ukraine relations. Shumylo-Tapiola says amendments to the bilateral gas deal are unlikely before Russia’s presidential elections and that Ukraine needs to be doing more to reduce its dependence on Russian natural gas. 

• What is the current state of energy relations between Russia and Ukraine?
 
• Will Russia and Ukraine be able to reach an agreement on a revised gas deal?
 
• Is another “gas war” between Russia and Ukraine likely to break out?
 
• How important is Ukraine’s gas transit system to Russia?
 
• What is Ukraine doing to decrease its dependence on Russian gas?

What is the current state of energy relations between Russia and Ukraine?

Russia and Ukraine are engaged in protracted negotiations over a gas deal originally concluded in 2009 by Russian Prime Minister Vladimir Putin and then Ukrainian prime minister Yulia Tymoshenko. Current Ukrainian authorities consider this deal unsustainable for their country and, with the Kremlin seemingly unprepared to make significant revisions, there seems to be no easy solution to the problem.

After taking office in spring 2010, Victor Yanukovych promised to improve Ukraine’s relations with Russia, especially in the energy sector. Two years on however, relations are worse than ever. Moscow is frustrated with Yanukovych’s pursuit of his own personal and corporate interests. Yanukovych, in turn, is frustrated with Russia’s unwillingness to make concessions to him in the name of Slavonic brotherhood.

From his first day in office, Yanukovych wanted to re-negotiate the 2009 gas deal. Three elements of the agreement are problematic for him and his fellow oligarchs: the price Ukraine pays for gas, the volume of Russian gas that Ukraine is obliged to buy on an annual basis, and the fee that Russia pays to use Ukraine’s gas transit system (GTS).

Kyiv feels that the first two figures should decrease dramatically, while the third should go up. At almost USD $400 per thousand cubic meters, Ukraine pays one of the highest prices for Russian gas in Europe—especially given its proximity to Russia. In addition, despite being the least efficient energy consumer in Europe, it is unlikely that Kyiv will need the 52 billion cubic meters of gas the agreement with Moscow stipulates in 2012. Moreover, European and Ukrainian experts agree that the transit fees Russia pays to Ukraine are low in comparison to those paid to other transit countries.
 

Will Russia and Ukraine be able to reach an agreement on a revised gas deal?

Some in Moscow say that an agreement addressing Ukraine’s concerns could well be reached. However, it would come at a high price.

By granting Russia a twenty-five year lease extension on its Black Sea Fleet base in Crimea, Yanukovych attempted to use the carrot in his negotiations with the Kremlin. Moscow responded with a small discount, knocking $100 off the price per thousand cubic meters of gas. But this was not enough for Ukraine. Ultimately, Russia will need a far larger carrot—control over Ukraine’s GTS or Kyiv’s membership in the Customs Union or potentially even the Eurasian Union—to make any meaningful concessions.

When “the carrot” failed, Yanukovych resorted to “the stick.” His government publicly blackmailed Moscow by claiming the 2009 gas agreement was illegal, arresting Tymoshenko, and threatening to take Gazprom to the Arbitration Institute of the Stockholm Chamber of Commerce (SCC).

When Moscow still refused to revise the contract, Ukraine opted to unilaterally reduce the contracted volume of gas it would purchase from Russia by nearly 50 percent. Russia now has three options. The Kremlin could accept Ukraine’s demand to import less gas, it could demand that Ukraine pay the penalties the 2009 contract stipulates, or, as a last resort, could take Ukraine to the SCC.

At present Russia is warning Ukraine that it may take legal action, but has not acted so far. In fact, Moscow is continuing to loan money to Ukraine to pay its bills with Gazprom—Ukraine paid its gas bill in October 2011 with money borrowed from Russia’s Gazprombank.
 

Is another “gas war” between Russia and Ukraine likely to break out?

The two partners are in a protracted process of negotiations as opposed to a full-blown conflict, which neither side can afford at the moment.

Any amendments to the existing gas deal are unlikely to be finalized before the Russian presidential elections on March 4 or a few weeks after. As it stands, however, Russia simply has no reason to make any concessions to Ukraine.

It is no secret that Moscow uses the price of gas as a political tool in its immediate neighborhood. With the leadership of neighboring countries reluctant to end their addiction to cheap gas, Russia has no reason to stop this practice. Energy relations between Russia and its neighbors will only become more equitable once neighboring elites instill some transparency in their own energy sectors and stop treating them as their personal fiefdoms.

Moscow, however, needs European support for alternative transit routes, such as South Stream, a pipeline connecting Russia and Bulgaria. Moreover, it would like to take control of Ukraine’s GTS without facing accusations of bullying. The Kremlin can therefore ill-afford the bad publicity.

But Moscow may still intensify the trade war with Kyiv. Exports of Ukrainian cheese to Russia have already been banned. Other exports, such as confectionary, dairy products, and meats may also be targeted. And, although it is unlikely that Russia will cut gas to Ukraine now, this generosity may not persist after the presidential elections.

The situation in Ukraine is slightly more complicated. The country’s leadership desperately needs cheaper gas to satisfy the needs of the oligarchs who support it. With parliamentary elections rapidly approaching, reelection campaigns will rely on the financial support of these businessmen.

Ukraine could take Gazprom to the SCC and perhaps even win. French, Polish, and German companies have already created the precedent for amending Russian gas deals in this court. However, Ukraine’s case is also political and may not be treated like other commercial disputes.

The Russia-Ukraine gas deal was negotiated by then prime minister Yulia Tymoshenko, who is currently the leader of Ukraine’s opposition. In October of last year, Tymoshenko was sentenced to seven years in prison following what the majority of European politicians and observers deemed a selective, politically motivated prosecution. Against this background, it is highly unlikely that Ukraine’s case against Russia will be treated as purely commercial.

Ukraine may also be forced to default on its financial obligations to Gazprom. The country’s coffers are virtually empty. The International Monetary Fund is unlikely to offer any assistance before the government raises domestic gas prices, which is unlikely to happen before the October parliamentary elections. Kyiv could continue borrowing from Gazprombank to cover its bills with Gazprom.

The experience of neighboring Belarus provides a cautionary tale. President Lukashenka was heavily subsidized by Moscow and even succeeded in ensuring the cheapest gas supply in Europe—$164 per 1000 cubic meters in 2012. But he had to give up full control of the country’s pipeline to Russia.

Protracted negotiations between Kyiv and Moscow are therefore likely to continue. Ukraine’s leadership is unwilling to make concessions on larger issues such as the GTS or membership in the Customs Union. The country’s leadership and fellow oligarchs benefit the most from Ukraine’s transit system, with its underground storage facilities and access it provides to Ukraine’s domestic market. Membership in the Customs Union would effectively lead the president to lose political control over the country as greater control over the country’s trade and economic policy are ceded to Moscow. Yanukovych will therefore continue his balancing act, insisting for revisions to the 2009 gas deal, while avoiding moves that might push Russia to escalate.
 

How important is Ukraine’s gas transit system to Russia?

Russia is heavily reliant on the GTS—roughly 80 percent of Russian gas exports to the EU transit through Ukraine. Having a controlling stake in the GTS would bring more stability for Russia in the short term. It would not, however, address the more systemic issue of Russia’s dwindling reserves in the gas fields in Siberia.

Although Russia has not given up gaining control of the GTS, it is building new pipelines to bypass its neighbor. The Nord Stream pipeline, started in November 2011, takes Russian gas to northern Germany through the Baltic Sea. By the end of 2011, Russia had also succeeded in securing support to the South Stream project by signing a deal with Turkey to build part of the new pipeline in Turkish waters in the Black Sea.

While Russia has been securing its transit routes to the EU, however, it is starting to experience supply shortages. Until 2008, Gazprom was extracting up to 550 billion cubic meters of gas per year. However, thanks to dwindling reserves in gas fields in western Siberia, extraction dropped by 15 percent in 2009. This forced Russia to seek alternative gas suppliers in Central Asia, such as Azerbaijan and Turkmenistan, to cover its commitments domestically and to Europe.

During periods of adverse weather that increase consumption, Russia cannot fully meet EU demand. Recent shortfalls in supply to the EU were a direct result of this problem. Having initially accused Ukraine of foul play, Gazprom eventually acknowledged the shortages. The problem is likely to return next year.

Ultimately, the situation can only be addressed in a sustainable manner if Gazprom launches new fields on the Yamal Peninsula in the northwest of Siberia. But even optimistic assessments say this will not happen until 2016-2017, with some experts saying it may not happen until 2030.
 

What is Ukraine doing to decrease its dependence on Russian gas?

In two words: not enough.

Having concluded the gas deal with Russia in 2009, Kyiv had an opportunity to overhaul its energy sector. It could have started by improving energy efficiency, which remains the worst in Europe, by developing its domestic gas fields or by bringing transparency to its energy sector. Moreover, Kyiv could have protected the country’s image as a credible partner and reliable gas transit route by insisting meters be installed on the EU-Ukraine and Russia-Ukraine borders.

If implemented, these solutions would not only make Ukraine less dependent on Russia but also, by freeing up resources that could be reinvested domestically, significantly contribute to the country’s development. The Ukrainian authorities, however, have thus far focused on short-term solutions, such as the unsuccessful attempts to revise the gas contract with Russia.

One of the clearest examples of Ukraine’s underwhelming performance in this area is its membership in the Energy Community, which it joined a year ago. The mission of this organization is to extend the EU’s internal energy market to southeast Europe and ultimately to ensure the security of the supply in wider Europe. According to the Accession Protocol it signed, Ukraine committed to implementing the relevant EU directives and regulations in the sphere of gas, electricity, and renewable energy resources.

According to a group of independent Ukrainian energy analysts, however, the country has not fully implemented a single obligation. Experts suggest that the Ukrainian authorities saw membership in the Energy Community as a safeguard against the South Stream project and a source of additional financial support from the EU. For its part, the EU hoped that Ukraine’s commitment and extra funding would finally push Ukraine to reform its energy sector. Mutual disappointment is growing.

Ukraine feels that the EU is not being supportive in the country’s talks with Russia. Many in Kyiv like to believe that the EU’s lack of engagement in the bilateral dispute can be attributed to Moscow’s warm relations with some EU member states. However, the EU is simply reluctant to become embroiled in escalating tensions between Kyiv and Moscow.

The EU, in turn, feels frustrated by the lack of reform in Kyiv. The Union now has little reason to support Ukraine in this battle. Failure to implement the Energy Community Treaty obligations was merely one incident in a negative trend in Ukraine that is sending a clear signal to the EU: the country’s leadership is not interested in further integration with the Union.

Reprinted by permission of the publisher from “Ukraine and Russia: Another Gas War” by Olga Shumlyo-Tapiola (Washington, DC; Carnegie Endowment for International Peace, 2012)  http://carnegieeurope.eu/publications/?fa=47240&lang=en.