A New Gas War in Europe?

BY ANDRIAN PROKIP

The current gas transit contract between the Ukrainian state-controlled Naftogaz and the Russian national gas supplier Gazprom expires on January 1, 2020. The parties are in negotiations but cannot agree on the terms of a new contract; their interests seem too far apart. On November 18 Gazprom made another offer to Naftogaz, but it was deemed as unacceptable as all the previous offers. Russia wants only a short-term contract, as a bridge to when its newest pipelines—which will bypass Ukraine—will be up and running. Ukraine, though not wanting to do business on those terms, cannot afford the near-term economic hit should it deny access to its system. Hence the stalemate.

The history of the Russia-Ukraine gas arrangements sheds some light on the current impasse. In the early to mid-1990s, Russian gas flowed to European states only through Ukraine. The volumes were substantial: in 1990 Ukrainian transit amounted to 114 billion cubic meters (bcm), reaching a record 141 bcm in 1998. In 1997, however, Russia opened talks over the future Nord Stream 1 lines with Finland, then with Germany. After various feasibility studies and the reshuffling of appurtenant companies, an agreement was signed in 2005, and work on a pair of pipelines that would bypass Ukraine’s transit system began late that year. A major impetus for Russia to engage in such a costly infrastructure project was Europe’s growing demand for gas and Russia’s desire for a greater share of the market. A closely connected reason was Russia’s decision to decrease its dependence on Ukraine for transiting gas.

Toward achieving those goals, from the mid-1990s to 2006, Russia had first tried, in various ways, to get control of Ukraine’s gas transmission system, the biggest in Europe. Avenues explored by Russia included renting, buying, or establishing a new joint entity to manage the transit system. But after all these attempts failed, and as the Ukrainian elites became more definitively oriented toward the West in the wake of the 2004 Orange Revolution, Russia finally set out to construct new pipelines that would release it from dependence on Ukraine’s system.

The first big gas dispute between Russia and Ukraine took place in late 2005 to early 2006. Russia claimed Ukraine had been diverting gas intended for Europe for domestic uses, a claim Ukraine first denied, then admitted to. On January 1, 2006, Russia simply cut off its gas supply. A provisional agreement signed a few days later saw gas once again flowing to Europe. The next “gas war,” in early 2009, had financial and technical components but was strongly political. This time Russia cut off gas supplies for thirteen days, ending only when Ukrainian prime minister Yulia Tymoshenko and her counterpart, Russian prime minister Vladimir Putin, signed an agreement. Both Ukraine and Russia were considered by outsiders to have suffered economic and reputational damage as a result of the spat. Meanwhile, Europe was without heating fuel for two weeks.

After the 2009 crisis, Naftogaz signed a ten-year agreement with Gazprom that provided Ukraine and the European nations with gas even during the darkest times of the Donbas war. This deal included a take-or-pay formula for Naftogaz: Ukraine had to buy between 42 and 52 bcm of gas annually without the right to resell it. The contract also stipulated transit-or-pay conditions for Gazprom: Russia had to transit 110 bcm to the West through Ukraine annually. This is the agreement that expires on January 1, 2020. Its terms were asymmetric from the start, and the whole deal was tinged politically.

In the intervening years, the economic situation has changed drastically. Market gas prices have fallen, and Ukraine has had to pay an excessive price to Russia under the existing contract. Also, Ukraine’s gas consumption has dropped considerably. Moreover, when the subsea Nord Stream 1 came on-line in October 2011, Russia began transiting less gas through Ukraine.

In light of the new situation, in 2014 Naftogaz appealed to the Arbitration Institute of the Stockholm Chamber of Commerce (SCC) for a review of the conditions and obligations of the contracts it had signed with Russia. The arbitration court ruled in favor of Ukraine in 2018, requiring Gazprom to pay $2.56 billion to Ukraine.

Gazprom never met its obligation under the ruling. Its debt to Naftogaz became a sticking point in relations between two state-owned companies.

Ukraine has since sought additional financial relief from Gazprom through the courts, lodging charges that Gazprom routinely fights; Gazprom also declines to pay fines when it loses. In early 2016, for example, the Ukrainian Antitrust Committee fined Gazprom for violating antitrust laws in the area of gas transit. Currently the fine and late fees amount to $7 billion.

Even as these matters wound their way through the courts, Russia has been constructing two additional pipelines that will bypass Ukraine, Nord Stream 2 and TurkStream. In approximately two years, Gazprom may have very little need for the Ukrainian gas transit capacity, which will mean staggering losses to Ukraine’s economy. Thus Naftogaz is considering going back to the SCC Arbitration Institute to seek compensation for its losses; the suit seeks $12 billion.

For the next two years, however, Gazprom cannot supply gas to its European clients without transiting at least part of it through Ukraine’s system. This is the reason behind Gazprom’s offer of a one-year contract extension with all penalties waived. To sweeten the deal, Gazprom has suggested a 25 percent discount for direct gas purchases of Russian gas by Ukraine. However, Ukraine has not imported Russian gas directly (it does so through intermediary countries) since November 26, 2015.

Naftogaz has no reason to trust any discount offer from Russia. Earlier discounts, part of the Kharkiv accords—which, among other things, stipulated prolonging the term of Russia’s Black Sea naval fleet in Crimea—were canceled after Russia annexed Crimea.

Thus talks are continuing at a snail’s pace. The European Commission has been mediating negotiations for more than a year, with very little to show for it.

On November 25, Naftogaz refused Gazprom’s offer of a one-year contract extension. It informed the EU and Russia that the company is prepared to continue negotiating a gas transit deal, but under the condition that the deal meet all EU gas regulations. Also, Naftogaz is pursing the $2.56 billion fine (plus late fees) the Stockholm arbitration court assigned Gazprom, $7 billion in antitrust fines, and possibly new monies from ongoing arbitration.

Ukraine’s Naftogaz is interested in a new long-term contract. The European Commission supports Ukraine in this demand. However, Gazprom has demonstrated an unwillingness to compromise and plans to decrease the amount it transits through Ukraine’s system in the very near future.

If there is no new contract between Naftogaz and Gazprom by January 1, winter gas delivery to Europe will be disrupted. European companies are filling their storage facilities to the maximum. Ukraine itself has stored more than 21 bcm of gas, a five-year record, to survive the winter if there is no gas coming from the EU.

There is no win-win solution to the problem. Someone will definitely lose. Ukraine may lose if it signs a short-term deal. Signing a direct agreement under nontransparent conditions, even with a discount, would be expected to complicate Ukraine’s attempts to get Russian troops out of its territories. Russia wants only a short-term deal because it anticipates its new pipelines, bypassing Ukraine, will be ready shortly. The EU will experience a gas shortage if no deal is struck. The winter of 2020 may turn out to be very hot politically.