A More Assertive Ukraine Returns to Russian Natural Gas

9 MINS READFeb 12, 2018 | 13:46 GMT
A worker walks among pipes and valves at the Dashava natural gas facility on September 18, 2014 in Dashava, Ukraine.

A worker walks among pipes and valves at the Dashava natural gas facility on September 18, 2014 in Dashava, Ukraine. Moscow has historically offered -- or withdrawn -- natural gas price discounts based on Ukraine's political decisions.

(SEAN GALLUP/Getty Images)
  • Ukraine will again purchase Russian gas, but Moscow will not be able to use energy supplies as leverage against Kiev to the same degree that it used to.
  • Pipeline politics remain a divisive subject in Europe, and Eastern European countries like Poland will continue to push back against key Gazprom projects on the Continent, including Nord Stream 2.
  • Gazprom's market share in Europe is unlikely to decline, but its ability to carve up the Continent and use energy exports as a political tool will diminish.

For years, Russia has politically manipulated natural gas exports to Ukraine, adopting a carrot-and-stick approach in raising or reducing the price of much-needed energy at will. Ukraine has been spared the need to import natural gas from Russia's Gazprom since November 2015, but the country is once again beating a path to Moscow's door to purchase natural gas. This time, however, the situation has changed: Ukraine is buying Russian natural gas, yet its achievement of strategic objectives in recent years means it is unlikely to ever be as dependent on Moscow's energy resources again — even as the issue of Russia's natural gas exports continues to loom large in European political discussions.

Forecast Update

In our 2018 Annual Forecast, we said Ukraine would spend the year preparing for the 2019 elections, the first since the Euromaidan uprisings in 2014. That unrest was partially triggered by Russia playing politics with natural gas exports to Ukraine, a dispute that ultimately resulted in arbitration between Russian and Ukrainian natural gas companies. Now that the arbitration has ended, Ukraine must restart small-scale imports of Russian natural gas. But with its contract for Russian natural gas supplies ending in 2019, Ukraine will have to think about how energy politics intersect with domestic politics — as it did in 2014.

Naftogaz and Gazprom Butt Heads

On Feb. 7, Ukraine's state-owned natural gas company, Naftogaz, announced that Kiev would renew imports of natural gas from Russia by March thanks to a two-year supply contract with Gazprom. The supply contract is part of a larger settlement between Naftogaz and Gazprom following a long-running arbitration process over a 10-year contract that will conclude at the end of 2019.

The dispute stems from a breakdown in relations between Moscow and Kiev during the Euromaidan protests in 2014. Moscow, via Gazprom, has used natural gas contracts as a means to gain leverage over Kiev in order to shape the latter's actions. And because Ukraine has historically been unable to avail itself of other natural gas resources, Kiev has had few cards to play against Moscow. The structuring of Gazprom's contracts were critical components in ensuring states like Ukraine remained beholden to Moscow: Gazprom officials arranged the long-term contracts to be take-or-pay affairs or structured them to oblige buyers like Naftogaz to purchase a minimum percentage of the natural gas volume specified in the contract — regardless of whether the end users consumed that much product. For example, Gazprom and Naftogaz signed a 10-year contract in 2009 for an overall contract volume of up to 52 billion cubic meters (bcm) per year. The deal stipulated, however, that Naftogaz would pay for 42 bcm annually, even if Ukrainian consumers did not require that much natural gas over a year.

Moscow frequently offered discounts — or withdrew them — based on Ukraine's political decisions, as occurred before and during the Euromaidan protests. In December 2013, then-Ukrainian Prime Minister Viktor Yanukovich secured a 33 percent discount on the price of natural gas from Russia, along with a $15 billion loan in exchange for a pledge not to sign an association agreement with the European Union. The deal was the main trigger for the Euromaidan protesters, many of whom backed the association agreement, and ultimately led to Yanukovich's ouster in February 2014. Following the overthrow, Russia promptly canceled the discount (and others), causing an 80 percent hike in natural gas prices.

Apart from the natural gas response, Russia also retaliated by seizing Crimea and allegedly fueling conflict in eastern Ukraine. Kiev accordingly took measures to increase efficiency and limit the import of natural gas from Russia by falling back on its stocks in storage and approaching Slovakia, Hungary and Poland to construct reverse flow pipelines so that Ukraine could purchase natural gas directly from Europe. While the natural gas was still from Russia, it was energy that Gazprom had sold to European companies — not Naftogaz — as part of a separate contract. European firms duly sold the natural gas, along with a small markup, to Naftogaz.

Russia, however, alleged that Naftogaz still owed it a large sum of money as a result of the take-or-pay clause in the original 10-year contract, ultimately driving the two parties to court. The Arbitration Institute of the Stockholm Chamber of Commerce issued a ruling in December 2017, ordering Naftogaz to pay Gazprom just over $2 billion for the natural gas it received in 2014. The Ukrainian company, however, won a reprieve on the clause requiring it to purchase a minimum of 42 bcm per year — which, at the asking price of $485 per thousand cubic meters, would have amounted to a pricey $20.4 billion per year. Nevertheless, the settlement also requires Ukraine to purchase 5 bcm per year for the final two years of the contract, thereby obliging Ukraine to restart small-scale imports from Russia, even though Gazprom's prices exceed those offered by European intermediaries.

Now that Kiev can simply purchase Gazprom's gas from the company's other customers, Moscow will not be able to play the same pricing game.

Although Ukraine is now returning to the Russian market, the dispute over the gas contract has allowed the country to better integrate itself with the European gas market through reverse flows. As a result, Moscow might struggle to pressure Ukraine via natural gas since Kiev can simply purchase Gazprom's gas from the company's other customers, ensuring that Moscow will not be able to play the same pricing game even if Naftogaz eventually signs another deal with Gazprom. And although Moscow could simply withhold physical supplies, that would inevitably cause problems with subsequent consumers whose natural gas supplies come via Ukraine.

The East's Nord Stream Challenge

An additional bone of contention between Gazprom and Naftogaz centers on the transit of natural gas through Ukraine to other European countries. During the post-Euromaidan tension between the two countries, Kiev attempted to increase the price of delivering Gazprom's natural gas via Ukraine to Europe, resulting in a separate arbitration process that is expected to conclude this month.

At present, it is unclear whether the parties will renew the transit contract, which also concludes at the end of 2019. Gazprom has previously said it will cease using Ukraine as a transit route to Europe after the termination of the contract in favor of the Nord Stream 2 (for Central and Northern Europe) and TurkStream (for Southeastern Europe) pipelines. The former, however, has ignited political battles in Brussels, while the latter is incapable of delivering natural gas to countries like Germany or Austria. Not unreasonably, Gazprom has said it would be cheaper to construct Nord Stream 2, which offers a more direct route between newer fields like Yamal on the Arctic Ocean and Northern Europe, than repair existing, Soviet-era infrastructure in Ukraine.

But the European countries that have experienced the most conflict with Gazprom — Poland, Slovakia, Latvia, Lithuania and Estonia — have all objected to the Nord Stream 2 plans in Brussels. The countries, many of whom are also involved in arbitration disputes with Gazprom, argue that the pipeline could reduce Europe's energy security because it would deepen the Continent's reliance on Russian natural gas. And because of the Nord Stream 2's direct route from Russia to Germany, countries like Ukraine, Poland and others fear they could suffer through some long, cold winters if they upset Moscow, as the Kremlin could cease separate deliveries to those nations while directly maintaining the flow to Germany — to say nothing about those countries' potential loss of lucrative transit contracts.

The European countries that have experienced the most conflict with Gazprom have all objected to the Nord Stream 2 plans in Brussels.

Germany has rejected its eastern neighbors' concerns, arguing that Nord Stream 2 is a purely commercial decision and not a matter for EU regulators. However, the European Commission could issue a new directive by March to extend the bloc's third energy package rules, which stipulate that the same entity cannot own both the pipeline and the natural gas using the infrastructure, to offshore pipelines, thereby imperiling further progress on Nord Stream 2. Ultimately, Brussels and Gazprom could decide to negotiate a special legal regime for Nord Stream 2, but any agreement would likely entail a side agreement to continue significant flows through Ukraine.

Poland Hatches a Plan

Some eastern members of the European Union are pursuing other measures to wean themselves off of Russian natural gas. Lithuania's Klaipeda LNG import terminal began operations in 2014, although a planned LNG project in Estonia has struggled to obtain financing. Poland, once one of Russia's largest customers in the world, also opened its Swinoujscie LNG import terminal in 2015. Due to its small capacity, however, Swinoujscie only accounted for 11 percent of Poland's natural gas consumption last year, in contrast to the 63 percent provided by Russia. Despite the gap, Warsaw hopes to cease imports of Russian gas when its own supply contract ends in 2022 by dusting off plans for the long-dormant Baltic Pipe project. The $2 billion project involves the construction of an offshore pipeline between Poland and Denmark that would tie into Norway's existing pipeline infrastructure in the North Sea. If the project, which would ship 10 bcm of Norwegian natural gas to Poland every year, continues to attract interest, it could serve as an adequate replacement to Russian gas once the Gazprom deal ends in 2022. 

Russia's vast natural gas reserves have long provided a critical energy source for Ukraine and other countries to the west, granting Moscow a tool of leverage that it has frequently wielded against its smaller neighbors, especially Kiev. Today, however, Ukraine has discovered ways of accessing cheaper natural gas thanks to reverse-flow deals with EU members, while countries like Poland have begun pursuing alternative energy sources that could reduce Warsaw's dependence on Russia. With Moscow's customers turning their attention elsewhere, the days when Russia could set the game on natural gas appear to be numbered.

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