assessments

Russia and Ukraine Seek a Contentious New Gas Transit Deal

7 MINS READSep 13, 2019 | 09:00 GMT
This photo shows the pipeline-laying vessel Castoro 10 working on the Nord Stream 2 pipeline project.
(STEFAN SAUER/picture alliance via Getty Images)

The ship Castoro 10 lays part of the Nord Stream 2 pipeline project off the southeast tip of the island of Rugen.

Highlights
  • Russia, Ukraine and the European Union have a shared interest in avoiding economic losses by reaching a new deal on gas transit before the current agreement expires.
  • But significant obstacles — including geopolitical competition and the impact of new energy infrastructure in the region — could lead to a delay or impasse in negotiations.
  • If the parties cannot reach an agreement before the current agreement expires Dec. 31, Russian gas deliveries to Europe via Ukraine could well experience interruptions.

Editor's Note: This assessment is part of a series of analyses supporting Stratfor's upcoming 2019 Fourth-Quarter Forecast. These assessments are designed to provide more context and in-depth analysis on key developments over the next quarter.

Representatives of Ukraine, Russia and the European Union are set to meet Sept. 19 in Brussels to begin negotiations over a new agreement on the transit of Russian gas to Europe through Ukraine. The current agreement, reached in 2009 only after tough negotiations resulting in a temporary cutoff of gas flows to Europe, expires Dec. 31. European and Ukrainian elections delayed the start of the upcoming talks, limiting the amount of time for a new deal to be struck before the old one lapses. Even without the time pressure, these negotiations would have been difficult, meaning talks could hit an impasse, and if they do, natural gas cutoffs could possibly result.

The Big Picture

Despite the Russian-Western geopolitical competition, Russia remains a major energy provider to European markets, in which Ukrainian gas transit infrastructure plays a major role. Though Russia has tried to reduce its reliance on Ukraine as a conduit for natural gas by building pipelines that bypass the latter, Moscow will continue to need access to Ukrainian pipeline infrastructure for some time.

Opportunities and Obstacles

Since all parties want a deal, one might well be reached before Dec. 31. Russia must have a transit agreement to be able to supply European markets with natural gas through Ukraine and would prefer to avoid any interruptions that reduce revenue. Though it no longer imports Russian natural gas directly, Ukraine makes about $3 billion a year on transit fees; interrupting that income would deal a significant economic blow to Kyiv. And the European Union, which will be participating in the negotiations as a mediator, naturally has a major interest in ensuring that a deal gets sealed to avoid the risk of supply disruptions.

Warming Ukrainian and Russian ties after their exchange of high-profile prisoners on Sept. 7 and related plans to resume the Normandy Four talks among Russia, Ukraine, France and Germany to negotiate the broader Ukrainian conflict will facilitate efforts to strike a deal. Russia has already offered Ukraine a one-year extension of the existing transit agreement; Ukraine and Europe have countered by asking for a 10-year extension.

A dispute over outstanding Ukrainian debt to Gazprom significantly hampered the 2009 negotiations for the current deal; similar disputes could do so again this round.

There are significant hurdles to reaching a deal, however. Despite the recent thaw in Ukrainian-Russian relations, continued bad blood related to Russia's 2014 annexation of Crimea and its involvement in the ongoing conflict in eastern Ukraine will serve as an additional complication to negotiations over matters like the term of the contract, minimum transit volumes and pricing.

So will a number of outstanding legal disputes between the countries directly related to gas transit and energy infrastructure — litigation that both will try to resolve in their favor via the current negotiations. Russia has already said that a transit deal is only possible in the absence of legal actions such as efforts by Ukrainian energy companies to obtain about $6 billion in compensation through international arbitration for the Russian seizure of their assets in Crimea. (Moscow has also refused to recognize the jurisdiction of international courts in the matter.) Separately, Naftogaz — which manages Ukraine's gas infrastructure — says Russian natural gas giant Gazprom owes it $2.56 billion in damages related to gas transit fees. A dispute over outstanding Ukrainian debt to Gazprom significantly hampered the 2009 negotiations for the current deal; similar disputes could do so again this round.

New Routes for Russian Natural Gas

New natural gas transport infrastructure also has Ukraine worried. Russia has sought to reduce its reliance on Ukraine as a transit route simply by building pipelines that bypass it. Through the development of the Nord Stream 2 pipeline in the Baltic Sea and the TurkStream pipeline in the Black Sea — both expected to come online within two years — Russia has created alternative capacity for less than the cost of rehabilitating existing Russian infrastructure leading to Ukraine.

Russia's infrastructure strategy will shape the current transit negotiations, though the new infrastructure will not allow Russia to completely bypass Ukraine. For instance, the European Court of Justice has upheld limitations on Gazprom's ability to use the OPAL pipeline, which will connect to Nord Stream 2 and allow Russia to distribute its gas in Europe. Even though the European Commission had granted Gazprom access to 90 percent of OPAL's capacity, the court has cut this to 50 percent. A significant reduction in the 85 billion cubic meters (bcm) currently transiting Ukraine annually would threaten financial returns on Ukraine's infrastructure. A certain amount of gas transit is needed to service and finance the pipeline network, which is already operating well below its maximum capacity of 140 bcm. 

And Ukraine is not alone in fretting over the construction of the new pipeline infrastructure. Nord Stream 2, in particular, has upset the United States as well as Eastern European EU members interested in reducing Russian influence over Europe through natural gas exports. These concerns, plus possible delays in the construction of the pipeline as a result of EU regulatory hangups or U.S. sanctions now under consideration, could force Russia to adopt a more conciliatory approach in transit talks.

The Dangers of a New Natural Gas Cutoff

If negotiations hit an impasse or continue beyond Dec. 31, natural gas flows through Ukraine to Europe could be interrupted. They have each prepared for this possibility over the past year: Gas reserves in the European Union have reached a record high as Europe seeks to build a buffer against short-term interruptions during winter, when consumption peaks.

Ukrainian gas storage is also at a higher level than it has been in recent years, and infrastructure adjustments are being completed to ease the delivery of natural gas nationwide in case of a Russian cutoff. Ukraine no longer buys gas directly from Russia but instead buys from Europe, which transits the gas to Ukraine in reverse. But until now, the configuration of Ukraine's infrastructure meant that the eastern and southern areas of of the country have to get their natural gas supply by siphoning off Russian natural gas headed for Europe, which Ukraine, in turn, replaces with domestically produced or stored gas in the west of the country. In this case, a cutoff would leave nothing for the eastern and southern regions to siphon off. For this reason, Kyiv began upgrading its infrastructure to allow direct delivery of gas from western Ukraine to its eastern and southern regions.

The stockpiling and the infrastructure changes could reduce the effects of any short-term disruption to gas flows through Ukraine along the lines of the two-week disruption to supplies in 2009. But if a cutoff stretched several weeks or longer, price hikes and shortages could affect significant portions of Central and Southern Europe reliant on Ukrainian transit, including Germany and Italy. The potential disruptions from a supply cutoff, which could cause shortages for domestic and industrial users during peak winter consumption, provide a significant incentive for the European Union to facilitate the current transit negotiations.

By the same token, of course, supply disruptions would cause Gazprom significant losses in revenue, and Ukraine would take a major hit from missed transit fees. But despite the common interest in avoiding a breakdown in negotiations, Russia's poor relations with Ukraine and the West and the effects of upcoming changes in energy supply infrastructure will still make talks difficult.

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