As much as Ukraine claims that it is completely independent from Russian gas, Kiev continues to keep the door open to cooperation with Moscow.

Pictured: A worker opening a gas pipeline in Russia. Photo: RIA Novosti

Gas-related controversies and quarrels between Ukraine and Russia are on the verge of becoming a traditional feature of the winter holiday season. This year is no exception as Kiev faces the prospect of enduring this year’s winter with record-low volumes of gas in its storage system.

Although in mid-October the Ukrainian gas transportation company UkrTransGaz, a subsidiary of Naftogaz, stated that it had finished replenishing its underground gas storage tanks and was ready for the 2016-2017 season, Ukrainian and Russian energy specialists are back at the negotiating table to discuss the possibility of Gazprom supplying additional gas to Ukraine.

Ukraine attempts to wean itself off Russian gas

The last few winters were fraught with dramatic negotiations over Ukraine’s gas supplies, yet they always ended in some sort of arrangement. In 2014, Gazprom and Naftogaz reached a European Commission-brokered deal on the supply of gas, with a price slightly lower than “reverse gas supplies.” [For Ukraine, “reverse flow” means gas supplies come from Central Europe to Ukraine, not from Ukraine to Central Europe – Editor’s note].

In 2015, another EU-facilitated accord provided Ukraine with the opportunity to fill up its gas reservoirs by means of Gazprom-supplied gas ahead of the winter heating season, once again at pricing levels comparable to those in Europe. Since November 2015, Ukraine has not been buying any gas from Russia. The Ukrainian political elite deems it no small feat to accomplish this, as it even had a special website counting down the days since Ukraine has not received any gas from Gazprom.

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Ukraine’s government, still struggling to get the country back to economic growth, has become more desperate in its efforts to position itself as being the leading force behind a European effort to wean itself off Russian dependence. Its leaders oftentimes succumb to the temptation of pointless provocation to showcase their independence.

One example of this is UkrTransGaz’s solemn vow to auction the last 0.5 cubic meters of Russian gas, stating that the proceeds would go to an orphanage in Severodonetsk, a city in the Luhansk Region under the central government’s control.

The fallacy of this seemingly radical stand is that the “reverse gas” supplied to Ukraine via Central European states’ pipeline systems, is also of Russian origin. The only difference between the two is that Ukraine buys “reverse gas” from European gas companies (i.e. via an intermediary), not from Gazprom.

Reality distortion has become a new normal, all the more so as Ukraine is no longer the country it was in even late 2015. Its gas consumption continues the freefall of the last five years (in sum it has fallen by almost 50 percent) and, if data for January-September 2016 are anything to go by, will tumble to 30 billion cubic metres (bcm). As part of Kiev’s striving to comply with the requirements of the International Monetary Fund (IMF), thus to receive the much sought-after financial aid packages, retail gas prices in Ukraine rose by more than 210 percent in the last three years, from $85 per 1000 cubic meters in 2014 to $261 per 1000 cubic meters in 2016.

Commercial-based gas pricing will help Ukraine transform its economy into a market-based with no energy subsidies, which previously ate up 6-7 percent of its annual GDP. Yet, given the radical nature of the price hikes, they also hindered economic development as industrial customers find it increasingly hard to make both ends meet.

Negotiations

It is against this background that the Ukrainian Naftogaz has signaled its readiness to take in an additional volume of 1.5-4 billion cubic meters of gas from Gazprom. This runs completely counter to the year-round Ukrainian claim that it would cease the imports of Russian gas. Oddly enough – it’s highly unlikely one will see many other cases in which the buyer dictates its terms to the seller – Kiev also demands that the take-or-pay peg to the Russo-Ukrainian gas supply contract be eliminated.

Russia refuses to modify an existing contract, claiming that there already exists a functional mechanism of supplying gas under the current contract, so Kiev should stick to it. Interestingly, the price for Gazprom-supplied gas is lower than current spot prices in Europe, as the 2009 contract stipulates a price formula that is 100 percent oil price-linked and as a result comes with a several months’ time lag.

Changing the existing 10-year gas supply contract, signed by then Ukrainian Prime Minister Yulia Tymoshenko and her Russian counterpart Vladimir Putin in 2009, is in fact impossible, as it remains to be the subject of an ongoing legal lawsuit.

The Stockholm arbitration is due to present its findings in the second quarter of 2017. It will deliver a verdict whether Naftogaz is authorized to demand that the prices of Russian gas supplies since 2010 be retrospectively modified to meet the requirements of the EU’s Third Energy Package and compensate for the alleged losses ($14 billion), which the Ukrainian side has borne due to prices that were higher than the European spot levels.

Naftogaz filed another suit – it claims it has lost $8.2 billion in gas transit expenses due to the underutilization of transport infrastructure. Both lawsuits are very unlikely to succeed, as it is impossible to recreate a valid contract at one’s wish without the other party’s consent and most likely were just an attempt to stave off the resolution of Naftogaz’s debt vis-à-vis Gazprom.

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Notwithstanding the arbitration ruling, Naftogaz has a plethora of immediate concerns as before the onset of winter, the company disposed of a record low of 14.5 billion cubic meters of gas in its underground gas storages. This is substantially less than the 16.5-17 billion cubic meters Ukraine garnered in the past years and what is more, it contradicts the government decree, which stipulates that Ukraine ought to have 17 billion cubic metres of gas in its storage tanks.

Andrei Kobolev, Naftogaz’s CEO, stated that due to lower aggregate national consumption and Kiev’s capacity to boost imports from Europe, it might be more than enough. Yet, such a calculation is at least partially wrong, as winter is the worst period to rely on “reverse supplies” as European suppliers are left with minimum spare capacity to export – they have their domestic markets to satisfy.

The art of cozying up

No one really knows whether the volumes Ukraine currently possesses will be enough to overcome the winter heating period, as it depends entirely on weather conditions in January-February, statistically the coldest months of the year in Ukraine.

If December is anything to go by – the lowest the thermometers of Kievan inhabitants got was -11°C (on one occasion only, during the night) – and during the last decade, the temperature was predominantly above 0°C, Naftogaz’s gamble might be playing off. Yet even if the 14.5 billion cubic meters were enough to cover Ukraine’s domestic needs, Naftogaz might be tempted to import several billion cubic meters of Russian gas solely because of its price.

In January-November 2016, Kiev imported 9.42 billion cubic meters of gas, mostly via Slovakia, Hungary and Poland (in that order). Kiev’s main suppliers were Eni, Engie and Axpo Trading, Western companies that seized the opportunity to offload excess Russian gas in times of seasonal oversupply. The pricing of the gas supplied differs from that under the 10-year gas contract with Gazprom as it is based on spot quotations rather than an oil-linked formula.

Thus, apart from the $7-8 premium that Ukraine traditionally pays compared to the average European hub price, Kiev has found itself in a position when Gazprom-supplied gas is cheaper than “reverse supplies” from its European partners. Russian Energy Minister Alexander Novak claimed that in December the price difference amount to $30 per 1000 cubic meters, which has resulted in Naftogaz overpaying around $70 million during the second half of 2016.

Therefore, completely severing its relations with Gazprom is not in the interest of Naftogaz and the usual “breaking free of Russian dependence” rhetoric has been diluted with occasional convergence initiatives. That Kiev and Moscow retain a certain level of cooperation possibilities is in the best interests of those nations that still depend on the Ukrainian gas transit route – Moldova, Bulgaria and to a lesser extent Slovakia, Hungary and the Czech Republic.

In any case, it is improbable that the January crisis of 2009 would ever be repeated – due to the commissioning of Nord Stream-1, Gazprom has managed to lower its Ukrainian gas transit to 39 percent of the total volumes exported. Moreover, since then, it has built up a considerable system of storage facilities in Western and Central Europe whose reserves might be utilized to alleviate any external shock.

However, having hedged most of its supplies to European partners, Kiev is still no closer to find a mutually beneficial mechanism of cooperation with Moscow.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.