By Bogdan Polishchuk

In many ways, the Ukrainian crisis is a fascinating case study in energy politics. Constant negotiating spats between itself and its primary supplier of energy, Russia, have racked the country. The disagreements are both political and economic, and go back long before the annexation of Crimea and the civil war in the Donbass. Previous governments in Kiev have had trouble keeping contracts with Russia’s Gazprom over the years, and this has often led to tension between them and Russia. Both sides have shown a willingness to leverage their advantages in an almost zero sum game to one-up the other. Gazprom threatened to use its monopoly supplier status to turn off the tap and Ukraine threatened to use its transit country status to cause Gazprom problems as well. This is just one example.

The nature of the relationship between Kiev and Gazprom has been rocky at best, and the political crisis that resulted at the end of the EuroMaidan only worsened matters for Ukraine. Put simply, the situation as it stands now does not look good for Ukraine. Unable to secure any other reliable supplies, Ukraine has started to repurchase Gazprom gas from neighboring countries further downstream. Ukraine has managed to stay afloat for now, but it is hard to predict how long it can continue to do so.

Ukraine’s Diversification Dilemma

As a result of the Crimean Annexation and the civil war in the Donbass, Ukraine lost access to gas reserves off the Crimean peninsula that could have been exploited in the near future, as well as the coal mines in the East. This leaves Ukraine in a difficult situation where they have lost two possible sources of energy supply within a short period of time. If Ukraine refuses to buy cheap Russian gas, then the race is on to diversify and find alternative sources. Despite the Donbass, and Ukraine losing some prospective offshore oil and gas territory in the Black Sea, Ukraine hasn’t lost all of its shale. In both the Carpathian Mountains and the areas East of Kiev, there are deposits that are cheap and easily extractable.

However, shale development in Ukraine can only be done by major “fracking” companies. Ukraine would need to give concessions to major shale companies to begin extraction. This process is already in the works, but there have been constant setbacks. The risky investment environment has led to companies like Chevron and Shell pulling out, citing unstable and insecure environment as the major reason for their inability to fully commit to the extraction projects. Without significant investment from abroad, there will be little progress on that front.

Ukraine still has the option of importing energy from abroad. OilPrice.com highlights the possibility of supplying LNG to Ukraine. The article concludes that such a plan is feasible even if still a distant possibility and states, “If you can get it through the Turkish-controlled Bosphorus Strait, you would have an endless supply of LNG going to Ukraine. The US now is pushing very hard to open up new LNG facilities in the US to get US shale gas/LNG shipped to Ukraine–but that won’t happen for five years, if it happens at all. Ukraine can’t wait for that.”

Ukraine also has the possibility of importing Turkish or North African gas. Ukraine can get a re-gasification terminal up and running relatively quickly, and the possibility of supply from the near abroad exists, the only major obstacle that stands in the way of this diversification plan is the shipping route that the LNG would have to take.

Turkey may be an obstacle, and the complicated relationship that Turkey has with Russia may ultimately factor into any Turkish decision. Turkey may or may not allow LNG shipments through the Bosphorus, and the decision is up in the air. In the past, Turkey and Russia have had periods of warming and cooling in their relations. Where the two countries stand now is anyone’s guess after the downing of a Russian bomber by the Turkish army, and the subsequent failed “coup” attempt by supposed pro-American factions in Turkey led to President Erdogan’s apology to Russia and re-pivot. Could Russia pressure Turkey to keep the straights shut, or would other players like the EU, the United States, and even perhaps Ukraine itself prevail? It is difficult to say, as the situation seems to change on the ground every couple of months or so.

All in all, Ukraine’s diversification options are constrained by a myriad of problems and both external and internal factors are not wholly in Ukraine’s control.

Ukraine’s Reverse Energy Supply Strategy

Ukraine’s irregular gas payments have been a topic of contention between Russia and Ukraine. Even before the Crimean crisis, Ukraine managed to run up a significant debt with Gazprom, and bickering over gas discounts, long-standing debt and accusations of illegal siphoning of gas in transit to other countries have been long-standing problems. Still, Ukraine used to receive regular gas shipments from Russia, and could rely on this mainstay for its energy needs, but recently Ukraine has stopped purchasing Gazprom gas, with Gazprom in turn claiming that it had simply cut Ukraine off for failure to pay.

To make up for energy shortfalls, Ukraine has started purchasing “reverse supplies”, namely surplus gas from Slovakia. Now, the gas is Russian, but Ukraine is not buying it from Russia, and that makes it a curious situation. The Ukrainian strategy was made possible because of fortuitous conditions. As Bloomberg states, “The winter of 2014 was warm in Europe, and there was a surfeit of gas. In Slovakia, the gas was Russian, delivered by the state-owned monopoly Gazprom through the Ukrainian pipeline system.” This move by Ukraine certainly raised questions about the legality and long-term viability of the strategy.

In regards to the legal status of these supplies, unsurprisingly, Gazprom challenged Ukraine’s decision to repurchase Russian gas already sold under contract to Slovakia: “Gazprom had tried to ban resale, but those conditions were in violation of European rules. In April 2015, the European Commission cited such stipulations as an example of Gazprom’s abuse of its dominance in eastern and central European gas markets. Gazprom, which is trying to avoid steep fines and arrive at a settlement with the commission, could do nothing to prevent its customers from supplying Ukraine.”

In a show of solidarity with Ukraine, the European Commission decided in favor of Ukraine. This gave Ukraine a political lifeline – even if it did little to smooth over strained relations between the EU and Russia.

From the press release of the European Commission concerning the ruling we can see the legal rationale that was used to allow for reversed gas supply purchase by Kiev. “On the basis of its investigation, the Commission’s preliminary view is that Gazprom is breaking EU antitrust rules by pursuing an overall strategy to partition Central and Eastern European gas markets, for example by reducing its customers’ ability to resell the gas cross-border. This may have enabled Gazprom to charge unfair prices in certain Member States. Gazprom may also have abused its dominant market position by making the supply of gas dependent on obtaining unrelated commitments from wholesalers concerning gas transport infrastructure.”

Gazprom may dispute this ruling in the future, but the decision stands for now, and while surplus gas supplies exist in Slovakia, Ukraine will be able to continue re-purchasing Russian gas.

Political Reality Trumps Economic Expediency

Political realities often get in the way of rational decision-making. Naturally, this creates problems in any rational long-term gas strategy plan drawn up by governments. In the case of Ukraine, the re-purchase of the same gas, only from another country at marked up prices raises questions about market irrationality. How can an economist square away such obvious market inefficiency? One has to take into account the tension between Ukraine and Russia to make any sense out of this irrational action by Ukraine’s government.

The “reverse supply” of gas certainly raises many questions going forward. Mild weather years can allow for surplus gas to accumulate because of existing long-term contracts in neighboring countries, but is this a reliable strategy going forward? We now know that existing pipeline infrastructure can be used to pump gas back further up the supply chain, but what are the political ramifications of this new policy?

Russia may find itself in a convoluted position, as it tries to adjust to the new scenario. So far, Gazprom tried cutting gas supplies to Europe to fight excess reserves of gas that could be resold to Ukraine, but in March of 2015, resumed regular supplies. Overall it is tempting to view Ukraine’s reverse gas purchases from Slovakia as emblematic of a European-wide trend to shift away from Russian gas because of security concerns. However, this may be a far-reaching conclusion to make. Ukraine did not plan for this, rather the government in Kiev reacted as best they could to an energy supply crisis.

Diversification is a Cost that Many Countries are Willing to Bear

In some sense, what Ukraine has done is not that different from what Lithuania did when it opened an LNG terminal in Klaipeda. Buying more expensive gas to achieve greater energy security is a political decision that trumps economic rationale. In Ukraine, we have a similar situation. Ukraine is trying to diversify its energy sources, despite many obstacles. Diversification as a policy seems to justify the increased costs associated with it, and examples abound of countries not behaving as rational cost/benefit analyzers. Russian gas is cheaper, more abundant, and the infrastructure for its distribution within Ukraine already exists. And yet, without a political solution, the rational economic choice of cheap Russian gas as a fuel mainstay seems impossible to realize. While a political solution might be possible for Ukraine in the long term, in the short term it seems that Ukraine is committed to avoiding buying Russian gas and diversifying its supplies.

The LNG revolution that Russia has largely missed may play large part in this diversification scheme. As gas from other sources becomes more abundant in Europe, it becomes easier to receive gas supplies from the West and South and not necessarily the East for Ukraine. Whether there is any real will for diversification or if this fits more in the realm of political wrangling, is still a question that remains to be answered. Ukraine has a history of spats with its gas supplier, and while this one seems far more serious, it may not lead to any real long-term strategies for diversification.

All we can say with certainty for now is that Ukraine continues to buy more expensive gas – all while it remains in a dire economic situation. The “reverse supplies” that Kiev has received represents a step, but not yet a wholesale effort to diversify Ukraine’s energy supplies from the leadership in Kiev.

Going forward, a compromise solution would be ideal – with Ukraine and Russia reconciling enough to conclude a new gas deal. But realistically speaking, Ukraine’s existing gas bill will be a sore point of contention between Gazprom and Kiev, and any real economic deal will be subject to the results of a successful political compromise over Crimea and the breakaway regions in the Donbass. What does the future hold? It seems unlikely that compromise and the resumption of a normal gas regime in Ukraine is anywhere in the near future.

 

Szilvia Batkov. Russia’s Silent Shale Gas Victory in Ukraine. EurActiv.com. September 2, 2015. https://www.euractiv.com/section/europe-s-east/opinion/russia-s-silent-shale-gas-victory-in-ukraine/

James Stafford. What the Loss of Crimea Means for Ukrainian Energy: Interview with Robert Bensh. OilPrice.com. March 19, 2014. http://oilprice.com/Interviews/What-the-Loss-of-Crimea-Means-for-Ukrainian-Energy-Interview-with-Robert-Bensh.html

Turkey’s President Erdogan in Moscow to ‘reset’ Russia. BBC. August 9, 2016. http://www.bbc.com/news/world-europe-37018562

Ukraine Stops Buying Russian Gas, but Gazprom Says It Cut off Service. CBC News. November 25, 2015. http://www.cbc.ca/news/business/ukraine-russia-gas-1.3336586

Leonid Bershidsky. How Ukraine Weaned Itself Off Russian Gas. Bloomberg.com. Bloomberg, January 12, 2016. https://www.bloomberg.com/view/articles/2016-01-12/how-ukraine-weaned-itself-off-russian-gas

European Commission. Antitrust: Commission sends Statement of Objections to Gazprom for alleged abuse of dominance on Central and Eastern European gas supply markets. April 22, 20165. http://europa.eu/rapid/press-release_IP-15-4828_en.htm

Ukraine Will Not Buy Russian Gas, Coal – PM. Novinite. April 21, 2016. http://www.novinite.com/articles/174141/Ukraine+Will+Not+Buy+Russian+Gas,+Coal++-+PM