Introducing a Gas Prepayment System with Ukraine Is the Right Move

The key to resolving Russia-Ukraine gas disputes is to ensure the solvency of Naftogaz and Ukrainian consumers, but this is an unlikely scenario for the next two to three years.

Gas supplies have traditionally been a cornerstone issue in the economic relations between Russia and Ukraine. The change of power in Ukraine, as well as the deterioration of the economic situation there, have led to yet another gas conflict.

Beginning in mid-February 2014, the Ukrainian side stopped paying for Russian gas, and has accumulated a debt of almost $5 billion since then. This led Gazprom to revise its gas prices (termination of the December 2013 agreements whereby the gas price was fixed at $268 per 1,000 cubic meters). In addition, the denunciation of the Kharkov agreements led to an increase in gas prices by another $100 per 1,000 cubic meters. As a result, the price for gas for the National Joint Stock Company Naftogaz of Ukraine amounted to $485 for 1,000 cubic meters in the second quarter of 2014. This is an all-time high for Ukraine, but Naftogaz was not discouraged by that, and began taking as much gas as it could, while simply refusing to pay for it. After a series of talks between Russia and Ukraine, including with the participation of European partners, failed to bring success, Gazprom announced a transition to advance gas payments.

Ukrainian Minister of the Energy and Coal Industry Yury Prodan confirmed that Ukraine considers $268.5 per 1,000 cubic meters to be a fair market price, and proposed establishing a compromise of $326 per 1,000 cubic meters for the next 18 months, during the time it will take the Stockholm Arbitration Court to consider the case. In turn, Gazprom has asked Ukraine to cover the November-December 2013 debt ($1.45 billion) and confirm its readiness to pay for current supplies in the amount of $500 million (without fixing the supply price). However, a substantial agreement could not be reached.

Amid reduced summer demand, Ukraine is managing to meet internal demand through domestic production (19-20 bcm annually). Therefore, the coming months may bring a certain lull. However, if no agreements are reached before the heating season, the conflict will flare up again.

Even though gas relations between Russia and Ukraine have always contained an important political component, the problem cannot be resolved without addressing several key economic issues for the Ukrainian gas market. Without them, no agreement between Russia and Ukraine will have a chance of success.

First, Ukrainian consumers pay too little for Naftogaz to be able to cover the expenses involved in importing Russian gas. On May 1, the average gas price for households grew by 56 percent and for the industry by 50 percent. However, these increases only offset the devaluation of the hryvnia: the hryvnia fell against the U.S. dollar by 45 percent in December 2013 alone. Currently, the price of gas for households, including the increase of May 1, 2014, is about $100 per 1,000 cubic meters, and for municipal heating companies, about $150 per 1,000 cubic meters. According to our estimates, even maintaining the price at $268 per 1,000 cubic meters in 2014 would spell a loss of $0.3 billion for Naftogaz in domestic sales (that is, if 100 percent of gas bill are paid), and with an average price of $356 per 1,000 cubic meters, losses will exceed $1 billion.

Second, Naftogaz should get the most attractive segment of the domestic market back: industrial consumers. In 2012-2013, private gas traders have been consistently squeezing Naftogaz out of gas supplies to industrial customers, which are the most reliable paying customers. As a result, Naftogaz sales fell by 33 percent in 2011-2013, and gas sales to households and heat power plants now account for the bulk of the company's sales. In 2013, households accounted for 55 percent of the company’s sales, and thermal power plants, 33 percent. At the same time, households, and especially thermal power plants, are problematic consumers, with the collection rate among households standing at 85-90 percent, and thermal power plants 30-35 percent, which explains the company’s low overall collection rates.

Without fulfilling these conditions, the Ukrainian gas market is unlikely to be in good shape. Naftogaz will try to resolve its financial problems by not paying Gazprom, which will provoke conflicts. Transferring Ukraine to advance gas payments is a reasonable, albeit a belated, decision. Gas prepayments are justified, because neither Naftogaz, nor the Ukrainian government, is able to guarantee gas payments, which was clearly shown during the April-May talks. Prepayment would at least stop the snowballing debt of Naftogaz, whose debt is now comparable with Gazprom’s quarterly investment plan.

Gazprom demands debt payment of $4.5 billion. Naftogaz wants the gas prices that it has been paying since 2010 to be revised, and overpaid sums in the amount of $6 billion returned to it. Proving that it had been overcharged for gas supplies will be difficult for Ukraine, because Hungary, Poland, Lithuania and many other countries pay even more for their gas.

In June, Gazprom also broke off the agreement on compensation of daily fluctuations in gas supplies with the gas transport system operator Ukrtransgas. The agreement was signed in 2010 and provided for prompt coverage of daily fluctuations in the demand for gas from Ukrtransgaz’ own resources, and subsequent payment for these services by Gazprom. However, the contract was almost never used, and the supplies under it have always been a fraction of a percent of the transit flows. Therefore, Gazprom Export decided to terminate it, and rely primarily on its own underground gas storage facilities (UGS) in Europe to cover temporary fluctuations in demand. Essentially, this is a technical issue, and it does not constitute a waiver of gas transit through Ukraine.

Filling Ukraine’s underground gas storage facilities remains the key current issue. Prepayment can help stop pumping gas into them, which would mean serious problems for European transit this winter (the Ukrainian authorities admit that they will be able to provide gas until October, but don’t say what will happen next). The Ukrainian Ministry of Fuel and Energy hopes that the ongoing reform of Naftogaz will attract European energy companies to manage Ukraine’s gas transportation system (GTS) and fill Ukrainian UGS with gas. According to the Ukrainian government, making GTS and UGS separate from Naftogaz should increase the transparency of gas transportation and allow European companies to pump the gas purchased from Gazprom in Ukrainian UGS (to be used in winter). This is unlikely to resolve transit problems, though. European companies are reluctant to pump gas in Ukrainian underground gas storage facilities, since neither the European Commission, nor the government of Ukraine, can guarantee the safety of the gas. However, the problem runs even deeper. The gas that is taken from the UGS located in western Ukraine actually compensates the increasing use of Russian gas by Ukrainian enterprises in eastern and central Ukraine. Therefore, even if the European companies start pumping gas in Ukrainian underground gas storage facilities, the transit problems will remain, and Ukraine will have to take more Russian gas in winter, for which it won’t be able to pay.

The key to resolving the conflict is to ensure the solvency of Naftogaz and Ukrainian consumers, but this is an unlikely scenario for the next two to three years. Thus, it is imperative to minimize risks, set the price at a level of $380-$390 per 1,000 cubic meters (even the European Commission believes that this is a fair market price for Eastern Europe) and adopt prepaid arrangements. These are the right moves to make.

Views expressed are of individual Members and Contributors, rather than the Club's, unless explicitly stated otherwise.