October 20, 2012
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№ 7 (July - August 2012)

Ukraine Looks to Foreign Investors To Shake Russian Gas Dependence

   Few expected a breakthrough in the renegotiation of Ukraine’s burdensome gas contract with Russia when President Vladimir Putin met Ukrainian President Viktor Yanukovich in Yalta on July 12.

By Tom Balmforth

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   And perhaps it also came as little surprise that Putin stole the headlines when he arrived four hours late to meet the Ukrainian head of state after what appeared a less than pressing photo op with a leather-clad biker known as the “Surgeon.” The diplomatic snub spoke volumes about how Russia sees itself as the ultimate arbiter in any revised gas deal that would lessen the burden to Ukraine. But in the meantime Ukraine is trying to chip away at its reliance on Russia by attracting foreign expertise to tap in to its shale gas fields and offshore reserves in the Black Sea.

   Ukraine’s President Yanukovich has wanted to revise the price Ukraine pays for Russian gas since he came to office in February 2010, a year after his bitter rival Yulia Timoshenko agreed the current price for Russian gas with Prime Minister Vladimir Putin.
   Ukraine pays one of the highest prices for Russian gas in Europe.
Moreover, the terms of the contract require Ukraine to import at least 52 billion cubic meters a year. At $425 per thousand cubic meters last quarter, the gas price, calculated through a complex formula pegged to the price of oil, is a burden for Ukrainian industry – even after Yanukovich bartered Russia to shave $100 off the price of gas in exchange for prolonging the lease of Russia’s Black Sea Fleet until 2042 in an arrangement known as the “Kharkiv discount.”
Olga Shumylo-Tapiola, a Ukraine expert and visiting scholar at Carnegie Europe, said Russia is in a position to dictate the terms of any revised deal, but that Ukraine has so far resisted Russia’s proposals which has led to impasse in negotiations that have lasted over a year. Moscow is prepared to make a concession either if Ukraine joins the Moscow-led Customs Union with Kazakhstan and Belarus or relinquishes a swathe of its transit pipeline network and storage facilities. On the latter, Russia has been gunning for a consortium deal whereby Russia’s Gazprom would receive a 50 percent stake.
   This would remove the leverage over Gazprom afforded to Ukraine’s state-owned Naftogaz by its ownership of the transit pipeline network which carried 104 billion cubic meters of Russian gas to Europe in 2011. Russia has twice accused Ukraine of stealing gas destined for Europe in the last three years and Russia still fears a repeat, should tensions escalate again at the height of winter. Last month, Gazprom agreed to advance Naftogaz $2 billion to finance its purchase of gas so as to secure the safe passage of Russian gas through Ukraine, to prevent shortfalls in westward gas deliveries.
   Neither of Russia’s proposed solutions has much traction in Ukraine.
Yury Korolchuk, an expert with the Kiev-based Institute for Energy Research, warned that even if Ukraine relinquishes a fifty percent stake now, it may find itself having to make more concessions further down the line. “We have to take into account the difficult situation on the oil and natural gas markets – by that I mean the high prices.
   The economic situation is not getting better in Ukraine, just as it isn’t in Europe. There are negative global trends and the economic crisis continues,” said Korolchuk. “One eventuality is that in five years time, Gazprom will simply come for the other fifty percent [of the transit network]. So in 2012 or 2013 they could get fifty percent of the transit pipelines and reserves and five years later they’ll take the rest. Ukraine will have nowhere to run and it will sell them.”
Ukraine is open to the idea of a consortium, but one split between Naftogaz, Gazprom and a third European company. Analysts say that neighbor Belarus’ experience is a warning to Ukraine: Minsk has managed to negotiate Europe’s cheapest price for Russian gas but at the price of entering the Moscow-led Customs Union and relinquishing control over its pipeline infrastructure to Gazprom. Moreover, the long-term value of Ukraine’s transit infrastructure as a bargaining chip is dropping. Fewer Russian volumes are flowing through Ukraine this year due to lower European demand, the opening of NordStream as an alternative route to Europe and an increase of volumes through Belarus.
Against this backdrop, Ukraine would like to dispute the terms of its gas contract in court and has tried to coax Russia into legal action, according to Korolchuk. In June, Ukrainian Energy Minister Yuriy Boyko supposedly unilaterally announced that Gazprom had agreed that Naftogaz only import only 27 billion cubic meters in 2012, instead of the contracted volume of 52 billion cubic meters. Gazprom denied the charges outright.
   It provoked Gazprom CEO Alexei Miller to threaten to sue Ukraine if it does not import at least 80 percent of its contracted volume.
   But in tandem with this apparent maneuvering, Ukraine, however, has gone on a concerted drive to attract foreign investment into projects that would replace Russian gas imports. Ukraine has successfully courted Chinese sponsorship for a coal revival in order to wean itself off gas. On July 16, the Ukrainian Energy and Coal Industry Ministry told Bloomberg that China has agreed to lend Ukraine $3.7 billion to switch its power plants to coal from gas. Korolchuk said this could cut Ukraine’s consumption of Russian gas by 6 billion cubic meters.
   Ukraine is also looking to offshore Black Sea reserves. Ukraine’s state-owned Chernomornaftogaz, a subsidiary of Naftogaz, last year bought two drilling rigs from Singapore’s Keppel FELS in a bid to boost domestic gas production. One if these rigs drilled its first well in July at the Odesskoye natural gas field in the Black Sea. The second rig is expected to be delivered by the fourth quarter of 2012.
   Despite embezzlement allegations surrounding the purchase of the two rigs at $400 million apiece, Chernomornaftogaz has said it hopes to use them to boost domestic gas output to 3 billion cubic meters by the end of 2014.
   Ukraine has also held a series of tenders to attract foreign know-how and technology to tap into its unconventional gas reserves. Ukraine has the third largest shale gas reserves in Europe with an estimated 1.2 trillion cubic meters, according to the U.S. Energy Information Administration. Shell and Chevron are already partnered to explore and potentially develop the Yuzovskaya shale gas area in eastern Donetsk and the Olesskaya shale gas area in Lviv region respectively. Ukraine is reported to be considering inviting majors to another tender for the Slobozhanska shale gas area in the eastern Kharkiv region in September.
   “These are good projects,” said Shumylo-Tapiola. “But they are costly and they are not going to materialize very quickly, so I would take it more as an attempt to pressure Russia – for the moment. Maybe they will get serious about it, because those companies that are now allowed to extract in Ukraine are serious about it.”
   Foreign investors are vying for offshore Black Sea positions too. On June 4, Ukraine invited foreign majors to a tender for the Skifskoye and Forosskoye fields on the Black Sea shelf. Korolchuk said we could see bids from Shell, ExxonMobil, Sinopec, Eni, OMV, Petrobras and Total.
   He said Gazprom had shown interest in offshore exploration and development in the Black Sea, but does not have the technology to drill deep enough. Russia’s largest private oil company, LukOil, is also partnered with Chernomornaftogaz to explore and produce oil and natural gas by developing the Odesskoye, Bezymyannoye and Subbotinskoye deposits.
   These signals of intent among foreign investors are a boost for Ukraine, according to Korolchuk. “Ukraine has no choice but to attract foreign investors who can invest in gas production and thus reduce Ukraine’s dependence on Russian gas.”

William Powell, the Editor, International Gas Report, Platts

   Ukraine now pays Russia $425 per 1,000 cubic meters, which is more expensive than “spot” prices at European hubs ($315 per 1,000 cubic meters in Germany), but cheaper than Platts estimates to be the long-term prices for Russian gas delivered to Germany in the third quarter of 2012 ($460 per 1,000 cubic meters ). There are also the questions of transit fees and the Russian lease at Sevastopol to consider when looking at the economic and strategic cost to Ukraine of buying Russian gas.
   Ukraine wants to pay no more than $250 per 1,000 cubic meters, and it also wants to cut its Russian imports by a third this year, from 40 billion cubic meters in 2011 to 27 billion cubic meters. But it is not clear what it is offering Russia in return for these concessions, if anything. Gazprom wants to form a joint venture to control the pipes and has been pushing for a deal for over 15 years, but the two seem unable to agree on terms.
   Ukraine is looking for alternatives to Russia. It has borrowed Chinese money to help it displace gas with coal in the power generating sector, and has done a number of deals with foreign gas producers, hoping to transform itself into a shale gas giant. But the geology of shale is very complicated and commercial production of gas on the scale that would allow it to eliminate Russia must be many years off. It is also considering building an LNG import terminal.
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