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The Krem­lin's gas pipe­lines by­pass­ing Ukraine are a threat to the coun­try's en­ergy se­cu­rity. What can it do to pro­tect it­self from up­com­ing risks

The Ukrainian Week - - CONTENTS - Olek­sandr Kra­mar

How Ukraine can pro­tect it­self from up­com­ing en­ergy risks with the con­struc­tion of by­pass­ing Rus­sia-con­trolled gas pipe­lines

The Euro­pean gas mar­ket and the ar­chi­tec­ture of its sup­ply routes are un­der­go­ing tec­tonic changes, af­ter which it will never be the same as in pre­vi­ous decades. There­fore, it will be im­pos­si­ble for Ukraine to take the same place and play the role that it did in the pre­vi­ous con­fig­u­ra­tion. At­tempts can be made to slow the process down, but it is im­pos­si­ble to stop. In ad­di­tion, the peren­nial pas­siv­ity of Ukraine in­ex­orably leads to it be­ing pushed to the pe­riph­ery.

The chance to be­come the cen­tre of the new gas ar­chi­tec­ture – a di­ver­si­fied hub through which the fuel would be de­liv­ered from dif­fer­ent sources (not only Rus­sia, but also Azer­bai­jan, Turk­menistan, Iran, etc.) – has al­ready been snatched away to Turkey. In re­cent years, Ukraine has even been re­nounc­ing this role to Poland, which has built a LNG (liq­ue­fied nat­u­ral gas) ter­mi­nal on the Baltic coast to ac­cept ship­ments from Qatar, the United States or any other coun­try and is pre­par­ing to build a pipe­line from Nor­way.

Hold­ing on to Ukraine’s sta­tus as the main tran­sit coun­try of Rus­sian gas at any price would be both dan­ger­ous and naive. Firstly, this could only hap­pen if the Ukrainian GTS is fully trans­ferred un­der the con­trol of the Rus­sian Fed­er­a­tion and con­sent is given to vas­sal-like de­pen­dence on the lat­ter in the po­lit­i­cal sphere. Se­condly, even un­der such con­di­tions, Rus­sia would seek to di­ver­sify its sup­ply routes to elim­i­nate any risks of de­pen­dence on an­other coun­try, even a loyal one.

This is clearly demon­strated by the ex­pe­ri­ence of Be­larus, whose tran­sit po­ten­tial in sup­ply­ing Rus­sian gas to the EU has been put on the back burner for many years in fa­vor of de­vel­op­ing new lines of Nord Stream. Full con­trol of Gazprom over its GTS and a pro-Rus­sian ori­en­ta­tion have not helped Minsk.

Against this back­ground, more and more flows of nat­u­ral gas will by­pass Ukraine. Over the last decade, the share of Rus­sian fuel trans­ported to the EU through the Ukrainian gas trans­mis­sion net­work has de­creased from 70-80% to 44% in 2017 and in the com­ing years it is sup­posed to drop to 10-20% or, at worst, a neg­li­gi­ble amount. In the mean­time, about 25% of tran­sit now takes place through Be­larus and 30% via the ac­tive part of Nord Stream. In the fourth quar­ter of 2017, Ukraine's share of tran­sit dropped all the way to 39% due to an in­crease in the use of Nord Stream, which reached 100.7% of its nom­i­nal ca­pac­ity.

Gazprom is not only on the home stretch of Nord Stream 2 de­vel­op­ment, which should dou­ble the ca­pac­ity of the Baltic route, but is also com­plet­ing the con­struc­tion of the first line of the Turk­ish Stream along the bot­tom of the Black Sea. The lat­ter is ca­pa­ble of putting an end to the tran­sit of Rus­sian gas through Ukraine to not only Turkey, but also at least sev­eral neigh­bour­ing EU coun­tries that now re­ceive it via Ukraine. In fact, by the third week in April the Pi­o­neer­ing Spirit pipe-lay­ing ves­sel was only 30km away from the point where the Turk­ish Stream will come

ashore near Kıyıköy. Com­ple­tion of work on the seabed for the first line, which has a ca­pac­ity of 15.75 bcm (bil­lion cu­bic me­tres), is ex­pected as soon as in early May. Although the fur­ther route of the gas pipe­line from Turkey to Europe is still un­cer­tain, at the very least Bul­garia and its neigh­bours in south-east­ern Europe will be able to re­ceive Rus­sian fuel through an al­ready ex­ist­ing gas pipe­line sys­tem. In par­tic­u­lar, those that pre­vi­ously sup­plied fuel to the re­gion and west­ern prov­inces of Turkey through Ukraine (the Trans-Balkan gas pipe­line with a ca­pac­ity of 12 bcm). For ex­am­ple, in 2017 Bul­garia and Ro­ma­nia alone re­ceived 4.5 bcm of tran­sit through Ukraine and Greece an­other 2.93 bcm. This is al­most half the ca­pac­ity of the first line of the Turk­ish Stream, although most of the gas from it should go to Turkey.

While Gazprom is di­ver­si­fy­ing its sup­ply routes to the EU, the EU and its in­di­vid­ual mem­ber-states are ac­tively work­ing to vary their own sources of fuel. Ger­man Chan­cel­lor An­gela Merkel was right when she re­cently com­mented on the Nord Stream 2 is­sue to say that re­gard­less of how Rus­sian gas is sup­plied to the EU – along the bot­tom of the Baltic Sea or through the Ukrainian GTS – this will not in it­self in­crease or de­crease de­pen­dence on Rus­sian gas.

What Nord Stream 2 could do is un­der­mine Euro­pean unity and in­crease Gazprom's ca­pa­bil­i­ties for ex­ert­ing pres­sure on in­di­vid­ual coun­tries, es­pe­cially for­mer tran­sit part­ners. How­ever, a real de­crease in de­pen­dence on Rus­sian gas does not de­pend on whether or not it is built, but on whether the sup­ply of fuel from other sources will in­crease. The EU is work­ing on this. For ex­am­ple, in or­der to en­sure the sup­ply of Caspian gas from Azer­bai­jan via the South­ern Gas Cor­ri­dor, the Ger­man gov­ern­ment is pre­par­ing to lend EUR 1.2 bil­lion to an Azer­bai­jani state-owned en­ter­prise through a Ger­man bank. More­over, in Oc­to­ber 2017, the Euro­pean In­vest­ment Bank (EIB) also re­leased in­for­ma­tion that it had al­lo­cated US $1.3 bil­lion for the con­struc­tion of this very route.

Im­ports of LNG to the EU are also grow­ing – there was an in­crease of 12% in 2017 and even 16% in its fourth quar­ter com­pared to the same pe­ri­ods in 2016. The main sup­pli­ers here are Qatar, Nige­ria and Al­ge­ria, but fuel sup­plies are also in­creas­ing from new sources, such as the United States or Trinidad and Tobago. How­ever, LNG is bought most en­thu­si­as­ti­cally by Mediter­ranean coun­tries in the EU, for which pipe­line trans­porta­tion from Rus­sia or Nor­way is more ex­pen­sive due to the long dis­tance. In Novem­ber 2017, the Pol­ish PGNiG an­nounced a 5-year con­tract with Cen­trica for the sup­ply of Amer­i­can LNG. At the mo­ment, how­ever, US sup­plies to the Euro­pean mar­ket are still very low and the Amer­i­cans pre­fer other mar­kets due to higher re­turns there. For ex­am­ple, in 2017 the US ex­ported an equiv­a­lent of 17.2 bcm of LNG, of which only 2.2 bcm came to the EU, while al­most 60% went to Asia and the re­main­der to Latin Amer­ica (26%).

WHAT TO DO

Ukraine alone is not ca­pa­ble of stop­ping Rus­sia's by­pass routes, and here it re­ally has to rely en­tirely on the po­si­tion of the EU and es­pe­cially the US, for which it is im­por­tant to stop this project both geopo­lit­i­cally and eco­nom­i­cally. If ac­tive diplo­matic op­po­si­tion does not work and con­struc­tion of Nord Stream 2 starts af­ter all, sanc­tions against com­pa­nies that par­tic­i­pate in it will re­main one last ar­gu­ment in Washington's arse­nal.

How­ever, Ukraine still holds suf­fi­cient tools for in­ter­nal ac­tions to min­imise threats to the coun­try even in the event that Rus­sia's by­pass gas pipe­lines are com­pleted. Af­ter all, the loss or a sharp de­crease in the tran­sit of Rus­sian gas through the Ukrainian GTS would mainly lead to fi­nan­cial losses. But the in­abil­ity to sat­isfy de­mand for the fuel due to a short­age of do­mes­tic gas pro­duc­tion, which cur­rently cov­ers one third of con­sump­tion and is slowly de­creas­ing, is a chal­lenge to na­tional se­cu­rity.

If the large-scale tran­sit of Rus­sian gas through the Ukrainian gas trans­mis­sion sys­tem comes to an end, pur­chas­ing the nec­es­sary vol­umes from EU com­pa­nies un­der the vir­tual re­v­erse flow scheme could be­come a prob­lem. Trans­porta­tion from fur­ther afield – from routes like TANAP – or pur­chases from liq­ue­fied gas ter­mi­nals on the Baltic coast of Poland or the Mediter­ranean in Croa­tia can­not be con­sid­ered the best op­tion. In­deed, the cost of such gas in Ukraine would be sig­nif­i­cantly higher than in other Euro­pean coun­tries, mak­ing a sig­nif­i­cant pro­por­tion of Ukrainian man­u­fac­tur­ers un­com­pet­i­tive.

The best op­tion for Ukraine in these new cir­cum­stances is to get rid of the need to im­port nat­u­ral gas at all. It seems that this has been de­clared at the gov­ern­men­tal level. How­ever, the prob­lem is that in prac­tice ev­ery­thing is quite dif­fer­ent. Mea­sures to save en­ergy and money or in­crease fuel ex­trac­tion are still funded resid­u­ally or blocked by ad­min­is­tra­tive in­ter­ven­tion. For ex­am­ple, lo­cal au­thor­i­ties sab­o­tage the pro­vi­sion of nec­es­sary per­mits for the in­crease of do­mes­tic gas pro­duc­tion by the largest player in the sec­tor, the state-owned com­pany UkrGasVy­dobu­van­nya [Ukrainian Gas Ex­trac­tion].

As a re­sult, af­ter a slight in­crease in pro­duc­tion in 2016-2017, since Fe­bru­ary 2018 the gas in­dus­try has re­turned to re­duc­ing pro­duc­tion (1.59 bcm in­stead of 1.6 bcm in the same month of 2017 and 1.61 bcm in the same month of 2016), which con­tin­ued in March (1.74 bcm com­pared to 1.78 bcm in March 2017).

Ukraine’s lead­er­ship demon­strates its in­abil­ity or re­luc­tance to counter the sab­o­tage of plans to in­crease gas pro­duc­tion by lo­cal rep­re­sen­ta­tions of the cen­tral gov­ern­ment, or equally un­der­mines the ac­tiv­i­ties of in­di­vid­ual com­pa­nies that are as­so­ci­ated with po­lit­i­cal ri­vals. For ex­am­ple, UkrNafta [Ukrainian Oil] re­duced its vol­ume of gas ex­trac­tion by 17% in 2017 – from 1.3 to 1.1 bcm. The main rea­son for this was the fact that the State Ge­ol­ogy Ser­vice blocked the ex­ten­sion of the com­pany's spe­cial per­mits. The vol­ume of gas ex­trac­tion by pri­vate pro­duc­ers in the same year

Af­ter a slight in­crease in pro­duc­tion in 2016-2017, since Fe­bru­ary 2018 Ukraine's gas in­dus­try has re­turned to re­duc­ing pro­duc­tion: 1.59 bcm in­stead of 1.6 bcm in the same month of 2017 and 1.61 bcm in the same month of 2016. The trend con­tin­ued in March with 1.74 bcm ex­tracted com­pared to 1.78 bcm in March 2017

also de­creased to 4.1 bcm from 4.2 bcm, although in pre­vi­ous years they had dra­mat­i­cally in­creased their per­for­mance.

Even worse is the sit­u­a­tion with de­creas­ing gas con­sump­tion. Since 2015, it has re­mained al­most un­changed: ac­cord­ing to Naftogaz, the na­tional oil and gas op­er­a­tor, con­sump­tion in 2017 fell by only 6% – from 33.8 to 31.9 bcm. This de­crease mainly came from the in­dus­trial sec­tor, whereas the mu­nic­i­pal and house­hold sec­tor has the big­gest po­ten­tial for sav­ings. For ex­am­ple, ac­cord­ing to of­fi­cial data, in 2017 house­holds con­sumed prac­ti­cally the same amount of nat­u­ral gas (11.3 bcm) as in 2015 (11.2 bcm). This is es­pe­cially sur­pris­ing when one looks at re­gional heat­ing plants re­duc­ing con­sump­tion by more than 20%, from 7.1 to 5.6 bcm over that pe­riod.

Yet again fer­tile ground has ap­peared for abus­ing price dif­fer­ences for cer­tain cat­e­gories of con­sumers. While fuel for mu­nic­i­pal needs is sold at UAH 6.94 per cu m, the price of gas for com­mer­cial cus­tomers in May 2018 will amount to UAH 9.14-10.04 per cu m, de­pend­ing on their vol­ume of con­sump­tion and sta­tus with debts and pre­pay­ments. The loop­hole whereby fuel can be writ­ten off as that used for house­hold con­sumers at US $100 cheaper per thou­sand cu­bic me­tres cre­ates a breed­ing ground for cor­rup­tion and in­hibits en­ergy sav­ings. So does the cur­rent ill-con­ceived sub­sidy sys­tem, which pro­vides no ad­e­quate in­cen­tives for en­ergy con­ser­va­tion or the re­sources that Ukrainian cit­i­zens need to do this, in­clud­ing loans.

The old sys­tem of cross sub­si­diza­tion within Naftogaz, which un­til 2013 pro­voked waste­ful en­ergy con­sump­tion, is cur­rently sim­ply im­ple­mented through the state bud­get in a slightly dif­fer­ent way. Naftogaz pays tens of bil­lions of hryv­nias in taxes and rents from do­mes­ti­cally pro­duced gas at prices close to mar­ket level and then these funds flow to con­sumers through the sub­sidy mech­a­nism of the Min­istry of So­cial Pol­icy.

Over the past few years, a black hole in the mar­ket has been grow­ing, made of losses dur­ing trans­porta­tion and dis­tri­bu­tion, im­bal­ances and so on that are writ­ten off, which in the case of Ukraine were al­ready sky high com­pared to in­ter­na­tional stan­dards. From 2015 to 2017, 5.5 bcm of gas was writ­ten off in this way, com­pared to 3.7 bcm in 2015. Rep­re­sen­ta­tives of in­ter­na­tional or­gan­i­sa­tions in Ukraine are al­ready tak­ing about this prob­lem with­out minc­ing their words. In par­tic­u­lar, the man­ag­ing di­rec­tor of the Euro­pean Bank for Re­con­struc­tion and De­vel­op­ment (EBRD) in East­ern Europe and the Cau­ca­sus, Fran­cis Malige, frankly stated re­cently that "A lot of gas still 'goes miss­ing' dur­ing dis­tri­bu­tion. In say­ing this, I don't mean that it goes miss­ing for every­one. Too much gas is still be­ing stolen dur­ing dis­tri­bu­tion."

There­fore, it is ob­vi­ous that the plans to re­duce con­sump­tion and in­crease pro­duc­tion that would give Ukraine a chance of reach­ing self-suf­fi­ciency in the gas sec­tor by the 2020-21 heat­ing sea­son can­not be re­alised. This, in turn, shows not only the need for de­ci­sive steps to in­ten­sify the re­duc­tion of fuel con­sump­tion in the do­mes­tic sec­tor and in­crease of pro­duc­tion by pri­vate com­pa­nies, re­gard­less of their own­er­ship. It is also nec­es­sary to pre­pare in­sur­ance mech­a­nisms to cover the time lag be­tween the prob­a­ble sus­pen­sion of large-scale tran­sit on the Ukrainian GTS – and con­se­quently the vir­tual re­v­erse flow scheme – and Ukraine's achieve­ment of self-suf­fi­ciency in the gas sec­tor by bal­anc­ing do­mes­tic pro­duc­tion and con­sump­tion at ap­prox­i­mately 25 bcm per year.

In this re­gard, it is al­ready nec­es­sary to make a com­mit­ment at the state level to fill Ukrainian stor­age fa­cil­i­ties to a max­i­mum level and cre­ate a strate­gic re­source while gas is still pass­ing through the Ukrainian GTS in large vol­umes. Af­ter all, if Ukraine could bring re­serves in its un­der­ground gas stor­age to 30 bcm be­fore the start of the 2019-20 heat­ing sea­son, a re­duc­tion in con­sump­tion and in­crease in pro­duc­tion would make it pos­si­ble to pro­vide the coun­try with the fuel at least un­til the end of the 2021-22 heat­ing sea­son, or maybe even 2022-23.

This time – al­most three years af­ter the prob­a­ble end of the trans­porta­tion of large vol­umes of Rus­sian gas via the Ukrainian GTS in 2019 – should be enough to find an ac­cept­able al­ter­na­tive to im­ported fuel. Or to bal­ance pro­duc­tion and con­sump­tion in a way that makes it pos­si­ble to get through the 2022-23 heat­ing sea­son and all the fol­low­ing with ease.

If it is not pos­si­ble to fill stor­age fa­cil­i­ties to the brim be­fore the start of the 2019-20 heat­ing sea­son, the coun­try may face se­ri­ous prob­lems with fuel pro­vi­sion by late 2020. Pre­par­ing for them un­der time pres­sure will be much more dif­fi­cult and more ex­pen­sive, po­ten­tially leav­ing Ukraine vul­ner­a­ble to black­mail from Rus­sia.

At the mo­ment, Naftogaz is pur­su­ing a di­a­met­ri­cally op­posed pol­icy aimed at max­imis­ing short-term fi­nan­cial gain (less re­serves means less funds held up and no pro­cure­ment means more sav­ings) to the detri­ment of the coun­try's long-term en­ergy se­cu­rity. At the end of this year's heat­ing sea­son – April 2018 – re­serves in the coun­try's UGS fa­cil­i­ties were at one of the low­est lev­els in re­cent years.

Ukr­transgaz, the na­tional gas trans­mis­sion and stor­age op­er­a­tor, boasts that "Ukraine started 2018 with its largest un­der­ground gas re­serves for 5 years – 14.7 bcm. This made it pos­si­ble to suc­cess­fully get through the 2017/18 au­tumn-win­ter pe­riod with its record long-last­ing low tem­per­a­tures in March this year, as well as re­duce the need for gas im­ports from the EU dur­ing a pe­riod of tra­di­tion­ally high prices at Euro­pean hubs."

From a solely cor­po­rate per­spec­tive, this pol­icy from Naftogaz lead­er­ship may be cor­rect. There­fore, po­lit­i­cal de­ci­sions and the will of the coun­try's lead­er­ship are needed to en­trust Naftogaz to act as an agent of the state in guar­an­tee­ing long-term en­ergy se­cu­rity and form­ing the max­i­mum pos­si­ble strate­gic re­serves of nat­u­ral gas in UGS. There is still time. Re­v­erse flow ca­pa­bil­i­ties make it pos­si­ble to ac­cu­mu­late up to 30 bcm of the fuel in Ukrainian stor­age tanks by Novem­ber 1, 2019. How­ever, every month of de­lay in de­ci­sion-mak­ing will in­crease the cost and make the per­for­mance of this task more tech­ni­cally com­plex.

PO­LIT­I­CAL DE­CI­SIONS AND THE WILL OF THE COUN­TRY'S LEAD­ER­SHIP ARE NEEDED TO EN­TRUST NAFTOGAZ TO ACT AS AN AGENT OF THE STATE IN GUAR­AN­TEE­ING LONG-TERM EN­ERGY SE­CU­RITY AND FORM­ING THE MAX­I­MUM POS­SI­BLE STRATE­GIC RE­SERVES OF NAT­U­RAL GAS IN UGS

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