Gazprom’s “Game of Poker”
There are a few visible “poker game”moves undertaken by both sides as well as by third parties in the post-arbitration period:
Gazprom’s seeming unwillingness to pay what is due to Ukraine ($2.56 billion). Some experts, however, point out that the likelihood of payment is still rather high. Apart from possible reputational risks, Gazprom’s refusal to do so will give Ukraine a legitimate possibility to chase the company’s assets both in Ukraine and abroad. In view of politically controversial NS-2 project, such a disregard for international arbitration rulings could be considered by the public and Gazprom partners as a serious reputation risk. The key question, therefore, may be when Russia is going to pull “the arbitration payment card” out and what strings are going to be attached to it.
- Gazprom’s move to terminate 2009 gas supply and transit contract. The threat to cancel the contract should be seen as a step to gain better leverage to renegotiate a transit deal with Ukraine on more favourable terms. This move may have several reasons behind it: a) to put direct pressure on Ukraine by creating a potential threat of discontinued gas transit after 2019 as well as to exert additional psychological pressure on Europe to weaken European resolve and unified position regarding Russia sanctions; b) to prevent Ukraine from claiming, through Stockholm arbitration, losses due to unused pipeline capacity since each 1.0 bcm (out of 110 bcm maximum transit capacity) may cost Gazprom additional $30 million in compensation. The Gazprom transit contract does not imply an immediate termination when the agreement is broken. The contract envisages that if the parties fail to reach a mutually acceptable solution within 30 days of the occurrence of any dispute or disagreement, any dispute, disagreement or claim in connection with this contract or its violation, termination or invalidity will be finally settled by arbitration in accordance with the AISCC regulations.
- Russia’s consideration of the gas-debt-for-sovereign-debt swap. According to some media reports, Russian authorities may be considering a scenario to accelerate and intensify efforts to enforce repayment of Ukraine’s sovereign debt to Russia ($ 3.0 bn). Under this scenario, when Gazprom transfers $2.56 bn to Naftogaz, Russia could try “to intercept” the payment as a partial settlement for sovereign debt owned by Ukraine.
- Ukraine’s initiative to seize Gazprom’s international assets. By triggering the confiscation of Gazprom assets, Kyiv is trying to take advantage of deteriorated political relations between Moscow and the West due to escalated sanctions, “Skripal Affair” and recent chemical attack in Syria. Ukraine hopes to get backing from the EU and the USA to force Russia into either paying or negotiating a broader format of debt settlement.
- Ukraine’s declared intention to enter into foreign concession or management contract for its main gas pipeline (MGP). This move is obviously caused by at least two reasons: 1) the need to modernise MGP. In this context, one of IFIs that supports EU energy sector reform agenda in Ukraine has been discussing with Ukrainian authorities a possibility to partially finance MGP modernisation as well as its management or concession. 2) Ukrainian side also realises that direct talks with Gazprom, provided the circumstance, could be extremely complicated. Therefore, a foreign management partner is seen as a better counterpart for direct talks with Gazprom. A number of European companies have already expressed potential interest: Eustream (Slovakia), SNAM (Italy), Gazunie (The Netherlands), GRTgaz (France), GAZsystem (Poland), Desfa (Greece), Reganosa (Spain), Verbunddnelz Gaz AG (Germany), Fluxys (Belgium) and Transgaz (Romania).
- The recent move by the US Administration to toughen sanctions against Russia as well as to threat NS-2 with targeted sanctions or even with a trade war against Germany. The US position vis-à-vis Russian gas supply to Europe has become particularly aggressive after the 2017 report by the US Congress Committee on Science, Space and Technology. The report concluded that “Russia, as part of their sophisticated information and disinformation operations, engaged actively with so-called nongovernmental organizations – environmental organizations working against shale gas – to maintain dependence on imported Russian gas.” Most recent Report by US Congress Committee on Foreign Relations “Putin’s Asymmetric Assault on Democracy in Russia and Europe” explicitly stated that that Moscow’s construction of NS-2 and the TurkStream pipeline, if completed, would “bypass Ukraine as a transit country, heighten the vulnerability of Poland and the Balkans, and deepen European dependence on the Russian gas monopoly.’’ Resulting US tough position on the EU energy cooperation with Russia creates serious project implementation risks as well as puts a lot of pressure upon the German government. According to the media, President Trump openly blackmailed Chancellor Merkel on the NS-2 project: the US might retaliate with a fully fledged trade war with Europe, should Germany stick to the project.
- It has been largely due to the US position that two major geopolitical players in the EU gas business, Germany and Russia, have modified their approach to the NS-2 project and Ukraine transit, at least to declare willingness to consider a transit guarantee for Ukraine. Russian side already emphasized that the future of transit depends not so much on its political will or a lack of thereof as on Kyiv’s ability to offer Gazprom commercially attractive terms in order to be competitive with alternative routes.
So, the “NS-2 poker game” gets more and more complicated. And it now seems that the Europe’s bargaining chip vis-a-vis Russia may be significantly changing. Especially after Angela Merkel, according to German media, came up with a new NS-2 conditionality: for the project to reach its planned capacity, not only a transit guarantee for Ukraine is required but also the Russia’s withdrawal from Donbas and facilitation of a peaceful resolution of the armed conflict.
Most scenarios demonstrate that in 2020 Gazprom will not be able to supply contracted volumes to Europe without transit through Ukraine. Completion of new pipeline routes (NS-2, TurkStream and Trans-Caspian Pipeline) could help only partially. If a new transit agreement between Gazprom and Ukraine is not agreed upon, only a doubling of TurkStream capacity to 64 bcm together with completion of Nabucco West Pipeline between TurkStream and Austria or the ITGI Poseidon Pipeline between TurkStream and Italy might compensate for the shortfall in the gas supply. However, due to many uncertainties, risks and political obstacles, chances for these projects seem now rather slim.
Even if completed in late 2019, the NS-2 pipeline will be able to pump no more than 34 bcm since infrastructure to transport gas across Germany (connecting Eugal pipeline) is expected to reach full capacity only by end-2020. It means that in the best case scenario, NS-2 may reach its maximum throughput capacity (55 bcm) only in 2022-2023. In addition, Gazprom’s long-term contractual obligations with third countries, many of which expire well into 2020s, will need to be renegotiated to change their destination points from Ukraine-based connections to the European gas hubs. As far as TurkStream is concerned, most probably this pipeline will be used to supply gas only to Turkey since the process of issuing construction permits in neighbouring countries have not yet even started.
There are two key questions, apart from general geopolitical risks and other considerations that could affect this outcome: 1) a level of transit fees charged by Ukraine; 2) agreed volumes of transit.
Transit Fees. The most controversial element in the Gazprom-Naftogaz gas relations. In order to maintain some share of the gas transit business post-2019, Ukraine should be as flexible as possible and re-focus its transit negotiation strategy towards “cynical” pragmatism based on existing commercial realities. In fact, Ukraine could have produced a much more compelling economic case against the NS-2 by declaring voluntarily reduction in the cost of its transit.
Price for transit was set for 2010 (as per 2009 contract) at $1.9/1000cm/100km for 1,240km transit distance with the cost of transportation at around $23m/bcm, excluding the fuel cost. According to estimates, the actual cost of transit varied from $29m/bcm in 2011 to $32m in 2013 and back to $28m in 2016-2017.
However, and much to the upset of the EC, Naftogaz, since 2016, has been trying to implement a new transit tariff methodology introduced by the state regulator that envisages a departure from existing contract-based pricing towards so called regulated asset base methodology and regulated entry/exit capacity-based tariffs. Tariffs for all entry points to Ukraine’s gas transmission system are set at $12.47m/bcm while different tariffs are applied for various exit points that range from $16.74m/bcm to $32.80m/bcm. According to experts from The Oxford Institute for Energy Studies, if the current contract between Gazprom and Naftogaz is transformed into a regulated contract for 100 bcm capacity booking through the end of 2019, the cost of transit through Ukraine is likely to increase from $27m/bcm on a flow basis to $45m/bcm on a capacity basis.
Even though a new tariff rate cannot be introduced unilaterally without amending the existing contract with Gazprom, such a policy move by Ukraine potentially prices its transit capacity out of the “market” and makes position of Gazprom and its European partners much stronger with respect to the NS-2 project since the calculated cost of transmission through the NS-2 (based on NS-1 costs) could be around $37m/bcm or less. Thus, the “tariff offensive” launched by Ukraine unfortunately provided Gazprom with a very strong argument in its “by-pass Ukraine” campaign.
Volume of post-2019 transit. The table presents different scenarios for Ukraine transit. They imply that the EU demand remains constant and that the NS-2 pipeline is completed. The good news is that most probably in all three scenarios, Gazprom would have to negotiate and sign a new transit contract with Ukraine.
But the key question, which has tangible financial implications not only for Ukraine but also for the EU is to what extent Ukraine stands to lose from the future arrangementand how the losses are to be compensated.
In all three scenarios, Ukraine is likely to experience a serious “gas transit shock” – a significant loss of the country’s gas transit revenues. The worst-case scenario when both by-pass projects NS-2 and TurkStream are completed on schedule, would leave demand for Ukraine’s transit capacity at 10-15 bcm.
It is now very difficult to predict which of the above scenarios has higher probability since too many factors are in play that are difficult to foresee: likelihood of passage of new EU legislation on gas transit pipelines, possible delays and costs overruns for the by-pass projects due to legal and political reasons (particularly, receipt of projects permits from Denmark), possible escalation of geopolitical tensions and a new wave of anti-Russia sanctions, including those targeting Ukraine by-pass projects, etc. New energy legislation proposed by the EC, if passed, would stipulate that national regulators are required to either set or approve tariff costs on pipelines. In reality, this might mean that the German regulator for the NS-2 would be setting transmission tariffs and would have to make this information public. This could create an opportunity for Ukraine to offer lower tariffs to encourage off-take of gas at Russian-Ukrainian border thus encouraging competition in the sector. If, for instance, NS-2 is significantly delayed, for example, by late permits from Demark or even refusal, Gazprom would face a transportation bottleneck to meet its obligations vis-à-vis existing EU customers unless a new transit contract with Ukraine is signed.
But, at this time, it would be safe to assume the following:
- Both Gazprom and Ukraine would have to negotiate a new transit contract before 2020, which they probably will.
- Both Gazprom and Naftogaz (as well as other parties involved) will continue to play “gas transit poker game” and the war of nerves in their efforts to weaken a negotiating position of their counterpart(s).
- Volume of transit through Ukraine will inevitably go down resulting in a significant shortfall of hard currency revenues for the cash-starved budget.
Ukraine’s Expected “Gas Transit Shock”
Assuming that for 2018-2019 period remaining to the expiry of the transit contract, Gazprom ships to the EU more or less on par with recent volumes (circa 90 bcm) and provided that Ukraine is paid more or less what it received for transit in 2017 (around $28m/bcm), this could give a possibility to assess the scale of the gas transit shock (a shortfall in transit revenues) Ukraine could experience after 2019.
Possible shortfall could reach: in the best case – $1.5 billion (or 1.6% of GDP), in the worst case – $2.3 billion (or 2.4% of GDP). Such reduction in the country’s export revenues could significantly hamper prospects for economic recovery and growth that could stagnate at or below 2.0-2.5% per annum, rate clearly inadequate to provide for much needed boost to household incomes and investment. As a result of the “gas transit shock”, Ukraine could be expected to request additional financial assistance from the EC and international donors to compensate for the shortfall.
Some general conclusions could be made:
- Mutual EU-Russia-Ukraine dependencies ought to facilitate a trilateral dialogue and cooperation. Currently, there is no platform for multilateral consultations. And this seems to be at the moment the most problematic part due, mainly, to Russia’s position. Gazprom doesn’t want any third-party intermediation in its talks (relations) with Naftogaz (Ukraine). Russia’s strategy is to keep things suspended and uncertain as long as possible by initiating new arbitration proceedings to terminate the current gas supply and transit contract. Gazprom’s “poker game” is that of bluff and blackmail: the monopolist must realise that a new contract with Ukraine may be inevitable, whatever the volume, but doesn’t want any transparency in the talks as well as participation of other parties that could potentially enhance Ukraine’s negotiating position. Playing its cards in the dark, creating as much uncertainty and ambiguity as possible coupled with intensified efforts to complete the NS-2 pipeline allows Gazprom to put a continuous pressure on Ukraine in order to negotiate much better terms.
- Potentially, Russia could use its “last-minute consent” on future gas transit through Ukraine as a political instrument to further divide Europe’s position on economic sanctions or even as a trade-off for their easing.
How Could Ukraine Be Assisted?
Ukraine’s international supporters should consider establishing an informal situational “think tank”, something like “Ukraine Gas Transit Task Force” (UGTF), probably under the aegis or “blessing” from the EC European Support Group for Ukraine to focus on the following urgent objectives:
- To assist Ukrainian side to build a more cohesive and productive negotiation effort vis-à-vis Gazprom. In this “Gas Transit Poker Game”, Naftogaz of Ukraine is facing an ominous and well-coordinated propaganda and information machine with well-thought-over effort supported by the advanced intelligence, controlled mass media, spin experts, troll factories and abundant financial resources. As this Russian machine has been acting not only against Ukraine but also against Gazprom’s main market competitor, fracking gas of the overseas origin, it is very unlikely Ukraine will be able to counter this “hybrid warfare” machine on its own. In this context, Ukraine should be able to benefit from the best possible international advice, from an offer of best negotiation techniques and industry experience as well as effective PR and GR management.
- This Group should be able to help generate some unconventional negotiating strategies and creative ideas as well as formulate proper policy recommendations (re: transit fees). Instead of the prevalent focus on creating the pan-European “anti NS-2” coalition, the main effort should probably focus on how to achieve the highest possible volume of transit in a future gas transit contract. The tactic “Take it or Leave It” should also be in Ukraine’s arsenal: in 2020 and probably next few years beyond, Gazprom, without Ukraine’s transit, will fail to deliver contractual volumes to the European consumers.This potentially could be a huge blow to the monopolist’s long-term objective to become a good and reliable European corporate citizen. Ukraine should be able to capitalise on this window of opportunity and play this card tough and timely provided its tariff policy is within the market. Ukrainian side should also be able to quickly and flexibly transform some of its key messages and objectives into effective international mass media campaign.
- Due to Ukraine gas transit being now in the centre stage of international efforts on conflict resolution in Ukraine, including the Minsk-2 and Normandy format, GTSG could also become of internationally supported peace settlement in Ukraine. Finally, it must be obvious that positive resolution of the ongoing “gas war” between Russia and Ukraine as well as international “gas transit poker game” could have an important bearing on any prospects for peaceful solution of the armed conflict in Donbas, for improved international security situation as well as general easing of geopolitical tensions in the world.