07/05/14 – Ukraine, Russia and the geopolitics of energy

Speakers: Patrick Heren, Founder of the Heren Index and senior adviser to Government on energy procurement, and Katya Zapletnyuk from ICIS

The All Party Parliamentary Group on Energy Costs

7 May 2014 – meeting notes

Chair Laura Sandys MP

Laura Sandys MP opened the meeting, in the Chair in place of Lord Palmer, and introduced the speakers.

Patrick Heren

Development of European gas trade with USSR took place in much more fraught circumstances than today’s, namely the second half of the Cold War.

Governments – Germany, France, Italy – remain committed to strong bilateral trade ties with Russia, and less committed to maintaining territorial integrity of Ukraine

Gas trade is not embodied in or controlled by state-to-state or EU level agreements, but in commercial contracts with enormous financial penalties for non-performance

Past interruptions have been due to poor Ukrainian behaviour both in paying for their own imports and maintaining westward transit flows

Gazprom (apparently backed by Putin) has departed from its historic adherence to local market pricing – i.e. it was always a pragmatic price taker – and is trying Canute-like to hold back the tide of gas market index pricing by sticking to oil indexation – thus making its gas decreasingly attractive

EU attempts to impose capacity limits on Gazprom’s use of the South Stream conflict with its own need for security of supply

The EU members who are most dependent on Russian gas are former Comecon members and the Baltic states. Some of these have not tried that hard to reduce that dependency, usually opting for the cheaper Russian gas, but also the relationships they understand. Therefore, in the medium term (i.e. not in 2014) countries like Poland need seriously to re-examine their commitment to open and competitive markets

Whatever the outcome of the current crisis, European buyers will be looking elsewhere for incremental supplies, including eventually the USA, Middle East, Africa. But that probably means higher wholesale gas prices in a European market whose electricity sector is currently swamped with cheap coal and squeezed by subsidised renewables.

By the same token, Russia will be looking both to repair its trade relations with EU buyers and to develop new export markets, especially in China

Ironically, pipeline gas trade has always been incredibly stable, almost a token of peace between nations. Diminishing the role of pipeline trade inevitably moves the world to amore dynamic and therefore potentially more chaotic trade centred on LNG – which, like oil, always seeks the best market price.

Katya Zapletnyuk

Katya supplied some useful fact sheets (circulated previously).

There are three key factors in understanding the potential impact on gas markets of the current Ukraine/Russia relationship:

  •  The Role of Ukraine as a transit country
  • The importance of Ukrainian storage
  • The Reverse-flow of imports into Europe

Transit

The Ukraine pipeline is a Soviet legacy with capacity of 120bcm per year. Historically it  transported 80% of Russian supplies to Europe. Since 2009 there have been changes, Russian has built the Nord Stream (capacity 55bcm and which is still only being used at part of its capacity) and Yamal (direct to Germany via Poland 33bcm). This has displaced some of its flows through Ukraine which carried only 54% of Russian supplies to Europe in 2013 and these flows are expected to fall by around 18% in 2014. The proposed South Stream pipeline would add 63bcm of capacity. This is a controversial plan but supported strongly by President Putin.

Ukrainian Storage

There are storage sites on the Western border with capacity of 30bcm. This storage is important to the security of Europe supply. Ukrainian gas demand is highly weather dependent and most consumption is in the East.  In the winter the Ukraine takes supplies for the East from the transit pipeline and tops up supplies to western Europe from storage. Ukraine needs to have at least 19bcm in storage at the start of the winter to enable smooth transit to western Europe. Therefore, it is important to  inject gas in the summer. This week the Ukrainian oil and gas company joined the European Gas Storage and transparency platform, they claim they will provide weekly updates on gas storage.

Reverse Flow

In 2009 Ukraine signed a long term  purchase agreement with Russia. It is unhappy about the price at which gas is supplied. Russia has provided discounts to the price, but these were in exchange for political favours. The Ukraine has been trying to find alternatives to Russian Gas and in 2013 it started to import gas from Europe through Poland and Hungary. The volumes supplied are very small because of limited pipeline capacity. Domestic production is also very small.

Reverse flow input stopped last year when Gazprom gave a large price reduction, but re-surfaced as an issue in March this year (with the start of the unrest). In 2013 reverse flow went through Poland and Hungary. What Ukraine wants is to buy gas via reverse flows through Slovakia. The EU supports this alternative route and this is the main point of tension with Russia on gas flowing through Ukraine. As a result of the degree of control that Gazprom has on the Ukrainian transit system Ukraine cannot operate a “virtual reverse flow” whereby the gas stays in the country. Instead a solution has been to refurbish an old gas pipeline which has a capacity of 8bcm a year. The first flows from this are due to start in autumn 2014.

The question is if this will resolve the gas supply problem for the Ukraine, the volumes are not that big and it is uncertain who will supply the gas to this pipeline, German and Italian companies have been attached to the programme.

The unrest since the start of March has had an effect on wholesale gas prices, although there has never been any supply interruptions, the price spikes have been headline-driven. This effect can be seen in the graph of Dutch TTF prices.

Questions

How far is South Stream from being built?

Gazprom expect it to be operational by the end of 2015

Laura Sandys MP: The situation is an accelerator for Italy, German and Romania to look at diversity of supply.

Patrick Heren : The immediate alternative supply LNG is going to Japan, prices are and will continue to be high (so long as several of Japan’s nuclear reactors remain off).

There was a suggestion from the floor that Iran, with huge supplies, seemingly ready to go, might offer a viable alternative source. The panel explained that that country struggles to supply its own and the Turkish markets.

Would a buyer’s strike be viable?

Patrick Heren: This is not possible

Laura Sandys MP: A year from a general election in the UK, this is not plausible.

Would the supply from the Yamal pipeline be enough if the Brotherhood pipeline were taken off line?

Laura Sandys MP: The Ukraine and Russia are extremely inefficient users of gas. In 2009 there was probably a 10% decrease in temperature with a gas demand increase of 15%, it’s like a “J-curve”. If the two countries could address the inefficiency they would require less gas.

The Russian’s are unpredictable, is it likely that President Putin might decide to cut the gas supply?

Russia has no desire to cut supplies to Europe, its only market, and relies heavily on the income.  Little Russian gas physically reaches the UK, any impact on UK would be a knock-on impact.

Were the contracts negotiated on a forward basis at a time when prices favour Gazprom, when are they due to expire?

Patrick Heren:  Most will expire in 2035, however there is an amount of flexibility in the contracts. There are 3 yearly price re-openers (generally when the price is re-visited the contract is to some extent also) Gazprom often gives rebates.

Could Ukraine buy their gas more cheaply elsewhere?

Katya Zapletnyuk: It is cheaper to buy back Russian gas from Europe that directly from Russia.

Could Ukraine source all its gas from other sources?

Laura Sandys MP: The situation has caused a freeze on investment security; an increase on the costs of capital for infrastructure building or the money is just not there at all.

Patrick Heren: The costs of South Stream are not pragmatic but the project has been able to attract partnerships.

The Russian system means that the cost of capital is always increased. Bringing in outsiders makes things relatively cheap.

As the original Soviet gas field, Ukraine itself has lots of potential.

Will the annexation of Crimea prompt the re-routing of South Stream, through Crimea, creating a shorter route?

The panel agreed that it is now too late for plans to be re-drawn. No one is talking about doing that.

The meeting closed.