Crisis in Ukraine: What role does energy play?

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    Mar 17, 2014

    Ukraine is the most important transit country in the energy trade relationship between Russia and Europe. Europe as a whole receives roughly 30 percent of its natural gas supplies from Russia. More than half of the Russian natural gas destined for Europe travels through Ukraine in spite of Russia’s continued efforts to build expensive pipelines to bypass the country. Ukraine is heavily dependent on natural gas. 40 percent of Ukrainian energy consumption is natural gas, and 60 percent of domestically consumed natural gas is supplied by Russia.

    In addition to Ukraine’s reliance on Russian gas, Ukraine also receives most of its domestically refined crude oil from Russia. Several countries in Europe are also very dependent on Russian oil supplies transited through Ukraine – e.g., Slovak Republic and Hungary. The dependency is mutual; more than 90 percent of Russian gas exports go to Europe , as does about 80 percent of Russia’s crude oil exports (evenues from oil and gas exports make up more than 50 percent of the Russian budget).

    Ukraine’s status as an important transit country and a history of high profile and contentious contract negotiations, price disputes, failed payments, and supply cut-offs has elevated the strategic importance of energy in the geopolitical context of the region.  Energy is symptomatic of the broader geopolitical issues at the heart of this current crisis. It is more likely that the energy solution will flow from a broader resolution to the crisis rather than the other way around.

    Q1: How did energy contribute to the crisis in the region?

    A1: Energy did not precipitate this crisis, but has been an important dimension of it. Since the collapse of the Soviet Union, Ukraine and Russia have been engaged in a cycle where Russia uses gas debt and pricing to gain leverage over Ukraine and its leaders in a murky trade involving opaque middlemen.  This latest crisis is one in a series of similar incidents, although the risks are higher because the dispute involves more than just energy.

    In 2013, Ukraine imported approximately $10 billion worth of natural gas from Gazprom, the Russian state controlled gas company, and owed $3.3 billion at the start of the year. This debt is a significant point of leverage for Russia. In December 2013, the deal reached between Vladimir Putin and Viktor Yanukovich partly around gas debts touched off broader protests. Russia agreed to buy Ukrainian government bonds to pay for the debt and reduce the price of gas by about a third. When Yanukovich left Ukraine, Russia cancelled the remaining bond purchases and announced the gas price would rise beginning April 1. Naftogaz, the Ukrainian national oil and gas company, currently owes Gazprom about $1.9 billion for gas delivered in February (it already paid about $1.3 billion of the $3.3 billion it owes). Gazprom has been seeking payment since January, but Naftogaz is broke.

    Energy is also complicating the dynamic in the mounting crisis over the future of Crimea. Crimea receives most of its electricity (90 percent) and other energy supplies (25 percent of its gas) from Ukraine. This dependence could result in further Russian actions to secure Crimea’s supplies, which has the potential to aggravate existing tensions or trigger a broader conflict. On March 15, Russia seized a gas terminal in mainland Ukraine just across the border from Crimea, presumably because of supply security concerns in Crimea. It is uncertain whether the Russians would attempt to commandeer additional energy infrastructure in order to secure energy supplies to the breakaway region. Ukraine could also respond to Russian actions by cutting energy to Crimea, although that would have significant repercussions for managing their own electric grid.

    Q2: What is the likelihood that Russia would cut off natural gas supplies to Ukraine and Europe?

    A2: There have been no threats by the Russian authorities or by the Russian gas giant Gazprom that they are planning to cut off the gas because of geopolitical tensions. That does not mean that the situation is static. A significant escalation of the military dimension of the crisis could incite the Russians or the Ukrainians to change their calculus. The announcement on March 17 that the U.S. and EU imposed sanctions on Russian officials added to the uncertainty about whether there will be a cut off.

    But it is impossible to divorce the geopolitical tensions from the issue of debt payments. European and Ukrainian gas may be threatened if the Ukrainian government fails to pay Russia for its imports in a timely manner (non-payment of debts was the immediate trigger for the 2006 and 2009 cut-offs). On March 7, after Naftogaz missed a payment for February’s gas supplies, Gazprom’s CEO stated that non-payment could lead to a crisis which would ultimately result in a supply disruption. On March 14, Miller told reporters that Gazprom does not want a crisis “but they [Naftogaz] have to pay for gas,” adding “This situation can’t go on forever.” Starting April 1, the lower price that Gazprom had extended Naftogaz on gas prices will be rescinded, compounding the payments problem. There are countervailing factors, however, primarily that Gazprom receives most of its income from sales to Europe, including Ukraine, and may be loath to jeopardize that.

    In the event of a gas cut-off there are mitigating factors. Unseasonably warm weather in Europe has translated into reduced need for gas for heating. Consequently, there are significant natural gas inventories in most countries in Europe which could moderate any impact of a cut-off (more data). The impact on Ukraine would be more severe. Press reports based on information from the Ukrainian energy ministry suggest Ukraine has enough gas on hand to last four months in the event of a disruption.  This number is highly misleading however as some of this inventory is gas that is necessary to stay in the system in order to run it, while other volumes are owned by Gazprom and third party gas traders.  Finally, using stocks now is a strategic trade-off. Gas supplies used now cannot be used later, and moreover Ukraine should now be building their stocks to prepare for the heating season.

    Q3: Can Europe use energy to put pressure on Russia or reduce its own energy vulnerability?

    A3: In the immediate term, Europe and Ukraine have limited tools at their disposal to reduce their energy vulnerability. The most obvious and immediate solution would be to provide the Ukrainian government with cash to pay down its debts (conditional on fundamental reform of Ukraine’s highly inefficient and corrupt energy sector). That would almost certainly remove the immediate prospect of a gas cut-off, although it would do little to resolve the broader political issues that are the main cause of the crisis. Europeans are also taking other short-term energy steps, most prominently by halting talks over the South Stream pipeline which would carry gas from Russia to Europe. In addition, the EU has stopped Gazprom from increasing gas through a different pipeline, a decision that was supposed to be approved on March 17.

    The reversal of some European pipelines to move gas from west to east is another immediate option that is under review. There may be deterrent value in reversing pipelines but in a real cut-off crisis the value of such reversals is doubtful. During a supply cut-off countries that were supposed to send the gas to Ukraine would presumably need it themselves and be unwilling to send it east. Of course, European countries can import additional gas to send to Ukraine, but they would have to pay for it since Naftogaz is broke—the very reason for any ostensible pipeline cut-off.

    In the medium to long term, however, there are a variety of options for Europe and Ukraine to increase their energy security. These include:

    • Seeking alternative supply options. There has been much discussion of using U.S. liquefied natural gas (LNG) exports to aid the Europeans and Ukrainians (in addition to expanding imports from Norway, Algeria, and Qatar). In the short-term this is not possible because the U.S. does not have any LNG export facilities at present. In the medium- to long-term, LNG may flow to Europe, but because the decision to export gas is made by commercial companies and not the U.S. government, LNG will only flow to Europe if the relative price in Europe is higher than or equal to the currently higher price in Asia. This is not an option for Ukraine at all because it does not have an LNG import facility (although it could receive gas from other European countries that do have LNG facilities, but new pipeline connections would be needed).
    •  Increasing domestic production. Ukraine has known conventional gas reserves which are relatively accessible and do not require the type of advanced technology needed for unconventional gas or offshore production. Ukrainian conventional gas production could be increased substantially over the course of the next few years, but the commercial terms and investment conditions would have to improve. Currently, producers are paid a price significantly less than the price of imported natural gas, disincentivizing domestic production.
    • While much of the focus has been on the supply side, reducing natural gas consumption is also a medium to long-term option for both Europe and Ukraine. The Ukrainians have already significantly reduced consumption, but there is a lot of room left for greater efficiency, contingent on price reform. In the European Union, primary energy consumption has already slowed dramatically due in part to the recession and in part to efficiency gains; however, imports from Russia have increased as Gazprom revises its pricing terms to be more competitive relative to LNG imports.

    Q4: Can the United States use energy to put pressure on Russia, support Ukraine, or reduce European vulnerability?

    A4: There has been significant interest among some members of Congress to use the abundance of U.S. natural gas as leverage against Russia, in support of Ukraine, and to reduce European vulnerability. As explained above, in the short term the United States has no ability to supply gas to Europe since it does not have any export facilities and in the long term, the U.S. government does not direct commerce. The other option some have suggested is to speed up the trade pact between the European Union and the United States (the Transatlantic Trade and Investment Partnership). For the same reasons that simply calling for LNG exports to Europe is not a solution, expediting TTIP, even if possible, is not a solution.

    The only way to extract Ukraine from the immediate payments crisis is to provide money for Ukraine to pay down its debts. However, that does not address the fundamental problems that resulted in Naftogaz indebtedness in the first place: massive corruption, opaque markets, and poor pricing. In the longer-term, the United States could ease Ukrainian and European vulnerability by encouraging reform in the Ukrainian gas sector.

    Others have suggested exporting U.S. oil to indirectly hurt Russia by lowering global prices and therefore hurting Russian government revenues. Some have interpreted the recent test sale of 5 million barrels of U.S. crude from the Strategic Petroleum Reserve as a signal to Russia that the United States will work to undercut global oil prices. However, the United States government has virtually no control over global oil prices, and attempting to flood the market with U.S. oil would be unlikely to significantly change oil prices or impact Russian government revenue. Another option, a coordinated stock draw among International Energy Agency member countries, may have more impact but there has been very little public discussion of such measures to date.

    The best way to put pressure on Russia in the long term and reduce European vulnerability is by encouraging significant structural reforms in Ukraine that result in a vibrant, transparent, and market-oriented energy sector. Pricing reform is a key element of these structural reforms and would encourage domestic production and result in efficiency gains that could boost the Ukrainian economy. Reform—including pricing reform—will require persistence over a number of years, sustained engagement, a significant infusion of resources (more than a billion dollars), and substantial technical assistance. Nonetheless, the only way to truly lessen dependence in Ukraine—and by extension, Europe—requires a coherent plan that cannot be achieved overnight. Now is a difficult but opportune time to act.

    Edward Chow is a senior fellow at the Energy and National Security program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Sarah Ladislaw is the director of the Energy and National Security Program and Michelle Melton is a research associate with the Energy and National Security Program.

    Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

    © 2014 by the Center for Strategic and International Studies. All rights reserved.

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