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The conflict between Ukraine and Russia has taken on many facets, of which the energy-related ones are seemingly the easiest ones to solve. As Kiev and Moscow are exploring the limits of arbitration, it seems that all the necessary prerequisites and conditions for a potential settlement are present. It has to be said that such a dispute adjustment faces numerous obstacles, with political headwinds dominating not only the two nations energy discourse, but also its coverage in the media. If one is to avoid the temptation to have recourse to the usual finger-pointing and rather delve into the realm of figures, the potential for cooperation is easily detectable.

Ukraines gas market is in a dire condition. Despite many potentially favorable measures initiated by the cabinet of ministers, i.e. the unbundling of Naftogazs activities, the corruption-ridden character of Ukraines public administration has led to scant progress in their implementation. In just three years, gas consumption has fallen by 40 percent (see Graph 1) due to the ongoing conflict in Ukraines Eastern regions, as well as several-fold increases in gas prices, as mandated by the IMF. Ukraines gas transmission system urgently needs refurbishment and modernization, only immediate costs to cover for supplies by 2030 amount to at least $3 billion. Moreover, its pipelines are becoming obsolete, too, Gazproms Nord Stream pipelines operate under 120 bar pressure, whilst Ukraines are 75 bar. Yet on the back of arbitration dealings, visceral political atmosphere and full cessation of Russian imports, Russian transit to Europe has actually increased in the last two years and Ukraine assured supply safety for transited volumes, so coming to an agreement is not a delirious idea.

Graph 1. Ukraines Domestic Gas Consumption, Russian Gas Imports and Transit 2000-2016.

(Click to enlarge)

The protracted arbitration proceedings at the Stockholm Arbitration Court have so far only partially indicated where the Russo-Ukrainian gas issue could develop further. The claims and counterclaims are very unlikely to yield any sensational result, Gazproms $44.8 billion take-or-pay non-payment claim seems to be dismissed on the ground that Kiev neednt have paid the minimum take-or-pay price as there was a material change in market circumstances, a clause included in the contract. Naftogazs claim that Gazprom applied unfair pricing from 2011 is also believed to be significantly curbed, as the Stockholm Court ruled that it was only after 2014 that such practices could be observed. The Courts overall ruling will try to counterbalance the two sides claims, possibly with a little tilt towards Naftogaz (apart from legal factors, politics will make an impact, too, as any large Gazprom victory would result in a Naftogaz bankruptcy). Yet the arbitration will achieve what the two sides by themselves could not place the Russo-Ukrainian gas issue into a wider European context, equating it to effective terms that became norm with Gazproms other European partners. Related:The Only Way OPEC Can Kill U.S. Shale

Since December 2015, Ukraine is buying gas to its own detriment. In every single month since the abrupt cessation of supplies, the price of reverse gas supplies has significantly exceeded that of Gazproms European average (see Graph 2). By buying reverse Russian gas, supplied to Kiev by European traders, Ukraine is losing $35-40 million on a monthly basis, which, given the wretched state of its public finances and its economy (GDP-wise it is back to 2005 levels), is a sore neglect. Although it would be politically suicidal to express interest in resuming supplies, Ukraines Naftogaz has admitted that the price it pays for reverse gas could be more favorable. Hopes that LNG supplies transported to Ukraine via Poland might be profitable are plainly wrong under current market conditions, only a considerable price hike in global oil prices could alter the balance as both Poland and Ukraines gas supply contracts (valid until 2022 and 2019, correspondingly) are oil-indexed.

Graph 2. Gazproms Average European Gas Price vs Ukraines Average Fact Price (December 2015 June 2017)

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Since 2015, Gazprom has repeatedly confirmed that it seeks to nullify the Ukrainian transit route after the currently effective 10-year contract runs out in 2019. There are numerous obstacles to this, however, as even the 55 BCm/year throughput capacity Nord Stream 2 and TurkStreams 15.75 BCm/year branch destined for Southeastern Europe cannot fully cover Ukraines 82.2 BCm transit (as of 2016, expected to reach 88-90 BCm in 2017). Therefore, Gazprom officials have acknowledged the full cessation of gas transit via Ukraine is improbable and stated that approximately 15 BCm per annum will be supplied after 2019. Even if a sweeping renaissance of relations were to take place between Moscow and Kiev, Ukraine will no longer be a priority for Russian exporters, as the Baltic route is economically more profitable. Apart from being 1800km shorter than the Ukrainian route and as a consequence being closer to Russias leading gas-producing regions which are drifting all the more to the north, it entails no transit fees. Related:4 Reasons Oil Will Rally Back To $50

Whilst the Stockholm Arbitration will curtail Gazproms maneuvering possibilities in Ukraine and dovetail it with dealings vis--vis other European partners, it is unlikely to influence Ukraines tariff-setting much. Yet it remains one of the key factors if Ukraine is intent to keep at least the 15-20 BCm/year transit further on. The Kiev-set tariffs are currently prohibitively high, for instance, transiting to Slovakia totals $32.8/MCm, almost the same as the total fee for Nord Stream ($37/MCm). According to Naftogaz, this is due to cover amortization costs which occurred as a result of the 115BCm/year pipeline systems underutilization it now operates around 60% of capacity, in 2014-2015 it was oscillating around 50%. Traditionally, Naftogazs transportation branch has been used to cross-subsidize pretty much all the other branches which operated at a loss, yet this has to change. The underlying logic is fairly obvious. Even though the re-export clause that Gazprom incorporated into the previous contracts is now gone, Ukraine has no chances whatsoever of exporting gas to Russia. If it wants to garner any transit money, it must reconsider the foundations of its tariff-setting.

All in all, the resolution of the gas dispute between Ukraine and Russia is both feasible and desirable. Moscow needs it because it seems unlikely it will be able to find another viable transportation route for Central European countries that would not jeopardize its other commitments, Kiev, on the other hand, ought to come to terms with the fact that no one apart from Russia will use its gas transportation system for transiting. Even if gas transit is limited at 15-20BCm/year, the $500-600 million to be earned from this is too big a sum to be shrugged off, especially for depression-stricken Ukraine. Political issues, such as the appropriate determination of Crimeas legal status or the unobjectionable fulfillment of the Minsk Agreements, represent a far bigger challenge it would be a waste not to normalize relations at least in the gas sector.

By Viktor Katona for Oilprice.com

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