BMI View: A new law approving the leasing of Ukrainian gas transit infrastructure to European and American companies will boost security of supply for Ukraine and the EU. However, this will be a long-term process due to the need to renegotiate gas contracts, meaning Russia will retain its trade leverage over Ukraine for the time being.
The Ukrainian parliament has approved a law allowing the leasing of its gas transit pipelines. Naftogaz will retain a 51% share in Ukraine's transit assets, though will open the remaining 49% to US and European companies. Despite this development, we see little short-term change in energy trade dynamics, though the law could improve security of supply for all parties if supply contracts can be amicably renegotiated.
Benefits For Europe
If European companies take a stake in the Druzhba pipeline and other transit infrastructure, they would have greater control over gas flows from the Russia-Ukraine border. This would substantially reduce the risk related to Russia-Ukraine politics impacting gas supplies to Europe's largest customers, improving security of supply to the bloc. This is a critical move given Europe's dependency on Russia, and the limited options to diversify away from Russian gas.
| Greater Control Over Dependency |
|Country-By-Country Gas Consumption, Russian Imports & Dependency 2012 (bcm, %)|
However, in implementing this change, companies purchasing gas from Gazprom would have to renegotiate their contracts to deliver from the Russian border with Ukraine, rather than the Ukrainian border with the EU.
Negotiations with Gazprom could be protracted and difficult. Gazprom is under no obligation to renegotiate contracts signed by European companies, and could wait until they are up for renewal or reach a contractually organised renegotiation window. This is a crucial issue given a number of the largest gas importing companies including E.ON, RWE and Eni, only recently (over 2013/2014) managed to renegotiate new contracts to lower pricing structures. With Gazprom losing out from lower spot gas prices in Europe and no sales to the Ukraine, new gas price negotiations would also likely lead to higher prices.
It remains unclear which companies will be interested in leasing parts of the Ukrainian gas network. The most obvious targets would be Gazprom's largest customers, including the large German, French and Italian utilities. However, being over exposed to Europe's ailing power generation sector, most European utilities are struggling to make a profit and may not see the financial benefit in investing in Ukrainian pipeline leases, which could ultimately lead to renegotiations with Gazprom and higher prices.
The new law would also further delay progression on the South Stream pipeline. We have long noted the political and economic barriers to the South Stream project and have seen even further opposition to its development from Europe since the Russo-Ukraine rift ( see 'South Stream's Tough Battle For Europe's Pipeline Spotlight', May 2013). If European companies are able to secure capacity through Ukraine, improving the reliability to supply, South Stream would make even less economic sense.
Ukraine Still Subject To Gazprom
Currently, Gazprom is the only company that sends gas through Ukraine, leaving Naftogaz dependent on one company for securing transit fees. By leasing the pipeline to a number of different companies, Naftogaz's income from transit fees and rent would be more diversified. This would secure a key long-term revenue source for the government, which is massively struggling with its finances.
The new law would also increase security of gas supply for Ukraine, a crucial factor given its import needs and limited options for supply.
| All Gas Imported From Russia |
|Ukraine Gas Production And Consumption (bcm)|
If European and American companies can gain control of gas from the Russian border, they will be able to sell it to Ukraine, offering alternative suppliers to Gazprom. This may also be a way around Gazprom demanding prepayment for gas deliveries to Ukraine.
That said, this process is likely to be drawn out with Gazprom remaining largely in control of the pace of renegotiating contracts. Over the short-term, and particularly over the coming winter, the current energy trade dynamic will persist and Russia will retain its energy leverage over Ukraine. Ukraine's gas supply will therefore remain highly vulnerable over the coming winter ( see 'Hoping For A Mild Winter', July 15).
Russia In No Rush
The law will not have an immediate impact on Russia, with the renegotiation of contracts with Gazprom needed prior to it having any real effect. This will most likely need to be carried out on a trilateral basis with the EU, Ukraine and Russia all agreeing on a solution. However, most of the gas supply contracts are long-term, E.ON for example holding contracts until 2036. Gazprom will not be in any rush to renegotiate, particularly after it has already made concessions through linking gas contracts to spot prices on a number of big ticket deals.
Further, even over the longer-term Russia will retain trade leverage over Ukraine. Aside from continued, and possibly intensified, covert support for separatists in Eastern Ukraine, we expect Russia to continue ramping up pressure over Kiev through trade. Russia is Ukraine's biggest trading partner (accounting for 25% of its exports), and while Ukraine has escaped Russia's recent imposition of food bans on the EU, Moscow is likely to resort to this tool to bend Kiev to meet its political goals.
Another way for the Kremlin to pressure Kiev is financially. Russia lent Ukraine USD3.00bn (in December 2013), which gives it significant leverage over Kiev's public finances. This is particularly true given that that according to a provision in the loan, Russia can demand immediate repayment of the loan, if Ukraine's debt-to-GDP ratio exceeds 60%. Russia can also pursue influence over Kiev through maintaining and/or forging links with Ukraine's political and business establishment.
Given the formidable ways through which the Kremlin can keep up pressure over Kiev, we maintain that the former will not resort to outright military invasion. The latter strategy remains highly unpalatable to Moscow, given the international outrage it would provoke, likely accompanied by further punitive sanctions by the West, and perhaps greater military and intelligence assistance to Kiev. Against this backdrop, we still expect the outcome of the Ukraine crisis to be some form of federalisation of Ukraine, with Russia maintaining considerable politico-economic influence over the country for the foreseeable future.