(Another) Gas Crisis

With another gas crisis between Ukraine and Russia unfolding the first good analysis of the energy sector in Ukraine is published in the current issue of The Washington Quarterly:

Edward Chow and Jonathan Elkind, "Where East Meets West: European Gas and Ukrainian Reality".

The article can be downloaded:

http://www.twq.com/09winter/index.cfm?id=328



Where East Meets West:

European Gas and

Ukrainian Reality

On January 11, 2008, on the eve of the NATO summit meeting in

Bucharest, the Ukrainian president, prime minister, and parliamentary speaker

wrote to Secretary GeneralJaap de Hoop Scheffer, asking that Ukraine be

invited to begin a Membership Action Plan (MAP) leading to membership in

the Alliance.1 In April, the NATO heads of state deferred the issue of MAP for

Ukraine, and fellow aspirant Georgia, saying that progress should be assessed at

the December 2008 NATO ministerial.2 In that same month, after a tumultuous

year of political recriminations and policy deadlock within the ruling coalition,

Ukraine is also scheduled, to have its third pre-term parliamentary election in

three years.

These events shine a harsh spotlight on the current policymaking environment

in Kyiv, and also on the country's longstanding aspiration to join the Euro-

Atlantic community. At present, Ukraine is caught between the old, post-Soviet

world and the new, European one that it says it wants to join. Nowhere is this

clearer and more consequential, both for Ukraine and for the Euro-Atlantic

community, than in Ukraine's natural gas industry. While Ukraine plays a

criticalrol e as the key transit connection between gas producers in Russia as well

as CentralAsia and gas consumers in the EU, its incomplete market economic

transition and culture of corruption weaken its own energy security, destabilize

its economy, destroy public trust in its politics, and undermine the interests of its

European neighbors as well.

# 2009 by the Center for Strategic and InternationalStudies

The Washington Quarterly ¥ 32:1 pp. 77
92

Edward Chow is a senior fellow in the CSIS Energy and National Security program and a

former internationaloilindustry executive. He can be reached at EChow@csis.org. Jonathan

Elkind is a nonresident senior fellow at the Brookings Institution and previously served on the

staff at the National Security Council. He can be reached at jelkind@brookings.edu.

THE WASHINGTON QUARTERLY/ j JANUARY 2009 77

Worse yet, Ukraine's leverage in the energy

marketplace is eroding rapidly. A Ukraine that

modernizes the practices in its energy sector can

contribute significantly to European security,

stability, and economic prosperity. Yet, this is

not the role that Ukraine has played since 1991

and, even most disappointingly, not the role the

country has played since the dramatic Orange

Revolution brought new leaders to power in

2005. Western leaders who have encouraged

Ukraine's Euro-Atlantic aspirations would be well-advised to examine critically

the current state of Ukraine's gas sector, its implications for the country's

democratic development, and risks for European security as it considers

Ukraine's bid to join the trans-Atlantic community in 2009 and beyond.

Ukraine's Abundant Energy Potential

Ukraine's energy situation is much more complicated and perilous than it should

be. The country has a generous endowment of hydrocarbon resources both

onshore and offshore in the Black Sea. It has a capable energy workforce, and

long experience in the exploration, production, transportation, and refining of

oil and gas. Most prominently, it is strategically located and has large-scale

infrastructure.

Today, roughly 80 percent of the gas being exported from Russia to Europe

crosses Ukrainian territory, roughly 120 billion cubic meters (bcm) per year.

This gas originates variously in Russia and Central Asia, and it passes Ukraine en

route to European clients who are the best-paying customers of the Russian gas

titan, OAO Gazprom. In fact, two-thirds of Gazprom's revenue comes from the

sale of gas that crosses Ukraine, which in turn represents more than 20 percent of

growing European gas demand. Moreover, Ukrainian gas throughput can be

increased by 25 percent, to roughly 150 bcm per year, on a cost-effective basis,

with comparatively modest capital investment relative to all other alternatives.

Ukraine also has strategic strength in the form of other energy transportation

infrastructure. Its oil pipeline network can transmit roughly one million barrels

of oilper day (nearly 7 percent of totalEU demand) to centraland eastern

European destinations. It also has immense gas storage capacity. The country can

store up to 35 bcm of gas (roughly 40 percent of Germany's annualdemand) in

underground gas storage systems, which are mainly located in the west of the

country*/an ideall ocation for serving European gas customers. Gas storage is a

particularly valuable asset because it allows one to match supply, which is

Ukraine is caught

between the old,

post-Soviet world

and the new,

European one.

78 THE WASHINGTON QUARTERLY/ j JANUARY 2009

Edward Chow & Jonathan Elkind

basically constant year-round, and demand, which

often varies widely due to seasonal changes or

other commercialor even strategic factors.

As for its domestic energy production, Ukraine

has severalhydrocarbon producing provinces onshore

and has vast geological potential both onand

offshore. Peak historicalgas production was

68.7 bcm in 1975 (more than the totalconsumption

of Germany, Italy, and the United Kingdom

at that time), compared to the current production

level of 20 bcm. Today there are opportunities for

enhanced oiland gas recovery from Soviet-era

fields plus previously untapped ''greenfield'' opportunities,

especially in deeper producing zones

and in the Black Sea. Industry experts, both inside and outside Ukraine,

commonly believe that with improvements in the overall investment climate

and with the right changes to the legal and regulatory environment, Ukraine

could double its gas production within a decade.

Enduring Energy Insecurity

Despite this resource potential, strategic location, and existing infrastructure, the

country struggles with energy security. The reasons are an incomplete transition

to market economics, chronic underinvestment, and profound opaqueness of

policymaking, which fuels corruption.

Seventeen years after the break-up of the Soviet Union, the energy economy

of independent Ukraine is still frozen in seemingly permanent transition. The

structure of the energy sector, particularly of the oil and gas industry, is a cross

between a Soviet branch ministry and private interest groups. The state-owned

company, NAK Naftohaz Ukrainy, contains many able and knowledgeable

professionals but is overly politicized in leadership, overstaffed, mismanaged,

impoverished, and operates under numerous fundamentalconfl icts of interest.

For example, one of the company's wholly-owned subsidiaries, UkrTransNafta,

operates the country's oil pipelines and is responsible for determining the terms

on which domestic crude oilis accepted into the system for transportation,

including from private oil companies that have invested in exploration and

production (E&P) activities. At the same time, other Naftohaz subsidiaries,

some of which have controlling private owners despite being predominantly

state-owned, are also in the business of extracting crude oil. Naftohaz's subsidiary

UkrTransNafta, therefore, is determining pipeline access for private E&P

investors even as they compete with other Naftohaz subsidiaries.

Ukraine's

corruption and

incomplete

economic

transition weaken

its own energy

security*/and

Europe's.

THE WASHINGTON QUARTERLY/ j JANUARY 2009 79

European Gas and Ukrainian Reality

Price signals, the most fundamental element of a

functioning market, are also profoundly confused and

obscured in the Ukrainian energy sector. For example,

in its current form, the gas industry employs

multi-tier pricing that reduces incentives to conserve

a precious resource and enables flourishing graymarket

trading. In other words, gas from domestic

Ukrainian production is theoretically earmarked for

use by residentialcustomers and government-funded

organizations at a subsidized price, while higherpriced

imported gas is meant to be used for industrialconsumption. Not

surprisingly, this schema is not honored in reality. Politically well-connected

individuals and companies use barter arrangements and re-export schemes to

profit handsomely while injuring the national welfare. Meanwhile, domestic gas

production is depressed by artificially low prices.

Non-transparency reaches its peak in internationalnaturalgas trade and

transit, where the poster child is the shady middleman, RosUkrEnergo (RUE).

The company's role is a political bone of contention in that an entity with no

assets, no track record, and no transparency was placed at the very center of the

Ukrainian gas economy. Moreover, RUE did not even have to compete for this

very lucrative position. It is also important to note that RUE was not the first

mysterious middleman to operate in the Ukrainian gas sector. One therefore

wonders: if RUE is thrown out, as the most senior Ukrainian officials have said

they would like to do, would RUE simply be replaced by another nontransparent

entity despite all declared policy to the contrary for supply contracts

with Gazprom and CentralAsian gas producers?

Similar to its predecessors Itera and EuralTransGaz (ETG), RUE makes a

fortune by re-selling gas in Ukraine and in neighboring central European

countries which has been imported from, or transported across, Russian territory.

Under the January 2006 gas agreement, Ukraine pays RUE in kind by giving it

more than 20 percent of the totaldel ivered gas, which is 15 bcm of the 73 bcm

that were nominally contracted for 2007. The value of the in-kind gas in late

2007 was $4.35 billion, assuming a gas price of $290 per thousand cubic meters

which was a representative price in centraland eastern Europe at the time.

Today, the value of this gas would be substantially higher, based on prevailing

prices for gas. According to numerous press reports and industry rumors, RUE's

ample profits flow into the pockets of well-placed officials in the Russian and

Ukrainian gas industries and governmentalstructures.

The Ukrainian oil and gas sector is dominated, some would say strangled, by

parties that controlinvestment decisions and cash flows, but who are not subject

to the responsibility of ownership. Typically, company owners must comply with

Ukraine's gas

sector presents

risks for

European

security.

80 THE WASHINGTON QUARTERLY/ j JANUARY 2009

Edward Chow & Jonathan Elkind

transparent government regulation and must

exercise discipline in their operations to

deliver financial performance for fear of

being rejected by the capitalmarkets on

which the company depends. Instead, the

parties who controlthe Ukrainian oiland

gas sector use their positions to block

development, to extract economic rent,

and to pick commercialwinners and losers

for their personalconvenience. For example,

only some projects get governmental approvals; only some companies get soughtafter

contracts. Consequently, control over the sector is a major prize in political

contests. When one political bloc is uppermost in national politics, no project

proceeds without the blessing of, and benefits for, people connected with that

bloc. When that group loses the political upper hand, deals are often subject to

renegotiation. At the same time, it becomes the job of each successive political

opposition to block all policy proposals, even the sensible ones, because the

opposition is not profiting. As a result, few major long-term policy initiatives

have been enacted or implemented.

One of the most damaging results of this pattern is chronic underinvestment

in the oiland gas sector. Opportunities to raise production, increase efficiency,

and improve reliability are lost because short investment horizons dominate. In

infrastructure-dependent, capital-intensive, long lead-time industries like oil and

gas, such actions severely damage the prospects for progress and development.

Consequently, the condition of Ukraine's oiland gas industry continues to

deteriorate. In May 2007, for example, one of the main gas transmission lines

near Kyiv experienced a failure and exploded. Had the accident occurred in the

winter, when cold temperatures hike demand and when all gas pipelines operate

at peak levels, the incident could have had a major humanitarian impact.

Instead, it only signaled the risks of underinvestment in operations, maintenance,

and upgrades.

Ukraine consumes between approximately 60 and 75 bcm annually, which

makes it the sixth largest gas consumer in the world, with consumption levels

that are completely out of proportion to the size of its economy.3 Its

consumption equals that of all the Visegrad countries*/Czech Republic,

Hungary, Poland, and Slovakia*/combined. Its energy intensity is not only

higher than Western European countries, but it is twice as high, or twice as

inefficient, as neighboring Poland. Ukrainian officials and lawmakers make

ritualistic comments about the need to reduce energy intensity, but the extent of

realaction is very limited.

Roughly 80 percent

of gas exported from

Russia to Europe

crosses Ukrainian

territory.

THE WASHINGTON QUARTERLY/ j JANUARY 2009 81

European Gas and Ukrainian Reality

Missed Opportunities

In the wake of the 2005 Orange Revolution, President Viktor Yushchenko and

Prime Minister Yulia Tymoshenko declared high ambitions for energy sector

reform, increasing public expectations. Three years later, none of the stated

intentions and expectations has been met. Most conspicuously, the gas sector

remains as convoluted and impenetrable as ever. In March 2005, Yushchenko

declared that gas trade with Russia would be conducted on a cash basis rather

than through non-transparent in-kind payments. Yet, no proper negotiation

process followed. Throughout the fourth quarter of 2005, tensions over the gas

issue grew, and both Russia and Ukraine resorted to the gas equivalent of saberrattling.

The Russians' version of this high-stakes brinksmanship was to threaten

to cutoff gas supply to Ukraine. The Ukrainian version was to threaten to stop

gas transit to Europe.

On January 1, 2006, Russia's Gazprom reduced gas throughput to Ukraine by

an amount roughly equivalent to what Ukraine would have been entitled to

extract if a contract were in place. In the midst of a bitterly cold winter

throughout Europe, Ukraine apparently retaliated by taking unsanctioned gas

from the pipeline system. Foreign governments, especially in Europe and the

United States, reacted quickly, criticizing the Russian cut-off and calling for the

two sides to reach a negotiated settlement. Early on January 3, Russia returned

the gas pipelines to normal operations, appearing to concede that it had lost the

battle for international public opinion.

On January 4, Naftohaz Chairman Oleksiy Ivchenko and Ukrainian Minister

of Fuels and Energy Ivan Plachkov announced a new gas agreement with

Gazprom and RUE. To those who had been monitoring the mounting crisis, the

agreement was as incomprehensible in its logic as it was unprofessional in its

form. Regrettably, it also established the pattern for two subsequent years of

negotiations. The result of the early 2006 negotiations was unfavorable to

Ukraine inasmuch as it gave away the previously-agreed nominal gas price of

$50 per thousand cubic meters and accepted a nominalprice of $95. In exchange

for this concession, Ukraine did not receive an agreed pricing formula for future

years, which would have removed the opportunity for politically-charged

eleventh-hour negotiations. Nor did Ukraine receive agreement on a period

for transition to higher prices or a long-term, ship-or-pay volume guarantee from

the Russian side, nor any other enforceable contract provisions. Instead, the

RUE import monopoly was expanded, and its non-transparent in-kind payment

further entrenched.

Late in 2006, under a new government led by Prime Minister Viktor

Yanukovich of the Party of Regions, Ukraine accepted a nominalprice of

$130 per thousand cubic meters for 2007. Late in 2008, the nominalprice rose to

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Edward Chow & Jonathan Elkind

$179.50, again without normalinternational contract protections. During the

same period, both Belarus and Bulgaria successfully negotiated multi-year gas

supply agreements with pricing mechanisms and multi-year periods for transition

to ''European'' pricing levels with Russia. Neither of these countries has

negotiating leverage comparable to Ukraine's, leverage which reflects the fact

that 120 bcm of gas transit Ukraine annually from Russia to European

consumers. For reasons that are inexplicable as a matter of basic negotiating

leverage, Ukraine failed to secure self-protection that less powerful neighbors

managed to secure with Gazprom.

Ukraine claims to receive gas, while Russia claims to sell gas, at nominal

prices that do not correspond with reality. These nominal prices have deceived

the Ukrainian public into thinking they were getting a better deal than they are,

and have created a disincentive to engage in gas sector modernization, a faulty

logic that is based on the fear that Ukraine could not survive economically if it

were required to pay European gas prices. False prices and faulty contract

compliance also allowed the Russian side to accumulate debt obligations from

Ukrainian entities, thus setting the stage for predatory buy-outs by entities with

the right connections (whether Russian, Ukrainian, or other).

The mechanism used to mask these false prices is simple. According to the

terms of the January 2006 agreement, Ukraine pays a stated price (initially

$95 per thousand cubic meters, then $130 for 2007, and $179.50 for 2008) to

import up to 58 bcm of gas per year (roughly three-quarters of Ukrainian

demand). To receive that volume of gas for domestic use, Ukraine must actually

buy 73 bcm of gas, out of which 15 bcm is transferred to RUE for the ''service'' of

delivering the total volume of gas to Ukraine. As a result, the actual price paid

by Ukraine is significantly higher than the nominal price, since approximately

one of every five cubic meters that Ukraine purchased (15 of 73 bcm) is actually

being turned over to RUE, with its beneficialowners pocketing the handsome

profits.

In 2007, gas was selling in several central and Western European countries for

around $290 per thousand cubic meters on a delivered basis.4 In that same year,

Ukraine paid the nominalprice of $130 per thousand cubic meters for 56 bcm of

gas that was said to be sourced from CentralAsia, and Ukraine paid $230 for a

further 17 bcm that was said to be sourced from Russia. In aggregate, Ukraine

paid $11.19 billion for 73 bcm in 2007. In exchange for that aggregate sum,

Ukraine actually received only 56 bcm of gas for its own consumption, making

the price Ukraine effectively paid in 2007 for each thousand cubic meter of the

usable gas $192.93, not $130. Similarly, the real price in 2008 that corresponds

to the nominalprice of $179.50 is roughly $240 per thousand cubic meters.

For RUE, this arrangement has been exceptionally lucrative. RUE has been

able to re-sell at European market value the gas it receives as an in-kind transfer.

THE WASHINGTON QUARTERLY/ j JANUARY 2009 83

European Gas and Ukrainian Reality

Certain Ukrainian industrialand export customers

are willing to pay close to full value, which means

that RUE can pocket literally billions of dollars

per year.5 The reason behind RUE's preferential

place in the Eurasian gas trade has never been

explained in comprehensible terms. Gazprom and

Russian government officials have always blamed

the Ukrainians while the Ukrainians have always

blamed the Russians. Nonetheless, the simple fact

is that Gazprom allowed billions of dollars of value

to flow into the pockets of a group of middlemen

without demonstrable industry expertise and without

compensating Gazprom's shareholders, or Russian taxpayers, in any

commensurate way. And the Ukrainian government and Naftohaz allowed

RUE to occupy an absolutely central place in the Ukrainian economy, earning

billions from the role, without ever having had to compete for the role or prove

its capabilities in any way.

From time to time since 2005, Ukrainian officials have proudly asserted that

they have extemporized skillfully, allowing their country to buy time and adjust

gradually to higher gas prices. Unfortunately, such claims ring hollow. Three

years after the arrivalof Yushchenko and the Orange forces, the gas sector is no

more transparent than it was in 2004, when RUE's role was more limited. As of

2008, Ukraine still lacks the stability and predictability that would come from

long-term gas contracts. Ukraine also lacks the protections that would come

from an international-style agreement that includes all the standard provisions

that Gazprom routinely negotiates and concludes with its German, French, or

centralEuropean counterparties*/provisions such as take-or-pay obligations for

gas buyers, ship-or-pay obligations for shippers, price adjustment mechanisms,

clear arbitration provisions, and many more.

Over the past three years, Ukraine's negotiating leverage has eroded greatly.

Gazprom is three years closer to its objective of commissioning bypass pipelines

that will allow it to transport more of its gas to Europe without having to cross

Ukraine. Blue Stream, which passes under the Black Sea to Turkey, is operating

at capacity while Nord Stream, which is meant to cross the Baltic to Germany, is

proceeding, though not without a number of headaches. And South Stream,

which is planned to pass under the Black Sea to Bulgaria, is now under

development. All three of these routes will bypass Ukraine entirely.

Even without these pipelines being completed, Ukraine's leverage is rapidly

eroding. Naftogaz's chronic and massive indebtedness*/it is currently in

technical default of its international bond obligations*/makes Gazprom the

only potential purchaser of its remaining valuable assets, namely the trunk gas

Three years after

the Orange

Revolution, the

gas sector is no

more transparent

than it was.

84 THE WASHINGTON QUARTERLY/ j JANUARY 2009

Edward Chow & Jonathan Elkind

pipeline and storage facilities. Gazprom's dominant position gives Russia the

possibility of taking over Ukraine's decaying infrastructure and strengthening its

controlover gas exports to Europe, including those from CentralAsia, even

without having to construct all the bypass pipelines it is planning.

Although gas trade and transit carries the greatest international impact, they

are not the only parts of the Ukrainian energy sector that remain distorted and

dysfunctional. Domestic production is stagnant to declining at the time when it

should be booming. Investment in exploration and production of Ukraine's oil

and gas resources, which could have been substantial at a time of historically

high internationalprices and constrained access to new prospects, has amounted

to a trickle at best.

The sole international competitive bidding for new development that

occurred in this entire period, for the Prikerchenskiy offshore block in the

Black Sea, has been a classic case of non-transparency, rent-seeking, and

professional incompetence. First, in 2005, Ukrainian officials deliberately chose

not to employ standard marketing techniques that are universally recognized as

proven approaches to increase industry awareness of new prospects, and thus

increase potentialbids from competing companies. Then in 2006, with the

country experiencing political turmoil associated with imminent parliamentary

elections, bids were collected under an ill-conceived process, and a small

independent American oilcompany with modest experience in offshore west

Africa, Vanco, was announced the tender winner.

In late 2007, with yet another new Ukrainian government about to arrive, the

terms of the production sharing agreement (PSA) were concluded and

formalized by the outgoing government. The timing struck knowledgeable

industry observers as unusual, a long-term deal concluded in haste by a lameduck

government just before its departure. Most observers assumed the deal

would be overturned by an incoming government, and unfortunately they were

proven right. In May 2008, it was officially revealed that Vanco's Pricherchenskiy

investor group includes the Ukrainian firm Donbass Fuel and Energy

Complex (DTEK), which is owned by Ukraine's richest man, Rinat Akhmetov,

the force behind the now-out-of-power Regions Party of Ukraine, as well as

other mysterious entities whose ownership and expertise have never been

revealed. The second Tymoshenko government, in turn, cancelled Vanco's

license, allegedly due to problems in the fairness and adequacy of the tender

process and license terms, which then led to an open disagreement between

Yushchenko and Tymoshenko. In the summer of 2008, Vanco announced it

would take the matter to international arbitration. The deputy head of the

presidentialsecretariat stated to the press: ''We do not have the right to revoke

the license unilaterally.''6

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European Gas and Ukrainian Reality

This entire experience calls into question Ukraine's interest in attracting

transparent foreign investment into its upstream oiland gas industry. Despite

numerous efforts, no major foreign investor has been able to achieve any success

in Ukraine's upstream oiland gas sector, including RoyalDutch Shelland

Marathon. The nature of the current investment climate should ring alarm bells

in the ears of Ukrainian policymakers along with the leaders of the Euro-

Atlantic community. If developing the country's domestic hydrocarbon

resources is a priority for Ukraine, as it should be, and if foreign investment is

essentialto the country's ability to develop those resources in a timely manner,

and it is, then it is important to acknowledge that, at present, the investment

climate of Ukraine is highly unattractive.

Improving Ukraine's Oil and Gas Sector

Currently, Ukraine's oil and gas sector is being operated in a completely

dysfunctional manner. Yet, there are several beneficiaries, well-positioned

individuals and key political forces, milking the energy sector, particularly the

oiland gas industry, for personalenrichment and as sources for politicalfunds.

The present state of affairs underscores the most essentialprerequisite for change

in Ukraine's oil and gas sector: political will. The needs of the nation, for today

and tomorrow, are consistently overridden by short-term political expediency

and personalgain, creating a corrosive effect on the entire politicalsystem, as it

contributes to a broad loss of faith in the political process among the Ukrainian

public. The open and free press that has exposed the corruption underlying the

oil and gas industry, however, is one of the truly important and hopefully lasting

changes after the Orange Revolution. Today's energy policy, which serves the

interests of certain political elites rather than the country, poses imminent

danger to the nation, yet it is not being addressed with any sense of urgency. To

date, no political faction has demonstrated a willingness to put aside parochial

interests for the good of the nation, a reality that must be changed if Ukraine is

to pursue membership in the Euro-Atlantic community.

As experience around the globe will attest, sound energy policymaking is a

difficult task. The United States, and many other political cultures that are far

more settled than Ukraine, struggle to make good choices in energy policy.

Effective energy policy requires political leadership, economic analysis, public

dialogue, consensus building, commercial awareness, planning, and professional

execution, not the enunciation of lofty goals. Energy policy should be based on

sound priorities, action plans, intermediate objectives, and realistic timetables.

At present, Ukrainian officials betray a lack of seriousness on energy strategy,

which undercuts the ability of commercial and public decisionmakers to plan

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Edward Chow & Jonathan Elkind

energy-related aspects of their future, and reinforces already high public cynicism

about the mishandling of the energy sector.

Gas supply and transit, which have been the source of so much controversy

and intrigue since Ukrainian independence, must form the core of a sound

Ukrainian energy strategy. Ukraine could credibly set the goal of reducing its

reliance on imported gas from the current level of approximately 75 percent to

50 percent within the next five to seven years. Achieving this objective would

require a range of efforts, some related to domestic supply and some to demand.

On the demand side, there is great scope for helping Ukrainians, particularly

those living in multi-family apartment buildings, to simultaneously reduce their

gas consumption and improve their comfort as well as quality of life by investing

in energy efficiency. Another essentialaspect of this initiative would be to

reduce gas consumption by allowing gas prices to increase to full-cost recovery

levels and by enforcing payment discipline. This is important because allowing

the accumulation of gas debts only makes Ukraine vulnerable to highly

disadvantageous debt-equity swaps.

In addition to reducing gas consumption, Ukraine could increase its domestic

gas production. Eliminating multi-tiered pricing would encourage new domestic

production, because domestic production is currently designated for sale to

residentialand budgetary-institution consumers, but at only a fraction of the true

market value. The current practice discourages domestic production and

subsidizes higher-priced imports.

For gas transit, Ukraine's goal should focus on stabilizing its contractual

relationship with Russia. At present, Ukrainian officials constantly declare that

their country is a reliable transit partner, but a short conversation with virtually

any European gas industry executive will reveal that this self-perception does not

correspond to the understanding of industry experts outside Ukraine. Nearly

seventeen years of post-Soviet experience have taught Europeans that Ukraine is

the part of the supply chain that often leads to disputes, mutual recriminations,

and endless charges and counters charges. It is the weak link. It is hardly

surprising that many Europeans conclude that it is better to pay lip-service to the

idea of closer gas-related engagement with Ukraine rather than formulate

policies that would lead to such engagement. At present, because of the legacy of

Soviet-style gas contracts, Ukraine is Russia's problem to manage. And Europe

does not appear to object to this reality.

Ukraine can transform its reputation by developing policies that aim to

improve its reliability as a transit partner. A first step would be to engage in a

systematic internationally-sanctioned assessment of the condition and investment

requirements of the Ukrainian internationalgas transit system (IGTS).

The assessment could identify opportunities to increase operating efficiency and

reduce bottlenecks, serving as the basis for increasing Ukraine's transit revenue

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European Gas and Ukrainian Reality

by increasing throughput volume, and not by extorting higher transit tariffs as is

often proposed by Ukrainian officials. Such a technical audit would be welcome

and possibly funded by the donor community. Needed capital improvements can

be financed by internationalcredit according to modern business standards.

Ukrainian officials often complain that transit across their country is

substantially less expensive than across many other European countries which

occupy a far less strategic position in the supply chain, a fact borne out by

analysis conducted by the Energy Charter Secretariat, among others. Transit

across Ukraine, however, comes with an uncertainty premium that the market is

no longer willing to bear. Ukraine would be better advised to build market

confidence and increase its transit revenues by increasing volume first and only

later by increasing transit fees if such increases can be justified by investments to

improve reliability and increase capacity in the Ukrainian IGTS.

Five Steps to Energy Sector Stability

To achieve the priorities outlined above, Kyiv can take five steps that will help

stabilize Ukraine's energy sector. First, Ukraine should seriously and professionally

negotiate with Russia to reach new long-term agreements on gas supply and

transit. At this writing, representatives of Naftohaz and the Government of

Ukraine continue to negotiate with Russian officials and Gazprom over a future,

multi-year gas agreement and a gas price for 2009. Senior officials from the

presidentialsecretariat and the Tymoshenko government continue to use the gas

issue as a cudgelto attack each other in hopes of scoring politicalpoints. This is

not only unproductive for the country but is also damaging efforts that aim to

improve Ukraine's reputation as a serious and reliable transit country. It is not

clear from press reports whether Ukrainian representatives are pursuing a clear

negotiating strategy that is informed by expert analysis and supported by duly

experienced professionals in fields such as international business practice, law,

and finance, or are simply building on old and inefficient policies and practices.

In any case, it is hard to imagine why Russia would agree to a firm contract prior

to the upcoming, pre-term parliamentary election in Ukraine. Yet, Ukraine's

winter gas supply and Europe's gas imports depend on agreements that expire on

December 31, 2008.

Second, Ukraine needs to transform the state-owned company Naftohaz into

a functioning commercialconcern. Naftohaz dominates the Ukrainian oiland

gas industry in the style of a Soviet branch ministry, and consequently simply

hemorrhages money. The fact that Naftohaz remains dominant, despite its

consistent financial losses, reflects a conscious dual choice on the part of

successive rounds of Ukrainian legislators, cabinets, prime ministers, and

88 THE WASHINGTON QUARTERLY/ j JANUARY 2009

Edward Chow & Jonathan Elkind

presidents: first, the choice not to address the

utter insolvency of the oil and gas sector and,

second, the choice to engage in asset-stripping

and rent-seeking.

Naftohaz is on the brink of bankruptcy due

to the absence of necessary and crucialreforms

in areas like gas pricing. The company is

responsible for buying gas for the needs of

Ukraine's population, governments, and some

industry, but is unable to collect payment from

consumers in amounts sufficient to replace the consumed gas and operate the

delivery system. As a result, Naftohaz's finances have reached the breaking

point. It borrows expensively in the debt markets, paying a high premium

because of its non-transparent business practices and precarious financial

position, and uses the funds for current operations instead of capitalimprovements.

The cycle repeats until Naftohaz is declared to be on the verge of

bankruptcy, at which point the government finally steps in and bails out the

company, declaring it to be too important to fail. The government then changes

absolutely nothing in the way Naftohaz operates, and the whole corrupted

process starts over again. Naftohaz received a bailout in early 2008 as the current

government entered office but went right back to losing money hand over fist.

By summer, a new bailout was already under discussion, and by early October, a

new bailout priced at $1.7 billion was announced.7 Unfortunately, there is no

reason to believe that the pattern will not repeat itself yet again.

To end this vicious cycle, Naftohaz must be subjected to fiscal discipline. It

needs to be able to charge its customers nothing less than the actual cost of the

delivered fuel. In addition, Naftohaz and all its lenders must be informed that

there will be no further government bailouts of the company. Naftohaz's

operations must be rid of non-core functions, and inherent conflicts among the

various Naftohaz functions must be resolved once and for all. In the long run, the

essentialfunctions of energy production, transportation, and distribution will

need to be unbundled, consistent with European reform efforts, and with

creating a competitive market. In short, Naftohaz must be transformed so that it

is no longer a big black hole.

Third, RUE and other middleman firms must be removed. These firms impose

a hidden cost not only on Ukraine but also on Russian taxpayers and Gazprom

shareholders. RUE also introduces serious risks and instability into the European

gas supply chain. In late April 2008, press reports about a possible new

Ukrainian-Russian gas dealindicated that RUE was to be removed, with all

wholesale gas to be purchased by Naftohaz while independent gas traders would

serve the intermediary function between Naftohaz and end users. Depending on

In the long run,

energy production,

transportation, and

distribution need to

be unbundled.

THE WASHINGTON QUARTERLY/ j JANUARY 2009 89

European Gas and Ukrainian Reality

implementation, this arrangement could open

opportunities for new intermediary companies to

establish themselves in the same way as RUE and

others did, with all the attendant risks that are

discussed above.

Fourth, Ukraine should promote efficiency by

reforming pricing and helping consumers use less

gas. The danger in multi-tier wholesale gas pricing

is that domestically-produced gas, which is nominally

designated for public and household consumption,

may get sold on the gray market to

domestic industrialusers or export buyers who are

willing to pay European prices. These illicit sales fuel corruption and muffle the

market signalthat would otherwise promote increased domestic production and

decreased consumption. Serious pricing reform is required*/based on a sensible,

transparent, and easily understandable rate methodology that allows gas

producers or sellers to recoup their costs plus a reasonable rate of return.

Price formation will require capable and independent regulators to operate in

a publicly transparent fashion so that the interests of producers and consumers

are adequately balanced and duly protected. Price reform will mean higher prices

all across the Ukrainian economy, which means the potential for negative

impacts on the poor, namely those least able to pay higher prices. In order to

lessen the impact on the poor, Ukraine should follow the example of other

eastern and centralEuropean countries that have already undergone price

reform. Energy efficiency programs can help reduce the energy consumption of

residentialand institutionalbuil dings as a first priority. Lending programs can be

created, expanded, or strengthened to allow Ukrainian industry to borrow money

in order to invest in upgrades for plants and equipment. And targeted assistance

can be introduced to alleviate the burden on those legitimately unable to pay.

The current system unfortunately operates in the interest of well-connected gas

consumers and penalizes the poor who suffer shortages*/making reform a

necessity.

Finally, Ukraine needs to improve its investment climate for exploration and

production of hydrocarbons. If naturalresource endowments were the only

relevant factor, Ukraine would be able to produce significantly greater quantities

of oiland gas than it does today. Significant improvement to the business

climate, however, is required to attract the investment of billions of dollars

needed for serious upstream development. Ukrainian energy legislation and

regulation will need to be updated to correspond with norms found elsewhere

around the globe. The updated system will need to provide for fair access to

geologic data, transparent decisionmaking processes, longer licensing periods,

The essential

prerequisite for

change in

Ukraine's oil and

gas sector is

political will.

90 THE WASHINGTON QUARTERLY/ j JANUARY 2009

Edward Chow & Jonathan Elkind

use of model contracts, and truly competitive tenders. In other words, almost all

of today's standard practices, which are optimized for insiders and those paying

for inside access, would need to be replaced. This will take time. Meanwhile,

Ukraine will need a success story or a demonstration case that can prove the

country's new political will to encourage upstream investment.

The Key to Euro-Atlantic Aspirations

Ukraine is a country generously endowed with many assets. Its well-educated

population of 46 million, industrial and technological prowess, huge agricultural

potential, and cultural wealth all make it a natural candidate for the Euro-

Atlantic community, if that is the wish of its people. The current form of the

country's energy sector, however, needs to be seen for what it is, a major threat

to itself and to its neighbors. If Ukraine fails to modernize its energy sector

practices, the sector will continue to undermine Ukrainian politics, economy,

and energy security. Most importantly, it will threaten Europe's own energy

security.

Ukraine has the potential to change this story line. Friendly governments and

international institutions can help with capacity building for effective policy

execution, but only after the political will for energy reform is in place. Serious

energy sector reform would not only help Ukraine but would also stabilize the

economic undergirding of all European gas importing countries. In this sense,

serious energy reform would arguably be Ukraine's single most important

contribution to improve the security of the trans-Atlantic community. On the

other hand, continuing failure to engage in energy reform, when the high stakes

are so obvious to all, would be a clear signal that Ukraine is not ready to pursue

its stated desire of becoming a more integralpart of the Euro-Atlantic

community.

Notes

1. Press Office of President Viktor Yushchenko, ''Joint Address to NATO Secretary

General'', January 11, 2008, http://www.president.gov.ua/en/news/8645.html.

2. Bucharest Summit Declaration, April 3, 2008, http://www.nato.int/docu/pr/2008/p08-

049e.html.

3. Gas consumption figures drawn from the BP StatisticalReview of World Energy 2008,

available at http://www.bp.com/productlanding.do?categoryId6929&contentId704

4622. GDP figures are purchasing power parity estimates, drawn from CIA's World

Factbook, available at https://www.cia.gov/library/publications/the-world-factbook/in

dex.html.

4. To compare (in a rough manner) the price of gas delivered to a given European country

X and the price of gas delivered to Ukraine, one needs to subtract from the gas price in

country X the price of transit from Ukraine's eastern border to country X. For example,

THE WASHINGTON QUARTERLY/ j JANUARY 2009 91

European Gas and Ukrainian Reality

in January 2007 Russian gas delivered to France cost on the order of $295 per thousand

cubic meters. If one deducts gas costs of transit between Russia and France, the

comparable price in Ukraine would have been roughly $230. This is only an indicative

comparison and should not be interpreted as implying that there is a standard or an

''accepted'' gas price in Europe. Gas prices under a given contract reflect the full range of

factors from competitive gas supply to quantity of demand, and from available alternative

fuels to skill of the commercial negotiators.

5. Since Ukrainian regulators never based their rate-making calculations on the actual

price of gas (rather, they used the nominal price for their calculations) Ukrainian

customers never paid the actualrepl acement cost of the gas they consumed. This fact

allowed debt to pile up, which then provided the basis for more non-transparent deals.

6. ''Ukraine president suspends cabinet's decision to controltop state companies,'' BBC

Monitoring KievUnit, May 20, 2008.

7. Alexander Bor, ''Ukraine Orders $1.7