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Ukraine Should Insist on a Viable Gas Agreement with Russia



Russia's state-dominated natural gas company Gazprom is again threatening to cut off its supply to Ukraine and thus to some of its European customers that receive gas transited through Ukraine. These dramas have been repeated often since Ukraine became independent in 1991. Ukraine's newly elected President Petro Poroshenko needs to put down his foot and clean up this corrupt and dysfunctional relationship.

At the face of it, the positions are clear and understandable. Gazprom is demanding $385 per 1,000 cubic meters (m3), payment of all Ukrainian arrears, and maintenance of the Russian–Ukrainian gas agreement of January 2009. Ukraine has rejected that price as too high and wants a price of $268 per m3, while promising to pay all arrears at that price. Ukraine also wants to cancel the agreement of January 2009, which was imposed on the country through a Russian cut of gas supplies in the middle of a very cold winter.

Prices can always be negotiated, but Ukraine is right to demand cancellation of the flawed January 2009 agreement. Parts of the agreement were supposed to last for ten years, notably the indexed gas price formula and Ukraine's fixed import volumes, while Russia's price concessions were limited to one year. On the other hand, the transit tariff through Ukraine's pipeline to Europe was fixed, and Russia made no commitment about transit volumes, which are dwindling.

Ukraine needs to revoke this agreement for many reasons. First, the gas price formula is unfavorable, and Russia's pricing is blatantly political. At present, Gazprom charges Belarus $167 per m3. In the first quarter of 2014, when President Viktor Yanukovych was still in power, Gazprom demanded $268 per m3 from Ukraine, but within the first three days of April it raised the price first to $385 per m3 and then to $485 per m3. Now Gazprom is offering to reduce it to $385 per m3. But the Russian government can hike the price again at any time.

The market price in this region, which has abundant potential natural gas from alternative suppliers, is presumed to be around $300 per m3. In addition, in recent years prices of natural gas have fallen worldwide. The Russian price formula indexes the price of natural gas to oil, but on the market gas prices have plunged relative to oil. Ukraine should not accept such a pricing principle, which the European Commission is about to prohibit as anticompetitive. Instead, Ukraine should opt for annual price agreements, consistent with actual practice in the marketplace.

In the 2009 agreement, moreover, Ukraine committed itself to purchase far larger volumes than it actually needed, and energy savings have reduced its consumption substantially in recent years. These large volumes were reinforced with a "take-or-pay" clause, compelling Ukraine to pay even if it did not need such large volumes. This is another stipulation that the European Commission intends to prohibit as anticompetitive. In the last two years, Gazprom has lost numerous anticompetition cases in the Stockholm Arbitration Court, and has been forced to return several billions of dollars to purchasers. Ukraine should opt for much greater energy efficiency and more domestic production of gas, which could render the country self-sufficient within half a decade.

Finally, the 2009 agreement also proscribes Ukrainian reexports of natural gas from Russia, which is also against EU policy. Any country should be allowed to trade gas that it has bought freely.

In 2011, Ukraine acceded to the EU Energy Community, which sets clear market-oriented rules for energy trade that Russia and Gazprom oppose. The European Union is now imposing its principles for the gas market, and is set to level the largest fine ever on Gazprom because of its anticompetitive practices.

For all these reasons, this is the right time for Ukraine to fully implement the EU market principles for its relations with Gazprom. The summer season sharply reduces Ukraine's need for gas, and the country has sufficient volumes of gas stored until September. Ukraine has a new president and government, which are prepared to break with the old corrupt gas trade with Russia. Given Russia's military aggression, Ukraine has little to lose by standing by its principles, and the West understands who the culprit is.

Commercially, Ukraine holds a far stronger hand than Gazprom, because even at the lower price Gazprom makes a sound profit on Ukrainian sales. Ukraine is effectively a monopsonist, since Gazprom cannot sell this gas to anybody else but has to keep it in the ground. Gazprom's share of stagnant EU gas imports has fallen from 37 percent in 2002 to 25 percent in 2012 because of its poor commercial skills. Ukraine, by contrast, can purchase gas at a reasonable price on the European market, and it is set to develop conventional and shale gas production. Since Russia is quickly eliminating its gas transit through Ukraine in any case, that factor might be ignored.

Sensibly, Ukraine's Prime Minister Arseniy Yatsenyuk has taken a firm stand: The old agreement must be cancelled, and Russia should offer a reasonable price that is contractual and not "concessionary," allowing Russia to raise it at any time, as happened twice in early April. Otherwise, Ukraine will take Gazprom to the Arbitration Court in Stockholm.

At present, Russia and Ukraine are pursuing negotiations nightly with mediation from EU Commissioner Gunther Oettinger. The latest round of negotiations ended at 2 am on Monday, June 16, as usual without agreement. Meanwhile Alexei Pushkov, the hardline chairman of the State Duma Committee on Foreign Affairs, is calling for a gas boycott of Ukraine for political reasons. The West must not pressure Ukraine to accept any half-baked compromise but support its government in its attempts to reach a viable solution, which starts with the revocation of the flawed 2009 agreement.

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