RUSSIA, Gas, WTO and other calamities

Gas Flame file photo

Subject: RUSSIA, Gas, WTO and other calamities
Date: Thu, 30 Sep 2021
From: Andrei Liakhov <gaffriloff@yahoo.co.uk>

RUSSIA, Gas, WTO and other calamities
By Andrei Liakhov

This is the view of the prequel to the brewing problems in the European gas markets of someone who was a part of most of the events set out below or read the underlying documents some of which I could make available for every honest journalist/researcher (Luke Harding, Arcady Ostrovsky, John Edwards, Mike McFaul and the other similar well paid people who sell their keyboards for 30 pieces of silver, please do not bother).

Introduction

No-one starts to spend money on development of a gas field unless he has secured at least an anchor buyer. This was and still is (despite an attempt to create something resembling a gas exchange) the most fundamental rule of the gas sector. Once the customer has been signed up a licensee could start developing his deposit. In parallel the licensee and the customer jointly agree on the route and mode of transport to be used.

The above is true of every gas field development story from Alaska to Turkmenistan.

Until relatively recently gas prices were set by agreement of the parties and were calculated on the basis of several factors which have very little to do with the “market”: cost of development; cost of building transportation infrastructure, cost of financing, cost of extraction, cost of transportation, level of taxation, cost of distribution to end customers, World oil prices, etc.

Inability to store gas at source (and at all until relatively recently, see below) created a unique interdependence of producers, customers and transiteurs which resulted in creation of a standard gas supply pack of documents based on mostly UK experience of developing North Sea gas assets in late 70s and the 80ies.

Every gas supply arrangement in the world until 1998 was on the principal terms developed for North Sea gas deposits.

The late Soviet Union pioneered an economics hardship clause in gas contracts which was based on the WWII English law concept of promissory estoppel pursuant to which a customer who claimed economic hardship was allowed to defer performance of his obligations until cessation of circumstances causing economic hardship. Initially it was used in 1985 in gas supply agreement with Poland. By 1990 it was also included into gas supply agreements with Bulgaria, Czechoslovakia and Hungary.

Origins of the Ukraine-Russia gas supply disputes

The first post Soviet gas supply agreement was entered into in 1992 using North Sea precedent. The price was set at $80 per 1000 c.m. from July 1993 (it was priced in roubles up to that date). At that time wholesale gas prices in Europe were fluctuating between $78 and $120 per 1000 cubic meters and were calculated by reference to the oil price (roughly by multiplier of 7, although the North Sea formula is more complicated).

Long term gas supply agreements (Ukrainian including) provide for regular (usually every 6 moths) adjustments of volumes and prices. The 1992 agreement (as well as every other up to 2009) contained an economic hardship clause.

In addition to the gas supply agreement Russia and Ukraine agreed to transport 100 billion cubic meters to Gazprom customers in Europe charging Russia $1,73 for transporting 1000 cm for every 100 km. However by July 1993 the total debt of Ukraine for gas supplied exceeded 250 billion roubles (some $8 billion at the prevailing exchange rate of the time). This caused Gazprom to switch off gas supplies to Ukraine for the first time (11 days).

Following urgent talks this debt was converted into the state debt of Ukraine to Russia (not paid yet) and supplies resumed.

Following this debacle and high level talks, a new 10 year agreement was signed in 1994 and given Ukraine’s financial situation allowed payment to be made in barter.

Roughly at the same time Ukraine created Naftogaz in the form known today. However this did not solve non payment problem which became chronic. The next stoppage of gas supplies happened in February 1994 (4 days) and was the result of the unauthorised taking of gas from the pipleline (a PC definition of theft) and Ukraine’s refusal to compensate Gazprom for the fines it had to pay its European customers. After long and protracted negotiations the accrued debt was restructured as Ukraine’s sovereign debt and converted into a 12 year bond. In addition Gazprom has agreed to enter into direct contracts with end customers rather than Naftogaz. This however has not solved the debt collection problem and by the end of 1997 United Energy Systems of Ukraine owed Gazprom some $450 million (not paid yet and written off in 2004). At the same time Gazprom gas has been stolen at the rate of some 660 million c.m. pcm.

Following high level informal talks both parties appointed in effect debt collection agents (Itera, UralTransgas, RosUkrEnergo, etc) who changed regularly and were widely reported to be the source of high income both for top politicians in Ukraine, gas managers in both countries and selective foreign traders. (It is said that each Ukrainian President profits personally from gas transit and supplies which, if true, could explain all recent hysterics surrounding Nord Stream and gas supplies to Ukraine).

By 1997 Gazprom was supplying Ukraine gas at $50 ptcm which was lower than prices in Europe and allowed Ukrainian business customers to maintain competitive edge (metallurgical and chemical industries were Gazprom’s largest customers by volume).

Amid allegations of theft of gas President Kuchma admitted in an interview to Spiegel magazine in 2000 that Ukraine was stealing some 1 billion cm of gas per annum.

Here comes the WTO.

Russia was negotiating membership in WTO since 1994. The negotiations were lead by German Gref who admitted that he wanted to be the first to make Russia join an international organization (which it did not do since 1970). The White Paper received by the Ministry of Fuel and Energy in 1997 made sales of gas “at market prices” a conditione sine qua non for Russia’s membership of the WTO.

If accepted it would have marked the end to Gazprom cozy relationship with its Ukrainian customers. Gazprom management understood perfectly well the fallout of that move and resisted for a very long time to levelling off of its prices for its FSU customers. After a long and rather hostile negotiations between the Gref lead WTO negotiation team and Gazprom, the latter finally succumbed and in March 2003 has sent letters to its FSU customers notifying them of the move to new price formation mechanisms from Q3 2003 (save for Belarus which for this purpose was considered as part of Russo-Belarus Union). However, following a three party negotiations, a 5 year transition period was agreed in August 2004 during which the price was fixed at $50 ptcm. As usual the other terms followed the North Sea precedent.

Need to cut losses and satisfy investors and auditors

Gazprom started to be actively present on international capital markets at the end of the 90s. Questions about Ukraine’s indebtedness and theft of gas featured on every investor call. It was increasingly difficult to justify continuation of preferential gas supply terms to Ukraine to Gazprom international investors and debt providers. Gazprom auditors also had difficulties reporting and explaining the rationale of maintaining such preferential arrangements given chronic non payment and theft.

Despite such preferential terms Ukraine continued to default on its payments and steal gas. That resulted in two more interruptions of supply in 2006 and 2008. In combination with the earlier interruptions and the apparent absence of any desire by Naftogas to honor its obligations Russia has taken a difficult decision to build pipelines bypassing Ukraine. The first, transiting through Poland, was commissioned in 1999. This decision has barely registered on media and political horizon. After Bulgaria blocked South stream after long and focussed lobbying by the US and the EU Gazprom in a record time has built Turkish stream. Neither investors nor EU or the US have raised any concerns of note to this project.

EU gas market and introduction of spot volumes.

The EC/EU has started its quest to create a pan European gas market in 1998. It culminated adoption of the 3 Energy Package in 2009. The aim of its unbundling provisions was, at the first glance, noble: to allow consumers to chose suppliers and routes of supply. At the same time a system of underground storage of immediately available gas became available to be used by independent traders. However, in reality it resulted in higher energy bills as independent traders with no own production were only re-selling gas purchased from either Qatar, North Sea, Groningen, Russia, Norway or (in much smaller volumes, US). Producers having spent billions of dollars on extraction and delivery infrastructure (either gas tankers or pipelines) have suffered substantial losses having to sell off its transportation and distribution divisions in a hurry. In addition they have lost certainty of supply which inevitably pushed prices up. Furthermore, they have used increased priced to rack up prices in their long term supply contracts (which are not prohibited by the 3D Energy Package).

Often never heard of before level of green tariffs and the drive to limit hydrocarbon fuel consumption also pushed gas consumption and prices up as many EU countries sought to exclude coal from their energy generation chains.

A lot is said about (and the EU has based its gas regulation largely in reliance on massive gas storage facilities) gas storage facilities in Europe which are portrayed as the main device to ensure stable and diversified supplies. At the same time it is conveniently forgotten that most of gas stored in such facilities is used to cover spikes in demand during high season (November to April) as no producer could immediately increase supplies to the required level during spike periods.

However, whilst long term contracts remained by far the largest source of gas supplies to the EU, the newly acquired ability of independent traders to independently contract relatively modest volumes of gas (primarily Qatar and US (aka Russian contracted by the US and re-routed to, say Biutiunge terminal in Lithuania) LPG) allowed the EU to claim that a gas market was created in the EU. Which of course is partly true. Physical nature of gas coupled with very modest consumer storage facilities, make existence of real gas market (combining spot, forward, future and gas derivative instruments) literally impossible.

However, in the usual stance of self delusion and self denial the EU collectively decided not to increase volumes of gas ordered pursuant to long term contracts in line with the increase in demand in a vain hope that the balance of demand will be filled in by “market gas”.

However, ignorance of the restrictions of the market like gas trading platform created by the EU has resulted in its inability to quickly plug the holes during peak demand periods.
EU planners also managed to totally ignore the basic fact that every producer cannot instantaneously increase supply volumes and needs some substantial lead time.

North Sea, Troll and Groningen

For many years North Sea and giant Groningen were the principal suppliers of gas to Europe. By 2021 gas reserves at giant Troll field in Norway fell to 50%, giant, bit fully depleted Groningen field is being decommissioned and UK production of gas from the North Sea fell to a record low of 1.6 million of barrel of oil equivalent. New exploration has virtually ceased with only 7 new exploration wells drilled in 2020. The UK has long time ago became net importer of gas with only 44% of its demand being satisfied by its North Sea deposits.

However the EU in vain hope of substituting gas by “green” energy has failed to secure additional volumes and relied on the market to plug in the hole if and when there is a need for additional volumes. However, the collective EU mind has totally forgot that market will sell to the highest bidder. And all highest bidders are in Asia.

2009 and modern woes.

Gazprom and Nafrogas met 2009 in a teleconference conducted from gas pumping station at Sudzha, on the Ukrainian-Russian border. EU was represented by the then Energy Commissioner Andris Piebalts. Unknown to Nafrogas, Gazprom and its Slovakian customers have been measuring theft from the transit pipe for over 7 months. Naftogas representative was asked to sign the protocol detailing, inter alia stolen volumes.

After some pressure Naftogas has quite nervously stated that “Ukraine stole, is stealing and will continue to steal gas”. This was the turning point and the last drop in the decision to commence construction of Nord stream pipelines.

The other two, perhaps more important reasons were anticipated increase of European gas consumption to over 500 billion cubic meters by 2050 and crumbling Ukrainian gas transportation system which even then required almost $3 billion worth of repairs to maintain its full throughput capacity of 195 billion cubic meters per annum. Gazprom and its German partners have by that time made several offers to Naftogas to invest into restoration of the UTS in exchange for a share of its ownership (show me an investor who would invest large amounts with no control or guarantee of proper use), which offers were “proudly” refused by Naftogas.

With the background of the end of the WTO transitional period which resulted in Gazprom being obliged to sell gas to Ukraine at the prices similar to those offered to its European customers ($232 per tcm) and mounting Ukrainian gas debts construction of pipelines bypassing Ukraine and capable of satisfying growing demand for gas in Europe became a necessity.

It must also be noted here that Gazprom rejected calls to commence design and construction work on what later became known as NS/NS-2 for quite some time.

HOWEVER, the 2009 contract had no economic hardship clause. This was taken out on the insistence of the then Ukrainian Prime Minster Timoshenko. It was later reinstated in the course of Naftogas claim against Gazprom which allowed the arbitrage to set off Nafrogas and Gazprom claims against each other and award the difference to Naftogas.

Strangely enough the allegation that Mrs.Timoshenko had no right to insist on exclusion of the economic hardship clause from the 2009 contract was not on her indictment list.

At the same time Gazprom has insisted on exclusion of all and any “intermediaries/collection agents” from Gazprom/Nafrogas relationship.

This deprived a lot of people from a lot of money. And it was the main reason (irrespective of how it was dressed up and sold to the world and Ukrainians) for Ukraine’s refusal to buy gas directly from Gazprom. To maintain the cashflow in the “right” direction several traders were set/bought/reached agreements with for a very simple exercise of formal purchase of gas from such companies. These traders are of course buying gas either from Gazprom directly or from Gazprom clients in Europe. The margin thus continues to flow in the right direction. And! The EU and Ukrainians could report that Ukraine has become an integral part of the European gas market. It does not bother anyone that purchase prices were several times higher than set by either 2009 and/or 2010 Naftogaz-Gazprom gas supply contracts.

Current Nagftogaz war cry could be boiled down to one sentence “we are the only reliable transiteur”. It does not bother them that their tariffs are the highest in Europe, that their pipeline system is close to the end of its natural life and is incapable of operating at full capacity, that its operation is not properly managed (it “leaks” and periodically blows up where collection pipes were incorrectly welded into the trunk system).

As long as the EU will ignore rules of natural science and market forces, live in a dreamworld which has very little in common with reality and refuse to admit the obvious Russia and Putin will “give English people permission to prepare morning coffee” (today’s Sky news) and held responsible for low grades of French schoolchildren (TF1 in August).

A clumsy attempt spearheaded by Ukraine to put the blame on Russia for the current crisis is falling apart at a cursory read of the true story of the EU gas market which is a story of a fight with itself. However, in the world run by Twitter, headlines sell, non one reads below the first three lines – hence Russia is responsible for everything!

Amen!

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