January 2009 Gas Shutoff to Europe

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“Who Shut Off the Gas to Europe in January 2009 and Why It Matters”
7/3/2009 NEW ISSUE OU
Author : Sergei Komlev The twelfth editio
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Sergei Komlev, Head of Contract Structuring and Price Formation, Gazprom Export and Daniel issues include Se
Satinsky, Esq., President, B.E.A. Associates, Inc. World and Sustai

In the aftermath of the Russia – Ukraine conflict over gas shipments in January 2009, a certain
understanding of these events has become entrenched “conventional wisdom” in European and
American public opinion that as a result of an unresolved commercial dispute with Ukraine, Gazprom THINK TANK EUR
shut off gas to its European customers. The facts show otherwise.

What actually transpired is that Ukraine was unwilling to accept a decrease in the size of the price
subsidy it has been receiving and a gradual transition to market-based pricing for natural gas. As a
negotiating tactic, Ukraine shut off Gazprom transit flows to Europe and converted the pipeline
system to serve its domestic market. The aim of this tactic was to put political pressure on Russia
and Gazprom and to maintain subsidized gas flows for the domestic Ukrainian economy.

Western media and analysts have not taken account of critical facts from this crisis and thus have
created a distorted view of the conflict.

Legacy Structure of Ukrainian – Russian Gas Relations

In the natural gas sphere, Russia and Ukraine are tied together through their joint history as part of
the Soviet Union and the unified energy and industrial complex created by the Soviet Union. Soviet
industrial development of Ukraine was predicated on supplies of cheap natural gas from other parts
of the Soviet Union. Gas was priced according to political priorities for industrial development, not
by market considerations. Meanwhile export sales of natural gas at market price became an
important source of foreign exchange earnings and Ukraine became the primary transport route to
European customers.

With the dissolution of the Soviet Union, Ukraine became the owner of the export pipeline system,
but became separated from the cheap natural gas upon which its industry depended. As an
independent country, Ukraine now transits 80% of Russia’s gas sales to Europe. It is also Russia’s
largest single export customer, purchasing roughly 40 Bcm per year.



In the aftermath of the breakup of the Soviet Union, Gazprom evolved into a market-oriented
company operating on the basis of common international business norms, i.e. purchase and sale of
gas under contracts based on market prices and transit arrangements on a contract basis, with cash
payments. As part of this transformation, Gazprom has moved away from the
political/administrative pricing and supply relationships with countries of the former Soviet Union.
This has meant separating the transit and supply functions and having each governed by market-
based contracts.

The real long-term cause of the dispute between Ukraine and Russia has been Ukrainian resistance
to transition to full market relations for gas transit and gas sales.

Market Transition

The first step in the transition to market relations between Russia and Ukraine was to separate the
transit functions from the domestic supply functions in gas relations. In 2002, the national gas
companies of both countries, Gazprom and Naftogaz, signed a transit contract that went into effect
on January 1, 2003, governing the volumes and conditions for transit of Russian gas through
Ukraine from 2003 to 2010.

This contract introduced a transit fee structure and a mechanism for amending this transit fee
through negotiations between the parties and for arbitration in Stockholm in the event of disputes.
Although gas in kind substituted for transit payments in cash until 2006, the 2002 contract was a
giant step forward in developing normal commercial relations between Ukraine and Russia.

Ukrainian Domestic Gas Supply

Given the economic crisis after the dissolution of the Soviet Union, the legacy fees for gas were
either not paid at all or were paid using barter. This combination subsidized Ukrainian consumers
and industry through relatively low-priced gas and provided enormous opportunities for private
profit-taking through the complicated, non-market mechanisms at work.

For the period between 2006 and 2008 alone, Ukraine received the equivalent of $30.3 billion
dollars in subsidies through discounted prices, calculated as the difference between the price
charged and the prevailing market price for the same period. By comparison, this subsidy amounted
to as much as 45 times more than the total of European Union aid to Ukraine after 2005.

By 2005, Gazprom had moved away from Soviet-era business practices and was establishing
Western-style system of sales and purchase agreements using market prices, formulas and cash
payments with all of its partners from the former Soviet Union. All of the countries of the former
Soviet Union had either agreed with Gazprom both on the necessity of moving in this direction and
on an algorithm of gradual gas price increases to European levels. Those that did not agree opted
out of the Gazprom system. Ukraine remained the only country of the former Soviet Union that
resisted any change in the pricing mechanism and refused to even discuss the issue with Gazprom.

This conflict resulted in the first gas conflict. When no agreement could be reached by Dec. 31,
2005, Gazprom shut off gas flows for Ukrainian domestic supply on Jan. 1, 2006. This dispute was
settled after a short 3-day interruption, but did not bring a complete solution to the underlying
problems. As part of the overall settlement, Gazprom agreed to pay transit fees in cash only.
However, market pricing for gas shipments for the Ukrainian domestic market remained an open
question. There was a compromise solution in which discounted natural gas was supplied to the
domestic market in Ukraine through a complicated network of intermediaries.

Breakdown of Negotiations Prior to the January 2009 Gas Crisis

As Ukraine and Russia approached the necessity of new agreements that were to begin on Jan. 1,
2009, Russia continued to push for market-based relationship with Ukraine for both transit to
Europe and for sales of gas for Ukrainian domestic consumption. Gazprom’s goal was to establish a
transition to market priced contracts for gas sales for the Ukrainian domestic market, after an
agreed upon period of time.

This objective was close to being achieved as Russian Prime Minister Putin and Ukrainian Prime
Minister Timoshenko met in October 2008 to outline terms for a new Intergovernmental Agreement.
The points of agreement realized from these negotiations were memorialized in an Oct. 24, 2008,
memorandum “On the Principles of Long-term Cooperation in the Gas Sector,” which was later
signed by the CEOs of both Gazprom and Naftogaz. The agreement included the principle of moving
to market prices and direct sales from Gazprom to Naftogaz.

As negotiations for a gas supply purchase agreement proceeded, Naftogaz rejected Gazprom’s offer
of $250 dollars per 1000 m3 proposed for 2009. Naftogaz refused to budge from its proposal of
$200 dollars per 1000 m3. It is important to note that market prices for natural gas were close to
$500 dollars per 1000 m3 in December 2008, so Gazprom was still proposing less than full market


price.

The $50 dollar difference between the price offered by Gazprom and the price that Ukraine insisted
upon translates to a $2 billion dollar subsidy for a 40 Bcm supply contract. This was a subsidy that
Ukraine was determined to keep.

The Ukrainian side had no commercial basis for insisting on such discounted prices for gas. The only
conceivable basis was to demand that the Russian government, as the majority shareholder in
Gazprom, should make a political decision to continue to subsidize Ukraine. The Russian government
was unwilling to continue the level of subsidy demanded by Ukraine and insisted on a process that
would move towards commercial relations and market-based prices.

As a result of the breakdown of negotiations, Gazprom decided not continue to supply the Ukrainian
domestic market after Dec. 31, 2008 without a contract and agreed-upon price. The shutoff of gas
to the Ukrainian domestic market has nothing to do legally with Ukraine’s obligations under the
transit contract to transport gas to European customers, which was still in force at this time.

Transit as Leverage

When price negotiations for Ukrainian domestic supply broke down, Naftogaz chose to use its near
monopoly position for transit of Russian gas to Europe as its ultimate negotiating leverage. It made
clear that it was willing to halt Russian transit to Europe as its major bargaining chip.

The groundwork for this tactic was set in a letter to Gazprom dated Dec. 30, 2008, in which
Naftogaz warned that without a new technical agreement addendum to the existing transit
agreement, it would not be obligated to continue gas transit, even though the transit contract did
not expire until 2013.

Following an application from the Ukrainian Energy Ministry for an expedited hearing on Jan. 5,
2009, the Kiev arbitration court ruled in favor of the Ukrainian Energy Ministry and ordered Naftogaz
to immediately stop providing transit services to Gazprom under the 2002 transit contract, ignoring
the international arbitration clause in the transit contract.

Even before the action of the Kiev arbitration court, Naftogaz already began a process of reducing
the approved amounts of gas that it was shipping to European customers. As shown by the chart
below from the two major gas metering stations of Uzhgorod and Orlovka (all numbers in million
cubic meters), Naftogaz began to decrease shipments to Europe on January 2. The transit of gas is
based on, and requires, a preliminary confirmation by Naftogaz of Gazprom’s request for
transmission of the next day’s volumes. Gazprom can only supply as much gas for transit as is
approved by Naftogaz. By reducing the approved volumes, as shown in the chart below, Naftogaz
increasingly pressured Gazprom by reducing the amounts shipped to Gazprom’s European
customers.
The Western media either misunderstood or
misrepresented that Gazprom shut off shipments
of gas through Ukraine in retaliation for alleged
gas theft. In fact, something more profound was
being undertaken by Ukraine that led to
Gazprom’s decision to shut down supplies.
Although Naftogaz was diverting gas for its own
purposes, this was not the main reason why
Gazprom ultimately shut off supplies to Ukraine
or better to say, was forced to do so. The real
cause of the Gazprom shut down was the fact
that Naftogaz was already refusing to allow
transit to Europe and had already cut off supplies
to European markets before Gazprom’s decision.
To understand this key point, it is necessary to
examine the sequence of events that occurred on
Jan. 6 and 7.

What Happened on Jan. 6 and January 7,
2009?

On Jan. 6, Ukraine made good on its threat to shut down Russian gas supplies to Europe initiated in
the Dec. 30 letter and later authorized by the Kiev arbitration court. On Jan. 6, Naftogaz completely
halted supplies to the Balkans, Slovakia, Turkey, Romania and Hungary. Gazprom was unable to
ship gas to Europe because Ukraine shut off all the major transit points on its western border. Gas
for Europe was entering Ukraine from the east, but not exiting on the west. After extensive
negotiations with Naftogaz on January 7 failed to re-open transit, Gazprom was forced to stop all
shipments for European customers


Naftogaz took this dramatic step of cutting off exports to Europe for two reasons. First, it exerted
maximum pressure on Russia, with the expectation of political support from the European Union.
Second, it allowed Naftogaz to service its own domestic energy requirements.

It is clear from what happened next that Ukraine had prepared for and planned this step in advance.
Ukraine accumulated huge reserves of gas in its underground storage facilities in the western part of
Ukraine and then simply reversed the flow of gas in the pipeline system to service its domestic
market in the eastern part of the country.

Reversing the flow of gas in the pipeline is a challenging engineering and technical task that could
not have been accomplished so quickly without advance preparation and conscious stockpiling of
gas supplies in storage reservoirs. Clearly, the Ukrainians were prepared in advance to use this
drastic measure as part of their negotiating position with Gazprom.

This state of affairs continued until new ten-year transit and supply contracts were signed on
January 19 and supplies were restored on January 20.

Does It Matter Who Was At Fault?

In sum, the events outlined above depict a different series of interactions between Russia and
Ukraine than Western media have led people to believe. While the European Union did not officially
blame Russia alone for this crisis, it failed to examine carefully what actually happened. Thus
Ukraine was able to hold southeast Europe hostage to its desire to maintain subsidized gas prices,
without any blame from the EU. In the process, Gazprom’s unbroken record as a reliable supplier of
gas to Western Europe, even through the various crises of the Cold War, was ruined and the
reputation of Gazprom as a reliable supplier has been under question.

Looking at the course of events, it was Ukraine and Naftogaz, not Russia and Gazprom, who
escalated a commercial dispute and negotiation into a gas stoppage. For the ordinary people who
suffered in the cold, it matters little who was at fault. What they know is that the gas stopped and
they had no means of heating their homes and offices. Given the way the crisis was covered in the
media, most seem to blame Gazprom.

This inaccurate understanding of the crisis is not sufficient for political leaders who have the
responsibility of solving problems and of guaranteeing European energy security. If one has the
wrong diagnosis of the problem, then one will choose the wrong solution.

Russia and Gazprom clearly prefer to have natural gas relations governed by normal commercial
contracts and to promote the security of gas supplies through multilateral cooperation. They look to
their European partners to show balance in searching for effective means to prevent any future
disruption. A de-politicized solution of European energy security would be advantageous to both
European consumers and to Gazprom as a major supplier of gas to Europe.

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