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    Naftogaz and Gazprom: accomplices in conflict? [GGP]

Summary

The high-stakes arbitration case opposing Naftogaz and Gazprom was never going to be straightforward like a boxing match. Sure, there are two opponents, high stakes, and judges whose decision is supposed to be final.

by: Michael Grossmann

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Complimentary, Global Gas Perspectives

Naftogaz and Gazprom: accomplices in conflict? [GGP]

The high-stakes arbitration case opposing Naftogaz and Gazprom was never going to be straightforward like a boxing match. Sure, there are two opponents, high stakes, and judges whose decision is supposed to be final. The Arbitral Tribunal of Stockholm designated a winner of sorts at each of the cases it reviewed. However, the analogies stop there. The Tribunal rendered awards on several separate cases:
•    Gazprom’s claim against Naftogaz in regards of the volumes that Naftogaz ought to purchase from Gazprom as part of its take-or-pay obligations under the same 2009 contract between Gazprom and the government of Ukraine, represented by Prime Minister Yulia Timoshenko. Gazprom’s extended claim was rejected twice by the Tribunal, but it did set a threshold of about 4bn m3/yr that Naftogaz ought to have purchased over the contract period, resulting in a ~$2bn award in Gazprom’s favour on December 21, 2017 for this case;
•    Naftogaz’s and Gazprom claims and counterclaims in regards of the volumes that Gazprom ought to transit through Ukraine. Naftogaz came out ahead on the transit question, with a net award of $4.6bn in its favour on February 28, 2018;

Adding up the awards, Naftogaz won a net award of $2.56bn. Unfortunately for Ukraine, this is not the end of the story for two reasons. Gazprom decided not to pay the award and contested the Tribunal’s award and on June 13, 2018, a Swedish appeals court ruled the suspension of the February 2018 award. If the Yukos case of opposing the oil company’s former majority shareholders and the Russian Federation is any guide, the legal battle may drag on for more than a decade and yield no payments for anyone in the end, except for lawyers and arbitrators.

Naftogaz, predictably, is seeking to seize Gazprom-linked assets in various jurisdictions in Europe and the US. More controversially, Naftogaz has also tried to revisit its transit tariff upwards, arguing that this is justified by the possibility that Gazprom would stop transiting gas through Ukraine in 2020. The argument runs as follows: since there is a limited amount of time left for transit through Ukraine, the assets it mobilises must be amortised at an accelerated rate. Applying the regulated asset based methodology, this mechanically leads to increased GTS usage fees, including transit fees. The additional fees claimed by Naftogaz against Gazprom amount to $12.5bn if transit is terminated early, or $2bn if transit continues. This tactic was attempted at the end of 2015, when these same assets were supposed to be amortised over four years. At the time, this would have led to a 50% hike in the tariff. In theory, the tariff increase would have applied to all users of the system but in practice, it was aimed at Gazprom. In practice, the accelerated depreciation tariff applied neither to Gazprom nor to Ukrainian users, and there is no reason it will this time around either. Trying to raise the transit tariffs and piling additional claims against Gazprom contradicts Naftogaz’s claim that the Ukraine route for Russian gas is competitive, but then this competitiveness is explicitly linked to transit volume expectations .

The EC is trying to facilitate an agreement between Gazprom and Naftogaz. Tripartite meetings have been held under the aegis of the EC. The latest one was held in Brussels on January 21 with Ukraine represented by Naftogaz and Gazprom. It lasted 40 minutes and yielded nothing. Gazprom clearly is in no hurry to reach an agreement by the end of April 2019, when the world will know which government will be in charge of Ukraine.

While the clock is ticking, Gazprom is advancing its gas pawns towards Europe. Nord Stream 2 is being built regardless of warnings about increased dependence on Russian gas. If completed, it will double the original Nord Stream’s yearly capacity of 55bn m3/yr from the Russian Baltic Sea to Germany. Turkstream, which links Russia’s Black Sea to European Turkey, will bring 31.5bn m3/yr capacity in two lines.

The first line would decrease the amount of gas transit through Ukraine to Romania and Bulgaria. The second line could, with approval from the EU, deliver Russian gas to Bulgaria without passing through Ukraine. The project would also compete with the Tanap/TAP pipelines via the projected Interconnect Greece-Bulgaria. All in all, with both projects, Gazprom estimates that transit through Ukraine could be maintained at 10-15bn m3/yr / year, down from 93bn m3 in 2017.

Naftogaz, which in effect controls Ukraine’s gas TSO, is now facing increasing pressure from the EC and its expert agency the Energy Community Secretariat to make headway with the unbundling of its gas transmission assets. The gas holding company claims it agrees with unbundling in principle, but it has repeatedly raised objections on how it should be implemented.

It has also stated that Gazprom objects to unbundling, or that the arbitration Tribunal does not allow it.  The award of the Tribunal on the transit case is not meant to be public. To its credit, Naftogaz chose to disclose most of the award documents. Thus, we know that the award in effect recommends unbundling.  Whatever the reason invoked, the longer unbundling is postponed, the longer Naftogaz can reap dwindling profits from transit; net profits from transit stood at $1.54bn in 2017.  What is optimal for Naftogaz now may not be in the long-term interests of Ukraine’s gas midstream.

Unbundling the gas TSO would bring advantages of its own in terms of supply competition to Ukraine; it would also enhance the investment attractiveness of its assets for foreign TSO partners.

However, the elephant in the room is the cost of not initiating a convincing, full ownership unbundling process before the end of 2019. As things stand, a system with a nameplate transit capacity of 110bn m3/yr risks being used at a tenth of its capacity, or not at all if all the pipelines Gazprom plans are built and used at capacity. Linking the TSO’s unbundling in Ukraine to international gas disputes dims the prospects of a long-term agreement on transit by the end of 2019. This, in turn buys Gazprom time: the absence of a deal on transit through Ukraine reinforces its argument that NS2 and the Turkstream lines are needed to supply Europe with gas.

Michael Grossmann

Michael Grossmann is a director of Tumbleweed Consulting

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