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Natural gas dilemma in Ukraine

Ukraine may soon face severe gas shortages due to a possible rise in prices for natural gas imported from the Russian Federation and Turkmenistan.

The Russian gas monopoly “Gazprom” is considering raising prices for Ukraine three-fold to 170-180 dollars per 1000 cubic meters in contrast to the current price of 50 dollars per 1000 cubic meters. Turkmenistan is also considering raising the natural gas price for Ukraine. Turkmenistan is discontented with the current level of payments and wants Kiyiv [Ukraine] to pay full price for imported gas. After the last visit of Ukrainian Prime Minister Jurij Jehanurov there were even rumours that Ashgabat, the biggest supplier of natural gas to Ukraine (50%), will stop gas supplies to Ukraine in 2006.

The simultaneous price hikes by Russia and Ashgabat allow us to conclude that their actions are fully or partly coordinated. The situation is aggravated by a bilateral agreement between Gazprom and Uzbekistan signed in late September about the use of the transit capacities of Uzbek gas pipelines (50 billion m3 of natural gas per year). The agreement means that Ukraine is fully cut off from the Turkmenistan natural gas supply. Gazprom and the Kremlin can celebrate their triumph over Ukraine.

Gas negotiations between Russia and Ukraine

Let us analyse the situation. Russia, as the biggest supplier of natural gas to Europe, is as dependent on Ukraine as Ukraine is on Russia. According to the long-term agreement between Russia and Ukraine, until 2013 Russia will transport about 130 billion m3 of natural gas via the Ukrainian gas transport system. In exchange, Ukraine gets about 24 billion m3 of natural gas. Experts say that Russian Federation will be reliant on Ukrainian gas pipelines for 20 years. Even if the North-European gas pipeline is built, Ukraine will have a monopoly on Russian gas supplies to EU because of growing gas demand in Europe.

Since 2000, Russia and Ukraine have been negotiating the terms and conditions of a joint gas transport consortium for operating the Ukrainian gas pipelines. The Russians insisted the consortium was necessary to guarantee Russian gas supplies to Ukraine. Ukraine had only one objection to the proposal – it wanted to involve Germany and other big European consumers of Russian natural gas in the consortium. The Ukrainian proposition was logical since the gas consortium would have a three-party structure: the supplier of gas (Russian Federation), the transport party (Ukraine) and the consumer (the EU). However, Gazprom objected since this proposal would decrease its control over the Ukrainian gas pipelines. The presence of the German gas company “Ruhrgas” and other European consumers of natural gas (France and the UK) would be a guarantee of the energy sovereignty of Ukraine over the world’s second-largest gas transport facilities.

The real problem of Ukrainian energy policy - addiction to cheap natural gas

But this fuss about a possible rise in gas prices diverts attention from the major problem of Ukrainian energy policy. Since 1991 when Ukraine declared its independence, it did nothing to cut its gas consumption. Moreover, the energy capacity of Ukrainian production per unit of GDP has more than doubled since independence. Ukraine is the fifth-largest consumer of natural gas after the USA, Japan, Russia and Germany. These are absolute figures. However the GDP of those countries is ten times larger than that of the Ukrainian. Thus, in real terms (in a calculation of 1000 m3 for 1000 dollars), Ukraine is the biggest consumer of natural gas in the world. The low price of imported gas from Russia actually costs a lot for Ukrainian economy. Almost 15 years have passed, but Ukrainian authorities have done nothing to slow the pace of this catastrophe, i.e. the volume of gas consumed by Ukraine.

Ukraine’s gas addiction is appalling. The government should do everything possible to cure the Ukrainian gas addiction; it should not reduce the price of this "drug." The former government tried to do something – it dismissed a committee for energy conservation. That action, of course, was a sheer absurdity.

The negative consequences of cheap natural gas

Today Ukraine, as always, tries to maintain the status quo, directing its efforts at asserting its position in the gas market. However, the cheapness of natural gas has several negative consequences for Ukrainian economy:

First, Ukraine subsidizes energy-wasting industries. Large amounts of gas consumption in Ukraine are a legacy of the energy-wasting economy of Soviet Union. Although one Soviet leader, Leonid Brezhnev, said that the “economy should be economical,” all the heavy industries that dominated the Soviet economy were energy wasting. This was not surprising since gas and oil were very abundant and cheap. Since the collapse of the Soviet Union in 1991, Ukraine has done literally nothing to stop guzzling cheap natural gas. By keeping the price of gas low, the Ukrainian government has actually stimulated energy-wasting industries, such as steel production, heavy machinery and the chemical industry. These industries also severely harm the environment.

The second consequence of cheap natural gas concerns investment priorities. A low price in natural gas gives investors incentives to pour funds not into IT or knowledge-based industries, but into those based on raw materials with low added value. The problem is similar to that of countries rich in energy sources like Saudi Arabi). These countries invest dividends from the oil and gas windfall into gas and oil extraction, neglecting other industries.

The only difference between Ukraine and those countries is that Ukraine doesn’t exploit its natural resources, but rather its geographical position. However, with the advent of new energy technologies such as LNG, the geographical position of Ukraine will no longer be a competitive advantage.

The third consequence of inexpensive gas involves market status. The Ukrainian state company “Naftogaz Ukrajiny” gives huge subsidies to metallurgy and chemical industries. Thus it gives foreigners a justification for trade barriers since production in these industries is subsidized by artificially cheap gas. Besides, it hinders Ukraine from acquiring market economy status and entering the WTO and the EU. Ukrainian exporters actually suffer from low gas prices because they create problems in external trade (for example, numerous anti-dumping investigations).

The fourth consequence has a direct relation to the low salaries in Ukraine. In highly developed countries of the West, the percentage of salaries in the cost of end-production is about 60 %. In Ukraine it is about 10 %. In contrast, the cost of energy and raw materials in Ukrainian production is 80%. In other words, the current state of affairs in the Ukrainian economy is favourable only for owners of enterprises and people who control gas supplies to Ukraine. It also makes possible the “shadow economy” which is now accountable for 40 % of the Ukrainian economy.

Efficiency and energy taxes

What can Ukrainian authorities do to solve this dilemma? It is obvious that the period of low prices in natural gas for Ukraine will end soon. Most experts predict price hikes next year after parliamentary elections. It is clear that the Ukrainian government should react right now to prevent an economic crisis triggered by the rise in gas prices. In fact, the Ukrainian authorities should have improved the energy efficiency of the Ukrainian economy back in the late 1990s when the economy stabilized and global gas prices were not very high. Today Ukraine urgently needs to reform taxation policy, shifting towards energy taxes (that is what Western countries did back in 1970s after the “oil shocks”). If Ukraine wants to join the EU and become less dependent on imported fuels, it has to introduce energy taxes within the next year or so. The time to debate such a reform has already run out.

Editorial Notes: It's encouraging to read energy analyses from countries beyond the Anglophone world of the US, UK, Australia and NZ. Author Serhiy Veret writes:
I am an international journalist, an observer of international energy for the Ukrainian analytical magazine "Energy policy of Ukraine".
-BA

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