Oil and Gas

Ukraine and Russia look to strike new gas deal amid US sanctions threat

Key Points
  • Geopolitical tensions between Russia and Ukraine, U.S. gas exports to Europe and controversial pipeline projects - just some issues complicating a new gas deal between Russia and Ukraine.
  • Ukraine and Russia are involved in an unresolved conflict over territorial sovereignty that has run for over five years.
  • The main route for Russian gas to reach Europe is via Ukraine.
Workers during the production process of pipes at the Nord Stream 2 facility at Mukran on Ruegen Islandon in Sassnitz, Germany.
Carsten Koall | Getty Images

Geopolitical tensions between Russia and Ukraine, a U.S. challenge to Russia's dominance in European energy markets and incomplete gas pipelines are just some of the issues complicating a gas transit deal between Kiev And Moscow's energy giants that needs to be signed before the end of 2019.

Ukraine and Russia are involved in an unresolved territorial conflict that has run for over five years but on the energy front, in the meantime, Russian gas has still traveled through its main route of Ukraine to reach Europe. But maybe not for that much longer.

A 10-year gas transit deal that has kept Europe supplied with Russian gas is about to expire on December 31 and while talks are taking place to strike a new deal between Gazprom and Naftogaz, Russia and Ukraine's respective state-owned gas firms, an agreement has not yet been reached.

Having to strike a new deal is inconvenient for Gazprom, as it was hoping that its multi-billion dollar grand gas pipeline project to Germany, called Nord Stream 2 (NS2), would be completed by now, meaning that it could bypass its current pipeline route to Europe that goes through Ukraine..

NS2 is estimated to cost around 9.5 billion euros ($10.59 billion) with several European companies, including Anglo-Dutch Shell and French firm Engie, co-financing the project.

However, Nord Stream 2 was expected to launch in mid-2020 but may be delayed now because of likely U.S. sanctions on companies involved in the project as part of its annual defense bill (the 2020 National Defense Authorization Act, which specifies U.S. defense policy and budget).

Essentially, Gazprom has been constrained to fall back on its Ukraine transit route, and to strike a new or extended deal with Naftogaz amid strained commercial and geopolitical relations.

The deal

Wary of being locked into a long deal, Gazprom has offered Ukraine's Naftogaz a one-year gas transit deal to continue the transit of Russian gas. Ukraine wants a longer contract, however, in order to guarantee supply to its consumers.

The relationship between Gazprom and Naftogaz is strained with several high-profile legal disputes over the gas contract, debts and transit tariffs, taking place between the two entities. In fact, Gazprom had said earlier this year that it would not agree a new transit deal with Naftogaz unless legal cases between the parties were resolved.

Yet, they need each other.

State-owned Naftogaz (and thus Ukraine) earns $3 billion a year from the transit fees of Russian gas through its country. Thus, once Nord Stream 2 comes online Ukraine will be bypassed and will lose that revenue, hence it has an interest in maintaining the current transit agreement as long as possible.

As such, any delay to NS2 would help strengthen Ukraine's hand in ongoing talks with Gazprom for a new gas transit deal. Ukraine has said it would like another 10-year transit contract.

Nord Stream 2 pipes are loaded onto a vessel in the northern German port of Mukran for transshipment to a storage yard.
Nord Stream 2 | Axel Schmidt

Russia, meanwhile, needs to maintain its market position, and reliability, as a gas supplier to Europe, particularly in the face of competition from the U.S. for Europe's gas market and a desire to keep Europe on side to some extent – particularly as it is still subject to sanctions.

Experts believe a deal will be reached, but not before some hard bargaining on both sides.

"The Naftogaz/Gazprom dispute is complicated by the fact that it involves corporate issues between both companies as well as the political conflict between Russia and Ukraine," Daragh McDowell, head of Europe and Central Asia at Verisk Maplecroft, told CNBC Thursday.

"In addition to settling the corporate dispute, both state-owned corporations are wary of giving the other side a geopolitical 'win.' This incentivises both sides to adopt maximalist positions and hold out until the last minute to achieve a deal, both to get the best possible deal and to convince domestic constituencies that they drove as hard a bargain as possible," McDowell added.

S&P Global Platts noted in its 2020 Energy Outlook, published last week, that a deal is looking more likely, given the recent peace talks between President Putin and President Zelensky. Furthermore, "Ukraine has agreed that Gazprom can repay its arbitration debt through the supply of gas, easing tensions around repayment," it noted.

Pressures on the deal

Aside from the legal tensions between Gazprom and Naftogaz, any potential new deal or extension of the existing agreement comes against a wider backdrop of continuing fraught relations between Russia and Ukraine despite a recent attempt at peace talks.

Relations between the neighbors collapsed in 2014 following Moscow's annexation of Crimea from Ukraine, and its role in in a pro-Russian uprising in the eastern Donbass region around the same time. European (and international) sanctions were placed on Russia for its actions and the lifting of these is tied to Russia's implementation of a peace deal with Ukraine, known as the Minsk agreements.

However, five years on (and despite a recent extension to sanctions in September) and there is notable sanctions fatigue in Europe regards to restrictions on Russia.

France, among others, has called for the EU to ease sanctions on Moscow and Germany's Nord Stream 2 project has given the EU (or at the very least Germany) another reason to normalize relations with Russia.

But the U.S. has been watching the construction of NS2 and TurkStream with concern. It sees the pipelines as a way for Russia to cement further its dominance in the natural gas market.

Russia was the largest supplier of natural gas to the EU both in 2018 and 2019 (only first trimester data is available), according to Eurostat. In 2018, just over 40% of EU imports of natural gas came from Russia, followed by Norway (at around 35%).

US on the hunt

But the U.S. is challenging Russia's market share too, with EU data showed that U.S. liquefied natural gas exports had risen 272% between April 2016 and July 2018.

The U.S. appears ready to attack further when it comes to the gas market with it looking likely that the U.S. Congress will approve sanctions on companies involved in the construction of Nord Stream 2 and TurkStream. Many lawmakers in the U.S. sees the pipelines as a way for Moscow to spread what they see as a malign influence in Europe, and one aimed at undermining the energy security of NATO members.

On Friday, the U.S. House of Representatives approved the 2020 National Defense Authorization Act (NDAA) in which sanctions would be imposed on the pipeline projects. The Republican-controlled U.S. Senate will now have to vote on the bill (slated for this week) and then it would have to be signed into law by President Donald Trump.

Washington says the measures will reduce Russia's grip on EU energy markets and Ukrainian officials have welcomed the proposed sanctions.

Other European officials (and, understandably, especially those in Germany) reject the sanctions, saying the U.S. just wants to advance its own commercial interests.

Last Thursday Germany's Foreign Minister Heiko Maas tweeted that "European energy policy is decided in Europe, not in the United States" and rejected "foreign interference" and "extraterritorial sanctions" being considered by the U.S.


Russian Foreign Minister Sergei Lavrov
Sergei Karpukhin | Reuters

Russia's Foreign Minister Sergei Lavrov said last Thursday that sanctions won't stop the NS2 or TurkStream projects and that he believes the U.S. Congress "is literally overwhelmed with the desire to do everything to destroy our relations."

CNBC requested comment from Gazprom on the proposed sanctions and how they could impact the NS2 project but is yet to receive a reply.

But Andrius Tursa, Central & Eastern Europe adviser at risk consultancy Teneo Intelligence, noted that European powers like Germany had to tread a fine line between the U.S. and Russia when it comes to energy.

"Berlin neither shares U.S. desires to severe European energy ties with Russia nor does it approve of Moscow's interest in fully circumventing Ukraine. For Germany, managing channels of economic exchange with Russia makes business sense but is also a strategic imperative at the geographical center of Europe," he said in a note Wednesday.

The U.S. might want to challenge Russia's gas supplier dominance in Europe but Verisk Maplecroft's McDowell noted that while U.S. LNG accounts for a growing share of Europe's overall energy mix, "supply and infrastructure constraints are such that it would be impossible for LNG exports to fill the gap in the event of a disruption of supplies via Ukraine."

As such, he noted that European states were hedging against interruptions through stockpiling. But, he added "opportunities for increased LNG exports are likely to be minimal even if a new contract is not agreed by the 31 December deadline."

"Ultimately, for the time being, both Ukraine and Russia need a supply contract – Ukraine because of the fiscal revenues gas transit supplies to the state budget, Russia because there is no other means of monetizing gas volumes connected to Europe's pipeline network," he said.

"A short interruption is possible, and potentially even likely if both sides want to demonstrate they are being 'tough', but financial pressures mean that some form of new contract will eventually be agreed," McDowell added.