5 Things Ukraine Must Do to Become Energy Independent

There are exactly five things Kiev must do to become energy independent and disentangle itself from the Russian-driven geopolitical gas war:

1. Sell its pipeline system (most importantly);
2. Sell the remaining state interest in oil and gas company Ukrnafta;
3. Aggressively farm out as brown-field developments areas licensed by state-owned Ukrgazproduction;
4. Develop additional import resources, either through Europe or liquefied natural gas (LNG) through the Black Sea;
5. Provide security in pricing and contracts.

Before we embark on the specifics of this roadmap, it’s important to look at exactly how we got where we are today.

Call it what you want — unrest, separatism, foreign invasion — but the fact is there are troops running around eastern Ukraine killing people. The current situation is dire from any standpoint; economically, it is disastrous, triggering high taxes and steadily increasing inflation.

In addition, Ukraine and Russia are once again fighting over gas supplies and the transport of Russian gas to Europe.

The primary reason we’re here, of course, is economics. We’re all familiar with the events of the Maidan protests, what led to this and what has happened since. However, one could argue — as I have chosen to do during the Fifth Annual Ukrainian Energy Forum that kicked off in Kiev June 24 — that the failure to secure and develop independent energy resources within Ukraine has allowed Russia to conductgeoeconomic warfare which has escalated to low-intensity conflict in eastern Ukraine.

Gas supply, and the threat to that supply for Europe, is what has forced Russia to move aggressively on multiple fronts to defeat Ukraine in its efforts to modernize and westernize its economy, its future, and its way of life.

So, how to start the liberalization process? Ukraine has argued that its gas transportation system is a strategic asset. Business-minded people take issue with this interpretation, which ignores the commercial potential of the pipeline system. Now that we have come full circle in a long-brewing Ukraine-Russia gas war, perhaps the pipeline should be considered “strategic” — if not in the way the Ukrainian authorities have long understood. The pipeline system, worth $20 to $30 billion, can indeed play a strategic and tactical role in resolving Ukraine’s crisis with Russia, but only if it’s sold off.

Ukraine should sell 50 to 75 percent of it for cash to a consortium involving the EU, U.S. and Russia and operated by a U.S. business enterprise, preferably based in Houston. This can only happen if Russia agrees to remove troops and other proxies in eastern Ukraine and then works with Ukraine to secure the border and cease all low-intensity conflict efforts, including on the ground, and in cyberspace and the trade arena.

Russia would pay cash for the gas transmission system and absolve Ukraine of the existing gas debt (given the Russian gas price of $395 per th.m3, Ukraine owes Russia $4.58 billion).

Doing so would allow Russia to continue to supply gas to Europe. The Ukraine crisis is as much about Ukraine not joining the EU and NATO as it is about Russia securing reliable and ongoing gas sales to Europe. A consortium-run pipeline system is the only neutral solution that allows Russia a face-saving way out.

The pipeline system, and the state-run company that manages it, should be turned into a transparent public company in London, for instance. The sale of 50 percent of the company could generate sizable profits, part of which could be invested in modernization.

All of this requires the recognition that Ukraine’s pipeline system is strategic only for Moscow — which needs it to control gas to Europe — while for Kiev, it should be a commercially viable asset.

The crippling level of debt, the loss of Crimea, the continued destabilization of eastern Ukraine by Russia through the use of various proxies — including Chechen mercenaries — the suspension of gas supplies to Ukraine only last week, an apparent terrorist attack that resulted in an explosion on the gas pipelines in central Ukraine — all of this points to the necessity of an urgent rethink of strategic versus commercial philosophies. As a privatized commercial asset, the pipeline could raise $50 billion for Ukraine.

Until now, the pipeline system has been nothing but a conduit for Russian gas into Europe. Russia already ships almost half of its gas to Europe via pipelines that bypass Ukraine, and in 2015, if Gazprom’s South Stream pipeline comes online as planned, it will be shipping a lot more gas to Europe without Ukraine. In this current dynamic, it could be even less than that. But it SHOULD be much more.

Beyond Pipelines

In this time of chaos and uncertainty, there is one thing about which there can be no ambiguity: Ukraine must transform its energy sector.

The ambiguity is more European than it is Ukrainian. The current crisis promises to become further exacerbated with Ukraine’s planned signing of the Association Agreement with the European Union on June 27. Ukraine hopes this will put pressure on Europe to resolve the gas sales issue, but it is unlikely to have much immediate impact on gas supply to Europe, particularly in the summer season, when gas stocks are relatively high.

Kiev presumably thinks that gas supply disruptions might just refocus EU countries back on the crisis in Ukraine, as they care above all about their own economic interests. The message Kiev is hoping to send is that if Europe cares about energy security for the next winter, it should help resolve the crisis in Ukraine now rather than letting it fester into the autumn.

The transformation must be comprehensive and it must be done with a clear understanding of what strategic assets really are. It is a process that must be completed over the course of years, and which must start definitively with the sale of the pipeline system, which is at the heart of the crisis in Ukraine.

Beyond this, Kiev will have to start selling off other assets and making the industry much more transparent, which will bring Western investors in to take advantage of the favorable gas price environment. But that’s the end game. Right now it’s about starting off the big transformation.

While it starts with the sale of the pipeline system, there are also abundant natural resources waiting to be development, and they will continue to wait without greater transparency. There are some other hard decisions Kiev will have to make as well, including selling off the state-run gas companies, Ukrnafta and Ukrgasproduction.

Kiev must realize that its eastern areas of Donetsk and Luhansk account for around 15 percent of Ukrainian GDP and have very significant linkages back to the rest of the Ukrainian economy. The risk in accepting the status quo in these two oblasts is an economic weight that the post-Maidan administration will not be able to handle and that will in the end be its downfall.

Right now, the Maidan government is tenuous, and the West needs to do much more to give it a chance to succeed, either by getting more serious with sanctions or lending financial support to Ukraine, or both. Ukraine assumes that sanctions pressure is keeping the Russian tanks from rolling across the border en masse, but this is a gamble at best.

This piece is cross-posted from OilPrice.com with permission.

One Response to "5 Things Ukraine Must Do to Become Energy Independent"

  1. fairweatherhill   July 3, 2014 at 8:47 am

    Ukraine’s problems can’t be fully addressed by simply changing the ownership of energy assets. This misses the potential for the Ukraine to solve its own energy issues, to make gains in energy security via energy efficiency, for example and by improving the management of state-run enterprises to get more out of its considerable domestic energy resources. As we’ve seen elsewhere, energy efficiency clearly requires an energy price signal. That can happen independent of ownership.
    Norway demonstrates that state run enterprises can function effectively in the energy business, provided they are given clear mandates by government and have competent management, free of political interference.
    If the Ukraine is to have secure supplies of competitively priced energy, then market reforms are clearly necessary to attract investment and Western technology.
    However, reforms, which include a determined attack on corruption, should be implemented by the new Government before there is any wholesale divestiture of state energy assets. To begin that process now, with current political instability and without market transparency, would guarantee a fire sale that would be hard for Ukrainians to accept as they are forced to adjust to higher energy costs leading to fuel poverty for many.
    Moving from a system of heavily subsidized energy consumers to a fully market-driven one in a single step, would create an enormous challenge to political and social stability and create fertile ground for outside mischief-makers.