Ukraine is currently one of the largest consumers of natural gas in Europe. The country’s sizeable population (45 million), low energy savings and heavy industry no doubt make it a lucrative energy market. In particular, the recent liberalization and diversification on the natural gas market makes it attractive to foreign investments. Moreover, Ukraine lies at the heart of geopolitical interests between East and West, and therefore acts as a crucial link in the European energy market. This is perhaps best illustrated by the so called “gas wars” between Ukraine and Russia of recent years.
Before we get to that, however, a little Ukrainian history. While the country is currently one of the biggest importers of natural gas in Europe, a little known fact is that it was actually one of the main producers in the past. The history of this particular fossil fuel starts in 1855, when the gas lamp was invented in the city of Lviv (in the west of the country). Large-scale extraction of natural gas began in the early 1930s. Initially, it was used as a source of light — only after several decades did gas start to heat peoples’ homes. By the way, the huge reserves of natural gas in Russia had not been found at this point, so in 1954 a pipeline from Lviv to Moscow was built. Another pipeline transported gas to Minsk, Vilnius and Riga. Later, in the 1960s, the production of natural gas in the Kharkiv region (in the east of Ukraine) began.
Ukrainian natural gas production peaked in 1976 at 68.7 billion cubic metres (bcm). By now, the country was exporting gas to Russia, Belarus, Moldova, Latvia, Lithuania and Czechoslovakia. However, the inevitable decline soon followed, as the majority of deposits were exhausted due to intensive extraction. Ukraine was still able to meed its own needs up to the 1980s, but the country soon became a net importer of natural gas. Moreover, this shortfall was to be met almost entirely by Russian supplies. By 2010, Ukrainian gas production totalled only 20 bcm, while consumption was 53 bcm. Nowadays, the country is, on the one hand, hugely dependent on imported gas from Russia (36 bcm in 2010). On the other hand, it also represents the major transit country through which Russia transports gas to other European nations. Among other things, this brings huge profits to the Ukrainian monopolist, Naftogaz.
The year 2009 represented a turning point in Ukrainian-Russian gas relations. During contract negotiations for the purchase of Russian natural, the two counter-parties were unable to agree on an appropriate price. Russian monopolist Gazprom demanded the market price based on long-run contracts (i.e. $450 per 1,000 cubic metres). However, this would imply a remarkable rise in the price of natural gas for Ukrainian consumers. The Russian contingent responded to the unsuccessful negotiations by banning the export of gas to (and through) Ukraine. This was a period of harsh winters and, recalling that Ukraine accounted for 80 per cent of Russian gas transit to Europe, a shortage of natural gas occurred in some European countries. The Ukrainian government was ultimately obliged to sign the contracts based on the terms imposed by the Russian formula.
The downsides were made apparent the following year. In 2010, a huge volume of liquefied natural gas appeared on European spot markets. This caused the price of natural gas to fall for European consumers. However, the price for Ukrainian clients of Gazprom remained the same. The situation nowadays is such that the price for Russian gas is much lower in Germany (for instance) than it is in Ukraine. This is even though the transportation costs for Germany are higher.
The “gas war” between Russia and Ukraine has ultimately changed the energy strategies of both countries. Gazprom decided not to be dependent on Ukrainian transit and began the construction of alternative pipelines. For its part, Ukraine now tends to diversify its sources of energy imports. For example, with the help of the EU, the natural gas market was recently liberalized and Ukrainian customers have started buying natural gas on European spot markets. Furthermore, the government has signed agreements with several transnational corporations (Shell, ExxonMobil and Chevron) regarding the extraction of shale gas in Ukraine. The aim is obviously to increase the production of natural gas inside the country. In addition, Ukraine has managed to attract investments for the construction of an LNG-terminal on the Black Sea. This should allow for the purchase of LNG on foreign markets and further decease reliance on piped (Russian) gas. Last but not least, the Ukrainian government aims to increase energy savings in the country. If the strategy succeeds, Ukraine should become energy independent by 2020.
This post originally appeared on the class forum for SAM460 – a course in Petroleum Economics that is offered on the master level at NHH. Students are required to submit several blog posts as part of their entrance requirements to the final exam. While the forum is closed to non-participants, we wanted to make a sample of these forum posts available to the public. A link to the SAM460 course description is available here.