• The relative dynamics of gas prices in different markets since early 2016Current European gas market situation

    In 2016, gas demand in Europe increased. This demand rise was due to higher prices for alternative energy sources (coal)1. Domestic gas production in the EU stood at a record low of 132.9 bcm (according to Eurostat), as the government of the Netherlands tightened gas production restrictions at the Groningen field from 27 bcm to 24 bcm. Against this background, imports of Russian gas to Europe reached a record high2 of 178.3 bcm, while imports from Norway stayed at the same level as in 20153 — at 108 bcm.

    The main reason for rising imports from the Russian Federation was that Russian gas prices were attractive for European customers under long-term contracts with Gazprom as a sharp drop in prices for oil and oil derivatives in 2015 and early 2016 (which are mainly linked to the price of Russian gas) was fully reflected in the contract price as early as 2016. This allowed European importers to increase imports from the east during the downturn in the oil market and reduce imports from other sources4.

    Russian gas prices were more attractive than LNG prices, while in 2016 volumes of LNG supply to the global market increased by 7.5% but were lower than expected. The main consumers of LNG were China, India and the Middle East, which offset the decline in imports from Japan and Latin America.

    The price for gas in Q4 was higher than previous periods due to seasonal factors, in particular due to the decrease in temperatures below the long-term normal temperature, and subsequent increase in gas demand. After a sharp temperature drop in late 2016 — early 2017, European gas prices rose sharply, but then gradually fell. The factors that contributed to such a temporary peak include low gas stocks in gas storage facilities in Northwestern Europe and the failure of the UK"s largest Rough gas storage facility5.

    Technical problems at the storage facility had a significant impact on the dynamics of gas prices throughout 2016 and raised concerns about future supplies. According to the latest data from Centrica Storage Limited operator, the gas storage facility will resume operations from May 2018. This factor will lead to higher gas prices in the UK during heating season 2017-2018.

    1Given that coal prices were higher than gas prices, in 2016 there was a partial shift from coal to gas in North-West Europe. The use of coal in the UK for electricity generation decreased mainly due to constant exposure on the price for coal, as well as due to decommissioning of a number of coal power plants.

    2http://www.gazpromexport.ru/en/statistics/

    3https://www.statoil.com/content/dam/statoil/documents/annual-reports/2016/statoil-2016-annualreport-20-F.pdf.pdf p.16

    4http://en.pgnig.pl/documents/18252/1757433/Consolidated+annual+report_GKPGNiG_2016.pdf/70fb36d6-4879-48aa-a323-f7e2d3a5fbd1 p.161

    5Rough is the only gas storage facility in the UK used for seasonal gas storage. It accounts for about 70% of the UK"s current gas storage capacity.

    Gas transit to European markets

    EC decision to expand Gazprom access to OPAL gas pipeline

    Another event that shook the Eastern European gas market in Q4 2016 was the decision of the European Commission regarding conditions for access to OPAL gas pipeline capacity. On 28 October 2016, the European Commission de facto permitted Gazprom to increase the share it uses in OPAL"s capacity from 50% to 80%. After additional capacity auctions, flow of gas through the OPAL gas pipeline began to grow in the second half of December 2016 and peaked in January 2017 (an average of about 95-100 mcm/d).

    Daily volume of transit via OPAL gasFor Ukraine, the EC decision means a decline in volumes of Russian gas transit and a reduction in Ukraine"s transit revenue. If Gazprom obtains access to an additional 30% of OPAL capacity, transit through Ukrainian territory is expected to shrink by 10-11 bcm/y, and Ukraine"s transit revenue will fall by more than USD 300 million (estimate based on the "old contract tariff").

    On 4 December 2016, PGNiG Supply & Trading Company (PGNiG ST) filed a lawsuit to stop the implementation of the EC decision. The company challenged this decision because it was made in excess of authority, violated the principles of legal certainty, protection of legitimate expectations and proportionality, is inconsistent with the principles of EU policy, and violates the Association Agreement between the EU and Ukraine. In addition, the company argues that in making this decision, Article 36 of Directive 2009/73/EC to exclude new gas infrastructure from the scope of certain requirements of the Third Energy Package was incorrectly applied.

    In late December, the European Court suspended the EC decision to expand Gazprom access to the OPAL pipeline. The courts are currently checking on the legality of the decision. Resolution was expected by the end of January, but as of March 2017, the decision had not yet been rendered. However, despite the fact that the decision to expand access was suspended in late December, Gazprom continued to transport gas in January as it booked capacities for the next month ("month ahead") in December. The chart below shows that OPAL"s utilization capacity significantly dropped on 1 February 2017 as the February auction for the sale of additional capacities could not be conducted due to injunctive relief6.

    The number of private importers of natural gasFinally, in February 2017, Naftogaz appealed to the High Court of the European Court of Justice with a request for involvement in the case upon a claim filed by PGNiG ST appealing the EC decision.

    Naftogaz sent this request for involvement, after having grounded it by the previous practice of the court and indicating the potential negative consequences of the EC decision for the company. First of all, it poses a threat to the security of natural gas supplies to Ukraine after the termination of gas flows from Poland, a deterioration of the Naftogaz competitive position, an unexpected change in the regulatory and market environment of the company.

    Involving Naftogaz in the case enables the Ukrainian company to submit additional arguments in the case and receive access to case files.

    Naftogaz request for leave to intervene in the case initiated by PGNiG ST is being considered by the court according to the procedure.

    In addition to the request for involvement in the case as a third party, on 27 March Naftogaz filed a lawsuit in the High Court of the European Court of Justice against the European Commission to cancel the decision of 28 October 2016.

    Adoption of the decision without consultation with Ukraine violates Article 274 of the Association Agreement between the EU and Ukraine, and the EU"s commitment under the Energy Charter Treaty and the Energy Community Treaty, since it strengthens the dominant position of Gazprom and associated companies.

    6http://www.platts.ru/latest-news/natural-gas/london/outlook-2017-european-gas-supply-demand-to-remain-26631430v

    Volumes of Ukrainian transit will depend on the development
    Russia's alternative pipeline projects

    Further implementation of the Nord Stream 2 construction project, a new export gas pipeline running from Russia, would have a negative impact.

    Nord Stream 2 is a new export pipeline from Russia to Europe via the Baltic Sea through Germany in the Greifswald district near to the exit point of the Nord Stream pipeline. The aggregate capacity of the two branches of North Stream 2 will be 55-60 bcm/y. In addition, Nord Stream capacity expansion was announced to 60 bcm. As a result, the total design capacity of Nord Stream and Nord Stream 2 will be 110-120 bcm/y.

    In addition to the decrease in volumes of transit through Ukraine, construction of Nord Stream 2 threatens the energy security of the EU, strengthens Russia"s position in Europe, and is contrary to the principles of the Energy Community.

    The Turkish Stream project that will run through the Black Sea and Turkey to Greece and have two branches with total capacity of 31.5 bcm/y threatens to stop transit through Ukraine to the south. 

    Dynamics of Russian natural gas volume sent via Ukraine and volumes of transit

     
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    NORD STREAM 2:

    The key to Russian dominance and potential abuses on the European gas market
    Background

    • Nord Stream 2 (NS2) is a gas pipeline project developed by Russia"s Gazprom in the Baltic Sea. It is aimed to double the capacity of Nord Stream (NS ), the existing underwater pipeline connecting Russia and Germany, from 55 billion cubic meters (bcm) to 110-115 bcm a year (German annual demand), starting from 2019.

    • In 2015, Gazprom reached a deal with five Western European companies (BASF, E.ON, ENGIE, OMV and Shell) to jointly develop the project. In 2016, following a decision of the Polish antitrust regulator, the Western companies pulled out of the partnership.

    • In 2017, Gazprom announced the partners would still contribute financing to the project.

    • Gazprom says it is ready to develop and finance the USD 10.3 billion project alone.

    • Russia currently accounts for approximately 30% of gas imports to the EU and 60% of imports to Germany.

    • The launch of the NS2 will further strengthen Russia"s dominant role in the EU gas market and raises a number of competition, energy security, geopolitical and security issues. There is no economic reasoning behind this project. The expected tariffs for the Ukrainian route in 2020 will be significantly (up to four times) lower than expected tariffs of NS2 after its construction.

    Outcomes

    Competition concerns:

    • NS2 will not connect the EU to new sources of gas and will lead to a redirection of Russian gas flows from existing sources. This redirection will result in a concentration of Russian gas flows in the Nord Streams.

    • Existing pipelines carrying gas from the East through Ukraine and Poland can become less sustainable because of the reduced load.

    • NS2 will create an overcapacity for Russian gas delivery in Germany, undermining the feasibility of LNG deliveries. Given stable forecasted gas demand in the EU, Russia is likely to win the share of the Netherlands, the UK and Norway gas suppliers (as their production declines), which will strengthen Gazprom"s dominant role.

    • Industrial gas consumers in Central, Eastern and Southern Europe will become less competitive compared to their German counterparts, because the gas price in the region will include additional transmission costs.

     

    Energy security concerns:

    • The redirection of gas flows may lead to gas shortages in Central, Southern and Eastern Europe (CEE and SEE) due to existing gas transmission capacity bottlenecks within the EU.

    • Northern and Western Europe will become more dependent on Russian gas.

    • The EU will be dependent on the offshore NS and NS2 for Russian gas deliveries. Unlike in the case with traditional onshore routes, an emergency event could cause a halt of the entire 1200 km underwater pipeline for several weeks.

    • The failure of even one of the four pipelines will have detrimental effects on the EU security of gas supply.

     

    Security concerns:

    • To avoid the inevitable supply interruption risks, Russia, as the owner of the pipelines and the gas they transmit, may want to increase its military presence in the Baltic Sea to safeguard this key gas delivery route. This may potentially result in tensions among NATO members over security vs. gas supply issues.

     

    Environmental concerns:

    • Unlike in the case of the Nord Stream, the NS2 does not have an inherent Union interest. The project constitutes excessive and objectively unnecessary gas infrastructure whose function could be easily performed by already existing onshore facilities. In the same time, construction and operation of NS2 will inevitably affect the living conditions of animal and plant species and put the marine environment at risk. Realization of this project would unjustifiably shift the balance between economic, private interests of the project promoter and environmental, public interests in favor of the former.

     

    Geopolitical concerns:

    • NS2 is an instrument of Russia"s "divide and conquer" strategy. CEE and SEE countries are already highly dependent on Russian gas. Having concentrated gas supply in its Nord Streams, Russia will expand its control of or influence on both the infrastructure bottlenecks and gas supply to Europe.

    • By redrawing the European gas flows map, Russia will be able to offer gas discounts in CEE and SEE in exchange for political concessions, gaining a tool to influence EU decisions.

    • Through NS2, Russia"s will have leverage in relations with Germany. Germany will be a host country of the key gas transit route to other EU member states. Russia has made pressure on transit countries through consumer countries more than once.

    • Furthermore, NS2 and its German section will be indirectly owned by Russia, which poses the risk that the key gas transmission infrastructure may be used for noncommercial purposes.

     
    Applicable legal regime dispute: "a legal void"

    • There is a dispute between the project"s supporters and opponents over whether EU law is applicable to NS2. If EU energy and antitrust regulations are fully applied, the project is not likely to be built.

    • The pipeline passes the territory of four EU member states: Finland, Sweden, Denmark and Germany. A formal clearance on environmental issues is required from each country for the project to proceed.

    • Germany and Gazprom insist that the project is a purely commercial deal that should only be governed by German law in its onshore part and that no European law is applicable to the offshore section.

    • Denmark and Sweden have asked the European Commission for a formal clarification on whether the EU law should be fully applied to NS2.

    • In its reply to the request of the Nordic countries, quoted by media, the EC confirmed that the rules for applying EU law, including the Third Energy Package, to gas pipelines built along the sea bottom are unclear. The commission also noted that NS2 should not be built and operated solely under the law of Russia or in a legal void.

    • The European Commission has requested a mandate from member states to negotiate with Russia over objections to NS2. The Commission is reported to have a view that key principles of the European energy law should be applied to the project, including the offshore section

    • In April 2017, Denmark announced its plans to amend its national legislation so that the project could also be blocked on security or geopolitical grounds.

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    Nord Stream 2 and Turkish Stream –

    Ukraine-Poland interconnector

    In order to increase gas imports to Ukraine from Europe through Poland and enable storage of European gas in Ukraine"s underground gas facilities, Ukrtransgaz continues to work actively on construction of a Ukraine-Poland interconnector. The project would enable the creation of the East European gas hub and the pumping of up to 8 bcm/y of gas from Poland to Ukraine, and up to 7 bcm/y of gas from Ukraine to the EU.

    The interconnector is part of the North-South Gas Corridor, which will connect the LNG terminal in Svynoustyi with Central and Western Europe. Currently, the maximum capacity of gas supplies from Poland to Ukraine is 1.5 bcm/y.

    The Ukraine-Poland Interconnector is included in the ENTSOG Ten-Year Development Plan for 2015-2025 and on the list of the Energy Community projects of mutual interest (PMI). In addition, on 4 March 2016, the State Expertise Service delivered a positive opinion with regard to the design documentation. Ukrtransgaz will finance the project and has already signed a design work contract.

    Currently, the joint Open Season procedure for shifting to the new interconnector capacity on both the Polish and Ukrainian sides is under development. Ukrtransgaz is interested in holding consultations with gas market participants. The Ukrainian and Polish sections of the interconnector are expected to be constructed simultaneously and ready by mid-2020.

    Natural gas imports to Ukraine

    Current account balance of Ukraine and imported gas price,In 2016, Ukraine did not import gas from the Russian Federation. By eliminating gas dependence on Russia, Naftogaz and other Ukrainian importers now have access to other sources of gas and can choose from several dozen suppliers. The joint efforts of numerous participants helped to organize gas supplies to Ukraine exclusively from the European route in quantities sufficient to meet the country"s needs. In 2016, gas imports decreased by 32% compared to the previous year, or from 16.4 bcm to 11.1 bcm. 10 years ago, Ukraine imported as much as 5 times more gas than now. The decrease in gas imports reduces the negative impact on Ukraine"s balance of payments and GDP.

    The drop in Naftogaz"s share in imports in favor of private importers and industrial consumers is a crucial shift. Last year, independent importers brought 2.6 times more gas than in 2015 (2.9 bcm versus 1.1 bcm). The number of private importers in Ukraine doubled and exceeded three dozen.

    In 2016, Naftogaz imported 8.2 bcm of gas from the European market, which is 1 bcm (11%) less than in the previous year. Total gas imports by Naftogaz decreased by 47% compared to 2015. In the reporting period, Naftogaz cooperated with 15 suppliers. None of these companies had more than 30% of the total gas imports of the company.

    Thanks to reverse gas supplies from the EU instead of satisfying Gazprom"s ungrounded "take-or-pay" demands (dismissed by the Arbitration Tribunal"s separate award) in Q2-Q4 2016, Naftogaz saved over USD 4 billion. In January 2017, Gazprom sent Naftogaz an invoice of more than USD 5.3 billion for April-December 2016, while Naftogaz paid only USD 1.24 billion for the gas imported within the said period, which is 4.3 times less. According to Naftogaz estimates, if Naftogaz had paid Gazprom as much as it wanted, Ukraine"s GDP would have fallen by more than 2% instead of a 2.3% growth. It also would be logical to expect a considerable negative effect on the current account of the balance of payments, currency exchange rate and budget deficit.

    Naftogaz efforts in the diversification of Ukraine"s gas supply routes and sources therefore resulted in axing the imported gas costs by more than 4 times compared with the assumed ones.

    Value of imported gas vs

    Natural gas production in Ukraine

    Based on the results for 2016, annual gas production was 20.1 bcm, which is 0.5% more than the previous year (19,9 bcm). Ukrgazvydobuvannya increased gas production by 77 mcm to 14.6 bcm, which made up 73% of natural gas production in Ukraine in 2016. Last year, the company announced implementation of several ambitious investment projects covering the purchase of new drilling equipment and attracting contractors for hydraulic fracturing operations. The company also announced a tender for drilling 90 wells during 2017-2019.

    Dynamics in the difference between market and regulated

    However, due to financial problems including a tax debt, Ukrnafta experienced a rapid decrease in natural gas production. By the end of 2016, its output result was 1.3 bcm, which is 14% or 205 mcm less than the previous year. The company is no longer the second largest gas production company in Ukraine.

     

    Private companies increased production to 4.2 bcm, or 5.5% compared to 2015, significantly slowing down production growth compared to previous years (when growth amounted to +15-24% y-o-y). This lowest growth rate for the private segment over the past six years was due to lower investment and operational activity over the past two years. This situation was caused by several factors: firstly, a record collapse in market prices for gas (consistent with import parity), and secondly, high rates of rental payments for hydrocarbon extraction in the period 2014-20157

     

    7However, 2016 began with a return to rates of rental payment for gas extraction for private companies to the previous level observed two years earlier: from 55% to 29% for mining to a depth of 5000 m and from 29% to 14% in production from wells deeper 5000 m. From the beginning of 2017, rental rates for Ukrgazvydobuvannya were reduced to a similar level.

     

    Natural gas usage in Ukraine

    In 2016, natural gas usage in Ukraine decreased by 2% compared to 2015, falling to 33.2 bcm against 33.8 bcm in 2015.

    Fluctuations in natural gas usage



    In 2016, total final consumption of natural gas was 88.6% of its aggregate usage. The remaining gas (3.8 bcm and 3.5 bcm in 2016 and 2015, respectively) was used to meet industrial and technological needs, including transit, transportation and distribution of natural gas and production of liquefied natural gas.

    Minor declines in gas usage are associated primarily with increased consumption by regulated market segments. In particular, in 2016 households used 11.9 bcm of gas, which is 0.6 bcm more than in 2015 (+5%).

    Lower volumes of natural gas used in 2016 compared to 2015 were due, in particular, to lower natural gas consumption by industrial consumers (against the background of some recovery in industrial production) by 11.4% (to 9.7 bcm against 11.0 bcm in 2015). Given that growth was observed in the sectors that are traditionally energy-intensive and large gas volumes used, it may be indicative of some reduction in the energy intensity of industrial production or its conversion to alternative energy sources.





    Dynamics of natural

    Much of these natural gas supplies involved meeting the direct needs of the households, district heating companies (DHC) and religious organizations by Naftogaz at state-regulated prices in line with its public service obligations (PSO). In 2016, these categories of consumers increased natural gas usage, and this increase was only partly due to low temperatures during the heating season. Households remained the main consumer of natural gas, with 17.6 bcm used to cover their needs (including gas consumption by DHC producing heat for the households).

    The inert state regulation of natural gas prices for consumers in the context of PSO caused some delay in the regulated prices established in spring 2016 as import parity price from the current level of its market equivalent — this resulted in a noticeable price differential, which at the end of 2016 had reached 40%. This situation creates tthe risk of structural imbalances in the economy and capital misallocation. For example, selling natural gas at a price significantly below the market level limits investments in exploration for new oil and gas deposits (to the amount of the price difference) and impedes increasing extraction to overcome Ukraine's dependence on energy imports.

    Dynamics of aggregate natural gas usage in Ukraine,

    To meet household needs in 2016, 17.6 bcm was used against 17.2 bcm in 2015, including 11.9 bcm used by households directly for their own needs (cooking, hot water and heating) and 5.7 bcm by heat generating companies providing services to households. Regionally, there are very noticeable geographical differences in volumes of gas usage by households — the northern and western regions of Ukraine increased volumes of natural gas consumption (excluding Kyiv region and the city of Kyiv), while the southern and eastern regions reduced them (except Luhansk region). This could be explained by temperature factors, in particular мcolder winters in the north.

    The main factors determining natural gas consumption by households were lower temperature during the heating months of 2016 (especially in November and December) and the upward revision of gas usege rates by households that are not equipped with gas meters (see CMU Regulation No.203 of 23.03.2016). The combined effect of other factors (including changes in consumer behavior when using gas to meet their own needs) led to a slight decrease in overall natural gas consumption to meet household needs, including through energy saving projects.

    According to independent experts, potential reduction in natural gas usage through energy efficiency enhancements and energy saving programs is seriously restricted by the current system of subsidies. This system needs to improve to preserve the motivation to save energy and engage in efficient use of natural gas. Monetization is one the main areas contributing to the efficiency of subsidy programs, with the inclusion of effective mechanisms aimed at motivating the prudent use of natural gas.

    Main factors of fluctuations in natural gas supplies

    Natural gas consumption by households in 2016 and change compared

    Current programs are insufficient

     
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