Ukraine’s Bleak Energy Future

After years of balancing between the European Union and Russia, this December saw Ukraine's government make a definite turn to the east, choosing to build its economic and political future away from Brussels. Apart from receiving the bailout needed to finance Ukraine's debt (around $15 billion), an important factor in making the decision to turn eastwards was Russia's reduction of current gas prices for Ukraine’s industry by more than 30 percent, to a rate of $268.50 per 1,000 cubic meters. But Ukraine’s energy problem runs a lot deeper than steep gas prices.

(c) Audrius Meskauskas
Granted, the reduced gas prices will save both the Ukrainian budget and its wider economy roughly seven billion dollars in 2014 only. Prior to the deal’s signing, Naftogaz-Gazprom agreement on delaying gas payments Ukrainians owed already pulled Ukrainians closer to the East than the West. However, the fact that the Ukrainian industry direly needs cheaper gas to keep the economy running is just the facade of a more complicated and tangled energy problem Ukraine has been facing for years.

Ukraine is producing around 30 percent of natural gas, while the bulk of the remaining supply is imported from Russia - with minor contributions of Azerbaijan and Kazakhstan. The country imported 25.7 billion cubic meters of Russian gas in 2013, 15.5 percent less than in the same period of 2012. The government has confirmed that planned natural gas supply and distribution for this year that sets imports somewhat higher, at 27.3 billion cubic meters. Despite being a big and energy-hungry economy, Ukraine covered only 27 percent of its needs for liquid fuels in 2011, making it very reliant on foreign imports. Evidently, Ukraine's energy position is a highly troubled one and the Russian gas price discount is most likely only to postpone the government from tackling them in a substantial manner. The most imminent problems are Ukraine’s nearly stagnating domestic gas and oil production, inadequate transmission and infrastructure and populist market policies, including subsidies for home consumers.

However, it seems that Ukraine is slowly moving towards solving its problem of inadequate domestic production, at least in the long run. During the course of 2013, Ukraine signed several agreements with foreign oil and gas companies in order to explore and utilize its gas and oil capacities. Italian ENI, together with a consortium of investors, is investing an approximate $4 billion to explore unconventional hydrocarbons in the Black Sea.

In fifteen years’ time, if her domestic gas reserves prove to fulfil expectations, Ukraine might be nearly self-sufficient in natural gas
Estimated production could reach 2-3 million tons of oil. Chevron is investing in shale gas fields exploration in Western Ukraine, and Shell signed a contract committing to a $10 billion investment in exploration of a field in the east of the country. Ukraine might hold up to 1.2 trillion cubic meters of shale gas. Naturally, since shale gas drillings are time-consuming, Kyiv will not see any major improvements in its energy self-sufficiency by 2020. However, if the initial results are promising enough, that momentum might change the geopolitical situation for Ukraine, making its turn to Europe more easily achievable. In fifteen years’ time, if her domestic gas reserves prove to fulfil expectations, Ukraine might be nearly self-sufficient in natural gas.

Infrastructure is another headache for Ukraine's energy policy makers. Some reports estimate that facilities serving up to 60 percent of households need urgent replacement or update. Heating and electricity transmission systems are in an especially poor state. On the other hand, a sudden drop in gas pipeline transmissions to Europe will leave Ukrainian infrastructure capacity at worryingly low levels in terms of its regular maintenance and operability. Diversification of supply routes for Europe is another negative factor for Ukraine, as Europeans attempt to procure more gas and oil from the Caucasus. This also means lower, further declining revenues from transit fees and contracts.

Ukraine’s efficiency is concurrently its biggest current difficulty and the field with greatest potential for improvement. Steel factories and many other metal industries have not been modernized for decades, making them highly energy inefficient. Households have no incentive to save energy or improve efficiency, due to Ukraine’s huge and unsustainable government subsidies. However, the current Azarov-led government is extremely sensitive to the issue: Ukraine backed off from IMF’s loan due to their demands to raise household gas prices. Even worse, only four out of 25 regions in Ukraine pay their gas bills regularly. Reducing energy demand could bring enormous savings and benefits for the energy sector and the government. Installation of meters and modernization of building codes is the easiest step. Few households actually pay proportionally to their consumption – most of them pay according to their living area. In addition to that, by 2030 some €150 billion will have to be invested in the transmission system to ensure necessary savings.

Since abandoning subsidies and getting closer to market prices requires a public consensus – as well as a lot of political capital from the government’s side - it is not easily imaginable this might happen anytime soon.

The entire energy market – currently heavily dominated by the state – needs to undergo deep reforms, with emphasis on more competition, deregulation, diversity and private investment
There has been some slow improvement in implementing a tariff regime in district heating systems, yet insufficient to yield notable results. The entire energy market – currently heavily dominated by the state – needs to undergo deep reforms, with emphasis on more competition, deregulation, diversity and private investment. However, these reforms might hit the east of the country especially hard (where most of the steel factories and other heavy industry is located), an area traditionally in favour of connecting with Russia and currently supporting President Viktor Yanukovych. That makes implementing proposed reforms even harder to achieve.

Furthermore, Ukraine must diversify its energy supply, aiming to invest in biomass and unconventional gas sources in its energy scheme. Before the gas discount deal from Russia was even near, in the summer of 2013, president Yanukovych announced that the government was planning to “almost completely” replace natural gas used to power steel factories with domestic and imported coal. Coal consumption is steadily growing as it is cheaper than gas and used extensively for power generation. However, technologically obsolete and dangerous coal mines are extremely expensive and Ukraine would be better off if it moved towards slowly closing and completely restructuring coal mines in favour of gas exploitation. The nuclear sector – making for 17 percent of primary energy production – is in need of similar reforms as other domestic energy production sectors. Making sure electricity prices account for long-term expenses of nuclear energy production and international cooperation would bring efficiency and total production up.

In the medium term, considering that the biggest part of these direly needed energy sector reforms are time-consuming and require either a wide political consensus or a high-risk political gamble, we might expect a slow increase in Ukraine’s self-sufficiency when it comes to natural gas in the next five to eight years. In the meantime, 2014 is going to be a good year for gas producers, such as JKX Oil & Gas, Serinus Energy’s Kub-Gas and Cadogan Petroleum. Ukrainian prime minister Mykola Azarov announced that the reduction for industrial consumers will be extended in time till the last quarter of 2014, since Ukraine has already created gas reserves of 8 bcm at a price of about $400/tcm. Accordingly, the Ministry of Energy has proposed to reduce the ceiling price of gas (for industrial consumers) each quarter in 2014, by 10 percent, 11.6 percent, 5.5 percent and 3.8 percent respectively. Judging by last year's consumption, Ukrainian industry is likely to spend all of its overpriced stockpile by May or June. This effectively means that the gas-producing industry will experience a good opportunity to earn greater profits as gas tax and import prices decline.

Luka Oreskovic is an associate in the fellows program at Harvard University’s Institute for Quantitative Social Science and an economic and political consultant. Domagoj Babic is a Princeton-based economic consultant.