As Europe is sweating out yet another hot summer, energy executives and policymakers are working out how their fellow citizens will survive the next winter. The urgency of their task is underscored by the current Ukrainian gas transit contract, which will expire on January 1, 2020. Unless this state of affairs is remedied, the gas flowing through the Ukrainian Brotherhood pipeline, the single largest stream of Russian gas entering the European Union, amounting to nearly all the gas consumed by Germany annually, will stop. Since July 2018, the European Union has mediated negotiations between Russia and Ukraine without success. Thus Europe faces the prospect of its third gas crisis (following the previous two in 2006 and 2009) in the past two decades. The second crisis, in 2009, which lasted a mere two weeks, saddled Europe not only with surging prices continent-wide but also physical supply shortages in some states. This time around there is a very real risk that the supply interruption will last considerably longer.
From a commercial perspective, the impasse makes no sense. The Russian energy company, Gazprom, ought to being doing everything in its power to ensure that the gas supply to Europe is not interrupted, since its commercial reputation is on the line. But for the Russian state, and thus for the state-controlled Gazprom as well, commercial interests are not necessarily decisive. For the new European Commission, which comes into office on November 1, it will be a real test of its mettle. Does the Commission, alongside the EU member states, panic and buckle as supply shortages appear and prices surge? Or do they hold the line, find temporary solutions from fuel switching to deploying reverse flows, and refuse to bow down to Russian energy blackmail?
Often neglected in much of the commercial and technical energy analysis as to whether another supply crisis may occur is the current relationship between Russia and Ukraine. The Russian Federation has annexed Crimea and is currently running part of eastern Ukraine with the assistance of military forces it funds and controls. So far 14,000 Ukrainians have been killed in the conflict and more than a million Ukrainians have been displaced by the conflict. Over the course of the conflict, Ukraine has expanded its army to more than 300,000 troops, most of whom are stationed near the occupied areas of the country. These forces continually exchange fire across the line of contact with the Russian-controlled forces, which include regular Russian army units.
By providing more Russian natural gas to Europe than any other route network, the Brotherhood pipeline creates two major problems for the Kremlin. First, it makes it more difficult to enlarge military operations in Ukraine without potentially threatening the movement of profitable Russian gas into Europe. Second, the gas transited across Ukraine generated, in 2018, transit payments to Ukraine of $3 billion. Three billion dollars is approximately the size of Ukraine’s defense budget.
Russia is also growing extremely frustrated with the European Union over the construction of the Nord Stream 2 pipeline, which would allow Moscow to substantially bypass the Brotherhood pipeline. An EU law that came into force in May extended the application of the bloc’s energy law to import pipelines, including the Gazprom-owned Nord Stream 2. EU energy law imposes a series of conditions, including the need for a non-EU pipeline owner to obtain security of supply certification, from EU and member-state authorities. Given its previous record of cutting off gas supplies to Central and East European EU states, Gazprom will likely have trouble obtaining this certification. Furthermore, the necessary permits are not yet in place to begin laying all of Nord Stream 2’s pipes (about 60 percent have been laid so far). So far Denmark has not granted any route permits for the pipeline, and currently the Danish Energy Agency and Gazprom are locked in litigation over the best route for the line. The Danish component of the pipeline, however, amounts to only 140 kilometers of Nord Stream 2’s 1,440 kilometer route. That final bit of pipeline could be laid in approximately one month.
The outlines of a Russian strategy are clear here: 1) Build all the pipeline, save the final bit in Danish waters; 2) Let the Ukrainian contract expire on January 1; 3) Sit back and wait. Moscow can then indicate that it is perfectly happy to provide more natural gas to Europe—but only via Nord Stream 2. To be sure, the Danish government will have to speedily permit the remainder of the pipeline, which will still not be in compliance with EU energy law. But what, in a chilly late January or early February, will the European Union do?
There is a final factor involved here, too: Moscow’s fury at the Stockholm Court of Arbitration, which awarded Ukraine’s state-owned energy company, Naftogaz, $2.8 billion (including interest) in its dispute with Gazprom. In the trilateral negotiations between the European Commission, Gazprom, and Naftogaz, Gazprom has made it clear that it wants the award to be set aside before any transit deal is put in place. Neither Naftogaz nor the Ukrainian government can accept such a condition for a transit deal, on either commercial or political terms.
Fear of a prolonged gas cut-off has resulted in much higher than usual Russian gas flows into European storage this summer. Energy executives, regulators, and policymakers are also seeking alternative supply sources for the coming winter. And the European Union’s own energy integration policy, adopted after the second cut-off in 2009, will make any cut-off, at least in the short term, less severe. Even so, any cut-off lasting more than a few days will create supply problems in Bulgaria and some of the other Balkan states and trigger a price surge across the EU gas market. If the cut-off lasts even longer, then Italy, which is significantly dependent on Russian gas, would also begin to face supply problems. At that point, Gazprom would have to invoke force majeure in reneging on its delivery contracts to a range of European countries, including France, Austria, Hungary, and Slovakia.
There are some alternatives available. In Western Europe, the United Kingdom has a massive capacity (51 billion cubic meters annually) to accept overseas deliveries of liquefied natural gas (LNG). It also has a significant reverse-flow capacity under the English Channel of 30 billion cubic meters, so LNG, probably from the United States, could be pumped from British terminals into continental Europe. Italy has three LNG terminals with low utilization rates and some spare pipeline capacity connecting it with Algerian natural gas reserves. However, in Central and Eastern Europe there is only one major terminal accessible to most of the market: Swinoujscie on the Polish Baltic coast, with a capacity of 4.5 billion cubic meters. (There is also a five billion cubic meter LNG terminal in Attica in Greece that could provide gas to some parts of the CEE market). Thus the Central and East European countries are likely to suffer most from physical shortages and price increases.
The Ukrainians themselves face a particularly acute long-term threat. Since 2015, Ukraine has taken no directly contracted gas from Gazprom; rather it has bought surplus gas from Gazprom’s customers that flowed through Ukrainian territory. This reverse-flow gas has not only proved cheaper than the gas it used to directly contract from Russia; it has also reduced Russian influence in Ukraine. But when the transit contract expires on January 1, 2020, that source of gas will dry up. As a result Ukraine has been stockpiling natural gas in its own storage facilities, with the aim of storing up at least one year’s worth of imports. Ukraine is also looking at boosting domestic production, investing in energy efficiency, and working with allies such as Poland to obtain alternative sources of supply.
Clearly, if Gazprom lets the existing contract expire, it would suffer significant long-term damage to both its reputation and its commercial bottom line. There are two factors that are likely to make the commercial damage worse. First, the United States is currently ramping up its LNG production—almost on time for the latest Russian gas crisis. In addition, even the Central and East European states may be able to access some of America’s LNG by means of leasing of ships that carry re-gasification technology on board. These re-gas ships are cheap. For example, Lithuania has one in Klaipeda harbor that costs only $127 million and has a capacity of four billion cubic meters. A prolonged gas cut-off would likely result in several Central and East European states commissioning such re-gas ships. Second, a gas crisis would make renewables, whose prices have collapsed over the past five years, a much more competitive option relative to Russian gas.
But again, with the Russian state-owned Gazprom, commercial concerns are not necessarily at the forefront. Thus it is quite possible that Moscow will let the Ukrainian transit agreement expire, allowing prices to surge and chaos to ensue for a couple of weeks, in hopes that the initial supply shock will provide Russia with enough leverage to force a more favorable deal with Ukraine and the European Union and to ensure rapid completion of Nord Stream 2. President Putin can then step in to “solve” the crisis, aided by a massive disinformation campaign to put the blame firmly on Ukraine and the European Union.
However, for such a plan to work, Russia would need the Europeans to panic and buckle in the face of supply shortages and surging prices. The problem for Moscow is that it is far from clear that such a “squeezing” strategy will work. The Europeans might not buckle. In a game of European gas chicken, it may end up being Moscow who chickens out first. To be sure, the longer the conflict drags on, the more states will be affected. However, the longer it drags on, the easier it will also become to fix many of the supply problems. The European Union can take rapid emergency measures to reverse pipeline flows, build small interconnector pipelines, and install re-gas ships. These “emergency measures” could end up becoming permanent and would have the effect of excluding Gazprom from a significant part of the EU market. And with exclusion comes both a loss of revenue and a loss of influence. Moscow must therefore carefully weigh the advantages of a short “shock and awe” cut-off in January tied in with a formidable disinformation campaign and a longer supply cut-off which might deprive Russia of key European political and corporate allies, while also undermining Russian revenues, power, and influence.
This analysis therefore suggests that Moscow is more likely to seek a shorter termination in the hope that the Europeans panic and fold. The thinking in the Kremlin is likely to be that, although a two- or three-week cut-off will not be that bad for the European Union in practice, Moscow can ramp up the panic in the hope of getting Brussels to fold. If however, the Europeans do not fold, President Putin will then step in to “solve” the problem by doing a deal to end the crisis, while of course blaming everyone else for causing it in the first place.