Naftogaz-Gazprom Arbitration: Who Is the Winner in the Gas War?

On November 16, 2014, NJSC Naftogaz of Ukraine (“Naftogaz”) and OJSC Gazprom (“Gazprom”) informed that they had filed lawsuits against each other at the Arbitration Institute of the Stockholm Chamber of Commerce (“SCC”). Whereas Naftogaz seeks to revise the gas price and recover USD 6 billion of overpayment for the gas supplied since 2010, Gazprom demands USD 4.5 billion in what Russian company claims to be outstanding debt for the natural gas provided to Ukraine in November-December 2013 and April-June 2014.

The dispute arose in April 2014 when, after occupation of the Crimean Peninsula, the Russian Federation abolished zero customs duty for the gas export to Ukraine. Gazprom thus set the gas price at USD 485 per 1,000 m³ and demanded USD 2.2 billion from Naftogaz for the gas already supplied. In turn, Ukraine confirmed its willingness to pay for the Russian gas provided that the price remains at the level of 1Q 2014, USD 268.5 per 1,000 m³, and transferred USD 786.3 million for the gas imports in February and March 2014. Further negotiations between Russian and Ukrainian energy monopolists proved to be futile. In June 2014 Gazprom switched Naftogaz to prepayment for future gas supplies and called for repayment of USD 4.458 billion in outstanding debts – USD 1.451 billion for November-December 2013 and USD 3.007 billion for April-May 2014.

The basis for the controversy is the natural gas sale-purchase contract for the period of 2009-2019 No KP of January 19, 2014 (“Contract”), the text of which was leaked to Ukrainian press. The Contract may be characterized by the following features: it links the price for gas to the oil prices (article 4.1) and contains so-called “take-or-pay” (article 2.2.5) and “price review” (article 4.4) clauses. The contractual price is set every quarter year on the basis of the gas oil and low sulfur fuel oil prices published in Platt’s Oilgram Price Report. The take-or-pay provision requires Naftogaz to pay for at least 41.6 bcm (80% of the 52 bcm “yearly contractual volume” set forth in article 2.2) of natural gas whether or not it actually consumes that amount of gas. Finally, the “price reopener” clause allows either party to request revision of the contractual price if this party believes that the situation on the energy market changed to the extent that the contractual price no longer reflects market prices for natural gas.

Oil-indexed formulas are common in long-term gas supply agreements for historical reasons: natural gas lacked liquid spot and forward markets; gas was primarily extracted along with crude oil which had more reliable market indicators, and thus it was reasonable to link the gas price to oil to make it competitive with an alternative fuel. However, the situation has substantially changed over the past twenty years: development of liquefied natural gas (“LNG”) infrastructure, shale gas boom, and emergence of gas trading hubs, including National Balancing Point (UK), Title Transfer Facility (the Netherlands), Gaspool and NCG (Germany), blurred the link between oil and gas trade and brought liquidity to the natural gas market. As a result, gas prices in long-term supply agreements that are linked to the prices for oil may significantly diverge from the spot market gas prices, therefore prompting purchasers to abolish oil-indexed formulas.

The present Naftogaz-Gazprom arbitration is not the first to address pricing in long-term gas supply agreements in Europe, but rather a continuation of the trend started several years ago due to the above developments in natural gas extraction and trade, as well as to the European Union’s gas market liberalization efforts, in particular through the Third Energy Package. To mention just a few examples, in 2012 Italian energy group Edison won in arbitration a EUR 450 million discount on its LNG purchases from Qatar’s Rasgas and a comparable sum from Algeria’s Sonatrach. Similarly, in 2013 the International Chamber of Commerce (“ICC”) arbitration adjusted price formula of a long-term contract between Gazprom and RWE, Germany’s second-largest utilities company, and awarded RWE compensation for the overpayments made since May 2010. In all these cases arbitral tribunals removed the link of the contractual gas price to the price for oil.

Faced with uncertainty of price review outcome, energy market players may prefer to settle their dispute rather than arbitrate them. For instance, when in 2012 E.ON, a German-based utility company, and Gazprom reached an agreement to retroactively adapt pricing conditions for the period since 4Q 2010 and thus end the ongoing arbitration proceedings, E.ON expected the settlement to have a positive effect of about EUR 1 billion on its half-year results. Similarly, in February 2014 Eni, an Italian multinational oil and gas company, signed a settlement agreement with Norway’s Statoil to adjust the terms of the long-term gas supply contract to the changed market conditions and bring to an end arbitration proceedings previously initiated by Eni.

Ukraine and Russia have also been engaged in negotiations for several months to reach a mutually acceptable solution and ensure the flow of Russian gas to Ukraine in winter. Finally, on October 30, 2014, representatives of Ukraine (Energy Minister Yuri Prodan), the Russian Federation (Energy Minister Alexander Novak) and the European Commission (Vice-President Gunther H. Oettinger) signed a trilateral binding protocol and an addendum to the Naftogaz-Gazprom Contract setting out the following framework:. Ukraine will pay to Gazprom USD 3.1 billion, calculated on the basis of a preliminary price of USD 268.5 per 1,000 m, in two tranches: USD 1.45 billion to be transferred immediately and USD 1.65 billion by the end of 2014. Naftogaz reportedly executed on November 4, 2014.

• Gas debts. Ukraine will pay to Gazprom USD 3.1 billion, calculated on the basis of a preliminary price of USD 268.5 per 1,000 m³, in two tranches: USD 1.45 billion to be transferred immediately and USD 1.65 billion by the end of 2014. Naftogaz reportedly executed the first tranche on November 4, 2014.

• Future supplies. Gazprom will deliver gas following advanced monthly payments by Naftogaz based on the price below USD385 per 1,000 m³, calculated according to a formula in the present Contract and a discount in export duties by the Russian Federation. Ukraine is free from the take-or-pay clause in the Contract and may order as much gas as it needs. Until the end of 2014 Naftogaz foresees to purchase 4 bcm of natural gas for USD 1.5 billion.

However, this solution is only an interim one: it covers the period until the end of March 2015, whereas the final price for gas and thus the sum of debt to be paid to Gazprom remains to be determined by the SCC arbitration.

In conclusion, taking into account development of the natural gas market, success of gas review arbitrations initiated by European purchasers, and presence of the price re-opener clause in the Naftogaz-Gazprom Contract, Ukrainian party seems to have good chances to obtain a positive decision in arbitration – adjustment of the oil-indexed price for the natural gas and rebate for the past excessive payments. Nevertheless, given that arbitration may be a lengthy process (not less than 1.5 years) and past results in other cases do not guarantee future success before the arbitral tribunal, Naftogaz and Gazprom may well try to have another round of negotiations, possibly with involvement of the European Union, to reach a more sustainable solution. And, due to confidential nature of international arbitration and traditional lack of transparency in gas relations between Russia and Ukraine, we will be able to see how the dispute unfolds only through the prism of the companies’ press releases and statements made by Ukrainian and Russian politicians.