Why Ukraine Needs Market-Based Gas Prices

A fundamental problem with Ukraine’s gas sector has been very low prices for consumption and domestic production by state-related companies, which have led to overconsumption and underproduction

ukrpetroleum.com

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A fundamental problem with Ukraine’s gas sector has been very low prices for consumption and domestic production by state-related companies, which have led to overconsumption and underproduction. However, Ukraine does not need to import gas or coal if it only offers normal market-economic conditions for the energy sector.

Gas trade with Russia and inside Ukraine has been one of the main sources of enrichment in Ukraine after the collapse of the Soviet Union. In 1998, Ukraine’s main gas trader at that time, Ihor Bakai, famously stated “All rich people in Ukraine have made their money on Russian gas.” The essence of their enrichment was to buy gas at a low state-regulated price and sell it at a high market price shielded by monopoly, or produce commodities for export using cheap gas.

Such gas trade has been the main source of top-level corruption in Ukraine. The only way of fighting this corruption is to unify all Ukraine’s many different gas prices at the market level¹. Unless Ukraine does so, top-level corruption will prevail, and Ukraine will not attain significant economic growth.

Last November, four Reuters journalists published an investigative article, “Putin’s Allies Channeled Billions to Oligarch Who Backed Pro-Russian President of Ukraine.” The person in question was Dmytro Firtash, who has been the dominant intermediary in the Russian-Ukrainian gas trade since 2002, soon after President Vladimir Putin took over control of Gazprom.

According to Reuters, “Gazprom sold more than 20 billion cubic meters of gas well below market prices to Firtash” during the years 2010-13. “The price Firtash paid was so low, Reuters calculates, that companies he controlled made more than $3 billion on the arrangement. Over the same period… bankers close to Putin granted Firtash credit lines of up to $11 billion. That credit helped Firtash, who backed pro-Russian Viktor Yanukovych’s successful 2010 bid to become Ukraine’s president, to buy a dominant position in the country’s chemical and fertilizer industry…” “When Firtash was arrested in Vienna” a Russian businessman considered to be close to Putin “loaned the Ukrainian businessman $155 million for bail.”

Firtash was considered to be one of the two biggest businessmen supporting Yanukovych, the other being Rinat Akhmetov, but in 2014 Forbes assesses his net personal wealth at only $500 million. The question arises whether he merely operated on the basis of the $11 billion credit line from Gazprombank and not as an independent businessman. Similarly, Bakai fled to Russia long ago, and another influential person in the  gas trade in the past, Viktor Medvedchuk, appears to be Putin’s closest friend in Ukraine. Whoever controls Ukraine’s gas purchases from Russia tends to reap rents for which he or she can buy the political leadership in Ukraine.

As a minimum, this gas trade needs to be opened up to transparency with proper measurement of imported volumes and prices, but that is hardly enough. In their eminent report “Putin and Gazprom,” late Boris Nemtsov and Vladimir Milov pointed out that the main purpose of that corporation was to enrich President Putin and his cronies. A second aim is geopolitical as is obvious from the price discrimination and many supply cuts that Gazprom has pursued against East European customers. Given that Gazprom’s main goals in Ukraine are to corrupt and combat the country, Ukraine should stop trading with Gazprom. Fortunately, that is possible in near future. Since the current leadership of Naftogaz Ukrainy has opened up for deliveries from Europe through pipelines from the West, Ukraine no longer needs to rely only on Russian gas, and it should stop buying it. Temporary lower prices are only a trick that no serious businessman should fall for.

A fundamental problem with Ukraine’s gas sector has been very low prices for consumption and domestic production by state-related companies, which have led to overconsumption and underproduction. Until April 1 2015, Ukraine’s household prices for gas were only 12 percent of the actual cost of gas. The natural consequence has been an aggravation of Ukraine’s poverty, budget deficit and foreign trade deficit.

The low domestic gas price also contributed to corruption. According to official Ukrainian statements, about 40 percent of the gas produced by Ukrainian state-controlled companies was sold at $50 per 1000 cubic meters (mcm) and resold illicitly to the private sector for some $380 per mcm in 2013. Populists call for more state control so that the cheap gas really goes to the population, but the Ukrainian state is not strong enough to deprive a few well-connected people of $2.5 billion dollars a year in illicit earnings. Therefore, the government did what it had to do when it quadrupled the gas prices for households on April 1. The main problem is that the prices were not raised to the market level straight away.

Last year, Ukraine spent no less than 10 percent of GDP on energy subsidies, roughly 8 percent on gas subsidies. The coal subsidies were rightly abolished at the beginning of the year. The price changes on April 1 abolished price subsidies of 5 percent of GDP, and another 2 percent of GDP in gas subsidies are likely to disappear because of falling international oil and gas prices. Altogether 8 out of 10 percent of harmful energy subsidies are being eliminated this year, which amounts to vital fiscal adjustment. Without these cuts, Ukraine would default in no time. Even with these cuts, the country is on the verge of bankruptcy. Incredibly, some populist Ukrainian politicians call for the gas tariffs to be cut substantially, but there is no financing. This is a hostile act to the Ukrainian state.

The savings are so large that cash compensation of only 1 percent of GDP can provide full compensation to the poorest third of the population. Ukraine has the administrative capacity to carry that out.

Because of its extremely low energy prices, Ukraine has had an extraordinary overconsumption of energy, the highest in Europe for unit of output. The new higher prices should rationalize Ukrainian energy consumption. In 2014, Ukraine’s gas consumption fell to 42.6 bcm. In 2015, it may fall to 35 bcm, since it declined by 21.5 percent in the first four months.

Ukraine’s domestic gas production is steadily 20 bcm a year, but it could easily increase to 35 bcm within a few years if private enterprises were offered decent tax, trade and regulatory conditions. In 2012, the International Energy Agency noted: “On the supply side… Ukraine can eliminate its natural gas import dependency in the foreseeable future by substantially increasing domestic gas production…”

For unclear reasons, the current Ukrainian government has refused to offer independent gas producers reasonable market conditions. Ukraine does not need to import gas or coal if it only offers normal market-economic conditions for the energy sector. It could even become a significant gas exporter. To demand that the low prices for Ukraine’s domestically-produced gas continues, as some populists do, means to discriminate against domestic production in favor of imports. Considering that Ukraine imported gas for $11.5 billion in 2013, gas market adjustment alone could eliminate Ukraine’s current account deficit.

For the market to function, it must be created. Fortunately, the current Ukrainian government has laid a base with its new law on the gas market, which is formed in line with the European Union’s third energy package. An open market with multiple producers, suppliers and distributors, free prices and private enterprise is the best means to fight subsidies, corruption, inefficiency and poverty to achieve greater national welfare.

¹  Given that Ukraine currently has to import gas, the import price is the market price.

Anders Åslund is the author of the new book “Ukraine: What Went Wrong and How to Fix It.”

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