Paying the piper

Contractual obligations

Ukraine became a transit territory for natural gas to Europe back in the 1980s, when the bulk of Soviet gas pipelines were built to transport gas from fields in Siberia and the Urals to Ukraine’s border with Europe. There, the gas entered a branched transport system and flowed further west into Slovakia, Hungary and Poland. From there the gas was distributed to other European countries, primarily Austria, the Czech Republic, Germany and Italy. Since then, and until the Nord Stream pipeline through the Baltic to Germany was opened in 2011, the Ukrainian gas transport system remained Russia’s principal gas corridor to Europe.

Immediately prior to the war in Ukraine, Russia delivered 150 billion cubic metres of natural gas to Europe, 40 billion of which transited Ukraine. Deliveries were made under a contract between Russian energy giant Gazprom and Ukraine’s state-owned oil and gas company Naftogaz. The five-year transit contract was signed in late 2019, during the first year of Volodymyr Zelensky’s presidency.

The basis of the agreement was the ship-or-pay principle, which obligated Gazprom to deliver a set amount of gas through the Ukrainian gas transport system, but, significantly, reserved the pipeline infrastructure regardless of the total volume transported. Naftogaz, in turn, undertook to ensure that deliveries went smoothly.

Ironically, at the time the contract was concluded, Ukraine was of relatively little importance to Gazprom as a transit hub, mainly as Moscow had been actively developing alternative gas routes to Europe, namely Nord Stream to Germany under the Baltic Sea, and TurkStream and Blue Stream under the Black Sea to Turkey and the Balkans. Nord Stream 2 was then also under construction, though faced significant challenges due to US sanctions on the controversial project, which Washington believed would raise Europe’s energy dependence on Russia to unacceptable levels.

Following Russia’s illegal annexation of Crimea in 2014, Ukraine stopped importing Russian gas itself, and so, by the time the agreement was signed five years later, “direct gas relations between the countries no longer existed,” according to Ukrainian energy expert Mykhailo Honchar, who heads the Strategy XXI Centre of Global Studies think tank. “Only transit remained”.

In 2021, the incoming Biden administration imposed no new sanctions on Nord Stream 2, clearing the way for Russia to prep actively launching the project. To this end, the Russian authorities began briefing that Ukraine had not been safe for gas transit since 2014, due to the War in Donbas, and promoting the fact that an alternative route would have to be launched soon.

“At that time Russia controlled around 46% of the gas market in the EU, and 55% in Germany. Of course, prices started rising,” says Honchar.

However, in February 2022, without waiting for the new gas corridor to be put into operation, Russian forces launched their full-scale invasion of Ukraine, which in turn led to Germany blocking the imminent opening of Nord Stream 2.

In March 2022 Russia set new conditions for so-called “unfriendly countries” wanting to purchase Russian gas: now payment would only be accepted in Russian currency, forcing European companies to open ruble accounts at Gazprombank. For their refusal to agree to this scheme, Gazprom cut off gas supplies to both Bulgaria and Poland.

However, things did not end there. The Kremlin soon levied its own sanctions on EU gas companies, including EuRoPol GAZ, which owns the Polish section of the Yamal–Europe pipeline, running from western Russia’s Tver region to Germany. Citing its own sanctions, Russia announced that gas transit through Poland was now impossible, and in May 2022 the flow of gas through the Yamal–Europe pipeline practically stopped.

Deliveries via Nord Stream 1 were also affected, first due to Gazprom closing the pipeline for scheduled and preventative maintenance in summer 2022, announcing that turbines at compressor stations had broken down and could not be repaired due to Western sanctions.

By July 2022, the pipeline was working at just 20% of its capacity, and by September it ceased operation entirely after Gazprom announced that its last operational turbine had broken down. Just three weeks later, an act of sabotage took place on the pipeline and explosions destroyed both lines of the suspended Nord Stream 1 and one of Nord Stream 2’s two pipelines, even though they had not been made operational.

Gazprom’s cashflow woes

Currently over half of the 25 billion cubic metres of pipeline gas Russia supplies annually to Europe passes through Ukraine. The rest travels via the TurkStream pipeline under the Black Sea to Turkey, from where it is transported to countries in southeastern Europe. No other fuel corridors remain between Russia and Europe.

While five years ago Russia was planning to end its cooperation with Ukraine’s Naftogaz, the war has changed its priorities. “If it hadn’t been for the war, Russia would have put an end to gas transit via Ukraine,” says Yury Korolchuk, energy analyst and cofounder of the Ukrainian Institute of Energy Strategies. “But now there is no Nord Stream and no Yamal–Europe. There is just Ukraine and Turkey.”

The Kremlin has made no secret of its interest in extending the gas transit contract with Ukraine, and in July Russia’s Deputy Prime Minister Alexander Novak publicly announced that Russia would be prepared to continue transporting gas via Ukraine after 2024, should Kyiv agree.

Above all, transit means foreign currency revenue which Gazprom would be very unhappy to lose.

Although European countries were forced to open ruble accounts in Gazprombank, they still buy these rubles from the same bank for euros. In the first year of war, the export of Russian pipeline gas to Europe dropped by 62%. In 2023 it continued to drop, and Gazprom’s revenue fell by 27%. For the first time since 1999 the company recorded a net annual loss, amounting to 629 billion rubles (€6.1 billion). Before the war, Gazprom’s annual profit from the sale of gas through the Ukrainian corridor likely topped €10 billion, and although it has since dropped, according to various estimates it is still worth somewhere between €4 billion and €7 billion per year.

Furthermore, it is unlikely that Gazprom would be able to find other buyers for such vast volumes of gas. “China won’t buy it, but even if it did, it would demand domestic Russian prices,” says Honchar, adding that Russia’s neighbours in Central Asia have their own gas supplies.

Should the Ukrainian transit stop, Gazprom would also potentially face fines for being unable to meet its contractual obligations to supply gas to European energy companies. Force majeure does not apply to ending contracts with Naftogaz, and so the supplier is legally liable for compensating its clients for unfulfilled deliveries.

Problems will also arise with the Slovakian gas transport company Eustream, which currently manages the transit of Russian gas from the Ukrainian border elsewhere into the EU. Gazprom signed the same contract with Eustream as it did with Naftogaz, but it doesn’t expire until 2028, and the ship-or-pay principle obligates the Russian company to pay for reserving facilities even if there is no transit.

Finally, the dependence of some EU countries on Russian gas deliveries allows Russia to influence decision-making at least indirectly within the EU, where unanimity is so important.

“At the other end of the pipe there is not some abstract Europe, where Gazprom used to deliver 155 billion cubic metres per year. At the other end of the pipe there are several Trojan horses which want to continue to receive Russian gas, and which provide the Kremlin with certain services,” says Honchar. “It is advantageous for Russia to provide gas to countries with which it enjoys good relations,” Korolchuk agrees. These countries are primarily Hungary and Slovakia.

This is also why the Kremlin predictably did not announce a force-majeure situation and stop the transit of its gas through Ukraine even after the Armed Forces of Ukraine (AFU) captured the Sudzha gas metering station in August, when the AFU began a surprise military incursion into Russia’s southwestern Kursk region.

Gas-thirsty Europe

Despite the political optics of continuing to do business with Russia, sourcing pipeline gas imports from Russia via Ukraine is also economically advantageous for Europe.

Before the war, Europe was connected to Russia by an extensive network of gas pipelines and imported almost half of the gas it needed from Russia. Since then, deliveries have dropped off significantly, and currently just 15% of European gas is Russian in origin. The shortfall has been made up by importing liquid natural gas (LNG) from the US, the UK, Norway, Algeria and Qatar. Erstwhile major purchasers of Russian gas such as Germany, Poland and Italy have now largely switched to alternative sources of fuel.

Nevertheless, the Sofia-based Centre for the Study of Democracy, a public policy institute dedicated to the values of democracy and market economy, believes that the EU is still heavily dependent on Russian natural gas.

Even at 15%, Russia is still the second largest supplier of gas to the bloc after the United States (19%), and in the second quarter of 2024, for the first time since the outbreak of war, the EU purchased 400 million cubic metres more gas from Russia than it did from the US.

Voluntarily foregoing cheap and available Russian gas under long-term contracts is not so easy, and finding a replacement at the same price is simply impossible.

Today the main purchasers of Russian gas delivered by transit through Ukraine are Slovakia, Austria and Hungary, and to a lesser extent Italy, Czechia, Croatia and Slovenia.

For the EU as a whole, the 15 billion cubic metres of gas a year which Russia now delivers via Ukraine would constitute a significant loss, being roughly equivalent to the annual consumption of several smaller EU countries put together.

If transit through Ukraine is stopped, countries in Central and Eastern Europe will only be able to receive deliveries of Russian gas through the Balkan and Trans-Balkan corridors, which branch off from TurkStream. According to an assessment by the Norwegian company Rystad Energy, to replace Ukrainian volumes the EU would have to import 7.2 billion cubic metres of LNG per year, though calculating the actual cost of such a move for Europe cannot easily be calculated, according to Christoph Halser, a gas analyst at Rystad Energy.

Owing to the nature of production and transportation, LNG already costs more than pipeline gas, and for Austria, Slovakia and Hungary and other countries with no direct access to the sea or their own regasification terminals, the cost will be even higher. This is why landlocked European countries are so loath to cancel their long-term gas delivery contracts with Gazprom, and favour continued transit in any form.

This is also why, after two and a half years of war, the EU has still not levied sanctions on Russian pipeline gas. Likewise, Ukraine has made clear that it will not violate its contractual obligations and will continue to allow the transit of Russian gas through its territory as long as individual European clients need it. And although the EU officially announced in February this year that it sees no need to extend the transit agreement with Russia, Ukraine will still have to take into account the interests of EU members on which they rely for the provision of military assistance.

Ukrainian energy under threat

The AFU’s capture of the Sudzha gas metering station in Russia’s southwestern Kursk region might well have put an end to discussions of whether to extend or annul the Russian-Ukrainian gas agreement. But as neither the pipes nor the compressor stations were damaged in the fighting, and as Ukraine earns significant gas transit fees from the arrangement, the unusual collaboration between two countries at war continues.

While contractually Kyiv is supposed earn at least €1.25 billion in transit fees from Russia per year, according to the Independent Commodity Intelligence Service, it currently receives around €714 million, since Gazprom ended deliveries via Sokhranovka, another gas metering station in the Russian-occupied Ukrainian region of Luhansk.

A large proportion of Ukraine’s transit revenue goes towards maintaining the extensive network of gas pipelines, including the purchase of industrial gas for compressor stations. Naftogaz CEO Oleksiy Chernyshov previously said that network maintenance alone cost €892 million per year, meaning that Gazprom’s current transit fees are insufficient to cover those costs.

Korolchuk provided a much lower estimate of maintenance costs — around €446 million annually — suggesting that the official figures may be overblown, but noted that while Ukraine’s revenue from gas transits was not zero, it was nevertheless “minimal” — after deducting maintenance costs, some €270 million is left over. “In better times, we earned more than €2 billion in transit fees,” he stressed.

At the same time, it is unclear how Ukraine will cover expenses for maintaining the entire system of gas pipelines without transit revenue.

In fact, Ukraine’s gas transport system not only provides transit, but also supplies gas to some of the most remote areas of the country through a branched network of pipes. The Soviet-built system was designed to work with a powerful through-flow of gas and so to function correctly, the network must be at full capacity.

“The system is designed to transport gas of the country’s own production, imported gas and transit gas. And all of these types of gas are in the same pipes,” Honchar explains.

At present there is almost no imported gas in Ukraine’s network as energy consumption has dropped drastically due to the war, and Ukraine’s domestic gas needs are covered by the country’s own production. However, as most of the gas extracted in Ukraine comes from gas fields in the Kharkiv and Poltava regions that are not connected by pipeline to the rest of the country, transit gas has always been used to supply other regions.

Thus, the biggest problem Ukraine faces if transit ends is not just a loss in revenue, but a drop in pressure in its gas pipelines, which will lead to serious difficulties in supplying consumers in remote areas of the country even with domestically produced gas.

Without the required transit flow, Ukraine will likely be forced to intensify pumping, or even modify gas pipelines to ensure they can function with reduced pressure. “Additional compressor stations will have to be built and supplied with gas. This gas also needs to come from somewhere, we’ll have to buy it or produce our own,” says Korolchuk.

However, certain experts and Ukrainian officials believe that the country’s gas system will be able to function without transit. “The system is adapted for this. Simulations have shown that it will continue to work — domestically produced gas and gas from underground storage can be used,” Honchar says. Similarly, Ukrainian Energy Minister Herman Halushchenko said in March this year that the country’s gas system had undergone a stress test and proved that it could also function without transit.

But the “stress tests” appear to have been purely theoretical in nature and based on computer modelling, and Korolchuk warns that things could be considerably different in reality, calling the assurances “just a populist political statement”. “[In the stress test] the transit kept going and did not stop. If it had been switched off and we’d lived without it in winter, in the cold weather, then there would be something to discuss.”

Nevertheless, even if the system works properly, some experts predict that gas prices for Ukrainian consumers will rise drastically — from 2 hryvnia (€0.04) to 8-9 hryvnia (€0.17-0.19), an enormous burden on a population already struggling due to the war. “We don’t have money for subsidies,” Korolchuk warns. “The consumer will have to bear the entire cost.”

Finally, there is a further risk that if Ukraine’s gas pipeline infrastructure is no longer used for the transit of Russian gas to Europe, it would become a target for the Russian military. So far neither side has intentionally attacked gas pipelines or compressor stations used for gas transit, but if it loses the Ukrainian corridor to Europe, Russia may no longer see the need to be so cautious.

Gas washing

Until spring this year Kyiv had indicated that it was prepared to allow Russian gas to continue transiting its territory as long as its Western partners required it to. But increasingly, the official position has been evolving to one that rejects doing business with Ukraine’s belligerent neighbour, and since then Ukraine’s Energy Minister, Chernyshov, and even Ukrainian President Volodymyr Zelensky have said that the transit contract with Russia would not be extended under any circumstances.

While Russia has already announced it’s looking into the possibility of delivering LNG by sea via “routes connected with Turkey”, the most logical solution would be to supply the required volumes to Europe via the second operational pipeline, TurkStream. However, the route’s capacity is limited, and much of it is already in use.

The Centre for the Study of Democracy has predicted that Russia is most likely to expand its deliveries to Europe via Bulgaria, however, by brokering a deal with Bulgarian network operator Bulgartransgaz. While Gazprom currently only uses 75% of the pipeline capacity on the Turkish-Bulgarian border, it has the right to use as much as 90%. By increasing this figure, Russia will be able to deliver an additional 2.5 billion cubic metres of pipeline gas through TurkStream.

As the main obstacle for all parties to continuing the current arrangement is political, one solution that may be acceptable to all parties is simply to change the origin of Russian-supplied gas on a technicality.

For example, Gazprom may make use of the fact that under the 2023 contract between the Turkish state gas monopoly BOTAŞ and Bulgartransgaz, Turkey may deliver 3.65 billion cubic metres of gas per year via Bulgaria to Europe. As all natural gas that enters Turkey legally becomes the property of BOTAŞ, Russian gas will technically become Turkish too.

In late August, Turkey announced it was planning to increase deliveries to Europe through Bulgaria to 7.5 billion cubic metres, using a creatively named mix of gases called Turkish Blend, primarily made up of Turkish and Russian gas, as well as LNG from the US, Qatar, Algeria, Nigeria and Oman.

Since 2023 Gazprom and BOTAŞ have also been working on a project to create a major gas hub in Turkey. So far Russia uses just two thirds of its potential capacity on the two gas pipelines connecting it with Turkey (TurkStream and Blue Stream). This allows Gazprom to deliver another 8-10 billion cubic metres of gas per year by pipes under the Black Sea, which has its “identity removed” at the Turkish hub and is then delivered to the European consumer under the guise of Turkish or Azerbaijan gas or LNG.

Azerbaijan is also another possible key intermediary between Russia and European consumers. Early this summer, there were reports that Central European countries were in talks with Azerbaijan about continuing gas transit through Ukraine, but replacing Russian gas with Azerbaijani gas.

The idea to pump Azerbaijani gas into Ukrainian pipes is original in itself, but even more surprising is Baku’s readiness to provide deliveries. For several years, Azerbaijan has been exporting up to 11–12 billion cubic metres of natural gas per year to Europe, and doesn’t have the capacity to supply more. Energy Aspects, which provides independent energy commodity data and intelligence, estimates that Azerbaijan could increase its annual gas exports to a maximum of 1.7 billion cubic metres.

“And suddenly Aliyev comes up with a figure of 20 billion,” Honchar says, referring to the Azerbaijan president’s promise to deliver “at least” 20 billion cubic metres of gas to the EU by 2027. “But who has this gas? Gazprom does.” Korolchuk agrees with him: “Obviously, this will actually be Russian gas.”

Kyiv no doubt realises that gas delivered from Azerbaijan under this alternative contract will still be Russian. But nevertheless, Naftogaz is interested in the idea of Azerbaijan or Turkey acting as an intermediary for continuing transit. Their main concern is that they don’t have to have any direct relations with Moscow after 2024.

According to Christoph Halser of Rystad Energy, Russia could keep its volumes of production, and Ukraine could keep its unique position as a transit country, while Azerbaijan could introduce a new export route, strengthening its position as a supplier to the EU. He added, however, that although a deal “could make sense for most sides”, the “relabelling of Russian gas” is met with some opposition “due to reputational risks”, as it effectively involves repackaging the same Russian gas under a different name.

Transit without a contract?

Whether or not the transit of Russian gas continues through Ukraine under a direct contract between Naftogaz and Gazprom after 31 December 2024 is a question to which experts are still unable to give a definite answer.

“I think that as long as the war continues, this transit will exist in some form,” says Korolchuk. “Whether this will be Azerbaijani gas, as they’re calling it — that’s another question. People’s main concern is for gas to be available at an affordable price. Continuing the transit will allow Russia to earn money from trade with the EU without losing any political influence. Ukraine will also be able to maintain its traditional means of leverage, and at the same time keep its gas transport system in shape. Every side has its own interests.”

“In my opinion, transit will stop,” says Honchar. “As long as Russian aggression continues, this is impossible. Not in any form. Transit only continues because Ukraine tries to maintain gas deliveries for its Western partners. But the contract will soon expire, and there’s no point in prolonging it.”

However, experts allow for a scenario whereby the current contract for transit between Moscow and Kyiv is not extended, but the gas transport system of Ukraine continues in one way or another to deliver gas that is not even “disguised” as Azerbaijani or Turkish gas, but openly designated as Russian.

For example, there is one option in which responsibility for transit will be entrusted to European countries. “If someone is so interested in Russian gas, then there may be an option when Ukraine signs a contract with a company buying Russian gas in Europe, and this company itself takes receipt of this gas on the Ukrainian-Russian border,” says Honchar.

In this case, European gas traders will directly purchase gas from Gazprom and then oversee its transport through Ukraine. Kyiv will provide services to European companies and will avoid any direct contact with Moscow.

Such a scenario was discussed in 2019 as an alternative to the current contract between Gazprom and Naftogaz, but the project did not attract much interest from EU traders at the time, as it involved taking on risks connected with the transport of gas through a warzone and unpredictable transit tariffs. But as there are now very few alternatives left, European energy companies have returned to discussing the scenario.

There is another option, as Bloomberg writes, which was practised before the war: even after the long-term contract with Naftogaz expires, Gazprom may continue to reserve capacities for Ukrainian pipelines under short-term contracts with European clients.

Finally, in this situation, Korolchuk says, there may also be an unexpected outcome, where transit continues without any contracts at all. “Russia will simply say — yes, there’s no contract, but we have an understanding with our partners in Europe, and as a gesture of good will we’ll extend the transit without a contract. Then Ukraine will find itself in a stalemate. We will also have to show a gesture of goodwill and say: all right, there’s no contract, but we’ll accept this gas. This may even become a condition of peace talks.”