There has been much discussion about how Russia – Europe’s biggest gas supplier – can best continue to supply gas to Europe over the coming decades. Gazprom and five of its European partners have decided that building two additional pipelines through the Baltic Sea (Nord Stream 2) is the best commercial solution to secure future gas supplies for the EU, where gas production continues to decline and demand is expected to grow. Ukraine and its supporters may disagree – it comes down to the economics of either supply option.
At present Gazprom can use different supply routes through which to transport gas to its customers in the EU: Nord Stream, Yamal-Europe or the transit route via Ukraine. Based on the performance of the existing Nord Stream pipelines there is concern in Ukraine and some Eastern European countries that the planned Nord Stream 2 pipelines will prove to be much more competitive than the traditional transit route through Ukraine’s aged gas pipeline system – and threaten revenues from transit fees.
Blocking Nord Stream 2 for the sake of preserving Ukraine’s transit business would not be a viable long-term solution, as much of Ukraine’s gas system has already reached or will soon reach the end of its operational life and would not be able to continue much longer transporting large volumes of gas to Europe safely and reliably without substantial investment.
Analysis carried out by the National Energy Security Fund, a private research centre, concludes that the Baltic Sea route is a cheaper way to deliver gas from Russia to the markets in North Western and Central Europe, and the same applies to the supply of gas to the Austrian hub at Baumgarten
Competition comes down to cost of gas transit
Despite statements from Ukraine’s Naftogaz, the competitive disadvantage that Ukraine has compared with Nord Stream and the planned Nord Stream 2 pipelines is quite stark: in 2015 the net cost for Gazprom to ship 39 bcm of gas through Nord Stream to Germany’s Baltic Coast worked out at €1.86 per 1,000 scm per 100 km. In the same period the cost to Gazprom of shipping 67 bcm via Ukraine to the EU border (over a similar distance to Nord Stream) worked out at €2.26/1,000 scm/100 km.
Looking to the future, the competitive disadvantage could eventually be even greater: in 2015 Nord Stream operated at 70 % of its 55 bcm annual capacity, partly because it was capacity-constrained by the EU Commission’s decision to restrict the flow of gas from Nord Stream through Germany to other EU countries via the OPAL connecting pipeline. If Nord Stream or Nord Stream 2 could operate at 100 % capacity, the cost to Gazprom would be only €1.32/1,000 scm/100 km. Furthermore in December 2015 Ukraine’s Naftogaz announced a new policy that would further increase its competitive disadvantage compared to the Nord Stream pipelines: Naftogaz unilaterally announced a new entry/exit tariff that would make transit via Ukraine twice as expensive as via Nord Stream or Nord Stream 2.
Comparative costs of shipping Russian gas to the EU via the Baltic Sea and Ukraine
Source: Gazprom data and NESF
Ukraine is in a difficult position: if it is to continue to play a major role in gas transit, it would need massive investments. This is the motivation for its planned dramatic increase in transit fees. This would however have the effect of making it even more uncompetitive compared with the Nord Stream and Nord Stream 2 pipelines through the Baltic Sea.
Current transit of Russian gas through Ukraine is regulated by a long term gas transportation contract concluded in 2009 after the most severe transit violation of gas deliveries to the EU. Before that Gazprom had to agree with Naftogaz on terms of gas supply to Ukraine and transit conditions on a year-to-year basis. After 2009 the separate gas selling and gas transportation contracts between the parties were signed for eleven years. These contracts are due to expire at the end of 2019.
Compounding the problem for Ukraine and Gazprom is that total modernization and reconstruction of the pipelines and compressor stations within Ukraine would be essential to avoid increased risks of failures and ruptures, as by 2020 the service life of its major transit gas pipelines will have come to an end.
Cost competitiveness issues
It is important to understand Ukraine’s competitiveness issues in comparison to what can be offered by the newer Nord Stream and Nord Stream 2 pipelines, which can for example transport gas over 1,220 km without the need for any intermediate compressor stations.
In 2015 the physical gas flow via Nord Stream was almost 39 bcm (70% of projected capacity). The operator’s revenue from Gazprom’s transportation service fee was €1.07 billion. Gazprom’s share in the net profit of Nord Stream AG was €185 million, in line with its shareholding. Thus Gazprom’s net payment for transit in 2015 was €885 million, or €1.86 for 1,000 standard cubic metres (scm) per 100 km. From the Russian coast to Germany’s Baltic coast the price is €22.7 for 1,000 scm. If the pipeline were to be operated at full capacity the effective fee would be reduced to €1.32 per 100 km and €16.1 from border to border for 1,000 scm.
We can accurately compare the Nord Stream rate with the actual fee Gazprom is paying to Ukraine. In the transit contract there is formula based on the previous tariff for transportation and the price of fuel gas indexed to inflation. In 2015 Naftogaz’s revenue from the international transit of 67 bcm (including 2.9 bcm to Moldova) was €1.88 billion. The average transportation distance from border to border in Ukrainian system is set at 1,240 km (very close to Nord Stream’s 1,220 km). The actual transit fee for Gazprom was €2.26 for 1,000 scm per 100 km or €28 from the Russian border to the border of the EU countries.
Last year Gazprom paid 19% less for gas transport via the Baltic Sea route than for transit via Ukraine and thus saved €207 million. As mentioned, this was in spite of the fact that the EU has set regulatory restrictions preventing Nord Stream from being used by Gazprom at full capacity utilization. Without such restrictions annual savings could be doubled.
Moreover when in December 2015 the Ukraine government set the new transportation fee mechanism, the new tariff based on entry/exit would require payment of €42 to transport 1,000 scm from the Russian border to Slovakia (including fee, fuel gas and new taxation), if it were to come into effect – i.e. twice as much as via Nord Stream.
Source: NESF calculations
Calculation of the estimated cost of transporting natural gas from the Russian border to Baumgarten is based on the current tariffs of transmission system operators. Gas passes through four transit zones – 1,220 km offshore (Nord Stream), 472 km in Germany (OPAL), about 400 km in the Czech Republic (Net4Gas) and about 70 km in Slovakia (Eustream). In winter 2014/2015 actual gas flow through the Northern Route reached Baumgarten, although initially the main destination point for the Nord Stream and OPAL transportation route was the Waidhaus interconnection point (in the Bavaria region of Germany). Net4Gas northern branch (between Lanzhot and Olbernhau) originally built for gas transit from the Soviet Union to Eastern Germany now operates in reverse mode and is capable of transmitting up to 67 million scm per day (24 bcm per year). There would be no problem to use the Slovak system in reverse mode to transport this amount of gas to Baumgarten.
Russian border – Baumgarten routes’ cost of transportation by segment, euro/ 1000 cu m
Source: operators’ data, NESF calculations
These calculations show why from border to border Nord Stream is much more attractive than the Ukrainian route from a strictly commercial point of view. A further consideration is that the main reason to increase transport capacity in the North is the additional demand for gas imports in North Western Europe, where we see a steady decline of its own gas production. During just the last five years it has declined by 58 bcm – a figure that exceeds the capacity of two Baltic Sea pipelines. For supply to the growing markets of North West Europe, Ukraine is at an even bigger cost disadvantage, even at 2015 prices.
The total cost of transporting Russian gas via Nord Stream and onshore pipelines to the Bunde interconnection point on the Netherlands/German border is now €33.7 per 1,000 scm. (€19.6 Nord Stream plus €14.14 within the EU) compared with €55.05 via Ukraine (€30.63 Ukraine plus €24.42 pipelines within the EU). Moreover physical flow via Ukraine would only be possible with new investments to build new transit pipelines in the Czech Republic and Germany. The current gas flow in the Net4Gas system goes from North West to East.
As European gas extraction will continue to decline in the future, a new direct supply route to North West Europe would be of great value for the market liquidity and security for customers.
As for Baumgarten, after landing in Greifswald Russian gas from Nord Stream has to travel another 850 km through Germany, the Czech Republic and Slovakia to reach Baumgarten. Based on the current fees of transmission systems’ operators OPAL Gastransport, Net4Gas and Eustream and full capacity utilization of the Baltic Sea pipelines, gas transportation will cost the shipper about €33 – €16 offshore and €17 onshore. It takes €34 to deliver gas to Baumgarten from the Russian-Ukrainian border under the current tariffs of Naftogaz and Eustream. This is only marginally more expensive than via Nord Stream, but Kiev’s new fee for transit would increase the actual transportation cost via Ukraine to Austria to €48 per 1,000 scm.
Transportation of 30 bcm/year for 30 years via Ukraine would involve an additional cost of €13.5 billion, much more than the full capex of the Nord Stream 2 project budgeted at €8 billion.
So if one compares the Nord Stream and Nord Stream 2 pipelines with transit routes via Ukraine just in terms of the costs of usage – without even considering issues of the reliability and safety of aged pipelines and CO2 emissions and the environmental impact of compressor stations – the result is striking! Commercial logic is not on Ukraine’s side. Ukraine therefore is trying to muster political support for a non-commercial “geostrategic” decision to block a feared competitor.
And that is not all: Russian gas brought to Europe via Ukraine, Belarus, Nord Stream or Nord Stream 2 will have to compete in the EU’s new single energy market with increasing supplies of LNG from further afield, as well as with pipeline gas from other sources. So if normal rules of competition apply and commercial logic informs the decisions of Europe’s energy groups and the EU, there could be big changes in the EU’s gas supply routes, and the EU’s industry and energy consumers should be able to benefit from competitive supplies of gas for many years to come.