The next winter is approaching fast in natural gas terms. While temperatures are slowly rising in the Northern Hemisphere and the cherry blossoms around the Tidal Basin in Washington, DC hit peak bloom over the weekend, across the pond the EU Commission kicked off a fresh series of trilateral gas talks between Russia, the Ukraine and the EU.

Prima facie, the objective is clear – to agree, by June, on a successor to the “Winter 2014/2015 Package” for Ukrainian gas purchases from Russia. In Brussels, Vice-President of the EU Commission for the Energy Union, Maroš Šefčovič, said after the inaugural meeting had convened to follow up on the expiration – i.e. March 31, 2015 – of the so-called “Winter Package” on the delivery of gas supplies to the Ukraine signed between the three parties in October 2014:

“I am happy that the parties were able to agree on a joint statement and on the steps forward. On this basis we can work towards a bridging agreement until the Stockholm Arbitration Tribunal settles the disputed issues. I am also reassured that the transit gas flows to the EU will remain unaffected.”

This statement is telling in at least two ways. First, EU officials obviously prefer to sit at the table of any gas negotiations given that the EU receives about a third of its gas from Russia, with around half that amount crossing the Ukraine based on 2013 IEA numbers. Moreover, they like to reassure the public that transit gas flows to the EU will remain “unaffected” hoping that Russian / Gazprom officials do not publicly cast doubts on that in any meaningful way.

Second, the above statement also sheds light on the EU Commission’s thinking and/or concerns. The VP of the EU Commission talks about a “bridging agreement until the Stockholm Arbitration Tribunal settles the disputed issues” with the goal of securing supplies throughout the entire winter season 2015/2016. Note, a tribunal decision is unlikely before the fall of 2016. So, this is quite an opportunistic definition on the part of the EU of what a “bridging agreement” means.

Unsurprisingly, this understanding did not fly with the Russian side and it appears that the EU even lost control of their Ukrainian protégé temporarily when the Ukrainian Energy Minister Volodymyr Demchyshyn said in grandstanding fashion in a March 2015 briefing that the Ukraine plans to stop buying Russian gas from April 1 onwards. “At the moment we don’t need to buy Russian gas. We will simply stop buying it,” Minister Demchyshyn asserted according to a report by Reuters.

The cash-strapped Ukraine appears to believe it has the leverage required to push Russia to lower the price it charges Kyiv for gas delivery, as increased imports from the EU during the Winter 2014/2015 season seem to indicate to the Ukrainian government that the Ukraine’s dependence on Gazprom supplies will also be reduced for the future. In this context, Vladimir Socor of the Jamestown Foundation elaborated in the Eurasia Daily Monitor on what he called a “dramatic reorientation of Ukraine’s natural gas supply strategy” and the dependence on Gazprom “a thing of the past.”

“Gazprom had traditionally supplied almost 100 percent of independent Ukraine’s annual gas imports. Gazprom accounted for 95 percent of Ukraine’s imports as late as 2013. Gazprom’s share in 2014 was still dangerously high, at almost 75 percent of Ukraine’s gas imports, but the country procured the remainder through reverse flows from Europe. Of 19.5 billion cubic meters (bcm) of gas that Ukraine imported in 2014, Russia supplied 14.5 bcm; whereas 5.1 bcm entered Ukraine through interconnections from Slovakia (3.6 bcm), Poland (0.9 bcm), and Hungary (0.6 bcm),” he detailed.

In particular, looking at reverse flows from Europe via Slovakia and taking into account optimistic projections by the Ukrainian Energy Ministry and Naftogaz of Ukraine, Vladimir Socor concludes that “[c]ompared with the first quarter of 2014, when Gazprom’s market share stood at 100 percent in Ukraine, the change in the first quarter of 2015 looks downright revolutionary in terms of Ukraine’s supply diversification.”

Well, even though there is ostensible improvement on that front, this may turn out to be a mirage due to the confluence of several favorable developments. First, gas consumption was down a result of a relatively mild 2014/2015 European winter. European gas demand has underperformed projections over the last couple of years due to weak economic growth. And reverse flows are viewed by Gazprom as a violation of contractual obligations – which is difficult to assess without seeing the actual contract – because those reverse flows consist predominantly of gas originally sold by Gazprom to European energy companies that is then re-sold.

Obviously, the latter may have been helped by the mild winter. One can only imagine the level of cooperation if the winter 2015/2016 were to turn out very harsh. So, the point is that energy security should not even indirectly rely on assumed future weather conditions. The following graphic shows the impact of a mild winter on primary energy consumption in Germany. The sharp drop (-12.6%) in German natural gas consumption in 2014 vis-à-vis 2013 stands out.

Primary Energy Consumption in Germany (2014)

Source: AG Energiebilanzen

Meanwhile, the EU is not as myopic as the Ukraine and therefore, behind the scenes, ensured that Ukraine accepted a Russian interim offer – equivalent to the Russian understanding of what “bridging agreement” means – for the upcoming April-June second quarter. As reported by the Kyiv Post citing Energy and Coal Industry Ministry reports of April 1, Naftogaz of Ukraine and Russia’s Gazprom signed a new agreement for the delivery of Russian natural gas to the Ukraine in the second quarter of 2015. Reuters provides further details on pricing citing Ukraine’s energy ministry data. Russian gas supplies would come at a price of $248 per thousand cubic meters for the upcoming second quarter, which compares to $329 per thousand cubic meters negotiated in the now expired “Winter Package”. Consequently, while the Ukraine is able to buy cheaper Russian gas for the next three months, it also gives all parties more breathing room to negotiate a new pricing agreement as well as an agreement that takes both the Ukraine and the EU safely through the winter season 2015/2016.

Nevertheless, it has to be conceded that Russia won the “first round” in this fight because Russia is now able to adjust prices upwards even if oil prices only stage a limited recovery in the short term and it also continues to hold all the cards if the EU were to consider tightening sanctions in the medium term in response to heightened military activity in the Eastern Ukraine, despite the Minsk Agreement to consolidate territorial gains further.

The EU is in a very delicate position. On the one hand, Ukraine could hold the EU’s energy security hostage at any time, while on the other hand Russia may be willing to endure even more pain for itself – i.e. responding by cutting all gas supplies to Europe via the Ukraine – if cornered and simply following the logic that the costs of the “Ukraine/Crimea geopolitical adventure” are already very high, so a little bit more pain – given Russia’s still significant foreign currency reserves – will not really make a difference. Note, the EU can only keep the Ukraine’s behavior in check and in line with European energy security interests if the EU continues to show willingness to provide the necessary funding for the Ukrainian gas purchases.

In line with other studies, a new EWI study entitled “The 2014 Ukrainian crisis: Europe’s increased security position – Natural gas network assessment and scenario simulations” attempts to convey a similar and familiar message; namely, that the EU’s exposure to the Ukrainian transit system is limited regionally in geographic terms – only Bulgaria representing a small market is seen impacted in the short term – and that the EU overall is “less vulnerable to a natural gas disruption through its main import route (Ukraine) than ever before.”

The 122-page study, clarifies this point:

“In 2013, Gazprom sales to EU-28 represented up to 29% of total EU consumption, and 14% of Europe’s demand was served through Ukraine. Dependence on this corridor is high, but has decreased for both Russia and Europe in the last decade. Between 2005 and 2014, transit through Ukraine to Europe has gone from levels of 121 bcm to levels of 57 bcm. The share of Russian gas to Europe transiting Ukraine has also decreased from levels of 80% in 2005, to levels of 50% in 2013 and 30% in 2014. (…) Out of the five EU largest natural gas markets with demand above 30 bcm/y (Germany, the UK, Italy, Netherlands, France and Spain), only Italy imported more than 15% of its consumption via Ukraine in 2014. Germany used to be the largest market with a large exposure to this route, but this has changed with the commissioning of the Nord Stream pipeline. The UK, Netherlands, France and Spain consume little or no gas transiting this route. Countries showing a high dependency on Ukrainian transit are all small gas markets with annual consumption below 10 bcm/y.”

Most importantly, another salient point for the EU’s energy security with respect to gas supplies via the Ukraine is addressed in the EWI study – the storage situation.

Source: Institute of Energy Economics at the University of Cologne (EWI)

The above table shows that EU storage facilities hold capacity for up to 95 bcm with levels of about 90 bcm on November 1, 2014. Total storage capacity – counting storage facilities in Turkey and the Ukraine – amounts to 127 bcm. Note, that by November 2014 EU storage facilities were 95% full while storage facilities in the Ukraine were only about half full (52%) with about 15.9 bcm in storage. In this context, it is important to understand that the storage picture in fall of 2014 was a reflection of favorable circumstances at the time.

The EWI study points to the following factors responsible for the very comfortable EU gas storage levels ahead of the winter 2014/2015 season: “[T]he 2014 injection season (…) already started with high working gas volumes due to a mild temperatures and low withdrawals in the 2013/14 winter (…). [Then] overall mild temperatures in 2014 have contributed to keeping storage levels high (…). [Additionally,] injection rates during the summer increased in response to the escalation of events in the Russo-Ukrainian conflict.”

In contrast, the situation now ahead of the winter 2015/2016 season is decidedly different, which will have a significant bearing on gas pricing and the new trilateral gas negotiations overall. An “EWI Security of Supply Update” (March 9, 2015) by Dr. Harald Hecking et alia of the Institute of Energy Economics at the University of Cologne (EWI) provides insight on the current ‘natural gas storage situation and levels in the EU and Germany’.

Gas Storage Levels in Germany (D) and the EU (End of February 2015)

The authors point out that current low gas storage levels are a consequence of low oil prices because those “oil market developments foster withdrawals from gas storages” for three important reasons:

1. A significant part of long-term gas import contracts is based on oil-indexation.
2. Price adjustments are reflected after 3 or 6 months, thus low contract-prices expected.
3. Traders have incentives to sell gas now.

The EWI graphics above illustrate the main point – “Gas storage in Germany and in Europe [is] on a lower level than usually at the end of February” – with potential ramifications for the upcoming winter season. Nobody should bet again on a mild winter. In sum, the leverage is now clearly on the Russian side. Remember, in October 2014 the EU and the Ukraine had the ‘luxury’ of comfortably filled underground gas storage facilities. Not anymore…In this situation, the EU Commission understands only too well that Naftogaz needs to begin replenishing its storage facilities. Those gas reserves in storage are indispensable to secure both supplies for the Ukraine and the gas that transits Ukraine before delivery to EU member states. EurActiv reported citing Gaz Infrastructures Europe data that “[s]tocks in the Ukraine, which produces some of its own gas and receives other supplies from Eastern Europe, amounted to 7.7 billion cubic metres on 31 March.” Importantly, another EurActiv article cites EU Commission officials putting the gas quantity in Ukrainian underground storage required to guarantee transit gas flows to the EU at 18-19 billion cubic meters (bcm) of gas.