Opportunities for Canada to Contribute to Energy Security in Ukraine and the Rest of Europe

Testimony before the Standing Committee on Natural Resources, House of Commons, Canada

May 1, 2014

It is a great pleasure and honor for me to testify to this Committee. The question I have been given is how Canada can contribute to energy security in Ukraine and the rest of Europe. Let me give you my thesis from the outset: Canada can play an important role in the energy security of Ukraine and the rest of Europe in the medium term by developing exports of liquefied natural gas (LNG).

The European oil market is well supplied with well-functioning markets and multiple suppliers and means of transportation. The great surprise in the last couple of years is how stable oil prices have been. The coal market in Europe is oversupplied and of no particular security interest.

A major European energy concern is the malfunctioning gas market in Eastern Europe, and the key culprit is the Russian state-dominated natural gas giant Gazprom. Gazprom stands out as possibly the worst managed big company in the world. Its market capitalization has plummeted from a peak of $369 billion in May 2008 to a current value hovering around $85 billion, or by 77 percent. Its current price per equity ratio is as low as 2.4, while the corresponding valuation of other large energy companies is 3 to 4 times higher. Even so, Gazprom was formerly the most profitable company in the world in 2011.

Investors take a dismal view of Gazprom because they know that they have no real share in the company's profits. Each year, it spends approximately $45 billion on so-called "capital expenditures," but it builds plenty of large pipelines that make no commercial sense. In particular, Gazprom built NordStream through the Baltic Sea to circumvent Ukraine, and now it has started building SouthStream to circumvent Ukraine through the Black Sea in the south as well. The Russian goal is all too obviously: to abandon the well-functioning Ukrainian Gas Transit System and leave it unutilized.

The construction of all these superfluous pipelines reveals the real purpose of the Gazprom management. First of all, Gazprom is best understood as an organized crime syndicate, because it purchases pipelines from selected companies at prices that are considered to be three times higher than competitive bids. Thus, out of the $45 billion in annual capital expenditures, $30 billion goes to what investment bankers delicately call "value destruction," which ordinary people would call waste and corruption. Much of that money has gone to some of the Russian companies that the US Treasury has sanctioned for having financial connections with a top Russian official.

The other goal of Gazprom is geopolitical—to bully countries dependent on its gas supplies. Ten European countries receive 100 percent of their natural gas imports from Gazprom, namely, Finland, Belarus, Estonia, Latvia, Lithuania, the Czech Republic, Slovakia, Bulgaria, Moldova, and of course Ukraine. Of these countries, all but Finland have experienced sudden, impermissible cuts in their gas supplies usually caused by a combination of geopolitics and corruption. In particular, in January 2006 and again in January 2009, Ukraine and much of Europe suffered from Gazprom cutting its supplies.

The reaction to Gazprom's sustained cut in supplies in January 2009 was severe and persistent. Gazprom's exports to Europe fell by 21 percent from 2008 to 2012. Its share of EU gas imports fell from 32 percent in 2008 to 25 percent in 2012. Russia has largely been crowded out by LNG supplies of some 10 percent, largely from Qatar. Nor is the European energy market expanding. On the contrary, it has fallen by a few percent in the last decade. Neither total energy consumption nor gas consumption is likely to rise in the foreseeable future.

The situation in Ukraine has been particularly dramatic. In 1989, Ukraine consumed 100 billion cubic meters (bcm) a year. That consumption has now come down to just over 50 bcm a year. Even so, Ukraine remains one of the least energy efficient countries in the world. The household price of gas in Ukraine covers only 15 percent of the cost recovery, though it is about to be increased by 50 percent. With only moderate energy saving, matching the endeavors of Poland, Ukraine could go down to a consumption of 30 bcm a year within 5 to 10 years.

Until the early 1970s, Ukraine was a major gas producer, whose production peaked at 70 billion cubic meters (bcm) a year, but that production was slashed to some 20 bcm a year by the Soviet authorities, who turned their focus to the giant gas fields in West Siberia. Ukraine's conventional gas production has remained at this level. That means that Ukraine has large underutilized holdings of conventional gas that can be exploited. The production has been kept low because the Ukrainian government offers only one-eighth of the price it pays for gas imported in Russia, that is, the previous government strangely kept down domestic production and subsidized Russian imports. With a normal price, Ukraine should be able to increase its production of conventional gas by 50 percent to some 30 bcm in the next five years. Thus, ideally Ukrainian production and consumption could be matched in half a decade.

In addition, Ukraine has plenty of shale gas potential. Both Chevron and Royal Dutch Shell have concluded product-sharing agreements about the development of different shale gas fields, Chevron in the West and Shell in the East. Each of them anticipates that they could reach a production of 5 to 10 bcm a year in a decade. Thus, Ukraine could reach gas balance in five years, even if it is not likely, and it could be oversupplied in 5 to 10 years.

The rest of Europe reacted also to the Gazprom gas cut in 2009. Their energy saving had already proceeded far, so it did not offer much more. Instead, they undertook four major measures. First, they accelerated the development of LNG infrastructure. Today Europe has more than a score LNG terminals, and the LNG tanker market is oversaturated. Second, they opted for all kinds of interconnectors so that the gas flows in the existing pipelines can easily be turned around in various directions. Third, gas storage was increased, especially in Central Europe. Fourth, the European Commission has reinforced its competition policy, launching its biggest case ever against Gazprom, whose whole business model is likely to be disqualified.

In the medium term, however, the situation is complicated. Alternative supplies are needed, and the only short-term supply possible is really LNG. To date, Canada does not produce or export LNG, but several gas liquefaction plants are about to be built, and Europe has sufficient capacity to receive much more LNG, gasify it, and transport it through pipelines to the countries in need in Eastern Europe, including Ukraine. Ukraine has long planned to build an LNG terminal of its own in Odessa, and the new situation makes that need more urgent. Moreover, if Canada declares that it is intent on exporting LNG for the benefit of Ukraine, that declaration on its own will have a positive impact on energy security in Ukraine and the rest of Eastern Europe.