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A Dangerous Energy Policy: Ukraine, Despite War, Is Making Itself Dependent on Russian Oil

Kremenchug oil refinery, Ukraine

When it comes to Ukrainian dependence on Russian energy, the spotlight is usually on natural gas. Here Ukraine has made unprecedented progress, writes Wojciech Konończuk, analyst at the Centre for Eastern Studies (OSW) in Warsaw. But what few observers notice, Konończuk adds, is that as a result of corruption and neglect Ukraine has let its domestic oil refining industry decay and has become critically dependent on Russian diesel and LPG supplies. Konończuk is author of a recent report on the Ukrainian oil sector.

Since 2014 Ukraine has successfully diversified its gas import, to the point where the country is independent of Russia for its gas supplies. This is rightly regarded as one of the biggest achievements of the post–Maidan authorities.

At the same time, however, Ukrainian diesel imports from Russia have growing quickly, a fact that has gone largely unnoticed. Russian fuel already captured a quarter of the Ukrainian market.

It would be difficult to find other big country in Europe so heavily dependent on foreign fuels as Ukraine. Its current share of import in total petroleum products consumption is around 85%. Traditionally the biggest supplier of diesel and petrol is Belarus, which controls half of the Ukrainian fuel market.

The collapse of the Ukrainian refineries

Ukraine’s critical dependency on imported fuels is easy to explain. The once powerful Ukrainian refining sector has been plunged in a deep crisis for years. Only one out of six existing refineries is currently in operation. For years all the refining companies have suffered from underinvestment, have not been modernised and have been unable to produce fuels in the quantities and at the quality required by the market. Therefore, import is the only option to meet domestic demand.

Since the Maidan revolution Ukraine has started on an ambitious gas market reform but the situation in the fuel sector has changed only very little. The country has succeeded in curbing illegal fuel imports and eliminating from the market some of the firms engaged in this which were linked to the previous government elite.

However, the main problems of the sector have remained unresolved – an effective management of the state-owned oil companies and a vision for the sector’s comprehensive development are still missing. As a result, the sector’s decline has continued and the Ukrainian refineries are unlikely to be modernised in the coming years.

Expansion of Russian diesel

In the previous decade Russia was a medium-sized supplier, with a share in Ukraine’s market of around 10% of diesel oil supplies and several times less petrol supplies. Recently imports of Russian diesel oil have significantly increased.

In 2015 the Russian companies sold 1.75 million tonnes of petroleum products in Ukraine, including 1.2 million tonnes of diesel oil. Total Ukrainian fuel consumption is around 7.5-8 million tonnes annually (70-80% of which is diesel fuel). Russia’s position was temporarily harmed by Moscow’s embargo on fuel exports to Ukraine that was in force between October 2015 and March 2016.

Three and a half years since the Maidan revolution with its calls for deep and structural reforms, Kyiv still has no consistent policy aimed at stimulating the modernisation and development of its own refining industry

There was a discussion in Ukraine in the spring of 2016, initiated by the then Prime Minister Arseniy Yatsenyuk, whether it was reasonable to ban imports of Russian fuels. Finally, this option was rejected – officially because of the risk of fuel prices on the Ukrainian market rising significantly, unofficially because of the participation of people linked to government members in fuel imports from Russia. As a result, Russian producers returned to the Ukrainian market in 2016, selling 1.2 million tonnes of diesel oil and 0.1 million tonnes of petrol. Fuels from Russia thus had a 16% share in total fuel sales.

The share of Russian fuels has started growing as a consequence of the reactivation of the product oil pipeline running from Russia via Belarus to Ukraine in June 2016. The pipeline with an annual transport capacity of 3.5 million tonnes, connecting the Russian-Ukrainian border with the Ukrainian-Hungarian border, was built in the 1960s.

After the collapse of the USSR, the ownership of the product oil pipeline, managed by a company named PrykarpatZapadTrans, was a subject of a long dispute between Ukraine and Transneft, the Russian state-owned pipeline monopoly. In 2011, a Ukrainian court transferred the ownership of this pipeline to the Ukrainian Treasury, and this was confirmed by a decision passed by the Ukrainian Supreme Economic Court in March 2015.

Unexpectedly, the decision was cancelled by another Ukrainian court, which resulted in the transfer of the ownership of the product oil pipeline to Transneft. In August 2015, the Russian company sold the pipeline to Switzerland’s International Trading Partners AG, and in December 2015 the Ukrainian Anti-Trust Committee approved this deal. It was finalised in March 2016.

It is unclear why, during the ongoing Russian-Ukrainian war, the government in Kyiv allowed Russia to take over control of this piece of strategic transport infrastructure and then to sell it to a money mule from Switzerland. Furthermore, according to information from the Ukrainian media, International Trading Partners AG is most likely controlled by Viktor Medvedchuk, a Ukrainian politician who is an important lobbyist of Russian interests in Ukraine.

The decision to give up a strategically important oil pipeline to a Russian state-owned monopoly is very difficult to explain rationally

Since its relaunching in June 2016 this route has been used to supply up to 180,000 tonnes of diesel oil (Euro-95) monthly to Ukraine. The new operator of the oil pipeline is a Geneva-based company, Proton Energy Group SA, which delivers to Ukrainian market Russian diesel produced by Rosneft. Allegedly it costs US$20–25 less per tonne when compared to supplies by rail. A few months ago Proton Energy Group’s  subsidiary company called Glusco Energy bought 141 petrol stations in Ukraine from Russian Rosneft.

In 2016 Ukraine imported 0.85 million tonnes of Russian diesel oil via this channel. In the first seven months of this year this was already 0.8 million tonnes or a fourth of Ukraine’s diesel market. The oil pipeline capacity means that the share of Russian fuel may increase even to half of the Ukrainian market. Additionally since April 2017 Proton Energy Group SA started to supply Russian diesel to Hungary via Ukraine. In July alone this was 117,000 tonnes.

LPG from Russia

Russia is also a major LPG supplier to the Ukrainian market. In 2016, supplies reached almost 0.8 million tonnes, which ensured a 54% share in Ukraine’s LPG market. For Russian (and Belarusian) producers, this is a natural territory for expansion, given the geographic proximity and the cost-effectiveness of exports.

Import from those countries is driven by growing popularity of LPG in Ukraine, which is much cheaper than diesel or petrol. While in 2012 LPG had a 17% share in retail sales at Ukrainian filling stations, in 2016 its share rose to around 33%. In the first half of 2017 LPG consumption increased by 13%.

A competitive fuel market has emerged in Ukraine over the past decade but this market is critically dependent on imported petroleum products mainly from Russia

The growing share of LPG in total fuel sales in Ukraine has made the government more interested in controlling this segment of imports and the market. Unexpectedly, towards the end of 2016, the Security Service of Ukraine (SBU) accused more than ten firms importing fuel from Russia of ‘financing terrorism’ and arrested part of the cisterns with LPG at the border checkpoint. Everything seems to indicate that this move was aimed at eliminating some firms which in aggregate control around 40% of the market.

This case was widely publicised by the Ukrainian media and the companies themselves, who found the SBU’s actions groundless and illegitimate. As a result, most of the charges were withdrawn. However, everything suggests that this operation was intended at replacing part of the present importers with firms which have connections with the representatives of the present government, most probably including – according to a Ukrainian media report – the above mentioned Viktor Medvedchuk and some people in the Ukrainian government.

Very risky policy

Three and a half years since the Maidan revolution with its calls for deep and structural reforms, Kyiv still has no consistent policy aimed at stimulating the modernisation and development of its own refining industry. The obstacles are the same as those seen over the past few years: lack of an effective state strategy, the enormous corruption, the involvement of a section of the government elite and the law enforcement agencies in various kinds of corruption schemes. The decision to give up a strategically important oil pipeline to a Russian state-owned monopoly is very difficult to explain rationally. Especially taking into account that it is the cheapest and fastest way to supply diesel on the Ukrainian market. Therefore, the relaunching of this oil pipeline should be perceived as a game changer.

As a result, the decline of the Ukrainian oil sector is continuing. This does directly not affect the availability of fuel at affordable prices at Ukrainian filling stations and to corporate clients. A competitive fuel market has emerged in Ukraine over the past decade but this market is critically dependent on imported petroleum products mainly from the neighbouring countries, including growing dependence on Russian diesel. For Ukraine, the country at war with its major fuel supplier it is indeed very risky policy.

Editor’s Note

Wojciech Konończuk is an analyst at the Centre for Eastern Studies (OSW) in Warsaw, where he heads the department for Ukraine, Belarus and Moldova. Recently he published a report on the state of the Ukrainian oil sector.

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