Ukraine Fails to Get Free Gas and Causes Higher Prices – Cameron Curtis
The New Year’s Eve Massacre
Natural gas stopped flowing through Ukraine at midnight on December 31, 2024.
Contracts between Ukraine and the Russian Federation were allowed to lapse without renewal. The result was increased gas and electricity costs for Greater Europe, financial loss for Ukraine and Russia, and a financial windfall for the USA. The media touted this as a brilliant move by plucky Ukraine against the Russian Federation.
Truth is always far more complicated than the mainstream media would have us believe. The truth is that Europe, Ukraine, and Russia were hurt to varying degrees by this shutdown. The truth is, the shutdown happened because one of the players – Ukraine – “got too cute.” Ukraine played a game of brinksmanship with the contract renewal. It was trying to get gas for free. When it finally realized Russia was not going to blink, it was too late to roll over the contract.
This article will explain the basics of Russian gas transit through Ukraine to Europe. It is an arcane subject, and we will try to simplify it to bare bones. Only by understanding the basics can one critically evaluate the headlines.
The Gas Contract – Ship or Pay
Natural gas is shipped in two forms. Pipeline gas (the subject of this discussion) and Liquefied Natural Gas (LNG).
The most important terms of the contract are price and term. Pipeline gas sold by Russia to Europe via Ukraine is sold on a long-term, fixed-price basis. That means Russia will sell quantities of pipeline gas at a fixed price per unit volume for ten, twenty, thirty, fifty, or however many years. In Europe, gas (say from Norway) is typically priced “spot” or on a variable price basis. The price goes up and down every day, many times a day. You buy it “at the market.” If there’s a gas shortage when you come to buy, you pay through the nose. That’s when you think a nice long-term fixed-price contract with Russia would be great. Crucially, LNG cargoes, shipped on LNG carrier vessels, are also sold on a variable price basis. You pay the seller whatever the going rate is for an LNG cargo when you ink the deal.
Crucial to this discussion, the pipeline gas contracts between Russia, Ukraine, and Europe were “ship or pay.” That means the contract said that if Russia committed to ship 100 units of gas in a certain period at a price of $X per unit, it had to ship 100 units. If Russia failed to ship 100 units of gas, it would have to pay its counterparty – Ukraine or Europe as the case may be – $X per unit not shipped. Any disputes are arbitrated by the European court in Sweden.
The New Year’s Eve Massacre
Natural gas stopped flowing through Ukraine at midnight on December 31, 2024.
Contracts between Ukraine and the Russian Federation were allowed to lapse without renewal. The result was increased gas and electricity costs for Greater Europe, financial loss for Ukraine and Russia, and a financial windfall for the USA. The media touted this as a brilliant move by plucky Ukraine against the Russian Federation.
Truth is always far more complicated than the mainstream media would have us believe. The truth is that Europe, Ukraine, and Russia were hurt to varying degrees by this shutdown. The truth is, the shutdown happened because one of the players – Ukraine – “got too cute.” Ukraine played a game of brinksmanship with the contract renewal. It was trying to get gas for free. When it finally realized Russia was not going to blink, it was too late to roll over the contract.
This article will explain the basics of Russian gas transit through Ukraine to Europe. It is an arcane subject, and we will try to simplify it to bare bones. Only by understanding the basics can one critically evaluate the headlines.
The Gas Contract – Ship or Pay
Natural gas is shipped in two forms. Pipeline gas (the subject of this discussion) and Liquefied Natural Gas (LNG).
The most important terms of the contract are price and term. Pipeline gas sold by Russia to Europe via Ukraine is sold on a long-term, fixed-price basis. That means Russia will sell quantities of pipeline gas at a fixed price per unit volume for ten, twenty, thirty, fifty, or however many years. In Europe, gas (say from Norway) is typically priced “spot” or on a variable price basis. The price goes up and down every day, many times a day. You buy it “at the market.” If there’s a gas shortage when you come to buy, you pay through the nose. That’s when you think a nice long-term fixed-price contract with Russia would be great. Crucially, LNG cargoes, shipped on LNG carrier vessels, are also sold on a variable price basis. You pay the seller whatever the going rate is for an LNG cargo when you ink the deal.
Crucial to this discussion, the pipeline gas contracts between Russia, Ukraine, and Europe were “ship or pay.” That means the contract said that if Russia committed to ship 100 units of gas in a certain period at a price of $X per unit, it had to ship 100 units. If Russia failed to ship 100 units of gas, it would have to pay its counterparty – Ukraine or Europe as the case may be – $X per unit not shipped. Any disputes are arbitrated by the European court in Sweden.
The Simple Model – A Pipe and Three Gas Meters
To simplify this discussion, we’ll look at a model that consists of a pipe that runs from Russia, across Ukraine, to Europe. Examine Figure 1.
Figure 1. Basic Model of Russia-to-Europe Gas Pipeline Through Ukraine
The pipe has a bleed-off valve in Ukraine where gas can be diverted from the main flow. Gas flows from East (Russia) to West(Europe). There are three meters on the pipe. One at the Russian end (call it R-1), one at the European end (call it E-1), and one in Ukraine (call it U-1).
The real world is only slightly more complicated, but this model strips it down to the absolute basics. Let’s say the price of gas is $X per unit. Europe contracts to buy 80 units of gas and Ukraine contracts to buy 20 units of gas. Russia pushes 100 units of gas down the pipe at R-1. Ukraine siphons off 20 units at U-1, and Europe sucks off 80 units at E-1. Europe pays Russia 80*$X and Ukraine pays Russia 20*$X. Total proceeds to Russia are 100*$X. The contract has been fulfilled and everyone is happy.
Notice the internal coherence of this model. Assuming there is no leakage, the three meters add up. The units drawn off from E-1 and U-1 equal the units pushed across from R-1.
“Reverse Flow”
When Ukraine bleeds off 20 units of gas in the example above, that is what the Ukrainians call “Reverse Flow.” The term makes it sound like they found a way to make gas travel both ways up and down a tube at the same time – like the Europeans took 100 units off at E-1 and shipped 20 units back to Ukraine at U-1. Not so. The physics can’t be overcome – it is obvious that gas can only travel down a pipe in one direction at a time – east to west in this case. Since the noughties and before, there have been legal disputes between Ukraine and Russia that were sent to the court in Stockholm for arbitration. Ukraine wasn’t paying for all the gas it took, and claimed it was receiving gas by “Reverse Flow” as though Europe was sending it gas going the other way. No. Just remember, Reverse Flow refers to Ukraine bleeding off gas as shown in the simple model above. Ukraine can’t overcome the laws of physics. Nor is there anything wrong with Reverse Flow, so long as you take only what you have contracted for and pay for it.
Pilfering Gas – a Simple Example
We only need to modify our basic model slightly. Europe contracts for 80 units at E-1. Ukraine contracts for 20 units at U-1 but actually requires 30 units, Russia pushes down 100 units at R-1.
Now, when we read the meters, we find Europe reads 70 units at E-1, Ukraine reads 20 units at U-1, and Russia pushed down 100 units at R-1. Europe isn’t happy because it got 10 units less than it contracted for. Where did the missing 10 units go? Ukraine pulled off the 30 units it needed and fixed its meter to show 20. When asked where the 10 units went, they shrug their shoulders and say, “there must be a leak.”
Russia now has to pay Europe 10 units*$X per unit under the ship or pay contract, accuses Ukraine of theft, and the dispute goes to the court for arbitration. Given this model, one can imagine various scenarios, all of them ending up in court. The gas wars of the noughties invariably had Ukraine accused of stealing Europe’s pipeline gas because Ukraine could not afford to pay for the gas it needed. Because Russia had to push its gas down the one pipe, it could not cut off a delinquent Ukraine without also cutting off Europe. This is because the pipeline passes through Ukraine and Russia has no control over the Ukraine bleed. Ukraine can therefore hold both Russia and Europe hostage.
For whatever reason (and one can immediately think of a few), the Stockholm court usually rules against Russia. When it doesn’t, Ukraine has been slow to comply with rulings or refuses to comply entirely. Russia makes a lot of money on oil and gas, so it has gritted its teeth and tolerated the losses. Until December 31, 2024.
The Wartime Period of 2022 to the Present
We will make the model only slightly more complicated. In reality, there are TWO natural gas entry points to the pipe from Russia. One in the east, and one in the northeast. Let’s call the one in the east R-1 (the one we have been talking about) and the one in the northeast R-2. They are located in towns that have names, but we label them R-1 and R-2 for purposes of exposition.
Examine Figure 2, which illustrates the reality of two physical entry points.
Figure 2. Model of Russia-to-Europe Gas Pipeline Through Ukraine, Two Entry Points
Everything else in the model is the same. Except now Russia sends 50 units from R-1 and 50 units from R-2.
Without getting into too much detail, Ukraine shut off the feed from R-1 at the start of the war. That means only half the capacity of the system has been available. That alone caused prices to rise in Greater Europe.
Ukraine then demanded that Russia make full payment for the 50*$X that Ukraine was no longer receiving via R-1 even though it was Ukraine itself that shut down R-1. They claimed it under the terms of the ship or pay contract, and sued Russia in the Swedish court. The Swedish court was expected to rule in Ukraine’s favor as it usually did, no matter how absurd the case. This claim has built up over several years and it’s a lot of money. It’s even more money going forward if the contracts are renewed.
From Figure 2, it is easy to see that Russia is delivering 50 units of gas through R-2, receiving 50*$X for that gas, and paying 50*$X for the gas it is not able to ship through R-1 (because of the ship or pay contract in dispute at the Swedish court). Russia is therefore giving Europe and Ukraine 50 units of gas for free.
Walking up to the Brink
Ukraine and Europe wanted to renew that contract. It was a great deal because they were getting free gas. Quite reasonably, Russia said, “We’ll renew the contract, but you have to drop the court case.”
It is worthwhile to look at the costs and benefits of the situation as the players stepped through the Christmas season of 2024.
If the contract was not renewed, Russia stood to lose $5 billion in sales for the coming year. This loss will be mitigated by ramping up turnover on the Power of Siberia pipeline to China, and paradoxically, by increased LNG sales to Europe! Since the start of the war, Europe has increased its purchases of LNG from Russia by an astronomical amount. It is also buying cargoes of Russian LNG resold by China. Europe is cutting itself off from cheap Russian pipeline fixed-price gas and paying three to five times more for Russian, Qatari, and US variable-priced LNG.
EU leaders would later say they had “prepared” for the Ukraine shutdown, but all they meant was that they were ready to pay five times more for LNG. Years ago, British consultants at the University of Oxford convinced the UK and Europe to buy almost all their gas on a variable price basis.
If the pipeline contract was not renewed, Ukraine stood to lose $1 billion in trans-shipment fees paid to it by Russia for the coming year. But Europe committed to provide Ukraine with the gas it needed if it cut off Russia. So, in fact, Ukraine had the least to lose of all the players. This is because Ukraine is already bankrupt. It has no money of its own. If it buys gas from Europe, it pays for it with money the US or Europe gives it in loans or direct transfers. So its only loss was the $1 billion in hard currency paid by Russia in trans-shipment fees.
If the contract was not renewed, Europe would have to buy all its gas from the variable-priced LNG markets, which are three to five times more expensive than Russian pipeline gas. Furthermore, it would have to supply Ukraine with additional amounts of that expensive gas, because Ukraine would also be cut off from cheap pipeline gas. The people in the UK and Europe who would suffer most were ordinary citizens, already paying exorbitant power bills. All manufacturing industries would be badly hit. German chemical and automobile manufacturers were being decimated by high energy costs. This would only add to their problems. The German economy is de-industrializing as a result.
The big winner in this gas war is the United States, which is going to sell high-priced LNG to a captive Europe. In early January 2025, three massive US LNG carrier ships were diverted to European ports, where they expected to sell their cargoes for hefty premiums.
The following video explains the codependent relationship between Russia and Europe. It is a bit dated, but provides a good summary.
Key points to note in the video: It does not discuss how Russia’s Nordstream II pipeline was blown up by persons unknown, it does not cover the increase of capacity in the Power of Siberia pipeline, and it ignores completely the fact that US exports of LNG are three to five times more expensive than Russian pipeline gas.
Over the Edge
Ukraine and Europe wanted the contract renewed, but Ukraine would not withdraw the lawsuit in the Swedish court. They wanted their gas for free.
Russia was done being played the fool, and Ukraine had let the brinksmanship go on too long. With three days remaining till the New Year, there was no time to renew the contracts.
Europe was ready to buy LNG at three to five times the cost of pipeline gas, at the expense of its citizens and economies. Why? European political elites are committed to de-carbonizing regardless of cost. For their part, Russia had already prepared to ramp up Power of Siberia and LNG sales. The bear has been turning east for a long time.
The contracts were allowed to expire. Vladimir Putin’s final statement was, “Very well, you’ve made your bed, now lie in it. Live without our gas.”
Conclusion
In general, one sees two narratives in the mainstream media. Narrative 1: The plucky Ukrainians, backed by Europe, stuck it to Russia by refusing to roll over the gas contracts. Narrative 2: The evil Russians, led by Vladimir Putin, decided one day to cut off gas to Ukraine and Europe – so those high prices are Russia’s fault.
A close examination of the mechanics of the market, infrastructure, and legal framework shows the truth. Ukraine and Europe wanted free pipeline gas, and Russia was fed up playing games.
While the vast majority of people in the West do not understand the reality laid out in this article, it is safe to say that the vast majority in China, India, Indonesia, Saudi Arabia, and other energy-producing and consuming countries do.
Cameron Curtis has spent thirty years in the financial markets as a trader and risk manager. He was on the trade floor when Saddam’s tanks rolled into Kuwait, when the air wars opened over Baghdad and Belgrade, and when the financial crisis swallowed the world. He’s studied military affairs and warfare all his adult life. His popular Breed series of military adventure thrillers are admired for combining deep expertise with propulsive action. The premises are realistic, the stories adrenaline-fuelled and emotionally engaging.
