Now we're cooking with gas: How Ukraine is trying to end its gas dependency on Russia

Self-reliance: Ukraine is set to boost its gas production

According to the Naftogaz strategy, Ukraine aims to eliminate gas purchases this year and rely entirely on its internal gas extraction. The CEO of Naftogaz, Oleksiy Chernyshov, explained that achieving independence from gas imports requires an 8% production increase on the part of the company and a 16% increase on the part of private enterprises compared to the previous year. This would entail extracting one billion cubic meters more gas than the previous year.

In pursuit of self-sufficiency, the Ukrainian government has implemented a ban on energy resource exports and is placing reliance on responsible energy consumption by citizens and businesses. The plan developed by Naftogaz does not foresee territorial losses or significant damage to the gas infrastructure due to potential attacks.

“Increasing domestic production is our strategic goal. It is not just a business matter – it's a question of Ukraine's survival and independence,” Chernyshov says. While some analysts predict that gas purchases may still be necessary, Chernyshov and Naftogaz view this as a pessimistic scenario, as the country is determined to rely solely on its own resources as a strategic goal for its survival and independence.

The decision to abstain from gas imports was preceded by a long and challenging history for Ukraine. Since gaining independence, the country heavily relied on gas supplies from Russia, and Russia, in turn, depended on the Ukrainian gas transit system as a primary route to Europe. However, supply disruptions in 2006 and 2009 prompted Western countries to raise concerns about gas being used as a tool of energy coercion by the Kremlin. As a response, Russia began constructing gas pipelines to bypass Ukraine, ensuring that gas exports to Europe would not be contingent on relations with its neighbor.

The endless disputes primarily revolved around the price of fuel and contractual terms. Ukraine deemed it unfair to pay more for Russian gas compared to other countries. Moreover, the contracts included a “take-or-pay” principle, obligating Naftogaz to pay for a specified amount of gas regardless of whether it was used or not. These terms were highly unfavorable for Ukraine, and Yulia Tymoshenko, who was in power when the agreements were signed in 2009, paid dearly for this political mistake, facing a criminal case and several years of imprisonment.

Regular conflicts between the parties escalated following the annexation of Crimea and the onset of the war in Donbass. Amid political tension, Russia raised gas prices and halted supplies to Ukraine for six months. In response, Ukraine refused to pay gas bills for the so-called “DNR” and “LNR” and demanded a renegotiation of the contract terms. Since 2015, Ukraine completely stopped importing gas from Russia, replacing it with gas through reverse flows from Europe, with prices aligned to those paid by European consumers, which sparked Gazprom's outrage.

Currently, Europe is also striving to reduce its dependence on Russian gas. The European Union is considering a collective solution to the gas crisis, with European countries aiming to cut consumption and establish a unified procurement system. Ukraine will be integrated into this mechanism, which should ease the country's gas imports. However, under such conditions, Ukraine finds itself in a relatively dependent position, as its gas supply directly hinges on how successfully European countries can secure fuel for themselves and their allies.

Attempting to abandon gas imports and relying solely on its own resources will be a historic first for Ukraine. Since 1991, the country has not gone a single year without gas imports from abroad. Gas plays a critical, albeit not leading, role in the Ukrainian energy system, covering 28% of its energy needs, with 29% covered by coal, 23% by nuclear power, and 14% by oil.

However, despite diversifying energy sources, for Ukraine, the “question of survival” is not just a poetic phrase. Gas holds the most significant importance in household and central heating: around 80% of Ukrainian families rely on central gas supply, and more than half receive warm water through gas. In total, households in Ukraine consume nearly as much gas as industrial enterprises. This structure makes the system vulnerable: attacks on gas infrastructure or a simple gas shortage during the winter months could lead to a humanitarian catastrophe.

As good as a Swiss watch: wartime gas independence

While ambitious, the plan does not seem unattainable. Ukraine possesses some of the largest gas reserves in Europe, approximately 719 billion cubic meters. Before the war, Ukraine used internal resources to cover two thirds of its energy needs, with its gas reserves sufficient for 70% of consumption.

The increase in fossil fuel production, which Naftogaz is counting on, becomes more challenging amid the war. However, consumption is decreasing due to economic downturn— in 2022, it dropped by a quarter, totaling only 20.1 billion cubic meters compared to 26.8 billion in 2021. Since 2016, gas consumption had been fluctuating at or above 30 billion cubic meters — the 2022 figure was the lowest in Ukraine's history.

The significant decline in gas consumption can be primarily attributed to the emigration of several million people from the country and the reduced activity of industrial companies. Both these groups, which constitute the main consumers, accounted for a 40% drop in demand for natural gas, impacting overall consumption levels.

On the other hand, gas production has not seen such a substantial decrease. Despite the ongoing war, Ukraine has managed to maintain a relatively stable level of production. In 2022, the country produced 18.5 billion cubic meters of gas, representing a 7% decline compared to the 19.8 billion cubic meters produced in 2021. The reduction in production is mainly linked to the military activities taking place in the Kharkiv region, where gas fields are located, or nearby.

Despite the wartime situation, exploration efforts in Ukrainian gas fields persist, with 47 new wells launched in 2022. Oleksiy Chernyshov has particularly highlighted the “heroic efforts” of gas producers in ensuring Ukraine's self-sufficiency. He attributed the decline in consumption to the “disciplined behavior” of households rather than the emigration of citizens or a decrease in production.

Thanks to the decline in consumption and only a slight decrease in production in 2022, Ukraine imported significantly less gas than in previous periods. Gas imports were reduced by 42% to 1.5 billion cubic meters. With a gas consumption of 20.1 billion cubic meters and production of 18.5 billion cubic meters, Ukraine achieved a historical high in terms of gas self-sufficiency—92% of its needs were covered by domestic production.

However, these impressive results were largely achieved due to significant government intervention in the gas sector. To secure the national energy system, Ukraine banned the export of coal, fuel oil, and domestically produced gas from June 2022. This measure aimed to prevent private companies from selling gas abroad, as European fuel prices were more favorable to them than internal prices. In April 2023, the Ministry of Energy responded negatively to the question of whether the export ban would be lifted, suggesting that the ban would likely remain in place until the end of the war.

“Undoubtedly, businesses are interested in exports. But looking back, we can say with certainty that if they had not been prohibited, considering the price situation on European markets, all private owners' gas would have been in Europe,” Minister of Energy Herman Halushchenko said.

Indeed, while the ban on exports, production volume, and consumption levels are controllable factors, there is one variable that remains beyond the control of Ukrainian authorities and producers—the weather. The strategy adopted by Naftogaz was partly influenced by the unusually warm weather of the past winter. Chernyshov openly admits that the higher-than-usual temperatures had an impact on Naftogaz's plan to abandon gas imports. In January of this year, the average temperature reached +1°C, making it the warmest monthly average since 2014. In contrast, in 2021, the average temperature dropped to nearly minus two degrees Celsius. If the next winter proves to be equally favorable, it would significantly increase Ukraine's chances of avoiding fuel imports.

Due to the warm weather, reduced consumption, and export ban, Ukraine was left with sufficient gas reserves in its storage facilities at the end of the 2023-2024 heating season, amounting to approximately 9 billion cubic meters. Throughout the heating season, 5.6 billion cubic meters of gas were extracted from the storage, and at the beginning of the season, the reserves stood at 14.7 billion cubic meters. For the following year, Ukraine plans to reserve 15 billion cubic meters to ensure the smooth operation of its energy system.

As long as the war continues, it is unlikely that gas consumption in Ukraine will increase, especially considering the country's uncertain economic future. According to forecasts, Ukraine's GDP may either grow slightly or decline in 2023. Moreover, there might be a continued population outflow, which could further decrease consumption. In case of a warm winter, increased production, and military successes, Ukraine may indeed be able to manage its gas needs without significant imports, or at least limit the volume of purchases.

Unknown risks: shelling, weather, territories

However, the Naftogaz plan has noticeable blind spots. The optimistic scenario for Ukraine overlooks potential military, financial, and even weather-related risks. Any deviation from the favorable conditions outlined in the strategy would make it unfeasible for Ukraine to go through the winter of 2023-2024 without gas imports.

The most obvious threat comes from the continuous shelling by Russia. Although the frontline remains relatively static and Ukraine's territorial losses may not be substantial, the damage from attacks on energy infrastructure is estimated to be in the billions of dollars. Electrical power facilities have been hit the hardest, while gas facilities have experienced less frequent but more concentrated bombardments. Nevertheless, the situation could change, as the risk of a humanitarian catastrophe is unlikely to deter Russia.

As of December 2022, the attacks by Russia have already damaged 350 natural gas production facilities, with an estimated cost of approximately $700 million. Ten critical facilities, responsible for one-third of the country's gas production, were heavily targeted in November. After these strikes, Oleksiy Chernyshov even said that Ukraine needed additional financial aid of $4 billion to purchase 3 billion cubic meters of gas, without which the country would not be able to get through the heating season. However, Prime Minister Denis Shmygal later reassured Ukrainians by reminding them of the 14 billion cubic meters of gas in storage.

Ukraine's extensive gas transportation system, one of the most intricate in the world, has also been under attack. Despite the fact that surface facilities are more vulnerable to attacks and 90% of pipelines are underground, more than seven thousand kilometers of networks were destroyed or damaged in 2022. Any damage to infrastructure associated with gas extraction, storage, and transportation could paralyze Ukraine's entire gas system.

Moreover, the attacks are also impacting the nuclear energy infrastructure, placing a greater burden on the gas sector. While gas is crucial for heating, its contribution to electricity generation was relatively minor, accounting for only 7% of the total electricity production. Before the war, more than half (55%) of electricity generation relied on nuclear power. However, Russia's deliberate attacks on infrastructure have disabled approximately 50% of the country's generating capacity. Currently, the Zaporizhzhia Nuclear Power Plant is offline, with all six reactors shut down, and the facility is under Russian occupation. This has heightened Ukraine's reliance on gas, and the demand for it may increase as other energy sources become threatened.

However, even ground warfare can undermine the gas system. Increasing production also requires the exploration of new gas fields. However, 80% of gas fields are concentrated in the eastern part of the country, with the most “abundant” area being the Kharkiv region. Consequently, some of the most promising sites for exploration are located in the front-line regions and conflict zones.

The second major vulnerability, after Russian attacks and military actions, is harsh winter conditions. In its optimistic forecasts, Naftogaz heavily relies on the favorable winter temperatures of 2022, during which both Ukraine and Europe experienced warmer weather, allowing people to save on heating costs. However, no one can guarantee that Ukraine will experience the same mild temperatures in the coming winter. If the mercury drops significantly, surviving solely on its own reserves will become much more challenging.

There is also an element of deception in Naftogaz's statements about zero imports. In early February, a month before Chernyshov's promises, Ukraine began “virtual” gas imports from Europe through Moldova. Gas purchased by Ukrainian traders in Europe may remain in Moldova, and Ukraine, in turn, retains the Russian gas destined for Moldova in its storage facilities. This way, both parties settle their bills while the gas does not physically cross the border.

Furthermore, under the best-case scenario for Europe, Ukraine will have favorable conditions for imports. The increased supply for European buyers will enable the possibility of deliveries to other countries, including Ukraine. Even based on existing agreements, Ukraine can reliably import around 54 million cubic meters per day from Poland, Slovakia, and Hungary – neighboring countries that are willing to supply small volumes of gas throughout the entire war. The mechanism of joint gas purchases, in which Ukraine is participating, should provide an additional 2 billion cubic meters. If the prices in the European market are acceptable, and supply is not constrained, importing gas may eventually prove to be a more convenient solution than a survival mode.

Obstacles to system transformation: corruption and monopolism

Increasing production and restoring the energy system will require ensuring international financial support and attracting investments, particularly from foreign partners. However, while post-war Ukraine will likely become a target for significant investments, at present, investing in its gas sector may appear to be a questionable idea to many. The country's economy has been under strain for two years, and Naftogaz, as the largest energy company, is working to regain trust after the default.

The gas sector in Ukraine also suffers from the same problems as the entire Ukrainian economy: insufficient legal regulation and lack of transparency. To attract investments, the country needs to address the issue of corruption and establish the rule of law. Normative and legal uncertainties deter investors just as much as the security risks associated with the war.

Ukraine lacks a proper normative and legal framework, which requires the revival of gas market reforms that were initiated in the late 2010s but suspended several years ago. Naftogaz will be most affected by this, as restructuring implies challenging its dominant role in the market and creating more space for private investors.

The structure of the Ukrainian market and the pricing regime are the most significant barriers to attracting investors. Ukraine needs to develop new legislation that includes transparent and predictable policies regarding licenses for exploration and development of gas fields. However, the process may prove to be quite complex: historically, the energy sector in Ukraine has been dominated by the state, with private companies playing secondary roles. If Naftogaz produced 13.7 billion cubic meters of gas in 2022, private companies contributed only 5 billion cubic meters. The monopoly on transit and extensive control over the industry have placed Naftogaz in a privileged position.

The problem is acknowledged even by Naftogaz itself. In the 2021 report, the then-head of the company, Yuriy Vitrenko, stated that Naftogaz lacks transparency, and the organization's structure falls short of being a “modern corporation” and needs changes. However, the approved transformation, endorsed by the Board of Directors, stalled due to reasons “often beyond the company's control.”

The report highlights that the “gas transit business made the company appear more successful than it actually was, concealing the lack of real progress.” The company's leadership, in the meantime, reassured itself with indicators that were the result of a parasitic strategy, through which Naftogaz had obtained valuable state assets practically for free.

Currently, there are no attempts to create more level playing fields in the market or modernize the legislation. The country is preoccupied with war and survival, and the role of the state is only growing. Moreover, there are no intentions to change anything after the war either. Ukrainian authorities have not promised that post-war economic reforms would include restructuring the gas market. The absence of clear prospects will not instill confidence in foreign investors and is unlikely to help private companies improve productivity.

In the long-term perspective, the country faces a comprehensive restructuring that is expected to contribute to a significant nationwide energy transition. This involves a shift away from natural gas in line with the European strategy. However, whether investors will be willing to invest in Ukraine's gas sector, considering the ongoing war, export ban, regulatory difficulties, and unclear prospects, remains an open question.

The symbolic plan to phase out gas imports looks promising on paper and stands a chance of being realized under ideal circumstances. However, the final volume of imports will largely depend on the course of further military actions. Increased production, reduced demand, export bans, and warm winters may help Ukraine get through 2023 without purchasing gas. Yet, in less favorable scenarios, the country may have to turn to its Western partners for fuel.

While Naftogaz remains optimistic, analysts, on the other hand, believe that in the 2023-2024 heating season, Ukraine will have to rely more on imports, mainly due to Russian strikes on critical infrastructure. According to the International Monetary Fund's estimates, Ukraine will need 5 billion cubic meters of gas in 2023 to refill storage to at least the previous year's level. Naftogaz does not rule out such a possibility either but considers it the worst-case scenario.