The “U” factor: Ukraine’s growing role in Europe’s natural gas market

Russia's 2014 annexation of Crimea caused the Ukrainian government to take a historic decision: It would no longer buy gas from Russia and would instead try to import what it needed from its western neighbors.

Immediately after, representatives of the Ukrainian transport system operator, then named Uktransgaz, its Slovakian counterpart and the European Commission, met to study how to enable physical reverse gas flows from Slovakia to Ukraine; and they found a way. Poland and Hungary would follow, enabling reverse flows on their border.

Ukraine's state-owned oil and gas company, Naftogaz, was so proud of this that for at least two years it kept a webpage with a timer counting the minutes spent with no direct imports of Russian gas.

What then sounded like a bold decision, and a very politically motivated one, has become one of the main triggers of structural change across Europe's gas markets in recent years.

As Poland is also preparing to halt direct imports of Russian gas from 2022, looking at the impact of the "U" factor will not just provide a better understanding of current price movements across Europe, but may also help predict what will happen as more Eastern European countries move away from a heavy dependence on Russian gas.

New hubs in the East

Data from Ukrainian transmission system operator GTSOU shows that during January-September 2020, the country imported about 15 Bcm from Slovakia, Hungary and Poland combined. Slovakia was the biggest contributor, with 9.7 Bcm shipped, a third more than a year earlier.

The government's decision to make Ukraine's huge and largely underused gas storage facilities available to foreign traders has been a major factor in the rise in imports.

Since 2017, foreign traders have been permitted to store their volumes of gas for up to 1,095 days – about three years – without paying value-added tax or customs duties. Stored gas can be sold to another non-resident and exported outside of Ukraine, also without levies. Taxes are paid only when stored volumes are sold to Ukrainian companies and imported into Ukraine.

In 2020, GTSOU was unbundled from parent company Naftogaz, and short-haul transport tariffs were introduced, making it even easier and cheaper for foreign traders to use Ukraine's gas infrastructure.

Ukraine received even more gas via its western borders from July to September 2020, when Slovakia's Eustream agreed to enable virtual reverse flows at Velke Kapusany. The entry point is on the Slovakia-Ukraine border and has historically been used to deliver long-term Russian gas volumes to Central Europe and Italy.

Eustream made 60 million cu m/day of virtual gas transport capacity available from Slovakia to Ukraine during the whole third quarter of 2020.

Over a period of years, access to both Ukrainian storage and inbound transport capacity resulted in large gas flows transiting Slovakia, the Czech Republic and Hungary destined for Ukraine. This in turn created the conditions for the growth of gas hubs in Central and Eastern Europe such as the Czech and Slovakian VTPs, and Hungary's MGP.

CEGH's volatility

One of the first and most important manifestations of the rise in flows and liquidity was at the CEGH gas hub, which used to be perceived as rather quiet or even boring.

Registered participants at the CEGH gas hub numbered 242 in May 2019, a 50% increase in five years. Traders were attracted by the Austrian hub's increasing volatility, fueled by the rising volumes being moved from Slovakia, Poland and Hungary to Ukraine. This happened as those operating at these eastern gas hubs traded on the spreads between each hub and the Austrian CEGH.

Along with the instability of the CEGH spot price, the spread to the Dutch TTF, the European reference hub, became one of the most volatile in the region. And "high volatility equals opportunity," as one Italian trader put it.

PSV-CEGH link fades

During the summer of 2020, Italian traders active on the Italian PSV and at the Austrian CEGH lost one of their traditional plays, exploiting arbitrage opportunities offered by the typical premium of the Italian PSV contracts to the CEGH equivalent.

Italy's PSV spot contracts were normally at a discount to the CEGH equivalent only rarely and during weekends. But for the first time in history, Italy's PSV spot contract was at a consistent discount to the CEGH equivalent for weeks at a time and most of the summer.

This change was mostly triggered by strong gas demand in Central and Eastern Europe and Ukraine. In oversupplied mainland Europe, where storage facilities were already nearing their limits halfway through the injection season, traders were keen to purchase gas at CEE hubs and ship it to Ukraine's emptier storage facilities.

High gas demand in the region meant that for several weeks in a row, Slovakia and Hungary became the two most expensive gas hubs in Europe, displacing the usual contenders, Italy and Spain.

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The Austrian CEGH spot contract, which also provides the basis for Slovakian and Hungarian gas prices, also spiked and rose above its Italian equivalent.

The phenomenon was only a seasonal one, and things returned to normal as soon as the injection season ended. But it showed the full extent of the impact Ukraine's flows can have on even the most historical gas hubs

TTF price spikes

But the impact of gas flows being drawn toward Ukraine went beyond volatility of local prices, and in a reversal of roles, hit one of Europe's most liquid hubs. A surge in demand for virtual reverse flows at the Slovakia-Ukraine border led to unprecedented price spikes on the Dutch TTF hub.

Velke Kapusany is the historical entry point on the Slovakia-Ukraine border for Russian gas destined for Central and Eastern Europe and Italy. Firm capacity is only available in the Ukraine-Slovakia direction. But gas can move virtually from Slovakia to Ukraine when interruptible reverse flow is offered by Slovakia's grid operator, Eustream.

When shippers book some of the virtual transport capacity from Slovakia to Ukraine, the volume is simply netted off physical flows from Ukraine to Slovakia.

For example, if on a given day 100 million cu m of gas are nominated to move physically from Ukraine to Slovakia via Velke Kapusany and 10 million cu m of gas are nominated for virtual reverse flow, only 90 million cu m of gas will physically enter Slovakia on that day.

So when Velke Kapusany reverse flow nominations for Monday Aug. 3 jumped almost sevenfold from the previous Friday to 44 million cu m, traders suddenly realized that of the 110 million cu m expected to enter Slovakia in forward physical mode, only 66 million cu m would actually arrive, a major and unexpected supply cut.

Traders were probably caught by surprise as Q3 2020 was the first time that so much reverse flow capacity was being made available at the Velke Kapusany reverse flow. Previous occasions involved less than 10 million cu m.

The impact of this supply cut was felt across the whole of Europe. On Aug. 3 the day-ahead price on the key TTF hub jumped Eur1.30/MWh or 25%. The corresponding contract on the German NetConnect hub rose by 95 euro cent/MWh (17.75%).

The TTF price spiked again on Sept. 1 when Velke Kapusany reverse flow nominations jumped to 55.5 million cu m from the 42 million cu m/d average in August.

Once again, strong demand for gas destined for Ukraine's storage facilities affected Europe's continental hubs.

West-East price spreads shrink

In addition to the seasonal and storage-related shifts, Ukraine is triggering a medium-to-long-term change across Europe's gas markets, one with much greater economic and geopolitical consequences than those seen so far.

Although Eastern and Southern European countries remain heavily reliant on Russian long-term contracted gas, the development of new gas hubs in this region triggered by Ukraine is slowly contributing to the diversification of regional sources of supply.

This, over time, translates in lower gas prices and a reduced spread between prices in the West and East.

According to data recently published by the European Union Agency for the Cooperation of Energy regulators (ACER), the spread between TTF and Eastern European hub prices has been narrowing over the past few years mostly due to rising traded volumes and liquidity in the latter.

However, this trend was reversed in 2019, when gas prices across Europe saw a big drop of more than Eur3/MWh year on year in most EU member states. This was mostly due to record LNG deliveries, above average winter temperatures and well-stocked gas storage facilities.

Still, prices did not fall equally across the EU member states and members of the Energy Community, an organization aiming to extend the EU internal energy market to Southeast Europe and beyond.

For example, the estimated average hub procurement price for gas in the Czech Republic during 2018 was Eur21.070/MWh. This represented a Eur0.220/MWh premium to the Dutch TTF 2018 hub procurement price, much lower than the premium in 2017, of Eur0.640/MWh.

But in 2019 the Czech premium to the Dutch 2019 hub procurement price rose to Eur0.990/MWh because of uneven price falls across the two hubs.

According to ACER, access to a variety of sources of gas and LNG as well as the presence of well-functioning gas hubs remain key elements for reducing price differentials.

While a new LNG terminal in Croatia is expected to increase the diversity of supply sources in Eastern and Southern Europe from January 2021, the increase of gas volumes moved from West to East is expected to continue to boost gas hub development in the region and reduce the price gap between Western and Eastern Europe. That would reinforce Ukraine's active role in shaping the European gas market.