4. A EUROPEAN APPROACH TO UKRAINE’S GAS DILEMMA

Road Map To Solve The Gas Dilemma

ANALYSIS & COMMENTARY: By Daniel Kurdelchuk,
President of Ukrinyurkolehiya, honoured lawyer of Ukraine;
Olexander Malynovsky, international law expert; and
Inna Novak, Vice President, Prudence Consulting Group.
Zerkalo Nedeli on the web, Mirror-Weekly,
International Social Political Weekly, No. 49 (577)
Kyiv, Ukraine, Sat 17-23 December, 2005

WHEN PASSIONS RUN HIGH, THERE IS NO WAY TO FIND THE TRUTH

The gas segment of Russian-Ukrainian relations has been seething with
passions lately. The Ukrainian party is trying to assert the earlier agreed
cooperation terms, whereby the transit dues for Russian gas is USD 1.09375
per 1000 cubic meters per 100 kilometers, while the price of gas supplied in
return for transit services is USD 50 per 1000 cubic meters.

The Russian party rejects these terms point blank insisting, instead, that
the gas price should go up to USD 220-230 and the transit dues to USD
1.75. They also argue that the two parties’ failure to sign the 2006
intergovernmental gas protocol on their conditions will create a regulatory
vacuum in the Russian-Ukrainian relations in the gas sphere.

In the meantime, legal logic in the Ukrainian-Russian gas negotiations is
gradually giving way to emotions. In legal terms, Ukraine’s position is
well-substantiated, but Russia is bringing a huge psychological pressure to
bear on Ukraine in order to impose its terms.

The authors of this article took part in the 2000-2001 Ukrainian-Russian gas
negotiations. The law firm Ukrinyurcolehia successfully represented
interests of the National Joint Stock Company Naftogas Ukrainy in American
and Russian courts in the cases dealing with its arrears to the Public Joint
Stock Company Gasprom for natural gas supplied to Ukraine. The Prudence
Group consulted for Naftogas Ukrainy in its negotiations with Gasprom on the
founding of the gas transportation consortium.

POLITICAL AND COMMERCIAL DIMENSIONS OF GAS TRADE
Straightening out the Russian-Ukrainian gas relations for 2006 is both a
political and a commercial issue. Therefore it should be addressed in a
sensible manner, i.e. by dint of methods and tools that would be in line
with European standards and the rule of law, and with due regard for two
key aspects.

FIRST, setting the gas prices and transit dues in annual intergovernmental
protocols is a political resolution to the gas issue, in form as well as in
essence. This practice was introduced into the Ukrainian-Russian relations
back in 2000-2001, primarily because of the Russian government’s desire to
exercise a more effective control of Gasprom headed by R.Viakhiriev.

Prior to that and according to the Ukrainian-Russian Intergovernmental
Agreement on Exporting Russian Gas to Ukraine and Transiting It through
Ukraine’s Territory to European Countries of 1994, these matters were
settled on a commercial basis – in contracts between Naftogas Ukrainy and
Gasprom.

In particular, Article 5 of the 1994 agreement laid down that the parties
(i.e. governments of Ukraine and the Russian Federation) mandated the
UKRGasprom Company (later succeeded by the National Joint Stock
Company Naftogas Ukrainy) and Russian Joint Stock Company Gasprom
to sign contracts stipulating annual volumes, commercial and technical
terms of Russian natural gas transit and export to Ukraine.

Article 11 envisioned that all payments for supplied gas and transit
services were to be made on the basis of agreed rates and dues in US
dollars, the mode of payment being defined in contracts between the two
companies. Thus, annual intergovernmental protocols emerged as a political
“superstructure” in Ukrainian-Russian gas cooperation based on the
commercial contracts between Naftogas and Gasprom.

SECOND, today many think of when Ukraine and Russia are going to sign the
2006 intergovernmental gas protocol. We suggest looking at the situation at
a different angle and answer another important question: what will happen if
the 2006 intergovernmental gas protocol is not signed, specifically, will
the existing contracts between Naftogas and Gasprom remain valid?

The Gasprom management gave their answer in the press release dated 7
December 2005. In their opinion, if this is the case, commercial contracts
between Naftogas and Gasprom for transporting Russian gas via Ukraine’s
territory will become null and void. According to the Gasprom management,
Ukraine and Russia should end up in a stalemate and the two countries should
stop, respectively, transiting gas and supplying it to pay for the transit.

This is absurd, both in the terms of commercial law and commonsense.
We will explain why.

FAILURE TO SIGN THE 2006 GAS PROTOCOL: LEGAL IMPLICATIONS

On the one hand, Gasprom is right in that, according to Article 2 of the
Agreement between the Cabinet of Ministers of Ukraine and the Government of
the Russian Federation on Additional Measures to Ensure Transporting Russian
Natural Gas via the Territory of Ukraine dated 4 October 2001, the volumes
of transited gas and transit dues (set either in monetary terms or in terms
of gas volume to be supplied as payment for transporting services) should be
adjusted annually in intergovernmental protocols for a respective year.

On the other hand, the above agreement of 4 October 2001 makes no provision
for terminating commercial contracts between Naftogas and Gasprom in the
event of the two countries’ failing to sign the intergovernmental protocol.
Moreover, the Agreement on Guarantees of Transiting Russian Natural Gas via
the Territory of Ukraine dated 22 December 2000 (which, coupled with the
agreement of 4 October 2001, makes up a cohesive legal package of
intergovernmental instruments in the gas sphere) stipulates in Article 11
that all intergovernmental agreements in the gas sector concluded in
2000-2001 complement the 1994 Agreement on Exporting Russian Gas to
Ukraine and Transiting It through Ukraine’s Territory to European Countries.

It means that unless the 2006 intergovernmental gas protocol is signed (in
other words, unless the gas issue is resolved politically), the provisions
of Articles 5 and 11 of the 1994 agreement cited above should remain in
force. Thus, the transit dues and gas price set in the contracts between
Gasprom and Naftogas should apply (i.e. commercial levers should be put
in motion).

Finally, Article 2 of the 1994 agreement stipulates that annual
intergovernmental protocols adjust, rather than establish, the volumes of
transited gas, transit dues, and volumes of gas supplied in return for
transportation services. It means, yet again, that unless a relevant annual
protocol addresses these issues, the earlier agreed terms should apply.

In our judgment, both Ukrainian and Russian parties tend to overlook an
important thing. In fact, Gasprom claims that annual intergovernmental
protocols serve as a legal basis for commercial contracts on the volumes
of transit, gas prices, transit dues, and gas supplies in return for transit
services.

However, none of the four earlier signed protocols took effect: Ukrainian
Parliament was to ratify them but did not, for a number of reasons. It was
evident from the protocol language that their signing did not automatically
lead to their coming into force.

Furthermore, those protocols did not make any provisions for their temporary
enforcement. Put differently, from the standpoint of international public
law and national legislations of the Russian Federation and Ukraine, annual
intergovernmental protocols signed in 2002-2005 did not and could not
constitute a legal basis for setting the volumes of transit, gas prices,
transit dues, and gas supplies in return for transit services in commercial
contracts between Gasprom and Naftogas, since they never took effect.

Nonetheless the Russian government did not use it as a pretext for
suspending gas supplies to Ukraine and its transit via Ukrainian territory
accepting, by default, that the contractual terms agreed upon by Gasprom
and Naftogas should apply!

In view of the above, one can conclude that unless the 2006
intergovernmental gas protocol is signed, provisions of the commercial
contracts between GASPROM and NAFTOGAS should apply.

COMMERCIAL TRANSACTIONS IN THE GAS SPHERE

Hence a question: how are commercial relations between GASPROM and
NAFTOGAS in respect of the 2006 gas supplies and transit regulated, if at
all?

In its press release of 7 December 2005, Naftogas refers to the Agreement on
Volumes and Terms of Russian Natural Gas Transit via the Territory of
Ukraine for 2003-2013, dated 21 June 2002, and Addendum #4 to it, dated 9
August 2004. NAFTOGAS also quoted Addendum #4 setting transit dues for
2005-2009 at USD 1.09375 and the gas price at USD 50 per 1000 cubic meters.

Establishing the fixed transit dues and gas price at the said level for five
consecutive years was neither a gift nor a concession to Ukraine; it was
part of the procedure for settling the Naftogas monetary debt to Gasprom for
the USD 1,250 million worth of Russian gas it received in 1997-2000.

The procedure for settling the gas debt was described in Resolution #1002 of
the Cabinet of Ministers of Ukraine of 6 August 2004. According to it,
NAFTOGAS received an advance from Gasprom (and immediately returned
it, in order to settle the accrued debt) as part of payment for the transit
services Naftogas undertook to render in 2005-2009.

The procedure was so designed as to allow Ukraine to annually receive
form Gasprom natural gas in payment for its transit services during the
stipulated period of time, in the volume reduced by 5 billion cubic meters.

Therefore, the fixing of the transit dues and gas price for a five-year
period (during which the gas debt is to be repaid) is a crucial, legally
defined element of the procedure for the settlement of Naftogas debt to
Gasprom. So any changes in gas prices will inevitably upset the balance of
interests behind the agreement on debt settlement and necessitate its
revision.

Some time ago, the former Ukrainian Minister of Justice R.Zvarych made an
attempt to initiate the reconsideration of this agreement when he stated
Ukraine was prepared to repay the debt in cash, which would allow the
country to earn an additional USD 2 million within five years. However, the
Gasprom response came quick and sharp: the deal of debt repayment was
closed in August 2004.

In its press release of 11 August 2004, Gasprom clarified: “The signed
documents envision a gradual reduction in the volumes of gas that Gasprom
supplies to Ukraine in payment for transit services. It will enable Gasprom
to export the remaining volumes of gas to the European countries and sell
them at a higher price”.

On the other hand, the Addendum #4 provisions in respect of transit dues and
gas prices for 2005-2009 are of universal character, i.e. they apply to the
entire volume of Russian gas supplies to and transit via Ukraine within this
period of time. More than that, Addendum #4 stipulates that neither party
can unilaterally revise the contractual terms.

Not a single document envisages a situation whereby some part of gas would
be transported through Ukraine’s territory on certain commercial terms (set
in Addendum #4 for repaying the gas debt), and another part on different
terms (set in the 2006 intergovernmental protocol), within one and the same
period of time. All effective international agreements, including commercial
contracts, should be based on uniform transit dues and gas prices within a
defined period of time.

It is noteworthy that the abovementioned Gasprom press release of 11 August
2004 specified that “the advance payment [to settle the debt] will allow to
fix gas transit dues for the period of 2005-2009 at USD 1.09 per 1000 cubic
meters per 100 kilometers.

Obviously, the statement pertains to the transportation of all transit gas,
rather than of its part. The press release does not mention the gas price,
but that it will remain stable can be inferred from a fixed correlation
between gas price and transit dues. Thus, the Gasprom official position at
that time is in total harmony with the Naftogas stance of today!

One should remember that Addendum #4 was signed on 9 August 2004 and
implemented throughout the entire 2005, while the 2005 intergovernmental
protocol was not in effect. So there will be no legal grounds for changing
the status quo should the parties fail to sign the 2006 protocol.

Even if the two governments manage to sign the document before 1 January
2006, it will take some time for the Supreme Rada to ratify it so that it
could come into force. If the 2006 intergovernmental protocol sets new
transit dues and gas prices, different from those stipulated in Addendum #4,
a legal collision will arise between provisions of the private treaty
(Addendum #4) and norms of the international instrument (2006 protocol)
to be transformed, upon ratification, into the national legislation norms.

Resolution of this collision will require amending Addendum #4 and
Resolution #1002 of the Cabinet of Ministers of Ukraine dated 6 August
2004 (since it will affect the procedure for the Naftogas debt repayment to
Gasprom), which will also be time-consuming.

In other words, even if the 2006 protocol is signed in the remaining days of
2005, the new terms of Russian gas transit and supply will not be legally
enforceable starting 1 January 2006. If the 2006 intergovernmental protocol
does not take effect, the commercial transactions between Naftogas and
Gasprom will continue to be regulated by the Contract of 21 June 2002 and
Addendum #4 of 6 August 2004.

GAS THEFT OR A LEGITIMATE RIGHT TO PAYMENT FOR SERVICES?

Of late, the Russian party has repeatedly declared that “gas extraction from
the export pipeline by Ukraine will be an outright theft” (in response to
the Naftogas chair of the board to the effect that starting next year the
company will extract gas from the pipeline as payment for its transit
services) and that “gas supplies to Ukraine will be suspended unless the
Russian-Ukrainian gas talks have been completed by 1 January 2006.” This
reaction seems overly emotional.

For one thing, the Contract of 21 June 2002, as far as we know, defines a
basic volume of annual transit of Russian gas via Ukraine’s territory. It
means that both Gasprom and Naftogas have a contractual (i.e. legal)
obligation to maintain the basic volume of gas transit. Moreover, according
to Article 1 of the agreement dated 22 December 2000 and Articles 1 and 3
of the agreement dated 4 October 2001, the governments of Ukraine and the
Russian Federation guarantee that gas will be transported in the volumes
stipulated by the Contract of 21 June 2002.

Under the circumstances, the European Union should not worry: Russian
gas transit via the Ukrainian territory is fully regulated, and there are no
reasons for suspending the transit.

For another thing, should Gasprom cease to supply gas to Ukraine in payment
for transit services (you will remember that this gas should be supplied at
USD 50 per 1000 cubic meters), it will breach its contractual obligations,
as Russian gas transit by Naftogas is a chargeable service to be paid by
Gasprom. Besides, the Russian government guaranteed payment for the
Naftogas transit services (Article 2 of the agreement dated 4 October 2001).

In the event that Ukraine’s counterpart stops supplying gas in return for
transit services, the former will be able to invoke Article 7 of the 1994
agreement stipulating whenever the Russian party under-supplies gas to the
Russian-Ukrainian border, Ukraine will proportionally decrease the volumes
of gas transit and export. So if the Russian party ceases to supply gas in
payment for transit services, thus reducing the overall volumes of gas
supplies, the Ukrainian party can get payment for its services by
withdrawing a commensurable volume of transited gas.

This provision and existing commercial contracts enable Ukraine to get the
payment for transporting Russian gas, should Gasprom refuse to honor its
contractual obligations. Of course, this scenario could entail shortages in
gas supply to European consumers, and in order to fulfill its obligations to
the European partners Gasprom could be forced to increase the volumes
of gas transit via Ukraine’s territory.

We believe both parties will benefit if Russia abandons its rhetoric about
“theft” and “unsanctioned gas extraction” by Ukraine and studies, carefully
and dispassionately, the intergovernmental gas agreements it sighed. Since
the Agreement of 22 December 2000, there has been no reason whatsoever to
resort to such rhetoric. The agreement admits and regulates the situation
whereby the Ukrainian party is entitled to extract Russian gas from the
pipeline in excess of the volumes defined in the contracts between
NAFTOGAS and Gasprom.

The agreement of 22 December 2000 characterizes these extractions as being
“in excess of contractual volumes” and lays down that Ukraine should pay for
them with Eurobonds issued for an amount approved by Ukraine and Russia
and properly calculated on the basis of the gas price of USD 80 per 1000
cubic meters. The Ukrainian party could use relevant provisions of the

agreement dated 22 December 2000 as a way to enforce the payment for
transit services if Gasprom suspends its gas supplies.
ARBITRATION AS A TOOL FOR RESOLVING THE GAS DISPUTE

We hope that the above legal arguments will be conducive to a mutually
acceptable resolution of the 2006 gas dispute by the negotiating parties.

At the same time, we admit that each negotiating party (Russian and
Ukrainian governments; Gasprom and Naftogas) is entitled to its own
position. However, if those positions are in conflict and the parties’ wish
to resolve it in a civilized and legitimate manner, they should agree about
available and appropriate tools for doing so.

The best way to settle disputes at the intergovernmental level is through
negotiations. International instruments regulating Ukrainian-Russian
relations in the gas sector do not provide for any other options that would
not require additional coordination between the Russian and Ukrainian
governments.

However, Naftogas and Gasprom agreed that all disputes between them,
pertaining to the Contract dated 21 June 2002 and Addendum #4 dated 6
August 2004, should be considered by the Arbitration Institute of
Stockholm Chamber of Commerce unless the parties are able to reach a
compromise within 45 days of the dispute origination. The companies
also agreed that decisions of Stockholm Arbitration Institute should be
binding for both of them.

Press releases Naftogas and Gasprom issued on 7 December 2005 reflect
the companies’ official positions. They testify to the existing difference
in the parties’ understanding and interpretation of the same provisions of the
Contract dated 21 June 2002 and Addendum #4 dated 6 August 2004, which
is not an uncommon situation in the world of business. Yet wherever the
contractual parties exhaust the means of settling their contentions
available to them, they seek recourse in court, including a court of
arbitration.

Naftogas and Gasprom have been trying to resolve their dispute for much
longer than 45 days, so they have the right to turn to the Stockholm
Arbitration Institute, which is unprejudiced toward either party, is
internationally renowned for its sound judgment, and is capable of
resolving the dispute over the Addendum #4 provisions.

Filing a petition with the Stockholm Arbitration Institute would be the most
civilized way of settling the Ukrainian-Russian gas conflict, particularly
if the two countries fail to address this issue at the political level.

We also believe that arbitration is the most practical way of settling the
gas conflict. Intergovernmental negotiations will hardly yield any desirable
results soon, whereas emotional outbursts and nerve strain can only
exasperate the situation further and have an adverse impact on final dues
and prices cited in the 2006 protocol. We would venture to suggest that
any document that will eventually be signed will offer worse terms and
conditions than those currently stipulated in the existing commercial
contracts, and will be economically detrimental to Ukraine.

The dispute resolution by the Stockholm Arbitration Institute will relieve
the leaders of Ukraine and Russian of the burden of political responsibility
for addressing of gas issue.

The history of Ukrainian-Russian relations in the gas sector has known
instances of seeking international judicial recourses. For example, in
2000-2003 US courts considered a claim against Naftogas and the state of
Ukraine in the case of allegedly unsanctioned withdrawal of Russian natural
gas from the pipelines running through Ukraine’s territory. The courts ruled
in favor of Ukraine then.

GAS ISSUE AND THE BUDAPEST MEMORANDUM

Lawyers usually disapprove of discussing specific legal matters and disputes
in public. They feel equally reluctant to expand disputes to other spheres
of bilateral relations. However, now that Ukraine has become subject to an
insistent and hard-edged foisting of onerous terms of cooperation in the gas
sector that could undermine its national economy, one cannot help
recollecting the Memorandum of Security Guarantees given Ukraine by the
nuclear states upon its accession to the Nuclear Nonproliferation Treaty on
5 December 1994 (the Budapest Memorandum).

According to Paragraph 3 of the Budapest Memorandum, the guarantor-states,
including Russia, committed themselves to abiding by the “principles of the
OSCE Final Act and refraining from economic pressure aiming to take
advantage of Ukraine and to submit Ukraine’s sovereign rights to their own
interests.” Isn’t the Russian Federation’s stance over the gas issue a case
of bringing overt economic pressure to bear on Ukraine?

One should also bear in mind that, while signing the 2005 intergovernmental
gas protocol, the Russian party agreed to set the gas price several times as
low as what Russia offers today (could the European market prices have risen
many-fold within a year?). In this context, noteworthy is the
Russian-Belarusian gas agreement signed on 8 December 2005 and setting the
price for Russian natural gas supplied to the Republic of Belarus at USD
46.68 per 1000 cubic meters (lower than the price Ukraine insists on).

At a briefing on 7 June 2005, A. Riazanov, Gasprom chair of the board,
acknowledged: “We will supply 23 billion [cubic meters] as payment for
transit services at USD 50. The price is low, indeed. Yet I still think it
is a very good deal for us; the transit dues in Ukraine’s territory are USD
1.09; hence this gas price of USD 50. Last year we exported about 106
billion cubic meters of gas via Ukraine. I believe we have reached a mutual
understanding and established a partnership with Ukraine.

You may remember that our basic approach was as follows: the gas price under
the relevant intergovernmental agreements is USD 80 and the transit dues are
USD 1.75 per 100 cubic meters per 100 kilometers. We agreed to decrease
both the transit dues and gas prices. If we press for the European prices
for gas, the transit dues will also grow. So will the Gasprom costs. That

is why we have to calculate all economic implications of this approach.”

Given all of the above, Ukraine’s leadership should fully and timely inform
the European Commission and the guarantor-countries under the Budapest
Memorandum (UK, USA, France, and China) of its political position vis-a-vis
the Russian-Ukrainian gas dispute to assure them that it is neither
counterproductive nor impractical.

ROAD MAP TO SOLVE THE GAS DILEMMA

IN CONCLUSION, we would like to offer the most adequate road map
for solving the Russian-Ukrainian gas dilemma:

1) Not to politicize the gas issue; not to hurry to sign a protocol for
2006, in which the terms of economic cooperation would be worse than
those stated in the commercial contracts between Naftogaz Ukrainy and
Gazprom. In any case, it is politically and economically advantageous
for Ukraine not to sign documents that contradict its national interests;

2) To bear in mind that, in accordance with the principal intergovernmental
agreements, non-conclusion of a protocol for 2006 automatically leaves
valid the current terms (the price of supplied gas and the tariff for
transit services), which are stated in the commercial contracts between

Naftogaz Ukrainy and Gazprom;

3) The government of Ukraine should propose to the government of the
Russian Federation to jointly recommend Naftogaz Ukrainy and Gazprom
to seek arbitration in the Stockholm Court as provided for by their contract
of 21 June, 2002;

4) In case the Russian government and Gazprom are not ready to appeal to the
Stockholm Court together with the Ukrainian party, Naftogaz should ask the
Stockholm Court for an official interpretation of the 21 June, 2002
contract, which would be binding for both parties;

5) The government of Ukraine should ask the government of the Russian
Federation to refrain from hampering Naftogaz and Gazprom in fulfilling
their mutual obligations under their commercial contract, pending the final
verdict by the Stockholm Court;

6) In case the Russian side ignores the juridical argumentation and
overrides the principle of supremacy of law in approaching the gas dilemma,
the government of Ukraine and Naftogaz should proceed exclusively from the
presumption of economic expediency and Ukraine’s monopoly status as the
transporter of Russian natural gas to Western Europe;

7) The government of Ukraine should present its position to the European
Commission, the UK, the USA, France, and China as the guarantor countries
under the Budapest Memorandum;

8) Should the gas problem escalate at the political level due to Russia’s
continued psychological pressure, to seek consultation with the guarantor
countries as provided for by Paragraph 6 of the Budapest Memorandum.

The latter recommendation may be applied if Ukraine fails to persuade the
Russian Federation to set emotions aside and turn to the Stockholm Court
for arbitration and a binding verdict on their dispute over the 9 August,
2004 Addendum to the contract between Naftogaz Ukrainy and Gazprom.

If the dispute resolves in a decision to conclude an intergovernmental
protocol for 2006, then the negotiating politicians and diplomats should
demonstrate reserve. It should be remembered that, in practice, the most
important provisions of such documents have been negotiated and inked at
the eleventh hour. That is why the negotiations on the 2006 protocol should
be dominated by professionalism and friendly constructivism rather than
emotions or time limits.

International diplomatic practice knows examples of very important
disputable issues resolved under circumstances of time shortage. In this
case, the sides may just as well stop the clock hands in the negotiating
room at 23.59 on December 31 and continue to negotiate in a calmer
atmosphere on the next day.

The above recommendations follow European standards of resolving business
conflicts. We are convinced that if Gasprom had a similar dispute with a
western European gas company, the government of that country would never
agree to conclude any intergovernmental agreement to the detriment of the
company’s commercial rights.

And since Ukraine declares its readiness to integrate with the European
community, it should resolve all gas-related disputes with the Russian
Federation in a “European” way, in accordance with European approaches
and standards. And the key standard is the principle of supremacy of law.

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