The Ukraine is at a crossroads trying to decide whether or not to join the European Union or to remain with more traditional ties that are Moscow-centric. This has a been flashpoint within the country that is addressing many old issues pertaining to public corruption, business practices, and political reform. The Ukraine was a key member in the Warsaw Pact. After the collapse of the Soviet Union it still remained a crucial trade partner in part due to its proximity to the Black Sea and also the strategic location between Europe and Russia.
Once the Ukraine started showing signs of favoring EU participation, Russia decided to leverage pressure to maintain its interests and keep the Ukraine out of the EU. Recent riots and public displays of dissatisfaction with Russia illustrate the growing division between the two nations. A growing fear of a coup much like the one seen during the Orange Revolution of 2004, which lasted until January 2005, has prompted Ukrainian leadership to charge opposition leaders with plotting to overthrow the government.
Reasons why Russia wants to maintain close ties to the Ukraine
Russia still maintains a very large naval base in the Ukraine on the shore of the Black Sea where a great deal of E&P speculation has occurred. This goes a long way to ensuring Russia's interest in the region, impacting politics and economics. Russia has also engaged in oil exploration on the shallow shelf of the Black Sea and has used the Ukrainian liquid fuel infrastructure as a key component to delivering their petrochemical products to European markets. Rosneft has entered into multiple JVs with European and American oil companies to further develop these opportunities. These deals follow a trail blazed by BP (BP -1.17%).
Rosneft is the primary petrochemical commercial presence from Russia, virtually holding a monopoly in the Ukraine. There is also the issue of the export tax Russia charges the Ukraine which is a significant amount of revenue for Russia. In November it voiced an interest in buying a 50% share of the Lisichansk oil refinery, which is one of the main refineries in the Ukraine held by the JV TNK-BP. Such a move indicates Moscow's continued interest in having control of oil exports to the EU.
A picture says a thousand words...
The map below shows the degree that Russia has invested in their LNG infrastructure with the Ukraine. Approximately 80% of the EU liquid fuels/crude oil comes from Russia via the Ukraine. The EU relies on 25% of LNG from Russian sources.
Source: Stratfor
The lure of competition
Eni (E -1.20%) in late November signed a $4 billion deal with Rosneft creating a JV to further oil exploration in the Black Sea. This comes at a time when Eni is looking for alternate E&P sites. The recent political turmoil in Libya, where Eni has many assets, as well as Nigeria have made E&P more costly and less reliable. This is a trend many oil majors are facing while doing business in those two countries, which ultimately put supply to EU markets at risk. The relative stability of the Ukraine compared to Nigeria and Lybia, as well as shared infrastructure, could potentially be very profitable for the oil majors. If the Ukraine joins the EU, the benefits from standardized contractual law as well as trade tariffs will prove profitable to EU members and partner nations.
Although, Eni's deal with the Ukraine comes before EU membership it is a sign that Western Europe is actively courting profitable relationships that could be less profitable for Russia in the long run.
ExxonMobil (XOM -0.09%) and Chevron (CVX 0.75%) have recently signed deals to export and develop LNG at a cheaper price. This will undercut Rosneft's and ultimately Russia's pricing monopoly in the Ukraine and by extension favor EU markets. This deal could cut up to two-thirds of the existing LNG costs that Europe has endured from Russian suppliers.
Royal Dutch Shell (RDS.A) signed a production-sharing agreement in January to develop shale deposits in the shale in the Yuzivska field, which is in eastern Ukraine. This is a growing trend in shale deposit development, which will give the Ukraine a greater degree of energy independence.
How will this impact investors?
The growing political instability could put supply to EU markets at risk. If the standing government is toppled it will be uncertain until the dust settles where EU membership for the Ukraine stands. Such a scenario could delay further development of E&P assets by European and American oil companies. Russia could react to the instability by offering incentives to the market through pricing schemes and further JV's with western oil companies.
The momentum of the political unrest is moving beyond the business benefits of EU membership to social and nationalistic benefits and a perceived independence from Russian interference. Protests on this scale have not been seen since the Orange Revolution that overthrew the government. It is unlikely that the current protests will be so radical.
Regardless of the political turmoil, oil companies have an ability to weather such storms and continue to deliver their products to market. The question remains: How will the products be priced and under what corporate structure?
