Odesa-Brody: Monument Worth $ 500,000,000

As one way of affirming the close relations that are developing between the Ukrainian and Polish governments, the two countries have established the “Sarmatia” joint venture to build an extension of the Odessa-Brody oil pipeline from Ukraine into Poland.

A geopolitical objective of a 490-kilometer pipeline extension from Brody in Ukraine to Plock in Poland would be to create a “Eurasian transport corridor” from the Caspian Sea in Kazakhstan, through Russia to the Black Sea, then through Ukraine and Poland to the Baltic Sea port of Gdansk. It is understandable that Poland and Ukraine wish to cement their growing friendship through a major commercial project such as this. A feasibility study of this route is now underway with European Union funding, but is there a sound commercial basis to attract the business partners to make such a pipeline a reality?

In 1999, our firms completed a feasibility study with Gulf Interstate Engineering of Houston, where we concluded that Caspian crude oil delivered through the Odessa-Brody pipeline would not be able to compete with Russian crude oil at central European refineries, including those in Poland. Our conclusion proved true. The pipeline was built and sat idle for two years until it was reversed in September 2004: to transit Russian crude oil in the southern direction from Brody to Odessa for export through the Bosphorus Straits to refineries in Europe.

Unfortunately, nothing much has changed, and growing political bonds between Ukraine and Poland will not be enough to render the commercial prospects of an Odessa-Brody-Plock route viable. Polish refineries have ample diversity of supply through their access to North Sea crude oil through the port of Gdansk. More critically, they require access to the most cost-effective sources of crude oil supply, which for the foreseeable future will be Russian crude oil.

In the last two years, the Urals/Brent oil price differential has increased over fivefold to $6.95 per barrel, driving the profitability of Polish refineries. In a report to shareholders in February 2005, PKN Orlen’s president and CEO, Igor Chalupec, indicated that the company expects the Urals/Brent differential to remain steady at no less than $2.95 per barrel through 2009, rendering Russian crude oil more attractive than alternative sources. Caspian crude oil at the Russian Black Sea port of Novorossiysk is already $5.30 per barrel more expensive than Urals crude delivered to Plock, even before the costs of additional transport across the Black Sea and through an Odessa-Brody-Plock route.

In addition, the Polish pipeline company, PERN Przyjazn, is well underway with an expansion of the western Druzhba oil pipeline that supplies Russian crude oil to refineries in Poland and eastern Germany. Its purpose, as stated by PERN, is “to meet the rising demand for cheap Russian oil by Polish and German refineries” and to serve as “an exporting route for oil through the port in Gdansk.” This expansion, which is slated for completion in 2006, would render any Caspian crude oil imports into Poland superfluous.

In the meantime, the southern reversal of the Odessa-Brody pipeline, which was to serve as an export route for Russian crude oil, has been operating at less than half its intended capacity. Plans to construct a Druzhba-Adria extension to export Russian crude oil through the Adriatic port of Omisalj could render obsolete the southern reversal of the Odessa-Brody pipeline. While the Ukraine and Belarus parliaments ratified the Druzhba-Adria accord last year, it is now stalled in Croatia’s parliament due to environmental concerns. Nonetheless, the southern reversal of the Odessa-Brody pipeline may still not offer a long-term solution for Ukraine, due to increasing shipping congestion in the Bosphorus Straits.

With the route to Plock and Gdansk facing many hurdles, what then are the realistic prospects to put Ukraine’s Odessa-Brody pipeline to good use? Last year the U.S. embassy in Kiev endorsed a plan to reroute 10 million tons per year of Caspian crude oil through the Odessa-Brody pipeline in the northern direction and onward down the southwestern branch of the Druzhba pipeline to the heart of Europe. This Caspian crude oil is currently shipped through the Bosphorus Straits to the port of Trieste and delivered by pipeline to refineries in southern Germany, the Czech Republic and Austria. Rerouting this crude oil through the Odessa-Brody-Druzhba route would alleviate shipping congestion in the Bosphorus Straits.

For this plan to succeed, the pipeline operators downstream from Brody in Ukraine, Slovakia, the Czech Republic, and southern Germany would need to agree to tariff concessions to make the route competitive and an investment plan of several hundred million dollars to increase transit capacity. Such actions could well be worthwhile, since the pipeline operators would benefit from the increased revenue of transiting higher volumes of crude oil. It is self-evident that urgent action is needed now on this plan, given the uncertain feasibility of a Brody-Plock-Gdansk route.

Unless this Odessa-Brody-Druzhba route is realized, the Odessa-Brody pipeline will likely stand idle again. With its $500 million of sunk costs, it would then serve only as a monument to the misguided policies of Ukraine’s previous regime. As the promise of the Orange revolution translates into concrete policy decisions, the people of Ukraine owe themselves another look at how to secure their energy future and a viable role for the Odessa-Brody pipeline.

Geoffrey BERLIN is the managing director of Privatization Partners Ltd., a U.S. financial advisory firm active in Ukraine since 1994. Raymond ALBRIGHT is managing director of GlobalNet Financial Solutions, LLC, a U.S. financial strategy firm based in Washington, DC.