Devil in the detail with Russia-Ukraine gas deal

By bne IntelliNews February 25, 2008

Roman Olearchyk in Kyiv -

Russian President Vladimir Putin and his Ukrainian counterpart, Viktor Yushchenko, reached what has been hailed as a landmark energy agreement on February 12, when they agreed to cut out a controversial intermediary company from the multi-billion-dollar gas trade between the two countries and Central Asian suppliers.

Their handshaken agreement is seen by analysts as a major step toward nudging out the controversial Swiss-registered gas trader RosUkrEnergo from its monopoly hold over gas supplies to Ukraine. But talks currently being held over the details of the new gas supply arrangement will determine whether Ukraine has made any serious headway in reclaiming profits that are needed to keep its state-owned energy holding afloat. Much will depend on whether the newly created gas supplier to Ukraine, a joint venture between Ukrainain state gas firm Naftogaz and Russia's Gazprom, will hold the rights to handle gas export contracts to high paying customers in Europe, or whether RosUkrEnergo will retain its grip over this lucrative business.

Cards revealed

In broad terms, the Putin-Yushchenko agreement stopped a repeat of the 2006 gas war, during which Russia cut gas supplies to Ukraine, whose vast pipeline system serves as the main artery for Russian and Central Asian gas supplies to Europe. Much of the noise during that standoff was over stiff price hikes that Kyiv ultimately had to accept; this time, it was centred on some $1.5bn in unpaid gas bills that Ukraine, or intermediary companies, had with Gazprom. But like in 2006, the core of this agreement centered on the control of gas supplies to Ukraine, over sales within Kyiv's domestic market, as well as the rexport of gas to Europe.

February's agreement envisions Gazprom and Naftogaz setting up two 50/50 joint ventures. The first joint venture would replace RosUkrEnergo in supplying Ukraine with gas from Central Asia and reselling more expensive Russian gas. RosUkrEnergo, itself 50/50 owned by Gazprom and two Ukrainian businessmen (Dmytro Firtash 45%; Ivan Fursin 5%), would be cut out of its role as monopoly supplier of gas to Ukraine, a position it's enjoyed since 2006. The second joint venture would take control of gas sales to Ukraine's best-paying customers - steel mills, chemical plants and other industrial megamoths. UkrGazEnergo, a joint venture between Naftogaz and RosUkrEnergo that has generated hundreds of millions of profits annually in this role since 2006, would be dissolved.

Prime Minister Yulia Tymoshenko, who has championed the cause of cleaning up the gas business with Moscow, rushed to praise the new agreement. To her satisfaction, the agreement squeezes out RosUkrEnergo, a company that both she and Washington claim is a corrupt organisation. Tymoshenko, who ironically enough earned a fortune in the 1990s trading in gas, has questioned the role of a select group of private Ukrainian businessmen in the intergovernmental gas trade and raised suspicions that the reputed crime boss Semyon Mogilevich - wanted by the FBI for money laundering, racketeering and fraud - had a piece of the business. RosUkrEnergo and its largest private owner, Firtash, have denied such claims. Mogilevich, arrested early this year in Moscow on tax evasion charges, has also denied being involved.

Both Putin and Yushchenko have in the past pointed the finger at each other when asked why a select group of businessmen were chosen to profit so much from the gas trade between their countries. But neither side has satisfactorily explained the value or precise role of such private businessmen in the billion-dollar energy dealings between former Soviet countries. Tymoshenko insists that until former Soviet energy markets are liberalized, which would allow for competitive trading by private firms, state companies should handle this business.

Gazprom's winning hand

The new agreement offers clear-cut incentives to Gazprom, boosting its share from 25% to 50% on the gas market of Ukraine, a top world consumer that guzzles some 70bn cubic metres (cm) of the blue fuel annually.

How much Ukraine and its debt-ridden energy holding, Naftogaz, gains depends largely on the crucial talks that lie ahead, sources say. And if talks on forming the new joint ventures between Naftogaz and Gazprom drag on for much of this year, as some suspect will happen, RosUkrEnergo is set for another good year, generating hundreds in millions in profits. In the meantime, debts at Naftogaz, estimated to exceed $2bn, will increase further. "I think it's fair to say that we still don't have the details on the timing, or exact mechanism of the new agreement," says Kaushik Rudra, executive director of Lehman Brothers in Kyiv.

"From what we see, it will be a clear win for Gazprom because they will increase their stake on the Ukrainian domestic market; for Naftogaz, it's too early to tell," Rudra says, adding that much depends on how Gazprom and Naftogaz split the dividends generated by the joint ventures, how profitable these companies will be, and whether Ukraine gets a share of exports to Europe through the new supply joint venture.

A clear way to ensure that the new firms generate decent profits would require a politically unpopular decision by Kyiv's government: raising gas tariffs for both industrial consumers and subsized households. Ukraine currently keeps prices for households below market levels with some 20bn cm of domestically produced gas a year. While this keeps voters happy, it restricts Naftogaz's profit margins. A source at Naftogaz says his company still hasn't been able to collect "several hundred million dollars" in dividends from UkrGazEnergo since its inception in 2006. This and a series of successive price hikes by Russia on gas imports have squeezed Ukrainian consumers, who have seen their energy bills skyrocket, and pushed Naftogaz toward bankruptcy. Once Ukraine's most profitable company, Naftogaz now finds itself deep in debt. In accepting the 2006 agreement, Ukraine simply handed over a large portion of Naftogaz's domestic sales to UkrGazEnergo, itself 50/50 owned by RosUkrEnergo and Naftogaz.

The new agreement envisions that Naftogaz will retain its current 50% stake in the supply to industrial consumers. The private shareholders of RosUkrEnergo will be cut out, giving Gazprom a larger stake on Ukraine's domestic gas market.

Ukraine's wildcard

While the new arrangement removes the shadowy intermediaries, it's uncertain whether it will do much to actually boost Naftogaz's profits. The Ukrainian side also needs to get a share of the lucrative gas exports to Europe through the joint venture that will replace RosUkrEnergo as the country's gas supplier. Doing so would secure an additional injection of several hundred million dollars into Naftogaz through dividends, which could be used to compensate for the high amount of subsidized gas sold to households and state-run heating utilities.

A source at Naftogaz says his company is hoping that the new joint venture with Gazprom would, in addition to supplying Ukraine with gas, nudge RosUkrEnergo further aside by securing the rights to export gas to European markets. At stake is 3bn-8bn cm of gas exports each year, much of which is sold from underground storage facilities in Ukraine for top dollar during cold snaps. "While the details are not finalized on paper, the current agreement made by both presidents envisions that RosUkrEnergo will no longer supply Ukraine with gas. But we also have hopes the from the talks with Gazprom that our new joint venture with them will be able to export significant quantities of gas to Europe," the source says.

Currently, Ukraine is limited to exporting 1bn cm of gas to Europe per year, and all of this must be of domestic origin, not so-called re-exports. Securing the right to re-export gas not needed on the domestic market "would enable the joint venture to earn additional profits," the Naftogaz source says. "It will help compensate for any possible gas purchases made at higher prices, enabling us to supply Ukraine with gas at competitive prices, namely at the target for this year of $179 per 1,000 cubic metres."

According to the source, talks over the details of the new gas agreement have entered into a "sort of timeout phase," allowing Gazprom to hold negotiations with RosUkrEnergo's private shareholders. The essence of these talks is to decide whether RosUkrEnergo will retain its full rights to export gas through Ukraine to European markets, be squeezed out of this position entirely, or hand over a share of these gas exports to the new Gazprom-Naftogaz joint venture, the source says. "The Russian side should in the near future, possibly within weeks, settle this issue with RosUkrEnergo. We expect that the new joint ventures will be formed and start operating by April. But the ball is now in Gazprom's court," the source says.

Asked if Naftogaz would try to retrieve hundreds of millions of dollars in dividends from UkrGazEnergo, the source says: "Certainly we would like to receive these funds, but the negotiation process could produce another solution, meaning compensation in a different form, such as gas export rights."

False dawn

Konstantin Borodin, head of the Kyiv-based Energy Research Center and a former spokesman for Ukraine's Energy Ministry, believes Gazprom is unlikely to allow Naftogaz to become a competitor by exporting significant quantities of gas to Europe. "Even if Gazprom forces RosUkrEnergo out of the export business, it has no incentive to let Naftogaz into the export business," Borodin says, suggesting that the Russian gas major is more likely to keep RosUkrEnergo in the game, or concentrate all exports under its export arm, Gazexport. "In my view, Naftogaz has no chance of re-entering the re-export gas business and rebuilding a position it had before 2004. Back then, Naftogaz had direct contracts with Central Asian suppliers; today, all of this gas is contracted for many years ahead by Gazprom."

Borodin sharply criticizes the new gas agreement with the Russians struck by Yushchenko and Tymoshenko, saying the tandem surrendered to Gazprom a major stake on the vast domestic gas market, which is expected to grow as prices are raised down the line. Even if Ukraine gains a stake in exports to Europe, the upside on the European market in terms of prices and amounts consumed are smaller than what could have been gained on the domestic market.

"This talk about regaining gas exports to Europe is a kind of propoganda by Tymoshenko and the current management of Naftogaz, both of which are trying desperately to convince Ukrainians they are fighting for Ukraine's national interests," he says. "It's a tool to rechannel attention from the crux of this agreement they are making, to overshadow the fact that they are basically strengthening Gazprom's position in Ukraine and weakening Ukraine's position overall."

Borodin suggests that Yushchenko accepted this agreement in the heat of a three-hour discussion with Putin, during which he was "warned that the Russian side would not back down, that it would cut off gas supplies to Ukraine for not paying its bills."

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