INTERVIEW: Naftogaz’s fragile success

INTERVIEW: Naftogaz’s fragile success
Yuri Vitrenko, Naftogaz commercial director.
By Fabrice Deprez in Kyiv March 6, 2018

Reforming Ukraine’s state-owned gas company is like doing surgery, Yuri Vitrenko argues.

The commercial director of Naftogaz has a thing for medical analogies, comparing the company to a human body and saying his goal is to turn it into a “healthy, fit person”. But he’s also careful not to oversell the company’s achievements in the last three years: “We’ve stopped the bleeding, we’re out of emergency care, but there still is a lot of rehabilitation to do” he tells bne IntelliNews in an exclusive interview in Kyiv.

Naftogaz found itself in the middle of yet another gas war with the Russian gas monopolist Gazprom on March 2. Naftogaz has just won a years-long arbitration decision in Stockholm and the Russian gas giant is supposed to pay $2.56bn in compensation for overcharging for gas and underpaying for gas transit through Ukraine to its Western customers. Gazprom looks like it will refuse to pay and threatened to break its supply and transit agreement with Ukraine the next day.

Dealing with an irate Russia is part of the company’s brief and catches the headlines, but more importantly for Ukraine has been the revolutionary change at the company. Gas subsides used to account for 8% of GDP and the company’s debt weighed heavily on the budget. But at the International Monetary Fund (IMF) insistence, the company has been through a dramatic transformation: tariffs have been hiked and today the $3.8bn Naftogaz paid to the state budget in the form of taxes and dividends makes it the biggest taxpayer in the country. It is now moving on to develop new gas deposits and said in January that it hopes to make Ukraine self-sufficient in gas by 2022.

Since he arrived at the leadership of the company with CEO Andriy Kobolyev in 2014, Vitrenko has overseen one of the more spectacular transformation in post-revolutionary Ukraine, helping to turn the strategic gas company from a corrupt, debt-ridden state-run monopoly into a profitable firm. Asked whether he expected this outcome when he took the position of CCO in 2014, Vitrenko let out a short laugh: “No, I have to be open with you, I did not.”

He and Kobolyev were appointed just after the fall of then-president Yanukovych in a period of major political uncertainty – and they did not expect to last long: “Presidential elections were coming and we have this “tradition” that the new president of Ukraine put his own men as heads of Naftogaz,” Vitrenko said. “So we thought we would be replaced after a couple of months.”

Instead, thanks to the support from Ukraine’s international donors, a quickly worsening economic and military situation and good initial results, the two men were kept on to drive Naftogaz’s reforms.

Their tenure quickly took the shape of a two-front war as Naftogaz tried to secure gas supplies amid a general breakdown of relations with Russia, while trying to turn what was, until recently, one of the symbols of the corruption of the Ukrainian elite into a “Western-style corporation”.

Keeping Ukraine warm

On both scores the new team have had some notable achievements. Gas supply was the most pressing issue, as Gazprom had announced in April 2014 it would cancel a previous gas discount to Ukraine. Prices jumped from $268.5 per 1,000 cubic metres to $485. Russia then cut off all gas supplies in June, saying Ukraine had failed to settle its debt.

Thanks to reverse flow from the West, a slight uptick in domestic gas production, and a sharp fall in gas consumption, Naftogaz was able to keep delivering gas without major cuts. It was one of the company’s “biggest success”, Vitrenko claims. “We managed to live without Russian gas, and for us it was an almost existential issue.”

In early 2018, the Stockholm Arbitration court that has been mediating the dispute between the two gas behemoths also rejected a claim by Gazprom that Naftogaz owed the company $56bn. The ruling was hailed as a major victory by Naftogaz, though the court also acknowledged a $2bn Naftogaz debt owed to Gazprom.

“The main thing is that Naftogaz managed to avoid tens of billions of dollars worth of claims on take-or-pay clauses; it could have been an unbearable burden both for Naftogaz and the state,” Fitch Ratings analyst Dmitry Marinchenko told Reuters.

Most impressive to outside observers, however, was the speed with which the company managed to improve its financial standing. Before the 2014 revolution, Naftogaz was routinely described as the “black hole” of Ukraine’s state budget, with a deficit as high as 5.7% of the country’s GDP. Just two years later, the gas company boasted a profit of about $984m, the first of its kind in five years, and became the biggest contributor to the state budget.

Partly, this was due to external factors. In 2016 and 2017, Ukraine entirely stopped buying Russian gas, which, combined with the fall of gas consumption that followed the major economic downturn in the country (between 2013 and 2015, consumption fell from 50.4 billion cubic meters to 33.8bcm) contributed to improve the company’s financial standing. “Before, money was flowing from Ukraine to Gazprom,” Vitrenko said. “Now we get $2.5bn from Gazprom each year for the transit services without buying gas, so it's a net inflow.”

But the turnaround was also the consequence of several internal decisions according to Simon Pirani, a senior visiting research fellow at the Oxford Institute for Energy Studies: “They’ve managed their cash flow much more transparently, separated the divisions within the company so that they can see what's going on, they dealt with obvious sources of waste and of course, gas prices for households have gone up sharply.”

In 2013, some Ukrainians were paying as little as UAH725 ($80 at prevailing exchange rates in 2013) for the first 2,500 cubic meters of gas. But In 2016, prices rose to UAH6,879 hryvnia ($272) per 1,000 cubic metres of gas used, a move which largely contributed to filling Naftogaz’s coffers.

The backlash

Gas prices proved to be a particularly sensitive issue, however. One of the main items in the law on gas reform adopted in April 2015, the sharp hike in household tariffs – and increase of almost five-fold – went from a hurdle to overcome to the source of a protracted struggle between Naftogaz and Ukrainian’s political elite, which, observers argue, has led to a major slowdown of the pace of reform.

After a first price rise in 2016, the Ukrainian government reneged on a promise to the IMF to boost household gas tariffs in October last year, just as the heating season got under way, arguing that higher prices would hit poor Ukrainians first and foremost.

President Petro Poroshenko had already seen his popularity plummet and the government calculated that the political cost of hiking gas tariffs was too high. However, the tariff increase is a key plank of the IMF imposed reforms.

"There are no plans to increase the gas prices," the online outlet quoted  Energy Minister Ihor Nasalyk as saying on October 2. "The prime minister has clearly stated that there are no economic justifications for this [gas price increase], and the ministry can confirm this."

Vitrenko argues however that this defence of low gas prices is due to “resistance from vested interests.”

“Surgery can be scary,” he added.

Western backers have also been critical of the way the Ukrainian government still tries to make Naftogaz pay for public service obligations, the complex system of subsidies still in place despite demands by Naftogaz to abolish it. “The government should pay for those, not Naftogaz,” an EBRD senior executive told bne IntelliNews, which has also played a crucial role in funding the company. In October 2015, Kyiv secured a $300mn loan from the EBRD to buy gas on the European market to cover the country’s heating needs during that winter.

But in April 2017 the bank’s president Sir Suma Chakrabarti lambasted the government for foot-dragging over reforms to the management of the company, especially a failure to introduce a corporate governance code, which had prompted several of its independent directors to resign.

“Naftogaz also need to become, as originally agreed, an entity of private law,” Chakrabarti said in a strongly worded letter to the prime minister. “I am asking you to do all that is necessary to have Naftogaz’s new charter and necessary enabling legislation in place before the end of this month [April].”

The conflict between Naftogaz and Ukrainian authorities only grew stronger in 2017, as the independent supervisory board appointed the previous year complained of increased political meddling.

In April, Ihor Prokopiv was appointed deputy energy minister. The announcement was interpreted as a particularly poor signal, as the man now effectively in charge of supervising Naftogaz had been fired from the company only a few months earlier for alleged misappropriation of funds. One member of the board resigned immediately in protest, and two more in September, citing the “dismantling of reform by the government”.

“The reform process was quite successful at the beginning, but it’s now in a deadlock.” Wojciech Kononczuk, a specialist on energy policy in Central and Eastern Europe for the Centre for Eastern Studies, a Polish think-tank, told bne IntelliNews.

The unbundling of Naftogaz, the other key provision of the law on gas reform, has been another major point of contention. The law plans for the separation of Naftogaz’s transmission service from production and supply activities to put it in line with the EU Third Energy Package, but showed “insufficient progress”, according to the EBRD senior executive.

Some observers have warned that the overall reform plan could be effectively frozen until the next presidential election in 2019.

The backlash hasn’t surprised Vitrenko, who argued it was a logical consequence of the reform: “Ukrainian elites are afraid of this reform because they realise that proper market reform mean they are out of business, because their business model is not to be competitive but to steal from the government.”

The shadow of Dmytro Firtash

Corruption also remains a concern for a company that used to be one of Ukrainian elites’ main channel for dirty money: in 2014, a Reuters investigation found out that Ukrainian oligarch Dmytro Firtash might have made up to $3b by buying gas from Gazprom “well below market prices” and selling it Naftogaz.

By most accounts, such corrupt deals have now all but ceased, and Vitrenko claims the company also dealt with one of the main sources of internal corruption in the procurement of equipment.

But Firtash, who is currently in Austria fighting a US extradition request, allegedly still controls a majority of Ukraine’s regional distribution companies, which act as intermediary between Naftogaz and the final customers. Naftogaz claims regional gas companies have accumulated UAH20.4bn ($714.8 million) of debts in 2017, and maintain an opaque system which encourages corruption. “We don’t need these intermediaries. They say they sell gas to households, but we cannot check, it’s all very murky,” according to Vitrenko. But the government remains reluctant to write off the debt as that would in effect put money into an oligarch’s pocket.

In September 2017, Naftogaz denounced a so-called “dead souls” scheme, in which a regional gas company in the Khirovograd region allegedly sold 9.8 million cubic meters of gas to more than 300 fictional addresses, while pocketing the subsidies.

This might explain that, despite real progress, Naftogaz’s leadership remains cautious about the company’s future prospects.

“We quickly realised that internal fights against vested interests can be more difficult than dealing with Gazprom or external powers,” Vitrenko says. “That's why, if we compare Naftogaz to some other companies I worked for, like PwC or private equity funds, we are still miles away from these standards.”