Ukraine has gone through a quiet revolution. Over the last two years an open gas market has been created and the first independent traders are already buying and importing significant amounts of gas from Europe to feed the country’s unquenchable thirst for energy.
Kyiv has caught a lot of flack for the slow pace of reforms, especially against endemic corruption. The banking sector is one exception where Ukraine has drawn praise for the rapid clean-up. But less well known is the deregulation and legal basis for a transparent and fully functioning gas market.
Andrew Favorov and his trading company Energy Resources of Ukraine (ERU) has pioneered the business and is already the biggest player on the market. And just in time. Relations with Ukraine’s biggest gas supplier Russia are at rock bottom as the two countries are effectively at war. Ukraine has turned west to its EU partners for help and Favorov is the man who stepped into the breach.
“We pioneered the first reverse flow gas deal in Ukraine,” says Favorov sitting in his modest office in downtown Kyiv. Gas normally flows from the giant gas fields in Siberia through Ukraine to Russia’s European customers, but Favorov managed to get the gas to flow in the other direction in some pipes so Ukraine could import gas from the West.
Ukraine used to be heavily dependent on Russian gas; at one point Ukraine was the most wasteful consumer of energy in the world, importing around 60bn cubic metres (cm) of gas a year from Russia in addition to the 20bn cm it produces itself. However, as the cost of energy rose and Ukraine’s unreformed economy shrank, tensions with Russia grew until December 2006 when Moscow abruptly cut Kyiv off for non-payment of bills.
That winter marked the beginning of the gas wars that preceded Moscow’s annexation of Crimea and the covert invasion of Donbas by Russian troops in 2014. Things were made worse in 2008 when then prime minister Yulia Tymoshenko signed a gas deal with Russia on the widely-held expectation that oil prices would fall, to which gas prices are linked. Oil prices rose instead, making Ukraine’s gas impossibly expensive.
Gas imports fell to around 40bn cm in this period, but now as imports from Europe grow, partly thanks to the gas traders, Ukraine has imported no Russian gas at all this year, although it recently suggested it was willing to cut a deal if the price is right. The collapse of oil prices in December 2014 means gas now sells for a quarter of the price Russia was charging at the end of the last decade.
Favorov is among the most experienced gasmen that Ukraine has. He graduated from Georgetown University in the US with an MBA in 2005 and went to work for American energy giant AES. That took him to Kazakhstan where the company had taken over the 4000-megawatt Ekibastuz GRES-1 power station, the first foreign-controlled power plant in the Commonwealth of Independent States (CIS).
“That was a good time to be in power generation,” relates Favorov in perfect English. “The Russians were in the middle of the privatisation of their power sector under young reformer Anatoly Chubais, who broke up the state-owned monopoly United Energy Systems (UES), earning the Kremlin billions of dollars in the process from enthusiastic investors – both foreign and domestic.”
“The power we were generating went into the domestic [Kazakh] market and was also exported over the grid to Afghanistan and Pakistan. We were pioneers and signed the first ever 10-year supply contracts in the region,” says Favorov.
The boom in Russia spilled over into Kazakhstan. AES was also interested in joining the Russian bonanza and wanted to buy some Russian assets just over the border from Kazakhstan, including Russia’s TGK11 power company But when AES ran the numbers on the deal, Favorov’s boss and now partner in ERU Dale Perry began to wonder whether the US company shouldn’t be selling rather than buying. “We looked at the valuations on TGK11 and thought that we could barely earn a return on an investment at those prices so decided to sell Ekibastuz instead,” says Favorov. “We hit the market about as close to the peak as was possible.”
AES bough Ekibastuz in 1996 for $3mn, but had to invest $200mn to bring it up to speed. It sold it in 2008 for a cool $3bn. “It is as far as I know so far the only successful investment into power that a foreign company has made in the CIS power sector, where the investor sold for a profit,” says Favorov.
Ukraine trading powers up
The sale of Ekibastuz ended Favorov’s Kazakh adventure and he returned to Ukraine taking a several jobs before ending up at DTEK, the largest power company in the country that belongs to local oligarch Rinat Akhmetov.
These were the boom years for Ukraine when foreign investors flooded into the banking sector on the back of the optimism that followed the Orange Revolution. DTEK expanded its output five-fold from 2 gigawatts to 10GW and was the recipient of the gas from Favorov’s reverse gas deal. Finally having done all he could do of interest at DTEK, Favorov struck out on his own and set up ERU. Ukraine's president Viktor Yanukovych was ousted in February 2014 and the question of organising market-based gas imports from somewhere other than Russia became a question of national security.
The new gas market has been made possible by a series of laws to create the legal basis of the transactions and open a wholesale market for gas. ERU can buy the gas from Europe and rely on guaranteed access to the pipeline network to transport it to customers in Ukraine. There are no restrictions on who you sell the gas to, nor what price you can charge for it. “The business is backed by the EBRD, OPIC, IFC and a bevy of other international financial institutions and it has already imported 500,000 cubic metres of gas in 2015,” says Favorov. “And we expect to import significantly more in 2016.” He won’t give financial details of ERU, but says they are in profit and growing, even if the margins are thin.
The gas market has been through some massive changes in the last year. As part of its $17.5bn stand-by agreement with the International Monetary Fund (IMF), the government in Kyiv has been forced to end domestic gas subsidies, which has transformed the business. At the height of the gas wars with Russia, Ukraine was paying over $450 per 1000 cm of gas to Russia, but only charging the consumer $50. Energy was free in Soviet days so hiking utility bills to cover the cost of energy has been massively political. But the subsidies are now gone and the population will get their new larger heating bills this autumn.
“[Prime Minister Volodymyr] Groysman targeted the subsidies. The gas market now works. When the consumer has to pay for gas what it costs, then they will start to think more carefully about waste and energy efficiency will improve too,” says Favorov. “The fact that oil prices collapsed, halving gas prices in the process, has made this whole reform much easier to implement. It has closed the spread from a ten-fold difference to a four-fold difference.”
ERU is focused on gas, but it is part of a wider entrepreneurial group that would like to spread its wings a little further. Favorov has already assembled a consortium to bid in the Centroenergo privatisation, an attractive 7.4GW Ukrainian power station that is on the docket to be sold, “but politics as usual meant the government has suspended the auction to sell it for the time being”, he says.
ERU is the largest gas trader in Ukraine today, but it has already branched out into oil and coal trading in a small way as new business lines, and has other projects up its sleeve. Much depends on the government and the pace of reforms, which are going slowly. “One of the few successful reforms the government has managed to make so far was creating a deregulated gas market,” says Favorov. “It's a real market where the Rada managed to eliminate 90% of the problems to trading gas.”
And the reforms to the sector are continuing. At the end of September, the Cabinet of Ministers took over full control of the national gas company Naftogaz as per the EU’s third Energy Package regulators demand. Ultimately Naftogaz will be split into two joint-stock companies: Gas Mains of Ukraine and Underground Gas Storage of Ukraine.
The ownership unbundling of Naftogaz will take place after the Arbitration Court in Stockholm has passed its verdict concerning the suit brought by Naftogaz against Gazprom for unpaid bills. The two new companies are expected to be turned into modern corporations and will be controlled by the Ukrainian energy ministry.
No way back
At the same time, the government is attempting to set up a new market-orientated regulator for the gas sector, but progress is slow in what is an intensely political business.
Eventually Ukraine hopes to become self-sufficient in gas, as it has two large basins of gas in the east and western parts of the country. Indeed the first gas pipeline between Russian and Ukraine actually carried Ukrainian gas to Russia; it was only once the giant Siberian gas fields were discovered that the flow reversed. Various investors are being wooed to invest in these fields and the Chinese have already expressed an interest.
Despite the slow pace of reforms and the obvious and persistent corruption, Favorov remains highly optimistic. “Now is the time for 25- to 35-year-old people in Ukraine. There has been so much change in the last two years. If you are young and want to do something, then you can if you work hard. There are cracks in the old asphalt and the green-shoots of growth and recovery are starting to show through,” says Favorov.
“Ukraine lost 20 years when it could have reformed, but now it is having its turn at the plate. The old generation didn’t know anything else but they have been washed away. Those that demonstrated on Maidan or volunteered to fight in Donbas, they will not go away. There is no way we can go back to the corrupt mess that the country was,” he concludes.