Ukraine aware of Russians bearing gifts

By bne IntelliNews May 10, 2010

Graham Stack in Kyiv -

Russian Prime Minister Vladimir Putin was recently named one of the world's leading persecutors of the press and, true to form, he cruelly upset many journalists' holiday plans when, on the eve of the long May Day weekend, he casually proposed merging Russia and Ukraine's respective nuclear power and gas sectors.

With rumours swirling and speculation rife, the outcome of the ongoing talks between the Russian and Ukrainian governments to deepen and thus improve the two's often-fraught energy relations is still anybody's guess. But some of the proposals made by Russia to Ukraine for tighter energy collaboration could benefit all sides, including Europe, if approached with caution.

The new administration under President Viktor Yanukovych has already shown its greater willingness to work with Russia when it struck a deal behind the scenes in early April to extend the lease of Russia's Black Sea Fleet in the Crimean port city of Sevastopol for at least 25 years in return for the signing of a new gas price agreement - which famously resulted in an egg-throwing melee in the an parliament following the ratification of it.

However, according to analysts, the "maximalist" option of a full-blown merger of the countries' nuclear and gas sectors is unlikely and may have been a bargaining tactic on Putin's part to make any final deal seem like a concession to Ukraine interests. Thus, some compromise solution involving asset swaps and joint ventures is more probable. Indeed, Putin said as much himself on April 26 when he told journalists that regarding the nuclear power sector, "we are proposing to create a powerful holding that would include united nuclear power generation, united nuclear power engineering and fuel cycle. But if Ukrainian experts think that this is a too revolutionary proposal, we can do this step by step."

Considering Ukraine and Russia's nuclear power and gas sectors were parts of the same Soviet complex, Russia's leadership sees synergies all along the line emerging from closer collaboration. The Kremlin frequently accused Ukraine's previous leadership under pro-western president Viktor Yushchenko of sacrificing Ukraine's real economic interests for the sake of ideological geopolitical considerations of not falling into 'Russia's sphere of influence'.

Analysts argue that if Ukraine prevents a full-blown merger of what are much small Ukrainian companies into their Russian counterparts - ie. Ukraine's state-owned gas utility Naftogaz being swallowed whole by Russia's gas giant Gazprom - and instead reaches a more balanced asset-swap deal, it could achieve a win-win situation. Ukraine's economic integration with Russia would increase, but this would help diversify its economy away from commodities towards technology. And with the country now focused on EU membership rather than Nato accession, its future will be determined not by geopolitics, but by whether it can change its institutional DNA.

Nuclear fusion

With the Russian-Ukrainian intergovernmental commission working overtime to hammer out collaboration plans, currently the most that's known about the proposals centres on nuclear power.

Ukraine generates around 50% of its electricity from nuclear power, and just maintaining this level in the future will demand construction of considerable new facilities, as envisaged by the official state Energy Strategy. But Ukraine has no money for this and is dependent on Russia for technology. "All the plans and designs of our nuclear power stations are still in Moscow," says Oleksandr Klyuchnikov, president of the Ukrainian Nuclear Society, illustrating the depth of inter-linkage between the countries. "Whenever we need to modernize or repair reactors, we have to ask Moscow for the blueprints."

Ukraine is approaching a critical threshold as the remaining life of its four remaining Soviet-era reactors nears an end. "They are all of one generation," says Klyuchnikov, "and thus their term of life end together over a short period of time, starting in 2011. Within five years, 60-70% of facilities will have exceeded their original term of life."

Putin is now offering Ukraine is a $5bn-7bn credit to complete the third and fourth reactors of the Khmelnitsky nuclear power station. But going ahead with Russian reactors will tie Ukraine to Russian fuel and to further Russian reactors in the future. "Given Ukraine is planning to double its nuclear capacity within next 20 years, an agreement on construction of two blocks at Khmelnitsky will indicate potential constructor of future nuclear objects," reckons Russian nuclear sector analyst Anna Kupriyanova of Uralsib brokerage in Moscow. According to Klyuchnikov, only the Russians can realistically complete the work that was started in Soviet times.

The decision to have Russia build new reactors, says Kupriyanova, will then also lock Russia in as main supplier of fuel for the future. Ukraine's fuel needs are worth $300m-400m per year to Russian fuel producer Tvel, about 25% of Tvel's total sales. So in parallel with the credit for the Khmelnitsky reactors, Russia is proposing a long-term contract for nuclear fuel. "The longer the contract, the greater the price reduction," head of Russia's nuclear energy state corporation Rosatom Sergei Kiriyenko said on TV on April 27. Kiriyenko added that signing a 25-year contract would get Ukraine a total $1bn price reduction.

But Rosatom is looking to do more than build reactors and supply fuel to Ukraine, which is basically what it already does. The corporation has been closing uranium-mining deals across Eurasia, and now is zooming in on large untapped Ukrainian deposits. "Russia will help in developing the largest uranium deposit in Europe, the Novokonstantinsky deposit with up to 100,000 tonnes of pure fuel," Kiriyenko has said.

Ukraine has practically ceased uranium mining for want of finance. The new Ukrainian president, Viktor Yanukovych, has stated the involvement of the Russians could see Ukraine cover 50% of its uranium needs. "Ukraine could indeed cover its own uranium needs," says Klyuchnikov. "But there is huge investment needed to start up production at Novokonstantinskii." According to Kiriyenko, Rosatom's investment could reach $500m.

As part of the deal for mining uranium and supplying fuel, Russia seems to be offering to build a fuel assembly production plant in Kharkyv, potentially as a joint venture, with Russia supplying the enriched uranium. "This could solve the problem of dependence on Russia for supply of fuel," says Klyuchnikov.

Kiriyenko has said the plant could also share in export of fuel assemblies to Soviet reactors across Central and Eastern Europe, which would also benefit the Russian company in lessening other customers' fears of dependence on Russian-produced fuel. Alternatively, Kiriyenko has mentioned the possibility of Ukraine taking stakes in Russia's domestic fuel producers such Novosibirsk Chemical Plant.

Finally, Kiriyenko has proposed setting up a joint venture between Ukraine's state-owned producer of nuclear power plant equipment Turboatom and Russia's equivalent Atomenergomash, although the parameters are still unclear. The joint venture could produce equipment for reactors built by Russia's international nuclear engineering arm Atomstroyexport, similar to a successful joint venture with German engineering concern Siemens. Such a deal would give Turboatom, currently a main supplier of equipment to Russia, a guaranteed slice of Russia's booming atom reactor export business, with reactors currently being built in India, China, Vietnam and potentially in Bulgaria and the Czech Republic.

So, according to these probable parameters, although substantially different from the "united company" that Putin has proposed, Ukraine gets a major new uranium mine, two and counting new reactors with financing, a new fuel assembly plant, and technological development of engineering, but loses out geopolitically.

Gas attack

Although Ukrainian Prime Minister Mykola Azarov called Putin's eyebrow-raising remarks on a possible Gazprom-Naftogaz merger "impromptu," Putin's press secretary Dmitry Peskov subsequently said the proposal was meant seriously. He even detailed the potential Naftogaz stake in Gazprom: 5%. But Gazprom boss Alexei Miller later indicated the company would favour an asset swap, offering Naftogaz the chance to get involved in upstream gas extraction in Russia.

"We regard an asset swap more likely, which could involve granting Ukraine direct ownership in some Russian gas assets in exchange for access to certain elements of Ukraine's gas infrastructure, such as underground storage facilities or pipelines," says Alex Burgansky of Moscow-based investment bank Renaissance Capital.

"For both financial and political reasons, a merger is the least likely course of action," agrees Chris Weafer of Uralsib. "An asset swap that allows Gazprom to gain an interest in the pipeline would be a net positive."

Gazprom has already initiated a number of asset-swap deals with European energy companies such as Italy's Enel and Eni and Germany's E.On and BASF, whereby partners participate in extracting gas in Russia in exchange for downstream assets in Europe. Cash-strapped Naftogaz has gas extraction subsidiaries producing about 50% of Ukraine's gas needs, but they're starved of investment and using obsolete technologies. In addition, it is forced to sell this gas to domestic consumers at state-controlled prices. Upstream access to Russia's resources could be a solution to some of the company's problems. "For example, in one of the Yamal projects," says Weafer. "That would allow Naftogaz to become more diversified and to move away from being just a gas utility."

In exchange, Gazprom probably wants a stake in Ukraine's gas transit system, similar to the one it has in Belarus' pipeline operator Beltransgaz, and the opportunity to invest in upgrading the increasingly decrepit, but strategically vital system.

According to energy analyst Ildar Gazizullin of Kyiv's International Centre of Policy Studies, this plan could see Ukraine's gas transit system (GTS) hived off as a separate and transparent business, as also demanded by the EU in the Brussels Agreement between Ukraine and EU of March 2009. "Gazprom and the EU share an interest in the unbundling of Naftogaz functions and upgrading of the GTS," says Gazizullin. The EU and international financial institutions have promised investment totalling $3.5bn when such steps are taken, and Gazprom's Miller has also said Russia could invest in upgrading. The Russians have even argued that the Ukrainian GTS is technologically the same system as the Russian, and cannot be modernized without Russian involvement.

Analysts note that if Gazprom had a stake in Ukraine's GTS, it could cut back on the proposed South Stream pipeline that is intended to bypass Ukraine and instead increase volumes through the country. This could even see Ukraine's GTS opened up to bring gas from Azerbaijan - the so-called 'White Stream' project - which would effectively kill the EU-sponsored Nabucco pipeline, which is desined to bring Caspian, Central Asian and Middle East gas through Turkey, avoiding Russian soil.

Furthermore, some of Ukraine's engineering companies, such as turbine producers Motor Sich and Sumy Frunze, are core suppliers of Gazprom. Were Ukraine's GTS to get a major EU- and Russia-financed overhaul, the economic stimulus affect could reach 3% of annual GDP, Alfa Bank economists calculated in 2009.

Again, it seems the asset swap model would boost and diversify Ukraine's economy, whatever the geopolitics of the deal.

Damned if you do...

At times, the Russian delegation to the intergovernmental talks has seemed like a horde of shoppers at the spring sales. In addition to Putin's bombshell a Gazprom-Naftogaz merger, the PM's close ally, head of Rosneft and Deputy PM, Igor Sechin, startled analysts by calling, for the first time, for joint Ukraine-Russia projects in hydroelectric power.

But Voldomyr Saprikin, energy expert at the Razumkov Centre in Kyiv, says he can see no role whatsoever for Russia in hydroelectric power projects in Ukraine. Analysts covering Russia's RusHydro hydroelectric company say that new CEO Evgeniy Dod, a Sechin ally, has stated some interest in international M&A, but the company has made only a few hesitant moves into Kyrgyzstan to date.

RusHydro has no integrated engineering arm, merely some research institutes inherited after the former power generation monopolist UES was disbanded, according to energy analyst Matvey Taits. The company is slowly nearing completion of the Siberian Boguchanskaya hydroelectric station in partnership with aluminium giant Rusal, its only large post-Soviet project to date.

More importantly, the company is morally and financially recovering from the horrendous August 2009 disaster at the Sayano-Shushenskaya hydroelectric power station, when a burst turbine flooded the engine hall, killing 75 workers, and causing $500m worth of damage. As a result, the company is now focusing on safety issues, modernization of existing facilities in Russia and boosting capex - leaving very little to offer foreign expansion.

Leaked documents published by the Ukrainian independent newspaper Zerkalo Nedeli detail Russian interest in particular in completing and operating the Dnestrovskaya hydroelectric power station. But work on the station has already received $166m in financing from the World Bank as a renewable energy project. "There is no need for Russian involvement there," says Saprykin. "Ukraine can complete the work self-sufficiently."

Analysts say the hydroelectric power idea is the personal pet project of the influential Deputy PM. "Sechin considers himself number 1 in terms of supervision of the entire energy sector," says Taits "But in Ukraine at the moment, it is all about Rosatom and Gazprom - ie. Kiriyenko and Miller."

Sechin is chairman of the board of Inter RAO - Russia's electricity export company, which under Sechin is mutating into something bigger, after remaining government stakes in power generation were transferred to the company in April. There have been rumours that a merger is on the cards between Inter RAO and RusHydro. Thus Sechin's lobbying for RusHydro of easy projects in Ukraine could be a sweetener in the run-up to a merger.

Analysts also say Sechin's interest in Ukraine's hydroelectric power sector aims at preventing cheap Ukrainian hydroelectricity competing with Inter RAO's international export business to Belarus and Moldova. A bad deal for Ukraine through and through.

Wings clipped

While Russia's sudden and unwelcome interest in Ukraine's hydroelectric sector caught many by surprise, the relatively innocuous plans for partnership between the flagship plane-builders, Ukraine's Antonov Design Bureau and Russia's United Aircraft-building Corporation (UAC), both state-owned, is causing less alarm.

With Antonov's planes - the further development of Soviet models - being built mostly at plants in Russia, and with Russia having far more extensive worldwide marketing and, crucially, post-sale servicing, some sort of share swap and integration seems a no-brainer. In fact, talks were already ongoing with the previous Ukrainian government of Yulia Tymoshenko on the issue. "It's completely obvious that we cannot develop plane-building on our own," acknowledged Ukrainian Prime Minister Mykola Azarov on May 5 at a press briefing. "We don't have the market. We can't even build a plane ourselves. And if we found the resources and built a plane, how would we find a market for the plane?"

But judging by recent official statements, there is no immediate merger on the cards. All that has been revealed is that UAC's Voronezh plant will assemble Antonov's An-148 planes, and Antonov's plant will assemble the longer An-158 models in Ukraine. According to UAC head Aleksei Fyodorov, the two companies will also form a joint venture for marketing and servicing.

Analysts speculate that either there are major merger plans in the pipeline, which Azarov's comments would indicate, and officials are keeping those secret until ready for signing, as happened with the controversial deal on prolongation of Russia's Black Sea fleet base in Sevastopol. Alternatively, UAC is simply not interested in developing Antonov because Antonov's An-148 and An-158 compete with UAC's own flagship Superjet 100.

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