Ukraine, Naftogaz to suffer as Russia agrees to Turkmen gas price hike

By bne IntelliNews November 28, 2007

Roman Olearchyk in Kyiv -

Russian energy giant Gazprom announced November 27 it had reached a deal with Turkmenistan to accept stiff prices hikes on natural gas that is resold to Ukraine through Swiss-registered trader RosUkrEnergo. The new price increases are expected to stoke inflation in Ukraine, whose economy is still adjusting to the sharp gas price hikes imposed this and last year, and put further pressure on the cash-strapped state energy firm Naftogaz.

Gazprom said for the first half of 2008, the energy-rich Central Asian state will be paid $130 per 1,000 cubic metres (cm) of gas, a 30% increase from the current rate. Fees will increase to a $150 rate for the second half of 2008. As a result, the price that Ukraine pays next year is expected to surge from the current $130 rate to $160-180, or more.

Ukraine, which fills most of its gas needs with imports from Turkmenistan and other Central Asian producers, has yet to sign a supply agreement with Gazprom and RosUkrEnergo. But earlier this month Kyiv officials had been predicting a less severe price increase for next year.

A government official told bne the "unexpected" price hike that Ukraine will face in connection with the increased price for Turkmen gas for next year is "unfortunate." He said the increase is largely the fault of Washington and Brussels who have in recent months courted Turkmenistan, telling the Central Asian country's leaders they could receive higher prices for their gas in return for backing gas pipeline project that would bypass Russian territory.

"We have to thank our western neighbours for this higher price," the official said. "Gazprom had a contract keeping the $100 purchase price with Turkmenistan in place until 2009. If Gazprom was forced to accept higher price from Turkmenistan, the only explanation we can see is that they did so to persuade Turkmenistan to back out of gas pipeline projects lobbied by the West."

Nevertheless, Ukraine will likely have to accept the higher prices, the official said, insisting all efforts would be made to avoid a repeat of the 2006 standoff in which supplies to Europe were disrupted, causing consternation among EU governments.

However, Ukraine's economy minister, Anatoliy Kinakh, said November 28 that Kyiv might retaliate by raising the transit cost for gas pumped through its vast pipeline system to Europe. The move could help Kyiv compensate for higher prices for gas, but such a move would equate to higher prices for European consumers. About 25% of Europe's gas needs are supplied by Russia and are pumped through Ukraine. "On the one hand, raising the transit fee will lower the attractiveness of Ukraine as a transit zone for Russian gas to Europe, providing more impetus for Russia to seek alternative routes," a source in the government told bne.

The big squeeze

The higher-than-expected gas price hikes are certainly negative news for Ukraine, which is already grappling with high inflationary pressures sparked by the gas price increases from 2006 and this year. The previous hikes caused higher prices across the board, foremost utility service fees for citizens and businesses. Inflation is expected to come in at 13% or higher for this year. Future gas price hikes are expected to lead to additional price increases on utilities, which could further complicate the finances of Ukraine's state oil and gas company Naftogaz Ukrainy.

The 2006 gas accord with Russia stripped Naftogaz of sales on the domestic market to the best payers, ie. industry. Instead, the company has been cornered into collecting from households and state-run utilities, where payment is poor and services subsidized. The state has increased tariffs and will likely need to do so again next year to compensate for the higher gas prices. But collecting could become more difficult for the already cash-strapped Naftogaz.

European banks with an interest in Ukrainian debt have expressed fears that sustained political paralysis and the prospects of higher gas prices will leave Naftogaz's growing troubles ignored. The state energy firm has failed to produce an audit for last year, thereby violating the covenants in its Eurobonds. Sources close to the company said the audit, prepared by Ernst & Young, won't be signed until parliament adopts tax relief laws for the company.

This month, bondholders agreed to a waiver, giving the company until the end of the year to produce an audited annual report. The cash-strapped Naftogaz has continued to make payments, but the fresh news about higher gas prices for next year have made bondholders increasingly nervous about the possibility of a default.

The gas price hike for next year is "clearly negative news for Naftogaz," says Kaushik Rudra, a debt strategist at Lehman Brothers. "Naftogaz's ability to pass the higher import costs on to end users is very limited. We expect this to further damage Naftogaz's distribution business, which was already a loss-making business. That said, the Eurobonds may not move much on the news, as they are already trading at very distressed levels."

The situation for Naftogaz is "quite negative, especially if the government doesn't pass on the price increase to consumers," says another debt strategist. "At the moment, Naftogaz sells at a significant loss to the general population and heating enterprises. I don't think the company could survive much longer without the government taking over the cost of subsidy into the budget."

Ukraine's parliament convened for the first time last week after snap parliamentary elections held on September 30, but political bickering has put off the formation of a new coalition government. If parliament remains deadlocked, analysts fear tax relief laws won't be passed by the end of the year, triggering a technical default.

Should Naftogaz, once Ukraine's largest company, sink into a technical default, the cost of corporate and sovereign borrowing for Ukraine would likely rise, hurting many Ukrainian borrowers and the economy overall.

Higher gas prices will also hurt the profits of Ukraine's gas-guzzling steel and chemical businesses, which compete on the export markets with Russian counterparts. In a report, Alfa Capital Ukraine suggested the higher gas prices will, however, be manageable for most of Ukraine's industry, which has in recent years moved to improve energy efficiency by reducing consumption of gas. While Ukrainian steel and chemical producers will face higher gas prices than competitors in Russia, they will still pay lower than EU levels, preserving their "competitive advantage through at least 2011."

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Ukraine, Naftogaz to suffer as Russia agrees to Turkmen gas price hike

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