Ben Aris in Berlin -

Ukraine sits on top of the seventh-largest proven coal reserves in the world, around 34bn tonnes, which is enough to fire the country's power stations for at least four centuries. As most of the country's power generators are currently dependent on the less-than-reliable Russian gas, using the country's coal reserves as an alternative and affordable source of fuel is a no-brainer. But with the government working in slow motion, production is still in decline and a long-mooted privatisation has yet to happen.

In Soviet times, half of Ukraine's fuel needs were supplied by coal. On the face of it, the recovery of the coal sector is only a question of time. Nowhere else is Europe's vulnerability to unpredictable Russian energy supplies more dramatically illustrated than in Ukraine, after Russia's state-owned gas producer Gazprom cut the country off in the middle of one of the coldest winters on record at the start of 2006.

Coal makes up 95.4% of the country's hydrocarbon reserves and is enough to meet 80% of the country's energy needs. By contrast the country's domestic deposits of oil and gas met only 27% and 21%, respectively, in 2005. Nevertheless, gas dominates Ukraine's energy fuel use, accounting for 42% of all fuel burnt in 2006. Coal was a distant second with 24%.

It was a wake-up call for Ukraine's government and should be a shot in the arm for coal producers, most of which are mired in debt and running at a loss despite the unrequited demand. In the wake of the Gazprom run-in, the government has launched a plan to shift the fuel needs of most power stations from gas to coal between 2007 and 2011. At the same time, the Coal Ministry, which owns most of the country's mines, plans to increase coal extraction from 81m tonnes in 2006 to 95m tonnes in 2011.

Ukraine should be a coal powerhouse, but because of underinvestment, the glacial pace of deregulation and worn-out equipment, production has been falling and Ukraine's share of the world market is declining. At the start of May, the government reported another hit to the domestic coal sector: total coal output in Ukraine fell by 2.8% on the year to 26m tonnes between January-April, while Ukraine's output of coking coal fell further, by 6.1% on the year to 9.8m tonnes over the first quarter. This follows a slight increase in overall production last year to 80.3m tonnes of coal, up 2.8% year-on-year, but a fall of 8.2% in the production of coking coal to 30.1m tonnes year-on-year.

Carrying coal to Kubas

Thermal coal producers are able to meet the domestic demand in full. The transformation from natural gas-fired to coal-fired power units at thermal power plants will be the main driver of production growth at domestic thermal coal mining companies.

In addition to thermal coal, coking coal is an important subclass of coal and an essential ingredient in the production of steel – Ukraine's economic mainstay. However, despite reasonably large deposits most steel mills are forced to import coke due to the poor quality of the domestic deposits. There is an estimate 3bn tonnes of mineable coking coal reserves, but imports make up 32% of the coking coal blend going to coke plants.

This is starting to change as local steel mills begin investing in production. Within a month of Gazprom's decision to turn off the gas taps, Vitaliy Gayduk, a co-owner of the Industrial Union of Donbas (IUD), one of Ukraine's biggest conglomerate and the holding company for Alchevsk Iron & Steel, announced he would invest hundreds of millions of dollars converting his blast furnaces from gas to coal. And all the steel mills are looking to introduce technologies like pulverized coal injection (PCI) in 2008 and beyond to heat their metal.

Privatization to stoke change

A few mines have already been privatized successfully and are amongst analysts' favourite Ukrainian stock picks. The successful sell off of Krasnoarmeyskaya Zapadnaya #1 Mine, Shakhta Komsomolets Donbassa, Pavlogradugol and Krasnodonugol has shown that private enterprise can turn an old world industry around to make a profit.

Coal companies are newcomers to the local stock market, with the first two - Komsomolets Donbasa and Chervonoarmiiska Zakhidna, which both have above average quality coal deposits - listed in the second half of 2006.

"Despite low liquidity, their share prices posted steady increases, backed by both growing domestic demand for coal and the companies' decent operating and financial results," Troika Dialog said in recent report.

The government drive to privatize has largely stalled and the process is not expected to really get under way until next year, once the current political brouhaha has settled down. In November, the Coal Ministry released a list of 10 pits slated for privatization this year, of which the only really big one was the Krasnolimanskaya mining company - a top-10 mine in terms of production volume.

But the government is keen to do more, as propping up the coal industry is a heavy burden on the budget. Subsidies to the coal sector will be around $1.1bn this year plus another $2.2bn the government has already spent over the last two years, according to Renaissance Capital. The Coal Ministry has suggested hiking prices several times as part of market-orientated reforms. The coal minister announced prices would be hiked by 6% a month from January - doubling the price over the next year - a plan that has failed to materialise. Other plans have called for increasing prices by 30% this and analysts believe the increases, when they come, will have to be modest for political reasons.

According to Ukraine's budget, which has already been approved by the president, investments into the reorganization and modernization of state-owned mines should reach $1.15bn in 2007, which is $144.4m higher than in 2006. Moreover, one fifth of this amount, or $365m, should be directed to the partial coverage of administrative costs, as well as to payment of wages and salaries to employees. The government hopes that privatization will add 13.2% to production volumes to reach 90m tones by 2010 and then another 21% over the following five years.

"As the coal minister pointed out, this financial support should help state-owned mines to reduce their operating-cost margins by an average of 2-3%, and this should help the mines to become profitable in 2007," say analysts at Troika Dialog.

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