Luke Coleman in Kyiv -

At the start of this year, the Ukrainian national oil and gas company Naftogaz was on the verge of bankruptcy. Amazingly, for a company that supplies Ukraine with the bulk of its energy needs, the government still isn't entirely sure what financial state the firm is in. Belatedly, it's trying to sort this mess out.

In January, the freshly appointed prime minister, Yulia Tymoshenko, launched her first sally in the campaign to dig Naftogaz out of the hole it had found itself in. She claimed that shady "criminal groups" were attempting to take over the company via an "artificial bankruptcy."

"It's hard to imagine that a key energy company of the country has been brought to a state that needs the setting up an ad hoc government commission with special powers, a commission that will make use of security and audit structures to try to find out for a month what the financial status of the company is," Tymoshenko said at the time.

The company's problems are not simply a function of bad management, but a symptom of the bizarre system of unnecessary intermediates that stand between the Russian and Ukrainian governments in their mutual energy dealings: RosUkrEnergo and UkrGazEnergo.

UkrGazEnergo was set up about two years ago and controlled the supply of gas to industrial customers in Ukraine. It is jointly owned by Russian gas giant Gazprom and the Ukrainian government, leaving Naftogaz with only the heavily subsidised and loss-making consumer business to sell gas to. The consumer business was bad enough before, but became worse after Russia imposed a series of price hikes on Ukraine over the last 18 months. In 2005, Ukraine was paying just $50 per 1,000 cubic metres (cm), but today the price is closer to $180. All the while, Naftogaz wasn't permitted to raise its prices.

Tymoshenko has claimed that businessmen and politicians alike have been looting the intermediary companies. As soon as she took over as PM in December, the woman who made a reputed fortune in the energy sector during the 1990s put gas at the top of her agenda.

Gas leaks

Tymoshenko began by scraping the dodgy intermediate deals and got rid of UkrGazEnergo altogether. "UkrGazEnergo was created with a dual purpose; firstly, to serve the most profitable industrial customers, diverting them from Naftogaz; and secondly, to support the scheme involving RosUkrEnergo, which in its turn has the aim 'To achieve maximum return on investment,' as it says on its website," says Viachaslau Herasimovich of the CASE Ukraine think-tank

The government agreed to end UkrGazEnergo's deal in March of this year, opening the door for Naftogaz to finally become involved in the lucrative industrial sector and actually start making some money again. "The important thing about the deal is that it resulted in a net redistribution of income from the profitable side of the market, selling gas to industrial consumers, effectively to Naftogaz, and away from RosUkrEnergo and UkrGazEnergo," says Geoff Smith, deputy head of research at Renaissance Capital in Kyiv.

Tymoshenko would have loved to turn Naftogaz into a state-owned energy monopoly. But because the company is entirely dependent on Gazprom for its supplies, she had to concede the Russian company a share of the business. The result has been a joint venture and Russia has limited Ukraine imports to 8.6bn cm. "By disregarding the less-interesting clients and concentrating on the more lucrative segment, Naftogaz is in a better position, not least because of the quota imposed on Gazprom of 8.6bn cm," says Bogdan Kochubey, senior analyst at Millennium Capital. And concentrating on these clients put Naftogaz in the position of being able to reduce losses incurred by the subsidised domestic sector.

Now earning bigger transit fees, Naftogaz should be in a position to start climbing out of the black hole it had fallen into. "The government will do its best to prop up the company and improve its bottom line, I would even expect the government to come to the rescue of Naftogaz if there are any problems with paying their current debts," reckons Kochubey.

Burden of debt

But the climb out will be a long one, as Naftogaz has rung up a massive $2bn in debt, which still needs to be paid off. It is this problem that Tymoshenko's government has to tackle first in remaking the domestic energy sector along more rational lines.

The company has been funding this debt with a $500m Eurobond that was issued in 2005. But with no income to speak of and unable to pay the regular coupons, Naftogaz nearly fell into technical default in February this year by failing to produce accounts for 2006. The bondholders gave Naftogaz a waiver, ensuring that action wasn't taken against it. Smith believes Naftogaz had a lucky escape. "If the Russians had wanted to cause trouble they could easily have done so by buying the bonds and refusing the waiver, it would have been an obvious lever to exert pressure on the company."

The accounts were finally handed into the auditors in May, and showed a $431m loss on revenues of $5.46bn. The company is now seeking a $2bn loan, possibly syndicated, part of which will be used to purchase gas to store underground in anticipation of the coming winter. By October, Naftogaz Deputy CEO Volodymyr Trikolych says the company will have purchased 14bn cm over the second and third quarters of 2008.

In the meantime, the government added a provision to the 2009 draft budget in July that would cover 85% of the company's losses of $1.6bn next year. "This would be directed at covering the sale of gas below the purchase price to households and state-financed organizations in 2006, and to municipal heating enterprises over 2006-2008," say analysts at Concorde Capital.

Since the changes, the company has already cleared the debts it ran up from the start of this year, but it still needs to find more money to clear the rest of its debts - only then can it start to negotiate a multi-year supply contract, thereby ensuring predictable price rises, rather than being beholden to Russia on single-year contracts.

And Gazprom is keen to see Ukraine pay the market rate for gas - and soon. Ukraine wants a five-year transition to the $400 per 1,000 cm that Gazprom's EU customers currently pay. However, the issue remains a bone of contention between the two countries and is unlikely to be resolved anytime soon.

Even so, Gazprom is unlikely to suddenly hike the price of gas to full market rates on January 1, 2009, as they are within their rights to do, because the transit fees it pays to Kyiv to send its gas across Ukrainian territory and into Europe are artificially low. "If [Gazprom] insists on January 1, then it's clear what the answer is going to be - it will be a unilateral, legally questionable, but imminently enforceable, increase in transit tariffs, as that is the only way that Ukraine will be able to compensate for such a dramatic leap in gas prices from one day to the next. Knowing this, I would expect the Russians to compromise."

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