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How Naftogaz Pulled Through

12 марта 2019, 15:29

 

Sometimes you listen to people and get the impression that they attribute our successful turnaround of Naftogaz to “the alignment of the stars”. But it is dangerous to think like that.

When we were starting out, basically no one believed it could be done. I can recall, Mr Günther Oettinger, the European Commissioner for Energy at that time, saying that it was impossible to replace the gas supplied by Gazprom with gas from Europe. So complicated was the matter – for a host of reasons – that it took us quite a while to find those who would take it on. Especially considering how bureaucratised and inefficient the Naftogaz management structure was, how little resources we had and how mired in controversy the company’s reputation was.

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So, we had to work hard, making full use of our knowledge, experience, professional network and creativity. We enlisted the help of partners from Ukraine, Europe and the United States, partners from both the public and the private sectors. We had to do a lot of persuading and devised complex strategies to improve the situation. And I am definitely grateful to all who have helped!

 
1. Securing Import Capacities from Slovakia

We needed alternatives to Gazprom as our only supplier, and the best option I saw was to use capacities for gas transmission from Ukraine to Europe for the so-called “virtual reverse” flow.

We approached gas transmission operators in neighbouring countries – Slovakia, Hungary and Poland – to discuss this option.

They all declined, citing probable complications that would create vis-a-vis their relationship with Gazprom – including possible disruptions in the supply of gas and loss of revenue.

So, we enlisted the help of Ukrainian authorities and the European Commission in resolving the issue. Our main focus was Slovakia.

Initially, we ran into a stalemate in our negotiations: the Slovak side reiterated that virtual reverse was impossible because of their contracts with Gazprom. Representatives of the European Commission, in turn, noted that contracts with the Russian monopolist were very important to Europe. Other options had to be explored.

Our colleagues at Ukrtransgaz said that they had long been proposing the option of a physical reverse, using two existing large-diameter pipes to transport gas from Slovakia to Ukraine. The Slovaks rejected this option as well because of that same contract with Gazprom. As an alternative, they proposed building a new pipe link with a capacity of 1.5 billion cubic metres per year within approximately twelve months.

But this option would not allow us to end our dependence on Gazprom fast enough – it would’ve been “too little, too late”. Specifically, we would not have survived the winter of 2014–2015.

Therefore, we needed other options. Ultimately, we found a way out of this dead end. It took some careful analysis of European legislation and the details of Slovakia’s relationship with Gazprom.

During one of the meetings, the Slovak operator mentioned that, besides the contract on the reservation of capacities, there was another contract in place between Slovakia and Gazprom. I probed further, and it turned out that this second contract appeared to grant the Russians the role of the operator on the Ukrainian side. I pointed out that this was a direct violation of European law on the territory of the EU.

Yuriy Vitrenko in Slovakia

Фото: Yuriy Vitrenko in Slovakia

Yuriy Vitrenko in Slovakia.
Photo courtesy of Yuriy Vitrenko.

 

That changed the tone of the negotiations. We were no longer asking someone to skirt European laws for Ukraine’s sake – we were highlighting the fact that Gazprom was in violation of EU laws in the EU territory, while our European counterparts were afraid even to recognise this fact because “Gazprom can cut-off gas supplies”.

We were no longer asking someone to skirt European laws for Ukraine’s sake – we were highlighting the fact that Gazprom was in violation of EU laws in the EU territory, while our European counterparts were afraid even to recognise this fact because “Gazprom can cut-off gas supplies”.

Only then did the Slovak operator meet us halfway, proposing to build the new link in four months instead of a year, while also increasing its capacity seven to ten times. This was an adequate solution to our critical problem, so we agreed.

The Slovaks did set another condition, however: capacities on the new interconnector had to be booked, with a guarantee for payment, for at least five years.

It turned out to be a challenge for us – on the one hand, we had to make sure the new interconnector would not get booked by Gazprom or its satellites (with a view to blocking us from using these capacities), while on the other hand, we had to clear all the bureaucratic hurdles on the Ukrainian side. But that’s a different story, of the thriller variety.

It would have been impossible to resolve all these issues without the help of our international partners, such as Dr Klaus-Dieter Borchardt, a representative of the European Commission, and Amos Hochstein, a representative of the US government. Constructive assistance from the Ukrainian government was provided by Deputy Minister of Energy Ihor Didenko. Naftogaz’s position was boosted by the active participation of its CEO Andriy Kobolyev. Roman Chumak, Naftogaz’s treasurer, worked wonders of ingenuity.

 

State of affairs as of April 2014

Capacity of incoming pipelines from Europe covers 25% of Ukraine’s import needs.
Guaranteed capacities: 0.

State of affairs as of October 2014

Capacity of incoming pipelines from Europe covers 85% of Ukraine’s import needs.
Guaranteed capacities: 6.3 billion cubic metres a year, covering 1/3 of Ukraine’s import needs. 

 

Slovakia (the reverse link).

Фото: Slovakia (the reverse link).

Slovakia (the reverse link).
Photo courtesy of Yuriy Vitrenko.

 

2. The Statoil contract

The possibility of transporting gas from Europe was only half the battle; we had to buy it somewhere.

I was aware that Europe had a well-functioning gas market where we could try to buy large volumes of gas for Ukraine. However, few believed we could pull it off – including European officials.

In practice, it was something that was extremely difficult to do in a short amount of time. Previously, Naftogaz had only bought relatively small volumes of gas from several European companies. And the terms of those contracts did not meet European standards, as they included a substantial premium on European prices.

We needed volumes on a completely different scale to be able to substitute for Gazprom’s deliveries. However, the European companies that Naftogaz was already buying from were unable to offer a substantial increase in deliveries. And most other companies with significant delivery capabilities did not want to work with Naftogaz at the time, fearing retaliation by Gazprom.

Another option was to buy gas on leading European energy exchanges and independently organise logistics across Europe. But this would have taken time, as well as resources and a management system that Naftogaz lacked back then – and still lacks now.

A contract with the Norwegian Statoil (now Equinor) is what saved us in this situation.

They had enough gas. And we hoped that they would not be afraid of Gazprom.

When I first met with representatives of this company, they were surprised, to say the least: a single representative of a company that had never purchased gas in Europe pays them a visit, saying that he urgently needs to buy very large volumes of gas.

I had to tell them at length about Naftogaz and about myself, trying to convince them that we are professionally-run, non-corrupt, reliable partners.

Statoil agreed to work with us. They did not even demand a premium over the market price. They did, however, set two conditions. Firstly, we had to work on standard European terms – they were not going to make any adjustments to accommodate us. Secondly, there would be no politics, no “business facilitation requests” on anybody’s part – this would have to be pure, modern commerce.

The second condition was relatively easy to fulfil: we simply didn’t mention to anyone back in Ukraine that we were working on this contract. The funny part is, we were instructed by the Ukrainian government to begin working with Norwegian companies only after Oleksandr Turchynov’s visit to Norway – that is, already after we had signed the contract with Statoil and as we were waiting for deliveries to begin.

It was, however, a whole different ball game to fulfil the first condition, because this required a shakeup of many domestic bureaucratic procedures.

Instead of buying gas at the Ukrainian border, under relatively simple contracts, with prices expressed in US dollars per thousand cubic metres, we had to start paying for gas in euros per megawatt-hour. Add to that a complicated contract, the concept of a virtual trading point in Slovakia, the need to coordinate supply routes from Germany and then to take care of organising the delivery to the Ukrainian border under a separate contract. Our team had to get a lot of approvals: from our in-house lawyers, from state auditors, from the FX regulatory agency and from customs.

Initially, it seemed impossible. But we did it.

 

Price for Gazprom gas according to its contract with Naftogaz, without discounts, as of October 2014:
USD 478 per thousand cubic metres

Price from Statoil, as of October 2014:
USD 351 per thousand cubic metres  

  

3. The winter package

The trilateral talks among Ukraine, the EU and Russia constituted Plan A for the Ukrainian side and the EU, since no one really believed in Plan B (reverse gas supply replacing Gazprom’s deliveries).

The negotiations centred on the idea of Gazprom resuming gas supplies on the condition that Naftogaz paid part of its debts. Another goal was to agree on a “temporary price” for the duration of the Stockholm arbitration proceedings.

As someone who participated in these negotiations, I can affirm that the Russian side agreed to resume supplies only after they understood that we had real alternatives (new capacities from Slovakia and a contract with Statoil).

With that realisation, Russians started behaving constructively in order to show the Europeans that they were meeting us halfway.

This was, in turn, important to Western politicians, since some of them genuinely worried about Ukraine freezing without the Russian gas; while some other Western politicians were keen to deflect allegations that they were cooperating with Russia despite its belligerent actions.

The negotiations on the temporary price that would remain in place until the arbitration tribunal rendered its ruling were also quite notable.

When the Russian side agreed to resume supplies, it offered a temporary price that was lower than that stipulated in the contract, but still exceeded European prices.

The official who represented the European Commission in the negotiations told us that it was a good price and that we should jump on it.

I remarked that we were buying gas from Europe at a lower price.

The official replied that this was a price for small volumes and, anyway, they were more familiar with market conditions in Europe.

I had to remind this person that we already had a contract with Europe’s largest gas producer, and the price in that contract was lower.

The response from the European Commission representative was very telling. They said: “We are politicians, not businesspeople, so we might not know all the details.”

Eventually, we were able to insist on a lower price.

To me, this was another confirmation that, while European market rules could be a lifesaver, we had to master them on our own. Otherwise, we could wave goodbye to reasonable contract terms.

There is currently a lot of spin surrounding this subject in Ukraine. The claim is that we are ostensibly still buying Russian gas, but buying it from European intermediaries, and thus it is more expensive. This is a misleading claim and a very dangerous mistake.

Previously, we had virtually no alternative. That is why Russia was able to sell us gas at a higher price than was the norm in Europe (and on worse terms). Gazprom held all the cards. If we protested, Russia would cut off the supply, which would spell disaster for Ukraine.

But, as soon as Russian gas enters the competitive European market, Moscow can no longer dictate who can buy it and at what price. In the European market, gas purchasers and sellers have no control over the flow of gas, because gas transmission is unbundled from gas trade. Prices do not depend on the origin or destination of gas. That’s why we can buy it there at the same price that everyone else does, not at a price that was intentionally jacked up for Ukraine. This is why access to a market where we have equal standing as gas purchasers and can buy gas of any provenance is so crucial for Ukraine.

 

4. Arbitration

We had another big problem: the Tymoshenko-Putin contract, which obliged us to buy huge volumes of gas from Gazprom and to pay for them even if we didn’t need them (the take-or-pay principle). Besides, Ukraine had to pay off a debt for gas off-taken in 2012–2013.

When we refused to pay, Gazprom submitted the matter to international arbitration. If the arbitrators had awarded Gazprom’s claims, Naftogaz would have had to pay over USD 95 billion to Gazprom before the contract term ended in 2019. This is more than Ukraine’s GDP in 2015 (USD 91 billion) and its entire sovereign debt as of the beginning of the same year (USD 70 billion).

We had to win the arbitration case whatever the cost – otherwise, the new European contracts would only have provided a temporary relief.

So, I saw the arbitration proceedings as part of the general overhaul of our business relationship with Gazprom. The Russian monopolist intended to intimidate us or, failing that, crush us after the arbitration tribunal handed down its decision – it was so sure of victory.

Moreover, even Western counsels retained by Naftogaz initially expected only to mitigate the defeat of the Ukrainian side.

Gazprom’s claims were also perceived as fair in the West – something along the lines of: “The parties have signed a contract according to European rules, so they must fulfil their contractual obligations.” This was the result of Russians having been able, with the help of Tymoshenko, to present the 2009 contracts as a transition from subsidising Ukraine to European market-based relations.

This is probably indicative of a larger problem, but the fact is, Western politicians – and even international organisations that provided technical aid to Ukraine – never bothered to check whether the terms of those contracts, in fact, met European standards, although I had written about this problem back in 2009.

The position taken by the Ukrainian side in 2014 was seen by many as unreasonable: the new government demanded that the rebate remain in place, while ignoring its contractual obligations under the take-or-pay clause.

So, I had no reason to expect that political support from the West would allow us to sort out the problem with our contract breach unless we achieved a victory in the arbitration proceedings.

What would a defeat in arbitration have meant for Ukraine? Gas transit payments would have dried up (USD 2.5-3 billion a year, or approximately three percent of GDP annually). Naftogaz’s assets, including the gas we bought in Europe, would be subject to seizure throughout the world. It would have cleared the way for Gazprom to sue Ukraine as a state, on the grounds that Naftogaz wouldn’t (or couldn’t) pay off its debts because of political interference on the part of the government. Gazprom’s position would have most probably found international acceptance.

But we prevailed against all odds.

Penalties under the take-or-pay clause for the years 2009–2017 were cancelled. <...> The price of gas has been reduced. <...> The tribunal also awarded us compensation for underdeliveries by Gazprom of transit volumes stipulated in the contracts.

And here are the results:

Penalties under the take-or-pay clause for the years 2009–2017 were cancelled. We no longer had to hand over USD 56 billion to Gazprom for the period up until 2017. For the years 2018–2019, the volumes to be off-taken under the clause were reduced tenfold to better align with our needs, so we have avoided another USD 14 billion in penalties for these years.

The price of gas has been reduced. For example, in the second quarter of 2014, which was when we requested a price revision from Gazprom, the arbitration tribunal decided that the price should be lowered by USD 133, from USD 485 to USD 352 per thousand cubic metres. The positive financial effect from price adjustments over the whole period, starting with the submission of the price revision request to Gazprom, came out to USD 1.8 billion – this is how much we were able to save.

The tribunal also awarded us compensation for underdeliveries by Gazprom of transit volumes stipulated in the contracts. This compensation came out to USD 4.63 billion. The tribunal has off-set USD 2.1 billion from this amount against our debt to Gazprom for gas delivered, which means that these USD 2.1 billion can already be recognised as received, all thanks to our victory in the transit arbitration.

 

5. Integration among companies of Naftogaz Group

The various victories we were able to achieve against Gazprom can also be accredited to cooperation between parts of the Naftogaz Group.

Naftogaz owns a number of companies: a gas production company, a gas transmission company, an oil transmission company, etc. All of them are parts of a complicated system that makes it possible to take gas from the deposits found 5 kilometres underground and deliver it all the way to consumers’ homes.

In an efficient market economy, they can work seamlessly as a single mechanism while still remaining independent.

When there are issues with market efficiency, as is the case in Ukraine, integrating these elements under the umbrella of a single company can be of critical importance to ensuring the uninterrupted functioning of the whole system.

If Naftogaz had not controlled Ukrtransgaz, and I personally, as a representative of Naftogaz, could not have influenced the position of this company (the gas transmission operator), we would hardly have been able to secure supplies from Slovakia in 2014. Another instance when a need for a time-sensitive intervention at Ukrtransgaz arose was in September 2014, when the pipeline throughput capacity on Ukrainian territory turned out to be lower than expected due to technical problems essentially caused by negligence, which could threaten Ukraine’s energy security and lead to losses for Naftogaz.

Unfortunately, during all this time we had to keep defending Naftogaz from attempts to tear it apart.

But who would benefit from it? Firstly, the Russian side – because losing control over our gas transmission subsidiary would ruin our legal position in the transit arbitration; besides, it was important for Russia to corrupt the government of Ukraine, since it ruins the Ukrainian statehood. Secondly, the corrupt individuals in Ukraine – because we were curbing their opportunities for graft at Naftogaz’s subsidiaries. Thirdly, certain representatives of international organisations and European institutions – because tearing Naftogaz apart could be presented as a “reform”, and thus allow someone, somewhere, tick some box. But we dug in and explained to everyone who would listen that this had nothing to do with European standards but everything to do with window dressing.

Naftogaz was a major headache for quite a few people.

Given the fact that these groups opposing us wielded significant influence, among other things, over mass media, civil activists and regular citizens, while our very limited resources restricted our ability to communicate with the public effectively, you can imagine how hard it was to find allies and build coalitions that would back Naftogaz’s continued existence as an integrated group.

Here is just one example. In the autumn of 2016, the government took over the control over Ukrtransgaz from Naftogaz, with nary a warning or any consultations. We explained that this was undermining our legal position in the transit arbitration . The government began justifying its actions with the need to carry out “European reforms”. No matter how much we argued that this was not the case, the Cabinet of Ministers refused to budge. It was only after a backlash from leading Western media that we were able to secure support from our international partners. But the government still wouldn’t budge. It became obvious that their position was driven by something else. We were able to persuade them to change their position only after a meeting of Ukraine’s international partners with the government, at which the US Ambassador took an especially resolute stance with regard to supporting real reform that would be in Ukraine’s interests. We now know how much this situation could have cost us if we had been broken up: USD 4.6 billion, the amount that was awarded to us in the arbitration case.

Everything we have accomplished so far would not have been possible without our corporate governance and gas market reforms, as well as a genuine fight against corruption and an attempt to make at least some headway in turning Naftogaz into a modern company. We have been doing that with the support of our international partners, to whom I am eternally grateful. Often, it was a matter of building personal friendships or of finding common ground –even with those who were consciously or unwittingly acting against Naftogaz; but even in the latter cases, I have always been forthright with my counterparts, openly persuading them to take a common stance on certain issues or making public the considerations that prevented them from taking a different stance.

*The feature series "Naftogaz Against Gazprom" is running in partnership with Yuriy Vitrenko, Executive Director of Naftogaz Group. Opinions expressed in these features do not necessarily reflect the views of Naftogaz Group or the NV editorial team.

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