Ukraine's leading English-language newspaper since 1995

It's time to pay for energy populism.

In the next few months, Ukraine is likely to witness the collapse of its national gas monopoly, Naftogaz of Ukraine. This shocking development has nothing to do with the global economic crises. It is merely the result of energy populism.

The repeated elections in post-Kuchma Ukraine are taking their toll. In the last four years, Ukrainians went to the ballot boxes four times and the nation is on the verge of yet another parliamentary election, and then a presidential vote in early 2010.

Populist slogans have dominated amid these never-ending electoral campaigns. None of the competing politicians proved prepared to tell Ukrainians the truth: natural gas prices are set to increase sharply and the nation must heavily invest in energy efficiency to pay less when gas prices reach international levels – an inevitable outcome in 2-3 years.

Instead, politicians pledged to leave utility bills intact. As result, the price Ukrainian households pay for their gas – $92 per 1,000 cubic meters – represents a mere 51 percent of what Russia’s Gazprom is charging for imported gas this year. Prices in Ukraine are even lower than those paid in resource-rich Russia. There consumers pay a rate of some $115.

This populist policy is a serious constraint for Ukrainian gas producers, who are critically short of spare parts and cash to even continue developing the existing fields. For the first time since 1999, Ukraine will produce less natural gas in domestic fields this year than it did in the previous year.

Projects aimed at tapping new reserves have been put on hold. For example, two new offshore fields – Odesskoye & Bezimyannoye – which were due to start producing 1 billion cubic meters in Nov. 2007, are at least two years behind schedule. They still require $200 million in investments – a modest sum for the petroleum industry. But the money is not showing up.

This investment would be returned in a mere four years, even if the government-owned producer continues to receive a miserable $50 per 1,000 cubic meters for its domestically-produced gas as it does now. But Naftogaz lacks money for even small investment projects, which alone could boost the country’s gas production by 5 percent in the near term.

Utilities that burn imported gas purchased at a $179.5 rate upon import are charged only $144 for it, including value-added tax and delivery. But the market value of such highly-subsidized fuel should cost $243 per 1,000 cubic meters. This $100 gap, totaling over $1.4 billion this year, is a heavy burden which has been covered by Naftogaz. It is a burden the company can not carry much longer.

The company is being levied with an increasingly heavier tax burden. In 2004, it paid more than $1.2 billion in taxes on a turnover of some $10 billion. This year the turnover is likely to remain the same, but Naftogaz’s tax bill increased to more than $2 billion, or about 25 percent of the company’s turnover.

In previous years, the Ukrainian monopoly bridged the gap with international loans. But now Naftogaz is being hit with a double whammy. The credit crunch has hit and bankers’ trust in the debt-ridden Naftogaz is at an all time low.

The problems at Naftogaz are further worsened by falling demand for Naftogaz’s only solvent consumers – industry. As industry in Ukraine grinds toward a halt, gas consumption is waning.

The market recently reached Naftogaz’s dire situation with the collapse of the company’s $500 million Eurobond issue quoted in Luxemburg. During October these bonds fell to a mere 49.5 percent of their nominal value, reaching an effective default profitability of 130-140 percent. Holders of the bonds openly speak of their intention on Nov. 14 at a bondholders meeting in London to declare Naftogaz in default.

Such a move would trigger a cross default on all of Naftogaz’s international obligations, totaling $2.4 billion. Though the Ukrainian government guaranteed these obligations with a special clause in the national budget, the government lacks money itself.

The burden is heavy indeed. There is some $2 billion in additional debt Naftogaz accumulated this year, but does not recognize. Yet these unrecognized debts do affect Naftogaz.

The official reason for default declaration by investors – as it looks today – is Naftogaz’s failure to provide audited financial results for 2007. But these results do not seem to exist as the company still does not have a purchase contract for the gas it distributed to its customers in November and December 2007.

In an effort to keep investors silent, the government tried to inject additional assets into the company. Recently the monopoly received 20 additional oil fields, bypassing normal tender procedures. It is likely to get five major utility companies in the industrial eastern Ukraine regions under its umbrella soon.

To encourage Gazprom to withhold a new $2 billion bill for this year’s supplies, international investors including U.S.-based Vanco Energy, Marathon Oil and the British CBM Oil were cut out of a Black Sea oil and gas exploration project.

But these efforts are too little and too late for Naftogaz. The monopoly is set to fall on its tall order of $4.4 billion in debt obligations.

The time to pay for energy populism has come. And the main issue now is arranging energy supplies to Ukraine in a post-Naftogaz era.

In my view, these efforts should be focused on swapping the company’s debt into equity and bringing in investors to own below 40 percent of its capital. And to secure the future for Naftogaz, all energy prices must be brought to cover costs with reasonable margins. The government must subsidize voters through the budget, if it wants. Naftogaz can no longer afford to perform this role.

Competition must be introduced to the domestic market based on equal access principles both to the pipeline grid and to customers.

And, finally, the door should be wide open to international investors to participate in upstream projects. Doing so will reduce the nation’s dependence on its single supplier.

Konstantin Borodin is the head of Kyiv’s Energy Research Centre and serves as an adviser to Ukraine’s ex-Energy Minister, Yuriy Boyko.