• Creating the conditions for more secure gas supplies to Ukrainian consumers and stable transmission of gas to consumers in other European countries remained one of the strategic objectives of Naftogaz in 2015.

    The Naftogaz team applies significant effort to address this issue with the support of the Ukrainian government, the European Commission, the Energy Community Secretariat and other international partners of Ukraine.


    The key elements of Naftogaz strategic activity in this strategic direction include the following:
    • Diversification of routes and sources of gas supply to Ukraine;

    • Building of mutually beneficial non-discriminatory relations based on market practices and requirements of European legislation with counterparts both in the East and in the West;

    • Full integration of Ukraine's gas market into the common European gas market;

    • More secure transmission of gas to consumers in Ukraine and other European countries.

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    Ukraine actively participates in the creation of a common European gas market as one of the continent's largest players in the markets of production, transmission, storage and supply of natural gas.

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    Over the past two years, Naftogaz has achieved a notable progress in the diversification of gas imports to Ukraine and in the building of transparent relationships with its partners.

    The next step is a struggle for the future configuration of a common gas market in Europe.

    Ukraine actively participates in the creation of a common European gas market as one of the continent's largest players in the markets of production, transmission, storage and the supply of natural gas.

    Due to the reforms currently being implemented, Ukraine is for the first time becoming open to international investments and is ready to offer Western companies attractive opportunities for cooperation in all segments of the gas market.

     

    IMPORT DIVERSIFICATION 

    Diversification of gas supply routes

    In 2015, Naftogaz increased reverse flow capacity from Slovakia, whose gas transmission system connects Ukraine to liquid gas markets in Western Europe.

    As a result, reverse flow capacity of gas routes from Europe increased by almost 20% in early 2015 and now exceed 20 bcm of gas per year.

    Considering the available capacities for gas imports from the European direction, Ukraine is now able to satisfy its annual needs for imported gas without buying from Russia. Ukraine can currently cover all gas needs from European suppliers.

    Access to the Slovak route has proved crucial for the energy security of Ukraine during the escalation of the conflict with Russia. In 2014, Naftogaz participated in an open competition run by Eustream S.A. and booked capacity of about 11 bcm/year until 2020 and 2.9 bcm/year until 2017 at the exit point from the Slovak to the Ukrainian GTS. Considering the long-term nature of these bookings, the costs are fixed for Naftogaz regardless of gas volumes imported via this route.

     

    Diversification of imported gas suppliers

    Besides ensuring sufficient gas transmission capacity from the EU to Ukraine, Naftogaz has actively continued to diversify suppliers of imported gas. Over the past two years, Naftogaz has managed to reduce Gazprom's share of the total gas imported to Ukraine from almost 100% to 0%.

    The EU supplied 8% of natural gas imported by Ukraine in 2013, while 92% was purchased from the Russian Federation. In 2015, 63% of imported gas was supplied from the EU and 37% came from Russia. As of the compilation date of this report in September 2016, both Naftogaz and private importers have been buying gas only from European suppliers in 2016.

    Selection criteria for imported gas suppliers

    For every purchase, Naftogaz chooses the lowest price among all offers by potential suppliers available at the time of purchase. Naftogaz is only able to consider Gazprom's proposals if a supplementary agreement is signed between the two companies in order to regulate the disputable issues until the end of the arbitration proceedings in Stockholm.

     


    COOPERATION WITH EUROPEAN SUPPLIERS

    In its relations with European suppliers, Naftogaz began using EFET contracts in 2015. These contracts are standard for the EU market.

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    Key selection criteria for suppliers — reliability and price.

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    Increasing number of suppliers

    The number of European suppliers to Naftogaz continues to grow. The company had 10 European contractors in 2015. In 2016, this number increased to 14.

    While maintaining its diversified portfolio of suppliers, Naftogaz only buys gas from leading and reliable Western companies. Six out of the 10 European companies that sold natural gas to Naftogaz in 2015 are listed companies with investment-grade ratings. According to the Financial Times Europe 500 for 2015, three of these vendors were in the Top 10 in the Gas, Water & Multi-utilities segment, and two featured in the Top 10 of Oil & Gas Producers. According to the Risk & Energy Risk Commodity Rankings for 2015, two suppliers were ranked in the Top 10 Natural Gas Dealers.

    Narrowing spread to NCG

    An enhancement of Naftogaz trading strategy helped to narrow the spread between the prices of imported gas and the gas prices at the German NCG hub by more than 2.5 times.
    In the result, in 2015 the spread was reduced to the cost of gas transmission from Germany through the Czech Republic and Slovakia with long-term capacity booking. Besides minimization of the company's gas purchase costs, this also enabled lower gas prices for Ukraine's industrial segment (in dollar terms), which correlated with the price of imported gas in 2015.

    Cooperation with the EBRD

    In 2015, Naftogaz signed a revolving loan agreement for USD 300 million with the EBRD for the purchase of natural gas from Europe. The bank set strict procurement conditions under the terms of the loan: EBRD procurement rules shall be applied; preliminary selection of suppliers must be according to agreed criteria; mandatory and non-discriminatory procedure for procurement must be followed.

    Another important requirement of the bank is to continue reforming Naftogaz. The EBRD strongly supported the launch of corporate governance reform in the group. The resolute position of the EBRD helped Naftogaz to become the first state-owned company in Ukraine to initiate the corporate governance reform pursuant to the OECD guidelines for state-owned companies (see Corporate governance).

    In December 2015 and January 2016, Naftogaz carried out 27 procurement procedures and signed 17 supply contracts for 1.7 bcm of gas under the EBRD loan agreement. The company fully repaid the EBRD loan according to the terms of the agreement in May 2016. At the beginning of 3Q 2016, Naftogaz purchased natural gas for the heating season 2016-2017, using funds secured under the EBRD agreement for the second time.

    Reverse capacity

    RELATIONS WITH GAZPROM AND
    THE RUSSIAN FEDERATION

    "Winter packages" for the interim settlement of disputes

    In 2014, taking into account the ongoing arbitration proceedings to review the gas supply contract between Naftogaz and Gazprom, representatives of Ukraine, Russia and the European Commission formed a balanced package of trilateral agreements, known as the "winter package". These agreements ensured secure and reliable supplies of Russian gas to Ukraine.

    Within the framework of the "winter package", Naftogaz and Gazprom signed a supplementary agreement specifying the procedures for gas payment, orders and supplies, as well as stating the non-application of the "take or pay" principle for the period agreed by the parties. This interim solution proved to be effective and was implemented by the parties for the period from 01.10.2015 to 31.03.2016 through the conclusion of a similar agreement.

    Naftogaz has always remained open to negotiations on bringing conditions of Russian gas purchase to the market.

    Number of contracts

    Relations with Gazprom in 2015

    Thanks to the expanded transmission capacity from the EU and a wider range of suppliers, Ukraine has gained a genuine ability to choose its sources of imported gas. The increase in reverse flow capacities from Slovakia from 8 to 15 bcm/year or up to 40 mcm per day in early 2015 made it possible to cover gas shortages during peak periods by imports from Europe.

    In winter 2014-2015, the price of Russian gas for Naftogaz was approximately 10% higher than the European price. As a result, Naftogaz significantly reduced imports from Gazprom and increased its purchases from European suppliers.

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    Naftogaz has managed to reduce Gazprom's share of the total gas imported to Ukraine from 34% in 2014 to 18% in 2015 

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    Gazprom's attempts to stop reverse gas flows to Ukraine in winter 2014-2015 failed, and, according to the Russian media, cost the company more than USD 5 billion. At the beginning of 2Q 2015, Gazprom significantly reduced its price offered to Naftogaz in order to compete with European suppliers.

    Although a supplementary agreement between Naftogaz and Gazprom that enabled purchase of Russian gas remained in force until the end of 1Q 2016, Naftogaz stopped importing gas from Russia in late November 2015. This decision was the result of a continuing decrease in gas prices in the European market and Gazprom's failure to match this decrease accordingly.

    Savings from diversifiсation of supply

    The diversification of routes and supply sources has helped Ukraine avoid significant costs. Should there be no access to the European gas market, Naftogaz would face payments to Gazprom of more than USD 50 billion for the period from mid-2014 to the end of 1Q 2016. The actual costs of imported gas for this period amounted to only USD 6.4 billion, 8 times less than the potential costs.

    By buying gas from European suppliers, Naftogaz has saved USD 450 million for Ukraine. Taking into consideration discounts offered by Gazprom, the savings amount to USD 5 billion.

    The biggest savings are related to potential fines arising from the "take or pay" principle. The parties agreed to suspend this principle for the effective period of the supplementary agreements concluded within the framework of the "winter package". The appropriateness of the application of this provision to other periods is being reviewed in the arbitration proceedings between Naftogaz and Gazprom.

    Eliminating critical dependence on a single supplier

    Gas supply contract arbitration proceedings


    In June 2014, Naftogaz and Gazprom claimed and counterclaimed against each other over an existing gas supply contract at the Arbitration Institute of the Stockholm Chamber of Commerce. The cases were later consolidated. Naftogaz actively participated in proceedings in 2015.

    As at 31 July 2016, Naftogaz claims in the arbitration case amounted to approximately USD 18.1 billion, including nearly USD 14.2 billion that Naftogaz is claiming back from Gazprom for gas supplied in 2010-2014 at above market prices. This sum covers the period following the first address of Naftogaz to Gazprom with a proposal to adjust the price to the current market level according to the contract. The rest of the sum represents penalties and interest to be paid pursuant to the contract and Swedish legislation.

    Gazprom claims that Naftogaz should pay about USD 38.7 billion, including USD 2.1 billion of a controversial difference between the price that Naftogaz believes to be reasonable for the gas imported in 4Q 2013 and 2Q 2014, and the price formed under the contact formula disputed by Naftogaz. Another Gazprom claim of about USD 29.2 billion arises from applying the "take or pay" provision to the period from 2012 to 2015, which means that Naftogaz would pay for gas that was not actually supplied.

    The rest of the sum represents penalties and interest to be paid.

    Total number of European suppliers

    Naftogaz insists that the "take or pay" provision, as well as some other provisions of the contract such as pricing mechanism and a prohibition on re-export, are discriminatory and cannot be applied to Naftogaz.

    Gazprom also demands that Naftogaz pay bills totaling over USD 0.7 billion for gas allegedly supplied by the Russian company in 2015 and 2016 to the temporarily occupied territories of Ukraine in Donetsk and Luhansk regions. It should be noted that, starting from 2014, Gazprom has supplied gas to Naftogaz on a prepaid basis.

    Naftogaz does not receive gas at the Prokhorivka and Platove GMS points which are located in the temporarily occupied territories of eastern Ukraine, as the company imports gas exclusively from entry points in territory controlled by the Ukrainian government (see Business overview — Effects of military aggression).

     

    Gas transit contract arbitration proceedings

    The contract for transmission of Russian gas to the EU via Ukraine also requires significant changes. This has been repeatedly discussed by the two companies and the relevant ministries of Ukraine and Russia, as well as during trilateral negotiations involving the European Commission. Naftogaz initiated proceedings over this contract at the Arbitration Institute of the Stockholm Chamber of Commerce in October 2014, and submitted detailed claims in April 2015.

    Within these proceedings, Naftogaz demands amendments to and replacement of certain provisions in the contract. Naftogaz claims the right to transfer its rights and obligations under the transit contract to a new operator of Ukrainian GTS according to the Third Energy Package. The calculation of transit fees should also be harmonized with the legislation of Ukraine and the EU.

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    Naftogaz has reduced its actual costs by more than USD 44 billion compared to potential costs thanks to diversification

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    Furthermore, Naftogaz demands compensation for failure to supply the contracted transit volumes. This claim is based on the fact that the tariff for gas transit depends on the volume of transmitted gas.

    The minimum annual volume that Gazprom must provide under the existing transit contract is 110 bcm. However, the annual transit volume averaged 94 bcm in 2009-2013, and 62 bcm in 2014. In 2015, the volume of gas transmitted to the EU equaled 67.1 bcm.

    The financial claims of Naftogaz to Gazprom in this arbitration totaled USD 10.2 billion at the end of August 2016.

    In October 2015, Gazprom issued a counterclaim against Naftogaz within the proceedings over the transit contract. In its lawsuit, Gazprom demands that Naftogaz pay for 5 mcm of gas supplied between July and November 2014. Naftogaz says that this gas was not used and accounts for it as balancing gas belonging to Gazprom, while Gazprom believes that it was withdrawn by Naftogaz. Gazprom's counterclaims within the transit case total about USD 6 million, which is less than 0.1% of the claims filed by Naftogaz.

    In July 2016, Gazprom filed additional claims concerning the amounts overpaid for transit services in previous periods that Gazprom wants to be recovered if the court satisfies the claim of Naftogaz to review the price under the supply contract.

    Naftogaz and Gazprom at SCC


    NORD STREAM 2: A TROJAN HORSE FOR EUROPE


    In 2015 and 2016, Russia and Gazprom enhanced activities promoting the Nord Stream 2 project. This project is a roundabout route for Russian gas transit designed primarily to replace the traditional Direct Stream that runs through Ukraine and other countries of Central and Eastern Europe (CEE). If the project is implemented, Ukraine will suffer significant losses. However, the biggest damage will be done to Gazprom's consumers in the EU.

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    Nord Stream 2 negates the efforts of the democratic world to support Ukraine while undermining sanctions against Russia for its military aggression in Crimea and the Donbas

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    Effects of Nord Stream 2 implementation for Ukraine

    It will be possible to create a liquid and integrated gas market in the Energy Community without virtually any additional investment if sufficient volumes of Russian gas are transmitted through Ukraine, virtual reverse flows between Ukraine and the EU are in place, and gas market reform in Ukraine is completed.

    However, implementation of Nord Stream 2 makes this goal impossible, as the Ukrainian gas transit route would be eliminated. This, in turn, negates the efforts of the democratic world to support Ukraine, while undermining sanctions against Russia for its military aggression in Crimea and the Donbas.

    Effects of the Nord Stream 2 implementation for the EU

    Nord Stream 2 will cause substantial damage not only to Ukraine, but also to other European countries. Implementation of this project is a direct threat to the energy security of the region, as it increases consumer dependence on one source and one supply route of natural gas.

    Redirecting gas flows to Nord Stream 2 will cause a significant drop in volumes of gas transmitted through CEE countries and lead to a rapid decline of these routes.

    As a result, all Russian gas will be supplied to the EU through the north of Germany. The existing gas transmission infrastructure between northern Germany and the CEE countries, including the OPAL pipeline, cannot transmit the necessary volumes of gas southwards to these countries.

    This contradicts the interests of the CEE and South European countries, which are largely dependent on Russian gas and have limited access to alternative supply routes.

    The launch of Nord Stream 2 will mean new opportunities for Gazprom to abuse its dominant position in the region, particularly through influence on critical infrastructure.

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    Nord Stream 2 is a politically motivated project designed to provoke disagreement within the EU

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    By implementing Nord Stream 2, Gazprom and Russia will receive an additional tool to put pressure on the EU members beyond gas issues and create artificial tensions among them.

    Nord Stream 2 is promoted despite the resistance of many EU countries. Italy, Poland, the Czech Republic, Slovakia, Hungary, Romania, Croatia and the Baltic countries have all opposed the project. Ukraine, as a member of the Energy Community, has also registered objections.

    Germany supports Nord Stream 2 with the expectation of receiving commercial benefits from the project. However, this project also concerns issues on the supranational level, such as energy security along with the solidarity and geopolitical stability of the EU. 

    Construction of Nord Stream 2 will serve to maintain high gas prices for the CEE countries (hub plus transmission costs). The concentration of Russian gas entry points in northern Germany will increase gas prices for businesses in CEE countries, which now receive gas through the shorter and cheaper Ukrainian route. These businesses will be put at a disadvantage compared to their German counterparts, which will become more competitive.

    The project poses a security risk for Germany, as the country will become more dependent on a single gas supplier. The Gazprom imports to Germany now stand at 60% of the country's gas consumption. If Nord Stream 2 is implemented, this share will increase to at least 70%.

    Nord Stream 2 contradicts European legislation

    Nord Stream 2 cannot be built without the support, assistance or direct involvement of European companies as well as the relevant approvals from several EU countries. In case of strict adherence to European energy and antitrust legislation the project is impossible to implement.

    Nord Stream 2 in its present form does not meet the legal requirements applicable in the EU and the Energy Community (Third Energy Package) for the following reasons:

    • The project can only be implemented if natural gas transmission is unbundled from supply and production, which makes the participation of Gazprom and EU suppliers impossible;

    • The project does not fit the criteria for exemption from the unbundling requirement, as it will not provide the EU with access to new sources of gas and is not a new supply route;

    • The project contradicts EU antitrust legislation, as it poses risks of possible market fragmentation, anti-competitive behavior, and abuse of the dominant position by one of the market players. It also creates barriers for the full-scale functioning of the common market in the Energy Community, which includes both the EU and Ukraine.

    Nord Stream 2 depends on the EU

    The European Union's determination in sticking to its energy and antitrust legislation can be enough to stop Nord Stream 2.

    Ukraine, in turn, has consistently demonstrated its willingness to fulfill the requirements of European energy legislation and remains a secure gas transit operator for the EU. The Ukrainian gas transportation system is the only transit corridor for Russian gas to Europe that is not controlled by Gazprom. This is one of the factors that limit Gazprom's ability to further strengthen its already powerful position in Europe.

    Gazprom's share of total gas consumption in Europe is currently 40%. Europe's attempts to implement projects giving European consumers access to alternative gas suppliers, in particular from Asia and the US, seem to be a rational strategy in this context.


    INVESTMENT OPPORTUNITIES IN UKRAINE AS A RESULT OF INTEGRATION INTO THE EUROPEAN GAS MARKET

    Gas market reform in Ukraine is based on principles that have been applied in other European countries. Ukraine is interested in mutually beneficial partnership and gas market practices that have proved their effectiveness in the EU.

    One of the strategic objectives of Naftogaz is to support the Ukrainian government in implementing the reform of the gas market in order to fully integrate into the European gas market. This reform process will create attractive investment opportunities in several markets in Ukraine.

    Gas supply and storage

    Ukraine remains one of the biggest natural gas markets in Europe, with 16.5 bcm of imports in 2015 and consumption at 33.8 bcm. Given Ukraine's aspirations to diversify gas supplies in light of Russian military aggression, European suppliers currently have an opportunity to expand their presence in the Ukrainian market. During 2015, the volume of gas delivered to Ukraine by private importers increased 7.5 times (see Business overview — Gas import and wholesale trading).

    Ukrainian underground gas storage facilities are the largest in Europe with a total capacity of over 30 bcm. The largest facilities are located at the border of Ukraine and the EU. Completion of gas market reform should provide suppliers with convenient and reliable mechanisms for bringing gas into Ukraine, storing it and bringing it back to the EU.

    Transmission

    Ukraine is interested in the optimal use of its gas infrastructure and is negotiating with potential Western partners on joint management of the gas transmission system and underground storage facilities. The Ukrainian gas transmission system remains a comfortable and secure transmission route for Russian gas to the EU. Over 40% of Russian gas was delivered to Europe and Turkey via this route in 2015.

    The Ukrainian gas transmission system can also be used for supplies from Western to Central, Eastern and Southern Europe. This will help to connect markets which are divided in terms of infrastructure, and strengthen the energy security of the most vulnerable countries in the region (see Business overview — Gas transmission).

    Gas production

    Ukraine has one of the largest proven reserves of conventional gas in Europe. Ukrgazvydobuvannya is the biggest player in this market. Gas market reform will provide the company with opportunities to attract investment for the increasing efficiency of gas production and the development of new deposits (see Business overview — Gas production).

    Energy efficiency

    Ukraine is an extremely inefficient consumer of gas and has significant potential to reduce the need for this resource through the use of modern technologies. Besides the gas trade, transmission and production markets, the current reform plan offers international companies the opportunity to enter another important market — energy saving and modernization. Investment needs for the modernization of housing and utilities are estimated at USD 36 billion (see Strategy and reform — Energy independence).

     

     

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