Conflict between Ukraine’s tax police and Naftogaz (amidst growing financial difficulties)

Update (11/29): According to an article in Nov. 28th’s Ekonomicheskie Izvestia, Naftogaz has secured a UAH 260 million ($52 million) one-year loan from the state-owned Oschadbank (Ukraine’s state savings bank) which will be used to refinance its current debts to foreign lending institutions. Naftogaz’s debts to creditors currently stand at about $2.2 billion, and it had budgeted about $800 million for this year to repay some of those debts and pay off their interest. In the face of mounting pressure from its crediting institutions, Naftogaz turned to the domestic credit market for the means to refinance and keep the foreign lenders at bay, thus avoiding a potential default.

Oschadbank answered the call, in a deal likely orchestrated at the top level of leadership. Vladislav Kravets, the head of “NRB Bank,” is quoted as saying,

“The conditions of granting the loan will have been decided at the political level and the rate of the credit will have been negotiated with the leadership of the industry.”

This rate is likely to be “below market because the liabilities of the state bank are sufficiently cheap,” according to Sergei Borisov, the deputy head of the bank “Finance and Credit.” Anatoly Gulei, chairman of Oschadbank, noted that they agreed to the loan after “verifying [Naftogaz’s] ability to pay, [and] evaluating their security [pledge, deposit].” A likely factor in the decision is the outstanding debt owed to Naftogaz from the Ukrainian public (via the public utility system) of nearly UAH 1 billion ($200 million) since the start of the year.

Given this mounting financial pressure, it’s no wonder Naftogaz has been negligent on its tax payments (see below) — however, relying on state-controlled banks to stay afloat is not tenable or recommendable for the future. Instead, greater collection rates and higher tariffs (and possibly outside investment) are likely to be the only options for a viable, sustainable future for Naftogaz.

Original (11/27): When the delegation from Ukraine’s national energy company Naftogaz Ukrainy urgently and unexpectedly left gas price negotiations in Moscow last week to fly back to Kyiv, early press reports suggested that Ukraine’s tax service was preparing to move against the company in an attempt to recover unpaid tax debts. According to a UNIAN representative,

Naftogaz possesses information regarding the possible forceful seizure of the [Naftogaz] administration building by the tax organ of Ukraine with the goal of the administrative arrest of the activities of the company.

The State Tax Administration (GNA) responded by calling such an idea “absurd:”

“This information is unreliable and even absurd, since forceful actions against NAK Naftogaz Ukrainy by the GNA were not only not conducted, but were not even planned.”

The GNA goes on to state that Naftogaz owes about UAH 2.3 billion (about $45 million) through November 1st, including UAH 90 million ($18 million) for the month of October alone. There doesn’t appear to be an agreement on the exact number, however, as the GNA had given Naftogaz’s debt at UAH 2.9 billion in October, while the company seems to think it only owes UAH 89 million.

Evgeniy Bakulin, the current head of Naftogaz, claims that the majority of the tax debt (however much it actually is) was accumulated during the first quarter of 2006, when the company was under the leadership of Alexander Bolkisev, implying that his management is not to blame. Of course, this was also the time-period directly following the contentious gas negotiations with Russia that resulted in unexpectedly higher prices — and problems — for Naftogaz.

Bakulin went on to issue a statement that suggests various interpretations of tax laws may be behind the different totals for the debt, but that he expects a resolution “soon:”

The financial plan of the company for 2007, approved by the Cabinet of Ministers Decree #1265, regulates all issues regarding tax debts, but due to irregularities of domestic law, there has arisen competition of some normative acts, resulting in different interpretations or varying obligations [debts].

The makeup of the relationship of Naftogaz and the GNA is an internal issue between the company and the tax service, and a settlement will be reached soon [в ближайшее время].

Also coming “soon,” he says, is Naftogaz’s deficit-free financial plan for 2008. I’m not sure which one is harder to believe — that Naftogaz will break even next year, or that it will pay all of its taxes (and debts) any time soon.

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Update on “sale” of Russneft as the firm faces the loss of licenses following violations

As the end-of-the-month deadline approaches for Russia’s Federal Anti-Monopoly Service (FAS) to rule on the purchase of beleaguered oil firm Russneft by Oleg Deripaska’s Basic Element (Basel), two events have further convoluted the picture surrounding the transaction.

First, the general director of Basel stated last Monday that they were holding sale negotiations not with Russneft-founder Mikhail Gutseriev (or his proxy, since he is currently on the run avoiding an arrest warrant), but rather “with different people, the new owners of the company.” Apparently, Gutseriev had in fact managed to quietly sell his stake in the Russneft some time previously. According to Kommersant’s source, an entity “close to representatives of the state” purchased it for $3 billion. Undetered, Basel is continuing to pursue Russneft’s purchase, with negotiations likely placing the new price around $5-6 billion — netting the unknown intermediary billions of dollars.

Exactly when this previous transaction took place, and who was involved, remains unclear. Indeed, FAS application documents list two off-shore holding companies, not Gutseriev, as the Russneft owners. Apparently, an agreement between Deripaska and Gutseriev was settled in July, but following the receipt of $3 billion, Gutseriev fled the country leaving Deripaska to apply to the FAS for formal ownership rights. According to Kommersant, figures within Putin’s presidential administration (PA) raised issues about the sale to Deripaska, throwing a wrench into the whole scenario. Igor Sechin is the first name to pop into my head, given his status within the PA as well as his leadership position at Rosneft, one of the few firms within Russia likely able to muster the necessary cash for such a sale.

Secondly, in an article that examines Russneft’s recently-released 3rd quarter report (.doc), Vedomosti notes gross violations by the firm’s subsidiaries that could result in the loss of development licenses for six fields. From Alexander Tutushkin’s article in Vedomosti (my translation):

Russneft’s report describes in detail the manner in which its subsidiaries fulfill the license agreements, and it recognizes numerous violations: failure to observe geological surveying work deadlines and a lag in oil production units as stipulated in the agreements.

Russneft hopes to fix these violations by the end of 2007, but given the severity of some of them, this will be very difficult for the firm to accomplish. For instance, Russneft subsidiary Benodet Investments was supposed to drill seven exploratory wells between 2004 and 2006 at the Yuzhno-Pudinskoe field, but by last month only one had been completed. The subsidiary Ulyanovskneft had yet to drill any of the four wells they were supposed to sink at the Pravdinskoe field, and subsequently produced only 3,800 tons of oil versus the prescribed 21,100 tons. Similarly, at the Raduzhoe field, none of the six wells stipulated in the license had been drilled, resulting in production of only 400 tons instead of 8,700.

The total A+B+C1 reserves of the fields in question are about 35 million tons, representing 5.5% of Russneft’s total, so their loss would not cripple the company. (I assume the figures quoted in the above graphic are not A+B+C1, and are instead a different classification, though no explanation is included in the article.) However, this represents another obstacle facing this embattled company, which had previously been enjoying relative steady and sustained growth.

Russneft’s vice president Edward Sarkisov stated that “the company does not have any serious licensing risks,” though some analysts quoted in the article disagree. If the violations are not addressed, Russia’s Sub-Soil Use Agency (Rosnedra) can reclaim the fields — though typically, firms are given time to self-correct the violations before these steps are taken. However, an examination into the violations has been launched by Rosnedra, to be headed by Oleg Mitvol of Sakhalin-II and Kovykta fame.

A source from Basel said that since the firm does not yet own the oil company, they have yet to investigate the licensing matters, “though we suspected that they existed.”

The combination of these two factors — having to pay around a 100% markup on the purchase, as well as the specter of further hounding from the state legal apparatus — is likely dampening Deripaska’s enthusiasm for the transaction. Nevertheless, it seems he remains set in his desire to break into Russia’s oil industry via Russneft. Hopefully his future there will not be as difficult as his entry into it.

Shell backs out from investing in Ukraine via Regal

About 24 hours after announcing a preliminary deal worth $410 million with UK-based oil firm Regal Petroleum, Shell pulled out of the agreement citing Regal’s surprise management shift. David Greer, the former head of Shell’s Sakhalin-II project, was tapped to replace Regal’s chief executive and chairman, both of whom resigned after news of the deal with Shell was announced — despite a general consensus that the agreement was a sound move for the firm. After Greer took over at Regal, he gave an interview to the Financial Times that seemed to call into question Shell’s involvement:

Mr. Greer said he planned a “dramatic” increase in drilling in Ukraine, with the aim of “markedly” increasing proved reserves.

“We have to evaluate this Shell offer and compare it against other funding mechanisms,” he said.

An article in the Nov. 26th edition of the Ukrainian daily Kommersant cites a source within Regal suggesting that Greer was seeking a price for a 51% stake in the fields that was 10-15% higher than what was agreed upon with Shell.

Shell, in announcing its withdrawal, cited the uncertainty caused by Greer’s comments.

“The management change … at Regal was not expected by Shell, and we see from the new management’s comments that they may have changed their thinking on this transaction,” Shell said.

Greer, while generally acknowledged as a competent and experienced manager, faced criticism over a stirring motivational email he sent out to his Sakhalin team earlier this year (that was later leaked), especially after it became obvious that some of the most bombastic statements (“lead me, follow me, or get out of my way,” etc.) were copied from speeches made by US WWII general George Patton. His removal — and the cancellation of this recent agreement — has been linked to a conflict with Shell’s chief executive of exploration and production, Malcolm Brinded. However, the above-mentioned Kommersant article cites a source within Gazprom as saying that Greer left Shell over a “personal conflict between the leadership of Shell and Gazprom,” likely stemming from the confrontational relationship between the two major energy firms over the Sakhalin-II project.

Frank Timis, who founded Regal but was forced out as head of the firm following a much-hyped oil field in Greece turning up dry in 2005, is cited by The Times as orchestrating the negation of the deal by bringing in Greer with the expectation that Shell would then back out:

One source close to the company claimed that Frank Timis, who was convicted in the 1990s for possession of heroin and who controls 20 per cent of the company’s [Regal’s] shares, may have orchestrated the termination of the Shell deal.

“Frank didn’t like the deal with Shell – he thought they were getting assets on the cheap,” the source said. “He thought the best way of breaking it was to get rid of the executives who had negotiated it and replace them with two that Shell had got rid of.” [Hendrikus (Harry) Alardus Verkuil, another former Shell employee, was also appointed as executive director of Regal’s board, effective January 15th, 2008.]

Regal has had problems in Ukraine for a while now, and has yet to produce any significant amount of gas there (see below for recent production figures). In 2004, it was granted a license to the Mekhediviska-Golotvschinska and Svyrydivske gas and condensate fields, but has been mired in legal trouble for much of the past few years. Timis — without the knowledge of the board or shareholders — apparently granted an option for buying the gas rights to the two Ukrainian fields to an unknown Hong Kong firm in June of 2005, which the Chinese company attempted to invoke following Timis’ dismissal from Regal. While Regal was eventually able to cancel the option in 2006, the firm was facing a court battle in Ukraine over the original grant of the license. According to the suit, the fields were to be given to Chernihivaftogasgeologia (CNGG), a subsidiary of the Ministry of Environmental Protection, which had originally awarded Regal the license.

However, on one last appeal to Ukraine’s supreme court, Regal enlisted the help (possibly through the influence of Timis, who was still a significant shareholder in the firm) of the Ukrainian consultant Dmytro Gelfendbeyn by offering him, through his firm Alberry Ltd., a 15% stake in Regal for about $200,000 that could then be repurchased for $51 million in the event of a favorable court decision.

In December of 2006, the supreme court granted the rights to Regal, and in June of 2007 Alberry Ltd received nearly 14 million of the firm’s shares, which were then worth about $60 million. (The transaction is described as a “non-cash charge” of $48.9 million in Regal’s 2006 annual report.) Later, it became known that CNGG and Nadra (a Ukrainian state-owned hydrocarbon exploration firm) were themselves major shareholders in Alberry. As of August 31st, 2007, Alberry — with Dmitro Gelfendbeyn acting as the controller — still held those shares (.doc), representing about 10% of Regal.

I am unfamiliar with this particular case, but it sounds like a fairly straight-forward bribery (or perhaps “settlement” is the right word?) situation — CNGG will agree to not aggressively pursue its case before the supreme court in exchange for a significant share in the firm. The shares to Nadra may have been included to help facilitate future cooperation with Ukrainian exploration projects. (I have contacted Nadra to ask for confirmation on their involvement, and am awaiting their response.)

Following the resolution of Regal’s litigation, production at the fields was once again ramped up, and ended up averaging 110,000 cubic meters of gas and about 450 bbls of condensate per day by the end of 2006, grossing the company $11 million for the year. The two fields, according to the firm’s 2006 annual report, have estimated proven and probable reserves of 23 billion cubic meters of gas and 25,000 Mbbls of gas condensate (totaling 169 MMboe), making the fields an attractive target for more thorough development. Regal’s “conceptual plan” has production reaching about 6.8 million cubic meters per day (about 2.5 billion cubic meters per year) and 8,800 bopd by 2016.

This potential led the company to actively seek additional partners for boosting production at the fields, the licenses to which it holds through 2024. The current set-up has the Ukrainian state firm Ukrnafta operating the six producing wells, while Regal — as the license holder — receives 7% of the total revenue. Despite the already lengthy legal proceedings, the Ukrainian government may yet try to re-examine Regal’s right to the fields — further complicating the picture for attracting outside investment. According to the Nov. 26th Kommersant article noted above, BYuT representative Mikhail Volynets said that following the establishment of a new government, “this question [of Regal’s ownership of the licenses] could be raised anew.”

Foreign investment in Ukraine’s energy exploration industry already took a hit when a decree took effect earlier this year, mandating that all natural gas produced through a shared venture with a state-owned entity be sold to Naftogaz at a capped price. The decree has already forced out independent firm Cardinal Resources:

“Populist actions taken by the Ukrainian Government – Decree 31, increased taxes and royalties – made all of Cardinal’s JAA gas sales subject to a disputed but mandatory price cap and, since January 2007, all JAA gas produced has been stored, resulting in a significant reduction in both the earnings of the company and its liquidity,” [Cardinal CEO Robert] Bensh added.

The decree, which was passed in late 2006 and came into force early this year, obligates companies in JAAs with the state, or majority owned by the state, to sell gas to the state-owned oil and gas company Naftogaz Ukrainy at a fixed government rate of around $1.50 per 1,000 cubic feet – a fraction of the current market rate of $4.80 per 1,000 cubic feet. According to Bensh, the rate is even below the company’s production costs.

Shell is also pursuing a $100 million venture with state-controlled Ukrgazvydobuvannya, and may face the constraints of this law when they begin extraction:

“Decree 31 does not currently affect Shell’s exploration activities, which are just entering the seismic study phase. However, should these studies prove successful, and Shell and its partner begin producing gas, it will have an adverse effect on the project’s ability to remain profitable and sustainable,” Shell’s spokesman in Ukraine, Antonius Papaspiropoulos, told the Post.

The aim of the decree was to boost cheap gas flowing into the state energy firm, boosting the troubled company’s budget as it continues to struggle financially due to low collection rates and subsidized prices to the public. However, it will also likely result in reduced production due to inadequate investment and increasing jitters among potential foreign investors (quoting again from the Kyiv Post article):

“The government achieved two goals by adopting Decree 31 and increasing taxes: It subsidized state-owned energy consumers and attracted additional funding into the state budget,” [Bensh] said.

Volodymyr Nesterenko, an analyst at Kyiv-based investment bank Concorde Capital, said the government decree was meant to ease the effect of increases in domestic gas and heat prices.

“It [the government] needed a sufficient volume of gas, about 30 billion cubic meters (bcm) a year, at a low price. Only 21 bcm is produced by all domestic companies, so the more gas the state can get at a discount, the more ability it has to restrict growth in prices,” he said.

Naftogaz is facing serious financial difficulties — a few weeks ago, Fuel and Energy Minister Yurii Boyko struggled to convince Eurobond holders that the company was not about to default. According to an Oct. 31st article in Economicheskie Investia, the state-owned company’s gross revenue for the first half of 2007 dropped 22.7% from the level for the same period of 2006. Combined with the recent debt scare to Gazprom and uncertain future price levels for natural gas via Russia (article still in the works — and a resolution still in waiting…), Naftogaz could use any help it can get in investing in Ukraine’s energy resources.

It’s too bad that a foreign firm, operating under a generally accepted joint venture agreement, scares off a potential major investor due largely to circumstances outside of Ukraine’s control. Of course, rumblings from the government about re-examining the convoluted issue are also damaging to the situation. We’ll see who else may step up to the plate…

Update on Privat’s role in the Ukrtatnafta affair as Glushko dismissal hearings begin

Hearings on the dismissal of former Ukrtatnafta head Sergei Glushko began yesterday in Kyiv, but I am still working on trying to gain access to them. In the meantime, the Ukrainian news magazine Kommentarii (Comments) ran an article in this week’s edition attempting to shed some light on the recent supplementary oil shipments routed to the refinery. The article alleges that Gennadiy Timchenko, a former KGB colleague of Russian President Vladimir Putin, is connected to the crude shipments, and is doing so in collusion with the Ukrainian firm Privat. From Kommentarii (my translation):

According to Kommentarii’s source, the supply chain of oil to Ukrtatnafta appears as follows: Rosneft — Gunvor — Rixo (a Turkish company, trading in mazut [low quality fuel oil] for thermal power plants). The key element in the chain is the transfer at the Odessa oil harbor of oil into railroad tankers to Kremenchuk for Ukrtatnafta. [see below]

According to Russian experts, the conductor of this operation is none other than the former colleague and friend of President Putin, Gennadiy Timchenko — 50% owner of the Swiss firm Gunvor. Through the firm are sent the majority of exports for Rosneft and Gazprom (its oil exports). As a result of the bankruptcy of Yukos, the assets of this company [Yukos] were obtained by Rosneft, and its exports–by Guvnor.

The article details the connection between Putin and Timchenko as beginning during a shared stint in the KGB’s foreign intelligence division, and reinforced through belonging to the same judo gym in St. Petersburg. Timchenko entered the oil trade in 1988 with the firm Kineks which grew to reach turnover of around $2 billion a couple years later. He later moved on to form Gunvor in 1997 with a Swedish partner Torborn Tornquist. In 2001, the firm moved its headquarters to a swanky banking district in Geneva, and business began to take off.

By 2006, Gunvor was exporting 60 million tons of oil and petroleum products, worth about $30 billion. That figure is expected to jump to $43 billion for 2007. According to Russian press, the growth of Gunvor’s oil trading activities corresponds to Putin’s ascension to power, as the firm was able draw upon its political connections to win beneficial contracts with state energy giants.

The Kommentarii article goes on to identify three possible reasons why the Russian government (via Putin’s links to Timchenko’s Gunvor) would help out Ukratatnafta — or at least, not prevent this assistance — despite harsh condemnations of the corporate raid:

• This is an attempt by the federal government to lower the influence of Tatarstan President Mintimer Shaymievym.
• This represents a desire by Putin to further entrench his agents within Ukraine’s energy sphere; similar to the introduction of Yurii Boyko and Igor Voronin in the RosUkrEnergo scheme, this would allegedly put a key Ukrainian energy asset at the whims of a close Kremlin ally.
• This is the result of cooperation between the Kremlin and the powerful Privat Group (led by Igor Kolomoisky), which has been lobbying for increased control in Ukraine’s oil market.

Here is a translation of the deeper explanation given for the involvement of Privat, which apparently stems from its efforts to entrench its recently-acquired holding Sintez Oil into the transferring and services sector at the Odessa oil port. (I am including the entire section — again, my translation — to try to give a fuller explanation of this theory.)

Implementing deliveries by tanker is practically impossible without interested partners who possess the necessary infrastructure and are interested in the conflict at the Kremenchuk refinery. Privat, whose representatives openly declared the firm’s participation in the conflict, is such a partner for the Kremlin. It shouldn’t be forgotten that this group controls the above-mentioned Odessa oil port.

The possibility of the collection of barter tariff payments (rather than monetary) for the services of port trans-shipment and loading of oil is one of the most attractive sides of the operation of the oil terminal at the port. Sintez Oil, the Cypriot International Petroleum Company [unclear…] and [Sintez’s partner] OAO Eximnefteproduct sell the whole spectrum of transit services: trans-shipment of cisterns [tankers] and their steam cleaning, use of the reservoir park for the loading of tankers, direct transfer of oil, along with services for the cleaning ballast water from the tankers.

The cost of this port service is high, since the market for the supply of large quantities of oil by pipeline and railway to Ukraine is extremely monopolized. It is dominated by two or three players. Control of the port would allow favored investors to enter into this market, escaping the risk of investing into refineries.

Only those that invest money into factories earn money on the import of oil in Ukraine. The circle of such investors is primarily narrow. At the same time, control of the port gives a peculiar free pass into the entrance of this club: who would argue about the importance of transit?

By receiving oil in payment for transit services, the managers of the oil port were able to avoid threats from major players in the market and enter into reprocessing at the Odessa refinery and into Ukrtatnafta, which are connected to the port by pipelines. From recent times, thanks to the new Zhulin-Nadrovnaya bridge, among these clients has appeared the Nadrovnyanskiy refinery of the group Privat.

Thanks to the inclusion of Nadrovornaya into the pipeline network, the firm received the opportunity to take from the Russian exports “natural payment” for the transit not in Odessa itself but, for example, in Brody or Mozyr. In fact, the scheme “transit in place of delivery” allows Privat to economize on the purchase of expensive imported oil.

Earlier, this economy allowed the former co-owners of Sintez Oil, Alexander Zhukov and Andrei Derkach to play a noticeable role in the Ukrainian oil products market. Their attempts to create an oil empire on the basis of control over the deliveries to the Kherson refinery and over the system of sales by Ukrnaftoprodukt came to an end in complete failure. Experts called the causes of the failure the weak connection with the owners of the Kherson and Odessa refineries.

Neither Lukoil nor the Bazhaev brothers from Alians [who controlled the refineries] trusted Zhukov or Derkach. It is unlikely that Privat will repeat the mistakes of its predecessors. After all, in the group [Privat] are two of its own smaller refineries, and not long ago Ukrtatnafta entered the orbit of the firm.

In sum, control over the last [presumably meaning Ukrtatnafta], along with control over the port, would allow Sintez to create a fully vertically integrated oil complex, which includes all technical chains “from the tanker and well to the filling station.” Over such a business stake in the large oil game that is now flaring up between Moscow and Kyiv, the Dnepropetrovsk-based Privat is fully capable of becoming the victor.

Apparently Privat is lobbying the Kremlin to allow these supplemental deliveries in order to cement both the role of Sinitez in the oil services sphere, as well as its newly-acquired influence over Ukrtatnafta. This combination would apparently bump up Privat’s stake in the regional oil market significantly. Where Moscow benefits — besides gaining a business partner (trustworthy or not) — is unclear.

Kommentarii’s source (backed up here) also says that 80,000 tons of crude from Rosneft was scheduled to be shipped from Novorossisk to Odessa aboard the SeaBravery tanker, but the shipment was delayed by last weekend’s storm. At the press time of the magazine (November 15th, or so), the ship had yet to leave port. By this point, it is still unclear if it has left yet. The prevention of further shipments from Novorossisk due to the storm’s aftermath may throw a wrench into Privat’s plans (if, indeed, this is all part of its grand plan), as it would presumably be forced to look beyond its sphere of influence for additional shipments to feed the Kremenchuk refinery. Undoubtedly, however, the group will develop a new scheme…

I’m still working on wrapping my head around these ideas, and am looking into some of the players. If anyone has further insight, feel free to add your own comments or send me an email.

Russneft ruling coming soon; frustrated Deripaska: “big company, big problems”

In a recent interview, Deripaska classified the situation he’s facing in securing the rights to go ahead and take control of Russneft — Mikhail Gutseriev’s former oil company — as “big company, big problems.” The Federal Anti-Monopoly Service, in a case muddled by tax problems and inter-governmental clashes, is expected to rule on his application to purchase most of Russneft’s assets by November 30th. As was reported earlier, Basic Element is joined by Swiss commodities trader Glencore in seeking Russneft’s assets. It now appears that the two firms are seeking to split the oil company 75%-25% respectively.

Deripaska also laid out his plans for Russneft, specifically how he hopes to concentrate on “the development of oil refining and petrochemical plants,” since the current oil situation in Russia is much more suited to profits from sales of refined products, rather than from crude (as explained by a recent Wall St. Journal article). This environment, combined with the fact that many of Russneft’s oil fields are apparently in decline, makes investing in refining capabilities the logical choice. Estimates for the cost of upgrading Russneft’s refineries stand at around $1 billion, however.

Oleg Deripaska’s attempt to buy Russneft is just one example of how the Russian billionaire is spreading his interests. His airplane unit is linked with Bombardier over a potential deal; his previous expansion into Canada’s auto-parts maker Magna has led to (denied) rumors that he’s interested in Land Rover, Jaguar, or other American auto players; he recently bought a quarter stake in the Austrian construction firm Strabag, with plans to cooperate on Russian infrastructure projects; and he is looking to partner with a Canadian mining company to enter into the gold industry, echoing the planned diversification outside of the aluminum industry for his mining behemoth RusAl. Despite these moves, Deripaska still pledges to stay focused on Russia.

Sifting through the aftermath of the Dnepropetrovsk gas explosion

On Monday, Gazeks-Ukraine submitted its own report on the causes of last month’s natural gas explosion that killed 23 people in Dnepropetrovsk. The Russian-owned company has been trying to defend itself from accusations of guilt submitted by various Ukrainian sources, particularly Yulia Tymoschenko, and suggests that the blame for the explosion cannot be solely placed on the firm’s failure to replace degraded infrastructure. According to the findings from the special “independent” internal commission (established by the supervisory board of Gazeks-owned Dneprogaz), “the guilt of Dneprogaz in the technological accident is not evident.”

An unsafe buildup in gas pressure has been generally accepted as the reason for the explosion, with previous explanations suggesting that this was the result of a failure by safety devices. Gazeks says this report asserts that this would not have been the case without physical interference by someone. Vitalii Demyanyuk, Gazeks’ director, emphasized two points:

First — the direct cause of the explosion was the attempts of some unskilled person to block the supply of gas into entrance #3 (the epicenter of the explosion).

Second — the supply of high pressure gas to the building was possible as a result of outside influence in the tunning and working of the safety equipment in the gas distribution network.

Following the explosion, the director of Gazeks’ parent company, IES (which is controlled by Russian billionaire Viktor Vekselberg), made a presentation suggesting that a concerted effort by Naftogaz and the Ukrainian government was forcing regional gas distributors into economic ruin, the result of which has been a lack of capital for making technical improvements to the aging system. This was being done, according to the report, so that Naftogaz could take control over the distributors at bankruptcy proceedings. (I have requested a copy of the report from IES numerous times, but have not heard back from them.)

Now, it appears that Gazeks is attempting to shift blame onto the individual level, beyond just a governmental one. Three Dniprogaz employees were detained immediately following the explosion, as they had apparently been fiddling with valves at the scene of the tragedy earlier that day. It would seem that human error likely played a role in the event.

However, that does not absolve Gazeks from responsibility (especially since it was Dniprogaz employees doing the fiddling, and you would expect them to be qualified), especially since there were also apparently breakdowns in the automatic safety systems as well. Clearly, the whole network is suffering from a lack of much-needed investment, if only at a basic safety level. Any sort of conservation or efficiency upgrade is similarly unable to be put forward due to the sad state of many regional gas distributors.

This isn’t simply a problem of having foreign ownership involved — this is a problem inherent across Ukraine’s domestic natural gas industry, as cash-strapped distributors are unable to collect payments from residential customers, unable to upgrade their infrastructure, unable to pay for their own gas supplies, and unable to make good on debt to Naftogaz. As a result, the system continues to depreciate, and Naftogaz falls into further and further economic trouble.

“Oil and Gas 2007″ roundup and Kremenchuk update

Last week Ukraine’s Ministry of Fuel and Energy sponsored its annual “Oil and Gas” conference in Kyiv, a part of its larger “Energy and Power” exhibition. While mainly serving as a product exposition for companies within the oil and gas industry (think valves, pipes, compressors, gauges, drills, etc.), there were also a few majors there such as Shell, E.ON Ruhrgas and TNK. I took the opportunity to talk with various company representatives about their work in Ukraine, and what they saw for the future.

The conference was opened with a speech by Fuel and Energy minister Yurii Boyko, before he left for natural gas negotiations with Russia (which I will be writing on shortly). At the exhibition, he touched on the upcoming negotiations, saying transit tariffs for gas through Ukraine would reach “market” levels in 3-5 years. This seemed to be a reminder of the leverage Ukraine holds over Russia on the eve of their price negotiations, but still falls in line with previous statements regarding the gradual rise in both transit costs and delivery price. Sure enough, later that week Gazprom announced that the two sides would be paying “market” prices for gas deliveries and transit by 2011. The headline from that statement, however, tended only to emphasize Gazprom’s commitment to charging Ukraine higher gas prices, and ignored the obligation for Gazprom to pay higher transit costs. (No word on bumping up storage costs to market levels, either.)

Anyway, back to the conference.

Nearly everyone there was optimistic, with most citing expected growth within Ukraine, particularly within the natural gas industry. This was true for firms like Shell, as well as the smaller service providers like Smith Ukraine and Weatherford who would look to capitalize on greater involvement by the majors. Ukraine still holds fairly significant hydrocarbon reserves (principally natural gas), especially within the Donbas, pre-Carpathian and Black Sea shelf regions. Developing these reserves is a key part of the Ukrainian government’s lofty Energy Strategy to 2030, though problems with financing at Naftogaz Ukrainy and unclear licensing and exploration laws have hindered much progress.

I swung by the Ukrtatnafta booth to see what they had going on there, but things were quiet. (For those of you not following the dispute between Tatneft and Ukraine over the Kremenchuk oil refinery, check out the rundown in the EDM.) The women upfront were mum, addressing any questions I had (specifically about the recent “management dispute”) to contact information on the back of the brochure they were handing out. Eventually, however, I was able to figure a few things out. In general, things at the company are proceeding as normal, despite the interruption by corporate raiders. While things were a bit up in the air, they are now continuing to receive oil shipments and are essentially going about their work. The new oil shipments will be more expensive from what they had been getting before, but they are continuing to pump out their products from the Kremenchuk refinery. Indeed, news reports have the the plant receiving oil via Odessa, despite the threats of an international lawsuit by the Tatar shareholders.

Meanwhile, the November 15th shareholders meeting that I had thought perhaps might facilitate a resolution to the conflict appears unlikely to do so now, as the Tatar shareholders stated that they will not be attending. This will prevent a quorum at the meeting, blocking any legitimizing motions from being passed. At this point, it’s appearing unlikely that Ovcharenko will be ousted from his current position atop the leadership, at least not without direct intervention from the top of Ukraine’s political ladder. The sense also seems that Tatneft will likely resume shipments of oil to the refinery due to the convenience of the natural conditions and in-place infrastructure, but at “less profitable terms for Ukrtatnafta.“

An Oil Special — Kremenchuk, Ukrtatneft, Naftogaz, Gazprom Neft…(and Privat?)

Sergei Ivanov, Russia’s powerful first deputy prime minister, weighed in on Friday about the ongoing conflict surrounding the Kremenchuk oil refinery, escalating the issue by further publicizing the opinions of the Russian government besides the previous condemnations from Tatarstan. From RIA Novosti:

“I consider the incident unacceptable, and we cannot ignore it, because the protection of Russian business interests has long been and is likely to remain a national priority,” Sergei Ivanov told a session of the government commission for industry, technology and transport development.
…
Ivanov said the incident, already denounced by authorities in Tatarstan and the Russian government, had also dealt “an obvious and considerable blow to relations between Russian investors and their Ukrainian counterparts.”

Ivanov does not believe the Ukrainian government is doing enough to resolve the issue, and while acknowledging the current transition period due to recent parliamentary elections, he says it’s no excuse for “anarchy.” Ukraine’s Ministry of Fuel and Energy had attempted to call a meeting of Ukrtatnafta’s supervisory board, but this was rejected by Tatarstan, which said it wouldn’t be sufficient to end the dispute. There is a shareholders meeting for Ukrtatnafta scheduled for November 15th, and a resolution may not come before then.

In the past, Yurii Lutsenko (former Interior Minister and current People’s Self-Defense headliner) has stated that he agrees that the refinery should be in state (i.e. Naftogaz) control, citing the shady privatization deals that led to the dispute over an 18% stake in the firm that precipitated the current conflict. Naftogaz recently appointed a new head, a representative from the Bloc of Yulia Tymoschenko. Lutsenko and Tymoschenko’s parties are expected to form the ruling coalition for Ukraine’s new government, propelling Tymoschenko to premiership.

A report by Tatarstan’s trade representative in Kyiv has cited major Ukrainian financial firm Privat as a driving force behind the current conflict:

“I am not saying that the raid was performed by Kolomoisky [a Privat co-owner], an entire conglomerate of interests is involved there. Others, quite powerful in Ukraine, who have certain influence in Russia, are also behind it,” [trade rep. Rostislav] Vakhitov said without specifying their names.

Privat, through it’s affiliated company Korsan, owns a 1.2% stake in Ukrtatnafta. Igor Kolomisky is sometimes accused of close ties the Orange camp and to Tymoschenko (which she denies), and he may have seen the turnover in government as a opportunity to push for the move against Ukrtatnafta. The last time Tymoschenko was Prime Minister, she spearheaded a re-privatization campaign for the large Krivorozhstal steel works, and she has not ruled out further re-privatization moves. The incoming administration, then, may be sympathetic to the refinery’s new ownership given the economic rationale being stressed by the current head.

Pavel Ovcharenko took over the factory claiming he was doing so in the best interests of the company, asserting that it had been driven into near ruin by the previous head. Indeed, the firm struggled financially in the past year, apparently losing about $25 million over the past 9 months after profits of nearly $30 million for the same period in 2006. Ovcharenko stuck by that economic message in a letter he sent to the Poltava SBU outlining signs of apparent financial ruin nearly brought upon the company, along with large amounts of unpaid back taxes owed to the Ukrainian government. This echoes a similar letter from Ovcharenko sent to President Yushchenko and other government representatives.

At the heart of the company’s financial problems, asserts Ovcharenko, is the use of middlemen in buying the crude and selling the products at unreasonable prices, rather than a system in line with market principals. President Yushchenko recently wrote an open letter to PM Yanukovich that called for government intervention into the oil trading sector, citing schemes that are taking advantage of tax loopholes and costing Ukraine’s government significant amounts of money while negatively affecting market conditions:

“Это, в свою очередь, предопределяет нарушение конкурентных условий во время осуществления субъектами ведения хозяйства предпринимательской деятельности, в том числе на рынке нефти и нефтепродукто.”

“This, in turn, predetermines the violation of the competitive environment during firms’ implementation of business conduct by management, including in the market for oil and oil products.”

This viewpoint was reinforced by the deputy director of Ukrnaftokhimpererabotka (Ukraine’s state oil and chemical refinery division) Vitaliy Daviy, who cited a shift in May of this year from direct shipments of Russian crude to the Kremenchuk refinery to the use of middlemen within the trading system. Previous to a March 2005 law that changed the tax regime imposed on oil importers, the use of intermediaries to skirt tax laws was widespread. However, that law:

“created a level playing field for all refineries, though this became the main reason for the halting of several refineries, exposing their uncompetitiveness in regard to their technical backwardness.”

Recent lax enforcement of the law has apparently led to a ressurgence in the previously employed schemes and an uneven market, which Daviy believes is costing the government around $100 million per month.

Another letter by Ovcharenko implicates some of Ukrtatnafta’s leadership in these schemes, including deposed head Glushko and deputy director Nail Maganov, who has been vocally critical of the actions and is forecasting economic ruin for the company stemming from current slashed production levels.

Tatarstan-controled Tatneft halted the flow of oil to the refinery following Ovcharenko’s takeover, drastically cutting the plant’s production. Tatarstan is now attempting to lead a protest against any Russian oil being sent in as a replacement, hoping to “starve” out the entrenched head.

“Today, I think not a single Russian company in this complicated situation will provide oil when even the recipient is unclear,” the Ukraine-based [Tatarstan trade] representative, Rostislav Vakhitov, told a news conference [on Thursday].

However, one major Russian oil company is preparing to step up its ties to Ukraine — Gazprom Neft recently announced that it is planning on exporting about 3 million tons of oil to Ukraine in 2008. According to an article by Svetlana Dolinchuk in Oct. 31st’s Ekonomicheskie Izvestiya, the Russian company is prepared to supply Naftogaz with 200,000-250,000 tons of crude per month starting at the beginning of the year. That is about half of Kremenchug’s monthly capacity, but represents about 17% of Gazprom Neft’s total exports for 2006.

According to the article, this announcement led to rumors on the possibility of Fuel and Energy minister Yurii Boyko (expected to be replaced by the incoming Ukrainian government) being invited to become Gazprom Neft’s vice president in charge of foreign activities and oil export. However, according to the article, a source close to the former leadership of Gazprom Neft called these rumors unsound, saying that “foreign top managers can engage in the leadership of companies only in extreme circumstances. Such circumstances are not foreseen for the future.” The press service for the ministry also denied the rumored move, saying that Boyko “is not planning to transfer to a job with a private firm neither in Ukraine nor beyond its borders.”

Boyko is now working on settling with Russia on next year’s gas deal, which he was tasked to finish within about a week. All in all, it’s proving to be a very busy end of his term as minister. It will be interesting to see if his future position in any way relates to these experiences…

 

Lukoil loses Iraq toehold

As was expected (and as I wrote about in August), the Iraqi government has voided Lukoil’s contract to develop the vast West Qurna oil field. The contract had been canceled by the Saddam government itself before the US-led invasion, so this final decision was relatively expected. However, the New York Times article makes an emphasis on the role of US advisers in the final decision:

Early in the American occupation, the question arose whether the Hussein government’s decision [to cancel the previously-awarded contract to Lukoil] was valid, said Michael Stinson, the former chief adviser to the Iraqi Oil Ministry. The answer was supplied by the principal American legal adviser to the ministry at the time, Robert Maguire, who Mr. Stinson said was then working for the Defense Department. Mr. Maguire drew on pre-Hussein-era law to justify the cancellation, Mr. Stinson said.

The article doesn’t mention US oil firm Conoco-Phillip’s 20% stake in Lukoil, which was thought to be a possible aid in bargaining to keep the Russian company’s hold on the oil field. Nor does it say that Lukoil may receive some form of preferential treatment in the field’s new tender given the firm’s pre-production work and experience in the area.

The article also ties in the Russian threat of reneging on Paris Club debt forgiveness to Iraq as a result of this move, but Russian officials had already made it clear that the two issues will not be directly linked. There may yet arise another issue surrounding the Iraq’s debt, but it is worth waiting until after the new tender and contracts for West Qurna are drawn up to make too many conclusions. Iraq seems to be attempting to reassert its own national oil company into future major projects.

While oil has been expected to be a major contributor to Iraq’s budget and economic recovery, the Times’ Sunday magazine has a lengthy article on the “Perils of Petrocracy” by Tina Rosenberg, which — covering Chavez’s “gospel greased by oil,” Terry Lynn Karl’s “paradox of plenty” — is a cautionary tale on too much state involvement within the oil sector.

In the future, though, state-run oil companies will be a driving force in the global energy market — a working rubric for their management will be essential for both the benefit of consumers as well as the producing countries themselves.

Note: My friend Sam raised a good point, that Iraq has a long path before entering the same level of “petrocracy” Chavez has created in Venezuela.  I just wanted to stress the importance of finding the best way to balance state oversight and private management in the current and future global oil market.  Iraq, given it’s relatively clean slate following the devastation and disruption caused by the US-led invasion, will be an interesting study as it further develops.