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НАК „НАФТОГАЗ УКРАЇНИ“. Річний звіт англійською (2017 рік) - 4

OUR MARKET AND REFORMS

ANNUAL REPORT 2017

Main disadvantages of the existing PSO

1. The sale of gas at below

market prices and the

absence of cost-recovery

mechanisms

Prices set by the government

are lower than market prices,

so independent suppliers have

no commercial interest for the

segment. The existing PSO

includes no effective mechanisms

for enforcement of financial

settlements between market

players. Current procedures do

not allow Naftogaz to restrict gas

supply to gas retail companies

in response to non-payment.

As a result, regional gas retail

companies have accumulated

more than UAH 34 billion in debts

in the approximately 2.5 years of

their existence.

In addition, the government has

not established compensation

mechanisms and funding sources.

According to Naftogaz group΄s

assessment, the compensation

accrued to the group for the

fulfillment of the duties in the

period from 1 October 2015 to

31 December 2017, is more than

UAH 111 billion, and the company

is forced to defend its legitimate

interests in court in order to

receive compensation. The

court ordered the government

to determine the sources of

funding, and the procedure

for compensation for PSO.

However, the decision is still to be

implemented.

2. The sale of gas through

intermediaries significantly

complicates monitoring the

use of gas as intended and

ensuring payments

The lack of effective mechanisms,

which enable monitoring the use

of gas as intended, creates a basis

for abuse. Not only vulnerable

consumers benefit from PSO,

but also people with a sufficient

income to pay for gas and heat

from their own pocket, which

leads to inefficient use of the state

budget funds.

To date, there is no effective

mechanism for confirmation by

regional gas retail companies of

supply of certain volumes of gas

to specific consumers under the

special duties framework. There

is no evidence that all the gas

at a reduced price is supplied to

households. Naftogaz is interested

in identifying evidence of the

actual volumes of gas supplies

provided to households because

it is the basis for calculating

Naftogaz group΄s expenses for

fulfilling its special duties. In

the absence of compensation

for the performance of special

duties, these costs become

Naftogaz group΄s losses.

2015–2017 PSO-RELATED LOSSES

COMPENSATION STATUS

111

UAH bn

74.8

UAH bn

24.1

UAH bn

12.1

UAH bn

incl.

• UGV and Naftogaz

are entitled to a compensation

of losses

related to PSO according to the law On Natural Gas Market

• CMU

failed to determine the compensation policy

when

imposing the PSO in 2015 and 2017

• Naftogaz was successful in court and court of appeal in proving

CMU

has to determine the policy and funding sources

Compensation for losses

related to PSO claimed by

UGV and Naftogaz

UGV

Foregone
revenue

Naftogaz

Related
losses

Naftogaz

Related bad
debt reserve

Gas supply and retail to households in PSO

Problem # 1.

Lack of transparency and access

to the consumer data base

Naftogaz, as a natural gas

supplier to households,

is exposed to many risks:

fluctuations in prices, volumes

and exchange rates, as well as

gas storage costs. Oblgazzbuts as

intermediaries only bill end users.

At the same time, they do not

provide Naftogaz with data on

actual volumes of gas usage. The

consumers do not pay directly

to Naftogaz, but to the accounts

of oblgazzbuts. As of 1 June

2017, Naftogaz has lost access to

data on actual gas payments by

customers.

Problem # 2.

Collecting debts

Naftogaz has no data on

debtors and so cannot

collect debts from them.

This is a function of the

regional retail companies and

subject to inefficiency. Since

oblgazzbuts do not bear the

financial costs of servicing the

gas debt to Naftogaz, they

have no effective incentive

to work efficiently with

debtors, which leads to the

accumulation of gas debts.

Problem # 3.

Consumption data

manipulation

An internal audit of

Kirovohradgaz, after the

restoration of operational

control and change of

management in June 2017,

revealed more than 9.8 mcm of

gas allocated to non-existing

consumers or so-called "dead

souls". Kirovohradgaz reported

to law enforcement authorities

about the detected facts,

but similar cases may exist in

other gas distribution system

operators (“oblgazes”) and

oblgazzbuts, which causes

losses to Naftogaz.

OBLGAZZBUTS

NAFTOGAZ

PRICE RISK
FINANCE AND GAS STORAGE COST

CURRENCY RISK

VOLUME RISK

Taxes and dividends

HOUSEHOLDS

Consumed
and paid

Consumed,
covered by gov't

Consumed
and not paid

Not consumed,
below norms

Not consumed,
fake addresses

PROBLEM

Naftogaz doesn't
get due share of
paid amounts

PROBLEM

Inefficient debt
collection

PROBLEM

Gas sold to ineligible
consumers, Naftogaz
will never be paid

PROBLEM

Risk of Naftogaz not
getting due share of
paid amounts

PROBLEM

Gas sold to ineligible
consumers,
government overpays

PAYABLE BY SUBSIDIES

PAYABLE BY CASH

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OUR MARKET AND REFORMS

ANNUAL REPORT 2017

Problem # 4.

Partial monetization of

subsidies

The settlement system for

gas used by the recipients of

housing subsidies is imperfect.

From 1 January 2018, the

so-called "monetization" of

housing subsidies began,

although in fact, as before, end

consumers neither receive cash

nor use the subsidy funds at

their own discretion. After the

introduction of "monetization",

the state does transfer funds

onto the treasury accounts

of regional retail companies.

However, no effective and

efficient mechanism for

monitoring their target use

exists. Although the Ministry of

Finance tries to ensure control

over and priority of payments

for gas, there are risks that Order

No. 1 dated 4 January 2018

"On the procedure for treasury

bodies to settle and finance

local budget expenditures for

implementation of measures to

implement state social welfare

programs using subventions

from the state budget" can be

challenged in court.

Problem # 5.

Excessive consumption rates

Along with price liberalization,

the government has expanded

the system of targeted subsidies

for households. As of the end

of 2017, about 6.9 million

households, which was about

45% of the total, benefited

from it. On the one hand,

subsidies helped to mitigate

the impact of rising prices on

people, especially low-income

groups. On the other hand, the

disadvantages of the subsidy

system have led to excessive

spending of state budget funds

to pay subsidies and excessive

uncompensated financial losses

for Naftogaz. These deficiencies

originated from inadequate

targeting of subsidies, excessive

social standards for subsidies,

and low motivation for saving

gas consumption by the

recipients of subsidies.

Analysis has shown that

recipients of subsidies consume

twice as much gas as consumers

who live in similar buildings in

the same area but pay from their

pocket.

1�6 times

more

1�3 times

more

2�1 times

more

1�6 times

more

Subsidy recipient

THAN THOSE WHO PAY

THEIR BILLS THEMSELVES

Recipient of social benefits

Subsidy recipients use

twice as much gas

as consumers who pay

their bills themselves

Gas use for heating by consumer category*

house

apartment

2016/2017

KIROVOHRAD region

73%

20%

* based on the analysis of Tsentrgaz client database (Kirovohrad region)

Lower than market prices and

the lack of effective control over

gas use and settlements for gas

induce no interest from potential

independent suppliers to this

market segment. Household

consumers cannot choose a

supplier, and therefore this

market remains uncompetitive.

On 1 October 2017, the

mechanism of automatic gas

price revision and bringing it to

import parity level should have

been launched. However, it is

still not in effect, despite the

government΄s commitments to

the IMF. The Energy Community

Secretariat has repeatedly drawn

the government's attention to

the flaws in the current special

duties model in the gas market

in terms of its discriminatory,

disproportionate character

and uncertainties from a legal

point of view. In the absence of

adequate government action

to address these deficiencies,

the Energy Community

Secretariat has started a process

of resolution disputes in case

ECS-2/17.

https://www.energy-community.org/legal/

cases/2017/case0217UE.html

How to solve the problem

In view of the above-mentioned

problems, in order to develop

a liberalized and competitive

retail market for gas supply

to household consumers, the

following steps are necessary:

1. To regulate the compensation

to market entities on which

PSO are imposed or abolish

the state regulation of prices

for natural gas and switch to

market pricing.

2. To eliminate intermediaries

in the retail gas segment.

Naftogaz is ready to compete

with regional gas distribution

companies and deliver natural

gas to households without

intermediaries.

3. Improve the housing

subsidies accrual and

funding mechanism,

including implementation

of subsidy monetization

at the level of the end

consumer.

These steps would produce a

number of desirable results:

– attract independent

suppliers to the retail

segment, which would

enable the consumer to

realize his right to choose

gas supplier;

– avoid excessive costs

paid by the company's

customers and losses

incurred by the company;

– increase the efficiency

of natural gas use, which

would increase the energy

security of the country,

improve its trade balance

and bring the country closer

to self-sufficiency in natural

gas.

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OUR MARKET AND REFORMS

ANNUAL REPORT 2017

The process of harmonization of Ukrainian legislation with the European rules of the natural gas market

and the Law of Ukraine "On the Natural Gas Market" significantly slowed down in 2017.

Regulatory changes

Impact of the changes on the market

Rent payments for natural gas extraction

were reduced.

The Law of Ukraine № 2245-VIII "On the Introduction of
Amendments to the Tax Code of Ukraine and Certain Legal
Acts of Ukraine On Ensuring the Balancing of the Budget
Revenue in 2018” of 07.12.17 was adopted. Thus, rent
payments for natural gas extraction for new wells were
reduced to 12% (for the wells up to 5 000 m deep) and
to 6% (for the wells deeper than 5 000 m). The Law also
provided for the reduction of the rent payment for gas
condensate from 21-45% to 14-29% from 1 January 2019.
The Law fixed adopted rent payments until 2023.

The Law of Ukraine "On Fighting Corruption"

has been extended to the members of the

supervisory boards of the legal entities of

public law, specifically, state enterprises and

state organizations whose aim is to receive

profit.

The Law of Ukraine № 1975-VIII "On the Introduction of
Amendments to Certain Laws of Ukraine on the Peculiarities
of Financial Control Over Certain Categories of Officials" of
23.03.17 has been adopted.

The licensing terms for performing

the economic activities in the natural

gas market were approved.

The NCREU Resolution № 201 of 16.02.17 "On Approval of
the Licensing Terms of Performing the Economic Activities
in the Natural Gas Market" was adopted.

A positive event for the market,

which concerns the fulfillment of provisions of the Law of
Ukraine "On the Natural Gas Market" and is aimed at the
formation of the natural gas market through establishing a
comprehensive list of requirements for the economic activities
on transportation/storage/distribution/supply of the natural
gas, and gas (methane) of coal fields, which are mandatory for
fulfillment by the licensee and which the license receiver should
meet in order to receive their license.

A negative event for the market.

The amendments to the Law of Ukraine "On Fighting Corruption"
pose risks for the attraction of qualified persons to the supervisory
boards of the economic entities of the state sector.

A positive event for the market that

would facilitate the development of the extraction industry and
fulfillment of the 20/20 Extraction Program for the purpose of
ensuring the country's power independence.

2017 IMPORTANT REGULATORY

CHANGES

Regulatory changes

Impact of the changes on the market

Measures aimed at the harmonization

of natural gas consumption metering to

European standards have been taken.

The NCREU Resolution № 84 of 26.01.17 "On the Approval
of Amendments to Certain NCREU Resolutions on the
Introduction of Use of the Units of Energy in the Natural
Gas Market" obliges gas distribution system operators to
provide natural gas consumers information in payment
documents on consumed gas volumes in units of energy
along with the volumes of natural gas in m3. At this stage
the transfer of the natural gas market to settlements in
units of energy has not taken place.

The period of installation of individual meters

for natural gas consumers has been extended.

The Law of Ukraine № 2260-VIII "On the Introduction
of Amendments to the Law of Ukraine "On Ensuring
Commercial Metering of the Natural Gas Consumption"
Concerning the Procedure for the Installation of the
Meters for the natural Gas Consumers" of 21.12.17
extends the period of installation of gas meters for the
population until 1 January 2021. It is envisaged that
meters will be installed at the expense of the state
budget. The consumers who install the gas meters
themselves during 2018 will receive compensation over
a 12-month period.

A neutral event for the market,

since currently the natural gas consumption metering in Ukraine
is carried out in m3 under standard conditions in accordance
with "GOST 2939-63 Gases. The terms for determining the
volume" (temperature 20°С and absolute pressure 101.325 kPa).
Natural gas consumption metering in EU countries is carried
out in units of energy. Ukraine and EU countries use different
measurement units for natural gas volumes, which creates
obstacles for doing business with European partners and slows
down the process of integration of the Ukrainian gas market into
the EU gas market.

A positive event for the market.

The extension of the period of installation of gas meters for
household consumers was conditioned by the inefficiency
of state regulatory policy over the period of validity of the
previous wording of the Law, specifically, concerning the tariff
regulation, which did not ensure the adequate financing of
measures for the installation of meters in order to meet the
requirements of the Law within the established deadlines,
and the inefficiency of measures of regulatory control
over the efficiency of use of the tariff revenue by the GDN
operators for financing the measures on the installation of
meters.

However, there are difficulties in the practical implementation
of the Law concerning the compensation of expenses to
household consumers who install individual gas meters
themselves.

State companies have started

implementing the new corporate

governance model.

Resolution № 142 of the Cabinet of Ministers of Ukraine
"On Certain Issues of Governing the State Unitary
Enterprises and Economic Entities, 50 Per Cent or More
of the Shares (Stakes) in the Authorized Capital of
which Belong to the State" of 10.03.17 has approved:

The procedure for the creation, organization of
activities, and liquidation of the supervisory boards of
state unitary enterprises and their committees;

The procedure for performing the competitive
selection of candidates for the position of independent
members of the supervisory boards;

The requirements for independent members of
supervisory boards of state unitary enterprises and their
appointment, as well as to performing the competitive
selection of candidates to positions of independent
members of supervisory boards of economic entities,
50 percent or more of shares (stakes) in the authorized
capital of which belong to the state.

A positive event for the market.

The government has begun implementation of a new model of
corporate governance for state companies for enhancing the
efficiency of the activities of public sector economic entities. It is
expected that the new model will provide a financial benefit for
the state budget while having a positive impact on the national
economy and business environment, which would enhance
Ukraine's attractiveness for foreign investors and ensure the
depolitization of the work of state companies.

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OUR MARKET AND REFORMS

ANNUAL REPORT 2017

Regulatory changes

Impact of the changes on the market

Amendments to the GTS Code concerning

balancing in the natural gas market have been

introduced.

On 27.12.17 the NCREU approved Resolution № 1437 "On
the Approval of Amendments to Certain NCREU
Resolutions on the Introduction of the Daily Balancing
in the Natural Gas Market and the Procedure for the
Development, Submission and Approval of the Gas
Transportation System Development Plan for the Next
10 years ".

A negative event for the market.

The said Resolution was adopted in violation of Article 33
of the Law of Ukraine "On the Natural Gas Market", which
fixed the GTS operator's right to develop the GTS Code.
Thus the GTS operator PJSC Ukrtransgaz developed a
new draft GTS Code for the purpose of implementation
of balancing in Ukraine in accordance with the
Regulation (EU) 312/2014 and submitted it to the
working group at the NCREU on 30.06.17.
In the course of work of the working group on this
project, the necessity to finalize the draft GTS Code arose.
Without having waited for the updated draft from the
GTS operator, the NCREU developed amendments to
the GTS Code concerning the daily balancing itself and
on 21.09.17 published them on its website for public
discussion. The draft GTS Code finalized by the GTS
operator and sent to the NCREU on 28.09.17 was left
without consideration by the regulator.

The company and PJSC Ukrtransgaz participated in all
the meetings held by the NCREU on daily balancing and
repeatedly voiced their comments on the inconsistency
of the amendments developed by the NCREU with
the Regulation (EU) 312/2014, as per both form and
substance.
Irrespective of these critical comments, the NCREU
approved amendments that compromise the existence
of the balancing system as such and risk causing
significant financial losses for the GTS operator and other
participants of the market. This immediately concerns
the incorrectly determined neutrality mechanism as
the basis for the daily balancing and the inclusion
of unauthorized off take volumes into the balancing
process in contradiction to the requirement of the
Resolution (EU) 312/2014.
Besides, the amendments approved by the regulator are
discriminatory in relation to the suppliers with special
obligations, since the approved new wording of the GTS
Code envisages that the GTS operator will determine
the consumers which shall be entitled to receive natural
gas under PSO through completing the information
platform, whereas the rest of the suppliers will carry
out the registration of their consumers themselves.
Such automatic registration contradicts the provisions
of the Law of Ukraine "On the Natural Gas Market", in
accordance with which it is the Cabinet of Ministers
of Ukraine that determines the terms for the supply of
natural gas under the PSO.
Neither does the new wording of the GTS Code, as
adopted by the NCREU, take into consideration the
GTS operator proposals, which would significantly
improve the work of the natural gas market
(specifically, concerning the elimination of limitations
for the allocation of capacity of interstate points,
implementation of the mechanism for exercising of right
to have several suppliers during one gas day by large
industrial consumers, etc.).

Regulatory changes

Impact of the changes on the market

A nontransparent mechanism for the

allocation of funds from the special accounts

of regional natural gas suppliers has been

approved.

On 01.10.17 the CMU Resolution №667 "On the
Introduction of Amendments to the Resolution of the
Cabinet of Ministers of Ukraine №296 "Certain Issues of
Settlements for the Consumed Natural Gas" of 26.04.17"
of 23.08.17 came into force. The provisions of Resolution
№ 667 have approved a nontransparent mechanism for
the allocation of funds from special accounts, which in
practice allowed unfair suppliers to receive more funds
than the maximum trade markup established by the
government.

Public service obligations have been

imposed on the company and the gas

extraction companies of the Naftogaz group

(Ukrgazvydobuvannya, Chornomornaftogaz).

By virtue of the CMU Resolution № 187 "On the Approval
of the Provisions for Imposing Special Obligations on
the Natural Gas Market Entities for Ensuring the General
Public Interests in the Process of Functioning of the
Natural Gas Market" of 22.03.17 (hereinafter – the "PSO")
the gas extraction companies of the Naftogaz group have
had imposed special obligations to sell gas of their own
extraction to the company for the purpose of formation of
a natural gas resource for household consumers, religious
organizations and heat energy producers (subject to
fulfillment of the established conditions thereby).

The CMU Resolution № 166 of 28.02.18 also included the
International children's center Artek in the PSO consumers
category.

The CMU Resolution № 228 of 28.03.18 extended the
period of validity of the PSO until 01.06.18.

The CMU Resolution № 415 of 30.05.18 extended the
period of validity of the PSO until 01.08.18.

A negative event for the market.

The effective PSO regime is excessive and goes beyond the
minimum sufficient for achieving the real goal of ensuring the
general public interest in the functioning of the natural gas
market. Instead, it has damaged competition in the retail natural
gas market, having created preferences for certain regional
suppliers (oblgazzbut). The adoption of the Resolution has raised
doubts over the proper fulfillment by Ukraine of its obligations
under the Treaty Establishing the Energy Community, which
forced the Secretariat of the Energy Community to initiate the
respective proceedings against Ukraine (Case ECS-2/17).

Besides, the price at which natural gas is sold and supplied
under the PSO does not correspond to the market price, which
contradicts the memorandum on economic and financial policy
approved by the International Monetary Fund on 01.09.16.

The implemented PSO mechanism in general causes significant
losses for the company and the Naftogaz group companies, due
to the high level of debt to the company for natural gas sold
under the PSO (as of 08.05.18 the debt of the regional suppliers
to the company comprised about UAH 25.4 bn, the debt of
heat energy producers comprised about UAH 27.3 bn), and the
lack of a mechanism of compensation to the entities where the
PSO has been imposed (which is required by the Law and is an
integral part of the PSO mechanism).

A negative event for the company.

The loss of validity by Part 6 of Article 11 of the Law of Ukraine
"On the Natural Gas Market" on 01.04.17 and the simultaneous
extension of validity of the special obligations regime has
resulted in the extension of validity of the special accounts
regime through adopting the CMU Resolution №296 of
26.04.17 according to which funds from the special accounts
of oblgazzbuts were transferred by authorized banks at rates
which were previously approved by the NCREU. However, the
CMU Resolution № 667 of 23.08.17 has significantly changed
the mechanism of special accounts and envisaged that from
05.09.17 natural gas suppliers (oblgagzzbut) would unilaterally
determine rates and amounts of fund transfers without
agreement with the other participants of the settlements and
provide to authorized bank institutions payment orders for the
transfer of funds.

The change of the procedure has resulted in further
accumulation of debt of oblgazzbuts to the company which as
of 08.05.18 constituted UAH 25.4 bn.

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OUR MARKET AND REFORMS

The procedure for financing benefits and

housing subsidies for the population has been

changed.

The CMU Resolution № 951 "On the Introduction of
Amendments and Recognizing Void Certain Resolutions of
the Cabinet of Ministers Ukraine" of 08.11.17 has changed
the procedure for the payment of subvention funds for
financing benefits and housing subsidies from 01.01.18.

A negative event for the company.

The positive idea of facilitating the procedure for the financing
of subsidies and their monetization at the level of providers of
housing and utility services as a result of implementation of the
non-finalized mechanism which contains a number of gaps and
weaknesses may result in the accumulation of debt for natural
gas to the company as the wholesale seller and supplier with
special obligations in 2018.

Besides, the adoption of the Resolution would also result in a
decrease in the transfer of funds to the company's accounts
from special accounts of heat supplying enterprises in
accordance with the CMU Resolution №217 of 18.06.14.

Regulatory changes

Impact of the changes on the market

The introduction of changes to the procedure

of allocation of funds from DHC special

purpose accounts.

During 2017, the CMU Resolution № 217 of 18.06.14 has
been amended three times (by the CMU Resolutions
№70, 492, and 951) and the amendments were aimed
exclusively at the reduction of the volume of settlements
of DHCs with the company and an increase of the share of
funds at DHC disposal.

A negative event for the company.

The CMU Resolution №70 has reduced the adjusting factor for
natural gas settlements with the company and, respectively, the
rate of transfer of funds. CMU Resolution №492 has increased the
maximum rate of transfer of funds by the DHC and, respectively,
reduced the maximum rate of transfer of funds to the company.
The total negative economic effect of the adoption of these two
resolutions for the company constituted UAH 0.4 bln in 2017.

The CMU Resolution №951 granted DHCs the right to reduce
the amount of settlements using ready cash by 25-30% of any
amount of settlements with the company when using benefits
and subsidies.

OUR PERFORMANCE

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OUR PERFORMANCE

ANNUAL REPORT 2017

BUSINESSES

OF NAFTOGAZ GROUP

CHANGE IN PRESENTATION OF BUSINESSES

In 2018, Naftogaz changed its

approach to the composition of

businesses (see details in Note

4 to Consolidated Financial

Statements for 2017).

The change in the composition

of businesses is explained by:

respective changes to

assessment and monitoring of

operational efficiency of key

businesses by management;

necessity of providing an

accurate picture of the

company's performance by

breaking its activities down

into different client-based

segments (that capture all

the relevant costs along the

value chain incurred providing

specific services and/or goods

to client or clients

In particular, segment result of Gas

production, import and sales to RSC's for
resale to households includes not only the
cost of production, purchased and sold gas,
but also relevant allocated storage- and
transmission-related costs, while results of
Gas Storage Business refect value chain of
gas storage services provided to third-parties
only (i.e. external users of underground gas
storages)

Among other key changes,

Naftogaz has started to:

identify four main groups of

customers in respect to gas

production, imports, sales and

supply:

• sales to regional gas supply

companies (RSC) for the needs

of households

• sales to municipal heat

generating entities (MHE) for

the needs of households

• sales to other customers under

PSO

• supply to other customers

outside PSO

Each group of customers has

its own selling price setting

procedure and its own

economic characteristics, such

as product delivery to end

customers, their credit risks etc.

Therefore, these four groups

constitute different businesses

according to management;

demonstrate results of

the Gas Transit business

separately from Gas

Domestic Transmission

business and Oil Transit

business separately from

Oil Domestic Transmission

business (because of high

concentration risks in gas

transit business from its only

client, PJSC “Gazprom”, and

in oil transit business from its

only client, JSC "Transneft");

disclose operating cash

flows for each business

segment of the group,

because it helps to

demonstrate segment-

specific problems related to

non-payments (in particular,

gas sales to RSCs, gas

supplies to municipal heat

generating entities and gas

transmission pipelines);

disclose net working

capital and value of

fixed assets of each

segment, because it helps

to calculate return on

invested capital of group’s

key businesses (with

appropriate adjustments

to demonstrate correct

value of invested capital).

GEOGRAPHICAL DISTRIBUTION OF NATURAL GAS RESOURCES IN UKRAINE

Naftogaz group has the largest

reserves of oil and gas in Ukraine.

According to the estimates by

Miller and Lents company and

DeGolyer and MacNaughton

company, according to the

PRSM

, classification, natural gas

reserves (proven and probable)

Petroleum Resources Management System

amounted to 308 bcm, oil and

gas condensate reserves (proven

and probable) amounted to

51 million tons.

Natural gas,

bcm

Oil and gas

condensate,

million t

Natural gas (million

barrels of oil equivalent)*

Oil and gas

condensate

(million barrels)*

Naftogaz**

proven developed

–

proven undeveloped

–

probable

–

production of hydrocarbons

–

increase in hydrocarbons reserves

–

Reserves as of 31.12.2017

–

Resources as of 01.01.2017

104.85

15.21

620.43

110.71

resources located in the ATO zone and theannexed territory

104.85

15.21

620.43

110.71

Resources as of 01.01.2016 (excluding the ATO area and the annexed

territory)

–

Ukrgazvydobuvannya

proven developed

205.80

4.18

1 218

37.60

proven undeveloped

19.76

1.18

117

10.90

probable

40.92

2.01

242

16.70

production of hydrocarbons in the second half of 2017

7.77

0.23

1.67

increase in hydrocarbons reserves in 2017

15.40

0.24

1.75

Reserves as of 31.12.2017

274.10

7.38

1 622

53.71

Resources as of 30.06.2017

186.20

6.40

1 102

48.40

Ukrnafta

proven developed

14.52

14.48

85.89

105.39

proven undeveloped

7.50

9.66

44.38

70.31

probable

10.72

16.28

63.46

118.50

production from 01.07.2016 till 31.12.2017

1.75

2.10

10.37

15.27

increase in hydrocarbons reserves from 01.07.2016 till 31.12.2017

–

Reserves as of 31.12.2017

30.99

38.32

183.36

278.94

Resources as of 01.01.2017

18.16

84.73

–

Egypt

proven developed

0.76

1.20

4.50

8.76

proven undeveloped

0.30

0.91

1.78

6.61

probable

0.47

0.80

2.80

5.82

production of hydrocarbons

0.51

0.92

3.02

6.71

Reserves as of 31.12.2017

1.04

2.05

6.12

14.95

Resources as of 01.01.2017

0.96

2.43

5.67

17.66

Group

proven developed

221.08

19.86

1308

151.75

proven undeveloped

27.73

11.63

164

87.03

probable

52.15

19.21

309

141.92

production of hydrocarbons

9.53

2.39

17.42

increase in hydrocarbons reserves

16.44

2.29

16.69

Reserves as of 31.12.2017

307.86

50.61

1822

379.97

Resources as of 01.01.2017***

205.32

93.56

1215

681.09

Sources:

The report on assessment of proven, probable and possible hydrocarbon reserves of PJSC Ukrgazvydobuvannya, prepared by Miller and Lents as of June 30, 2017. The report on assessment of
stocks and revenue and conditional resources in some deposits of Ukrnafta prepared by DeGolyer and MacNaughton as of July 1, 2016. The values specified are calculated by subtracting the
volumes of hydrocarbons produced in the second half of 2017 from and adding the reserves increments for the same period to the value of reserves estimation for the same period.

To convert the volumes of oil and gas condensate into barrels, a coefficient of 7.28 per 1 metric ton of oil is used. For the conversion of natural gas into the oil equivalent, a
coefficient of 169 cubic meters per barrel is used.

In 2017, DerzhGeonadra annulled the special permits for the use of the subsoil and the Naftogaz's right to develop the Budyschansko-Chutivsky, Obolonsky and Pysarivsky gas
fields, therefore the Naftogaz's reserves of hydrocarbons as of December 31,2017 are zero.

***

The resources do not include the resources located in the temporarily annexed territory.

-------------------------------------------------------------------------------------------------------------------------------------------------------------

DONETSK

REGION

DNIPROPETROVSK

REGION

KHARKIV

REGION

POLTAVA

REGION

SUMY

REGION

Yefremivka gas and
condensate field

Medvedivka

gas and

condensate

field

Kulychyha oil, gas and
condensate field

Yablunivka oil, gas and
condensate field

Komyshnia gas and
condensate field

Tymofiivka oil,gas and
condensate field

Melyhivka

gas and

condensate

field

Shebelynka gas and
condensate field

Kehychivka

gas and

condensate

field

Kobzivka
gas and
condensate
field

Western
Khrestyshche
gas and
condensate
field

Mashivka gas and
condensate field

Yuliivka

gas and

condensate

field

Kotelva gas and

condensate field

Berezivske gas and

condensate field

16.0

67%

73%

74%

64%

18%

63%

67%

50%

62%

85%

73%

67%

42%

91%

85%

13.8

90.9

2.5

4.1

4.9

3.1

22.2

5.2

5.3

7.4

17.2

2.4

0.9

3.8

0.5

0.4

0.6

0.3

0.9

0.3

2.2

0.4

0.9

0.4

0.3

1.0

0.3

EASTERN OIL AND

GAS REGION

ZAKARPATTIA

REGION

IVANOFRANKIVSK

REGION

LVIV

REGION

CHERNIVTSI

REGION

Bytkiv-Babche oil, gas and

condensate field

Bilche-Volytsia gas field

Svydnytsia gas field

Khidnovychi gas field

Letnia gas and

condensate field

90%

38%

36%

54%

85%

1.2

2.2

1.5

2.9

0.08

0.1

0.05

0.07

0.08

WESTERN OIL AND

GAS REGION

UGV FIELDS

Licensed fields
Fissure (Dnipro-Donets Rift)

Production in 2017, bcm
Remaining reserves as of 30 June 2017

, bcm

% extracted from reserves

that produced more than 2/3 of total production

Acting

licenses*

Licenses

issued over

the past 10

years*

Despite accounting for ≈ 45%

of licenses, UGB represents 75%

of production

Only 15% of all license applications

(36 out of 223) were granted to UGV

over the past 10 years

A third of all new licenses are issued

to companies accounting for only 3%

of production

59%

223

464

500-600

million t in oil

equivalent

20.5

bcm

22%

16%

32%

13%

18%

38%

31%

21%

45%

17%

75%

Recoverable

oil and gas

reserves

Production

in 2017,

bcm

*as of 2016
**estimate

Other private production companies
TOP-7 private companies
Ukrnafta
UGV

WITHOUT RECEIVING NEW LICENSES, UGV
WILL NOT BE ABLE TO INCREASE GAS
PRODUCTION IN 2020 AND BEYOND

licensed

fields

licensed

fields

Gas deposits deeper than 5000 m

Report on estimation of hydrocarbon reserves and resources calculated by Miller and Lents Ltd (USA)

-------------------------------------------------------------------------------------------------------------------------------------------------------------

OUR PERFORMANCE

ANNUAL REPORT 2017

SALES TO REGIONAL GAS SUPPLY

COMPANIES FOR THE NEEDS

OF HOUSEHOLDS

KEY RESULTS OF THIS BUSINESS SEGMENT:

Second largest business of Naftogaz group by revenues (23.9% of total).

Domestic production by Ukrgazvydobuvannya (which increased by 4% to a 24-year maximum in

2017) is the main source of gas for this segment.

Sales volumes to retail supply companies in 2017 were 11 bcm (-5% y-o-y). Naftogaz is still not

allowed to supply gas directly to households under the existing PSO regime.

Nontransparent and unfair intermediaries between Naftogaz and households are the main

roadblock for this segment. Due to accumulation of debt owed by retail supply companies

(equivalent to more than USD 1 bn for the last two years), average cash flow margin

in 2016-2017

was nearly 3%.

Return on Invested Capital (ROIC) of this business in 2017 was four times lower than cost of

capital rate (4.5% vs 18.7%). This gap suggests that the current model of this business does not

unlock the potential for creating additional value for the company's shareholder.

Operating Cash Flow Margin is calculated as operating cash flows from sales of gas to retail supply companies
(net of respective operating costs) divided by revenues.

In 2018, Naftogaz has changed

its approach to the presentation

of businesses. The segment

result is calculated based on

revenues from selling gas

to customers and all costs

incurred along the value chain.

These include costs related

to exploration, production,

purchasing and selling gas,

including allocated costs

related to the business without

applying transfer prices

between value chains.

The main gas source for this

segment, primarily for sale

to the regional gas retail

companies, is gas produced by

Ukrgazvydobuvannya (UGV)

(100% of which is owned by

Naftogaz). UGV produced 15.3

bcm of gas (74.3% of Ukraine’s

total) in 2017, which is 0.64 bcm

or 4.2% higher if compared to

2016. Over the past two years,

the company managed to

increase gas production thanks

to optimized field development,

increased production drilling

and production enhancement

operations including hydraulic

fractures, coil tubing, etc.

Meanwhile, delays in extending

and granting licenses by the State

Geology and Mineral Resources

Service of Ukraine, blocking of

licensing processes by regional

councils, and overregulated land

allocation procedure have all

hampered higher growth of gas

output.

In 2018, UGV plans to increase

gross output to 15.9 bcm of gas

(+650 mcm by 2017). The initial

production plan was 16.5 bcm

in 2018, but it was adjusted due

to problems with issuing of new

licenses by regional councils

and slow deregulation of the

industry. In order to increase gas

production, UGV plans to increase

its drilling volume by almost two-

fold to 460 thousand meters.

All marketable gas produced

by UGV in 2017 was purchased

by Naftogaz at a price of

UAH 4849/ tcm and sold

at UAH 4942/ tcm to cover

residential demand (from

households and municipal

heating enterprises). Prices,

conditions and supply procedures

are set out in the regulations

of the Cabinet of Ministers of

Ukraine. In particular, because of

the existing regulatory regime,

Naftogaz does not supply gas

to households directly but to

designated private intermediaries

who further resell it to

households.

As a result, gas supplying

companies, the so called

“oblgazzbuts” which supply gas

to households and are controlled

mainly by the group of one of

the notorious oligarchs remain

a monopolistic intermediary

between Naftogaz and

consumers in the retail market

due to preferences granted by the

government. In practice, all these

intermediaries do is generating

invoices and collecting

money from households.

The intermediaries receive a

commission envisaged by the

government, which increases

the gas price for the households.

They do not create any additional

value (since there are separate

companies – "oblgazes", and not

oblgazzbuts, which are involved

in the servicing and repairs of the

pipelines and meters), and do not

bear any risks related to ordering

natural gas and price fluctuations

when supplying natural gas to

household consumers.

There is an issue, that the RSC

business is nontransparent.

These intermediaries, on the one

hand, accumulate large debts for

gas they take from Naftogaz. In

2017, the total debt of regional

suppliers for the natural gas sold

to them by the company under

the effective PSO mechanism

increased by UAH 8.3 bn (or

by 38%), of which 65% are the

RSC companies (the ultimate

beneficiary being Dmytro

Firtash).

According to RSCs, this debt was

formed because of household

consumer debts to them. But

Naftogaz cannot check if the gas

sold by RSCs to other parties

had not been written off as

household consumer debt. Due

to non-transparency, there is

a substantiated suspicion that

RSCs write off the unconsumed

gas to the household consumers

whose consumption is covered

by subsidies (which in its turn

increases the amount of subsidies

and expenditures of the State

Budget).

There are grounds to believe

that the RSCs and related DSO

use their market position in the

retail gas supply segment and

the possibilities based on the

difference in prices for the PSO

and industrial consumers to sell

it illegally to industrial consumers

which is recorded as used under

the PSO and used to cover

technological needs of DSO. While

there remains a possibility to take

gas from Naftogaz on beneficial

conditions, this issue is unlikely

to be resolved. There should

also be a centralized consumer

base, but it would never work

in practice until there are

significant economic incentives

not to provide data on certain

consumers. In this situation, it is

logical that Naftogaz demands

bringing prices to the market

level and having direct relations

with the consumers.

Operating cash flow margin

of the “Gas production, import

and sales to RSC's for resale

to households” segment for

2017 considerably improved

compared to 2016, which was

mainly explained by an increase

in subsidies financing. As long

as operating cash flows for

2017 comprises repayments of

the debts for gas sold in prior

financial years (mainly in 2016),

average operating cash flow

margin for 2016-2017 better

represents the financial results

of this segment if compared

with operating cash flow margin

separately for 2016 and 2017.

The average operating cash

flow margin was just 3.1%. Such

a modest result reflects the

Operating cash flow margin is calculated as Net
segment cash flows from operating activities
divided by revenues of the segment according
to Consolidated Financial Statements as at and
for the year ended 31.12.2017.

Gas production by Ukrgazvydobuvannya, bcm

2016

2017

Total:

14.6

15.3

marketable gas (for households and other
PSO consumers)

13.0

13.9

joint ventures

0.9

0.5

operating needs

0.7

0.9

Trade accounts receivable

for gas supplied to RSC for

household needs, UAH bn

31�12�2015

31�12�2016

31�12�2017

3�2

21�8

30�1

-------------------------------------------------------------------------------------------------------------------------------------------------------------

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