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НАК „НАФТОГАЗ УКРАЇНИ“. Річний звіт англійською (2017 рік) - 5

OUR PERFORMANCE

ANNUAL REPORT 2017

high level of payments for actual consumption

NAFTOGAZ

TO SUPPLY GAS WITH DISCOUNT

CMU

OBLIGED

TO RSCs

HOUSEHOLDS*

INDUSTRIAL SECTOR

FOR CASH

NONE

PAYS NAFTOGAZ

GOR GAS

CAN BE SOLD TO THE

ATTRIBUTE GAS TO

The debt remains with RSCs
RSC is a dummy without assets
Gas is attributed to non-existing users as
their debt to RSC

SURPLUS

profit from

difference

in prices

Main

scheme

of RSC

PRICE LIMITATION ISSUES – PRICES ESTABLISHED UNDER THE PSO ARE LOWER

THAN IN THE UKRAINIAN WHOLESALE MARKET

1. Losses for the state. The under-receipt of income in comparison with the alternative to sell gas at

market prices. In turn, lower company income means lower state budget income. Even the increase

in expenses for subsidies does not change this simple rule, since by no means all consumers receive

subsidies.

2. Social injustice. The underpricing of gas sales to household consumers below the market level which

actually means hidden subsidies for gas consumers received even by those who are able to pay the

market price. Moreover, the higher the consumption – the more hidden the subsidy. Those who do not

consume gas, do not receive such subsidies at all. Such allocations of public wealth is unjust.

3. Distortion of economic incentives for energy efficiency and energy saving

4. It is impossible to create a real retail gas market. There are no substitutes to free pricing as the key

factor of market development. There is no competition without market pricing. World practice proves

that competitive pricing is better than state regulation of prices for consumers in the medium and long-

term perspective.

5. Drop in the investment attractiveness of gas production in Ukraine. Even now, private production

in Ukraine covers all consumers with an acceptable credit risk level. Therefore, investors understand that

additional volumes of produced gas would have to be sold to household consumers and heat producing

companies. Investors cannot forecast the prices to be established by the state for this category of

consumers. The impossibility of forecasting prices reduces the industry's investment attractiveness.

6. Incentives for arbitration (resale) and corruption, due to different prices for one and the same

product.

7. Difficulties in relations with international creditors, receiving respective financing and attracting

cheap loans.

problems with poor payment

discipline of regional supply

companies. As mentioned

above, during 2016-2017 trade

accounts receivable for gas sold

to regional supply companies for

resale to households increased

by USD 1 billion.

Low ROIC

of the “Gas production,

import and sales to RSC's for

resale to households” segment

was also low on average 4.7%

for 2016-2017 – both because

of lower than market gas

selling prices (imposed by PSO

Regulation) and accumulation of

debts.

In 2018, Naftogaz group asked

the Cabinet of Ministers of

Ukraine to compensate the loss

of UAH 111 billion for supply

of gas under public service

obligations (PSO). The right

of companies to demand the

determination of sources of

financing and the procedure for

compensation for PSO by the

government is confirmed in court.

According to the Gas Market

Law, the group has the right to

receive compensation for its

economically justified expenses

reduced by the income received

in the course of PSO performance,

and taking into account the

acceptable rate or return.

If PSO compensation claimed by

the company for gas sales to RSC

for resale to households was paid

for 2016 and 2017, hypothetical

ROIC of this business would be

10.1% and 14.5% respectively.

This hypothetical ROIC would be

significantly higher if compared

with unadjusted value, but it is

still lower than cost of capital of

18.7%

due to high invested

capital in fixed assets (mostly

Cost of capital is estimated by independent
appraisers to determine the fair value of
property, plant and equipment of PJSC “National
Joint Stock Company ’Naftogaz of Ukraine’” as of
31.12.2017.

production assets evaluated

according to the market value)

and net working capital.

The consideration underlying

Naftogaz group's corporate

strategy implies that an efficient

alternative to the current system

of gas supply to households is

the creation of a transparent

gas market for the population

with the possibility of selection

of the supplier. This would allow

Naftogaz group to receive the

money for the produced gas and

monetize the profit of the gas

business. So far, the gas business

is funded at the expense of

transit.

In order to do that, it is necessary

to get rid of the monopoly

intermediaries represented by

3.1%

AVERAGE OPERATING CASH FLOW MARGIN OF

"Gas production, import and sales to RSCs for resale

to households" for 2016-2017

4.7%

AVERAGE ROIC OF

"Gas production, import and sales to RSCs for resale

to households" for 2016-2017

2017

2016

ROIC Hypothetical ROIC Cost of capital rate

ROIC vs cost of capital, UAH-denominated, %

5�0

10�1

18�7

14�5

4�5

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OUR PERFORMANCE

ANNUAL REPORT 2017

the regional supply companies or

force them to make settlements

with Naftogaz. Instead, the

intermediaries attempt to divert

attention from the fact that their

position in the market results in

non-admission of competition in

gas supply to the population and

infringement of interests of other

market participants, which would

be impossible under significant

competition. Under certain

conditions (if non-payment

risks are eliminated, including

untimely financing or failure to

finance the accrued subsidies

by the state), the opening of the

household consumers market

would result in significant

competition and the emergence

of private suppliers.

WHAT NAFTOGAZ WAS AND IS PROPOSING?

1. To review the obligation

imposed by the CMU on

Naftogaz to sell gas to

the regional supplying

companies at a beneficial

price and without any

guarantee of payment

by the monopoly

intermediaries.

Consumers should select gas

suppliers themselves and the

suppliers should produce

gas themselves or buy it in

the free market. Naftogaz

may supply gas directly to

the consumers which do

not want to select another

supplier for any reason.

2. To monetize subsidies.

Money for subsidies

should be received not by

intermediaries, but by the

consumers directly. The

consumers must have the

right to spend this money

both for payment for gas

and energy efficiency.

They should also have an

opportunity to retain a

portion of the saved money

for themselves. This would

be the best incentive to

reduce gas consumption.

In its turn, it would help to

get rid of the necessity of

importing gas at all, and

result in export parity in

prices instead of import

parity.

KEY PROBLEM:

· Ineffective gas downstream market (due to market regulation and poor payment discipline of downstream

market players)

MITIGATION INITIATIVES:

•   gas market liberalization (incl. PSO revision, subsidies monetization, retail players transparency)
•   presence in retail household segment
•  strategic partnership with existing retail players or provider of retail services (e.g. UkrPoshta, Privat Bank,

Osсhadbank)

VALUE FOR OVERALL MARKET:

• Increase in efficiency of gas consumption
• Lower sustainable market prices and better service quality for end-consumers (stronger competition, reducing

system cost via eliminating inefficiency, stimulation of energy efficiency)

• Lower government expenditures on subsidies

GAS PRODUCTION, IMPORTS AND

SUPPLY TO MHE'S FOR THE NEEDS

OF HOUSEHOLDS

Current regulation defines

the right of municipal heating

enterprises producing heat

for households to purchase

natural gas from Naftogaz

under PSO, and the obligation

of Naftogaz to supply gas to

this category of consumers

at subsidised prices. Over

the last two years, gross debt

for gas supplied for these

purposes has increased

twofold, by approximately

UAH 7 bn. Almost zero

increase in debt over 2017 is

explained by accumulation

of debts for unauthorized

withdrawal of gas by MHE's,

which is allocated to another

business segment (see

section with description of

“Gas domestic transmission”

for details).

The abovementioned

accumulation of debts is

explained by unsustainable

model of residential municipal

heating “business” that

translates into low payment

discipline of segment

customers. In addition,

Naftogaz was obliged by law

to restructure MHE debts for

gas supplies before July 2016

for five years without any

indexation.

The Law of Ukraine “On measures aimed at
settlement of the debts of municipal heating
companies and enterprises of centralized wa-
ter supply and drainage for consumed energy”
# 1730-VIII as of 03.11.2016.

Trade accounts receivable

for gas supplied

to MHE (supplying gas

to households),

UAH bn

31�12�2015

31�12�2016

31�12�2017

UAH bn

6�76

14�15

14�13

KEY RESULTS OF THIS BUSINESS SEGMENT:

Fourth largest business of Naftogaz group in terms of revenues (10% of total).

Sales volumes to municipal heating enterprises supplying heat to households in 2017 were 4.6 bcm

(-20% change y-o-y). This segment sources gas both from imports and domestic production by the

group.

Financially unsustainable model of residential municipal heating “business” translates into low

payment discipline among this segment’s customers. That is the key problem for the segment.

Average operating cash flow margin of this business in 2016-2017 was negative, with average ROIC 6x

lower than cost of capital (3.0% vs 18.7%).

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OUR PERFORMANCE

ANNUAL REPORT 2017

Average operating cash

flow margin

of the “gas

production, import and

sales to MHE for the needs

of households” segment for

2016-2017 was negative

(-1.1%), though it improved

last year compared to 2016

mostly due to an increase

in the amount of subsidy

financing by the state. As long

as operating cash flows for

2017 comprises repayments

of the debts for gas sold in

prior financial years (mainly in

2016) and due to a substantial

reduction in gas supply to

MHE segment for residential

consumers by 20% in 2017 vs.

2016, average operating cash

flow margins for 2016-2017

are more representative of the

situation in this segment.

Average ROIC

of the “gas

production, import and

Average operating cash flow margin is

calculated as net segment cash flows from
operating activities divided by revenues of the
segment to third parties according to Consol-
idated Financial Statements as of and for the
year end 31.12.2017.

sales to MHE for the needs

of households” segment in

2016-2017 was 3% primarily

due to the subsidized (lower

than market) gas selling

price imposed by PSO

regulation on Naftogaz. If

PSO compensation claimed

by Naftogaz for gas supplied

to MHE for the needs of

households was paid in full,

hypothetical ROIC would

comprise 12.1% and 13.3% for

2016 and 2017 respectively.

However, this hypothetical

ROIC would still be lower than

the cost of capital of 18.7%

Continuation of this practice

is impossible for this business

segment of Naftogaz in a

financially sustainable way.

Mechanisms for settlement

of gas market players’ debts

that will allow resolution of

Cost of capital rate is estimated by independ-
ent appraiser to determine the fair value of
property, plant and equipment of PJSC “Nation-
al Joint Stock Company “Naftogaz of Ukraine””
as of 31.12.2017

2017

2016

ROIC, %
Hypothetical ROIC, %
Cost of capital, %

Gas production, import and sales to MHE for the needs of

households business: UAH-denominated ROIC vs cost of capital rate, %

3�1

12�1

18�7

13�3

3�0

AVERAGE OPERATING CASH FLOW MARGIN

of “Gas production, imports and supply to MHE's for the

needs of households” business for 2016-2017

3.0%

AVERAGE ROIC

of “Gas production, imports and supply to MHE's for the

needs of households” business for 2016-2017

–1.1%

municipal heating business

issues should be secured not at

the expense of destabilization

of the financial position of

Naftogaz by writing off this debt

(which is also, in its substance, a

hidden subsidy).

Therefore, a number of issues

must be addressed in order

to achieve “turnaround” and

the long-term viability of the

municipal heating sector. In

particular, addressing these

issues may involve changing

heating tariffs to:

i) eliminate hidden subsidies

that take needed funds

away from other things

including gas, operation and

maintenance, and return on

invested capital of municipal

heating companies;

ii) cover the return on new

invested capital needed to

maintain and refurbish the

system.

However, there is no easy way

to reach this goal based on tariff

change alone, because raising

tariffs has social constraints as

many people in Ukraine are

not willing to pay a full-cost

recovery heating tariff given the

current costs and consumption

levels of heat energy in Ukraine.

Measures like energy efficiency

improvements, optimization of

the municipal heating system,

public awareness campaigns,

and an enhanced role of the

national regulator can help

to realize a ‘turnaround’ in

a sustainable manner while

ensuring the affordability of heat

energy for end-customers.

The current business model of

municipal heating enterprises

creates a vicious cycle in which

companies do not have enough

money to maintain their assets

or invest in rehabilitation

and modernization of the

system. The deterioration of

district heating infrastructure,

in turn, leads to a decline in

quality of service. As a result,

willingness to pay drops, and

some customers

completely

disconnect from the district

heating system, leading to

decreased revenues that do not

even cover current regulated

revenues of district heating

companies. In order to break

this vicious cycle, tariffs need to

reflect the full cost of providing

service

. Quality of service

should improve, leading to

increased willingness to pay,

while customer retention would

improve leading to higher

revenues for MHEs.

Bad faith behaviour among

management of some MHEs

supplying gas to households

is another problem of this

business segment. Providing

financial guarantees by MHEs to

Naftogaz (eg. the requirement

to provide guarantees from the

owner of the district heating

network) may partially solve this

problem.

The Law of Ukraine No.

1730-VІІІ "On Measures for

Settlement of Debts of District

Heating Companies and Heat-

Generating Organizations and

Water Supply and Drainage

Enterprises for the Consumption

of Energy Resources" (Law

1730) came into force on

30 November 2016. It had a

negative impact on Naftogaz

due to further growth and the

accumulation of customer debts

because of a lower motivation

Particularly non-residential customers, though

earlier residential customers were also allowed
to disconnect.

Specifically, increasing tariffs will make possi-

ble to eliminate gas subsidies and allow MHEs
to allocate sufficient funding to maintenance
and investment in the district heating network
as well as pay their bills.

for timely settlements, and

a decrease in Naftogaz’s

contingent assets due to writing

off of accrued fines.

In 2017, Law 1730 also had a

negative impact on Naftogaz's

current operations, enabling

debtors not to maintain the

level of payments for consumed

gas at an appropriate level. As

stated above, in accordance

with PSO regulations, Naftogaz

is obliged to supply natural gas

to MHEs (even if there are debts)

under certain conditions. Such

conditions include the presence

of a contractual agreement on

the restructuring of the debt for

consumed natural gas within

the framework of the Law 1730,

in connection with which a

significant number of municipal

heat producers hoped to pass

the heating season of 2017-2018

by fulfilling only this particular

condition.

The Law 1730 extends to MHEs

included by the Ministry of

Regional Development in the

participate in the mechanisms

provided for by this Law. At the

end of 2017, there were 198

MHEs in this list, 182 of which

had debts to Naftogaz. During

2017, the company considered

the cases of 144 enterprises that

applied for the implementation

of the law and informed

participants of the decision to

write off fines or restructure

debts for natural gas.

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OUR PERFORMANCE

ANNUAL REPORT 2017

GAS PRODUCTION, IMPORTS

AND SUPPLY TO OTHER CUSTOMERS

UNDER PSO

In 2017, the business segment

of supplies to other consumers

under PSO was mainly repre-

sented by municipal heating

companies producing heat for

non-residential consumers (83%

of revenues) and retail supplies

to households by Naftogaz’s sub-

sidiary (17% of revenues). Since

PSO Regulation was introduced

in October 2015, its scope of

regulated supplies to municipal

heating enterprises has under-

gone significant changes.

Gradual extension of PSO Reg-

ulation with the inclusion of

additional supplies (see timeline

below) has led to 100% coverage

of MHE’s use of natural gas for

all categories of heat consumers

since April 2017.

Evolution of PSO scope

for municipal heating compa-

nies (MHE)

As was publicly commu-

nicated by international

organizations, extension of

the scope of PSO regulation

went beyond what is neces-

sary to ensure the stability

and affordability of district

heating services to vulnerable

final customers or other final

customers subject to special

protection. In its public con-

KEY RESULTS OF THIS BUSINESS:

Sales volumes to customers of this business in 2017 were

1.2 bcm (+43% change y-o-y)

Average operating cash flow margin of this business

in 2016-2017 comprised only 1.2%, with ROIC 6x lower than

сost of сapital (3.2% vs 18.7%)

Evolution of PSO scope for municipal heating companies (MHE)

Oct 2015

Oct 2016

Nov 2015

Arp 2017

100%

+MHE for religious

organisations

MHE for

households

+MHE for budget

organisations

+MHE for any other consumers

(including CHP)

of MHE's use

of natural gas

is covered by PSO

Regulation since

April 2017

ditional approval

of draft

PSO Regulation for 2017-

2018 dated March 2017, the

Energy Community Secretariat

expressed its opinion on the

abovementioned PSO exten-

sions as the following:
– Extension of public service

supplies of natural gas to

district heating companies

beyond the scope of serving

household customers and

religious organisations, given

their clearly commercial nature

in the interest of individual

district heating companies

and not in the public interest,

is excessive and thus not

necessary in view of the

objective pursued. It would

also constitute an unjustified

advantage for industrial

customers of district heating

services and cogenerated

electricity, and distort the

market for electricity.

Conditional approval of imposition of public
service obligations in the natural gas sector
of Ukraine for the period of 2017-2018 as of 7
March 2017, Energy Community Secretariat.
See details: https://www.energy-commu-
nity.org/dam/jcr:dc82686d-91a9-4aa1-a65f-
b5e550b6609e/APP_2017_PSO_UE.pdf

– Market distortions in favour

of the private commercial

interests of selected market

participants rather than in a

clearly defined public interest

should not be considered

proportionate to achieve the

goal of security of gas supply.

Hence, natural gas supply to

district heating companies

within the framework of pub-

lic service obligations may

be justified in the general

economic interest only for

providing district heating ser-

vices to household customers

and religious organisations

and, as the case may be, for

combined production of heat

and electricity (CHP). Natural

gas for any other operations,

in the opinion of the ECS of

district heating companies,

should be purchased on the

market.

These changes to PSO

regulations affected the

operational results of «Gas

production, import and sales

for other consumers under

PSO» business for 2016-

2017. Total revenues of this

business increased by 69% in

2017 vs. 2016, mainly due to

growth of the share of MHE

for non-residential consumers

(including CHP) from 49% of

business revenue in 2016 to

83% in 2017.

Cash flow margin of this

segment in 2016 was negative

(-48%), and was caused by gas

supply to PJSC "Odessa Port

Plant" under PSO Regulation

(25% of total revenues of

this segment in 2016). This

company has not yet paid

off this debt as of the date of

this report. Since April 2017,

natural gas was supplied to

this segment at a regulated

price with a 1.6 multiple to the

wholesale price for the needs of

households, which is lower than

the market price. The increase

in the volume of gas supply

to MHE’s for other consumers

(including CHP) within the

scope extension of PSO and

repayment of prior years debts

led to an improvement in the

operating cash flow margin

of this business in 2017 (30%),

however, the average operating

Customers structure of "Gas production, imports and supply to other customers under

PSO" business for 2017-2016 by revenues, UAH billion

2016

2017

2 255

1 156
1 146

6 439

1 269

MHE to consumers other than households (including CHP)
Retail supplies to households

Odessa Port Plant
Other customers

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OUR PERFORMANCE

ANNUAL REPORT 2017

cash flow margin of this

business in 2016-2017 was only

1.2%. This modest result reflects

the problem of low payment

discipline of MHE’s.

Negative

ROIC

for 2016 is

mainly explained by accrual of

provisions for impairment for

gas supplied to PJSC "Odessa

Port Plant" (as stated above,

this company has not paid its

debt for supplied gas). Due to

the non-market terms of gas

supplies to other consumers

under PSO in regard to gas

price and payment terms, ROIC

for this business for 2017 was

8.7%, which is lower than cost

of capital

of 18.7%.

Cost of capital is estimated by independent
appraisers to determine the fair value of prop-
erty, plant and equipment of PJSC “National
Joint Stock Company “Naftogaz of Ukraine”” as
of 31.12.2017.

UAH-denominated ROIC

vs cost of capital, %

2016

2017

–5

–2�23%

18�70%

8�70%

ROIC Cost of capital

GAS IMPORTS AND SUPPLY TO

OTHER CUSTOMERS OUTSIDE PSO

Customer structure and

sales volumes of “Gas

imports and supply to other

customers outside PSO” have

significantly changed in 2017

due to the following key

factors:

· expansion of the scope of

PSO Regulation related to

supplies to MHEs (100%

of supplies to MHEs are

subject to PSO regime

since April 2017);

· decrease in supply volumes

to industrial consumers

(to 5% of total gas uses by

industrial consumers excl.

consumption by CHP).

As a result, gas supplies

outside PSO became a very

small business of Naftogaz,

with a mere 2% share in

total revenues of the group

in 2017.

Negative ROIC

of «Gas import

and sales for other consumers

ROIC is calculated as NOPLAT divided by market
value of invested capital, which was determined
as a sum of invested capital in fixed assets based
on estimation of its market value and net working
capital as of the end of the year. Market value of
invested capital in fixed assets, was determined
based on proprietary estimate of opportunity cost
of hydrocarbon resources and other assets of
this segment. NOPLAT and invested capital were
converted from Ukraine hryvnia to US dollar using
annual average exchange rates of the NBU and
at the end of the relevant year, respectively (in
order to compare USD-denominated ROIC with
USD-denominated cost of capital).

outside PSO» for 2016 was

driven by accrual of provision

of accounts receivable in

amount of UAH 4 billion, mainly

attributable to gas supplies to

regional distribution companies

for their technical needs. There

were no such non-recurring

items in 2017, and as a result,

ROIC of «Gas imports and

supply to other customers

outside PSO» of 11.2% for 2017

KEY RESULTS OF THIS BUSINESS:

Supply volumes to this segment’s customers in 2017 were

0.6 bcm (-72% change y-o-y).

Naftogaz’s share of supplies to industrial consumers

decreased twofold, from 9% in 2016 to 5% in 2017.

USD-denominated ROIC of this business in 2017 (11.2%) was lower

than USD-denominated cost of capital (13.4%).

Customers structure of "Gas imports and supply to other customers outside PSO" business in 2016-2017

by revenues, UAH million

2016

2017

4 761

1 406

1 035

2 591

487

Industrial consumers

MHE for other consumers

Other consumers

6 713

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OUR PERFORMANCE

ANNUAL REPORT 2017

was lower than cost of capital

of 13.4%, indicating that issues

with generation of value are not

fully addressed in this segment

(business only generates value

in a financially sustainable way

when ROIC exceeds cost of

capital).

Wholesale gas market

liberalization brought a

number of challenges and

positive developments for

the market outside PSO as a

whole. With the opening of

imports for private traders

and integration of Ukrainian

and EU markets, Naftogaz

no longer enjoys dominance

on the relevant gas market.

Free entry capacities available

Cost of capital estimated in UAH by inde-
pendent appraisers to determine the fair
value of property, plant and equipment of
PJSC “National Joint Stock Company “Naftogaz
of Ukraine”” as of 31.12.2017, was converted
into US dollars with subsequent adjustment
of the elements of that rate for the better
displaying the risks associated with the spe-
cifics of this business, and the corresponding
comparison with ROIC of the business.

to alternative sellers are 10x

higher than Naftogaz gas sales

in 2016, thus private importers

may totally replace Naftogaz

volumes if the latter raises

prices above market prices.

Moreover, as a result of market

liberalization, the Naftogaz

share in supply to industrial

consumers decreased twofold,

from 9% in 2016 to 5% in 2017.

Naftogaz is going to face

a decrease of its share

in supplies to industrial

consumers by strengthening

and developing its trading

capabilities. Key benefits for

Naftogaz from developing

trading capabilities include:
· effective price discovery

mechanism;

· lower price of sourcing (spread

vs European hub prices);

· better portfolio management,

lower risk.

Gas imports and supply to

other customers outside PSO:

USD-denominated ROIC

vs cost of capital, %

2016

2017

–5

–10

–15

–20

–25

–20�2%

13�4%

11�2%

ROIC
Cost of capital

Production and net imports of gas, bcm

2013

2015

2014

2016

200

180
160
140

120

100

80
60
40

bcm

163

169

Relevant market volume
Naftogaz sales volume

Naftogaz on the relevant

market, %

73%

84%

14%

13%

2013

2014

2015

2016

Ukraine

48.1

38.1

36.9

32.1

Slovakia

5.6

4.2

4.5

4.4

Poland

17.7

17.0

17.1

18.8

Hungary

8.6

10.1

8.0

9.4

Czech Republic

8.6

7.5

7.7

8.3

Austria

7.7

9.0

7.2

8.7

Germany

85.9

78.2

81.3

87.6

Physical gas trading

Paper trading and risk management

Sourcing

Transaction

hedging

Portfolio

hedging

Assset-backed

trading

Prop

trading

Financial

engineering

Match
sales and
purchase
commitments

Physical gas
trading

Hedge
overall
portfolio
in paper
markets

Paper
trading
related to
physical
positions

Paper
trading
unrelated
to physical
positions

Trade
derivatives
for making
profits and
hedging risk

RETURN

NAFTOGAZ

TODAY

EXPECTATION

FOR 2020

RISK

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ANNUAL REPORT 2017

GAS BUSINESS:

PERFORMANCE SUMMARY*

In 2017, Naftogaz group

produced almost 80% of the

total natural gas produced in

Ukraine. The leading companies

among the Ukrainian enterprises

are Ukrgazvydobuvannya with a

share of 74% in the total Ukrainian

gas production, and Ukrnafta

with a share of 5% in the total

Ukrainian oil production.

The bulk of natural gas

production in Ukraine is in the

Kharkiv and Poltava regions,

which together provide about

90% of the group's production.

Exploration works are carried

out mainly in the Carpathian

and Dnipro-Donetsk oil and gas

regions.

In 2017, the volume of natural

gas production by Naftogaz

group companies increased

by 2.8% compared to 2016.

The increase was basically

due Ukrgazvydobuvannya

which increased its output

by 4.4% in 2017 - a record

level over the past 24 years,

thanks to the successful

implementation of the 20/20

strategy. Despite the natural

drop in production of about

1.4 bcm/ year cumulatively by

Total

15 253

mcm

KHARKIV

DNIPROPETROVSK

POLTAVA

LUHANSK

DONETSK

SUMY

KHERSON

CHERNIVTSI

VOLYN

LVIV

IVANO-FRANKIVSK

ZAKARPATTYA

7 917

6 116

445

137

528

0,3

The geographical breakdown of natural gas production by Ukrgazvydobuvannya in Ukraine in 2017, mcm

Gross production of natural gas, bcm

15.9

16.4

14.6

15.3

1.3

1.1

Total:

Ukrgazvydobuvannya

Ukrnafta

2016

2017

2016/2017

2,8%

4,4%

–14,7%

Includes four main groups of gas sales and supply customers

*Naftogaz does not operate in this market segment

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OUR PERFORMANCE

ANNUAL REPORT 2017

all fields, Ukrgazvydobuvannya

managed to offset the decline

and increase production by

646 mcm of gas compared

with 2016. Thus, in 2017, a

large-scale program was

implemented to intensify

the gas production process

which included 120 fracturing

operations, which resulted

in additional production

of more than 875 mcm of

gas. In addition, an effective

work-over campaign was

implemented, which included

the restoration of wells, coiled

tubing operations, various

reservoir treatments resulted

in additional 550 mcm of gas.

The further successful

implementation of the 20/20

strategy will require extended

exploration areas, improved

legislation on land issues,

transparent procedures for

granting and extending

licenses, and a foreseeable

taxation regime for mineral

production operations.

Increase in the volume

of gas production by

Ukrgazvydobuvannya are a

positive factor for the stable

gas supply to consumers and

an effective tool for reducing

Ukraine's dependence on

imports of energy resources

and ensuring the country's

energy security.

In 2017, Ukrnafta continued

to show a decline in natural

gas production and finished

the year with a decline

in production by almost

15%. Like in the previous

year, Ukrnafta's decline in

production was affected by

the high level of depletion

of most deposits that are at

the final stage of their use,

as well as the fact that the

State Service for Geology

and Subsoil of Ukraine

(DerzhGeonadra) blocked the

extension of the company's

special permits in April 2017.

According to Ukrnafta, about

76 mcm of gas were lost due

to the forced suspension of

production. Production was

renewed in late October and

November after the licenses

were extended and mining

areas allocated.

In 2014, with the active

involvement of Naftogaz, the

reform of the gas market was

launched in Ukraine, which

resulted in the adoption of the

Law of Ukraine "On the Natural

Gas Market" and the gas sector

reform plan. The reform of the

gas market provided for the

gradual liberalization of the gas

market and the introduction

of targeted subsidies. Starting

from November, 2015, gas

prices for consumers beyond

the scope of the Regulation

on the imposition of special

duties (hereinafter referred

to as the PSO Regulation)

ceased to be regulated and

are to determined by Naftogaz

independently on the basis of

the market conditions.

At the same time, since

October 1, 2015, and till now

the Resolutions of the Cabinet

of Ministers of Ukraine No. 758

dated 01.10.15 (as amended)

and No. 187 (as amended)

dated 22.03.17, the Company

has been vested with special

responsibilities (PSO) for the

formation of the natural gas

resource for households,

religious organizations and

heat energy producers and

some other natural gas

consumers. The categories

of consumers covered by

the PSO are continuously

expanded by the government,

and the term of the

special responsibilities was

continuously extended.

Thus, from October 1, 2015,

the company was vested

with special responsibilities

for the formation of a natural

gas resource for the needs of

households and heat energy

producers for the production of

thermal energy for the provision

of heating and hot water

services to the households,

its sale at determined prices

to natural gas suppliers to

the households and supply

at determined prices to the

producers of heat energy for the

households.

Subsequently, the scope of

special responsibilities imposed

on the company was gradually

expanded by the government:

- from November 4, 2015 –

resource formation, sale at

determined prices to the

natural gas suppliers and

supply at determined prices

to the producers of heat

energy for the needs of

religious organizations;

- from September 29, 2016 –

supply to PJSC "Odessa Port

Plant";

- from October 19, 2016 –

supply to thermal energy

producers for the production

of thermal energy for the

institutions financed from the

state and local budgets, and

from December 23, 2016 – at

a specified price;

- from April 1, 2017 – supply of

natural gas at a determined

price to the producers of

heat energy for all categories

of consumers, as well as for

the production of electricity

by such producers, while

the obligation to supply

PJSC "Odessa Port Plant" is

excluded;

- March 16, 2018 – formation

of a resource for the

producers of heat energy for

all categories of consumers,

resource formation and sale

at a determined price to the

suppliers of natural gas for

the state enterprise of Ukraine

"International Children's

Center "Artek".

Currently, the company's special

responsibilities have been

extended until August 1, 2018

by the Resolution of the Cabinet

of Ministers of Ukraine dated

May 30, 1848, No. 415.

In addition, the current

version of the PSO Regulation

states that if the price of gas

calculated at import parity

level as of July 1, 2017 exceeds

the current price more that by

10%, then in the period from

October 1, 2017 to August 1,

2018, the selling (supply) price

of gas to households, religious

organizations and heat energy

producers will be equal to the

calculated gas price at import

parity level. At the same time,

the Ministry of Energy and the

Coal Industry had to ensure

taking steps by July 1, 2017 to

calculate the price of natural

gas at import parity and to

place the information on that

price on its own official website.

Despite the fact that in the

2016-2017 the preconditions

for revision of the current price

emerged, the decision on the

question was not made.

Total sales of gas to Ukrainian

consumers decreased in 2017

compared to 2016 by 14%.

Consumption of natural gas by

households in 2017 decreased

by 5% compared to 2016. The

change in consumption was

significantly affected by the

following factors:

- milder weather conditions

during the heating season

compared to the previous

year, which led to a decrease

in the need for heat and 5%

- reduction of social standards

for natural gas consumption

- the in which subsidies for

individual heating were

provided since 16.10.2017,

which created additional

incentives for the recipients

of subsidies to savings in gas

consumption.

The use of natural gas by

municipal heat generating

entities (MHE) for the needs of

households decreased by 20%

in 2017 compared to 2016. In

addition to the weather factor,

which affected the households

category as well, the key factors

for this category were:

• withdrawal of gas by

MHEs without obtaining

nominations, which led to

attributing such volumes of

gas to the imbalance of the

respective gas distribution

pipelines operators and

ignoring them in sales

volumes for this category

• replacement of natural gas

with other fuels (primarily

coal) and

• shift from district heating to

autonomous and individual

heating systems in some

cities, with or without

substitution of natural gas for

other fuels or energy.

Sales volumes to other

consumers outside PSO

decreased by 70% in 2017

compared to 2016. The

major reduction occurred in

the category of enterprises

that produce heat for other

consumers, by 89%. This

significant decrease is due to

the extension of the scope

of the PSO Regulation and

inclusion in it in 2017 of the

new categories of consumers

The sales of gas for industrial

and other consumers and gas

distribution companies for

their technological needs also

decreased by 63% and 13%

respectively due to the general

reduction of gas consumption

in Ukraine and, partly, due to

the change of supplier for such

enterprises.

See timeline Evolution of PSO scope for Munici-
pal heating companies

Gas sales and

supply outside

the group, bcm

20�1

17�4

2016

2017

–14%

2017/2016

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