НАК „НАФТОГАЗ УКРАЇНИ“. Річний звіт англійською (2017 рік) - 6

OUR PERFORMANCE

ANNUAL REPORT 2017

85

84

  Weighted average gas prices by category, UAH/tcm

1

47

4 118

4 942

3 288

4 942

5 342

6 484–7 148

6 288

7 516–8 265

Gas production, imports and sales to RSC's for 

resale to households

Gas production, imports and supply to MHE's for 

the needs of households

Gas production, imports and supply to other 

customers under PSO

Gas imports and supply to other customers 

outside PSO

  2016    

  2017     

  2016/2017 

20%

50%

18%

47 

Price for gas, net of VAT and tariffs for natural gas transportation and distribution services

The trade accounts receivable 

for natural gas increased 

in 2017 compared to 2016 

by UAH 8.4 billion or 15%. 

The growth in receivables is 

observed due to the regional 

gas supply companies for 

the needs of households. At 

the same time, consumers 

outside PSO showed 

decreased arrears by 16% in 

2017 compared to 2016.

  Gas sales and supply outside the group, bcm

11.6

11.0

5.7

4.6  

0.9  

1.9 

1.2  

0.6  

Gas production, imports and sales to RSC's for 

the needs of households

Gas production, imports and supply to MHE's for 

the needs of households

Gas production, imports and supply to other 

customers under PSO

Gas imports and supply to other customers 

outside PSO

  2016    

  2017     

  2016/2017 

–5%

–20%

43%

–70%

UAH billion

Trade accounts receivable

Provision for impairment

31.12.2016

31.12.2017

2017/2016

31.12.2016

31.12.2017

2017/2016

Total

57.1 

65.5

15%

(21.5)

(23.0)

7%

   Trade accounts receivable for natural gas

 RSC's for resale to households

MHEs to households

21�6

10�1

0�8

20�2

8�2

9�7

2�4

3�2

3�5

0�2

0�1

–0�2

–3�1

-4�2

–1�2

  

Trade accounts receivable less 

than 90 days

  

Trade accounts receivable 

within 90-365 days

  

Trade accounts receivable 

more than 365 days

  

Provision for impairment

   

Trade accounts receivable less 
than 90 days

   

Trade accounts receivable 
within 90-365 days

   

Trade accounts receivable 
more than 365 days

  

Provision for impairment

  

Trade accounts receivable 

less than 90 days

  

Trade accounts receivable 

within 90-365 days

  

Trade accounts receivable 

more than 365 days

  

Provision for impairment

   

Trade accounts receivable 
less than 90 days

   

Trade accounts receivable 
within 90-365 days

   

Trade accounts receivable 
more than 365 days

  

Provision for impairment

21�8

UAH bn

14�1

UAH bn

30�1

UAH bn

14�1

UAH bn

2016

2017

2016

2017

0�4

0�03

–1�4

–16�9

–16�2

–1�4

1�4

0�9

0�4

3�0

3�5

0�3

1�4

15�1

16�0

1�6

UAH bn

19�6

UAH bn

4�8

UAH bn

16�5

UAH bn

Other customers under PSO

Other customers outside PSO

2016

2017

2016

2017

OUR PERFORMANCE

ANNUAL REPORT 2017

87

86

57

%

 RSC's for resale to households

MHEs to households

69

%

70

%

88

%

100

%

59

% 

37

%

44

%

   % of settlements, 

including

   % of settlements by 

subsidies

   % of settlements, 

including

   % of settlements by 

subsidies

48�9

UAH bn

18�9

UAH bn

54�3

UAH bn

22�8

UAH bn

2016

2017

2016

2017

   The level of settlements for natural gas

The state budget for 2017 

provided for funding of benefits 

and subsidies to households to 

pay bills for electricity, natural gas, 

heating, water and wastewater 

services, maintenance of 

buildings and structures and 

adjoining territories, the removal 

of household garbage and liquid 

sewage for a total amount of 

UAH 68 billion.

During 2017, Naftogaz 

group was actively working 

to match the allocations 

for housing subsidies in 

the state budget with the 

amount of funds that were 

objectively necessary for 

their funding in view of the 

changes in the regulatory 

environment throughout 

the year. Nevertheless, by 

the end of 2017, the issue 

of budget funding of the 

granted subsidies remained 

problematic. For example, 

out of the total amount of 

protocols subscribed of UAH 

64 billion only UAH 51 billion 

or 80% has been financed, 

which is 4% less than in 2016.

   The results of the business

48 

 gas supply to the municipal 

heat generating entities for 

the needs of households,  

UAH billion

4�9

3�9

2016

2017

   The results of the business

48 

 

gas supply to the other 

customers under PSO,  

UAH billion

2016

2017

–0�4  

1�6  

   The results of the business

48

 

gas supply to the other 

custome rs outside 

PSO, UAH billion

2016

2017

–1�7  

0�5  

The results of this business 

decreased by UAH 1 billion in 

2017. The slump in sales reduced 

the result by UAH 3.7 billion, 

which was partly compensated 

for by lowered royalties. 

48

48 

operating profit/(loss) before income tax

The results of gas supply to other 

consumers under PSO in 2017 

improved compared to 2016, from 

a loss of UAH 0.4 billion to a profit 

of UAH 1.6 billion. The key factor 

here was the increase in sales in 

this category, which is due to the 

extension of PSO categories to 

heat and power consumers

49

.

49 

CMU Resolution No. 187 of 22.03.17 "On Approval 
of the Regulation on the Imposition of Special 
Responsibilities on the Subjects of the Natural 
Gas Market for protection of General Public 
Interests in the Natural Gas Market Operations"

The results of the business 

improved by UAH 2.2 billion in 

2017 compared to 2016. The 

decrease in sales adversely 

impacted the result. The decrease 

in the provision for doubtful 

debts by UAH 4.2 billion in 2017 

as compared to the previous year 

positively affected the result of 

the business at the same time.

2016

2017

   Gas sales to RSC's for the needs of households results*, UAH billion

19�9

20�4

The results of this business 

improved by 2% or UAH 0.4 

billion in 2017 compared with 

2016. Although gas sales to 

Ukrainian consumers shrank 

due to lower gas consumption, 

decreasing the result by UAH 

2.7 billion, the positive result 

was achieved thanks to the 

reduced royalty (royalty for 

deposits deeper than 5 thousand 

meters was cut down to 29% in 

January 2017, while it was 70% in 

January-March 2016 and 50% in 

April-September 2016).

COMPLEX GAS 

TREATMENT 
PLANT (CGTP)

GAS 

SEPARATION

GAS

DRYER

COMPENSATOR

CONDENSATE 

STABILIZER

SEISMIC 

VIBRATORS

EXPLORATORY

WELL

DRILLING 

SITE

PRODUCTION 

WELL

COILED 

TUBING UNIT

WELL 

WORKOVER

BOOSTER 

COMPRESSOR 

STATIONS

LOW TEMPERATURE 

SEPARATOR

HOW GAS IS PRODUCED

EXPLORATION, PRODUCTION AND PROCESSING OF GAS

1. GEOLOGICAL EXPLORATION

Geological studies are conducted to 
identify areas where there may be new 
deposits. Seismic studies account for as 
much as 90% of the geological exploration 
budget.

2. EXPLORATORY DRILLING

On average, only one in three exploratory 
wells finds a new deposit. The cost of an 
exploratory well is between USD 2-3 million 
but sometimes it may cost more than USD 
10 million.

6. WELL REPAIR

Wells are regularly checked and 
repaired to ensure uninterrupted and 
accident-free production.

3. PRODUCTION DRILLING

Production wells are drilled to develop 
an explored field. The cost of a well 
depends on its depth and ranges from 
USD 2-3 million to USD 10 million.
The number of wells can range from a 
dozen to hundreds. Thus, this stage is 
considered the most capital-intensive.

5. PRODUCTION ENHANCEMENT

Booster compressor stations (BCS) 
maintain the pressure necessary for 
production at the final stage of field 
development. Most of the fields in 
Ukraine are significantly depleted.

8. GAS TRANSMISSION

Gas is transmitted from the 
production site to consumers 
through gas trunk pipelines. 

7. GAS TREATMENT

The final products of the mixture 
processed by a complex gas 
treatment plant (CGTP) are dry 
natural gas and gas condensate.

4. DEVELOPMENT OF THE FIELD

A mixture of gases (methane, ethane, 
propane, etc.), gas condensate, 
stratum water and other mineral 
impurities comes to the surface 
through a well. Subsequently, this 
mixture is purified and separated.

NON-PURIFIED GAS

PURIFIED GAS

MARKETABLE GAS

CONDENSATE

OUR PERFORMANCE

ANNUAL REPORT 2017

91

90

OIL AND 

GAS CONDENSATE

The production of liquid 

hydrocarbons of Naftogaz group 

in Ukraine is performed by 

Ukrnafta (75% of the group's total 

liquid hydrocarbons production) 

and Ukrgazvydobuvannya 

(25% of the group's total liquid 

hydrocarbons production). 

Ukrnafta sells liquid 

hydrocarbons through auctions 

and these volumes form the 

segment's financial result.

Based on 2017 results, Naftogaz 

group's liquid hydrocarbons 

production dropped by 7.6% (by 

152 thousand t), and Ukrnafta's 

production dropped by 9.2% to 

1.379 mnt and reached the new 

historical minimum.

13.3

12.8

11.2

14.1

Tax liabilities

Provision 

 for related fines 

and penalties

  31 December 2016    

  31 December 2017

   Ukrnafta's tax liabilities and provisions for fines 

and penalties, UAH bn

2.0

1.8

1.5

1.4

0.5

0.5

Total

Ukrnafta

Ukrgazvydobuvannya

  2016   

  2017    

  2016/2017

–7�6%

–9�2%

–2�7%

   Gross production of oil and gas condensate by the enterprises of the group, mnt

During 2017, tax regime for oil 

and condensate production 

remained unchanged, and the 

pricing situation improved: the 

average selling price of a barrel 

of oil was USD 51.8 compared to 

USD 40.5 in 2016. These factors 

allowed Ukrnafta to pay off  

UAH 10.2 bn of taxes  in 2017, 

which is higher compared to 

2016 when the company paid 

UAH 8.1 bn. In total, the company 

used 52% of its cash flow for tax 

payments.

The reason for the negative 

ROIC

50

 of the oil and gas 

condensate segment, which in 

50 

ROIC is calculated as NOPLAT divided by invest-
ed capital, which was determined as a sum of 
invested capital in fixed assets and net working 
capital. The capital invested in fixed assets was 
calculated based on proprietary estimate of 
opportunity cost of hydrocarbon resources of 
this segment.

2016 was -13%, was the accrual 

of Ukrnafta's receivables 

impairment reserve of UAH 

6 bn. Without this one-time 

accrual, ROIC  would have been 

9.4% in 2016. In 2017, ROIC 

increased almost twice (to 

16.6%) due to the growth of the 

market prices for oil and gas 

condensate and the decrease 

in rent payments (specifically, 

from 45% to 29% for the 

70

60

50

40

30

20

10

0

3�5

3�0

2�5

2�0

1�5

1�0

0�5

0

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

  Wells commissioned

 (right axis)                Liquid HCs production, mnt (left axis)

2�8

2�9

3�0

3�1

3�2

3�2

3�1

2�8

2�5

2�3

2�1

2�0

1�9

1�7

1�5

1�4

  Oil and gas condensate production by Ukrnafta in 2002-2017, mnt

KEY ISSUES OF THE SEGMENT'S PRODUCTION ACTIVITIES IN 2017:

· Liquid hydrocarbon production dropped rapidly due to the forced stop of production as a result of suspension of

the special permits by Derzhgeonadra.

• Ukrnafta decreased production despite the growth potential - reserves of  liquid hydrocarbons made up

38.3 mnt  according to the assessment as of  31.12. 2017 (based on the audit by DeGolyer & MacNaughton).

· The capital investments volume is lower than the minimum required for the fulfillment of stabilization and

production volume build-up programs.

· Only four wells were drilled and put into operation (three of them under JV agreements), which is 90% lower

compared to the 2010s.

· In September 2017,  Derzhgeonadra extended 9 special permits, which expired in 2017 and which provided the

reason for the production halt at these fields.

· In 2018,  27 more special permits expire, 11 of which are to be extended in accordance with the resolution of the

Kyiv administrative court of appeal. However, there is a concern regarding the approval of another 16 special

permits.

· At the beginning of 2018, further to the State Fiscal Service submission, Derzhgeonadra obliged Ukrnafta to

repay debts on rent payments by 1 July 2018, threatening to suspend 77 special permits for the production of

hydrocarbons in case of failure to do so.

OUR PERFORMANCE

ANNUAL REPORT 2017

93

92

production of oil from the wells 

with the depth of up to 5000m). 

The operating result for 2017 

would have been even better 

if Ukrnafta's special permits 

had not been blocked, and the 

special auctions for the sale 

of oil and gas condensate had 

not been suspended. Besides, 

the assets for the production 

of oil and gas condensate 

have been chronically 

underfinanced, which resulted 

in the descending trend 

in the production of liquid 

hydrocarbons.

With the ROIC of 16.6% in 2017, 

this segment was the second 

among Naftogaz businesses. But 

it is still lower than the estimated 

cost of capital which comprises 

22%

51

, and shows that even this 

almost unregulated business 

does not create value in a 

financially sustainable manner.

As of 31 December 2017, 

Ukrnafta's tax debt constituted 

about UAH 13 bn. This indicator 

includes the company's 

outstanding liability and debt 

on JV operations.

The risks for the repayment of tax 

debt include attempts to block 

special permits by regulatory 

bodies and the obstruction of 

government auctions for the 

sale of oil through which the 

company sells the oil and gas 

concentrate at regulated prices

*

. 

In order to turn around 

Ukrnafta without applying 

bankruptcy or financial 

rehabitation procedures, 

specifically for the reduction of 

social tension and preservation 

of the company’s personnel 

potential, the company's 

management is developing 

51 

Cost of capital is calculated based on an 
independent assessment of the alternative cost 
of capital for this segment.

several options of financial 

rehabilitation. Besides, 

Ukrnafta's management has 

repeatedly addressed the 

executive authorities with 

the proposal to restructure 

the tax debt. The company 

will continue to pay off the 

outstanding tax debt, service 

current tax liabilities and make 

critical investment to ensure 

basic production needs for the 

purpose of stabilization and 

the increase in production.

A very important government 

initiative for this segment 

is the reduction of the 

nominal rate payment for the 

condensate production to 

29% for wells with the depth 

of up to 5000 m, and to 14% 

for deeper wells (against 45% 

and 21% respectively, which 

were effective in 2015-2016) 

scheduled for the beginning 

of 2019. It is expected to 

have a positive impact on the 

acceleration of the Ukrnafta's 

debt repayment and to release 

additional funds, which could 

be used for the stabilization of 

hydrocarbons production.

Investments

Due to the critical limitation of 

financial resources, Ukrnafta's 

drilling volumes decreased by 

90% against the early 2010s, 

which immediately impacts oil 

production volumes. 

Capital investments in 2017 were 

UAH 710 mn against a planned 

2.4 bn, which was lower than 

the minimum required for the 

stabilization and production 

volumes build-up. 

In 2018, the company planned 

its investment program at the 

level of UAH 3.2 bn. It believes 

that these investments are 

critical for ensuring basic 

production needs, labor safety 

and failure-free operation 

of equipment. However, the 

fulfillment of the investment 

program would depend on the 

agreements on the mechanism 

of the tax debt repayment.

During 2017, Derzhgeonadra 

suspended special permits for 

the development of 9 fields. In 

2018, 27 special permits expire, 

which account for 53% of the 

company's annual oil and gas 

condensate production and 30% 

of the annual gas production. 

In 2017, Ukrnafta submitted to 

Dergeonadra in advance the 

applications for their extension. 

The extension of the special per-

mits is critical for the company 

and would have a significant 

impact on its production and 

financial indicators, fulfillment 

of the investment program, 

employment and state and local 

budget revenue contributions.

At the beginning of April 2018, 

the Kyiv administrative court 

of appeal ruled for Ukrnafta 

and obliged Derzhgeonadra 

to consider the company's 

applications for the extension 

of 11 special permits for 

   Oil and gas condensate: 

ROIC vs capital cost rate 

UAH-denominated, %

2016

2017

25

20

15

10

5

0

–5

10

–15

%

–13�0%

16�6%

22�0%

22�0%

   ROIC
  Capital cost rate

hydrocarbons production. 

Those are licenses which 

expire during the first six 

months of 2018 and which 

grant the company the right 

to produce hydrocarbons in 

the Rosilnyanske, Turutynske, 

Mykolaivske, Lukvynske, 

Dovbushansko-Bystrytske, , 

Oriv-Ulychnyanske, Dolynske, 

Strutynske, Spaske, and 

Andriyashivske fields. The ruling 

of the court of appeal came 

into force on 3 April 2018.

According to the company's 

calculations, during the year, the 

state and local budgets would 

receive income from production 

of hydrocarbons at the above 27 

fields of nearly UAH 3 bn from 

rental payments only.

At the beginning of 2018, 

Derzhgeonadra, further to the 

submission of the State Fiscal 

Service, set for Ukrnafta the 

term for the elimination of 

violations of special conditions 

of special permits for the use 

of the subsurface resources in 

terms of rent payments to the 

State Budget and threatening 

to suspend 77 special 

permits for the production of 

hydrocarbons. Ukrnafta has 82 

special permits for production 

of hydrocarbons in total.

Oil sale regulation 

mechanism

The state regulation mechanism 

for the sale of domestically 

produced oil and gas 

condensate  for the companies 

where the state share in the 

authorized capital is 50 percent 

or more was introduced starting 

from the 2000s. The group 

sells domestically produced 

crude oil and gas condensate 

at exchange auctions in 

accordance with the Law of 

Ukraine №2665-III On the Oil 

and Gas of 12.07.01.

Over the period of its existence, 

the said sales mechanism has 

undergone a number of changes, 

which often resulted in the 

non-transparency of the oil sale 

process and the reduction of 

profit under the transactions on 

sale of domestically produced 

oil and gas condensate. It 

specifically provided for reduced 

coefficients from the customs 

value, a price calculation which 

did not include the VAT, etc. 

This resulted in under received 

profit and the reduction of the 

profitability of this segment. In 

2007-2014, Ukrnafta's oil sale 

price did not fully correspond to 

the world prices in the specified 

period. Beginning from the 

end of 2014, certain changes 

to the oil and gas condensate 

sales mechanism have been 

introduced: 

•  a number of norms concerning

the oil and gas condensate

pricing mechanism have been

revised;

•  the reduced coefficients have

been cancelled;

•  the starting price of crude

at auctions in view of the

insignificant volumes of import

in Ukraine of the Urals and Azeri

oil grades is mainly determined

taking into account world oil

quotes.

Due to the absence of a 

competitive environment 

between oil buyers - refineries - 

the demand for crude oil and gas 

condensate in Ukraine is limited. 

They are processed in Ukraine 

by the Kremenchuk refinery 

(PJSC Transnational Financial 

and Industrial Oil Company 

Ukrtatnafta), which in 2017 

partially switched to Azerbaijan 

oil. The combined result of the 

existing rigid regulatory pricing 

ANNUAL REPORT 2017

THE PROBLEM

 

WITH ISSUING

 

SPECIAL 

PERMITS 

IS THE BIGGEST SHORT-TERM RISK 

FOR THE BUSINESS

120

100

80

60

40

20

0

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

  EU price of oil import (on CIF terms $/bbl)) 
  Estimated average sales price at auctions $ per 1 bbl 
  Platts Urals price $/bbl

   Evolution of sales price for domestically produced oil

Appearance of an 
alternative oil source  
for refineries

11 auctions failed

Estimated auction 
starting price brought  
to the market level

* See section The world oil market

OUR PERFORMANCE

ANNUAL REPORT 2017

95

94

mechanism and the absence 

of an efficient and competitive 

oil purchasing market was the 

failure of 11 energy auctions in 

2017 and an unsold oil volume 

of about 200 thousand t. Taking 

into account that the revenue 

from the sold volumes of oil 

and the gas condensate is the 

source for financing investment 

programs for the intensification 

of production and payment of 

rent payments, unpredictable 

volumes and irregular sell 

timelines mean big risks.

One of the possible options 

to overcome the dependency 

on one buyer is enhancing 

integration of the companies 

within Naftogaz group. Specif-

ically, this could mean further 

development and moderniza-

tion of Ukrgazvydobuvannya's 

production facilities and the 

attraction of Ukrnafta's produc-

tion resources for the purpose 

of processing and production of 

petroleum products. This would 

allow partial diversification of 

the oil sale chain and enhance 

Naftogaz group's position in 

the oil and petroleum products 

market.

Market deregulation 

perspectives

The initiatives on further liberal-

ization and deregulation of the 

wholesale segment of the oil and 

gas condensate market is a logi-

cal step, taking into account the 

tendencies of the Eastern Euro-

pean oil processing market. This 

concerns mainly the expected 

tax changes concerning oil 

supplies from Russia to Belarus

52

. 

Belarus buys oil at Russian pro-

ducers' prices, since it is a mem-

ber of the Customs Union with 

Russia, i.e. the export price of oil 

52 

From 2015 Russia initiated tax reform in the 
oil sector. The essence of the reform which is 
called the 'tax maneuver' is the reduction of the 
export duties for oil, their gradual equation with 
the export duties for light and dark petroleum 
products, and the increase of the mineral 
resource extraction tax rates (MRET).

from Russia does not include the 

export duty (as of April 2018 – 

111.4 $/t, or about 15 $/bbl) and, 

respectively the cost of produced 

petroleum products is lower. 

If Russia fully replaces oil 

export duties by mineral 

resources extraction tax 

within the 'tax maneuver', 

the oil price for Belarus 

would reach the market 

one to the maximum. In 

this situation, when the oil 

purchase price from Russia 

and the price of potential 

oil supplies from alternative 

sources are at world levels, the 

Belarusian refineries would 

be interested in purchasing 

oil with minimum logistic 

costs, including in Ukraine. 

The development of the 

situation under this scenario 

may have a positive impact 

on oil market development, 

since a competitive domestic 

oil and gas condensate buyers' 

market may subsequently be 

formed.  

Oil, gas condensate 

Mark

et der

egulation

Only one buying refinery

Free market price

• Ensuring free logistical access to the resource
• Formation of fair price for different oil grades of domestic production
• Integrated Eastern European market
• Enhancing the integration of production and processing enterprises
• Appearance of clear market and investment indicators for oil production

• Absence of competitive market
• Overstocking of storage facilities

during unfavorable price period
for the refinery

• Oil is sold at starting price
•  Only best quality oil is sold

Regulated price

AUCTION

UKRNAFTA

The state share in the 
company's authorized 
capital 50% and more

OIL AND GAS 

CONDENSATE SALE 

Naftogaz group extracted about 

90% of the total oil and gas 

condensate produced in Ukraine 

in 2017. Ukrnafta is the group’s 

leading company in oil and gas 

condensate production, with 

a 66% share of Ukraine's total 

production. Ukrgazvydobuvannya 

is the second placed oil and gas 

extractive company in Ukraine 

with a share of more than 22%.

In the territory of Ukraine, oil and 

gas condensate are produced by 

the Group's companies in fields in 

Poltava, Chernihiv, Sumy, Kharkiv, 

Dnipropetrovsk, Lviv, Ivano-

Frankivsk and Chernivtsi regions.

The results of oil and gas 

condensate extraction for 2017 

reflect the general trend to 

reduce production volumes. 

Overall, oil and condensate 

production fell by 7.6%. The 

biggest production reduction (by 

9.2%) was made by Ukrnafta. This 

was due both to internal causes – 

natural depletion of deposits and 

insufficient level of investment in 

servicing, equipment upgrading 

and drilling, and external – the 

refusal of the State Service of 

Geology and Subsoil of Ukraine 

to extend the validity of licenses 

which resulted in suspension 

of mining at 6 deposits from 

April to June 2017. The industrial 

losses during this downtime are 

estimated by Ukrnafta experts at 

about 92 thousand tons of oil and 

gas condensate.

Nevertheless, in H1 2017, the 

company managed to stabilize 

production at the level higher 

than natural production decrease 

despite limited investments. 

This was due to a number 

of budgetary and technical 

measures for production 

enhancement at the existing 

wells.

The volume of oil and 

condensate produced by 

Ukrgazvydobuvannya also 

dropped by 2.7% compared 

to 2016, due to the natural 

depletion of deposits. 

The extracted oil and gas 

condensate are used by 

Ukrgazvydobuvannya for 

the production of petroleum 

products at their own 

production capacity. The result 

of petroleum products sales 

is discussed in the section 

Petroleum products sales.

The results of this business 

improved in 2017 compared 

to 2016 by UAH 9 billion. The 

result was positively affected by 

the growth of oil sales prices in 

Ukraine in line with world market 

trends. The average Brent crude 

oil prices in 2016 amounted to 

USD 43.7 per barrel and in 2017 

they increased to USD 54.2 per 

barrel and exceeded the 2015 

average prices.

   Sales of crude oil and gas 

condensate by the group, 

thousand t

1  479   

1 270   

  2016   

  2017 

–14%

2017/2016

  Oil and gas condensate 

sale results*, UAH bn

2016

2017

6

4

2

0

–2

–4

–3�5

5�6  

5�5

5�0

4�5

4�0

3�5

3�0

January

February

Mar

ch

April

M

ay

June

July

Augu

st

Sep

tember

Oct

ober

No

vember

December

   Average daily oil and condensate production by Ukrnafta, 

thousand t/day

  2014        2015         2016          2017

Production loss due to the 

suspension of special 

 permits

* operating profit/(loss) before tax

OUR PERFORMANCE

ANNUAL REPORT 2017

97

96

GAS TRANSIT

KEY RESULTS OF THIS BUSINESS SEGMENT:

• The largest (32.5% of revenues) and the most capital-intensive (35% of PP&E carrying value) business of

Naftogaz group

• Transit volumes – 93.5 bcm (+14% y-o-y), a 6-year maximum
• Almost 50% of natural gas supplies from Russia to Europe were delivered through Ukraine in 2017
• Historical win in Stockholm arbitration on under-deliveries totaling USD 4.63 billion including interest

(for the period from 2009 to 2017)

• ROIC in 2017 (3.0%) was lower than cost of capital (11.9%)
• Uninterrupted transit flows during March 2018 artificial crisis, created by Gazprom

  Gas transit by direction for the period from 2014, bcm 

Slovakia

Romania

Hungary

Poland

Moldova

Total

31.4

37.8

48.8

53.5

18.0

16.8

19.3

20.9

6.5

5.9

6.7

11.7

3.5
3.7

4.5

4.7

2.9

62.2

2.9

82.2

2.9

67.1

2.7

93.5

 2014           2015           2016           2017 

In 2017, transit of Russian gas 

through Ukraine increased by 

14% to 93.5 bcm. This growth is 

explained by the increase in gas 

consumption on the European 

market due to weather-related 

factors (see “The European 

natural gas market” section), 

and, quite possibly, by economic 

incentives to pump more gas 

through Ukraine due to probable 

Gazprom estimates of the 

outcome in transit arbitration (i.e. 

because of high probability that 

Naftogaz would be successful 

with its under-deliveries claim). 

Due to such flows via Ukraine, 

in 2017 Naftogaz cemented 

the positive balance between 

values of gas transit services and 

Russian gas imports for Naftogaz 

(USD 2.77 bn, +19% y-o-y).

In spite of record supplies of 

gas to Europe by Gazprom 

in 2017 and the resulting 

6-year maximum transit

flows through Ukraine, such

volumes were significantly

lower than minimal contractual

volumes according to the

transit contract with Gazprom

(110 bcm p.a.) or historical

volumes transported through

Ukraine before construction

of Nord Stream and Yamal 

pipelines. Approximately 35% 

of exit capacities of Ukrainian 

gas transmission system on the 

border with the EU were not 

utilized. 

In addition to the above 

mentioned under-deliveries, 

Gazprom refused to implement 

the final award in transit 

arbitration

53

. The currently 

applicable transit tariff is both 

not cost-reflective and not 

compliant with regulated 

tariffs

54

 and as of the date of 

this report, the management 

believes that zero transit flows 

from 1 January 2020

55

 are 

highly likely. 

53 

Taking into account that Gazprom has appealed 
the final award in the transit arbitration, and 
the fact that the amount was not settled by 
Gazprom, management follows a prudent 
approach and does not recognise the amount 
owed by Gazprom (USD 2.6 bn) as receivable as 
at 31 December 2017

54  

As a result of transit arbitration, the Tribunal 

has rejected the Naftogaz claim to review the 
transit contract in accordance with European 
and Ukrainian law (incl. application of regu-
lated tariff), noting that the implementation 
of regulatory reform in Ukraine is a matter 
for the competent Ukrainian authorities, 
e.g. NCREU

55 

Due to alternative route developments 
(e.g. status of Opal case, construction of NS2, 
Turkish Stream, evidence of higher capacity 
of NS1)

As a result:

– ROIC

56

 of gas transit business

in 2017 was significantly lower

than cost of capital for this

capital-intensive business.

– Due to negative expectations

about gas transit flows starting

56  

ROIC is calculated as NOPLAT for the respective 

year divided by invested capital, which was deter-
mined as a sum of invested capital in fixed assets 
and net working capital as of the end of the year. 
NOPLAT and invested capital were converted 
from UAH into USD using NBU’s average annual 
exchange rate for NOPLAT and exchange rate 
as of the end of the respective year for invested 
capital (in order to compare USD-denominated 
ROIC with USD-denominated cost of capital, used 
by independent appraisers). Invested capital in 
fixed assets was estimated in two steps: 
(a)  Net replacement costs less physical 

depreciation of GTS (UAH 419 bn as of 
31/12/2017) was adjusted for the effect from 
expectation of zero or immaterial transit 
flows beyond 2019 (cf. pages 25-26 of 2017 
Consolidated Financial Statements). Should 
expectation of material transit beyond 
2019 have been used for revaluation, net 
replacement costs less physical depreciation 
of  the gas transmission system cash 
generating unit would be 10% higher, i.e. UAH 
460 bn.

(b)  UAH 460 bn was apportioned among key 

businesses of the group according to 
management approach to measuring group 
performance. In particular, capacity and 
distance were used as factors for allocation 
of assets between gas transit and other 
businesses.

UAH-denominated value of invested capital in 
fixed assets as of 31/12/17 was used as a proxy 
for UAH-denominated value of invested capital 
in fixed assets as of 31/12/16 for the purposes of 
ROIC calculation.

   Balance between gas transit and Russian gas import costs for 

Naftogaz, USD billion

  2009 

2010 

2011 

2012 

2013 

2014  

 2015 

  2016 

  2017

4

2

0

–2

–4

–6

–8

–10

–4�36

–6�33

–9�31

–7�60

–2�13

–2�95

0�38

2�33

2�77

US

D bn

OUR PERFORMANCE

ANNUAL REPORT 2017

99

98

from 1 January 2020, economic 

obsolescence was recognized 

in a report of independent 

appraisers of 16 March 2018, 

who determined the fair value 

of Naftogaz gas transmission 

assets as of 31 December 2017.

Generally, the uncompetitive 

and highly politicized behavior 

of Gazprom is the key problem 

of this business segment. For 

example, Gazprom has not 

recognized new RAB-tariffs 

for cross-border entry and 

exit points approved by the 

Ukrainian energy markets 

regulator in December 2015. 

It has continued to pay old 

contractual tariffs and rejected 

since 2016 negotiations 

about implementation of 

regulated tariffs with respective 

amendments of the transit 

contract. As a result, currently 

applicable transit tariffs in the 

contract between Gazprom and 

Naftogaz (determined during 

the negotiations between two 

companies in January 2009):

– is volume- and

distance-based;

– does not reflect Naftogaz's

actual costs of providing

transit services related to the 

investment in and operation 

of the infrastructure (which 

is a part of Naftogaz's asset 

base);

– is exclusive to Gazprom,

specific for transit as opposed

to other use of the Ukrainian

gas transmission system

(approximately 70 importers

pay regulated entry tariff );

– implies significant flexibility

to choose direction of transit

flows.

At the same time, European 

principles of tariff formation 

determine that tariffs should 

be capacity-based. They should 

be set taking into account 

the actual costs incurred 

for provision of services 

considering the level of 

complexity of the network, and 

that the actual costs are related 

to the investment in and 

operation of the infrastructure 

which is part of the regulated 

asset base for the provision 

of the services. Based on 

these principles, Naftogaz has 

estimated as of the date of this 

report that the transit tariff in 

2018-2019 should be increased 

by between 40% and 300% 

(depending on whether transit 

capacities of Ukrainian GTS 

will be utilized beyond 2019 or 

not). 

If one looks at the nominal 

unadjusted cost of gas 

transmission in Slovakia, they 

may say that Ukrainian transit 

tariff corresponds to the level 

of Slovakian transit tariff. But 

in order to compare ‘apples to 

apples’, the following should be 

taken into account: (a) current 

and expected reservations 

of capacity by Gazprom and 

their utilization; (b) if Gazprom 

pays for booked capacity or 

for volumes; (c) the level of 

complexity of the Ukrainian 

transit system, and the volume 

and destination flexibility 

provided to Gazprom; (d) 

effective distance of gas transit 

in Slovakia; (e) possibility 

of VRFs on interconnection 

points. For example, with 

adjustment for average 

distance and load factor, the 

applicable contractual tariff 

specified in contract between 

Naftogaz and Gazprom is 

significantly lower than the 

tariff Gazprom pays for transit 

through Slovakia.

As the tribunal in its final 

award on transit case from 

28 February 2018 found that 

communication between 

Naftogaz and Gazprom on 

revising the transit tariff 

fall short of some formal 

requirements, Naftogaz has 

filed a new tariff revision 

request in March 2018 

and held a first round of 

negotiations with Gazprom 

on this issue in April 2018. 

Renegotiating transit tariffs 

with Gazprom is currently one 

of key strategic initiatives for 

Naftogaz group. 

   Gas transit business: USD-

denominated ROIC vs  

cost of capital 

2016 

2017 

14

12

10

8

6

4

2

0

%

5�2%

3�0%

11�9%

11�9%

   ROIC, % 
  Cost of capital, %

Net replacement cost (without effect from zero 

transit assumption beyond 2019)

Net replacement cost (with effect from zero transit 

assumption beyond 2019)

VValue based on income approach (based on zero 

transit axpactation beyond 2019)

   Effect from expectations about transit beyond 2019 on value of 

the gas transmission system as of 31�12�2017, UAH bn

189

419

460

As mentioned above, one of 

key results of this business is 

the historic win in Stockholm 

arbitration over transit. 

Naftogaz did win USD 4.6 billion 

in damages for Gazprom's 

under-deliveries of transit gas, 

to some extent mitigating 

Gazprom's capacity hoarding 

in the Ukrainian transmission 

system, and resulting in a 

net payment obligation for 

Gazprom of USD 2.6 billion 

after settlement of Naftogaz's 

underpayments for gas 

deliveries in 2013 and 2014. 

However, so far Gazprom has 

refused to comply with this 

payment obligation.

In this arbitration, the tribunal 

refrained from applying the 

relevant competition rules, 

leaving the responsibility to 

the regulatory authorities in 

Ukraine. The tribunal's award 

in applying competition law 

left intact the provisions in the 

transit contract that prevent 

the free trade of gas between 

EU member states bordering 

Ukraine. For example, the 

role given to Gazprom Export 

at the metering stations at 

Ukraine's border with the EU 

prevents virtual reverse flows 

through Ukraine and the use 

of the system by third parties 

more generally. To cement its 

position, Gazprom still refuses 

to provide shipper codes to 

Ukrtransgaz. These codes are 

necessary in order to enable 

trade in natural gas across 

borders, and the refusals to 

supply could be considered 

an abuse of dominance by 

Gazprom in its own right.

Without the restrictions 

implemented by the existing 

transit contract and Gazprom's 

conduct, the Ukrainian gas 

transmission system (including 

the largest underground gas 

storage in Europe) could be 

used to enable EU member 

states such as Poland, Slovakia, 

Hungary and Bulgaria to 

trade surplus gas with each 

other, using the Ukrainian 

infrastructure as a "bridge". In 

particular, virtual reverse flows 

through Ukraine could allow 

European importers to divert 

surplus gas to the currently 

isolated South East European 

market. 

Naftogaz follows a rigid 

approach to capital 

investments allocation when 

reviewing and approving 

long-term development 

plans and financial plans 

related to gas transit. As 

stated above, management 

decisions are currently based 

on the expectation of zero (or 

immaterial) transit after the 

expiration of the contract with 

Gazprom (in December 2019), 

but at the same time, Naftogaz 

secures reasonable funding 

   Level of transit tariff: comparison with Slovakia

Note: Data about long-term capacity booking is taken from EUSTREAM web-site (https://tis.eustream.sk/TIS/#/?nav=bd.ltc)

Booked 

entry capacity?

–64.7 bcm of entry 
capacity is booked 
by Gazprom for 2018
at Velke Kapusany, 
eastern border of 
Slovakia
(91% of technical) 

110 bcm/year of 
entry capacity is 
booked by Gazprom 
on the Ukrainian 
border with Russia 
and Belarus

(39% of technical)

~62.5 bcm of exit 
capacity is booked for 
2018 at Baumgarten 
and Lanzhot, western 
border of Slovakia

(90% of technical)

De facto 161 bcm/
year of exit capacity 
is booked by 
Gazprom on the 
Ukrainian border 
with EU and Moldova

(100% of technical)

Entry capacities 
at Velke Kapusany 
and exit capacities 
at Baumgarten are 
booked

 

until the end 

of 2028

Capacities are 
booked by Gazprom 
until 

the end of 2019� 

Gazprom and top 
Russian politicians 
said they intended 
to 

halt gas transit 

after 2019

For 

capacities

For 

volume

 

transported
(thus booked 
capacities are not 
paid)

Available

 

at 

Baumgarten point

Blocked 

by Gazprom

Booked 

exit capacity?

Tenor of long-term 

bookings?

What Gazprom 

pays for?

Availability of VRFs 

on exit points?