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

OUR PERFORMANCE

ANNUAL REPORT 2017

101

100

KEY PROBLEM:

UNCOMPETITIVE AND HIGHLY POLITICIZED BEHAVIOR OF GAZPROM:

high risk of Gazprom’s non-compliance with Stockholm arbitration award
potential litigations incl. appeals and tariff revision
risk of loss of gas transit post-2019 due to non-market-driven behavior of Gazprom

INITIATIVES TO ADDRESS THE PROBLEM:

Gain scale to counterbalance Gazprom’s bargaining power (by leveraging on existing transit contract

and final decisions in Stockholm transit case)

Attract strong international partners to TSO

VALUE FOR OVERALL MARKET:

Positive effect for GDP, trade balance and sustainability of public finances
Ensuring development of infrastructure and related services
Full integration with the European gas market

for maintenance projects

to prevent any breach of

operational ability of Ukrainian

GTS. Capital investments

in this segment for the last

2 years were approximately

1.7 UAH billion/year, enough

for securing uninterrupted

transit flows.

GAS TRANSIT

Ukraine's gas transportation

system is one of the most

powerful in Europe. The

capacity at the entrance is

about 300 bcm, of which

23 bcm/year from the EU,

and its capacity at the exit

is 178.5 bcm/year, including

146 bcm/year towards the

EU and Turkey. The main

component of the Ukrainian

gas transmission system is a

network of trunk gas pipelines

and gas pipelines-branches,

which comprise the integral

technological complex that

operates in continuous mode.

The total length of the gas

pipelines operated by the

Naftogaz group is more than 38

thousand km.

Gas transit volumes,

bcm

82�2

93�5

2016

2017

14%

2017/2016

Gas transit results*,

UAH billion

24�6

14�5

2016

2017

The total volume of natural gas

transit in 2017 amounted to

93.5 bcm, which is more than

the actual figure for 2016 by

14% and is the highest volume

over the last six years. This

increase is due to the increased

demand for natural gas in

Europe mainly because of

weather factors.

The result of this business

segment in 2017 decreased

by 40% or by UAH 10 billion

compared to 2016. The reduction

of the result is basically caused

by a significant increase in

depreciation charges in 2017

- by UAH 16.5 billion. This

increase is due to events that

took place in early 2017 and led

to a significant increase in the

probability of zero gas transit

through the territory of Ukraine.

As a result, Ukrtransgaz revised

the remaining useful life of some

assets used in gas transit and

which will be decommissioned

after 31 December 2019 in such

conditions.

At the same time, an increase in

the volume of gas transit in 2017

improved the result by UAH 8.2

billion.

operating profit/(loss) before income tax

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HUNGARY

POLAND

Mozyr

Sudzha

Platove

Tekove

SLOVAKIA

ROMANIA

MOLDOVA

RUSSIA

BELARUS

Capacity

entry: 25.5

Capacity

entry: 107.5

Capacity

entry: 48.5

Capacity

entry: 13.0

Capacity

entry: 46.0

Capacity

exit: 32.5 entry: 3.3

Capacity

entry: 6.0

Capacity

exit: 26.8

Capacity

entry: 3.5

Capacity

exit: 4.5

Capacity

exit: 13.2 entry: 6.1

Capacity

exit: 98.4 entry: 15.5

Capacity

exit: 5.0 entry: 1.5

Capacity

entry: 28.9

Capacity

entry: 6.0

АТО

ZONE

7.9

7.1

5.9

5.7

6.4

6.5

5.9

1.1

0.6

0.5

2009

2010

2011

2012

2013

2014

2015

65.2

67.9

70.6

51.8

53.5

31.4

37.8

3.6

9.7

2009

2010

2011

2012

2013

2014

2015

2.8

3.4

3.8

3.9

3.5

3.7

0.1

0.9

0.1

2009

2010

2011

2012

2013

2014

2015

3.1

3.5

3.1

3.4

2.6

2.1

2009

2010

2011

2012

2013

2014

2015

5.4

4.3

3.3

2.8

0.5

2.4

2009

2010

2011

2012

2013

2014

2015

77.6

83.8

72.1

47.3

46.4

2009

2010

2011

2012

2013

2014

2015

8.6

11.1

9.5

9.4

10.5

7.4

7.5

2009

2010

2011

2012

2013

2014

2015

2009

2010

2011

2012

2013

2014

2015

19.4

21.1

15.2

13.1

12.8

2009

2010

2011

2012

2013

2014

2015

0.8

3.3

2.8

1.9

0.9

1.1

2009

2010

2011

2012

2013

2014

2015

0.7

0.9

0.7

0.6

0.0

0.0
0.0

2009

2010

2011

2012

2013

2014

2015

16.6

16.7

19.9

19.6

16.7

2009

2010

2011

2012

2013

2014

2015

3.2

3.1

2.4

2.8

2.9

2009

2010

2011

2012

2013

2014

2015

0.3

0.7

0.3

0.2

2009

2010

2011

2012

2013
2014

2015

8.1

3.7

4.4

5.7

2009

2010

2011

2012

2013

2014

2015

Gas flow
to Ukraine

Transit
through Ukraine

134.4

98.6

2010

137.7

104.2

2011

118.0

84.3

2012

114.2

86.1

2013

81.8

62.2

2014

83.5

67.1

2015

93.3

82.2

2016

107.6

93.5

2017

122.8

95.8

2009

0.0

0.1

5.1

1.3

0.9

0.0

Source: Ukrtransgaz, 2017

Capacity

exit: 32.5 entry: 3.3

Designed GTS exit capacity

Gas metering

stations located

close to the border

Designed GTS entry capacity

Gas volume transmitted
on GTS entry

Gas volume transmitted

on GTS exit

2016

2017

2016

0.0

2017

2016

1.6

2016

16.5

19.2

2017

1.6

2016

0.0

2017

0.0

2016

7.1

2017

6.6

2016

57.0

2017

66.2

2016

0.0

2017

0.0

2016

0.0

2017

0.0

2016

1.0

4.5

2017

1.3

4.7

2016

9.1

48.8

2017

9.9

53.5

2016

1.0

6.7

2017

2.8

11.7

0.7

2016

0.7

2017

3.0

2016

2.8

2017

18.5

2016

20.2

2017

0.0

Kobryn

Valuiky

Serebrianka

Pysarivka

Sokhranivk

Drozdovychi

Uzhhorod

Berehove

Oleksiivka

Orlivka

93.5

bcm

In 2017, the volume
of natural gas transit
to Europe reached

UKRAINE’S GTS 2017

bcm

Prokhorivka

temporarily occupied and uncontrolled territories

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OUR PERFORMANCE

ANNUAL REPORT 2017

105

104

KEY RESULTS OF THIS BUSINESS SEGMENT:

• ROIC in 2017 (0.01%) was significantly lower than cost of capital (11.9%)
• Rapid accumulation of debt for unauthorized gas withdrawal (UAH 20.0 bn as of 31/12/17, +38% y-o-y)
• Uninterrupted gas supplies to vulnerable local consumers during March 2018 artificial crisis created

by Gazprom

• Total domestic transmission volumes – 27.4 bcm (-7% y-o-y)
• Maximal gas imports from European direction – 14.1 bcm (+27% y-o-y), including 5.4 bcm for third parties

(+84% y-o-y)

Gas domestic transmission

is the third largest business

of Naftogaz group (11% of

revenues), but it remained

one of key underperforming

segments in 2017. ROIC

remained almost nil in 2017

ROIC is calculated as NOPLAT for the respective

year divided by invested capital, which was
determined as the 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 the gas transmission
system (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 the
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.

(compared to 11.9% as cost

of capital

), with NOPLAT

equal just to UAH 3 million

(compared to UAH 2.5 billion

in 2016).

Cost of capital is estimated by independent
appraisals in USD to determine the fair value of
gas transmission assets of PJSC “National Joint
Stock Company “Naftogaz of Ukraine”” as of
31/12/2017.

Key reasons behind such results

in 2017 were:

• the accumulation of bad

debts for unauthorized

gas withdrawal caused by

regulatory flaws in secondary

legislation and the unfair

behavior of some network

users (see Nature of debt for

unauthorized gas withdrawals);

• the shift to domestic cost-

reflective tariffs is not finalized

yet (e.g. implementation

of domestic entry tariffs is

blocked by court decision).

USD-denominated ROIC vs

cost of capital, %

2016

2017

6�79%

0�01%

11�89%

ROIC, %
Cost of capital, %

Debt for unauthorized gas

withdrawal, UAH bn

01�01�2016

01�01� 2017

6�6

20�0

4�1

14�5

Gross amount
Provision for impairment

GAS DOMESTIC TRANSMISSION

NATURE OF DEBT FOR UNAUTHORIZED GAS WITHDRAWAL

Kharkivmiskgaz
Donetskoblgaz
Kryvorizhgaz
Dnipropetrovskgaz
Kyivoblgaz
Other 57 companies

19%

15%

12%

40%

24.7

UAH bn

Debts for unauthorized gas

withdrawal by Ukrtransgaz’s

counterparts as of 31�03�2018

As of today, Ukrtransgaz as

a GTS operator balances the

system for transmission service

customers on a monthly basis

(i.e. based on the actual data

in accordance with the signed

monthly acceptance-transfer

acts). This creates high risks for

the business for the settlement

of imbalances between the

transmission service customers

according to the results of

the month. For this reason,

the requirements for financial

security, which is linked to the

In March 2018, the total counterparties debts to Ukrtransgaz for unauthorized withdrawal of gas

had increased by UAH 3�3 bn

The circumstances that led to the emergence of significant volumes of negative gas imbalance

are related to the entry into force on 27 November 2015 of the Resolution of the NCREU No. 2493

of 30 September 2015 "On Approval of the Code of the Gas Transportation System". According

to this resolution, the operators of the gas distribution system were obliged to perform the

allocation, i.e. the confirmation of the distribution of natural gas submitted for transportation

to and actually withdrawn from gas distribution systems. Therefore, operators of the gas

distribution system actually got the opportunity to include unauthorized withdrawal of natural

gas in their networks in the allocation to other customers, in particular, to Naftogaz.

The consumed volumes of natural gas for which no nomination has been submitted and the

supply of which has not been documented by Naftogaz are considered unauthorized and should

be reimbursed by the respective gas distribution system operator in favor of PJSC Ukrtransgaz.

However, gas distribution systems operators failed to comply with the requirements of the current

legislation of Ukraine

and continued to perform allocation and report on the actual volumes of

natural gas distribution by suppliers in which not themselves but Naftogaz

was indicated as the

supplier of natural gas.

As of January 2018, almost 70 cases initiated by Ukrtransgaz against its debtors on collection

for transportation services, including for unauthorized gas withdrawal, are pending before

the commercial courts. The enforcement services are in process of enforcement of more than

50 orders for the collection for natural gas transmission services, including for balancing services

and penalties.

The illegitimacy of such actions by gas distribution system operators is confirmed by the decision of the Kyiv Commercial Court of Appeal dated

15.02.107 and the Supreme Commercial Court dated 06.07.2017 on case No. 910/10225/16. This established that the consumed volumes of natural
gas for which no nomination has been submitted and the supply of which have not been documented by Naftogaz constitute unauthorized with-
drawal and should be reimbursed by the respective gas distribution system operators in favor of PJSC Ukrtransgaz.

Following the introduction of Resolution No.615 dated of 28 April 2017, Ukrtransgaz performed allocation of actual volumes of natural gas by customers of
transmission services with the goal to determine imbalance volumes of such customers for the certain period.

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OUR PERFORMANCE

ANNUAL REPORT 2017

107

106

monthly transmission volumes,

are rather high.

The introduction of daily

balancing

will reduce the

risks for all natural gas market

participants and, as a result, will

reduce the financial burden on

transmission service customers.

In addition, daily balancing

will allow for the launch of a

full-fledged market of short-

term products (one day ahead,

during the day) and stock

trading, where international

traders and domestic

producing companies will be

able to trade, and will allow full

usage of the underground gas

storage facilities.

Ukrtransgaz as a GTS operator

is currently in the process

of launching an information

platform

and administering

the market of bilateral exchange

trade agreements using a

model that will fully meet the

requirements of the EU’s Third

Energy Package. At the same

time, Naftogaz is guided in

this process by the following

principles:

• introduction of European

network codes in Ukraine

(including on balancing)

• takes the position that the

Market Regulator’s role is to

approve or not approve the

code developed by the GTS

On 27 December 2017, the NCREU approved

Resolution No. 1437, which provides for the
introduction of daily balancing from 1 August
2018. According to the resolution, the operator
of the gas transmission system will be
responsible for ensuring daily balancing of all
users of the system, informing the customers
about the expected imbalances during the
day of transmission, receiving and processing
of daily allocation, and calculating customer
imbalances per day, which requires the
appropriate software and business process
optimization.

As of the date of this report, an independent

technical audit by an international company
found that the information system that
is in place in Ukrtransgaz does not meet
the requirements for systems of this level
and is exposed to unreasonable risks. The
management of Ukrtransgaz is currently
working out ways to address this situation.

operator, rather than create its

own code or modify separate

articles of the code developed

by the GTS operator.

Naftogaz's interest in bringing

the rules into line with European

standards, in particular in the

gas transmission segment, is as

follows:

1. European rules will allow for

a more efficient balancing

of supply and demand that

means more efficient gas

consumption and supply.

Greater efficiency means less

import that brings the market

closer to energy independence.

Moreover, greater efficiency

would lead to better consumer

solvency.

2. Opportunities for abuse by

unfair market participants,

who use Naftogaz's gas free

of charge, will diminish.

3. Transparency, clear and fair

European rules, elimination

of opportunities for manual

control at the GTS operator's

level for corruption purposes

is a guarantee for Naftogaz

that the GTS operator will

not be a tool for pumping

money from state-owned

companies.

In the implementation of

European norms, another major

problem for the GTS operator is

to generate revenue that covers

all its costs. In this regard, the

incomplete shift to the RAB

tariffs at the internal entry and

exit points is the critical issue:

• as of the date of this report,

the tariffs for the points of exit

from the gas transportation

system to Ukrainian

consumers are not approved

by the NCREU;

• the establishment of tariffs for

the natural gas transmission

services for internal points

of entry was suspended by

a decision of the District

Administrative Court of Kyiv

dated 27 April 2017

Claimer in this case was a People's Deputy
(whose name is not indicated) who mentioned
that the National Commission illegally and
incorrectly replaced the resolution of 28.03.2017
with a new resolution of 10.04.2017 instead of
abolishing this document.

1.2

UAH billion per year

REVENUE TO BE

LOST

BY THE GROUP AS A RESULT

OF NON PAYMENTS AT DOMESTIC ENTRY POINTS

1) Establishment of the branch "Operator of the Gas Transportation System of Ukraine"

In pursuance of the company's Restructuring Plan designed to separate gas transmission and

storage activities (unbundling) approved by the Cabinet of Ministers of Ukraine Resolution

No. 496, in October 2017, a branch of OJSC Ukrtransgas named "Operator of the Gas

Transportation System of Ukraine" (OGTSU) with GTS operator functions was established.

At present, OGTSU provides operational management of the Ukrainian GTS and is a functionally

self-sufficient structural unit with an approved organizational structure and staff schedule for

290 positions. As of 31 December 2017, the OGTSUU is staffed with 189 employees. The branch

serves more than 1000 gas transmission contracts in Ukraine.

2) Shift to transparent procedure for purchasing gas for own needs

In 2017, Ukrtransgaz conducted tenders for the purchase of natural gas for its own production

and technical needs through the electronic public procurement system ProZorro, which

resulted in improved transparency and made it possible to save UAH 3.8 billion. In total,

13 auctions (23 lots) with a total volume of 4.7 bcm of natural gas were conducted.

15 companies participated in the tender, including subsidiaries of the international gas traders

The Trafigura group and MET group.

Key achievements of the segment in 2017:

• continue work on daily balancing introduction

• carry out legal collection of the accumulated debts for unauthorized gas withdrawal (which reached

almost USD 1 billion)

• facilitate the finalization of introduction of entry/exit tariffs for internal points

• optimize operating costs and processes to bring them into line with European counterparts, to

develop additional functions that are common for standard European GTS operators. As part of this

process, the group considers the option of involving a technology partner for the GTS operator

• start the procedure for selling future capacity in the framework of the Poland-Ukraine interconnector

construction project (this will allow better understanding of the demand for these capacities and to

attract part of the investments required for project implementation)

Group’s plans for the business in 2018:

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OUR PERFORMANCE

ANNUAL REPORT 2017

109

108

GAS DOMESTIC

TRANSMISSION

The Ukrainian gas transmission

system also provides domestic

gas transportation services for

Ukrainian consumers. Since

the end of 2015, Ukrtransgaz

has been offering two new

types of services: balancing

service (physical balancing and

commercial balancing), and since

the beginning of 2016 - capacity

distribution service for cross-

border entry points (import) due

to the transition to RAB tariffs.

Pursuant to the Code of the

gas transmission system,

Ukrtransgaz provides the

customer with one or several

components of natural gas

transportation services (capacity

distribution order, natural gas

transportation order, balancing

service). Customers who ordered

transportation services pay the

operator of the gas transmission

system the cost of the services

received.

The system balancing service

includes:

• commercial balancing -

activity of the gas transmission

system operator which

consists of identifying and

adjusting the imbalance that

arises from the difference

between the volumes of

natural gas entering through

the entry points and the

volumes of natural gas exiting

through the exit points in

the context of the customers

who ordered transportation

services, whereas such activity

is carried out on the basis of

data received through the

allocation procedure; and

• physical balancing -

measures taken by the

operator of the gas

transmission system to

ensure the integrity of the

system, namely the necessary

ratio between natural gas

volumes that have physically

entered through entry points

and natural gas volumes

that have physically been

removed through exit points.

In March 2017, the NCREU

approved UTG's transmission

tariffs for Ukrainian consumers

at entry and exit points as well

as gas distribution tariffs for

distribution system operators

calculated based on connected

capacity according to new

methodology. However, in

April 2017 the NCREU adopted

another resolution which

cancelled its previous decisions

on transmission and distribution

tariffs set as payment for utilized

capacity. The award by the

Kyiv District Administrative

Court of 27 April 2017 stopped

the NCREU's Regulation

№348 of 28.03.2017 “On

UTG's transmission tariffs for

Ukrainian consumers at entry

and exit points”. Naftogaz group

continues to emphasize that

gas transmission tariffs for both

transit and domestic supply

must be non-discriminatory as

required in Directive 2009/73/EU

on common rules for domestic

gas market and Regulation

(EU) 715/2009 on access to

gas transmission systems. This

requires an urgent transition

to tariffs based on long-term

incentive-based regulation

according to the methodology

approved in the resolution

The volume of natural gas

transportation for consumers in

NCREU Resolution “On denouncing some NCREU
Resolutions” dated 10.04.17 No.494

NCREU Resolution dated 30.09.15 N

2517

Natural gas volumes transmitted to

consumers in Ukraine

Natural gas volumes transmitted

through cross-border points

(transmission capacity

at the entry points)

The volume of natural gas transportation and distribution to

customers outside the group, bcm

29�5

5�4

27�4

2�9

2016

2017

-7%

2017/2016

+84%

2017/2016

Ukraine in 2017 decreased by

7% compared to the previous

year due to the reduction in

the total volume of natural gas

consumption because of factors

described in the Gas production,

imports and sales to various

consumer categories section.

The volume of capacity

distribution at the points of

entry/exit in 2017 increased by

84% due to a decrease in the

total natural gas imports to

Ukraine by companies outside

the group.

The result of this business

decreased by UAH 3 billion

in 2017 compared with 2016.

The major negative factor was

the increase in doubtful debt

allowance caused mostly by

unauthorized gas withdrawal

and relevant reserves generated

because of the failure by gas

distribution operators to comply

with Ukrainian law (see “Nature

of debts for unauthorized gas

withdrawal” section).

Gas domestic

transmission results*,

UAH billion

3�1

0�004

2016

2017

6�2

2016

The level of settlements

for unauthorized gas

withdrawal, UAH billion

% of settlements,

including

% of settlements

by subsidies

16�1

2017

operating profit/(loss)

before income tax

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OUR PERFORMANCE

ANNUAL REPORT 2017

111

110

UNDERGROUND

GAS STORAGE

KEY RESULTS OF THIS BUSINESS:

•  Injection volumes by third parties – 1.5 bcm (15% of total injection volumes, incl. by the group).
•  Withdrawal volumes by third parties – 1.0 bcm (13% of total withdrawal volumes, incl. by the group).
•  Negative ROIC in 2017 (-0.35%).

31% of carrying PP&E value as of

31.12.17 allocated to gas storage

business. It makes this segment

the second largest business

after Gas Transit in terms of

invested capital. However, with

low demand for gas storage

services in Ukraine from the

third parties (gas storage system

is used mainly for security of

gas sales and supply by the

group), revenues of this business

constituted less than 0.1% of

2017 group’s revenues.

In terms of NOPLAT, the results

of gas storage business are

even worse – this indicator was

negative (-329 UAH million)

in 2017. As a result, ROIC

this business is also below

zero: on average it was -0.36%

in 2016-2017. Therefore, the

key problem of this business

ROIC is calculated as NOPLAT for the respective
year divided by invested capital, which was
determined 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 the NBU
average annual exchange rate for NOPLAT and
exchange rate as of the end of respective year
for invested capital (in order to compare USD-
denominated ROIC with USD-denominated сost
of сapital, used by independent appraisers). The
capital invested in fixed assets was estimated
based on net replacement costs less physical
depreciation of Underground Gas Storages
(see page 25 of 2017 Consolidated Financial
Statements). 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.

is that it faces a substantial

gap between ROIC and its

сost of сapital

(estimated as

11.89%) due to significantly

underutilized UGSF capacities.

Comparison of ROIC with сost

of сapital reveals that invested

capital is used ineffectively and

additional economic value is

not created

68.

Cost of capital is estimated by independent
appraisals in USD to determine the fair value of
gas storage assets of PJSC “National Joint Stock
Company “Naftogaz of Ukraine”” as of 31/12/2017.

At the same time, the value for group’s customers
from the use of gas storage capacities utilized
by the group itself (mostly related to security of
supply initiatives) is significant.

Low utilization of gas storage by

third parties and resulting poor

financial results of this segment

are explained by:

– Highly excessive gas

storage capacities due to

‘historical heritage’. Among

European countries, Ukraine

has the largest capacity

of UGSFs, and most of

them are concentrated in

Western Ukraine. During

their development, their

main purpose was to ensure

uninterrupted supplies of

gas from the Soviet Union

to European countries. The

Revenues of gas storage

business (from third

parties), UAH million

2014

2015

2016

2017

338

401

184

purpose of other UGS was

to ensure the supply of gas

to regional consumers at

the location of the UGS and

to compensate for seasonal

and daily fluctuations in

demand. Due to significant

decrease in gas transit

volumes through Ukraine

(which was ~140 bcm

in the late 1990s) and

domestic consumption

(up to 120 bcm in early

1990s) demand for seasonal

and peak storage has

significantly decreased.

– High cost of capital in

Ukraine and narrower

summer-winter spread on

European markets makes

maximum import in summer

commercially unattractive.

– Problems with international

traders’ perception of credit

risks related to Ukrainian

counterparties. Perception

of legal risks, associated with

storage of gas in Ukrainian

gas storages.

– Specifics of national

emergency plan on the

gas market. In accordance

with the government’s

decree #860 of 16 November

2016, in case of emergency,

suppliers of natural gas are

obliged to create a security

stock of 10% of expected

monthly supply volumes to

their consumers. According

to the same decree, security

stock in 2016-2017 security

stock was equal to zero. As a

result, there was no demand

for storage services related

to security of supply (from

private suppliers).

Due to the large total capacity

of UGS, Ukraine has 10-15 bcm

of spare capacity that could

be offered to European

consumers. As mentioned

above, the largest storage

capacities are located at the

western border of Ukraine,

at the crossroads of key

gas pipelines that link GTS

of Ukraine, Belarus, Poland,

Slovakia, Hungary and

Romania. The major share of

gas transit from Russia also

passes through these gas

transmission routes.

Based on the initiative to

increase utilization of Ukrainian

UGS by private traders, on 1

June 2017, following a year

of joint efforts of Ukrtransgaz,

Naftogaz, the Ministry of

Finance, and the Power

Customs Office of the State

Fiscal Service of Ukraine,

Ukrtransgaz was granted

permission to open and

operate a customs warehouse

using Ukraine’s UGS. This

enables gas traders to store

natural gas for over 1000 days

without customs clearance

With the new option, all gas

traders are able to store their

gas on Ukrainian territory

for up to 1095 days without

paying taxes and customs

duties if the gas is going to be

transported away from Ukraine.

All legal barriers have been

thus removed in Ukrainian

regulations for providing non-

residents with the services of

gas storage in UGS facilities.

On 13 June 2017, Ukrtransgaz

pumped the first 3 million

cubic meters into gas storage

in the "customs warehouse"

mode, commissioned by

leading international traders

TrafiguraSarl (Switzerland),

Trafigura Ukraine and MND

(Czech Rep.). Actual processing

of natural gas in this "customs

warehouse" regime began

in late August 2017, and

within the next four months,

Ukrtransgaz concluded 23

contracts with international and

Ukrainian traders for the total

volume of 52.7 mcm.

At the same time, based on

analysis of the gas storage

market in Europe, management

Previously, it was possible to clear natural gas
transported to the customs territory of Ukraine
only in ‘customs transit’ mode. In this case, the
Customs Code of Ukraine allows for 31 days
to secure customs clearance for gas. These
conditions were not economically attractive for
most foreign gas traders.

EUR/

MWh

Historical summer/winter price spread on TTF hub

2010

2011

2012

2013

2014

2015

2016

2017

0.3

2.9

12.8

14.3

4.8

0.8

1.4

2.5

3.3

30.9

3.1

0.6

24.6

9.0

3.5

6.4

0.5

2.6

17.8

1.9

2.1

2.3

17.0

1.3

0.7

0.4

1.5

0.3

Overview of EUgas storage capacity

145.8

bcm

30.9

bcm

Acquifer

Salt cavity

Depleted O&G field

Other

Ukraine

Total capacity

ROIC, %
Cost of capital, %

Gas storage business:

USD-denominated ROIC vs

сost of capital, %

2016

2017

-0�37%

-0�35%

11�89%

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

OUR PERFORMANCE

ANNUAL REPORT 2017

113

112

realizes that there is limited

opportunity to increase

utilization of Ukrainian storages

by leveraging international

demand. Over the last 7

years we observed significant

decrease of gas consumption

in most European countries,

combined with increases of

domestic gas storage facilities,

creating oversupply and

pressure on gas storage tariffs

(this has led to concerns of

lower use of gas storage and

has even to closure of some

gas storage facilities in Europe).

Market participants can choose

alternatives to gas storage

such as flexible gas production,

import contracts, line pack,

swaps, interruptible contracts,

scale down contracts, LNG etc.

Due to such expectations,

a large study of UGSFs in

Ukraine was launched in 2017.

Storengy, one of the leading

operators of underground

gas storages in the world, in

consortium with a top global

management consulting

firm and the international

law firm CMS Cameron

McKenna Nabarro Olswang,

are contributing to this

comprehensive study. This

strategic, technical and legal

assistance project, funded by

the European Union bilateral

program with Ukraine, is

designed to build up a

sustainable business case for

Ukraine’s underground gas

storage facilities in the context

of the European and Ukrainian

energy markets. The project

encompasses a trustworthy

and up-to-date analysis of

the technical, commercial

and legal viability of each

underground gas storage

facility, with recommendations

in terms of their optimal

usage and strategic fit while

considering opportunity

cost of invested capital (in

particular, value of cushion

gas). Several scenarios are to

be generated and adequate

strategic options developed

with a roadmap to ensure

efficient implementation of

preferred option.

Although the project is still

underway and the estimations

are preliminary, it is apparent

that:

– current active capacity should

be significantly adjusted;

– under the most probable

scenario, international

demand is very modest or

insignificant;

– even with such an adjustment

and non-zero international

demand, there is an excessive

capacity.

On top of low utilization of UGS,

the segment’s negative financial

result may be partly attributed

to the currently economically

unfeasible tariffs for natural gas

storage. As of the date of this

report, the Regulator still has not

approved new higher regulated

tariffs

calculated based on the

methodology agreed in 2016.

In future, the group expects

to transition to RAB tariffs for

gas storage, with a cap based

on a competitive level of tariffs

in neighboring European

countries. That will ensure fair

returns from the regulatory asset

base and improve the segment’s

result.

Though all supporting calculations were filed
with the Regulator by the designated operator
of UGS, Ukrtransgaz

KEY PROBLEM:

Excessive UGS capacities, value-destroying business

INITIATIVES TO ADDRESS THE PROBLEM:

Maximization of value by:

Identification and possible decommissioning/mothballing of

identified excessive UGS

OPEX savings on labor intensity

VALUE FOR OVERALL MARKET:

Increase of gas production from excessive storages – faster

transition to energy independence

Financially sustainable security of supply

Movement of gas in storage facilities in 2017

310

Design capacity (mcm)

Free capacity (annual average)
Volume stored (annual average)

[%] Activity (movement)

Pumped in
Withdrawn

6 674

2 423

10 376

3 987

BILCHE-VOLYTSKO-UHORSKE

41.10%

17 050

455

242

1 446

312

UHERSKE

3.60%

1 900

287

407

1 633

583

OPARSKE

6.30%

1 920

468

526

532

577

PROLETARSKE

7.10%

1 000

147

273

160

KRASNOPOPIVSKE

2.00%

420

176

224

VERHUNSKE

0.00%

400

214

OLYSHIVSKE

0.00%

310

464

244

236

460

KEHYCHIVSKE

4.50%

700

936

205

364

207

SOLOHIVSKE

2.60%

1 300

857

430

643

559

CHERVONOPARTYZANSKE

6.30%

1 500

1 251

738

899

939

DASHAVSKE

10.80%

2 150

1 041

1 078

1 259

1 364

BOHORODCHANSKE

15.70%

2 300

GAS STORAGE

The volume of UGS injection/withdrawal to customers outside

the group, bcm

Ukrtransgaz manages one of

the largest gas storage networks

in Europe. It is an important

integral technological part of

the Ukrainian gas transmission

system. Today 12 storage facilities

are in operation, two of which

are based on water-bearing

structures. The rest are based

on depleted gas fields. The total

capacity of the gas storage

facilities is about 31 bcm.

The storage facilities are multi-

purpose objects. They are used

to ensure the smooth and

efficient delivery of natural

gas to consumers, reliable gas

transit through Ukraine to the

EU, and to serve as long-term

gas emergency reserves and

balancing peaks periods in gas

consumption.

2016

2017

Gas injected into

UGS

Gas withdrawal

from UGS

0�9

1�5

1�0

1�8

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OUR PERFORMANCE

ANNUAL REPORT 2017

115

114

Gas storage results*

UAH billion

0�5

–0�5

–1�0

–0�3

2016

2017

The group provides gas storage

services in its storage facilities

to both gas suppliers and

consumers.

The volume of natural gas

withdrawn from underground

gas storage facilities in 2017

is less than in 2016 by 46%,

which is the result of a later

start of the heating season:

active withdrawal of gas from

the UGS in 2017 started on 1

November 2017, two weeks

later than during the heating

season in 2016/2017. At the

same time, the total volume

of natural gas injected into

underground gas storage

facilities in 2017 compared to

2016 increased by 75% due to

more active pumping of natural

gas into UGS in May-September

2017. The group's stocks at

the beginning of the heating

season (that is, as of 15 October

2017) 2017/2018 amounted to

16.8 bcm, which is 14% more

than in the same period of

2016.

The results of natural gas

storage business in 2017 did not

change much compared to 2016

and it remained a loss making

segment. The negative trend

of the business indicates that

tariffs on natural gas storage

are economically unreasonable.

The group expects in 2018 to

switch to the RAB methodology

for calculating gas storage

tariffs, which will ensure that

fair returns are accrued on the

regulatory asset base and lead

to improved business outcomes.

* operating profit/(loss) before income tax

OIL TRANSIT AND DOMESTIC

TRANSMISSION

KEY ACHIEVEMENTS IN 2017:

13.9 million tons – 0.8% increase in oil transit volumes through oil transmission pipelines

Volumes of oil transmission to Ukrainian refineries increased by 64.1% to 1.7 million tons.

Operation of the oil pipeline Odesa-Kremenchuk section and the first phase of Mozyr-Brody oil

pipeline were renewed

In January 2018, Ukrtransnafta and Ukrtatnafta concluded an amicable settlement to a three-year

dispute on the value of storage and the terms for returning the crude oil linefill in the amount of

239 thousand t, which had been stored in the Kremenchuk refinery reservoirs since 2014

ROIC for the oil transit and transmission was 6% in 2017, which is less than the appraiser’s cost

of capital (17.4%). ROIC for oil transmission business (-6.3%) was the lowest among Naftogaz’s

businesses in 2017

Oil transmission through

Ukrainian oil pipelines is

performed by Ukrtransnafta,

which is a part of Naftogaz

group. The oil transmission

system includes 19 oil

pipelines with a one-line total

length of 4767 km, the entry

capacity of 114 million tons

and exit capacity of 56.3

million tons. Ukrtransnafta

comprises the Druzhba Oil

Pipelines, Prydniprovski Oil

pipelines and Southern Oil

Pipelines.

In 2017, decline in domestic

production of oil was partly

compensated by higher

imports, resulting in marginal

improvement of ROIC.

Nevertheless, ROIC

of oil the

domestic transmission business

was still negative, the lowest

among other businesses in 2017

(-6.3%), and lower than the cost of

capital for this business

(17.4%).

This situation was caused by the

following key factors:

• low utilization of the system

owing to domestic crude

oil production decline for

ROIC is calculated as NOPLAT divided by the sum
of invested capital in fixed assets (associated
and allocated to domestic oil transmission
system) and net working capital. Value of
invested capital in fixed assets is equal to
the amount of depreciated replacement cost
before the test for economic obsolescence,
estimated by independent appraisers during
determination of fair value of oil transmission
assets of Naftogaz as of 31.12.2017.

Cost of capital is estimated by independent
appraisers to determine the fair value of oil
transmission assets of Naftogaz as of 31.12.2017.

the last ten years and low

level of demand for oil from

local Ukrainian refineries

(see section “Oil and gas

condensate”);

• approximately 20% of oil

transmission pipelines are

mothballed, but maintenance

and repair costs associated

with these assets remain;

• oil transmission tariffs are

regulated and do not even

cover the operating costs of

Ukrtransnafta.

ROIC of oil transit business

(app.20% for 2016-2017)

exceeded the cost of capital

(17.4%), mostly due to

unregulated tariffs for oil transit

and low amount of invested

capital allocated to this business.

The value of the oil transmission

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НАК „НАФТОГАЗ УКРАЇНИ“. Річний звіт англійською (2017 рік) - 7