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НАК „НАФТОГАЗ УКРАЇНИ“. Річний звіт англійською (2018 рік) - 4

2018

OPERATIONS

ANNUAL REPORT 2018

INTEGRATED GAS

BUSINESS DELIVERY UNIT

Integrated Gas Business Delivery Unit structure

Integrated Gas Business Delivery Unit

(further – Integrated Gas or Integrated

Gas BDU) includes all activities of

Naftogaz group related to exploration

and production of domestic natural gas

and liquid hydrocarbons, imports, sales,

trading, supply and distribution activities

of Naftogaz group.

The Integrated Gas BDU composition

aims to enable end-to-end P&L

responsibility for gas-related activities –

from producing or importing a molecule

of hydrocarbons to getting it to the final

customer of Naftogaz group. Integrated

Gas primarily focuses on the following

sets of activities along the gas value

chain:

1) in upstream, Integrated Gas focuses

on growth and commercialization

of the hydrocarbons reserve base

of Naftogaz group through effective

management of its brownfield

and greenfield license portfolio,

improving its own geological and

reservoir management capabilities

and exploring partnership options

for de-risking and accelerating

reserve development;

2) in midstream, Integrated Gas focuses

on working efficiently with the

transmission & storage business of

Naftogaz group to ensure security

of supply while optimizing capital

investment into natural gas stocks;

3) in downstream, Integrated Gas focuses

on developing trading capability while

building out its retail function and

working on its accounts receivable

portfolio.

HYDROCARBON RESERVES AND RESOURCES OF NAFTOGAZ GROUP

Natural gas, bcm Oil and gas

condensate, mmt

Natural gas (mmboe)*

Oil and gas

condensate

(mmbbls)*

Naftogaz**

proven developed

proven undeveloped

probable

production of hydrocarbons

increase in hydrocarbons reserves

Reserves as of 31.12.2018

Resources as of 01.01.2018

34.96

1.31

209.73

9.52

resources located in the Joint Forces Operation (JFO) zone and the

annexed territory

34.96

1.31

209.73

9.52

Resources as of 01.01.2016 (excluding the JFO zone and the annexed

territory)

Ukrgasvydobuvannya

proven developed

201.73

4.03

1 210.37

36.40

proven undeveloped

17.34

1.09

104.06

10.27

probable

28.87

1.49

173.19

11.53

production from 1.07.2017 till 31.12.2018 (2)

23.27

0.68

139.62

5.94

increase in hydrocarbons reserves in 2017 and 2018 (1)

31.63

1.96

189.76

14.25

Reserves as of 31.12.2018

256.29

7.9

1 537.16

66.51

Resources as of 30.06.2018 (3)

25.84

155.06

Ukrnafta

proven developed

14.52

14.48

87.10

105.42

proven undeveloped

7.50

9.66

45.00

72.96

probable

10.72

16.28

64.34

121.37

production from 01.07.2016 till 31.12.2018 (2)

2.84

3.58

17.01

21.49

increase in hydrocarbons reserves from 01.07.2016 till 31.12.2018

Reserves as of 31.12.2018

29.90

36.83

179.43

278.25

Resources as of 01.01.2018 (4)

17.12

20.63

102.74

150.19

Egypt

proven developed (5)

0.27

0.40

1.65

2.91

proven undeveloped (5)

0.12

0.14

0.73

1.06

probable

0.06

0.16

0.39

1.17

production of hydrocarbons from 1.04.18 till 31.12.18 (2)

0.03

0.07

0.15

0.52

increase in hydrocarbons reserves

Reserves as of 31.12.2018

0.44

0.63

2.62

4.62

Resources as of 01.01.2018

0.37

1.15

2.20

8.42

Group

proven developed

216.52

18.91

1 299.12

144.72

proven undeveloped

24.97

10.89

149.79

84.29

probable

39.65

17.93

237.92

134.06

production of hydrocarbons (2)

26.13

4.33

156.78

27.95

increase in hydrocarbons reserves (2)

31.63

1.96

189.76

14.25

Reserves as of 31.12.2018

286.63

45.36

1719.21

349.38

Resources as of 31.12.2018

43.33

21.78

256.41

158.55

Sources:

The audit of hydrocarbon reserves of Ukrgasvydobuvannya performed by Miller and Lents as of 30 June 2017. The audit of reserves, revenue and resources in some deposits of Ukrnafta
performed by DeGolyer and MacNaughton as of 1 July 2016. The audit of hydrocarbon reserves of Naftogaz group in the Arab Republic of Egypt and additional report on assessment of
contingent and prospective resources performed by Ryder Scott as of 30 April 2018. The audit of the group’s reserves with assessment of prospective resources of Naftogaz of Ukraine
performed by Ryder Scott as of 31 December 2014.

* To convert the volumes of oil and gas condensate into barrels, ratios according to the audit and their physical properties were used: for oil deposits in the ARE, a ratio of

7.33 bbl/t was used; for light liquid hydrocarbons (mostly condensate) of the deposits of Ukragazvydobuvannya, the ratio varies from 7.75 to 9.4 bbl/t (average 8.8 bbl/t); for
Ukrnafta, the ratios vary from 7.22 to 7.42 bbl/t for oil and from 8.07 to 8.61 bbl/t for condensate; in the event of lack of updated audited ratios, a ratio of 7.28 bbl/t was used.
To convert volumes of natural gas into oil equivalent, a ratio of 1 boe = 167 cubic m was used.

** In 2017, State Geological and Subsurface Survey of Ukraine (SGSSU) annulled special permits for the use of subsoil and Naftogaz’s right explorated within the Budyschan-

sko-Chutivsky, Obolonsky and Pysarivsky permits, and licensed fields located in the ATO zone and Black Sea and Azov Sea areas were expropriated, therefore Naftogaz’s
resources of hydrocarbons as of 31 December 2018 are zero.

(1) - an increase in hydrocarbon reserves of Ukrgasvydobuvannya is not audited under SPE PRMS and is the company’s estimate in accordance with the Ukrainian classification

(audits are expected in May-June 2019);

(2) - cumulative production data of Ukrgasvydobuvannya since the last audit of reserves and resources till 31 December 2018 are presented;
(3) – volumes of liquid hydrocarbons of perspective resources of Ukrgasvydobuvannya were converted into gas volume equivalent using a constant ratio of 6 mcf/boe
(4) – Contingent resources resources of Ukrnafta (Contingent resources) with uncertain probability of commercialization, and the application of risk factors does not equalize this

probability with the class of recoverable reserves;

(5) – proved volumes of commercial extractable hydrocarbon reserves in the ARE include volumes of hydrocarbons classified as contingent resources (2C Contingent resources,

under SPE PRMS) due to the lack of a full-scale field development project approved by the shareholders.

Integrated Gas Business Delivery Unit structure

Gas production, import and sales to

RSC’s for resale to households

and direct supply to households

Gas production, imports and supply

to MHEs for the needs of households

Gas production, imports and supply

to other customers under PSO

Gas imports and supply

to other customers outside PSO

Oil and condensate production

Naftogaz

Teplo

Exploration

Production

Imports

Transmission

Storage

Gas

wholesale

Distribution

Supply

Ukrgasvydobuvannya

Naftogaz

of Ukraine

Naftogaz

Trading

Europe

Naftogaz

Trading

Naftogaz

of Ukraine

Kirovogradgaz

GSC

Naftogaz of Ukraine

Integrated Gas Business Delivery Unit

Not applicable

The geographical breakdown of natural gas production by UGV in 2018, mcm

Total

15 497

mcm

KHARKIV

DNIPROPETROVSK

POLTAVA

LUHANSK

DONETSK

SUMY

CHERNIVTSI

VOLYN

LVIV

IVANO-FRANKIVSK

ZAKARPATTYA

8 003

6 261

431

144

554

0,6

Source: Ukrgasvydobuvannya

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

DONETSK

REGION

DNIPROPETROVSK

REGION

KHARKIV

REGION

POLTAVA

REGION

SUMY

REGION

Yefremivka gas and
condensate field

Medvedivka

gas and

condensate

field

Melyhivka

gas and

condensate

field

Shebelynka gas and
condensate field

Kehychivka

gas and

condensate

field

Kobzivka
gas and
condensate
field

Mashivka gas and
condensate field

35.5

68%

75%

64%

19%

65%

51%

63%

86%

78%

67%

44%

91%

85%

18.8

106.1

17.9

16.2

6.6

3.1

53.0

8.8

11.0

8.5

57.4

10.8

2.0

4.6

0.6

0.4

0.5

0.3

0.9

0.2

2.3

0.4

0.9

0.3

0.4

0.2

1.1

0.8

0.2

EASTERN OIL AND

GAS REGION

Despite accounting for ≈39%

of licenses, UGV represents 75%

of production

Only 15% of all license applications

were granted to UGV over the past 10 years

A third of all new licenses are issued to

private companies

ZAKARPATTIA

REGION

IVANOFRANKIVSK

REGION

LVIV

REGION

CHERNIVTSI

REGION

Bytkiv-Babche oil, gas and

condensate field

Bilche-Volytsia gas field

Svydnytsia gas field

Khidnovychi gas field

Letnia gas and

condensate field

90%

91%

37%

52%

85%

4.0

5.3

3.3

7.4

4.8

0.09

0.1

0.06

0.08

WESTERN OIL AND

GAS REGION

Issued exploration licenses

-3

-5

2013

2014

2015

2016

2017

2018

UGV

Private companies

UGV to private companies ratio

x 2.8

x 1.3

x 3.6

x 4

Kulychyha oil, gas and
condensate field

Yablunivka oil, gas and
condensate field

Komyshnia gas and
condensate field

Tymofiivka oil,gas and
condensate field

Western
Khrestyshche
gas and
condensate
field

Yuliivka

gas and

condensate

field

Kotelva gas and

condensate field

Berezivske gas and

condensate field

UGV FIELDS

New exploration permits in 2014-2018
Borders of Dnieper-Donets basin

Production in 2018, bcm
Remaining reserves as of 31 December 2018

, bcm

% produced to date out of original reserves

that produced more than 2/3 of total production

Gas deposits deeper than 5000 m

Estimation based on Ukrainian classification of hydrocarbon reserves and resources

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2018

OPERATIONS

ANNUAL REPORT 2018

In addition to gas-related activities,

Integrated Gas BDU includes

production of oil and condensate by

Ukrgasvydobuvannya (which is transferred

to Oil Midstream & Downstream Business

Delivery Unit at intra-group prices).

While focused on creating customer value

and business delivery, Integrated Gas will

delegate all its capital project execution

activities to the Technical Business Enabling

Unit (further – Technical or Technical BEU).

Technical BEU will be in charge of procuring

and delivering turnkey capital projects

according to plans agreed with other

business delivery units.

Until the start of transformation, Naftogaz

group’s management lines reflected legal

and historical structures. The essence

of the organizational transformation in

Integrated Gas would be to follow the

established best practices and implement

streamlined organization and processes as

well as review upstream asset organization

structures.

Upstream organization. In upstream, the

transformation will take the form of asset-

based organizational structure enabling

management teams to control assets while

aligning objectives and integrating across

disciplines.

Assets have a high degree of autonomy in

decision-making and compete for

funding.

The new organizational model assumes

most accountability moved down to the

level of asset managers who will:

• manage all operating gas and oil fields

within a certain geographical region ;

• be accountable for the production, costs,

profits and safety of their asset;

•have these accountabilities reflected in

their KPIs;

• have final decision authority over all

activities within their asset.

The key benefits of the new organizational

structure will be higher accountability

and responsibility from asset managers

and more agile organization because of

decision-making at lower levels, including

data quality and resources management.

Downstream organization. In downstream,

the organizational transformation assumes

creating a classic trading organization split

into Front Office, Middle Office and Back

Office units.

The transformation will primarily aim at

strengthening unified portfolio-based

decision-making for import and trading

operations, creating a strong analytics

center to support decision-making

across all decisions of Integrated Gas

as well as throughout the group, and

building capabilities around transaction

management and controls.

To complement these organizational

changes, Integrated Gas will also

implement an ETRM system to enable

pricing, portfolio management, risk

management and trading activities.

Naftogaz group (through

Ukrgasvydobuvannya) has been investing

major efforts and resources into the

development of a national reserve base

and domestic hydrocarbons production

with some substantial results to show

over the past three years.

However, due to license acquisition

delays, regulatory issues, funding

availability and other issues, initial

production plans have not been

achievable.

Integrated Gas BDU plans to ramp up its

efforts to strengthen its geological and

reservoir management capabilities and

building capacity for 100% digitization

of all Naftogaz group’s upstream

activities and carrying out a fully-fledged

modernization and digitization

program.

Some of the major modernization and

digitization projects include:

1) construction of dynamic 3D

models for all brownfields of

Ukrgasvydobuvannya;

2) switch to international standards

in reserve base assessment and

management;

3) construction of modern core storage

and core analysis laboratory;

4) completion of large-scale 3D seismic

program for the entire brownfield

portfolio;

5) strengthening of tight gas expertise.

Integrated Gas plans to actively pursue

deeper partnership opportunities in

Key strategic objectives and initiatives

of Integrated Gas Business Unit

Today, the management of Naftogaz group and of

Integrated Gas BDU have identified a set of priority

objectives to focus on in order to lay the foundations for

sustainable development:

1) Drive upstream growth through modernization and

strategic partnership.

2) Build a strong and agile Integrated Gas organization,

which would accelerate decision-making.

3) Build the Naftogaz group retail business.

4) Build a 3 bcm extra safety cushion to hedge for possible

zero transit and gas import disruption in 2020.

5) Obtain compensation for implementing Public Service

obligations, imposed by the Cabinet of Ministers of

Ukraine by its Resolution No 867 of 19 October 2018

(PSO).

Goal #1: Drive upstream growth through modernization and strategic partnership

Goal #2: Build a strong and agile Integrated Gas organization

developing its current field portfolio and

when acquiring new licenses.

One of the most imminent partnership

processes that Integrated Gas plans to

launch is a Production Enhancement

partnership where a set of fields in

western Ukraine would be given to an

operator, which would run these fields,

drive production, and cost optimization

at its own risk in return for a fixed fee per

each unit of hydrocarbon production.

Naftogaz group achievements in 2016-2018

Integrated Gas BDU strategic partnership considerations

25-year record of production achieved

– 15.5 bcm in 2018

+970 mcm (+6.7%) of annual produc-

tion increase since 2015

+5.35 bcm – of cumulative incremen-

tal production in 2016-2018

9-year record of daily production

achieved – 43.9 mcm in 2018

+38.6 bcm – of resource base increase

since 2015

3.6x increase in 3D seismic volume

since 2015

(2 894 sq. km in 2016-2018)

8 fields discovered in 2016-2018

Naftogaz objectives

Partnership considerations

oduction

Geology & geoph

ysics

UGV gross production in 2015-2018

13,8

14,0

14,2

14,4

14,6

14,8

15,0

15,2

15,4

15,6

15,8

2015

bcm

2016

2017

2018

14.5

14.6

15.3

15.5

•

Partner requirements – proven track record, significant
capital exposure, readiness to scale up in Ukraine

•

Contract type – Production Sharing Agreement (PSA)

•

Share risks and invest in resource base development

•

Ensure sustainable production increase through
greenfield development

•

Optimize capital commitment

•

Partner requirements – proven track record, technological
excellence, readiness and ability to scale in Ukraine

•

Contract type – Integrated Project Management (IPM)

•

Commercialize Naftogaz' and Ukraine's tight
gas resources

•

Efficiently scale up

•

Build technological capability

•

Maximize value of depleted brownfield
reserves

•

Optimize costs and increase profitability

•

Partner requirements – proven track record, operational
efficiency, excellence, willingness to invest

•

Contract type – Production Enhancement (PEC)

New exploration

effort

Unconventional

resources

Brownfield

redevelopment

Source: Ukrgasvydobuvannya

Goal #3: Build Naftogaz group retail business

Today Naftogaz’s retail business is

represented largely by 0.3 million

customers mostly in Kirovograd region.

The remaining household supply is done

via regional supply companies under

PSO obligation, which leads to two major

negative consequences for Naftogaz

group:

1) Naftogaz group does not get paid timely

and in full for the natural gas volume it

sells to the regional supply companies

with limited ability to monitor and

influence payment discipline from the

final consumer;

2) Naftogaz group is not able to monitor

and prevent possible leakages when

natural gas sold under PSO is directed for

commercial usage.

At the same time, regional supply

companies earn a guaranteed margin of

2.5% on the supply of gas to households.

In addition to the above, Naftogaz group’s

entry into the direct household supply

business is aimed at ensuring a smooth

transition to the post-PSO environment

in May 2020 and prevention of potential

supply disruptions.

Although limited in its current retail

presence, Naftogaz believes it can

leverage its scale and partnership

opportunities to quickly ramp up its

presence while offering retail customers

an attractive service and financial value

proposition.

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

2018

OPERATIONS

ANNUAL REPORT 2018

Goal #4: Build a 3 bcm extra safety cushion to hedge against possible zero transit and

gas import disruption in 2020

Goal #5: Obtain PSO compensation

Due to the risk of zero transit from the

Russian Federation starting from 1 January

2020, and the consequent potential

disruptions in imports of gas to Ukraine,

Integrated Gas has begun the creation

of an extra safety stock of natural gas of

3 bcm to ensure availability of extra gas

withdrawal from underground storages in

case of disruption. While this is a one-off

measure, it requires additional funding

of USD 0.9 bn that was budgeted in the

financial plan for 2019.

Since 2015, Naftogaz group has

accumulated pre-tax losses from its

activities under PSO obligations of

UAH 114 billion as of 31 Dec 2018.

The above and need in development of

in-house production and import of natural

gas to supply during the heating season

of 2019-2020, as well as keeping a safety

stock in case of import disruption, has put

Integrated Gas BDU and Naftogaz group

as a whole in a position of being unable to

finance its activities with internal cash flow.

Summary:

Integrated Gas goals for 2019 are to cope with the challenges of the current year while laying down a

strong foundation for the profitable and sustainable growth of the group while ensuring the national

interests of Ukraine.

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2018

OPERATIONS

ANNUAL REPORT 2018

Mykola Havrylenko

OIL UNIT

The matrix approach to management is

a widespread form of modern business

asset management. For 20 years, all

the companies of Naftogaz group were

managed as legal entities, when each

company existed in its own closed

production cycle and was unable to

thoroughly assess the potential for

optimization of production processes.

I believe that a completely new approach

to the analysis of business operations is

one of the key positive outcomes of the

transformation.

The Oil Unit includes assets related to

transportation of oil and oil products as

well as manufacturing and sales of oil

products. Those include Ukrtransnafta

(the trunk oil pipeline system operator),

Ukravtogaz (compressed natural gas

(CNG) production and sales through a

chain of CNG stations), Ukrspetstransgaz

that provides liquefied petroleum

gas (LPG) transportation by railroad

tanks, and two departments of

Ukrgasvydobuvannya (UGV): the sales

department and a gas condensate

processing branch.

The unit’s key tasks are adding value to

assets and increasing profits.

Based on the method used in the

baseline assessment, we have designed

a development program for the assets

that are part of the unit. The program

includes both managerial solutions and

capital investments. It means that the Oil

Unit should increase both its operating

profit and the value of assets. According

to the business plan, the three-year

investment program will increase the

value of the unit’s assets by more than

USD 500 million.

The major investments focus on the

construction of an LPG plant. This is

our top priority business project with

a payback period of 2.5 to 3 years. The

investments will amount to nearly USD

100 million, with the design capacity of

100-120 thousand tons per year.

The next investment project is the

modernization of the Shebelynka gas

processing plant, which is aimed to

increase production profitability.

Most of the investments will be provided

by the unit, while the two projects

included in the business plan will funded

with loans.

A substantial investment program is

planned for the next three years to

upgrade production facilities that are

part of the oil transmission system

and automate business processes.

The implementation of this program

is expected to reduce operating costs

and improve the forecasting of system

operations. For example, over the past

30 years, there was a maintenance

regulation, according to which repairs

of oil pipelines were held based on the

schedule rather than actual need. This

required significant and sometimes

unjustified investments. We have

almost completed the modernization

of the linear part of the trunk oil pipeline

and plan to finalize the automation of

both pipelines and compressor stations

within two years, which will enable

future maintenance based on the current

condition.

This will reduce both our operating

costs and capital investments,

which amounted to about

USD 1.5 billion over the past

three years.

The modernization program also provides

for a reduction of staff, since wages are

the major component of production

costs for a company like Ukrtransnafta.

Of course, most skilled employees will be

retained.

The unit will use some of its investments

to contribute to the governmental

program for the reserve of oil and oil

products. By 2022, the state reserve

is expected to accumulate 500-600

thousand tons of oil and 1.5 million

tons of light petroleum products. Being

the only licensee that is eligible to

transport oil, Ukrtransnafta will operate

the oil reserve. We are upgrading all

our facilities so that they can participate

in this program. Modernization of

oil reservoirs with total capacity of

about 700 thousand tons will allow

us to consider the whole system as a

participant of the program. The draft

law “On minimal reserve of oil and oil

products” stipulates that the storage

provider will be compensated for storage

costs. We have calculated the costs,

submitted the relevant proposal.

Currently, the major share of the unit’s

revenues accounts for gas condensate

and LPG trading, equalling about

USD 7 billion per year. Oil transportation

is the second largest revenue totalling

about USD 5 billion. For now, four routes

are in operation: transit to Western

Europe via Ukraine, transportation

of Azeri oil from Odesa to the

Kremenchuk oil refinery, transportation

of domestically produced oil from the

Poltava fields to the Kremenchuk oil

refinery and Western Ukraine (about 350

thousand tons). Kremenchuk oil refinery

is the only one currently operating

in Ukraine, while other refineries are

unlikely to resume their operations

within the next 5-7 years.

Significant capacity of Ukraine’s trunk

oil pipeline system is not used now. We

are operating the Druzhba oil pipeline

system in a completely stable mode.

The design capacity of this system is

about 17 million tons per each of its

two strings. We can therefore provide

transmission of up to 30 million tons of

oil per year. Instead, the volume of oil

transit in 2018 was only 13.5 million tons.

This is the total demand of the three

European refineries located in the Czech

Republic, Hungary and Slovakia, which

receive Russian Urals oil. Over the last

three years, there has been a trend for

diversification of oil supplies to these

plants and we lost about 1.5 million tons

of transit in this period. This is due to

the fact that European companies are

gradually shifting to other oil brands.

The oil transportation market is one

of the most conservative markets. It is

closely connected to production and

refining sites. Recycling facilities are quite

conservative too. They were designed

and constructed based on the quality

of oil. Our outlook for the next 10 years

is therefore rather stable in terms of

projected volumes of oil transportation

of about 12-13 million tons.

The Unit’s key

objectives are

to increase the

value of assets

and generate

more profit

Mykola Havrylenko

head of Oil Unit

The oil

transportation

market is one of

the most conservative,

being closely tied

to oil production

and refining

sites

ROIC for the Oil Unit was 2.7% in

2018 versus the estimated cost of

capital of 15.0%. ROIC for the Oil Unit

is largely affected by domestic oil

transmission segment performance,

which is the result of below reasons

historical oil transmission infrastructure

underutilization and sub-optimal tariff

structure.

• 13.3 million tons of transit, which is 4.3% decrease as

compared to the previous year.

• Volumes of oil transmission to Ukrainian refineries

increased by 0.2% to 2.1 million tons.

• Operation of the oil pipeline Odesa-Kremenchuk section

and the first phase of Mozyr-Brody oil pipeline were

renewed.

• Volumes of LPG transportation increased almost two-

fold to 295 thousand tons year-over-year

• ROIC for oil midstream was 2.0% versus the estimated

UAH denominated cost of capital of 15.1%.

• Shebelynka refining volumes reached 454 thousand

tons, which is 8 % less compared to 2017.

• Over 85% of produced fuel products were sold through

wholesale channels.

• ROIC of oil downstream was 10.0% in 2018, which is less

than the estimated UAH denominated cost of capital of

18.5%.

Key results in oil midstream:

Key results in oil downstream:

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OPERATIONS

ANNUAL REPORT 2018

2018

OIL UNIT STRUCTURE

Oil Midstream and Downstream

Business Delivery Unit faces a number

of challenges along its core operating

dimensions.

In its oil midstream segment, the

challenges of Oil Midstream and

Downstream BDU are the following:

• dependence on one client in its transit

business;

• low utilization of domestic transmission

infrastructure along with big and

expensive-to-maintain asset base and

below break-even domestic tariffs.

In its downstream segment, the

challenges of the BDU include:

• suboptimal scale and still outdated and

inefficient refining technology resulting

in suboptimal fuel product mix and high

cost;

• low utilization and limited options for

economically attractive liquids

supply;

• insufficient sourcing/trading capability

and retail channels.

To address these challenges, Oil

Midstream & Downstream BDU will be

focusing on the following objectives:

1) preserve the oil transit business

while trying to minimize losses in the

domestic transmission business;

2) modernize and scale up refining

capacity with a focus on high-margin

products;

3) develop oil and fuel product trading

capability;

4) optimize retail network.

The Oil Midstream & Downstream BDU

management team is working hard to

negotiate and sign an oil transit contract

(the current one expires at the end of

2019) with Transneft. Preserving this

contract is essential to sustain the overall

business and maintenance of Ukrtransnafta

assets.

While the oil transit business of Oil

Midstream & Downstream BDU will

remain profitable if a future contract is on

comparable terms, the current national

refining and consumption landscape does

not allow any hope to fix the profitability

issue with the domestic oil transportation

segment.

Making it sustainable may require a

strategic solution at the level of the

national refining and transportation

landscape.

Oil Midstream and Downstream Busi-

ness Delivery Unit (Oil M&D or Oil M&D

BDU) includes all activities of Naftogaz

group related to import/export, trans-

portation, sale, supply of oil, natural

gas refining, gas condensate, petroleum

products, petrochemicals, components

and related services of Naftogaz group.

Oil Midstream & Downstream BDU

encompasses Ukrtransnafta, refining and

liquids and fuel products commercial

operations of Ukrgasvydobuvannya, LPG

transportation by Ukrspetstransgaz and

CNG retail by Ukravtogaz.

Oil Midstream & Downstream BDU consol-

idates the oil and fuel product midstream

and downstream operations of Naftogaz

group, ensuring an integrated approach to

developing the Naftogaz fuel product port-

folio and sales channel mix. Oil M&D BDU

focuses on the following sets of activities

along the oil and fuel value chain:

1) In midstream, Oil M&D BDU focuses

mostly on ensuring security of

supply and oil pipeline infrastructure

maintenance to ensure the oil

transit & transmission business as

well as managing the biggest LPG

transportation railcar fleet;

2) In downstream, Oil M&D focuses on

efficiency and the portfolio of its refining

operations and optimization of its sales

channel mix, including managing a CNG

station network.

Similar to Integrated Gas, Oil Midstream

& Downstream will delegate all its

capital project delivery activities to

the Technical BEU while focusing on

business development and operational

efficiency.

Key strategic objectives and initiatives of Oil M&D BDU

Goal #1: Preserve oil transit business and diversify supply in oil midstream segment

Goal #2: Modernize and scale up refining capacity with focus on high-margin products

2015

2016

2017

2018

62%

14%

15%

16%

21%

23%

24%

18%

62%

63%

64%

8.6

9.6

10.1

Gasoline

LPG

Diesel fuel

Structure of the Ukrainian fuel market by key types of fuel, million t

The current fuel product market is

dominated by the following trends that

are essential for the current performance

and future of the downstream segment

of the Oil Midstream & Downstream

BDU:

• falling – although levelling off - gasoline

sales vs. recent rapid growth in LPG;

• limited local production with market

dominance by imports, mostly from

Russia and Belarus.

Key strategic initiatives undertaken by

the Oil Midstream & Downstream BDU

assume the following initiatives:

1) modernization of Shebelynka refinery:

construction of isomerization and hydro

cleaning unit and benzene production

system which would allow to switch

from A92 to A95 gasoline type and reach

~30kt benzene production from the

currently loss-making pygas;

2) increase of LPG production capacity:

given the high demand and growth

dynamics, together with competitive

position in the market as well as

strong economics of LPG extraction

from Naftogaz-produced gas,

the BDU is initiating a project to

construct the Khrestyshche LPG

plant with a total LPG capacity of

~100k tons per year.

Source: The State Fiscal Service of Ukraine, UPECO, Oilnews, in-house calculations

Today Oil Midstream & Downstream

BDU experience insufficient capability in

sourcing the needed hydrocarbon raw

materials to supply Shebelynka refinery.

In addition, the BDU sells over 95% of

its fuel products through wholesale

channels.

Developing its own wholesale trading

capability for liquid hydrocarbons and

fuel products, also through leveraging

existing and new sea terminal

Goal #3: Develop oil and fuel

product trading capability

Key fuels by supplying country

Lithuania

Russia

Belarus

Ukraine

The structure of gasoline supplies to the Ukrainian market, million t

The structure of diesel fuel supplies to the Ukrainian market, million t

The structure of LPG supplies to the Ukrainian market, million t

Other

Ukrnafta

Ukrgasvydobuvannya

2014

2015

2016

2017

2018

Lithuania

Russia

Belarus

Ukraine

Other

Ukrnafta

Ukrgasvydobuvannya

2014

2015

2016

2017

2018

Other UKR Other

Ukrnafta

Ukrgasvydobuvannya

Ukrtatnafta

2014

2015

2016

2017

2018

Lithuania

Russia

Belarus

Ukraine

11%

27%

18%

21%

16%

11%

10%

17%

44%

15%

19%

49%

15%

56%

14%

21%

40%

47%

19%

12%

15%

27%

17%

20%

13%

24%

30%

12%

14%

12%

4%
8%

53%

28%

33%

45%

11%

13%

2.5

5.4

1.0

1.2

1.5

1.6

1.8

5.4

5.9

6.0

6.4

2.1

2.2

2.0

1.8

10%

39%

24%

15%

10%

47%

20%

12%

10%

40%

31%

34%

43%

infrastructure for transshipment of

new volumes of fuel products, will

become an important enabler for

increasing the profitability of the

refining and distribution operations of

Oil Midstream & Downstream BDU.

Source: UPECO, А-95 consulting group, in-house calculations

Oil transit

LPG transportation

Petroleum product sales

CNG sales

Fuel

retail

Exploration Production

Oil imports

Liquids

wholesale

Oil/fuel

transmission

Oil/fuel

storage

Refining

Fuel

wholesale

Ukrgasvydobuvannya*

Ukrtransnafta*

Ukrspetstransgaz/

Ukrgasvydobuvannya*

Ukravtogaz

*Ukrgasvydobuvannya’s relative departments

Oil Midstream and Downstream Business Delivery Unit structure

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

OPERATIONS

ANNUAL REPORT 2018

2018

The two retail networks within the scope

of Oil Midstream & Downstream are

historical underperformers with their

own individual set of fundamentals:

• retail network of Ukrgasvydobuvannya

has been loss-making due to a low-

scale, mono-fuel model, poor service

and unfavorable locations (with the

notable exception of the new branded

U.GO station);

• large 81 CNG station network has

suffered from steeply declining market,

poor location, equipment, and historic

mismanagement.

Today’s strategy towards retail chains

focuses primarily on optimization through

detailed location studies, due diligence,

operational efficiency measures, and

optimization of the number of stations.

Following this turnaround, the BDU’s

management is considering investing

in 50 new full service multi-fuel retail

stations.

Goal #4: Optimize retail network

Lithuania

Russia

Belarus

Ukraine

The structure of gasoline supplies to the Ukrainian market, million t

The structure of diesel fuel supplies to the Ukrainian market, million t

The structure of LPG supplies to the Ukrainian market, million t

Other

Ukrnafta

Ukrgasvydobuvannya

2014

2015

2016

2017

2018

Lithuania

Russia

Belarus

Ukraine

Other

Ukrnafta

Ukrgasvydobuvannya

2014

2015

2016

2017

2018

Other UKR Other

Ukrnafta

Ukrgasvydobuvannya

Ukrtatnafta

2014

2015

2016

2017

2018

Lithuania

Russia

Belarus

Ukraine

11%

27%

18%

21%

16%

11%

10%

17%

44%

15%

19%

49%

15%

56%

14%

21%

40%

47%

19%

12%

15%

27%

17%

20%

13%

24%

30%

12%

14%

12%

4%
8%

53%

28%

33%

45%

11%

13%

2.5

5.4

1.0

1.2

1.5

1.6

1.8

5.4

5.9

6.0

6.4

2.1

2.2

2.0

1.8

10%

39%

24%

15%

10%

47%

20%

12%

10%

40%

31%

34%

43%

Source: UPECO, А-95 consulting group, in-house calculations

Key fuel products by supplier

Summary:

Oil Midstream & Downstream goals for 2019 are to ensure extension of oil transit contract while kicking

off modernization of Shebelynka refinery and boosting LPG capacity as well as starting to build trading

capability and diversifying liquids and fuel products supply.

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

2018

OPERATIONS

ANNUAL REPORT 2018

Andriy Khomenko

head of Technical Business Enabling Unit

Andriy Khomenko

TECHNICAL BUSINESS ENABLING UNIT

Technical Business Enabling Unit overview

Research and development (R&D)

Oil & Gas field services

Research and development

• Technology development
• Innovative project

implementation

• Patent and

license acquiring

Drilling and well-construction

• Turn-key drilling projects
• In-house drilling fleet

management

• Contractor drilling fleet

management

• Drilling supervision
• Integrated procurement of drilling

solutions (both internal

and external inputs)

Down-hole treatment

Geophysical operations
• Geophysical operations

well logging,

perforation, etc.)

• Well-workover
• Coil tubing
• Hydraulic fracturing
• Side-track drilling
• Other production

enhancement oprations

Capital projects

Procurement

Design

Capital projects

Diagnostics, maintenance

and overhaul

Capital project procurement

• Preparation of

design documentation

• Project cost

estimation and budget

preparation

• Coordination

of state expert review

• Capital construction

and commissioning

• Overhaul, reconstruction

and modernization

• Decommissioning

of oil and gas

infrastructure facilities

• Technical monitoring

and diagnostics

of equipment

• Prevention

of breakdowns and

emergencies

• Maintenance and overhaul
• Recovery operations

• Procurement planning

and implementation

• Warehouse control
• Development of strategic

framework agreements

• Procurement of goods

and services

• Logistics management

For several decades, the company's

asset structuring into business units has

been the standard for the world's largest

oil and gas companies. This structure

has proven its efficiency primarily in

terms of a clear separation of functions

and responsibilities. One of the key

ideas for the transformation of Naftogaz

is the clear specification of structures,

business processes and individuals

responsible for implementing strategy

and for the results for each business

line.

The technical business enabling unit

was created as an auxiliary service

unit, which would be responsible for

the relevant business processes and

optimize their implementation. For

example, the budgets of Naftogaz, its

subsidiaries, the procurement budgets,

capital investments and the drilling

process are not currently sufficiently

synchronized with each other, which

jeopardises the optimal use of resources

in one unit and non-fulfillment of

production plans in another. In order to

use funds as efficiently as possible and

to make this process more transparent,

Naftogaz group decided to streamline

production budget management and to

make the technical business enabling

unit the central unit responsible for it.

The goal is to achieve the best

possible result at a lower cost

Our unit will make purchases for the

benefit of the group's companies, as

well as capital investments according

to approved plans. According to our

predictions, the majority of purchases

(about 100% for Ukrtransgaz, about 80%

for Ukrgasvydobuvannya) will be carried

out through the of electronic purchase

system ProZorro. At the same time, we

are negotiating with representatives

of the Big Four of the world's oil and

gas service companies – Schlumberger,

Halliburton, Weatherford and Baker

Hughes, on direct procurement

opportunities. These companies are

operating under extremely rigorous

US anti-corruption legislation, so

we estimate the risk of abuse in

transactions with their participation as

minimal.

The scope of responsibility of the

unit will include R&D, design and

engineering, and capital construction

from design to commissioning.

Today, these functions are scattered

throughout a range of companies, many

of which belong to Naftogaz group. For

example, both Ukrgasvydobuvannya and

Ukrtransgaz include companies involved

in construction. They build roads, gas

infrastructure objects, gas pipelines,

compressor stations, and much more.

All these companies became part of the

unit. According to the recommendations

of international consultants, the unit

will also perform drilling operations as

well as hydraulic fracturing for group

companies. There is sufficient reason

for this as Naftogaz group has its own

internal contractor, Ukrburgaz company.

The planned number of staff within the

unit is up to 15 000 employees. The

number of staff will be optimized based

on a number of priorities including unit

efficiency, labor productivity, etc.

My main function, as I see it, is to

centralize the scattered financial,

production, and procurement

functions, and to create an effective

project management system. We have

already started establishing a Project

Management Office (PMO) that will

deal with these issues. The PMO will

work in close co-operation with the

Capital Projects and Capital Construction

Department, which will report to me,

while from the organizational point of

view, it will be under Naftogaz.

The key tasks of the unit for the

current year include the following:

●

Development of standards and

policies

●

Development of an updated CAPEX

plan for 2019

●

Optimization of processes and

purchase plan for 2019

●

Introduction of functional structure of

the unit

●

Implementation of project

management system

●

Development of business interface

and internal SLA contract

The necessary organizational measures

are expected to be implemented in about

half a year. After that, the efficiency of

fund usage should increase considerably

and significant savings become possible.

We have already started optimizing

basic regulations, including those

on procurement issues. Expected

outcomes of the unit’s activities include

improvements in the implementation

of production plans, efficient and timely

procurements, and the reduction of

stocks of unmarketable goods.

The ultimate goal of these initiated

transformations is to increase the

capitalization level of Naftogaz

group

My personal KPI will be the same as the

KPI of Andrew Favorov, the head of the

integrated gas business unit – the level

of production. All activities of

the unit will focus exclusively on

increasing the level of extraction with

the most efficient use of

resources.

The development of so-called interfaces

and rules of interaction between

our two units is an important task.

Regulations should ensure the most

efficient cooperation. I am convinced

that if the unit structure had been

introduced five years ago, we would

already be extracting 20 bcm of gas a

year. I expect to have a key effect of

management system restructuring in

2020-2021.

My key objective

for the near future,

as I see it, is to centralize

scattered service

and procurement

functions and build an

effective project

management system

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