Welcome to the U.S.-Ukraine Business Council

Timothy Ash, RBSMarketplace
Local Markets Strategy  | LM Alert | CEEMEA
Royal Bank of Scotland, London, UK, Tuesday, August 4, 2009

Naftogaz 09's have been subject to some extreme price movements over the past week following a somewhat oblique announcement from the cabinet of ministers which suggested that the external liabilities of the company could be restructured as part of an IMF-induced effort to overhaul the company's finances.

The bonds, which mature in September, had been trading in the low 90s in mid-July, but dropped to the mid/low 70s, before recovering to trade in the mid-80s as of writing.

Naftogaz is the 100% Ukrainian state owned gas transit/supply company, responsible for the production of gas in Ukraine, the purchase of gas from Russia, and its distribution in Ukraine, and also for the transit of Russian gas via Ukraine to Western Europe; some two thirds of Russia's gas exports have historically been routed through Ukraine.

The company is often in the headlines given that it is at the centre of political/financial squabbles between Ukraine and Russia over gas pricing/transit. It is also one of the largest companies in Ukraine - it has been the largest single tax-payer. The company is of huge significance domestically in Ukraine as in effect it is responsible for the supply of, in effect, subsidized gas to the domestic population.

The company's basic problem is that the import price for gas is set by inter-governmental agreement, in effect, while it sells gas domestically in Ukraine, also mostly at fixed prices. In 2009, for example, the company is set to import gas at an average price of around US$228 per 1,000 cu metres, while it sells gas to household/municipal users at a price of US$110-150 per 1,000 cu metres.

The company struggles to cover the shortfall via profits on much reduced sales to industrial users and the gas transit fees earned from transporting (much reduced volumes also) Russian gas. In effect the company is constantly forced to go to the government for bail-outs/subsidies.

The answer to the company's problems obviously lay in hiking domestic gas prices to cost recovery levels, but gas pricing is a hugely charged political issue in Ukraine, even though payments for gas make up a relatively small proportion of household bills. With presidential elections due in January, it is thought that the government would be loathed to significantly hike domestic gas prices, before that date.

A further complication is that gas pricing of municipal heating companies is not set centrally, but by local municipalities, and hence beyond the remit of central government. Any effort to change gas prices for gas supplied via municipal heating companies would thus require enabling legislation, which could be difficult/time consuming to enact, again especially before presidential elections.

The IMF understands the importance of Naftogaz to Ukraine. In a press release which accompanied the completion of the second review under the SBA, in which the IMF mission recommended the disbursement of the latest US$3.3bn in financing the IMF noted that:

"To cushion the impact of the sharper economic contraction and to reflect the imbalances of the state gas company, Naftogaz, the revised economic programme targets a broadened fiscal deficit. Corrective fiscal measures and structural reforms are a priority to ensure fiscal sustainability and to avoid crowding out of private sector borrowing. The authorities have reduced non-priority expenditures as well as taken a number of steps to restore viability in the natural gas sector.

A key step is a schedule of natural gas price increases to bring domestic prices in line with international prices. Vulnerable households will be protected by a better targeting of the social safety net programmes. The authorities are also moving ahead with a strategy to strengthen the financial situation and transparency of Naftogaz".

In discussions with various IMF officials over a number of years it has not been our impression that the Fund was pressing for the restructuring of the sovereign/quasi sovereign liabilities of the company or indeed the sovereign.

Herein it was recognised that, given Ukraine's relatively modest public sector debt/GDP ratio (probably around 20-25% at present), Ukraine's problems were not really one of public sector debt sustainability - the assumption was that any restructuring herein would yield limited benefits in terms of NPV reductions, against the potential downside from securing a default rating/loss of market access - i.e. the IMF saw the resumption of private sector lending, as its exit strategy from Ukraine.

A restructuring of sovereign/quasi sovereign liabilities when the sovereign appeared to have the ability to pay (US$25bn+ in FX reserves, versus a stock of just short of US$30bn in public sector debts) would likely prove very damaging to Ukraine's international image.

Returning to the government decree published at the end of July, the wording is vague. It speaks of instructing the MOF to address the long term financial feasibility of Naftogaz, and in particular looking at the short term debt service obligations which it argues should be lightened. There appeared to be no indication whether this referred to the US$500m Eurobond falling due, or the other US$4.5bn external liabilities of Naftogaz outstanding.

Our own investigations with officials in Kiev have suggested that the decree gives Naftogaz/MOF the right to restructure its external liabilities, but as yet it is unclear whether this will actually happen. Any restructuring, according to the official sources, will happen on a voluntary basis, and should be attractive to creditors. However, as yet there are no clear indications as to whether a restructuring/rescheduling will in fact take place; much depends on the negative/or otherwise reaction of creditors.

Further clarity, or otherwise, was given in an IMF conference call, with its mission chief to Ukraine, Ceyla Pazarbasioglu, on July 29, 2009. In answer to questions on Naftogaz Ms Pazarbasioglu made the following comments.

"QUESTIONER: Was repayment of Naftogaz eurobonds part of the agreement? Can a certain amount of IMF tranche be used for Ukraine's external debt?

MS. PAZARBASIOGLU: Of the last disbursement, half went to the budget, and in this review, all of the tranche will go to the budget, basically to meet external obligations. Which external obligations the government decides to use this for is their internal decision. But, basically, the idea is that the government has external obligations, and that this disbursement would support the payment of those obligations, be it balance of payments needs, be it external debt payments, or otherwise.

QUESTIONER: My question also relates to Naftogaz. Does the IMF actually support the restructuring of Naftogaz debt, specifically this $500 eurobond coming in September? Do you think it's a good idea? Do you think Naftogaz needs to restructure these debts?

MS. PAZARBASIOGLU: We believe in good asset liability management, to make sure that the assets and liabilities of the company are properly designed and to ensure its profitability and financial soundness. We had a conference in Kyiv last Friday that was coordinated by the EC, and, earlier on, there were two more meetings in Brussels where Naftogaz issues were discussed. Obviously, it's very important for the company to have good asset/liability management, and that may include discussions about some voluntary restructuring of its debt and so on.

We would be in close contact with the authorities to look into details of any such proposals, but, at this current time, we have not seen any details and there is nothing concrete. Therefore, it would be too early for us to say anything, other than what I just said, which is the IMF's policy of supporting the good management of debt, be it this company or any other private sector company. As you know, many of the private sector companies in Ukraine are discussing voluntary restructuring of their debt.

QUESTIONER: Does that mean this was something that you had already talked about with the government? Was it even a recommendation that the government restructure Naftogaz debt?

MS. PAZARBASIOGLU: No. Restructuring of Naftogaz debt was not necessarily a recommendation. The recommendation was, since the start of the program, to look carefully at the debt obligations of the government and any state-guaranteed debt, and to make sure that there is good asset/liability management, which can include voluntary restructuring of its debt.

If the debtholders want to increase the maturity with some other details, and if it makes sense for the company and the fiscal balances, than that would be something that we would look at carefully and we would welcome. But I think what I would like to stress here is that it should be a voluntary restructuring of debt.

QUESTIONER: Under this agreement, can Ukraine use part of its loan to pay Russia for gas, specifically the bill in early August?

MS. PAZARBASIOGLU: What the agreement basically says is that the government can use this tranche to honor its external obligations. Exactly for which purpose they use it is their own decision. The idea is that they have balance of payments needs, including gas purchases, including external debt payments, and these funds are available to help the government make those governments.

QUESTIONER: So would you expect them to use it? I mean, I guess their gas bill could be around $500 million to $100 billion. You would expect them to use it to pay down that kind of obligation, right?

MS. PAZARBASIOGLU: As far as we know the government stands ready to honor the external debt obligations of Naftogaz. But as I said, how they use different resources they have to make external payments is the government's own decision. Whether they use their own funds or Naftogaz's funds or some other ways, that's an internal decision.

What we do in our work is to calculate the external needs and provide support based on that. And exact details of it, obviously as it becomes more concrete, we would discuss. But there are no specific details that we would provide to them other than saying this is earmarked or this is basically provided to meet external obligations, which is the role for the Fund, balance of payments support.

QUESTIONER: Is that gas bill taken into account for the size of the tranche?

MS. PAZARBASIOGLU: The program takes into account the calculated balance of payments needs. Of course, it takes into account imports and exports and debt payments because those are the foreign currency needs of the country. So, yes, it does take into account the relevant contracts the authorities have signed and the import gas bill that they need to pay."

As an additional insight to the above discussion, Ukraine has also been holding discussions with the EC, alongside the IMF and other potential bilateral/multilateral donors with regards to securing credits to buy gas imports for storage over the next few months.

In conclusion to these negotiations, on July 31, the EC announced that EURO1.7bn in credits would be provided to Naftogaz to purchase gas imports from Russia, comprising EURO750m from the EBRD, US$450m from the EIB and US$500m from the IBRD. These credits are in addition to IMF disbursements under the SBA, but are also linked to commitments to reform the finances of Naftogaz.


As part of efforts to ensure that Ukraine has the finances to purchase sufficient gas into storage over the next few months to ensure sufficient gas supplies both for transit to Europe and supply domestically, the government and official creditors are clearly looking at ways to provide new financing and reschedule/restructure existing commitments.

For the IMF this does not appear to be a prior condition for the release of the next tranche of the SBA, but the above commentary would suggest that the IMF would look favourably on such a development it proved relatively painless and did not unduly undermine Ukraine's broader credit worthiness. Other lenders may, however, be pressing more forcefully for such rescheduling/restructuring.

The difficulty for the Tymoshenko government is that it has made numerous commitments to creditors of Naftogaz in the past, in terms of its commitment to support the company. This goes back as far as the eve of Tymoshenko's appointment as prime minister in December 2007, when the company was on the brink of a technical default and an agreement appeared to have been concluded with creditors to extend a sovereign guarantee for the company.

In the event the 2008 budget included a provision in the budget to cover the US$2.7bn outstanding debts (as of then) of the company albeit the sovereign guarantee was not formalised in law.

Creditors have, on numerous occasions in the past, been re-assured that the company is not bankrupt and that the state will stand behind the company. As recently as early July we were re-assured that the company had the resources to meet its external liabilities. After making such promises, and given that the Tymoshenko administration is eager to be portrayed as "investor friendly" any rescheduling/restructuring seems likely to be friendly/voluntary.

An obvious problem with any such deal would be the short period from now until the bonds mature at the end of September. Securing a deal which could be interesting enough to secure agreement from a quorum of bondholders, without a protracted legal battle, could still prove difficult. And, given that this all falls within the looming presidential election campaign, presumably the government will not want the issue to be used by the opposition with a stick to beat the government.

Tymoshenko's likely opponents in the presidential campaign (Yanuykovich and likely Yatseniuk) will both likely argue that the company did not default on their watch; herein the question is whether any restructuring could likely trigger a default, and then itself trigger a host of CDS contracts. Her opponents would also likely argue that a Naftogaz restructuring/default would make it that much more difficult for other Ukrainian companies to secure external financing; if Ukraine's "most important" company is forced into a restructuring, what hope have the rest, they might argue.

All this could prove extremely messy for the government and more particularly for Tymoshenko in the run up to the president election. Indeed, any positive spin to be gained amongst the domestic electorate (e.g. not paying foreign creditors, to fund delays in domestic gas price hikes) would have to be balanced against the significant long run cost to her reputation, and to Ukraine's amongst foreign creditors.

Restructuring external liabilities when you cannot pay is one thing, but when the IMF has just disbursed US$3.3bn, with a big chunk earmarked for external debt service is another. In essence this is about willingness, not ability to pay.

Meanwhile, all this comes as Ukraine's external credit worthiness seems to be improving, as reflected in the fact that 5Y Ukraine CDS is reported to have pushed back below the 1,000 bps mark, its lowest level since the fall of Lehman. S&P also announced at the end of July that it had moved its admittedly lowly CCC+ rating on Ukraine onto a positive outlook. A protracted and potentially messy restructuring of Naftogaz liabilities could well prove disturbing to these positive trends.

Net-net, and going back to comments from the IMF and officials in Ukraine, we sense that the government will want to tread extremely carefully with negotiations with creditors on this issue, and will want to ensure that any restructuring/rescheduling is voluntary, and hence favourable to investors.

Getting the balance though between making it favourable enough to investors to agree terms, while also not handing her political opponents with the gift of "giving cash away to creditors will be acutely difficult. Cynics might though argue that all this has just provided Ukraine with a window to buy back debt below par in the run up to redemptions.


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