Transforming the State Committee of the Oil, Natural Gas, and Oil-Processing Industry into the national joint stock company Naftogaz of Ukraine was an important step in the sustainable development of the country’s oil and gas sector.
But it would be hard to overlook one important detail – the election of Vladimir Putin as president of Russia in 2000. Russian policy towards Ukraine began gradually changing from that point on.
Gas sector professionals in Gazprom’s leadership, who were friends and former colleagues of their Ukrainian counterparts, were replaced with people drawn from Putin’s circle of former KGB officers and the relationship with Naftogaz was being put on a new footing.
Organised crime was another factor which cannot be ignored. Journalists have long pointed to the role played by the Solntsevo gang headed by Semion Mogilevich in various gas scams.
Specifically, it has been alleged that organised criminal syndicates took control of Turkmen gas supplies in concert with Gazprom. Misha Glenny, the British journalist and researcher of organised crime, couldn’t conceal his amazement when recounting this episode: “It is hard to ascertain whether it was gross corruption or simply criminal, or, indeed, where the boundary between the two lies.”
Whatever the case may be, the end result is well known: intermediary companies, first Eural Trans Gas and then RosUkrEnergo, headed by infamous oligarch Dmytro Firtash, inserted themselves into Ukraine’s gas trade.
With Putin’s ascent to power, anything which could be utilised as a means of “gathering the lands” (a long-standing policy pursued by many Russian rulers from as early as the 15th century) would immediately be put to this precise use.
Gazprom was no exception, and Russia has since been making extensive use of energy as a weapon in its multipronged aggression. Criminal gangs too played their role.
In line with the realities of colonial policy, enough people could be found in Ukraine who were willing to help tighten the noose around the neck of their own compatriots. Their motives ranged from greed and hunger for power, via the existence of compromising material (kompromat) which could be used to blackmail them, to sheer stupidity – some people simply turned out to be “Putin’s useful idiots”.
A strong Naftogaz and the sustainable development of Ukraine’s oil and gas sector were hardly in the interests of Russian colonial policy.
On the contrary, what would definitely serve these interests was corruption in Naftogaz and all around it. Shady privatisation of a number of Naftogaz subsidiaries complicated vertical and horizontal integration, weakening the competitive position of the whole complex.
Appointments of Naftogaz CEOs were subject to tugs-of-war between politicians and oligarchs. The company was forced into oppressive and opaque contracts which helped syphon money from Ukraine to Russia. There was resistance to market reform as well as excessive state regulation.
All this was crippling Naftogaz. It severely undermined the company’s ability to meet its customers’ needs and to protect the nation’s economic interests. Unfortunately, even international aid was mainly inefficient due to a number of reasons, including indirect influence by Russia and a superficial root-cause analysis.
Five examples: destroying Naftogaz as a way to destroy Ukraine’s economy
RosUkrEnergo
RosUkrEnergo inserted itself as an intermediary between Naftogaz and Gazprom. This company was a joint venture founded by Gazprom with two Ukrainian citizens – Dmytro Firtash and Ivan Fursin.
According to an investigative piece by Reuters, Firtash’s role is explained by his ties to Mogilevich, while Fursin had links with Serhii Lovochkin, a former top aide to president Leonid Kuchma.
The arrangement between Gazprom and Firtash, along with the latter’s political partners inside Ukraine, cost Naftogaz its gas supply deal with Turkmenistan. This led to huge losses and made Ukraine critically dependent on gas supplies from Gazprom.
Russia, in turn, took advantage of these conditions to make exorbitant profits, which were then partly used to bribe Ukrainian politicians at the highest levels, take control of a leading TV channel, finance certain political forces and so forth.
Aftermath of “reforms”: privatisation and demonopolisation of Ukraine’s oil processing industry
Privatisation of Ukrainian oil refineries began in the mid-1990s. It was accompanied by high-flown claims of “destatisation” and “demonopolisation”. The slogans were all well and good, but not in the case of a vertically integrated industry like oil and gas. The ultimate outcome was a total disruption of value chain which took oil from production to refining. Furthermore, the new owners were not interested in spending money on modernising facilities which were gradually becoming obsolete.
So refineries closed one after another over the next 20 years, while the volume of petrochemical production declined sharply. By 2017, the only refinery still in operation was the Kremenchuk facility. This had escaped closure only because it was part of a vertically integrated group of companies . Since that integration is limited, the refinery operated in 2017 at only 12 percent of its capacity.
Unconscionable contract provisions in 2009
On 19 January 2009, Yulia Tymoshenko, then prime minister of Ukraine, and Vladimir Putin agreed contracts, key provisions of which were subsequently recognised by an international arbitration tribunal to be “unconscionable” to the Ukrainian party.
Why was this? The terms obliged Naftogaz to buy 42 billion cubic metres of gas per year at a jacked-up price, without the right to re-export it, and with huge penalties if it failed to take this volume. The arbitration tribunal found this take-or-pay provision of the contract deviated from established market practice and industry standards.
The price was excessive because Tymoshenko had agreed with Putin on the worst possible formula for calculating the gas price – a formula which merely paid lip service to European principles.
In its judgement, the Stockholm tribunal found that: “According to Naftogaz, the take-or-pay clause in this case operates as a penalty clause and the penalty is far higher than Gazprom’s loss, if any at all. … [T]he provisions now discussed exceed what is market practice and allowed under competition law. The destination clause is according to Naftogaz a hard-core restriction on competition, prohibited on every conceivable market. Thus, the three interacting clauses – volume, destination and take-or-pay – were, already at the date of the Contract, exceptional and clearly deviated from industry practice.”
Naftogaz managed to amend those flawed contracts only after challenging them in arbitration in Stockholm in 2014. However, the price formula for gas was revised only from 2014, and could only be reduced to the level of the German market. Such were the consequences of the terms agreed for the contracts.
Calculations by Naftogaz show that failure to base the 2009 Tymoshenko-Putin contracts on truly European principles of gas-price formation had cost Ukraine USD 28.9 billion in overpayments for gas in the period of 2009-15.
That is the case even after taking account of the “rebates in exchange for independence” which Putin extended to president Viktor Yanukovych in exchange for leasing Russia a base in Crimea for its Black Sea Fleet and for abandoning plans to integrate with the EU.
Privatisation of regional gas distributors (RDCs) or oblgases
An oblgas is a regional distribution company (RDC) which operates the distribution pipelines linking the transmission system to the “last mile” gas supply installations, as well as providing associated equipment such as residential gas meters. RDCs also keep account of gas consumption, tracking volumes taken from the distribution system.
Until 2015, they also supplied gas to the end consumers. With effect from 2015, the RDCs transferred this function to their sales subsidiaries (RSC or oblgaszboot). These merely collect money from the end consumers.
Were this a genuine reform, it would be accompanied by market liberalisation. The government, on the other hand, obliges Naftogaz to sell gas to the RSCs at less than the market price and without guarantee of payment. And this, in effect, creates a monopolistic intermediary between Naftogaz and the end consumers.
Privatisation of oblgases began at the same time as the oil refineries were transferred to private hands in the mid-1990s. This infrastructure, which was of critical significance for the state, was taken over by corrupt groups with connections to oligarchs and the political elites of the period. Having assumed control over gas metering and revenue collection, they put several schemes in place which have allowed them to rake in huge amounts of money.
Billions of Ukrainian hryvnias a year siphoned off. The most widespread abuse involves recording gas deliveries to “dead souls” (fictive end consumers) and setting inflated consumption quotas for end consumers with unmetered connections.
This gas is then sold to industrial consumers for cash or transferred to companies controlled by the same group that controls the oblgases in question – chemical plants, for example. The RDC and RSC does not pay Naftogaz for this gas, running up huge debts without fear of penalties. Alternatively, it might pay Naftogaz at the subsidised price levels specified by the government for households, or use subsidies received from the government and intended to benefit households.
RDCs might also launder their revenues by buying goods and services at inflated prices, taking advantage of the government’s leniency in not obliging them to conduct all their purchasing in a transparent fashion through the ProZorro system – even though their status as natural monopolies is self-evident.
Ample evidence is publicly available that no effective control is exercised over the cash the RDCs and RSCs receive in revenues from households, the subsidies meant for the economically disadvantaged or the volumes of gas the RDCs distribute.
Combined with the special status which the RSCs enjoy in the government-designed structure of gas deliveries to households, this creates endless opportunities for manipulating both the distributed volumes of gas and payments to Naftogaz.
The Boyko rigs
Chornomornaftogaz, a subsidiary of Naftogaz, purchased two offshore drilling rigs in 2011 at a price which was at least double the market level.
This scam has been under investigation for four years. The prosecutor general’s office has determined that the illegal income amounted to USD 144 million. Among the suspects are the former president of Ukraine, former governors of the National Bank of Ukraine and another 15 top officials from the Yanukovych regime.
A former head of Naftogaz is wanted by the authorities. One of his deputies has already been convicted. The interesting part is that Yuriy Boyko, the minister of energy who exercised control over Naftogaz at the time, is not a person of interest to the investigation, according to prosecutor general Yuriy Lutsenko.
State capture
During all this time, at every level in Naftogaz, people could be found who would step up to defend national interests at a time of crisis and thereby ensure, at least in part, that the national company was not national in name only. This was largely made possible by the remains of vertical integration.
Ukraine’s external and internal enemies were not happy about this. Nor did it please the greedy people eying the wealth of state assets available for plunder. So the plan was to break Naftogaz up.
This was like trying to butcher a dairy cow while it is still alive. To justify their actions, the butchers claimed it was a “European-style” reform – unbundling the gas transmission business.
In reality, this had nothing to do with EU policies. The opposite was actually the case, since the result envisioned would not be any genuine separation of the gas transmission operator from those controlling production and distribution, as European law requires.
The goal was simply to dismember Naftogaz and split its parts between Gazprom, which would get the gas transmission system, president Yanukovych’s family, which would gain control of the production business, and two oligarchs, Ihor Kolomoiskyi and Dmytro Firtash.
Ihor Kolomoiskyi expected to secure the whole oil production chain in exchange for a huge bribe, while Firtash was thought to have “secured” for himself by then the whole gas distribution network and the chemical industry (basically, producing fertilisers from natural gas).
This was a very peculiar kind of unbundling, Ukrainian-style. The International Monetary Fund’s country report no 17/84 of March 2017 commented on it as follows:
“Oligarchy and its effect on law making and on the plurality of the media is a specific impediment in Ukraine. The level of concentration of resources in a small group of people is a major difference with Latvia, Poland, and Romania … The ‘state capture’ by blocks of powerful political and economic elites that are pyramidal in structure and entrenched throughout public institutions and the economy has been seen as a specific feature of Ukraine’s corruption.”
Putin’s regime would take advantage of these conditions while paying lip service to established business practices, and actively corrupting elites – not only in Ukraine, but also elsewhere in Europe. Most venal politicians and oligarchs would readily advance Russia’s interests. The only question was the price.
The outcome of all this was the capture of the Ukrainian state.
The end result:
UAH 18 billion (USD 2.25 billion) – net loss reported by Naftogaz in 2013.
UAH 88.4 billion (USD 7.43 billion) – net loss reported by Naftogaz in 2014.
*The feature series “Naftogaz Against Gazprom” is running in partnership with Yuriy Vitrenko, executive director of Naftogaz Group. Opinions expressed in these features do not necessarily reflect the views of Naftogaz Group or the NV editorial team.