Sabotage of Naftogaz

National gas company Naftogaz of Ukraine has been through a rough couple of weeks. An unverified government auditor’s report was leaked to the media, CEO Andriy Kobolyev took ill with COVID-19 and supervisory board member Amos Hochstein resigned citing a growing opposition to reform and political interference in Naftogaz’s work.

She warned that various Russia-linked Ukrainian political factions were currently trying to (re)gain control of Naftogaz’s lucrative assets.

The escalation in pressure has spooked investors, who fear Ukraine may be slipping faster than previously anticipated from its reform- focused track. Increased talk of early parliamentary elections has only heightened those concerns.

Naftogaz has faced undue political pressure on numerous occasions during the past six years since Ukraine first committed to radical gas market reform

In the meantime, the campaign against Naftogaz, Ukraine’s biggest taxpayer, is resulting in real financial costs. On October 20, the company confirmed it would postpone a Eurobond placement of $500 million after “a series of negative news” drove up interest rates.

Dr. Aura Sabadus

Rather than signalling problems within Naftogaz itself, however, experts see these events as a red flag, potentially heralding attempts to reverse gas market reforms implemented in recent years and a return of corrupt schemes. In Hochstein’s own words, the state-owned enterprise is “facing sabotage.”

Audit attacks against Naftogaz

On October 6, a leaked audit report from the State Audit Service of Ukraine controversially stated that Naftogaz, which contributes roughly a sixth of Ukraine’s budget, was in fact the country’s biggest tax debtor. It claimed the state-owned gas company had committed $6.5 billion worth of violations and underpaid government taxes by $2.8 billion. Experts were not convinced.

Andriy Favorov, a former head of integrated gas business at UkrGasVydobuvannya, a subsidiary of Naftogaz, noted the company has long been audited by leading international “Big Four” auditing firms KPMG and Deloitte, and has consistently received favourable opinions.

I stopped counting after I was personally fined 8 billion hryvnias in 2018. Such a fine was issued to me as an individual by the State Customs. Then in the courts we were able to prove that there were no grounds for the fine and this fine is incorrect

Further undermining the view that the leaked audit is an isolated event, a criminal case was opened against the CEO Kobolyev. Speaking to Hromadske Radio, Kobolyev dismissed this as but the latest in a series of attacks.

But Kharchenko noted that the audit and personal attacks against the CEO are coming at a huge cost to Ukraine’s perception among the international community. “They can’t even estimate how dangerous and how bad this is for Ukraine’s image,” he emphasized.

Andriy Kobolyev

I’m very sceptical about this audit the report wasn’t done in a professional way. In my perception, it’s like a political tool to pressure Naftogaz’s management.

Oleksandr Kharchenko

Investors are fully satisfied with the audit of Naftogaz held by international auditors and they pay little attention to the opinion of the State Audit Service of Ukraine known for its bureaucratic and formalistic approach. The resignation of Amos Hochstein was more important to investors than the state audit, as he is a symbolic figure in the financial world. His statement was that really mattered

Serhiy Fursa

A deteriorating climate for investors

In the years following the Euromaidan revolution Naftogaz built a strong reputation among foreign investors and supporters of reform in Ukraine. Previously used by politicians for personal enrichment and political horse-trading (which left it unprofitable and in need of state subsidies), it changed radically after new management took over in 2014.

An attack on Naftogaz, hence, is viewed by many as an assault on the legacy of reform and successes achieved in previous years. It has not helped that the National Bank of Ukraine (NBU), another important institution associated with post-2014 reform, has faced its own set of challenges.

In July 2020 the NBU head Yakiv Smoliy, a respected technocrat, resigned from his position. His statement cited “systematic political pressure,” and warned “against further attempts to undermine the institutional foundations of the central bank.”

Ukraine observers were reminded of those threats just weeks ago, when the NBU council reprimanded and declared its distrust of the only two board members left with tenure of over 3 months.

The episode resulted in a rebuke from the International Monetary Fund and worried investors who are already “increasingly concerned about the political and economic situation in the country” in the words of Naftogaz CFO Peter van Driel.

Even more concerning for many has been the early October resignation of Hochstein. A former US diplomat who served in the Obama administration, Hochstein was a guarantor of the integrity of Naftogaz and its ability to withstand political meddling.

Ukraine’s gas sector has historically proved to be the country’s Achilles Heel and has served as a source of endless corruption. However, in recent years, Naftogaz has become a model for the reform of state-owned entities

Dr. Aura Sabadus

“The American’s departure adds to mounting fears of a return to the corrupt practices that plagued Naftogaz for many years prior to a major shake-up in the Ukrainian gas sector beginning in 2014,” explained Sabadus, adding that the resignation was not a “complete surprise to Ukraine observers who have been paying attention to the removal of numerous reformists from key positions in recent months.”

Real financial costs

Attacks on Naftogaz, a critical piece of Ukraine’s economy, have not
gone unnoticed by investors and have already resulted in real costs for both the state-owned enterprise and the country’s taxpayers.

Ukraine is currently facing an increasingly challenging budgetary situation, but relations with the International Monetary Fund (which provides critically important loans) are strained by what experts describe as a growing trend to reverse anti-corruption reforms from recent years.

According to Alexander Paraschiy, head of research at investment bank Concorde Capital, there is a fundamental lack of understanding by the administration of the culture and values of international institutions.

Despite the recent challenges, however, there has also been some progress. The government of PM Shmyhal has made important steps forward in reforming corporate governance at Naftogaz.

Naftogaz plays outsized role in the country’s finances. The gas heavyweight is Ukraine’s biggest taxpayer by far, contributing $3.5 billion in taxes to the national budget through September this year alone – 11.5% of total budget revenue.

But just a week later, on October 20, faced with a growing tide of negative news that caused interest rates to rise, Naftogaz confirmed it would postpone the placement.

“As a result, those corrupt parties that are threatened by the reforms have been able to influence the administration in reversing them, using various forms of pressure and incentives for corrupt individuals,” he wrote in a note to investors.

The Cabinet has approved a long-awaited ownership policy and a new charter for Naftogaz. These changes will make the company more operationally resilient and better insulated from political meddling. Furthermore, the government has removed populistic limitations on salaries of supervisory board members and management of state-owned enterprises. Thus the struggle between pro-reformists and revisionists in Ukraine continues. Which wing is going to win in this fight is yet to be seen.

On October 14 Naftogaz initiated a tender to purchase $335 million in its bonds coming due in 2022 and 2024, hoping to finance them through a placement of a $500 million Eurobond and thus to extend its average debt maturity.

But while politics continues to interfere in the life of state-owned companies like Naftogaz, proper administration and managerial tasks are falling behind. Annual financial plans for 2020, for instance, have not yet been approved by the government.

International investors that were eager to invest in Naftogaz began to doubt in Ukraine’s investment environment. The attempt to dismiss several members of the Board of the National Bank, then the leaked audit report – all these bad news influenced the investors’ decision

Petrus van Driel

“When it is one incident you can digest it, when there are two – it's already hard. When there is a whole sequence of different incidents, the market votes with its own feet,” van Driel noted while speaking on Energy Inside, a weekly expert discussion hosted by the Federation of Employers of the Oil and Gas Industry.