Ukraine's energy industry has gone through huge changes since new management took over national energy company Naftogaz in 2014. Market reforms were implemented, governance became more transparent and financial performance improved dramatically.

This has gone a long way to lift both the company's and Ukraine's image among international experts and potential investors. But political roadblocks and a lack of decisive steps in areas like unbundling or boosting domestic extraction have tempered optimism.

The election of President Volodymyr Zelensky, and upcoming snap elections, have raised expectations for a fresh start. Successful reforms could open Ukraine's energy market to international firms and integrate the country into the European gas market. Yet some experts fear the temptation to return to bad old ways.

A bumpy road to accomplishments

The management team that came in after the 2014 revolution inherited a company with a complicated legacy — for years Naftogaz was used by Ukrainian politicians for personal enrichment and political horse-trading.

The turnaround started after CEO Andriy Kobolyev and Executive Director Yuriy Vitrenko took over in 2014. The company soon became profitable (by 2018 taxes paid accounted for 19 percent of the state budget), and key internal policies, anti-corruption regulations and a code of ethics were adopted.

Naftogaz started publishing comprehensive annual reports with detailed financial statements. Corporate social responsibility came next, with support for charities and local communities (in 2018 a Naftogaz subsidiary spent $1.5 million on rural infrastructure development).

"Naftogaz changed heavily since 2014," said Wojciech Jakobik, an analyst at the Warsaw-based Jagiellonian Institute think tank and chief editor of BiznesAlert.pl. "We see greater transparency, communication activity. It's easy to get information about the company, and this is crucial for potential western partners."

European gas through reverse flows, together with efforts to reduce local consumption, helped Naftogaz deliver independence from Russian gas in November 2015. One victory followed another, when Naftogaz won a four-year arbitration battle with Gazprom for failing to deliver gas to Ukraine for transit to Europe (among several other rulings). Russia's energy giant was required to pay almost $2.6 billion to Ukraine.

"[The] Naftogaz team presented clear ways to beat Russia in court in line with European rules," Oleksandr Kharchenko, head of the Energy Industry Research Center, summed it up.

Political roadblocks

The initial strong pace of reforms, however, soon slowed. The international community expected demonopolization and retail market liberalization to quickly follow 2015 reforms aimed at creating a competitive gas market based on European legislation. Instead progress stalled.

"Gas reform and reform of Naftogaz is an unfinished process," said Wojciech Kononczuk who heads energy in Ukraine, Russia and Belarus at Poland's Center for Eastern Studies.

Despite the unprecedented transparency and wide range of achievements, Kononczuk said it's not all up to management. The biggest open question is the new government's view on energy sector reform.

"This is probably the most professional management Naftogaz has had," said Edward Chow, an expert at the Washington DC-based Center for Strategic and International Studies. "But there has never been a unity of purpose inside the Ukrainian government on energy reform," Chow noted.

Chow highlighted the long-standing disagreements between Naftogaz and the cabinet of ministers, particularly regarding the choice of unbundling model. Naftogaz needs to separate its gas transmission activity from gas production and supply to comply with the requirements of Europe's Third Energy Package by January 2020.

European rules allow for three options, two of which are feasible under Ukrainian legislation. But Naftogaz complains the government is not giving it a chance to choose, instead insisting on a third option that doesn't fully comply with European rules, particularly regarding investor protection (making it difficult to create an international consortium, a standard practice).

Naftogaz also claims the government option threatens the company's legal position in new arbitration cases, recently initiated by Gazprom, and where counterclaims of Naftogaz depend on the choice of the unbundling model.

Jakobik says this conflict leaves foreign partners uncertain about whether Naftogaz and government present the same line of development as they communicate different messages.

"Until it's (unbundling) completed, we won't see any investments from Western companies," Jakobik warned. "It's crucial for the modernization of gas pipelines, needed to be ready for a decrease in gas transit from Russia, which will happen eventually if Nord Stream 2 is built."

The arrival of a new government (expected after snap elections on July 21), presents an opportunity to reset relations, Chow said. To do so, Naftogaz invited international operators to advise on the independent transmission operator. The next step is to for the new parliament to make legislative changes to allow concession of the system in line with European rules.

High expectations

The international community is now focused on boosting local production and securing transit of Russian gas supplies to Europe, which is threatened by the ongoing fight between Naftogaz and Gazprom. Gazprom's work on alternative pipelines meant to circumvent Ukraine and refusal to comply with the Stockholm arbitration has experts worried about a potential gas crisis this winter.

"[Signing a transit deal] is crucial for the image of Naftogaz and, first of all, the country," Kononczuk said. While Ukraine is interested in a long-term contract, Russia wants to finish the Nord Stream 2 pipeline to deliver gas directly to Germany. Kononczuk believes a no-deal can happen in early-2020, and Gazprom would blame Ukraine for the failure of negotiations.

Conversely, potential increases in domestic production could boost Ukraine's energy self-sufficiency and the economy. But this requires a change in the old licensing system, Chow says.

State-owned UkrGasVydobuvannya (UGV), a Naftogaz subsidiary, accounts for 75 percent of domestic gas extraction. Domestic production has long been stuck at around 20 billion cubic meters a year, but experts believe the potential is much higher, partially due to so-far undiscovered reserves.

Chow recommends reforming UkrNafta, UGV and the Ministry of Ecology and Natural Resources. License holders, including UGV, should dispose of assets they aren't investing in to allow new investors to come in. For that, the government needs to liberalize the market, but Chow says he doesn't see Naftogaz pushing for this.

Regardless of disagreements with the government, Naftogaz needs to put out a plan on increasing domestic production and send direct signals to investors. For outsiders, it's hard to know if tenders are truly open for foreign investors or written under local players, Chow says.

"If you are a foreigner investor, you wouldn't dare enter the Ukrainian market unless you have an insider to help you," Chow says. The success of Naftogaz will ultimately depend on the government's ability to resist temptations to tip the scales. Some experts worry it's in the interest of oligarchs to stop reforms aimed at building a modern rules-based company and market, and potentially even sign a deal with Gazprom.

"There is a huge temptation for Ukrainians to stop reforms," Jakobik concluded.