By Brian Bonner

If there’s a single company that is the bellwether of where Ukraine’s reforms are heading, it’s state-owned Naftogaz, the energy monopoly with close to $10 billion in annual revenue that contributes at least 15 percent of revenues to the state budget of nearly $40 billion.

And the Naftogaz story is a complicated one.

In some ways, the Naftogaz turnaround is remarkable: from losing up to $8 billion a year as recently as 2014, to making a net profit of $1.5 billion in 2017, the most recent year for which figures are public. The transformation from losses to profits was largely accomplished through hikes in household natural gas prices started by ex-Prime Minister Arseniy Yatsenyuk’s government.

But the transformation is also far from complete and, according to the man who has led Naftogaz since March 2014, under constant threat from an array of corrupt, monopolistic and political interests.

CEO Andriy Kobolyev told the Kyiv Post in an interview at Naftogaz headquarters that he fears the giant enterprise will return to its “darkest times” because of current political demands that undermine the independence and restrict the authority of the company’s supervisory board.

If such political interference returns, Kobolyev said in the Feb. 8 interview, “everything that has been achieved so far can be destroyed.”

Kobolyev is under fire from many quarters, including Prime Minister Volodymyr Groysman, who on Jan. 16 demanded a new contract for Kobolyev with lower pay.

“I believe – and not only me – that the contract, which has been in force for five years, contains conditions that are currently unacceptable,” Groysman said. “I mean the conditions of labor remuneration and various rewards that the Naftogaz board receives.”

Kobolyev received $1.7 million in total compensation in 2017. He didn’t want to talk about his 2018 pay until Naftogaz’s official financial statement for the year is released in April.

His current five-year contract was initially set to end on March 22. But he said the decision on the contract’s extension and its terms should belong to the supervisory board, not the prime minister or Cabinet of Ministers.

Defusing the salary issue

“If we go back to a situation when politicians have a say over the authority of the supervisory board, then we will end up going back to the darkest times of Naftogaz,” Kobolyev said.

He would know something about that era. From 2006 to 2007, he was director of the corporate finance and price policy department and from 2008 to 2010 he was an adviser to the chairman.

To defuse the issue of his salary and focus public debate on protecting the independence of the supervisory board, Kobolyev in January announced that he will donate his entire 2019 compensation, including salary and bonuses, to three charities. One of them supports families of slain soldiers, another helps the army and a third assists children with cancer.

“I can afford to be doing this to make sure corporate governance reform and Naftogaz’s achievements will not be dismantled,” he said.

Kobolyev wasn’t the only top manager of a state company who came under fire for his salary. In December, President Petro Poroshenko had a special televised meeting with Igor Smelyansky, the CEO of the state postal service Ukrposhta, where he told him to review his salary.

Smelyansky was paid about $145,000 in 2017, or 10 times less than Kobolyev. But even that was unacceptable, according to Poroshenko, who also demanded that Smelyansky not lay off any postal workers.

Kobolyev thinks that the issue of Naftogaz top managers’ salaries has been politicized because of the coming presidential and parliamentary elections this year. He believes elected officials’ real aim may be to get rid of the supervisory board or further curb its powers.

The supervisory board was the creation of such elected officials: they established it as a means of strengthening governance in Ukraine’s top state-owned enterprises after the EuroMaidan Revolution that ousted President Viktor Yanukovych on Feb. 22, 2014. The members of the board, in turn, were chosen by the Cabinet of Ministers.

Kobolyev believes that the supervisory board should have greater authority, not less, including the power to approve the company’s strategic and financial plans as well as appoint executives. It currently approves only contracts, loan agreements and procurement.

The powers to decide the terms and conditions of the CEO’s contract would shift to the Cabinet of Ministers “if there is no supervisory board,” Kobolyev said. “Why would Groysman make a public statement about something which is not within his authority and put public pressure on the supervisory board, which is designed not to take into account politics and public pressure?”

Having a supervisory board that bows to political demands, Kobolyev said, will be a “suicidal step because you undermine the whole point of your existence.”

“This brings me to the conclusion that salary was not the object or major aim of this political request. Corporate governance was. What happens when supervisory boards are put under severe political pressure? They might resign. For Naftogaz, in a year of elections, the resignation of the supervisory board can mean a full reverse of all we have done so far.”

‘Last bastion’ remains

“That is why preserving existing corporate governance is one of the major tasks of those who support reforms of state-owned companies,” Kobolyev said. “They are the last bastion preventing outside political forces, corrupt forces, from putting their hands back into Naftogaz, Ukrposhta (the state postal service), Ukrzalyznytsia (the state railway) and other state-owned enterprises. The more people that understand this, the better and sooner the reforms will be .”

The board, he said, insulates him from the way Naftogaz used to be run, when politicians “could call the Naftogaz CEO and ask him to do something.” Without the insulating role of the supervisory board and market salaries for top managers, he said the company will be taken over by executives who will return to the days of taking bribes and not running the company in the interests of the nation.

“Some of them were buying Boyko’s drilling rigs, some were establishing RosUkrEnergo,” Kobolyev said.

His reference was to Yuriy Boyko, the member of parliament and former Yanukovych vice prime minister and energy minister who also ran Naftogaz from 2002-2005 under ex-President Leonid Kuchma.

After the EuroMaidan Revolution, Boyko came under criminal investigation for the alleged large-scale embezzlement of $700 million during the sale of natural gas and a separate case involving the alleged embezzlement of $400 million during the purchase of oil and gas offshore drilling rigs.

But lawmaker Sergii Leshchenko and prosecutor Sergii Gorbatuk have alleged that Prosecutor General Yuriy Lutsenko thwarted the prosecution as part of a political deal. Boyko and Lutsenko deny the charges.

Firtash’s monopoly

RosUkrEnergo was a gas-trading intermediary that used to be owned by billionaire oligarch Dmytro Firtash, who is fighting U.S. bribery charges that he denies from exile in Austria. Firtash amassed great wealth through non-transparent gas deals. RosUkrEnergo’s most lucrative and controversial period stretched from 2004 to 2009, when his company was the sole gas intermediary in Ukraine.

Firtash still controls many gas-dependent heavy industries as well as most regional gas distribution networks and other intermediaries that Naftogaz is forced by goverment decree to sell gas at discounted prices.

Firtash and others linked to the former Party of Regions privatized the regional gas distribution business in 2010-2011, shortly after Yanukovych became president. In 2015, these distribution companies spun off gas supply companies, which they still own, Naftogaz says.

Kobolyev, in an interview with the Atlantic Council think tank in 2017, said that he had evidence that gas was being stolen by regional intermediaries. Additionally, last year Kobolyev said the state is losing at least 1 to 2 billion cubic meters of gas annually because intermediary trading companies were legally allowed to hide from the public the true customers of gas. He suspected that businesses are the true beneficiaries of subsidized prices that are supposed to go only to individual households.

Additionally, on Jan. 28, Kobolyev said that local and regional gas distributors now owe about $2.2 billion to Naftogaz.

Oleksandr Kharchenko, managing director of Energy Industry Research Center in Ukraine, said that a move to solve the chronic debt problems was scuttled by Groysman in 2017. The change would have forced the regional gas traders such as Firtash-owned ones to make automatic payments to Naftogaz on delivery instead of accruing debts.

Kharchenko wrote on July 28, 2018 for the Atlantic Council that Firtash owns almost 75 percent of Ukraine’s gas distribution companies.

The “oblgazes,” as they are known “were artificially created during Viktor Yanukovych’s presidency as cash cows between the state-run Naftogaz and consumers, where gas prices are regulated by the government,” Kharchenko wrote. “Let’s be frank: oblgazes were created to implement corrupt schemes, rip off taxpayers, and they do not belong in a country that aspires to move to Western business practices.”

Moreover, Naftogaz released a statement in December saying that the regional distributors are trying to “disrupt the demonopolization of the gas market by any means necessary.” Additionally, according to Kharchenko, regional distributors were allowed to keep up to 15 percent of their cash flow, up from 2.5 percent before January 2018, and were keeping subsidies meant for poor customers.

Naftogaz representatives have expressed doubts that the state enterprise will ever be repaid the money.

Suspicions about why Firtash still commands such political power were fueled when Poroshenko and now Kyiv Mayor Vitali Klitschko flew to Vienna ahead of the May 2014 presidential election.

The talks led to what has been derided by many, including lawmaker  Leshchenko, as the “Vienna Agreements” in which Firtash and Poroshenko reached an agreement to scuttle criminal investigations of the exiled oligarch. Both Firtash and Poroshenko have denied such back-door deals took place.

Multbillion-dollar savings

One big victory for Naftogaz came in two rulings of the Arbitration Institute of the Stockholm Chamber of Commerce against Kremlin-controlled Gazprom. Those cases, he said, saved Ukraine potentially $70 billion in fines.

The court made two rulings, the first on Dec. 22, 2017, involving the gas supply contract, and the second on Feb. 28, 2018, involving a gas transit country.

The court upheld Naftogaz’s claim that Gazprom failed to meet the agreed transit volumes, awarding it $4.6 billion in damages, discounted to $2.6 billion because of debts owed by Naftogaz to Gazprom for supplies.

The dispute over gas supply, transit and pricing centered on the 2009 agreement between Ukraine and Russia, brokered under duress when the Kremlin cut gas supplies to Ukraine. Ukraine is trying to recover the money by getting courts to seize Gazprom assets outside of Russia.

Other problems

But Naftogaz is facing numerous other challenges as Ukraine struggles to become energy independent.

While Ukraine’s gas consumption remained steady at 32 billion cubic meters in 2018, and the nation cut its gas imports by 25 percent to 10.6 billion cubic meters, it has a long way to go to reach energy independence.

The nation hasn’t produced much more than 20 billion cubic meters of natural gas, mostly from its state-owned Ukrgazvydobuvannya, annually since independence in 1991.

One reason critics cite for the lackluster performance is delays in the unbundling process to separate production, storage and distribution functions. There is also contradictory messages sent out about whether Naftogaz will remain state-owned or eventually be privatized.

The Stockholm Arbitration ruling complicated the unbundling by not approving transfer of the gas transit contract with Gazprom to someone else. Meanwhile, Gazprom has refused to change the transit contract with Ukraine that is valid until Dec. 31, 2019, preventing Naftogaz from unbundling its gas transportation function.

Ukraine faces further uncertainty ahead as Russia and Germany press forward with completion of the undersea Nord Stream 2 pipeline that bypasses Ukraine, which has been the main transit route of Russian exports to Europe, reaching 93 billion cubic meters in 2017.

Will not hit 27 bcm production goal in 2020

Domestically, Kobolyev acknowledges that Ukraine will not reach its 2020 goal of producing 27 billion cubic meters of gas domestically.

He said that existing gas fields are 90 percent depleted.

“We need to start growing faster,” Kobolyev said. “We are not making up as much on our capital as proper international companies do… For the Naftogaz group, the major source of growth in future should be greenfields” — completely new projects — “or unconventional sources. That’s what we’re working on.”

As part of the plan, Ukrgazvydobuvannya, or UGV, has been split into three separate business units run by three different individuals. CEO Oleg Prokhorenko stepped down by mutual agreement in the reshuffle.

But there are huge obstacles to tapping new fields in the search for what has been estimated as potentially 1 trillion cubic meters of natural gas deposits.

Among them are unfavorable regulations that govern licensing, dissemination of geological data, production sharing agreements, along with lack of trust in courts.

And not least of the problems, Kobolyev said, are unfair obstacles erected by regional government authorities in licensing land plots to allow drilling for new gas.

“Without changing this problem, without changing the situation in this area, Ukraine will not succeed in increasing production,” Kobolyev said. “Our political establishment should understand they will not grow production” without fair licensing of land, improvements to rule of law and better production sharing agreements to attract investors with the latest exploration technologies.