OREANDA-NEWS. Ratings has affirmed NJSC Naftogaz of Ukraine's (Naftogaz) Long-term foreign and local currency Issuer Default Ratings (IDR) at 'CCC'.

Naftogaz's ratings reflect its strong links with the state of Ukraine (CCC), its sole shareholder, its weak though gradually improving financial profile and its exposure to political and legal risks. The state continued to support the company in 2015, via equity injections to cover the disparity between imported gas prices and domestic regulated gas prices for households and heating utilities. However, the company's negative operating deficit significantly improved in 2015, and should improve further on the gradual liberalisation of the natural gas market. We expect the state will continue to support the company, eg by assisting in re-financing its debt portfolio. A significant part of Naftogaz's debt portfolio is represented by domestic banks and is guaranteed by the state.

Naftogaz is Ukraine's major natural gas production, supply and transit company. In 2015, it produced 16 billion cubic meters (bcm) of gas and imported 15.4bcm from the EU and Russia.

KEY RATING DRIVERS
Rating Linked With Sovereign
Naftogaz's ratings are aligned with those of Ukraine. This reflects Naftogaz group's strategic importance to the state as the sole gas operator of the gas transmission system and its status as a guaranteed natural gas supplier. In 2015, Naftogaz continued to receive equity injections from the state budget, which may not be needed in 2016, provided the planned natural gas tariffs adjustment takes place. The state directly guarantees some of Naftogaz's loans, which is another indication of its support. In addition, Naftogaz's performance is closely monitored by the IMF, Ukraine's major lender, which creates incentives for the state to keep Naftogaz adequately funded.

Reducing Operating Deficit
Ukraine has committed to eliminate Naftogaz's operating deficit by 2017, when the 100% parity between the domestic gas tariffs and the cost of imported gas is to be achieved, as part of its deal with the IMF. As expected, in April 2015 the state raised domestic natural gas prices for households to 56% and for heating utilities to 30% of the imported gas price. However, a further increase, to 75% of the parity intended to come into force from 1 April, 2016, was delayed due to political reasons.

Naftogaz's operating deficit in 2016 will largely be driven by the pace of price liberalisation, as well as the level of imported gas prices and the hryvna exchange rate. The company may not require equity injections from the state if the price liberalisation process proceeds as planned. However, we expect the state to step in and support Naftogaz if the planned indexation does not take place, or other factors (such as rising imported gas prices or further hryvna depreciation) significantly affect the company.

Disputes With Gazprom
Naftogaz's strained relations with its former major supplier PAO Gazprom (BBB-/Negative) mirror the political tensions between Russia and Ukraine and negatively affect Naftogaz's credit quality. There are a number of claims and legal disputes initiated by both Naftogaz and Gazprom against each other, with yet unclear implications.

Naftogaz and Gazprom signed a 10-year gas supply contract in 2009. However, this has effectively been abandoned as Naftogaz believes the contract is unfair and is disputing it with the Stockholm arbitration court. Naftogaz claims it overpaid for natural gas delivered in 2010-2015, and seeks to recover losses, while Gazprom is attempting to enforce the 'take-or-pay' provision.

In addition, Naftogaz and Gazprom signed a 10-year gas transit contract in 2009. This contract is also being disputed in the Stockholm arbitration court. Naftogaz believes it incurred losses as Gazprom decreased transit volumes from those originally contracted; it also claims the transit fees should be calculated in accordance with the EU regulations, rather than as originally stipulated in the agreement. Gazprom denies the claim.

The legal proceedings between Naftogaz and Gazprom may take a significant amount of time and the outcome is difficult to predict. This exposes Naftogaz to significant legal risks. Potential interruption of transit and/or supplies is another risk.

Transit Volumes To Decrease
Ukraine remains a major transit route for Russian natural gas sold to Europe. However, its significance has reduced after Russia launched the Nord Stream pipeline in 2011-2012. In 2015 transit volumes remained at 67bcm, compared with 93bcm in 2011; we expect such volumes to remain relatively stable in 2016. We also expect that the total transit fee for 2016 will not exceed USD2bn, compared with USD3bn earned in 2011. In the longer term, the decline in transit volumes may take on greater significance, considering Gazprom's efforts to bypass Ukraine as a transit country.

Lower Import Prices Positive
Falling natural gas prices in Europe and the diversification of supplies have led to lower import prices for Naftogaz, which has helped reduce its operating deficit. In 4Q15, Naftogaz's average imported gas price fell to USD228/thousand cubic meters (mcm), compared with USD360/mcm in 4Q14 (-37% year-on-year). We expect that Naftogaz's average import price will not exceed USD200/mcm in 2016; however, prices are likely to increase further as we expect oil prices to eventually rise from the current low level. European natural gas prices are largely driven by the dynamics of oil prices, though the share of traditional oil-linked contracts has reduced in recent years.

Supply Diversification
Naftogaz's has taken steps to diversify away from Russian gas and these have helped reduce effective import prices and strengthened its business profile, as political tensions between the two countries continue. In 2015, Naftogaz purchased 9.3bcm of natural gas from the EU and 6.1bcm from Gazprom, compared with 4.9bcm from the EU and 14.4bcm from Gazprom in 2014. Ukraine imports gas from the EU through the so called "reverse flow" scheme, via Slovakia, Hungary and Poland. Currently, the reverse flow capacity is around 58mcm per day, which technically allows Naftogaz to satisfy its gas import needs.

Upcoming Reorganisation
Ukraine's government has committed to reform the energy sector, according to the EU Third Energy Package; this implies marked liberalisation and the unbundling of transmission and distribution functions from trading and production. We believe that Naftogaz is likely to remain as a legal entity after a possible reorganisation, and that its ratings should not be immediately affected, as long as its links with the state remain strong.

KEY ASSUMPTIONS
- Gradual indexation of gas tariffs; the state steps in to support the company if required.
- European natural gas prices remain below USD200/mcm in 2016, gradually rising thereafter.
- Natural gas transit fees of around USD2bn p.a.
- Naftogaz's domestic loans falling due are mostly extended; EBRD and Gazprombank loans
are being repaid according to the schedule.

RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to negative rating action include:
- sovereign rating downgrade, resulting from intensification of political and/or economic stress, potentially leading to a default on government debt; and
- evidence of less state support.

Future developments that may, individually or collectively, lead to positive rating action include:
- sovereign rating upgrade, resulting from an improvement in political stability, progress in implementing the economic policy agenda agreed with the IMF, and an improvement in external liquidity;
- positive free cash flow from rising domestic gas tariffs; and
- greater financial transparency, such as more prompt publication of consolidated financial reports.

LIQUIDITY
Weak Liquidity
Naftogaz's liquidity remains extremely weak; at end-2015 its cash balances were at UAH7.1bn, (USD297m) compared to short-term debt of UAH15.5bn (USD644m). We expect that Naftogaz will continue to service its external debt, including the USD1.4bn Gazprombank loan due 2018 and the recently received USD300m EBRD loan. We also expect that Ukraine's domestic banks will refinance Naftogaz's loans falling due, as has been the case in recent years.