OREANDA-NEWS. Fitch Ratings has upgraded NJSC Naftogaz of Ukraine's (Naftogaz) Long-term foreign currency Issuer Default Ratings (IDR) to 'CCC' from 'CC'. The local currency IDR has been affirmed at 'CCC'.

The rating actions follow the upgrade of the sovereign rating to 'CCC' from 'RD' (see 'Fitch Upgrades Ukraine's Foreign Currency IDR to 'CCC'' dated 18 November 2015 at www.fitchratings.com).

Naftogaz's ratings are aligned with those of Ukraine, its sole shareholder, and reflect its strong links with the state, the continued weakness of the company's financial profile and its exposure to political risks. We consider that timely financial support from the state remains critical for its solvency as Naftogaz still has a significant operating deficit - albeit reducing due to staged price liberalisation - caused by the disparity between imported gas prices and domestic gas tariffs for households and heat generation companies. We believe that the company is likely to default without such support.

Fitch upgraded Ukraine to 'CCC' as the country has emerged from default on commercial external debt, issuing new bonds on 12 November to holders of USD15bn in defaulted Eurobonds. The restructuring pushed out maturities to 2019-2027.

Naftogaz is Ukraine's major natural gas production, storage and transportation company. In 2014 it produced 17 billion cubic metres of gas (bcm) and imported 19.3bcm from Russia and the EU.

KEY RATING DRIVERS
Rating Linked With Sovereign
Naftogaz's ratings are aligned with those of Ukraine. This approach reflects Naftogaz group's strategic importance to the state as the sole gas operator of gas transmission system and a guaranteed natural gas supplier, as well as state subsidies and other forms of tangible financial support provided to Naftogaz. 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 IMF, Ukraine's major lender, which creates incentives for the state to keep Naftogaz adequately funded.

Operating Deficit Remains
Naftogaz's operating deficit will remain high in 2015, as domestic gas tariffs, especially for heat generation companies, are still insufficient to cover imported gas prices. The oil-indexed imported gas price has decreased in 2015 following falling crude prices, but this has been largely undermined by the hryvnia depreciation and weak receivables collection in certain regions,. The IMF memorandum targets Naftogaz's deficit to be eliminated by 2017.

Disputes With Gazprom
Naftogaz's strained relations with its former major supplier OAO 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. This exposes Naftogaz to significant legal risks. Potential interruption of transit and/or supplies is another risk.

Lower Import Prices
The decrease in gas prices in the EU gas market (covered 25% of supplies for Naftogaz in 2014 and 70% in 1Q15-3Q15) has led to lower import prices for Naftogaz. Low oil prices are positive for Naftogaz, as prices for imported natural gas are linked to those of oil products with a nine-month lag. In 3Q15 Naftogaz's average import gas price went down to USD266/mcm, compared with USD353/mcm in 3Q14 (-25 yoy). However, lower import prices will have a limited effect on Naftogaz's operating deficit in view of other negative factors, such as the hryvnia depreciation and weak receivables collection in certain regions.

Supply Diversification Positive
Naftogaz's steps taken to diversify away from the Russian gas should strengthen its business profile as political tensions between the two countries are likely to remain in place. In 2014 Ukraine purchased 14.4bcm of natural gas from Gazprom compared with 4.9bcm sourced from the EU. In 2015 EU countries have taken over as Naftogaz's main gas supplier. Ukraine imports gas from EU through the so called "reverse flow" scheme via Slovakia, Hungary and Poland. Currently the reverse flow capacity is around 58 million cubic metres per day, which technically allows Naftogaz to satisfy most of its gas import needs.

KEY ASSUMPTIONS
- The state continues to support Naftogaz through subsidies
- Gradual indexation of gas tariffs
- Natural gas transit volumes about 64bcm in 2015.
- Naftogaz's domestic loans falling due are mostly extended; Gazprombank's loan due 2018 is 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.
- Evidence of less state support.

Future developments that may, individually or collectively, lead to positive rating action include:
- Sovereign rating upgrade, resulting from improvement in political stability, progress in implementing economic policy agenda agreed with the IMF and improvement in external liquidity.
- Positive free cash flow from rising domestic gas tariffs and improved receivables collections.
- Greater financial transparency.

LIQUIDITY
Weak Liquidity
Naftogaz's liquidity remains extremely weak and the company is likely to default without state support. At end-2014 its cash balances stayed at around UAH2.3bn (USD145m) compared to short-term debt of around UAH16bn (USD1.0bn). We expect that Naftogaz will continue to service its USD1.4bn Gazprombank loan due 2018. We also expect that Ukraine's domestic banks will refinance Naftogaz's loans falling due, as has been the case for the last several years.

In October 2015 Naftogaz agreed a USD300m loan from EBRD to finance purchases of around 1bcm of gas for the coming winter, subject to Naftogaz's corporate governance restructuring and guaranteed by the state.