Fitch substitutes Naftogaz perspectives to negative

Fitch Ratings has today revised the Outlook on OJSC Naftogaz of Ukraine's Long-term local and foreign currency 'BB-' (BB minus) ratings to Negative from Stable, the FitchRatings reports. This is to reflect the medium- to-long-term negative credit implications for the company and its USD500 million Eurobond from the recent significant increase in the pricing of natural gas imports from Central Asia, specifically Turkmenistan.

Although the recent price increase will be partly mitigated by higher transportation tariffs Naftogaz earns to transport Russian gas across the territory of Ukraine, (see 'Fitch Sees No Likely Credit Impact from Gazprom and Naftogaz Pricing Dispute' dated 05 December 2005 on www.fitchresearch.com), Fitch did not envisage that the negotiated price increase would affect imports from Turkmenistan.

Naftogaz is now to pay USD95 per 1,000 cubic meters (cm) of gas, up from USD50/1,000 cm paid to Gazprom and USD44/1000 cm paid to Turkmenistan in return for USD1.60/1,000cm/100km transportation tariff from Gazprom. At these prices, total cost increases to Naftogaz for Russian gas are approximately USD200 million-250m, which in Fitch's view are not enough to warrant a change in the company's ratings.

"The problem is, however, that the increased pricing to USD95 per 1,000 cm does not only affect the approximately 25 billion cm of gas Ukraine imports from Russia, but also applies to the approximately 35 billion cm the country imports from Turkmenistan," says Jeffery Woodruff, Director in Fitch's Energy team.

At the new price of USD95/1,000 cm, Naftogaz's net gas bill (total gas costs less earnings for transportation) for 2006 is expected to rise by nearly USD1.8 billion-2.0 billion. This amount could vary slightly, depending on the degree to which Naftogaz varies the mix between Russian and Central Asia gas, but Fitch bases its analysis using the average price of USD95/1,000 cm on the Russian-Ukrainian border to import 60 billion cubic meters of gas.

The Negative Outlook is also affected by the new agreement reached with Gazprom over the terms and conditions of the contract. Under this agreement, Gazprom's transportation tariff through Ukraine is fixed for five years, whereas gas prices for Ukraine could be reviewed every six months. This effectively puts a cap on Naftogaz's ability to recover any additional cost increases from Gazprom and could place downward pressure on the company's ratings. Of additional concern to Fitch is the inability of Naftogaz to pass on these cost increases to industry and utilities in Ukraine's fixed domestic price environment. Politics are also expected to play a significant role in protecting industrial users from sharp price increases that may cause financial problems leading to layoffs and social unrest in an election year. A rating downgrade would likely result from an inability to adequately offset rising costs, resulting in a deterioration of the company's key cash flow and credit metrics.

The Outlook could return to Stable if Naftogaz were able to demonstrate an ability to offset rising natural gas costs either through a renegotiation in prices, an increase in transportation tariffs, or an ability to pass on these costs to domestic end users. Additionally, Fitch factors in a degree of state support, as Naftogaz is 100% state-owned and is a vital part of the country's gas transportation infrastructure. Fitch anticipates that some kind of sovereign support could be forthcoming to help offset some of these negative cost implications.