Energy: Industrial heartland rattled by stiff price rises

Blessed with rich deposits of ore and coal, Ukraine’s eastern provinces serve as its industrial heartland and home to vast steel mills, chemical plants and machine-building factories. It is this export-oriented region that brings in much of the country’s foreign currency, and earns it the status as a top steel and chemicals exporter. It is also the region that exhibits an Achilles heel inherited from Soviet days when the factories were built: excessive consumption of fuel imported from Russia and Central Asia.

When energy prices were low in the 1990s, Ukraine’s industry kick-started its economic growth spurt, most recently buoyed by sharp domestic consumption. But its weakness was exposed and its economy rattled by three successive stiff price increases in natural gas imports in as many years.

The price rises coincided with Ukraine’s westward foreign policy shift, a by-product of the Orange Revolution of 2004. The profit margins of many Ukrainian factories have suffered considerably. Another big price increase is expected in 2009, but thus far, the industrial sector has surprised many analysts by sustaining the shock.

Energy costs are now significantly higher than for Russian peers, but most have retained a competitive edge over European counterparts, where energy costs are even higher. And Ukraine’s billionaires are investing heavily to cut wasteful consumption.

“During 2006-2008 the gas price for Ukrainian enterprises almost tripled from $80 per thousand cubic metres to a rate of $250,” says Sergiy Maslichenko, an analyst at the Kiev offices of the European Bank for Reconstruction and Development.

“Such price shocks have obviously affected most Ukrainian companies by reducing margins substantially,” at energy intensive industries such as cast iron, steel, chemicals and cement, which still use outdated Soviet technologies.

Energy efficiency investments implemented thus far have helped but much work still lies ahead.

“Less than $1bn has been invested in energy efficiency by Ukrainian industries since the first price increase in 2006,” he says.

“Ukraine is now about 30 per cent more energy efficient than it was in 1991,” when the USSR collapsed. “But it remains one of the most energy-intensive economies in the world.” Mr Maslichenko says about $10bn in efficiency investments are needed by 2015 and another $10bn by 2030.

At the steel mills, wasteful open-hearth furnaces need to be replaced by electric arc systems along with more efficient burners. Chemical plants need to diversify towards higher-value products such as urea and ammonium nitrate. Cement plants need to switch from wet to less energy-intensive dry processing technologies.

The EBRD has stepped up efforts to fund energy efficiency. Cash-rich oligarchs who snapped up $1bn industrial assets years ago have also made efficiency a top priority. Oleg Popov, CEO of System Capital Management, which manages the assets of Rinat Akhmetov, Ukraine’s richest man, says the group is pushing ahead with plans to improve competitiveness of its steel mills and electricity generators.

“The group’s DTEK power holding hopes to raise efficiency by 34 per cent with $1.5bn worth of upgrades by 2012,” says Mr Popov.

Andriy Bespyatov, head of research at Kiev-based Dragon Capital, says steel mills have been less affected than chemical plants as gas accounts only for 6 per cent of their costs.

Chemical plants must cope with energy-thirsty technologies and fierce competition with Russian chemical companies, which pay much less for natural gas.

“Domestic companies buy natural gas, the main input in many chemical production cycles, at nearly $230 per 1,000 cubic metres, while Russian companies pay just $70-$80 per 1,000 cubic metres.” The damage has been “partially mitigated” by rising global demand for fertilisers.

Also affected is Ostchem, the Vienna-based chemical group controlled by Ukrainian billionaire Dmitry Firtash, who plays a big role in the Ukraine gas supply trade.

Mr Firtash owns a 45 per cent stake in Swiss-registered Rosukrenergo, monopoly supplier of gas to Ukraine, which is 50 per cent owned by Russia’s Gazprom. But his special relationship with Russia’s top energy company has not served as protection for his Ukraine factories.

Oleksiy Fedorov, Ostchem’s spokesman, describes the price rises as a “wake-up call for all energy-heavy industries in Ukraine”, but insists the group’s Ukrainian enterprises, Crimean Soda and Crimean Titan, have kept margins stable with upgrades.

The painful transition could force some to sell assets rather than fund costly upgrades. But analysts do not expect the industry to come to a halt. Mr Maslichenko says factories that survive will retain a competitive edge over peers elsewhere in Europe in the long term.

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