Naftogaz Defaults, Bondholders Rejoice

A little update on my post a few weeks back on Naftogaz. As "kind of" expected, the company failed to make the principal payment on its $500 million bond issue back on Sep 30, generating what the rating agencies called a "technical default".
They did come up with the interest coupon, however. LINK

Since then, and also as expected, the company held a bondholder vote, and with an overwhelming majority (92%), holders of Nafto paper agreed to swap their "defaulted" paper for the to be issued 9.5%, 5 year, govenment-backed bond that Naftogaz was offering in exchange. Even the dissident group went along. LINK

A few lessons here. One is that despite the showdown and drama that played out in the press, there was no real interest in any other outcome. Bondholders weren't necessarily obsessed with collecting their money, just getting a decent deal in the exchange (which they did). It's not like there are ton of better opportunities elsewhere.

The next lesson is that not all defaults are created equal. There is a huge difference between this "pseudo-default" (although it was defined as such for effects of making good on CDS), and defaults such as the Argentine default in 2001 and the recent Ecuadorian default. No one's going to lose money on this one, and I wouldn't be surprised if the new Naftogaz bonds were trading above par in less than a year.

Finally, if Ukraine wants to be a player in the capital markets, they really have to get their act together. This back and forth about paying or not paying and letting everything go down to the last minute (and beyond) was totally unnecessary and counterproductive. A little professionalism and foresight go a long way towards reducing country risk (and hence interest expenses). Ukraine could certainly take a lesson from Russia in this aspect, as much as it may pain them to do so.

The Long and Short of Naftogaz

Ukraine’s state-owned gas company is not usually at the top of the business news here in the Western Hemisphere. But there is a story to it, and like usual in this blog, an investment opportunity.

So here’s the short story and the long story.

The Short Version

Naftogaz, 100% owned by the Ukraine Government, is not in the finest of financial conditions these days. But as a government entity, the Ukraine government by way of subsidy or capital infusion has bailed it out, time after time.

The company has a series of loans and other debt obligations coming due over the next two years, which it wishes to reschedule. The total is $1.7 billion. The interesting part (for us) of these obligations is a $500 million bond issue coming due September 30. Two weeks from now.

All summer long, Naftogaz has fueled speculation about whether it would pay these bonds on time. At one point, it seemed they would pay. And then they’d be back in the “restructuring” mood.

Two weeks ago, they hired Credit Suisse to help them with the process, so the “restructuring” seemed to back on. LINK. Yesterday it was announced that talks with bondholders were beginning. Some tentative terms were leaked to the press. LINK.
Not everyone is happy with this, and there is a dissident group trying to block the efforts and make Naftogaz pay up on time. LINK.

Naturally, all this has bondholders quite nervous and that 2009 bond (with a 8.125% coupon) maturing in two weeks is trading at 85-86%.

The terms “leaked” about the restructuring are a coupon of 9.5%, an additional five years, an explicit government guarantee and possibly an upfront “consent” payment. If that’s it, sign me up.

Certainly, Ukraine is not an easy place to invest, and there is a rocky road ahead. But it’s not easy finding double digit yields anymore, not even in the emerging markets. This is a risk I can stomach. This isn’t Ecuador, who thumbed its nose at the international financial markets, recently. LINK.
Ukraine has a $16 billion program with the IMF established last year in the midst of the global crisis. You don’t sign on with the IMF, if your plan is to default a few months later. (You default FIRST, and THEN go to the IMF)

Now the LONG version
(more interesting…but well, LONGER)

The Ukraine and Russia have had a complicated relationship going back centuries. I’ll let you wiki that if you will, but here’s how it all relates to gas.

Russia has gas, with 25% of the worlds known reserves. Europe needs gas, since it gets cold in the winter (and at other times also) Since the 1970’s, the Soviet Union has been exporting gas to Eastern and Western European countries through a network of pipelines.

Here’s a great map of those pipelines. LINK. (Don’t you just love maps?)

I did write “Soviet Union”, but the USSR is no more and the main trunkline of the pipeline now goes straight through now independent Ukraine. That pipeline now belongs to Naftogaz. But the gas belongs to Gazprom (Russia).

If this sounds like fertile grounds for conflict, it has been. Through the 1990s, Ukraine and Russia quibbled about these issues and in particular gas debts, since Ukraine had the habit of getting behind on payments for the gas it consumed.

Not surprisingly, things really started to get testy after the Ukrainian “Orange Revolution” of November 2004-January 2005, from which a pro-Western government emerged with talk of joining the European Union and (OMG) even NATO.

So at that time, Gazprom figured out that it was about time to look at the easy terms (below “market”) that Ukraine was enjoying for the gas it consumed, and of course, Ukraine wanted more money for “transit fees” through its territory. Naftogaz admitted to “turning the valves” its way (diverting gas for domestic needs).

The dispute culminated with Gazprom turning off the gas for EVERYONE on Jan 1, 2006. The Europeans, not really enjoying the prospect of freezing in January, helped broker a deal and supply resumed. A similar spats over debts and prices resulted in a disruption in supply earlier this year, again with some Western European intervention.

At the moment, Naftogaz is current with its payments to Gazprom, but that probably doesn’t leave a lot of room for other creditors (hence the proposed restructuring). Add to this the fact that Naftogaz still subsidizes local gas consumption heavily (something the IMF isn’t particularly happy about) and Naftogaz’ financial situation is still suspect. But, as stated above, there is an “implicit” government backing and frankly for all practical purposes, Ukraine can not cut Naftogaz loose.

If all this weren’t convoluted enough, Ukraine is scheduled for presidential elections in early 2010. The incument president (Yushenko) AND primer minister (Tymoshenko) are expected to run, as well as former president (and loser in the “Orange Revolution”) Victor Yanukovych, (Putin’s favorite., BTW)

If all this is a little too complex for your stomach, well, maybe investing in the emerging markets is not your cup of tea. Personally, I love this stuff, especially when I’m sitting 6,000 miles away. I’ll take the Florida heat over the Ukrainian winter (with or without gas) anytime.

PS. The picture is of Prime Minister Yulia Tymoshenko, who has the Princess Leia look down pat. She appears to be Yanukovych’s (the pro-Russia ex-prez) strongest opponent in the upcoming elections. Incumbent President Yushenko, the Orange Revolution “Victor”, is nowhere to be seen in the polls.