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Industry Report

Ukraine coal

July 2013

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ABBREVIATIONS AND DEFINITIONS

BP – British Petroleum

CAGR – compound annual growth rate

C. (circa) – approximately

Coking coal (or metallurgical coal) – is used to make metallurgical coke which is further added as a reducing agent in a blast furnace to temper iron ore into

steel products

Lean coal – quasi–anthracite, easy to ignite coal that is used as a fuel for thermal power plant. A sub-grade of Steam coal.

LNG – liquefied natural gas

MECU – Ministry of Energy and Coal of Ukraine

Mt – million tons

PCI – pulverised coal injection

PCR – proved coal reserves

PPP – private-public partnership

R/P ratio – reserves-to-production ratio

SSC – State Statistics Committee of Ukraine

Steam coal (or thermal coal) is burned for steam to run turbines to generate electricity either to public electricity grids or directly by industry consuming

electrical power (such as chemical industries, paper manufacturers, cement industry and brickworks). During power generation the coal is ground to a powder and

fired into a boiler to produce steam to drive turbines to produce electricity.

TER – techno economic rationale

TPP – thermal power plant

UAH – Hryvna, national currency of Ukraine

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CONTENTS

1. Executive summary ................................................................................................................................................................................................................................................................ 3

2. Ukrainian coal in the international context ........................................................................................................................................................................................................................ 4

3. Domestic market .................................................................................................................................................................................................................................................................... 6

4. Ukrainian energy strategy ...................................................................................................................................................................................................................................................... 9

5. Recent developments and news ......................................................................................................................................................................................................................................... 11

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1. Executive summary

Ukraine is the fourth-largest coal producer in Europe (85.8Mt excavated in 2012) after Russia, Germany and Poland. With PCRs of some 33.9 Billion tons, the

Ukrainian coal industry accounts for 4% of the global coal reserves. This is enough to support the current levels of coal production in the country for more than

390 years.

There are three coal basins (Donetsk, Lvov-Volyn and Dnieper) on the territory of Ukraine, the largest being the Donetsk basin (87% of Ukraine’s PCR).

Geologically, a majority of coal beds have low-powered seams (c. 0.6-1.5 m) laid relatively deeply (c. 1,000 – 1,300 m) and characterised as explosive owing to the

high gas content. This makes the Ukrainian coal mining a challenging exercise, both technologically and environmentally.

Steam coal is a substantial contributor to the Ukrainian energy output. Coal-based thermal power generation is the only reliable and import-free energy source

capable of delivering adequate energy volumes with flexibility required by the industrial and individual consumers in Ukraine.

Impact of the Ukrainian coal on the European coal market is insignificant due to availability of the large high-quality coal reserves in Germany and Poland.

Plentiful supply of the US coal is also a market-defining factor.

Main factors currently affecting the Ukrainian domestic coal market are:

On the negative side – significant unsold stockpiles, high concentration of buying power, unregulated mining, shrinkage of the global steel demand, shale

gas boom, planned commissioning of LNG-terminal, installation of the PCI equipment at a number of the Ukrainian steel mills;

On the positive side – gradual shift to steam coal as a source of energy, construction of coal gasification plants, government determination to reduce

reliance on the Russian natural gas.

Ukraine’s energy needs are largely served by natural gas imported from Russia even though coal is the country’s richest source of the fossil fuels. Ukraine’s Energy Strategy 2030 is based on the government’s declared intention to decrease the country’s dependence on the imported fuels, including the plans to increase coal production.

Ukrainian coal industry has recently undergone substantial change including mine privatisations, closures of unproductive mines and, in some cases, modernisation of equipment and safety improvements.

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2. Ukrainian coal in the international context

Coal is generally regarded as the world’s most affordable and sustainable source of energy and thus is a major contributor to the world energy supply. According to The BP Energy Outlook 2030, coal consumption grew by 5.4% in 2011. Coal is the only fossil fuel to record the above-average growth and is the fastest-growing form of energy outside renewables. Coal now accounts for over 30% of global energy consumption, the highest share since 1969. According to International Energy Agency’s Medium-Term Coal Market Report 2011, global demand for coal will continue to grow aggressively over the next five years despite public calls in many countries for reducing reliance on the high-carbon fuel as primary energy source. Due to the current low price of the Emissions Reduction Units, the European energy enterprises may also reconsider switching from cheaper coal consumption to alternative sources of energy. With PCRs of about 33.9Billion tons of proved coal reserves, the Ukrainian coal industry accounts for 4.0% of the global coal reserves – enough to support the current levels of coal production (85.8Mt in 2012) for more than 390 years (Figures 2.1. and 2.2.) Steam coal market Steam coal is consumed as a primary fuel for power generation worldwide because of its relatively even allocation of coal deposits on the planet and low cost of heat content relative to other fossil fuels such as oil and natural gas. For steam coal, prices and demand in Europe tend to be relatively stable as there has been little shift in the source of electricity generation and heat production from year to year. During 2012 and into 2013, significant stockpiles of inventories have been built up in the region, due to the mild winter conditions and slower economic activity. This has puts downward pressure on the coal prices in 2013. Global steam coal markets have been disrupted in recent years by the boom in shale gas extraction in the US, which reduced the share of coal in the electricity mix in the U.S. below the historic 50%. The large amounts of new gas supply available on the US market and the subsequent drop in gas prices globally have undercut the competitiveness of steam coal.

Figure 2.1. World proved reserves at end 2011

Source: The BP Energy Outlook 2030

Figure 2.2. R/P ratio at end 2011

Source: The BP Energy Outlook 2030

28%

18% 13%

9%

7%

5%

4%

4% 3%

9% US

Russian Federation

China

Australia

India

Germany

Ukraine

Kazakhstan

South Africa

471

390

290

239

216

184

118

103

33

0 100 200 300 400 500

Russian Federation

Ukraine

Kazakhstan

US

Germany

Australia

South Africa

India

China

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This drop in thermal coal demand has resulted in many US coal miners being forced to seek new export markets overseas. Europe and its neighbor countries became the natural targets: import of coal from North and South America to Europe increased by 29% in 2012 as a result. The increase in supply to this region has put downward pressure on overall exports of the Ukrainian steam coal which fell by 12% to 5.9Mt in 2012 as sales to the key EU markets dropped by 21% to 3.4Mt (Figures 2.3 and 2.4). The key reasons for the Ukrainian coal losing its share in the EU countries were lower prices and better quality of the American coal. Despite the recent price fluctuations on the European coal market, the Ukrainian coal prices have been less volatile as there are currently no viable substitutes for coal. In summer 2012, the Ukrainian government announced construction of several new coal gasification plants, an initiative likely to support the coal price in the near future. Coking coal market Traditionally, steel industry has been the largest consumer of the coking coal thus highly impacting developments in the coal market environment. Steel industry in Europe has struggled during 2012 as prices and demand fell in line with reduced economic activity. Overcapacity of steel production has been considered by the industry’s members a major challenge to profitability. Consumption of steel in Europe in 2012 compared to 2011 decreased by 8% (the decrease was almost 30% compared to 2007). This underperformance of the steel sector was translated into a decrease in prices and revenues on sales of coke and coking coal. Being pegged to international benchmarks, prices for domestic low-sulphur coking coal should follow a similar trend. At the same time, the rising surplus of poorer-quality coal from Ukraine will cause its prices to decline more significantly. Important trend to be noted is introduction of the PCI technology as a partial alternative to the use of coke in steel production. PCI equipment is being installed at a number of European as well as Ukrainian steel mills (in 2013, the number of blast furnaces exploiting PCI equipment in Ukraine is expected rise from 9 to 13 out of the total of 27) which should require extra supplies of high-quality coking coal in the future. Ukraine is poorly placed to meet this new demand due to the high sulphur content of the country’s traditional coals. As in the past, import is likely to be the only viable response: in 2012, some 37% of the coking coal consumed in Ukraine was imported, from Russia mainly.

Figure 2.3. Breakdown of Ukrainian steam coal export in 2012

Source: SSC

Figure 2.4. Export of Ukrainian steam coal, Mt

Source: SSC

21%

14%

11%

7% 7%

5% 4%

31%

Bulgaria

Turkey

Belgium

Poland

Russia

Spain

Canada

Others

4.8

6.0 6.7

5.9

0

1

2

3

4

5

6

7

8

2009 2010 2011 2012

CAGR 7.1%

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3. Domestic market

Ukraine has a wide variety of energy sources available including nuclear fuels, hydro power, oil & gas however coal remains by far the most important and dependable. Over the last 12 years, the Ukrainian coal production volumes fluctuated from the minimum of 73.8Mt in 2009 to the maximum of 86.8Mt in 2011. The domestic coal consumption remained relatively stable at above 50% of the production volumes (Figure 3.1). Product-wise, the domestic coal market is made up of two key segments: steam coal, which is used primarily for energy generation and coking coal, which is used mainly for steel-making. The Ukrainian coal market is defined by a deficit of the coking coal, by an excess supply of the steam coal of anthracitic group and by the deficit of Grade ‘T’ lean coals demanded by the power generators. On the supply side, the defining feature of the market is preeminence of Ukraine’s largest group, SKM Holding. Its one subsidiary, DTEK produces some 90% the country’s private steam coal. Another subsidiary, Metinvest produces some 22% of Ukraine’s private output of the coking coal (Figures 3.2 and 3.3 on the next page). Steam coal Steam coal constitutes 71% (2012) of the entire coal production, part of which is exported mostly to the European countries (Figure 2.3 earlier). Domestically, some 90% of the steam coal output is consumed by the energy-generating companies. The balance is distributed to metallurgical plants (4%), individuals (3%), cement producers, soda and sugar mills, ore enrichment works and railways. Spurred by the high prices on the imported natural gas (traditionally used in Ukraine for electricity generation), the government has announced the programme of switching TPPs from gas to coal starting from 2013; these efforts are likely to bear fruit in 2015-2016. According to the Ministry of Economic Development and Trade of Ukraine, steam coal consumption in Ukraine should grow by 8.7% in 2013 driven by an increase in Ukraine’s electricity production (the ministry foresees a 0.8% increase for the year). Industry members, agreeing with this forecast in general, nevertheless expect that this consumption growth will be insufficient to liquidate the coal inventories accumulated at the end of 2012. Moreover, some experts expect the surplus to build further still.

Figure 3.1. Trend of coal consumption and production in Ukraine, Mt

Source: The BP Energy Outlook 2030 (2000-2011); MECU (2012)

40.0

40.7

39.9

41.3

40.1

38.3

40.6

40.7

41.2

36.0

38.8

43.4

61.2

81.0

83.9

82.5

80.2

81.3

78.8

80.2

76.8

79.5

73.8

76.8

86.8

85.8

-10.0 10.0 30.0 50.0 70.0 90.0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Production Consumption

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Coking coal Ukraine’s coking coal is primarily used by the domestic iron and steel industry which collectively account for approximately 90% of the total coking coal demand. The remainder is consumed by the foundry industry and other small industrial users. Ukrainian producers satisfy domestic demand to a large extent yet over 1/3 of the consumed coking coal is imported, mainly from Russia (Figure 3.4). In recent years, the demand was boosted by both the declining domestic output (owing to exhaustion of the easy-to-extract deposits) and lower quality of the coal excavated (high-sulphur coal is unacceptable for steel mills). Introduction of the PCI equipment at the Ukrainian steel mills is likely to cause further structural

changes in the coal market. Specifically, demand for the low-sulphur premium coal will further

increase, and the demand for low-quality, high-sulphur coals will stagnate. Consequently, coking

coal imports are expected to grow to 12.3Mt in 2013, according to Ukraine’s cokemakers’

association Ukrkoks. Only a handful of the domestic producers are equipped to deliver the quality

of coal required by the PCI technology, namely Donetstkstal’s Pokrovske Mine,

Yuzhnodonbaskaya 3 Mine and Skochinskogo Mine. Such companies will benefit from the

structural shift in the coal market; other coal producers are likely to struggle in a recessionary

economy and challenging technology environment. Due to the coke-saving effect and stricter

quality requirements at the PCI introduction, the demand for ‘standard’ domestic coal is set to

decrease with the corresponding increase in the share of imported coal.

Figure 3.2. Main Ukrainian steam coal producers in 2012

Source: Energobusiness

Figure 3.3. Main Ukrainian coking coal producers in 2012

Source: Energobusiness

39%

17%

18%

11%

8%

4%

1% 0.5% 2%

Pavlograd coal

Sverdlovantrazit

Rovenkiantrazit

KomsomoletsDonbassaDopropolye Coal

Coal Energy

Belorechenskayamine

DTEK

34%

22% 6%

5% 1%

3%

29%

Pokrovskoe Mine

Krasnodon Coal

Zasyadko

Krasnolimanskaya Mine

Coal Energy

Pavlohrad Coal

Others

Metinvest

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In terms of state vs. private production, the general trend of the past several years has been towards greater share of the privates in both steam and coking coal (Figures 3.5 and 3.6). Main driving force behind the trend is technological obsolescence of the Ukrainian state mines of which by number some 70% have been operating for over 30 years without technical overhaul or upgrade of any kind. The state coal mines have been hugely underfunded; the mines are unprofitable and cannot finance the investment projects independently. This created the background for a gradual transfer of the state coal-mining assets into the private ownership that took place in 2009-2012. Another critical issue plaguing the Ukrainian coal industry is unregulated mining. According to various sources1, the unregulated market contributes some 6-9Mt per annum of coal (chiefly of the steam variety) or c. 7-10% of the total Ukrainian steam coal output. Dependable statistics on the unregulated mining are hard to come by yet the apparently lower costs of unregulated mining operations make the coal so produced price-attractive for the buyers and extremely disruptive for the rest of coal producers.

Figure 3.4. Breakdown of Ukrainian coking coal consumption in 2012, %

Source: SSC

Figure 3.5. Coal production in Ukraine, Mt Figure 3.6. Coal production in Ukraine, Mt

Source: MECU Source: MECU

1 http://forbes.ua/magazine/forbes/1351902-kak-ustroen-biznes-na-kopankah

http://korrespondent.net/business/companies/1556731-korrespondent-chernaya-dyra-ukrainy-nelegalnaya-dobycha-uglya-priobretaet-gigantskij-razmah

http://www.kommersant.ua/doc/2122477

63%

26%

8%

2%

1%

37%

Ukraine Russia USA Kazakhstan Others

Imported coal

35.2

29.3 30.9 30.8

17.6

10.3 9.1 7.4 7.5 7.2

0

10

20

30

40

2008 2009 2010 2011 2012

State mines

Steam coal Coking coal

15.8 17.4 20.1

26.2

43.5

16.3 16.4 16.5 17.3 17.5

0

10

20

30

40

50

2008 2009 2010 2011 2012

Private mines

Steam coal Coking coal

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4. Ukrainian energy strategy

Energy is an area of high impact and, correspondingly, high importance for the state planning. Instead of the resource-intensive energy development on which Ukraine has relied for decades, power generation must switch to effective energy utilisation to sustain the economic development. With this goal in mind, the Ukrainian government initiated an update of the Energy Strategy in mid-2012.

The Updated Energy Strategy considers development of core energy sectors and aims at substantial energy savings to be attained in years leading to 2030.

Under the Strategy, coal remains one of Ukraine’s preeminent sources of energy supply and continues in its strategic role as the Ukrainian state’s main safeguard against excessive reliance on energy imports.

Accordingly, the Strategy envisages and calls for certain practical initiatives to be undertaken

in order to develop the economic potential of the coal industry:

Encouragement of privatisation via enhancement of the industry’s investor

attractiveness;

Modernisation of the coal mining assets by state and private investors and optimisation of the management systems;

Improvement of the state subsidy and social support mechanisms, including reduction of the coal-mining subsidies and job placements for the displaced miners;

Liberalisation of the coal market.

The Strategy envisages the maximum additional ‘economically justifiable’ production volume of steam coal in Ukraine of up to 30Mt per annum, conditional upon the

total investment of UAH50 Billion (c. USD6 Billion at the current exchange rate). Construction of the state mines commissioned in the earlier years is planned; the new

mines will have the aggregate capacity of 3Mt per annum.

The Strategy also proposes to close down the mines for which private investors were not found on condition that such closures do not result in the deficit of the coal of

the corresponding grade. Mines which will deplete their own production reserves before 2030 will be closed as well. As a result, the steam coal production volume is

expected to decline by c. 5Mt per annum.

Liberalisation of the coal market will include support of the coal trading on the electronic exchanges and coal price setting on the basis of calorific value.

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According to the Strategy, the issue of forward-looking concern is the coal mining utilisation i.e. usage of the coal bed methane.

Provided that all the above initiatives are implemented by 2030, the Ukrainian steam coal volumes are set to increase by 50% in comparison with the production levels

reached in 2010. This would allow the industry to satisfy the coal demand in line with the planned increase in the domestic power generation capacity.

Attainable level of coal production in 2030 is stated at 115Mt of which 75Mt is attributed to the steam coal. Simultaneous achievement of the broader industry-wide

‘break-even point’ and complete phase-out of the col subsidies are also envisaged as key strategic outcomes.

Implementation of the Updated Energy Strategy for coal industry is planned in three stages:

First stage (2011 - 2015) – industry restructuring, completion of the state mines privatisations, implementation of legislative framework for the PPI arrangements, closures of unprofitable mines;

Second stage (2015 - 2020) – active modernisation of the coal mine assets by private investors; optimisation of the management systems. Coal industry reaches

the industry-wide ‘break-even point’; state coal subsidies cease;

Third stage (2020 - 2030) – sustainable growth in coal production and gradual replacement of mining technologies (including termination of the reserve-

depleted mines); effective development of the new reserves for mines with adequate production and economic potential; reconstruction of mines and

commissioning of new equipment; cost reductions required to support the new levels of economic efficiency.

11

5. Recent developments and news

Quotas on imported coal

In March 2013, the government announced plans to introduce, for 2013, a quota of 10.2Mt of imported

coking coal, including 2.5Mt of the PCI coal, and to ban imports of coke. Later in the year the

government revised the decision and compressed an initial 12-month period (full 2013) into the seven

months starting from 1 June and ending 31 December 2013 with the quota size remaining the same.

Quotas were set initially for a three-month period from 1 June to 31 August; further revisions are planned

as the year 2013 progresses. As quid pro quo, the metallurgical plants agreed to purchase, during 2013,

additional 4.05Mt of the below-grade coal from the state mines.

Construction of coal gasification plants

According to MECU’s comments, commencement of construction of the first coal gasification plant in

Ukraine was scheduled for June 2013, to be funded by a loan from China Development Bank Corporation

in line with the Ukrainian-Chinese strategy of gas-coal substitution. Three coal gasification plants are to be

constructed – in Lugansk, Donetsk and Odessa region using the Shell Corporation technology field-tested

in China.

Government support of the state mines

In Budget 2013, UAH8.1 Billion (USD1.0 Billion at the current exchange rate) is allocated for financial

support to the state mines, mostly to cover partly the production costs. In Budget 2012, government

support amounted to UAH14.6 Billion (c. USD1.8 Billion equivalent) according to MECU.

LNG terminal

TER for LNG terminal in Odessa region were worked out by Spain’s Socoin and stated publicly in

September 2012. The construction once commenced is planned to take six years to 2018, with the first

stage coming on-steam in 2015 and allowing the processing of 5 Billion cubic meters of LNG per annum

(approximately 1/5 of the Ukrainian total gas consumption. The second stage will contribute capacity for

processing of the additional 5 Billion cubic meter of gas per annum. At the time of writing this report, no

construction commenced.

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