Ukraine prices local coal at premium to API2 index, positive for DTEK

Ukraine’s utility sector regulator, the NERC, announced last week that it has increased its forecast of the wholesale electricity price, which was flat since last July. In particular, it estimated the average wholesale price for May-June at UAH 1,237/MWh (+13% yoy, +5% qoq), for 3Q16 at UAH 1,280/MWh (+8.7% yoy, +3.5% qoq) and for 4Q16 at UAH 1,319/MWh (+12% yoy, +3% qoq). This forecasted price directly affects prices for final industrial consumers.

More importantly, in its price forecasts NERC began applying for the first time a new methodology for calculating the selling prices of Ukrainian coal-fired thermal power plants (TPPs) that it adopted on March 3. Based on this methodology, the electricity price sold by TPPs will cover in full the coal costs calculated based on the  API2 coal index (the CIF price of coal in Amsterdam-Rotterdam-Antwerp), plus the costs of coal delivery from Rotterdam to Ukrainian TPPs. For pricing purposes, the API2 index (which takes coal with a calorific value of 6,000 kcal/kg) is adjusted for the real calorific value of coal consumed by TPPs. The API2 index and delivery costs are calculated as trailing for the last 12 months. On top of that, the forecasted price of electricity will cover the TPPs’ other costs (based on historical costs plus producer-level inflation) and allow for a certain profit margin (the figure is not disclosed in the publicly available regulatory documents).

Alexander Paraschiy: This is a positive breakthrough for DTEK (DTEKUA), the leading producer of steam coal in Ukraine and the largest operator of TPPs. The new regulation will not only enable DTEK’s TPPs to start generating profits, but will also boost the profits of DTEK’s coal mines. The holding was trying to persuade key policy makers since early 2015 that local coal should be priced on par with global benchmarks, and now it seems to have received even more than it was initially requesting. Before the regulation was applied, DTEK had to sell its coal at about UAH 1,100-1,200 per ton to Ukrainian power plants (any higher coal price won’t be covered by the TPPs’ regulated prices), while now it potentially has an ability to sell coal at about UAH 1,400-1,500/t.

Interestingly, with such regulation fully in place, Ukraine will have probably among the highest prices of steam coal globally. For instance, we estimate the last 12-month average coal price in Rotterdam (the basis for calculating the price of Ukrainian coal today) is USD 51.8/t, which is 13% more than today’s Rotterdam price.

More importantly, if this methodology is sustained for the future, DTEK’s revenues in its coal and power-generating segments (its key profit generating units) will be linked to the dollar prices of coal. So its P&L in dollar terms won’t depend on the volatility of the Ukrainian currency any more.

The key risk now is it’s too good to be sustainable. As this regulation affects all industrial power consumers, and given that the new coal pricing methodology overly positively discriminates local coal producers as compared to global peers, there will always hang the looming risk that it will be revised to DTEK’s detriment.

Thus far, this regulation strengthens our bullish view on DTEK’s bonds.