In August of last year, when the Ukrainian government was faced with declining revenues and budget shortfalls it decided to double royalty payments on private natural gas producers. The changes increased the royalty tax for most producers to 55 percent of revenues, before payment of other fees and taxes. At the time, the government sold the measures as temporary and included a discount for newly drilled wells so as to retain an incentive for new investment.
This Christmas past, the government in a snap reversal of its previous pronouncements, made the tax increase permanent and cancelled favorable treatment for new wells. This was heralded at the time as an anti-oligarch tax which was designed to make the rich pay.
In truth, the tax falls most heavily on foreigners.
Billionaires Rinat Akhmetov’s DTEK, Oleg Kolomoisky’s Privat, and Vadim Novinsky’s Smart Group control the deepest and most prolific wells, which are taxed at only 28 percent- so the oligarch tax doesn’t actually tax oligarchs. Other beneficiaries of this oligarch discount are former Region’s Party member Alexander Onishenko and Yanukovych’s Environment Minister, Mykola Zlochevsky; whose Burisma Energy has two licenses benefiting from this provision.
Publicly traded foreign-owned companies do not benefit from the oligarch discount. One Canadian investor, Serinus Energy, has suspended all new drilling in light of the changes. A British investor, JKX PLC, also suspended its capital program, and has gone even further and sued the government in Stockholm under the Energy Charter and received interim relief.
This is pretty incredible. The arbitrator found that in doubling taxes on JKX, the Ukraine government’s royalty rates are not treating foreign investors in a “fair and equitable” manner. For an arbitrator to issue interim relief it must have found that there was prima facie evidence that there is a clear and imminent risk of irreparable damage to the company.
Oilmen have a saying that most new oil is found where you already found oil. As a consultant who has worked with foreign investors in Ukraine I can also say that most new investment comes from existing investors. Ministers may be blinded by the never-ending carousel of road shows and fact-finding missions and foreign delegations that come through their offices, but the vast majority of future investment will come from investors already in the country. That is why it is so worrying that the government has manufactured a crisis in the energy sector and targeted publicly traded foreign owned companies.
Evidence is pilling-up that the royalty tax is: unfair; doesn’t tax oligarchs; alienates scarce foreign investment; hurts Ukrainian energy independence; and according to many independent sources will actually result in lower revenues in the near future. With all this; the Yatsenyuk government not only didn’t reverse course, it perpetuated this failed policy.
While Yatsenyuk’s government voices rhetoric of reform and austerity, the only stand-out item in the revised 2015 Budget provides for a billion dollar loan facility for building up a strategic reserve of either natural gas or bunker oil. This is probably a prudent move and may even give Ukraine the opportunity to time a cyclical downturn in energy prices this summer.
All the same, when one considers the otherwise hostile policies pursued by Yatsenyuk’s government against the energy industry, this strategic energy reserve reminds me of what Warren Buffett once said about the absurdity of gold reserves: “[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it.”
In this case, the absurdity is very real. The Yatsenyuk government is taxing private gas producers so heavily they won’t drill new wells and will leave 6 billion cubic meters of gas in the ground over the next three years. The government in turn borrows $1 billion (enough to buy 4.5 billion cubic meters at today’s prices) to buy Russian gas and bury it underground.
Yatsenyuk is no Kamikaze. His new watchword is “survival.” His energy policy, on the other hand, is certain to crash and burn. Taxing domestic gas producers to death to pay for Russian gas imports can only be described by one word: suicidal.
Christopher Glover is a Canadian lawyer and businessman, he has worked in Ukraine for more than six years and is an expert in Ukrainian energy, primarily assisting foreign investors in unconventional gas exploration.
