Ukraine possesses the third-largest natural gas reserves in Europe, after Russia and Norway. Ukrainian proven reserves amount to 1.2 trillion cubic meters.
Including probable and other gas reserves, total gas reserves of Ukraine amount to 5.4 trillion cubic meters. With a gas consumption of about 32 billion cubic meters (bcm) per year, Ukraine’s proven reserves life (reserves to production ratio) is approaching 40 years, compared to 11 years for the United States and 15 for the European Union.
At its peak in 1975, Ukraine produced 68 bcm of gas per year. Since then gas production gradually declined and has stabilized in recent years at around 20 bcm. As a result, Ukraine is now highly depended on imports to meet its energy needs.
Given the proven inability of the state-owned gas company, Naftogaz, to significantly increase gas exploration and production, Ukraine needs to attract significant amounts of private investments into oil & gas exploration and production.
Of particular importance to a private investor is the stability of the legal relations between the investor and the state during the time period of validity of the agreement, which is long-term and require considerable investments by the investor. In fact, contract stability is one of the main features of production sharing agreements (PSA).
Under a PSA the relations of the investor with the state are structured on a civil-legal basis and cannot be changed unilaterally by the company or state, even by law.
Furthermore, under a PSA, the conditions governing oil & gas exploration and development can be consolidated into one single legal document. For new foreign investors, unfamiliar with the legal and operating environment in Ukraine, this may be particularly helpful since the necessary provisions (including fiscal relations) can be consolidated in the PSA and the way in which the law will be applied can be clarified.
The PSA is a straightforward way in which contractual assurances, additional to statutory rights, can be offered to investors. In addition, almost all PSAs provide for international arbitration should conflicts arise, an important consideration for foreign investors when there is still low confidence in the country’s legislative system.
A PSA would enable the investor to have access to independent international arbitration in case of interpretation disputes. The set-up of PSA is in marked contrast with Licensing.
By granting a license, the state uses its authority to allow the investor to exploit subsoil resources on conditions unilaterally established by the state. But the state may also unilaterally cancel its decisions by restricting the investor’s rights or just canceling the license. In a country with an unreliable legal system, a licensing system will not be of interest to large foreign investors.
For these reasons, production sharing agreements are among the most common types of contractual arrangements for oil & gas exploration and development in many emerging economies.
They have been used in such countries as Brazil, China, Russia, Azerbaijan, Indonesia, India, Nigeria, Malaysia, USA, Egypt, etc. In many countries, only this type of contractual arrangement will be capable of attracting large foreign investors and develop expeditiously the country’s energy resources.
Other alternative arrangements, such as licensing, would only attract local or small foreign investors that will not change significantly the energy situation of the country.
An advantage of PSAs for the state is that under a PSA the state retains the ownership of the mineral resources, which is not the case in other arrangements such as concessions.
Under concession agreements, the investor will acquire the ownership of the oil & gas produced. Under a PSA, the state engages a private company to provide technical services and financial resources for exploration and development operations. For the financial risk taken and for its services, the investor acquires an entitlement to a stipulated share of the oil & gas produced. The state, however, remains the owner of the hydrocarbon produced subject only to the contractor’s entitlement to its share of production.
For the government, the PSA has the advantage that full ownership of the resources remains with the state, an important consideration in many countries concerned about giving resources away to foreigners. For the investor, a major advantage of a PSA is that it locks the initially agreed upon contract conditions for periods that could be as long as 50 years. The government cannot change these conditions arbitrarily even by law.
Other arrangements do not offer this security of contract terms. Therefore, PSAs are distinguished from other types of contracts in three ways.
First, the terms of the contract are locked at the beginning and cannot be changed arbitrarily by the parties.
Second, the investor carries the entire exploration risk. If no oil is found the company receives no compensation.
Third, the government owns both the resource and the installations.
It is because of these features of PSAs that they are better arrangements to attract significant investments into the country. Without PSAs, only local companies will participate in licensing auctions as no large foreign companies will take the risks involved.
Another important country characteristic needed to attract significant amounts of foreign investments in oil & gas is the degree of market freedom and competitiveness of the industry. International experience shows that strong competition and freedom to operate in the market with minimum government interference are the main drivers for investments in revenue-generating activities.
In Ukraine, the development of a free and competitive oil & gas sector was seriously repressed by vested business interests, which benefited from maintaining the monopolistic pre-market status quo.
In fact, Ukraine’s oil & gas industry still retains many of the characteristics of the former Soviet Union, with a heavy concentration of the hydrocarbon business in the state monopoly Naftogaz.
Today, government monopolies and quasi-monopolies are competing unfairly with the private sector in many revenue-generating sectors, such as oil & gas.
The role of the government should be to support private sector activities, rather than to suppress or compete with them. As is the case with all monopolies, Naftogaz uses its position to inhibit competition as it enjoys privileges not available to the private sector, including easier access to government information and decisions.
Despite the merits of PSAs to attract larger volumes of private investments, Naftogaz has been criticizing these contractual arrangements.
It appears that the main reason for this criticism is to keep foreign capital away and preserve the current monopolistic position of Naftogaz.
Naftogaz has indicated its preference to use foreign firms only as sub-contractors under Naftogaz control, which is not going to bring large sums of foreign capital.
In light of the government’s stated commitment to demonopolize, increase domestic production of oil & gas, and achieve energy independence, the government must dismantle the activities of Naftogaz in an organized fashion, to give way to open markets. Along with more extensive use of PSAs, the breakup of Naftogaz would encourage more investments in the sector and the development of truly free and competitive oil & gas markets.
Edilberto Segura is a partner and chief economist at SigmaBleyzer and the chairman of the board of The Bleyzer Foundation. He joined the company in 1998. Segura is also an honorary member of the supervisory board of the European Union-Ukraine Business Council and senior advisor to the U.S.-Ukraine Business Council.
Oleg Ustenko is an executive director at The Bleyzer Foundation.
