According to Prime Minister Arseniy Yatsenyuk, Ukraine has taken a number of important steps to reform the energy sector, made success in the fight against corruption, signed open and transparent contracts for purchase of the natural gas from European Union member states and is now looking forward to Western companies’ investment in Ukraine’s gas transportation system.
“I would like to point out where we have succeeded: we have succeeded in overcoming corruption in the energy sector. Billions of dollars, which previously used to flow into the pockets of Ukrainian oligarchs, are now being brought out of the shadows. At present, Ukraine purchases gas under transparent and open contracts with European companies,” Yatsenyuk has recently said at a joint press conference with German Chancellor Angela Merkel in Berlin.
Even President Petro Poroshenko has made misguided and naïve statements this past week at the World Economic Forum in Davos, declaring that “Ukraine will build new ways for receiving Norwegian gas and gas from Europe, and Ukraine will also produce shale gas.”
While gas has been received from Norway in reverse flows, Ukraine’s current energy strategy, taxation and fiscal regime has forced current producers of oil and gas to stop drilling new wells and curtail production. The development of the nation’s potential shale gas is even further afield with Chevron announcing their departure from Ukraine and only Royal Dutch Shell and Cub Energy remaining in the country as an operator with both technical and local expertise in developing the shale. It’s still a question whether shale gas in Ukraine can actually be developed.
Reality check
In reality, however, these statements do not match the actual actions of the government and to most of the Ukrainian gas market players would seem deceptive. In the course of last year Ukraine’s private gas producers were doing their best to overcome, if not survive, the consequences of the government significantly increasing fiscal and administrative pressure on the industry without any consultations with the latter, not delivering on its own promises and undermining what was left of any trust to it.
Ukraine’s current regulatory and fiscal systems in the energy sector are overly complicated and non-transparent. There is also the major political and military conflict with Russia and annexation of the Crimea. As a result of that, in 2014 all major oil and gas projects in Ukraine have significantly slowed down if not suspended production.
Rising taxation
The government recently raised the tax burden on private natural gas producers twofold (55 percent of the sales price – for the natural gas extracted from deposits up to five kilometers, and 20 percent – for the natural gas extracted from deposits deeper than five kilometers), instead of implementing the long-awaited market reforms.
It was supposed to be a temporary measure until January, but at the initiative of the Finance Ministry, the parliament just a few days before the New Year made the increased tax rates permanent as of this year, in violation of the parliament majority’s Coalition Agreement.
It is interesting to note that the practicability of these high rates was based on the calculations and official data of the ministry of finance for the old huge fields that had been explored and developed in U.S.S.R. times by state-owned oil and gas companies, while the gas producers were deprived of the opportunity to present their own figures and assessments for the new wells drilled on their smaller fields,
The government just brushed the matter off stating that the costs and expenses claimed by the investors are overestimated. The tangiest piece of news is that the figures suggested by the ministry are so much out of accord with the facts that even the state-owned oil and gas companies refuse to acknowledge them.
For example, recently state-owned Naftogaz has calculated the economical production cost of natural gas extracted by its subsidiary Urgazvydobuvannya up to Hr 5,430 ($344) for 1,000 cubic meters (excluding VAT), which is much higher that the data submitted by the Finance Ministry. According to the ministry, gas production expenses do not exceed Hr 230-240 ($14.6-$15.2) per 1,000 cubic meters.
Investors are ready for cooperation
Private gas producers have been open about their costs and expenses. Some of them are actually publicly traded companies (JKX Oil & Gas, Serinus Energy, Regal Petroleum and Cub Energy), and their financial data is open, transparent and publicly available. Over and over again investors sent letters to the ministry of finance, with a call for cooperation and open dialogue, demonstrating the relevant figures and presenting underlying documents and statistics. For some reasons the ministry chose to ignore their efforts and decline any suggestions to establish the joint working group on this matter.
Instead of working closely with the industry, the government has already deprived independent businesses out of the gas market by introducing Naftogaz’s monopoly on gas supplies to the large industrial consumers. That is due to the fact that the government has been desperately trying to ensure financial support to the abundant and always cash-starving Naftogaz, which is why the financial flows from the gas consumers were forcefully re-directed in favor of Naftogaz. Such administrative measures shocked the Energy Community, which demanded explanations from the Ukrainian officials as such measures completely contradict European 3rd Energy package.
Corruption in the energy sector
Needless to say, such state of matters only encourages corruption in the country. In spite of the prime minister’s promises and assurances to the opposite, the energy sector is still the biggest source of corruption in the Ukrainian economy.
Reports by the IMF, the World Bank, and the International Energy Agency keep bringing up the issue of corruption in the energy sector. They strongly recommend to abolish price subsidies and cross-subsidisation and to raise the gas prices for population and heating companies to a level that will at least cover the production costs of the state producers.
The reason for that is Ukraine’s system of gas subsidies for households, which has long been abused by the gas distribution companies that are able to buy gas intended for households at subsidized price and sell it to businesses (at much higher market price) with 200-400 percent margin. The estimated budget losses exceed hundreds of millions of dollars per year. No need to say that the existing system only further destabilizes Ukraine’s economy and puts enormous pressure on Naftogaz and its subsidiaries, at whose cost these subsidies are cross-directed by the Government.
No reforms, no success
It is obvious that the measures and steps taken by the Ukrainian government have nothing in common with successes and reforms claimed by Yatsenyuk, as neither doubling tax rates and serving the oligarchs’ interests nor corruption and monopolization of the gas market correspond to the recommendations given by the Energy Community and IMF to Ukraine.
Despite repeated announcements, implementation of the reform has been held back by fear of losing the electorate’s support and approval of the oligarchs’ groups. Under the mask of nominal fight with the oligarchs the government takes populist decisions and the parliament adopts killing laws. One must admit that the government seems to be unwilling to undo the money-making mechanisms in the energy sector.
Impact on Ukraine’s economy and energy security
In the desperate situation, which Ukraine finds itself in these days, it should have become extremely committed to the proper development of its domestic gas production, as that would bring some extra volumes of the gas produced, in addition to 20 billion cubic meters extracted domestically, into the local market to satisfy Ukraine’s ever-hungry annual consumption of around 53 billion cubic meters, thus allowing Naftogaz to save some foreign currency reserves on buying imported gas in lesser volumes, including the gas coming from Russia.
As a result, financial pressure on the state budget and government (which attempts to plug Naftogaz deficit by any means necessary – including loans from state-owned banks, international financial institutions and currency reserves of the National Bank of Ukraine) could have been significantly lowered.
However, in contrast to the above, the government’s directed actions against independent gas producers and continuing crackdown are already affecting both the country’s energy independence and its currency reserves. Huge fiscal and administrative burden and lack of investments in the national gas extraction industry will only result in further decline of gas production, worsening of economic conditions and higher degree of Ukraine’s dependence from Russia.
One must admit that the revenues that the government hoped to generate from taxation of the oil and gas companies with the concomitant politically popular taxation of the oligarchs is proving to be a failure, as its actions are not only killing the independent gas production industry in the country, but are in fact depriving Ukraine of the opportunity to become a strong, energy independent economy. Without implementation of the necessary reforms, the Ukrainian energy sector will continue to be the nursery of corruption and playground for blackmail, which our Eastern neighbor enjoys greatly.
Robert Bensh is an American energy and security expert and managing director and partner with Pelicourt LLC, a private equity firm focused on energy and natural resources in Ukraine.
