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Making Ukraine Europe’s new gas supplier Even if they return, these companies will
want production-sharing agreement-type
and 45% (liquids). Anything deeper gets
14% and 21%, respectively. But a large share
current trends, Ukraine will consume
28bn–30bn cm in 2020. State-owned up-
UPSTREAM  /  Kiev must lower upstream taxes, cut red tape and scrap barriers that deter projects, which will take years to negotiate. of Ukraine’s existing reserves are found at stream player UkrGasVydobuvannya plans
Ukraine’s state-owned firms will contrib- 3,000–5,000 metres, where costs are not to increase output from 14.5bn cm/y now
small investors. Self-sufficiency and even exports would follow  /  Philip Vorobyov, Kiev ute, but are too big and unwieldy to simul- significantly lower than for the projects that to 20bn cm in 2020. That means private
taneously direct investment and technolo- get the discounted rate. That creates temp- companies will have to more than double
Ukraine’s new prime minister, Volodymir But all this can only be achieved through this doesn’t even include the full conven- gy to hundreds of projects that differ greatly tation for graft, in borderline projects, and their production of around 4bn cm/y to
Groysman, wants his country to be energy massive investment, technology-transfer tional resources number (up to 5 trillion in their individual technical characteristics. eliminates 25–30% of reserves and resourc- plug the gap. That would bring self-suffi-
independent by 2020. The nation still im- and knowhow brought in from abroad. cm) or Ukraine’s technically recoverable Attracting, and keeping, the kinds of es from investors’ radar. ciency—but it can’t happen without com-
ports over 40% of its natural gas needs, so And, so far, the government has paid little unconventional potential, which might be dynamic small firms that led the US renais- This tax change would have a surpris- petitive tax rates. Without them, private in-
it’s a tall order. attention to the reforms that would stimu- 10 times as great as conventional reserves. sance—instead of waiting for the majors to ingly small impact on Ukraine’s budget. In vestors would stop investing and their gas
But it’s achievable. The government’s late private investment in gas production. A 2011 study from IHS Markit reckoned come back—will depend on Ukraine of- 2017, the budget receipts from gas taxation production would stagnate.
decision to raise residential gas prices Ukraine remains uncompetitive from an Ukraine could produce as much as 70bn fering an attractive, transparent and stable are expected to account for just 5% of the Such tax reductions are not, though,
to international market levels from May international investor’s point of view, but cm/y by 2030—levels not seen since the fiscal regime for the upstream. At present, total. Private producers account for less on the government’s agenda. Last year,
2016—a faster target than even the IMF changes are needed in the taxation of gas 1960s. Ukraine’s production tax rates aren’t just than 1%. So the proposed reduction would Ukraine and the IMF instead agreed a roy-
demanded—is an important first step. production. The government also needs a The physical characteristics of the uncompetitive, they’re uneconomic. At account for just 0.5% of the total budget. alty of 20% and a new profits tax surcharge
In one fell swoop, Ukraine eliminated regime that will draw in private investment conventional reservoirs that dominate prevailing prices, maximum royalty rates of The additional investment and production of 15–30%. At best, these changes will be
cross-subsidies, which were both a heavy from small, independent exploration and Ukraine’s reserves base are promising: of- 29% for gas and 45% for liquids production as a result of this tax cut, however, would be neutral for investors—but, more likely,
burden on the budget and an opportunity production companies and financiers— fering permeability between 10 and 100 just don’t work. net-positive for the budget within two to new income-tax surcharges as early as next
for corruption. Market pricing will drive the kinds of firms behind North America’s times higher than those of the main shale three years as Ukraine’s tax base expands. year will make the regime more complex
energy efficiency and reduce consump- unconventional energy surge. So Kiev will plays that drove the US’ recent hydrocar- Reforming reform And the prize could be significant. On and unpredictable, for both investors and
tion. Over the past two years, Ukraine has need to make the upstream more econom- bon production surge. Yet the productivi- The government has changed some of the
also been able to significantly diversify its ically attractive, lower the entry barriers ty of Ukrainian rigs can be five to 10 times rules. But last January’s reduction in taxes
sources of imports and, in 2015, for the for investment and offer new, material op- lower than those in the US. on gas production for private producers
first time imported more gas from Europe portunities to investors. While the potential is great, Ukraine’s from a maximum of 55% to 29% was, in
than it did from Russia. current resource base is mature: the Car- reality, just a return to the rates set before
Self-sufficiency, though, means Life below pathian basin in the west and giant Dnepr August 2014, before the previous govern-
Ukraine will also need to increase gas Start with the potential. Ukraine’s gas re- Donetsk basin in the east have been pro- ment dramatically raised taxes to support
production from 20bn cubic metres a serves range from 0.6 trillion cm (BP’s ducing for a century. Giant fields like She- the budget. Moreover, the subsequent fall
year now to around 30bn cm/y. Despite estimate) to 1 trillion cm (the govern- belinka, producing since the Soviet era, are in gas prices since 2015 has meant that pro-
more than a century of gas production, ment’s). At current production rates rapidly declining. What remains are hun- ducers haven’t improved—and there isn’t
Ukraine’s geological potential would allow that yields up to 50 years of reserve life, dreds of relatively small fields and explora- enough interest to spur investment in new
for this and more. In fact, Ukraine could far more than the 11 for the US or 15 tion prospects, with complex geology, and projects (including exploration and ap-
not only meet its own needs, but become years for the EU. Doubling Ukraine’s re- often at great depths (up to 7,000 metres). praisal). The breakeven price for Ukraine’s
a significant new gas supply source for Eu- serves-to-production ratio in the next Combined with a poorly developed oil- relatively small and technically difficult
rope—as soon as the middle of the next ten years would allow for output of 40bn field-services sector, this difficult geology fields ranges from $100 to $200 per 1,000
decade. cm/y from its existing reserves base—and will make many upstream projects rela- cm, say the Association of Gas Producers
tively high-cost, as technology and skills of Ukraine and IHS. But that’s more than
will need to be imported. Special kinds producers now earn. At the very least, taxes
of investors will be needed—small, inde- should fall in line with the drop in prices
pendent E&P companies able to focus on and netbacks. The Association of Gas Pro-
opportunities from wildcat exploration to ducers argues that, in the short term, a sim-
mature-field redevelopment to unconven- ple royalty of 12% (in line with the global
FIG. 2: Laggard wells: rig productivity in Ukraine vs US [boe/rig/day]. Source: Petroskills
tional gas. So far, Ukraine’s strategy has not average), assessed on the basis of transpar-
focused on these kinds of firms or private ent European gas-hub pricing, would make
capital. Fortunately, higher gas prices in investors start to pay attention again.
the 2006–14 period encouraged private More than that, two of the percentage
investors, and their production has nearly points from this 12% royalty should be
doubled. But state-owned or controlled directed towards hydrocarbon-producing
companies—whose output has been stag- regions—a way to coax more support from
nating—still dominate Ukraine’s gas sec- local people for increased upstream activ-
tor: they produced 80% of the country’s ity nearby. At present, locals in Ukraine’s
20bn cm in 2015. main gas-producing regions like Poltava,
The country needs to encourage small Kharkov and Dnepropetrovsk see no direct
investors further. Hopes that big interna- benefit from gas production, because most
tional oil companies would do the job have of the tax revenue goes to the central bud-
been dashed—the big projects for offshore get. Ukraine should also apply this tax rate
and unconventional exploration pursued to all investments, instead of the current
by Shell, Chevron, Eni and ExxonMobil in system that offers different taxes based on
2011–13 have all been scrapped, victims of the well’s depth. So, for example, projects of FIG. 3: Spot the growth: Ukrainian gas production, private vs state. Source: Infotek;
FIG. 1: Westward leaning: Ukraine’s gas sources, 1991–2015. Source: Infotek; Energorynok the conflict with Russia and the oil price. 5,000 metres or less get taxed at 29% (gas) Energorynok

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EUROPE EUROPE

Ukraine’s fiscal authorities. sprawling web of often duplicating and nomics or modern technology—also The new entry-exit transportation tar-
Taxation based on profits, not reve- contradictory permitting and monitoring need an overhaul. Basic techniques used iff system mandated by EU rules will shift
nue—the norm for hydrocarbon taxation requirements—which hydrocarbon pro- around the world, like underbalanced up to a third of the cost of transporting gas
in the West—should be the long-term goal. ducers must follow at the central, regional drilling and multiple-zone completions, from consumers to producers. The new
Such a system is more flexible and better and local levels—is a major barrier to new remain illegal. Stringent requirements rules—once fully implemented—require
reflects the widely differing economics of entrants in the upstream. The govern- for forecasting production (5% margin the sale of all gas at Ukraine’s new Virtu-
multiple projects in mature basins (every- ment eliminated a number of these rules of error) and getting state approval for al Trading Point, which means paying a
thing from exploration of relatively small in the past year and several draft laws have the number of operating wells mean a transportation-capacity entry fee. This is
and deep fields to old-field redevelopment been put before parliament, to further constant need to update and change pro- common practice in Europe, but trans-
and proving up of unconventional resourc- simplify regulation. But, in essence, the duction plans. It all consumes time and portation fees in Ukraine are double to
es). But such a regime can only be adopted system remains unreformed, unwieldy capital. A draft for new field-develop- triple those in many west European coun-
when Ukraine is ready. First, the country and, for an investor, risky. ment rules has actually been made—but tries. Meanwhile, the process of setting
also needs to implement full-scale and it remains incomplete and stuck in what transportation tariffs remains opaque be-
transparent IFRS-based accounting, train Digging deep seems to be an endless approval process. cause the cost base of the system operator,
new staff and reorient the industry’s regu- To be fair, Ukraine’s hydrocarbon li- Another major investment barrier has Ukrtransgas, remains bundled inside state
latory approach. This would assure inves- censing procedures have been modestly been the lack of transparency in upstream monopoly Naftogaz.
tors that the government would apply the updated: auctions are now more trans- data. It’s a legacy of the Soviet penchant The new Network Code has intro-
new regime fairly and transparently. parent. But the ultimate goal of creating for needless secrecy and—in the not-so- duced new requirements for gas quality
But that’s not all. Ukraine’s official a functioning secondary market for li- distant past—the urge of corrupt bureau- and metering. The trouble is that not one
gas-sector reform plan, announced in cences remains a distant prospect. Such crats to keep information under wraps. company in Ukraine today meets those
April 2015, contained a section on the re- a secondary market is critical for raising Some headway has been made, and basic requirements, which could result in ar-
form of antiquated upstream regulation. financing, because it makes licences information about existing licences and bitrary enforcement of the rules. A clear
While several reformist deputies in par- themselves viable collateral for banks: at fields is now available. But much critical transition period for upgrading processing FIG. 6: Small slice: gas revenue as share of Ukrainian budget. Source: Ministry of Finance
liament pushed forward this least known present, a bankruptcy of a licence-holder technical data—like field seismic data, and metering facilities is needed. of Ukraine; JKX Oil&Gas
part of the reform programme, it wasn’t leads to a recall of the licence by the state. necessary for reprocessing and subse- All this creates a key risk: that rising
given strong external or internal backing, Field-development rules inherited quent reinterpretation, or information costs and tougher regulatory require-
and the results have been minimal. from the Soviet era, with super-giant about drilled wells—are expensive to buy ments will see the industry consolidate
This is a problem, because Ukraine’s fields in mind, and little regard for eco- or simply deemed a commercial secret. around the strongest existing players, re-
Ukraine needs to develop an integrated ducing competition. Ukraine need only
upstream data base that could be accessed look at the gas industry in several Cen-
at little cost by existing and potential in- tral and East European countries, where
vestors. Well information should be made EU-prescribed reforms have hardly in-
public after a limited period after comple- creased competition or private invest-
tion (as is the case in North America, the ment. Ukraine should seek to avoid, not
UK and Norway). Some policymakers replicate, those examples.
have tried to do all this in the past two or So, in its quest for energy indepen-
three years, but without much success. dence, Ukraine faces a fundamental di-
Finally, the gas-sector reform process lemma: how does it rapidly reduce its re-
itself is adding problems for investors. serves-to-production ratio—making good
Over the past year Ukraine made sever- on its abundance of gas potential? In three
al changes to the regulations so it could ways. First, it must make its upstream proj-
meet EU regulations (in particular those ects more attractive to private investors by
in the 3rd Energy Package). So Kiev has reducing taxes in the short term and, in
FIG. 4: Break uneven: netbacks vs project costs, 2012–16. Source: NKREKU; passed the Gas Market Law, which com- the longer term, bringing its tax system in
Association of Gas Producers of Ukraine; IHS Markit; JKX Oil&Gas mits Ukraine to a market-based gas sec- line with those used in the West. Second,
tor by unbundling transportation from it must remove the barriers to investment
supply along with other measures to en- that lurk in outdated upstream regula-
courage transparency and competition. tion—and not inadvertently erect others
FIG. 7: Private capital unleashed: Ukraine’s gas balance by tax regime, 2015–20
Yet many of the changes have added to through the otherwise logical and posi- Source: JKX Oil&Gas
business costs and lumped on more risks tive gas-sector reform programme. Finally,
for private producers and wholesale-gas Ukraine must embrace private property
traders. in its energy sector, start privatising state- production would also allow for some putting increasing pressure on the hydro-
For example, producers and wholesale owned assets and, in doing so, offer materi- exports—giving Europe a new unexpect- carbon industry. Inaction and state pater-
traders wishing to supply end-users must al new opportunities to qualified investors. ed source of supply by the middle of the nalism over the industry would mean a
keep a share of their gas in storage and The prize for Ukraine—and other next decade. Ukraine could even provide large share of Ukraine’s natural riches re-
provide financial guarantees to the sys- countries—would be large. Self-sufficien- a market for spare services capacity that main buried forever. PE
tem operator as a hedge against any fail- cy in gas would save as much as $3bn in has accumulated in North America, where
ure of physical gas deliveries. These direc- gas imports between now and 2020. In- efficiency gains have sharply reduced the PHILIP VOROBYOV is responsible
tives are now some of the most onerous vestment and technology would flow into rig count. But Ukraine also needs to un- for strategy and communications at JKX
in Europe and have been estimated to add Ukraine, providing economic growth and derstand that time to reform is running Oil & Gas, a UK-based firm with assets in
FIG. 5: Hard squeeze: Ukraine’s royalty rates vs peers’. Source: Deloitte; JKX Oil&Gas $5–10/’000 cm to the supply cost. employment. A doubling of Ukrainian out. Advances in energy technology are Ukraine, Russia, Hungary and Slovakia

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