Lies And Deception In Ukraine’s Energy Sector

Ukraine is still living the legacy of its Soviet past with its State owned energy industry, corruption, oligarchs, etc. And in typical bureaucratic fashion Ukraine continues to  treat its energy industry as a cash cow to be milked or perhaps worse a pig to be slaughtered. ~ Tim McMahon, editor

The Energy Situation in Ukraine

The Ukrainian government is claiming that it is doing its best to improve the oil and gas investment climate, but official statements are not borne out by reality. According to Prime Minister Arseniy Yatsenyuk, Ukraine has taken a number of important steps to reform the energy sector, has achieved success in the formidable fight against rampant corruption and signed open and transparent contracts for purchase of the natural gas from EU member states. He also claims Ukraine is looking forward to Western companies’ investment in Ukraine’s gas transportation system.

This past week in Davos, the Ukrainian President declared that “…Ukraine will build new ways for receiving Norwegian gas and gas from Europe, and Ukraine will also produce shale gas.”

The stark reality is that these official statements don’t reflect reality. The real story is that while Ukraine has received gas from Norway in reverse flows, Ukraine’s current energy strategy, taxation and fiscal regime has forced Ukraine’s current producers of oil and gas to stop drilling new wells and curtail production.

The development of Ukraine’s potential shale gas is even further afield with Chevron announcing its departure from Ukraine leaving Cub Energy as the only remaining operator in the country with both the technical and local expertise to develop the shale. But, even if shale can be developed, it will be extremely challenging given the highly service-oriented logistics necessary, which does not presently exist in Ukraine.

In the course of the last year the Ukraine’s private gas producers have suffered under the government’s move to significantly increase fiscal and administrative pressure on the industry. But a lack of communication between the government and the producers has undermined any trust the industry may have had in it.

Ukraine’s current regulatory and fiscal systems governing the energy sector are complicated and non-transparent, even without the major political and military conflict with Russia and annexation of the Crimea. The implications have been significant. Since last year, all major oil and gas projects in Ukraine have significantly slowed down or been suspended entirely.

Rising Taxation

Instead of implementing long-awaited market reforms, the government recently raised the tax burden on private natural gas producers twofold (55% of the sales price – for the natural gas extracted from deposits up to 5km, and 20% – for the natural gas extracted from deposits deeper than 5km). Originally it promised this to be a temporary measure to end by January 1, 2015, but at the initiative of the Ministry of Finance, just a few days before the New Year, Parliament rendered the tax increase permanent–in violation of the Parliament majority’s Coalition Agreement.

Investors Are Ready for Cooperation, Not the Government

Private gas producers, some of them publicly traded companies (JKX Oil & Gas, Serinus Energy, Regal Petroleum and Cub Energy), and their investors have sent letters to the Ministry of Finance, calling for cooperation and open dialogue, demonstrating the exorbitant nature of these taxes but the Ministry has declined any overtures to establish a joint working group on this matter.

Instead of working with the industry the Government has pushed independent businesses out of the gas market by reinforcing the state owned Naftogaz’s monopoly on gas supplies. The government has been trying desperately to ensure financial support for the eternally cash-starved Naftogaz. The Energy Community has demanded explanations for these actions from Ukrainian officials as such measures contradict the European 3rd Energy package.

Corruption in the Energy Sector

In spite of the Prime Minister’s promises and assurances to the contrary, 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 (IEA) continue to stress the issue of corruption in the energy sector. They strongly recommend abolishing price subsidies and cross-subsidization, as well as raising gas prices to a level that will at least cover the production costs of the state producers. Ukraine’s system of gas subsidies for households has long been abused by the gas distribution companies that are able to buy gas intended for households at subsidized prices and sell it to businesses at much higher market prices, with a 200-400% margin. The estimated budget losses exceed hundreds of millions of dollars per year.

No Reforms, No Success

It is obvious that neither doubling tax rates nor serving the oligarchs’ interests in monopolization of the gas market correspond to the claims of the Prime Minister regarding change. Despite repeated announcements, implementation of reform has not been forthcoming. It is held back by fear of losing the electorate’s support for price subsidies and the power of the oligarchs’ groups.

Given the desperate situation in which Ukraine finds itself today, it should make developing its domestic gas production a priority since it currently only produces 20 bcm domestically, but consumes around 53 bcm. Domestic production would allow Naftogaz to save its foreign currency reserves on buying imported gas, including gas coming from Russia.

Instead, the government has directed its actions against independent gas producers and the continuing crackdown is severely affecting both the country’s energy independence and its currency reserves. The massive fiscal and administrative burden  will result in further decline of gas production, worsening of economic conditions and create a higher degree of Ukrainian dependence on Russia. Ukraine’s short sighted policy moves ensure that investment in the sector will cease and attracting new capital will become nearly impossible.

The revenues that the government hoped to generate from taxation of the oil and gas companies 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.

This article originally appeared here and has been reprinted by permission.

By Robert Bensh for Oilprice.com