Gas dreams

January 19, 2015

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At the beginning of January 2015 Representative of Ukraine at the EU Kostiantyn Yeliseyev told about the upcoming international conference on domestic gas market reform.

According to him, the Ukrainian side was interested in attracting investors and interested parties not only in the modernization and further management of pipelines belonging to domestic gas transportation system (GTS), but also to the use of other GTS facilities, in particular underground gas storage (UGS).

Mr. Yeliseyev did not exclude as well that negotiations on the “gas relations” of Ukraine, the EU and Russia could also be made at the same time. In particular, it would decide whether Ukraine should move to the so-called Summer Package (conditions of natural gas supply from Russia to Ukraine).

It is worth considering that the planned changes in the domestic gas industry “imposed” by the need to implement in 2015 the Third Energy Package, which requirements provide functions separation for operating systems on transportation, storage and gas balancing (please, see “Legal regulation” on page 24).

So far last week, Prime Minister Arseniy Yatsenyuk said that the part of a loan in amount of $ 2 billion provided by the US government would be directed to reform Ukraine’s energy sector.

The European Vector

However, it was worth noting that the negotiations on attraction of investments in the gas transmission sector intensified at the end of last year. So, there were consultations held in mid-December between the European Bank for Reconstruction and Development and National JSC “Naftogaz of Ukraine” regarding the possibility of providing a loan in the amount of $ 200 million for modernization of the main gas pipeline Urengoy – Pomary – Uzhgorod.
 
Chairman of the Board “Naftogaz of Ukraine” Andrey Kobolev emphasized: “We are pleased that the credit project which Ukraine has discussed with the EBRD since 2009, will be finally implemented. This funding will make GTS more reliable and will help our country to save the business on gas transit.”

In addition, on December 17, 2014 PJSC “Ukrtransgaz” and Polish Gaz-System SA signed an agreement on the preparation of the Polish and Ukrainian gas systems union, providing the integration of gas transport systems of both countries in order to increase the supply and storage of reverse European gas in Ukrainian underground storage facilities.

In this regard, it was planned to build a new gas pipeline Drozdovychi – Bilche – Volitsa with the length of 110 km and a capacity of 8 billion cubic meters per year in the direction of Poland – Ukraine and 7 billion cubic meters a year – in the direction of Ukraine – Poland (project cost – $ 245 million).

According to Mr. Kobolev, the project could be the first step towards the creation of the Eastern European gas hub capacity with about 20 billion cubic meters per year, which would solve issues of balancing, storage, redistribution of gas supplies between Ukraine and the EU.

The sources of its content could be supplies from Russia, Poland, the European spot market, and others. Politically, the project could rely on the Visegrad Group union (Poland, the Czech Republic, Slovakia and Hungary), and which the President Petro Poroshenko stated about the intention of Ukraine to enter into at the end of last year.

As all European projects were inextricably linked with the Third Energy Package, Ministry of Energy and Coal Industry of Ukraine announced the schedule on implementation of its requirements last week. In particular, the Ministry planed to establish a single wholesale price on gas, tariff system “input-output” of gas supply and to complete the evaluation of reserves “Naftogaz of Ukrain” in II quarter of 2015.

By the end of the III quarter it was awaited to approve the rules for access to the gas transmission networks, and finalize the principles of corporate governance – GTS and UGS operators. It was expected that, the partners for the companies – operators GTS and UGS would be determined and the first investment in the modernization of gas transportation system would be invited as far as at the end of 2015 if keeping such a schedule (please, see “The price issue,” on page 26).

Member of the Supervisory Board of the Institute of Energy Strategies Yuri Korolchuk notes that Ukraine is clearly behind schedule of reforming the gas sector: “We should eliminate or separate the NJSC long time ago, and, to create three companies instead of one regional power distribution company.

In other words, the “packages” should set limits for vertically integrated companies for the ownership and management of gas and electric networks. The EU is trying to divide the business for sale and transportation of gas. It tightens the competition and reduces energy prices” (Please, see “Outward Glance” on page 25).

Production Perspectives

However, experts warn, the government’s efforts to attract investment in the modernization of Ukrainian gas transportation system does not solve the problem of gas import dependence of the country. The internal gas market can only be balanced by the development of domestic production.

However, the situation here is not as we would like. In Ukraine there are 108 separate companies – owners of licenses to develop oil and gas, but the production of natural gas in the country remains stable over the years – about 20 billion cubic meters per year.

“Gas production in Ukraine stagnates the past 10 years. Technologies and equipment have remained at the level of 1970ies – it was at that time when gas production and transportation system of Ukraine have experienced the peak of its development”, – says Andrey Favorov, Director of a company with foreign investments “Energy Resources of Ukraine”.

At the same time, as Naftogaz of Ukraine NJSC Business Development Director Yuri Vitrenko recently recognized, “if we have a normal adequate price regulation, the normal adequate taxation of production, then gas production will be able to grow up to 22 billion cubic meters in 2015”. It should be noted that both requirements of mentioned Mr. Vitrenko are not kept.

What an adequate price regulation is within the meaning of the state monopoly it can be understood from the joint calculations of the NJSC and the PSC “Ukrgazvydobuvannya”, according to which the economic cost of Ukrainian gas production is now 5430 UAH for 1 thousand cubic meters (or about $ 319 at the rate of 17 UAH./ USD). Ukraine will not get import “needle” off ever with such a cost. Because the price of Russian gas at the border with the European Union is just about $ 320.

In addition, the Verkhovna Rada has extended the high rates of rental fees for usage of mineral resources, as a result gas companies have become unprofitable to increase production volumes and to drill deeper than 5 km.

As noted by Mr. Korolchuk, profitability of mining companies in general allows to bear such a rental fee. Another thing is that investment is almost “frozened” with this tax and the players interest in the development of production is killed. The calculation is simple: the gas production capacity of 1 cubic meter per year requires investments of $ 1.

Иными словами, чтобы полностью обеспечить внутренний рынок газом украинского происхождения, потребуется $20-30 млрд. Поэтому выделяемых “Укргазвидобування” $300 млн в год хватает только на поддержание нынешнего объема добычи. In other words, it will require $ 20-30 billion in order to fully provide the domestic market with gas of Ukrainian origin. That is why $ 300 million a year allocated by “Ukrgazvydobuvannya” is enough only to maintain the current level of production.

According to Mr. Korolchuk, rents could improve under the condition that, for example, either payments will be reduced, or rental “vacations” will be set in five years. In this case, investors would be interested in increasing production.

“Another problem is the state owner, unable to finance the development of the industry. State property on deposit has been used to subsidize consumption by population.

Four- and five-times difference in gas prices for individuals and industries have created a huge amount of economic motivations for corruption and neglected consumption and have built barriers for investment in production. Therefore, in my opinion, one of the main drivers of development of the gas industry can become transparent privatization “, – adds Andrey Favorov.

Meanwhile, according to Natalia Slobodian, Energy Department Director of the International Centre for Policy Studies, the majority of private mining companies in Ukraine has attracted direct foreign investments, allowing them to renew the fleet of drilling rigs and upgrade technological component production. By and large, private players are capable to provide 100% internal needs of Ukraine in the blue fuel in five years.

Shale Perspectives

It seems that the opportunity widely publicized by the authorities to get away from dependence on import of gas through the development of domestic shale deposits will remain still unrealized. As BUSINESS has already written (please, see Article “ETL points”), it was reported on the refusal of the American company Chevron from the development of Oleska shale gas area.

“The company Chevron rejected from the draft production sharing agreement – (PSA – Ed.). Meanwhile, Chevron has planned to send approximately $ 350 million for seismic surveys, well exploration and drilling already on the first stage (two to three years) and expected resources of the Oleska area are estimated at 2.98 trillion cubic meters of gas.

Annual production was planned at the level of 5-10 billion cubic meters a year,”- says Ms. Slobodian. Although Chevron is still not officially commented on the reasons for refusal of development, Ms Slobodian is sure that the main one is “extremely high taxes for subsoil use, imposed by the Ukrainian authorities in August 2014, making the company’s projects in Ukraine unprofitable”.

At the same time it is worth remembering that works on Yuzivska area development of shale gas (Shell company) were stopped as a result of the military conflict in eastern Ukraine. As Yuri Korolchuk noted, they even failed to start drilling exploration wells. “As far as I know, Shell has postponed commencement of work until January 1, 2017 and is now considering extension of this period up to 2020″, – said the expert.

Thus, the willingness to continue the “shale” development in Western Ukraine was confirmed only by a subsidiary of Italian Eni – Eni Ukraine Llc. (Eni bought 50.01% shares of Zahіdgazіnvest LLC in 2012 which had licenses for the development of nine shale gas with a total area of about ​​3.8 square kilometers).

At least, this information was announced during the meeting with Minister of Ecology and Natural Resources of Ukraine Igor Shevchenko with CEO Luigi Barberis at the end of December last year. However, the question of the commencement of work, the amount of investment and the planned production volume remains open, as the Italian side, according to the Minister, is still “waiting for support from the Ukrainian government in matters of coordination of work plan.”

Therefore, experts explain, the Ukrainian authorities have to carefully analyze the situation with the PSA on field development and the refusal reasons of the world giants in cooperation with Ukraine in the “shale” projects.

The more especially, as stressed by Mr. Korolchuk, now the attractiveness of such projects fell sharply, as “decrease in oil prices below $ 70 per 1 barrel is beginning to affect the high cost of shale gas production.” As a result, international investors will not hesitate to come out the PSA in the event of any dispute, the legal uncertainties and unjustified increase of the tax burden.

Passion for Transit

Last week, Gazprom Chairman of the Board Alexey Miller “dumbfounded” the public by stating that Russia would completely reject from the transit of natural gas to the EU via Ukraine within a few years, and all the gas flow would be directed in the Turkish pipeline (thus, the European consumers will have to buy Russian gas at the border of Turkey and Greece). He advised Europeans to begin construction of appropriate infrastructure from the Turkish border as quickly as possible.

Andrey Kobolev assessed colleague’s the statement as follows: “The Gazprom intention to stop sharply long-term relationship with the European Union, if the Europeans will not start urgently building a gas pipeline to take Russian gas at the Turkish-Greek border, is economically senseless and surprising”.

According to him, last year Naftogaz of Ukraine NJSC has proven the reliability of the gas transportation system of Ukraine and its ability to guarantee gas supply to European consumers, even in conditions of Russian aggression on the territory of the country. However, no European company receiving Russian gas via Ukraine has claimed about the quality of NJSC work.

In addition, billions of dollars that Russia tries forcing the EU to invest in the construction of new gas transportation routes will inevitably fall on the shoulders of European consumers. And technical risks increase: subaqueous section of the pipeline is less reliable than the ground. “This proposal does not give any additional benefits for the Europe. It is a political bluff “, – says Mr. Kobolev.

It should be noted that Gazprom proposal of has not caused any excitement among representatives of the EU (European Commission Vice-President Maroš Šefčovič expressed surprise regarding this issue) or Turkey particularly. As Prime Minister of this country Ahmet Davutoglu has stated, the Turkish government hopes that will continue to supply Russian gas to Europe via Ukraine. At the same time, Mr. Davutoglu has softly hinted that Turkey plans to increase the supply of gas through Ukraine, as well as from Azerbaijan and Iran.

Legislative Regulation

In late 2014 the specialists of the American Chamber of Commerce in Ukraine, prepared a comprehensive position document “Oil and Gas Sector Reforms,” which paid special attention to the situation with the regulatory control of the industry.

Among other things, the experts drew attention to the fact that Naftogaz of Ukraine has acquired the right to selectively treat the independent gas suppliers in 2014. This situation was a result of the adoption of sequential decisions by the Cabinet of Ministers No.596 dated 07.11.14 and No.647 dated 26.11.14 (please, see BUSINESS No.46 dated 11.17.14, pages 16-18). In addition, a bill passed in the first reading early in the beginning of July.

“The special period in the energy sector.” Specialists of American Chamber of Commerce argue that these regulations violate well-established European practice in response to crisis situations. In particular, the Polish government has the ability to set the priority categories of consumers to suppliers in case of crisis, but has the right to set the price of gas (which is interpreted as expropriation).

Therefore, suggestions were made to cancel these regulatory acts, replacing them with the new law “On the gas market,” a draft of which was proposed by the Energy Community in April last year. Here, the fact should be taken into account among other things that the current Law “On the basis of functioning of the natural gas market” does not satisfy the requirements of the Third Energy Package, which should be implemented in 2015.

It should be noted that representatives of local oil and gas industry fully supports the proposal, as the new law will create transparent conditions for the gas market. In fact, it has paid attention to the security and stability of fuel supplies throughout the chain “producer – supplier – customer”, provided a restriction for revision of the key principles of the functioning of the market, guaranteed access to the gas transport system of all players, to free choice of suppliers and consumers, etc.

Outward Glance

The access of foreign companies to the gas transportation system of Ukraine is some barometer of the investment attractiveness of our country. The future of the gas industry in Ukraine depends largely on the way how reform GTS is implemented on practice.

This is the opinion of Board Advisor Vadym Pozharskyi of one of the largest private gas producers in Ukraine Burisma Holdings (It is the second largest independent natural gas producer in Ukraine in 2013-2014 according Ministry of Energy and Coal Industry of Ukraine).

 “The key principles should become the promised transparency and non-judgmental attitude to the choice of partners, and the winner must remain Ukrainian gas industry. But it is important not only to attract foreigners, but also to create conditions for their effective work here. After transparent competition in the selection of the partners the appearance of foreign companies in the gas sector of Ukraine should follow”, – says Mr. Pozharskyi.

At the same time, as expert emphasizes, increase of its own gas production in Ukraine – is not a myth, but a reality that must be provided by the projected legislation, effective fiscal policy and a favorable climate for investment. “Only in this case, our country will be of interest to strategic investors and get impulse for a new development phase of the gas sector,” – says Mr. Pozharskyi.

Price Issue

Ukrainian gas transportation system is the second largest in Europe and one of the largest in the world. The total length of gas pipelines, excluding new and under construction is 37.1 thousand km (including the main gas pipelines – 22.2 thousand km of branch pipelines – 14.9 thousand km).

1449 gas distribution stations and one of Europe’s largest underground gas storage facilities (12 underground gas storage facilities with total active capacity of more than 32 billions of cubic meters, or 21.3% of the all European active capacity. See also “Gas fields …,” p. 27) are operated in Ukraine.

The capacity of the Ukrainian gas transport system on the border with Russia is 288 billion cubic meters of gas per year, and 178.5 billion cubic meters per year – on the border of Ukraine with the EU, Belarus and Moldova. The system is operated by Ukrtransgaz PJSC, 100% owned by Naftogaz of Ukraine.

The official estimate of the cost of gas transportation system has been carried out in 2012, but its results have not yet been made public. However, Andrey Kobolev has said in the summer of 2014 that, according to various estimates, the cost of Ukrainian gas transport system is $ 25-35 billion.