Last gas for Ukraine

March 20, 2015

An alternative version on calculations according to tax liabilities is offered to private gas companies. Subsoil users will be able to transfer part of produced gas for the sum of their rental obligations to National Joint-Stock Company (NJSC) “Naftogaz of Ukraine”.

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This provision is contained in the Draft Law No. 2395, initiated by Alexander Onishchenko, People’s Deputy (parliamentary group People’s Will), Deputy Head of Fuel and Energy Complex, Nuclear Policy and Nuclear Safety Committee. “A big tax burden is put on the shoulders of gas producers today; mentioned document should reduce the fiscal burden on the industry,” – thinks Onishchenko.

Pass-Fail?
The document says that the NJSC shall conclude a special agreement and Gas Delivery-Acceptance Act within three working days after the written request of gas producer. The Sum of the contract shall not exceed the number of tax liabilities for paying rent. The gas price of producing company will be calculated on the basis of the limited cost level, established for industry and other consumers by Energy and Utilities the National Regulatory Commission (NKREKP). After the actual transfer of blue-colored natural gas to NJSC gas producer is released from paying rent and the liability for delay in payments.

The reasonability of such a law is at least doubtful. This initiative is a returning back in the 1990s, where barter schemes have been used in practice that kills liquidity, a representative of a major gas company, who has wished to remain anonymous, states: “Markets need money and liquidity, but not barter.”

Burisma Holdings CFO Alexander Gorbunenko points out that the mentioned document contains a potentially serious bureaucracy and corruption component. “Imagine that every company needs to approve, sign and legalize everything with the state company. In theory, such an approach would reduce the fiscal burden on private companies, as they would not have to pay the rent under a deficit of own funds, but there is a lot of unclear with the manner how such operations will be accepted by the State Fiscal Service,” – he complains.
It is rather a help to “Naftogaz” but not a support to gas producers, says PJSC “Karpatygaz” Chief Financial Officer Arthur Somov. He has explained that the NJSC has started selling gas to commercial customers from December and declares unrealistic amounts of fuel, while the transfer of gas against the rent will allow state companies to fill the missing amount of fuel.

Tightened belts
However, the most important is that such an initiative would not solve the main problem in the industry. Today, private gas companies are “on the brink of extinction”. The problems have started in August last year. Referring to the difficult political and economic situation and the need to fill the state budget, officials have decided to increase the rental fee at gas producing from depth up to 5 km from 28% to 55%, from depth above 5 km – from 15% to 28%.

Energy Research Center Director Alexander Kharchenko explains that they have initially wanted to increase the rent only for private traders who work under joint operation agreement (JOA) with state-owned companies. And it was quite logical, as the government has attempted to close the schemes which gas producers have enriched to, using ready-made wells, without making their investment in development. But later they have included the rest private gas producers too.

Moreover, this step of government has been positioned as a temporary, emergency one, and rent rates have been promised to return to the previous level starting from January 1, 2015. But this step has been extended for other six months unexpectedly for everyone. Most unlucky are entrepreneurs working under JOA. They have to pay rent 60% from the cost of gas starting from January 1st, and 65% – in the second quarter, 70% – the third.

The results of rapid worsening of working conditions for gas producers are unfavorable. If the average increase of gas production by private companies has been exceeded 30% at the beginning of 2014, then at this figure has dropped to 11% at the end of January 2015, says Naftogazvydobuvannya PrJSC. Domestic industry associations predict that private gas production sector will reduce by 1 billion cubic meters as early as this year, and it is about 4 billion hryvnias of rent payments to the budget, reminds Smart Holding.

According to Naftogazvydobuvannya PrJSC estimates, Ukraine will not receive 5 billion cubic meters of gas produced domestically only for 2015-2017 in the current situation. This amount should be imported with high risks for the energy and economic security of the country.

The tax burden together with limits of industry gas sale (Cabinet of Ministers Resolution No. 647) has forced producers to reduce significantly or even shut down their investment programs. For example, Smart Energy has reduced planned amount of investments from $ 44 million to $ 22 million only in 2014. The company has also limited investments by $ 15 million this year.

According to Mr. Gorbunenko, Burisma has reduced investment for year of 2015 in exploration and production of gas from $ 175 million to $ 25 million. Poltava Petroleum Company JV (British JKX subsidiary) CFO Eugene Palenko informs that the company has decided in general not to make investments this year, although several tens of millions of dollars have been planned to invest: “Issue about return of capital investments becomes unclear with these tax rates, so we are forced to stop investments”. Within this situation, companies are forced to fire massively the staff.

Foreign companies are leaving the market together with them which were major donators of advanced technology to the domestic industry, which development has remained at the level of 1980-1990-ies. USA company Chevron has rejected from the project on shale gas production in Western Ukraine in December 2014, specifying among the motives a double increase of tax burden on the industry. The British and Dutch company Shell has made a similar statement, which has stopped exploration in the Kharkiv region on March 12th.

And they can be understood, because today gas production has not only stopped to make profits, but some has a loss. According to All-Ukrainian Public Organization “Gas Market Liberalization Members Union” Acting President Oleg Bakulin’s estimates, the average production cost is currently $ 150 or 3493.5 hryvnias (at the rate of the National Bank of UAH 23.29 / $) per 1,000 cubic meters of natural gas. the limited cost level is fixed for industrial consumers at the level of 8900 hryvnias per 1,000 cubic meters on March 1st. In general, companies pay 55% of the rent. As a rule, enterprises give a discount of 10-12% from limited level to suppliers in order to support the realization, i.e. it is about 7900 hryvnias per 1,000 cubic meters of natural gas. The economy is as follows: 7900 hryvnias (price with discount) – 4985 hryvnias (55% of rent) – 3943 hryvnias (initial cost). Total loss is 488 hryvnias per each 1000 cubic meters of gas.

Still Possible To Save It
Rates of rents in Ukraine are one of the highest in the world. The rate of rent is fixed at level of 19% in neighboring Poland, 30% – Romania, 26% – in Azerbaijan, an average of 18-20% – in the USA  (data according to Smart-Holding). It is well understood in the government, but months of talk about reducing taxes by Prime Minister Arseniy Yatsenyuk has been failed so. There is a draft law in Parliament, which returns rates of rent to its previous level, but it has not proceeded further after registration.

Somov says that the attractiveness of gas production will return when the rent does not exceed 30%. Gorbunenko agrees, adding that to create the optimal regulatory and investment environment requires a systems approach involving a range of activities. For example, the granting of privileges on customs duties for import of equipment (stimulates drilling of new wells) equal access of producers to the pipelines, a full restart of the legislation in the oil and gas sector – it is required a modern professional (on the basis of the views of industry and experts) a complex set of laws (for example, Code) which would solve that acute issues facing the industry, etc.

The only Naftogazvydobuvannya PrJSC has the potential to increase gas production up to 6 billion cubic meters during the next five years in case of making rapid and effective reforms of oil and gas industry. It will help to compensate 25% of the current needs of Ukraine in imported energy carrier. If other companies develop similarly in the next 5-7 years, the need for gas imports would be reduced to a minimum or completely disappeared.

According to Mr. Alexander Gorbunenko, one of the biggest factors is the return of trust to the state as a whole and its policies. “It may take 1.5 or 2 years from the beginning of investment decision-making process till receipt of first gas cubic meter from a new well. The investor must be sure during this time that the rules will not change 4-5 times, greatly affecting the economic reasonability of each individual project. Meantime, we have had the rules changed three times during less than six months”- summarized Gorbunenko.