Ukraine looks to reinvigorate moribund gas industry by cutting taxes

September 2, 2015

Ukraine’s authorities announced a plan to amend the tax regime for private sector natural gas producers, which was imposed a year ago in a desperate attempt to replenish the government’s empty coffers but has backfired. The punitive royalty rates led to stagnation in the gas industry and triggered criticism from the country’s main donor, the International Monetary Fund (IMF). The question is: will the government be able to restore investor confidence in the industry?

Aivaras Abromavicius, Ukraine’s minister of economic development and trade, announced on August 28 that the country’s reform council would consider two different taxation reform drafts at the beginning of September, one of which would be drawn up by the Ministry of Finance.

Earlier in August, the finance ministry published a presentation that supplied some details of the body’s approach to tax reform, including proposals on possible amendments to the existing tax regime for private sector gas producers. According to the document, royalty rates for gas extracted from deposits up to 5,000 metres in depth would be reduced to 29% from the current rate of 55% as of October 1, with the rate for gas extracted from wells deeper than 5,000 metres being reduced to 14% from 28%.

The ‘updated’ extraction tax rates would bring them close to the previous tax regime of 28% and 15% that existed in January-July 2014. Alexander Gorbunenko, chief financial officer at Burisma Holdings, tells bne IntelliNews that the new proposed regime would end the tax “torture” being inflicted on the industry, which has already set the sector’s development back by two years “and led to a significant production slide of at least to 10% on a monthly basis”.

Burisma is one of the largest private sector gas producers in Ukraine, with a 26% market share among independent oil and gas companies. The firm became well-known for appointments to its board of directors, including Aleksander Kwasniewski, a former president of Poland, and Hunter Biden, son of the US Vice President Joe Biden.

The finance ministry also intends to reduce the production tax rate to 20% (10% at more than 5,000 metres) and to introduce a special profit tax starting January 2018. “We find the suggested tax decrease good news for Ukrainian private gas sector, however some key details of reform implementation are still missing,” Gorbunenko says.

He adds that there will be a period of more than two years in which the government and market players can agree on a new, possibly more efficient and stimulating tax regime that “will hopefully bring much-needed energy security and independence to Ukraine”. Until recently, Ukraine has relied on Russian gas imports for around half of its annual consumption. This makes Ukraine highly vulnerable to its giant neighbour, which is fueling a war in the east, cutting off gas supplies – something Moscow has done several times over the past decade, the most recent cutoff coming in July.

The Ukrainian government increased royalty rates for private gas producers in August 2014 in an attempt to obtain addition funds for the state budget. However, the increase in the cash flow was insignificant compared with the previous period. “Private companies are experiencing falling production volumes, thus the base for taxation is decreasing,” Andrey Shcherban, executive director of the Ukrainian Oil and Gas Association, explained in a June interview with Ukrainian media outlet Apostrophe. He added that gas producers had reduced investments in the sector to below $1bn in 2014, compared with $1.5bn the previous year.

Under IMF pressure

Dennis Sakva of the Kyiv-based brokerage Dragon Capital, reckons the “chances are high” that Ukraine’s parliament will adopt the proposed amendments to royalty rates, given the current tax regime has resulted in “the leaching of companies’ working capital and a sharp decrease in the volume of drilling”.

Alexander Paraschiy at Kyiv-based Concorde Capital agrees, pointing out that reducing taxes in this area is one of the commitments that Ukraine gave to the IMF as part of its efforts to secure emergency funding. “Hopefully, this will initiate a period of more predictability in the tax regime for gas producers, at least for the next two years until the beginning of 2018,” he said in a note to clients published on August 18.

Since late 2014, the IMF has insisted that the Ukrainian government should abandon its policy of applying revenue-raising pressure on the industry. The multinational lender underlined in its country report published in early August that the royalty rates introduced in 2014, “are high by international standards and could be discouraging investments in the industry”.

The IMF added that, with assistance from its staff and in close consultation with the industry, the Fund would develop amendments to the Ukrainian tax code with the aim of striking a balance between preserving revenue and encouraging investment in the industry. “It is not only a question of the [pressure imposed by] the IMF, but also of the survival of the gas industry as a whole,” Sakva says.

What a state

In 2014, Ukraine’s annual consumption of natural gas dropped by 16% to 42.6bn cubic metres (cm), while gas imports declined to 19.5bn cm, from 27.9bn cm a year earlier. In pre-crisis years, the country’s annual consumption stood at about 55bn cm and gas imports at 28bn cm in 2013.

In August, Ukrainian Prime Minister Arseny Yatsenyuk said the country’s annual gas production had reached 19bn cm, with the largest part down to the state-owned producer Ukrgasvydobuvannya, a subsidiary of state energy firm Naftogaz, which produced 15.1bn cm in 2014.

Yet the state producer is forecasting a decline in production of 3% in 2015, due to the depreciation of equipment and the depletion of gasfields. No doubt a crucial factor in this fall will be a lack of investment – the result of the government’s decision to impose unprecedented royalty rates of 70% on state-controlled companies in 2015. “The taxation of Ukrgasvydobuvannya is too severe,” says Dennis Sakva. “It is impossible to develop gas production at a normal pace if the company receives only $400 per 1,000 cm of gas produced. That is why royalty rates should be reduced to a more acceptable level.”