The Ukrainian government has repeatedly claimed it is doing its best to improve the oil and gas investment climate, but official statements are the opposite of the reality, as Prime Minister Arseniy Yatsenyuk is leading the great deception.

According to Prime Minister Yatseniuk, Ukraine has taken a number of important steps to reform the energy sector, and has even achieved success in the formidable fight against rampant corruption, as well as signed open and transparent contracts for purchase of the natural gas from EU member states. Now he claims Ukraine is looking forward to Western companies' investment in Ukraine's gas transportation system.

"I would like to point out where we have succeeded: we have succeeded in overcoming corruption in the energy sector. Billions of dollars, which previously used to flow into the pockets of Ukrainian oligarchs, are now being brought out of the shadows. At present, Ukraine purchases gas under transparent and open contracts with European companies," Yatseniuk recently told a joint press conference with German Chancellor Angela Merkel in Berlin.

Even the President has made misguided and naïve statements this past week in Davos, declaring that “…Ukraine will build new ways for receiving Norwegian gas and gas from Europe, and Ukraine will also produce shale gas." Related: Ukraine’s 2015 Tax Reform Will Damage Its Energy Independence

The stark reality is that these official statements are in no way reflected by government action, and the gas market players in Ukraine recognize the deception as does the energy industry as a whole.

The real story is that while gas has been received 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 and only Cub Energy remaining in the country as an operator with both technical and local expertise in developing the shale. Even if shale can be developed in Ukraine it will be extremely challenging given the highly service-oriented logistical train, which does not presently exist in Ukraine.

In the course of the last year the Ukraine’s private gas producers were doing their best to overcome, if not merely survive, the consequences of the government’s move to significantly increase fiscal and administrative pressure on the industry without any consultations with the latter. The government failed to deliver on its promises, and the only thing it managed to achieve was an undermining of any trust the industry may have had in it.

Ukraine’s current regulatory and fiscal systems governing the energy sector are overly 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 at best, and been suspended entirely at worst.

Issue by issue, the lies continue to mount.

Rising Taxation

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), instead of implementing long-awaited market reforms. Notwithstanding its own promises for this to be a temporary measure by 1 January 2015, 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.

It is interesting to note that the practicability of these high rates was based on the calculations and official data of the Ministry of Finance for the old huge fields that had been explored and developed in Soviet times by state-owned oil and gas companies, while the gas producers were deprived of the opportunity to present their own figures and assessments for the new wells drilled on their smaller fields. The government simply brushed the matter aside, stating that the costs and expenses claimed by the investors were inflated.

Most poignantly here, the figures suggested by the Ministry are so wildly out of line with the facts that even state-owned oil and gas companies refuse to acknowledge them. Recently state-owned Naftogaz calculated the economical production cost of natural gas extracted by its subsidiary, Urgazvydobuvannya, up to UAH 5,430 [USD 344] for 1,000 cubic meters (excluding VAT), which is much higher that the data submitted by the Ministry of Finance (according to which the gas production expenses do not exceed UAH 230-240 [USD 14.6-15.2] per 1,000 cubic meters).

Investors Are Ready for Cooperation, Not the Government

Private gas producers have been open about their costs and expenses. Some of them are actually publicly traded companies (JKX Oil & Gas, Serinus Energy, Regal Petroleum and Cub Energy), and their financial data is open, transparent and publicly available. Over and over again investors sent letters to the Ministry of Finance, with a call for cooperation and open dialogue, demonstrating the relevant figures and presenting underlying documents and statistics. For some reasons the Ministry chose to ignore their efforts and declined any suggestions to establish a joint working group on this matter.

Instead of working closely with the industry the Government has already pushed independent businesses out of the gas market by introducing Naftogaz’s monopoly on gas supplies to large industrial consumers. This is because the government has been trying desperately to ensure financial support for the eternally cash-starved Naftogaz. Forcefully redirecting the financial flows from gas consumers in favor of Naftogaz was a small-minded, short-sighted remedy. Such administrative measures shocked the Energy Community, which demanded explanations from Ukrainian officials as such measures completely contradict European 3rd Energy package.

Corruption in the Energy Sector

No need to say that such a state of affairs only encourages corruption in the country. 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. Related: Ukraine Will Have Russian Gas, For Now

Repeated reports by the IMF, the World Bank, and the International Energy Agency (IEA) bring up 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 need to say that the existing system only further destabilizes Ukraine’s economy and puts enormous pressure on Naftogaz and its subsidiaries, at whose cost these subsidies are cross-directed by the Government.

No Reforms, No Success

It is obvious that the measures and steps taken by the Ukrainian Government have nothing in common with successes and reforms claimed by Arseniy Yatseniuk, as neither doubling tax rates and serving the oligarchs’ interests nor corruption and monopolization of the gas market correspond to the recommendations given by the Energy Community and IMF to Ukraine. Despite repeated announcements, implementation of the reform has been held back by fear of losing the electorate’s support and approval of the oligarchs’ groups. Under the mask of nominal fight with the oligarchs the Government takes populist decisions and the Parliament adopts killing laws. One must admit that the Government seems to be unwilling to undo the money-making mechanisms in the energy sector.

Given the desperate situation in which Ukraine finds itself today, it should have become extremely committed to the proper development of its domestic gas production, as that would introduce some extra volumes of the gas produced, in addition to 20 bcm domestically, into the local market to satisfy Ukraine’s ever-hungry annual consumption of around 53 bcm. This would also allow Naftogaz to save some foreign currency reserves on buying imported gas in lesser volumes, including gas coming from Russia. As a result, financial pressure on the state budget and government (which attempts to plug Naftogaz’ deficit by any means necessary - including loans from state-owned banks, international financial institutions and currency reserves of the National Bank of Ukraine) could have been significantly lowered.

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 and lack of investment in the national gas extraction industry will only result in further decline of gas production, worsening of economic conditions and 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 as Ukraine will be viewed as hostile based on it’s treatment of businesses currently operating in the country.

The revenues that the government hoped to generate from taxation of the oil and gas companies with the concomitant politically popular taxation of the oligarchs is proving to be a failure, as its actions 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. Without implementation of the necessary reforms, the Ukrainian energy sector will continue to be the nursery of corruption and playground for blackmail, which Russia enjoys greatly.

By Robert Bensh for Oilprice.com

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