2010 for Ukrainian Oil and Gas Sector in Review
Vitaliy V. Radchenko
2010 was indeed a tough year for Ukraine and all sectors of its economy. Climbing slightly out of the economic crisis downturn the country witnessed substantial changes in the state governance, political and legal systems. The energy sector was no exception and below I am going to touch upon the most crucial events that happened during 2010 in chronological order.
1. Clear rules for public procurement
The On Public Procurement Act of Ukraine No.2289-VI adopted by the Ukrainian Parliament on 1 June 2010 is aimed at ensuring non-discriminative and transparent procedures during the procurement of goods, works and services at the expense of the state budget. The Act introduced a number of important novelties and must unconditionally be taken into account by any investor when dealing or having any joint projects with a state company.
2. Legal framework for PPPs
On 1 July 2010 the Verkhovna Rada adopted the On Public Private Partnership Act of Ukraine No.2404-VI, which purports to regulate relations between the state and private partners undertaking joint projects for inter alia the exploration and production of minerals, including those based on production sharing agreements. Although adoption of the long-suffering PPP Act was surely a great achievement of Parliament, the Act merely governs the basis principles of the PPP system and does not go into reasonable details.
3. Liberalisation of the natural gas market
A landmark event for the Ukrainian natural market (though with some positive influence from the IMF and Energy Community) — adoption of the On Basic Principles of the Natural Gas Market Functioning Act of Ukraine No.2467-VI of 8 July 2010. The Act was adopted in pursuance of Ukraine’s compliance with EU Directive No.2003/55 EC of 26 June 2003 concerning common rules for the internal natural gas market from the EU’s so-called 2nd Energy Package. Its primary goal is the liberalisation of the Ukrainian natural gas market by virtue of ensuring equal access rights to pipelines, introduction of market-driven pricing, guaranteeing supply for qualified consumers and undertaking steps for separation of gas transportation, production, storage, distribution and supply functions on the market and within incumbent market players (having Naftogaz Ukrayiny in mind). The reform is supposed to be completed by 2015 and should ultimately lead to the unbundling of the Naftogaz’s monopoly in the gas transit and transportation sector.
4. Changes in the subsoil licensing regime
On 23 June 2010 the Cabinet of Ministers of Ukraine, by its Resolution No.596, adopted a new yearly Procedure for the Issuance of Special Permits for Subsoil Use in 2010. The regime introduced by CMU in 2010 was much more lenient in comparison to the one which had been in effect in 2009. It finally reinforced the pre-emptive rights of a subsoil user for a production special permit (licence) and extension of the licensed acreage. The Procedure removed some other gaps in Ukrainian subsoil legislation and expressly confirmed that foreign legal entities may obtain special permits for subsoil use. At the same time, the procedure for holding competitive auctions for the sale of these special permits for subsoil use has become less transparent. We do hope that the licensing rounds in 2011 will be more transparent and we will no longer see any precedents of 9 oil and gas licences being granted to a “soon-to-be-privatised” state-owned coal mine without an auction.
5. Changes to legislation on production-sharing agreements
The fight for the adoption of this Act has been tough, but at the end of the day, after being vetoed, the On Amendments to Certain Legislative Acts of Ukraine with Respect to the Performance of Production Sharing Agreements Act of Ukraine, No. 2470-V² was signed by President V. Yanukovych. The Act is an attempt to improve the PSA regime and includes important amendments inter alia aimed at streamlining the legal framework governing PSAs, taxation, execution and termination thereof.
6. Shale gas rush
In 2010 we witnessed huge interest on the part of the leading international oil and gas companies to the exploration of tight gas reserves in Ukraine: according to the media TNK-BP, Shell, PKN Orlen, ENI, Gazprom, Chevron, Kuwait Energy Company — have all expressed their interest in pursuing this opportunity. While reserves of tight gas have not yet been proven, we would really want to see these projects be successful, as the phenomenon of shale gas, in case of commercial discovery, would play a vital role in safeguarding the Ukrainian energy security and development of the industry in general.
7. Joint projects of Naftogaz and Gazprom
There have been a lot of rumours and media coverage on assets swap and a joint venture between Gazprom and Naftogaz. According to a recent press release, only a memorandum of understanding for setting up a joint venture for a coal bed methane project has been signed between the companies to date. We are anxious to see the further steps to achieve a final agreement on creating a joint venture between these companies in 2011.
8. Upgrading of Ukrainian Gas Transportation System
Finally, in 2010 the project to upgrade the Ukrainian GTS was begun. The European Bank for Reconstruction and Development, as the provider of a grant in the amount of EUR 2.5 million, has completed the first phase of assessment of winners for the right to develop a feasibility study on reconstruction and modernization of the Ukrainian gas transportation system. At this stage, out of the 12 companies, five candidates that will continue the further bidding process, have been selected. These are the UK-based Mott MacDonald Ltd, Spanish Mercados Energeticos S.A., US-based PACE Global Energy Services LLC, Finnish Sweco Industry Oy and Dutch Tebodin BV. These companies were to submit their detailed proposals to the EBRD tender board for the feasibility study.
9. LNG terminal at Black Sea in Ukraine
A LNG-terminal could be a decisive tool for Ukraine to increase its energy security and, gladly, in 2010 we have seen some action on part of the Government in this direction: a business idea of a 10 billion m3 LNG terminal has turned into a project of national importance, then a special Governmental entity has been created for its implementation within 4 years on a PPP basis and raising up to USD 1.4 billion in financing. The next step is a tender for the development of a feasibility study for the project, which is supposed to be announced by the Government on 19 January 2011 and be completed by the end of the year.
10. RosUkrEnergo vs. Naftogaz
The long-standing battle involving RUE over the volumes of natural gas that it was deprived of now seems to be resolved. After winning the arbitration proceedings in Stockholm and going through all the levels of the Ukrainian court system to recognise and uphold the arbitration award, RUE has recently claimed that it has paid the agreed amounts to Naftogaz and Gazprom, be leaving the Ukrainian market and waiting for Naftogaz to return 12.1 billion m3 of gas to RUE, which, as just reported by the media, has already commenced.
11. Ukraine joining Energy Community
Ukraine joined the Energy Community on 24 September 2010 by signing the accession protocol at the Eighth Ministerial Council meeting. Ukraine’s entry into the Energy Community should enhance Europe’s security of gas supply and assist the establishment of the energy market and cooperation among regional countries. Ratification of the accession protocol should also prompt development of Ukraine–EU consolidating policies and expand cooperation in terms of gas markets and gas transit. On the other hand, the accession protocol should be viewed as a mandatory checkbox on the list IFI’s “must-haves” for the upgrading of the Ukrainian gas transportation system.
12. New Tax Code
The new Tax Code adopted on 2 December 2010 has become a great disappointment, not only for small businesses, but also for oil and gas production companies, and has led some of them to moan that the overall taxes of their business have totalled 50% of their income. Indeed, without even taking corporate profit tax and value added tax into consideration, the principal subsoil taxes alone (i.e., (i) charges for subsoil use and
(ii) royalty payments) imposed on the oil and gas producers have been increased by up to 40%.
13. State of Ukraine vs. Vanco International Ltd
It seems that finally, after 2 years of a dispute with regard to revocation of the special permit for exploration and production of oil and gas in the Black Sea pursuant under the one and only hydrocarbon production sharing agreement in Ukraine, its parties have decided to suspend their arbitration proceedings and try to find a mutually acceptable settlement. This must be viewed as a good signal for potential investors that are also considering PSA as an option for their oil and gas exploration projects in Ukraine.
14. Ukrnafta challenging its domestic supply obligations
This year was quite a fortunate one for Ukrnafta, the largest oil producing company in Ukraine. Naftogaz holds a 50% plus one share in Ukrnafta, thus being a state-owned company, any of which under the law is obliged to sell all extracted natural gas to Naftogaz for the needs of the Ukrainian population at heavily discounted prices. Investors working with state oil and gas companies should always account for this restriction on their part.
Ukrnafta, however, on a number of occasions in 2010, was quite successful in challenging this domestic supply obligation in courts and winning the right to supply this gas to industrial consumers at much more attractive prices. Therefore, supposedly making some huge extra profit and causing some commotion on the gas market by an unexpected intervention. This was a ground-breaking precedent, which allows a state-owned gas producing company to increase its profitability, though at the expense of reducing the volumes of gas, which otherwise would have been supplied to the population. If this practice is employed by UkrGazVydobuvannya — the largest gas producing company subsidiary of Naftogaz, it would probably lead to a significant mismatch in the gas balance of the country, primarily in the residential customers segment.
15. Outlook for 2011
With so many things happening last year, in 2011 we are particularly looking forward to seeing more international oil and gas companies come to Ukraine; state-owned oil and gas companies willing to jointly and productively work with their foreign partners; further improvement of oil and gas licensing legislation and adoption of the restated Subsoil Code; new licensing rounds and, hopefully, PSA tenders being announced by the Government; reasonable adjustment of the State Tax Administration’s attitude towards joint activity agreements in the oil and gas sector and taxation of the industry in general.
In order to achieve the challenging goals Ukraine now seems to be aiming at, we would encourage the industry and state authorities to support and root for any initiatives to make the oil and gas market in Ukraine de-monopolised, stable, more transparent and accessible.
