20.04.2012
Sophie’s Choice: Ukrainian Energy Policy : Oil and Gas. Part II

 

Sophie Thomas, a UK private investor, gives an independent review on recent energy issues in Ukraine. A Story of Great Potential and Rhetoric -v- Reality. Part II - Part I

 

Current Trends in Transit and Production - Past Rhetoric and Talk of Change - Twin Strategic Challenges - A Perfect Storm - But could this be about to change;

 

 

 

Current Trends in Transit and Production.

Both of Ukraine's major gas and oil activities, production and transit, face a number of inter-related problems and threats. These problems and threats may, if allowed to develop, seriously impede Ukraine's ability to resist the influence of its more powerful neighbouring countries.

In the sphere of transit following the gas disputes of 2006 and 2009, the Russians are transporting less crude through the country, 31% less crude in the year to August and 17% less gas. Whilst these levels may increase over the short term, over the long term they may well reduce further, affecting not only the revenue Ukraine receives in transit fees and seriously impairing GDP, but even more importantly, the bargaining power of Ukraine when it comes to negotiating gas imports. 

The gas transit system also lacks the funds needed for significant investment.

Once the Nord Stream Pipeline via the Baltic Sea comes on-line, scheduled for 2012, a significant amount of Western Europe's gas imports will be able to circumvent Ukraine.

There is also the proposed South Stream Pipeline, promoted by Russia, which will transit the Black Sea and also circumvent Ukraine construction which is due to begin in 2010, and be completed in 2015, although there are doubts about the economics of this pipeline.

Matters are no better when it comes to domestic production and the lack of domestic and Western investment.

The effects of this are evidenced by the declining levels of production from Ukraine's oil and gas fields, with the latest Ukraine Oil and Gas Report Q3 2010 forecasting a 31% decline in oil and gas liquids production between 2010 and 2019, and around a 25% decline in gas production. This is set against rising consumption for both oil and gas - the shortfall covered by imports, principally from Russia and the East.

Past Rhetoric and Talk of Change

The prospect of declining domestic production of oil and gas, taken together with Ukraine losing its status as a major transit country for Russian and Central Asian gas exports, may be enough to concentrate minds in Kiev.

But Ukraine is well aware of its shortcomings, and for many years there has been talk of change and opportunities for Western Investors.

Talk of boosting production and investment is nothing new: not only did the London listed oil and gas companies come to Ukraine in the late 1990s, and in the early years of this century; BP also had a presence in the country in the late 1990s but later withdrew without making significant investments.

In the later 1990s Ukraine also had a programme entitled "Oil and Gas Ukraine 2010" under which it would boost oil and gas production and meet 50% of its own gas demand by 2010. The World Bank also had a programme for breaking the monopoly of the state gas trading houses over the industry.

Vanco Energy of Texas signed a 30 year agreement with the Ukraine government in 2007 to explore for oil and gas on the black Sea continental shelf. Vanco's initial investment was to be $2Bn but could have increased to $15Bn over time, depending on the value of resources found. But by 2008 it found that its 30 year licence had been revoked, over allegations of licence violations, and that it was about to sell its stake to Gazprom. Again there were allegations that some of Vanco's partners were linked to oligarchs and even Russian organised crime bosses. Such is the opacity of the Ukrainian oligarchs that it is impossible to say whether some, or if any, of the allegations were true. Vanco is presently taking the matter to the Stockholm Arbitration Court.

Given the troubled history of Western investments in the Ukrainian oil and gas sector, Ukraine - despite its vast potential is struggling to obtain any significant Western support in the sector.

Twin Strategic Challenges - A Perfect Storm?

The twin problems of declining domestic production of oil and gas, and energy generally which shows no real sign of abating, combined with the prospect of Russia and its partners building oil and gas pipelines which will circumvent Ukraine completely, are likely to have important repercussions for Ukraine generally.

This may completely negate Ukraine's bargaining power in any future gas disputes, and provide a twin strategic challenge to Ukraine.

If left unresolved, this could seriously compromise the future independence of the country in dealing with its more powerful neighbours to the West, and particularly Russia to the East.

But could this be about to change?

These twin challenges may be driving policy in the new Yanukovich government to finally attempt to deal with the multiple and inter-related challenges of corruption, lack of domestic production, and influence of the oligarchs which have so prejudiced the effort of Western companies to establish production bases in the country.

Recently supposedly pro-Russian President Yanyukovich said in an interview with the Wall Street Journal that Ukraine was moving steadfastly along the road towards European integration, and that Ukraine should reach modern European standards as quickly as possible. 

But he emphasised that Ukraine also needed to maintain strong ties with Russia, and emphasised that there was no need to build the south stream Pipeline now that relations with Russia had improved.

In late September 2010, Ukraine signed a treaty with the EU and became a member of The European Energy Community, and as such agreed to align the principles of Ukraine energy policy with those of the European Union. The effect will be to ensure that countries share the same legal framework for energy investments. The ultimate objective of this is to create a pan European energy market, and the effect of Ukraine signing is to extend the EU's internal energy market into south Eastern Europe in an effort to boost security of supplies.

This followed the introduction of the Ukrainian Gas Law which was published in July 2010. The next step is for the Ukrainian Parliament to ratify the treaty.

Becoming a member of the Energy Community is no mere piece of paper? 

At least it is not regarded as such by the EU. Even before the treaty was signed, the European commission indicated that the effect of the treaty would be to force Ukraine to break up Naftogaz and separate its transmission capacity from its production arm, and prevent monopoly control over the gas pipeline system.

In September 2010 at a meeting at the British Embassy in Ukraine, attended by the British Ambassador Leigh Turner, an unnamed British company announced a major new push into the Ukrainian energy market. A senior Ukrainian minister attended the event and spoke with confidence and enthusiasm about the forthcoming licence round, which he said would be open and transparent, and about measures to cut regulation including the number of inspections the industry faces.

But it isn't all "good" pro-Western leaning news. The Ukraine courts have recently overturned the 2005 Constitution calling it "unconstitutional" which has effectively transferred Ukraine back to a more Presidential system, rather than the Parliamentary system which existed following the Orange Revolution. This has resulted in a more "Power Vertical" type of arrangement, similar to that seen in Putin's Russia.

And Russia, whilst it has lost its East European Empire is seeking to reassert its control over its neighbour's economies in other ways.

In May 2010, a few days after visiting Italy and Austria to gain approval for the South Stream Pipeline, Vladimir Putin made a gas merger offer to Ukraine, in which he proposed merging Gazprom and Naftogaz. Ukraine would gain access to Russian gas fields, but Russia would gain control of Ukraine's gas pipeline system. Given the size of Gazprom it would effectively be a Russian takeover of Ukraine's oil and gas industry. But Gazprom control would be difficult for many Ukrainians, including many oligarchs to stomach and would be contrary to the newly signed EU treaty.

However President Yanukovich may be attempting to plot a fairly pragmatic middle course.

In April 2010, Ukraine agreed to extend Russian leases over a naval base in exchange for cheaper gas. In October, Yanukovich proposed including the EU in any Gazprom/Ukraine pipeline deal, which would be directly contrary to President Putin's proposal. Whilst stepping up co-operation with Russia in a number of areas he has also signed a 25 year deal with TNK-BP to invest $2Bn in Ukraine exploring for gas over the next 25 years. A Gazprom/Naftogas joint venture, rather than a merger has also been floated.

At the end of September, President Yanukovich visited China which resulted in agreements that would see a $4Bn investment in Ukraine including investment in the oil and gas sector.

Cadogan Petroleum has recently had its licences confirmed, whilst presently Regal Petroleum’s remain in dispute.

An attempt by unknown forces to revisit and declare illegal the privatization of the ArcelorMittal steel plant, for which they paid $4.8Bn was quickly terminated by President Yanukovich. EastOne a vehicle of oligarch Victor Pinchuk is exploring floating oil and gas assets on the Warsaw Stock Exchange (maybe London is no longer the stock exchange of choice).

In July 2010 under a deal with the IMF, Ukraine agreed to increase domestic gas prices in order to reduce losses at Naftogaz, and allow it to breakeven in 2011.

Ukraine has also earlier this month announced increasing energy co-operation with Syria, which has also had some difficulty in obtaining Western investment to develop its own oil and gas assets. A deal to develop shale gas with TNK-BP, and plans to build a LNG terminal on the Black Sea coast which by 2016 would be able to import 20% of Ukraine's gas needs, bypassing Russia.

Conclusion

Reform at present is taking place slowly, at an almost glacial pace.

The question which Ukraine's political and oligarchical elite must determine in the coming years, is whether it would be more advantageous than not for Ukraine (and of course themselves) to accept Russian control of its most important oil, gas and transit networks. 

This would result in political, economic and ultimately de facto military domination, and become some form of vassal state closely associated with its more powerful neighbour, with little opportunity to conduct any form of independent policy.

Alternatively, Ukraine's elite could resist Russian attempts to effectively take over large swathes of its oil and gas industry and prized transit network, and seek to negate the intended Russian pipelines which will bypass Ukraine's transit system - thereby retaining a large degree of political and economic independence.

The latter course probably carries the greater risk, particularly given the present weakness and inefficiency of its economy, and particularly in the areas of energy production and transit.

However, there are signs that the present leadership are following a pragmatic course and are resisting Russian overtures, whilst seeking European investment and alternative supplies of gas, and ways of boosting domestic production.

If Ukraine is serious about boosting domestic oil and gas production, then Western investment is essential. That implies a different manner of dealing with Western investors with a more transparent licensing procedure, and fundamental reform of the legal system.

If indeed that is their decision, then Ukraine could yet become a quality investment destination for Western investors.

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