Welcome to the U.S.-Ukraine Business Council

Jim Davis, Business Ukraine magazine
Kyiv, Ukraine, Monday, January 21, 2008

Ukraine's well-documented energy woes are regularly cited as a driving force behind the country's current rising inflation. An over-reliance on Russian energy supplies is compounded by the unwillingness of politicians to take a leadership role in convincing the social and industrial sectors of their energy profligacy and encourage changes in consumption patterns, which remain largely unchanged since Soviet times

For years, Ukraine's economy managed to stumble along from one minor energy crisis to the next, with the people and their leaders always assuming that somehow Ukraine would be able to cobble together some plan that would allow the continuation of the country's blatantly excessive use of natural gas, the major element in its energy equation.

Russia's aggressive policies to extract the highest prices possible for the Russian and Central Asian gas fields which it controls may finally force Ukraine to develop much more comprehensive and effective energy conservation measures.

Any energy policy rethink would necessarily include a look at the incredibly wasteful energy consumption of the country, with its centrally controlled residential heating systems and gas-guzzling heavy industry.

It would also mean introducing measures which would encourage the exploration of Ukraine's own energy resources, a process that has long been blocked by political spoiling tactics designed to maintain the energy sector status quo and protect Russia's regional dominance.

Barriers to self-sufficiency

Some experts believe that, properly explored and exploited, Ukraine could eventually provide a great deal more of the natural gas and crude oil that it needs from internal sources alone.

However, the country's political infighting and tendency to create immensely complex legal structures to its own disadvantage has made the exploration for oil and gas so complicated as to give pause to any but the hardiest of exploration companies.

The whole bag of legal hurdles through which an exploration company must jump were described by one of the country's most respected international lawyers thus: "In 2007 the government continued to carry out hostile policies against investors and cultivated an unpredictable, contradictory and arbitrary regime for investment in the energy sector." These are strong words, indeed, but there is plenty of evidence that they represent the stark reality.

With the entire world energy pricing structure being forced upward by burgeoning demand for crude, and prices for top quality crude recently topping USD 100 per barrel, there has been no end of investors knocking on Ukraine's door with proposals that would seem attractive in most of the known world.

However, Ukraine's politicians and the financial interests that support them have managed to construct a legal structure that appears deliberately designed to dampen the interest of even the most enthusiastic and hopeful investors.

Some suggest that with Ukraine's energy-cost driven inflation already raging at levels unprecedented since the early 1990s, Ukraine's current rules on exploration and exploitation of its underground resources are not only destructive to any efforts to gain energy independence, but also serve to further endanger a worsening economic situation in the short term.

Fuelling inflationary fears

Some of Ukraine's best educated and best informed economists are currently predicting that the country will see levels of inflation in 2008 unprecedented since the early 1990s. The causes are myriad but escalating energy costs top the list.

The immense jumps in crude oil prices are a factor, but Ukrainians do have the option to use their cars and trucks less and at least exercise some control over their consumption.

The jump in natural gas prices which Ukraine has experienced due to deteriorating relations with Russia presents a much more difficult problem because so much of Ukraine's Soviet-era industrial and social infrastructure was built around the incorrect assumption that natural gas would always be readily available and cheap.

While the availability issue may be several years away from being a problem, the cost factor is a major burden today that will remain so until Ukraine manages to either use less natural gas or produce more of its own.

Ukraine has some natural gas resources, but they are small when compared to existing demand. There is always the possibility that Ukraine could eventually explore and exploit large amounts of natural gas, most likely from those parts of the Black Sea shelf to which it lays claim.

Black gold in the Black Sea

The possibility of both crude and natural gas finds in the Black Sea is a strong incentive in a world energy situation in which so much of the most easily exploited and highest quality reserves have already been discovered and largely exploited to extinction.

There was a time when rugged wildcat drillers led the charge to find and exploit new energy fields. Those days have now long gone as escalating costs and greater regulation force up costs to the point that energy exploration has became the province of large corporate entities rather than individualist entrepreneurs.

A Texas-based company, Vanco, which seems to combine some elements of both the old wildcatter spirit and modern corporate financing, has recently appeared on the Ukrainian energy exploration scene and has concluded a production-sharing agreement (PSA) with the Ukrainian state.
Vanco officals now say they will relatively quickly begin exploration of the Prykerchenska area of Ukraine's Black Sea shelf.

Although exploration is just getting organised, Vanco's Gene Van Dyke, a geological engineer with over 50 years in the oil and gas exploration business, is singing a happy tune.

In an interview published in the November 26 issue of the Houston Chronicle, Van Dyke said that he is convinced that the Black Sea exploration programme will be successful and contribute to lessening Ukraine's dependence on foreign energy sources. "We don't know at this stage if we'll have oil or gas, but we're quite sure we'll have one or the other," Van Dyke told the Chronicle.

Given the fact that world energy demand increases daily amid ever-rising prices, one is forced to ask why there aren't 10 or 20 Vanco's sinking their drills into the Black Sea shelf and other prospective locations in Ukraine.

As Dr. Irina Paliashvili [President, RULG - Ukrainian Legal Group] pointed out in a paper for the US-Ukraine Business Council [USUBC][as chairman of the USUBC Legal Committee], the Ukrainian government has put into place regulations that make it almost impossible to justify undertaking exploration in Ukraine.

Any company looking at energy exploration finds that the type of settled law governing exploration simply no longer exists in Ukraine. What the Ukrainian parliament did was to take an existing law, somewhat outdated and ambiguous but adequate as the basis for energy agreements, and turn the law into something that changes every year as a part of the annual budget law procedure.

Since 2004, parliament has suspended the standard law structure through annually adopted laws on the state budget, and stipulated an ad hoc system for the licensing regime based not on laws, but on regulations adopted annually by the Cabinet of Ministers.

At the time of the 2004 suspension, the change appeared to be only a temporary, emergency measure based on just a few lines in the budget law, which had no basis in the subsoil legislation. However, over the years, this temporary measure has in practice evolved into a new system all of its own.

What this means in effect is that any company investing money in energy exploration in Ukraine must be willing to put its money at risk with the knowledge that the conditions under which it might be able to exploit any finds would always be subject to the whims of the government in power at the time that any question arises.

Scaring off essential investors

As if the complexity of Ukrainian law relating to energy exploration was not enough to discourage investors, the possibility for expanded exploration suffered another major setback in 2007 with the government's open interference in the gas market. The Budget Law for 2007 and the later Cabinet Resolution No. 31, dated January 16, 2007 introduced restrictions on the sale of natural gas extracted in Ukraine.

Companies in which the state owns a majority stake are now required to sell their natural gas exclusively to Naftogaz Ukrainy at a price approved by the National Commission for Regulation of the Electric Power Industry (NCRE), i.e. at low prices set by the state.

It is important to note that these restrictions apply not only to gas owned by companies in which the state owns a majority stake, but also to gas owned by their privately owned partners.

For example, if a foreign investor happened to have a joint agreement with a state-controlled company, the share of extracted gas belonging to this foreign investor would also be subject to these restrictions, and the foreign investor would be forced to sell its share of gas to Naftogaz Ukrainy at an artificially low, regulated price.

Because of the above restrictions, 2007 saw gas prices in Ukraine set not by the free market, but by the government. This changed the rules of the game to the disadvantage of those who had already invested their money under earlier legislation.

Protests and court decisions have so far done nothing to dissuade the government from its avowed path of setting natural gas prices at artificially low levels and the Budget Law for 2008 contains the same restrictions, so we expect this issue to again wind up in the courts in the coming months.

Time for a policy reappraisal?

Despite the experiences of the past few years, when the country has been repeatedly exposed to the energy extortion of the Kremlin, Ukraine has still done very little in the way of investigating what energy resources actually lie within its borders.

Unfortunately, with the imposition of laws and regulations that are subject to change at the whim of the government in power and a well-deserved reputation for corruption, it is hard to imagine any significant change in the situation in the near-term future.

Few companies with the resources and the technical capacity are willing to put their money at risk to do the necessary exploration to ascertain just how much subsoil energy resources Ukraine actually possesses.

LINK: http://www.businessukraine.com.ua/energy-dependency-fuelling