Step into the world of oil and gas though, and the clouds darken.
I am not going to try the patience of the reader by moaning about taxation, beyond saying that in Ukraine it is not a question of how much tax we pay but more what type of tax we pay – in most countries, oil and gas companies are taxed on profits so if they make a lot of money, they can expect to pay a lot of tax but if they aren’t making profits they don’t pay much.
This is not the case in Ukraine.
But enough about tax. The generally accepted principle internationally is that an oil and gas company will pay the owner of subsurface rights, which is the state in every jurisdiction except the USA, where it is a physical person, some up front money for those rights for a certain period of time – normally at least 20 years.
The amount paid may be negotiated or determined via a tender, and will be determined by the appetite of the investor which in turn will reflect the prospectivity of the area, having reviewed all available data. It follows therefore, that it is in the interests of the owner of the subsurface rights, which in Ukraine is the state, to provide potential bidders with as much information as possible so that the prices obtained for leases of subsurface rights are maximized, allowing the state to collect the most money. For this reason, most countries have state geological institutes collating data for this very purpose.
Note however, that in the Soviet Union even maps showing surface topography were considered state secrets.
The oil and gas exploration and production business is risky and requires a long-term outlook. Exploration, while very exciting, is the most risky and frustrating part of the business. Globally, the proportion of success in exploration wells is thought to be around 1 in 6.
With the aid of modern geoscience, attempts can be made to fairly accurately quantify the risks associated with a particular well – but the probability of success is seldom more than 30 percent. This means that the overwhelming probability in exploration is the loss of all the exploration investment – which in most cases is going to be at least $10 million and in some cases more than $50 million. Taking these roulette style risks is of course the every day business of the exploration companies – and it is in the interests of the host state to encourage such risk taking. Without exploration, there can be no big increases in oil and gas production.
So what must a state do to encourage exploration?
First and foremost, the investor needs to know that the risk being taken is purely a subsurface one – so if they are lucky and have a commercial discovery, nobody is going to take their license away. They need to have trust in the state that the state will not change the rules of the game if the investor has luck with the subsurface roulette wheel. That trust is built up through a track record of stability, dialogue and co-operation.
Secondly, the investor needs to understand that there will be no hidden obstacles to the development of the oil or gas field after discovery, and the state will do what it can to facilitate speedy development (which the investor will need to recoup their investment).
Thirdly, the state should do what it can to allow the investor to mitigate its risk – for example by agreeing to forego state revenues from early production to allow the investor to recover its investment quickly (this is not about the amount of tax paid, it about how it is paid).
Unfortunately almost none of this happens in post-Soviet Ukraine, with the result that there has been little investment in exploring for Ukraine’s oil and gas future.
Many state bodies exist, but collectively their treatment of oil and gas investors more resembles stern teachers with naughty schoolchildren rather than modern state institutions.
Of course there needs to be a planning process to ensure oil and gas developments are undertaken in a safe and ecologically sensitive manner. But having taken the risk with its own funding, and if lucky enough to make a discovery of oil or gas, that investor needs to be free to develop the discovery as it sees fit (within internationally accepted safety and environment criteria).
In Ukraine, if new reserves of oil or gas are found, the investor needs to agree a plan of development with the state bodies, which rigidly prescribe how the field is to be developed, where wells should be drilled and and at what pace.
State inspections have become an industry in its own right, empowered to suspend or even terminate the activities of the investor on spurious and irrelevant grounds, without legal or logical grounds. Deviations from field development plans are a minefield – the investor is compelled to adhere to the plan of development over which the state has the ultimate vote, and differences in production levels from the plan whether positive or negative are punishable with fines, suspensions or worse.
The investor expects, having made its up front payment and taken its risks, to have the freedom within normal safety and environmental criteria to develop what it finds how it chooses. In the international arena, there is normally a natural alignment of interests between the State and the investor, as the investor will want to recoup its investment by producing as much oil and gas from its discoveries as soon as it can, and if has success, doing it again. Others see this and are attracted too, resulting in more competition between producers and more demand for subsurface rights, driving up revenues for the state in a “virtuous circle.”
Why has the required reform not happened?
I am no political scientist, but I suspect that ironically the development of civil society has meant that the power of the state to act in an autocratic way has limited Ukraine from driving though a top-down change that has been successfully undertaken in some other parts of the former Soviet Union while grassroots level reforms have been insufficient for the bottom-up process to get under way.
It would be irresponsible to suggest that there is a quick fix – oil and gas is a long-term business, and the reputations of nations are quickly lost but only slowly regained.
However, with the benefit of far-reaching civic reforms, Ukraine now has the conditions necessary to undertake a complete re-focusing of the organs of the state to become smaller, better paid and professionally engaged in encouraging and assisting inward investment in the hydrocarbon sector through the dissemination of technical information, conduct of transparent awards of modern-style licenses, which should be inviolable except for legally established misconduct and light touch, pro-business regulation.
There is certain to be more oil and gas in Ukraine to be discovered through exploration and development – which in due course should allow Ukraine to establish true energy independence. But this is a long-term objective which requires long-term thinking.
Alastair McBain is CEO of Arawak Energy Ukraine B.V.
