The Ukrainian private gas industry began 2015 in a highly unattractive investment environment. The new tax and regulatory regimes are expected to result in a significant decline in new investment. At the same time, the global decline in energy prices has made new investment in the gas sector less attractive to the global majors and independents. Combining these developments, we should not expect to see a rapid return of investment into the Ukrainian energy sector.
After the adoption of amendments to the State Budget and the 6th annual International Ukrainian Energy Forum, we asked Alan Apter, an investment banker and Non-Executive Chairman of the Board of Burisma Holdings to comment on this situation. Mr. Apter has been an investment banker for 30 years and has been involved in the Ukraine market since 1996 with firms including Renaissance Capital, Troika Dialog and Morgan Stanley.
What
has changed investor sentiment towards Ukraine? Why do we face
outflows?
The
major factors include the conflict in the east of Ukraine, concerns
about political stability, the substantial drop in GDP and economic
output and the dramatic devaluation of the currency. In the case of
the private gas sector, the highly unfavourable changes in the tax
and regulatory regimes have also been a determinative factor.
However,
the Government says that these changes in the tax and regulatory
regimes are temporary and related to the difficult financial
situation in the country and the inability to meet its obligations to
foreign gas suppliers.
We
understand the challenges that the country is facing and want to be
as helpful as possible in these difficult times. But the ability of
Burisma and the other independent gas producers to continue to invest
in the gas sector in Ukraine is highly dependent on our ability to
attract new funding to support such investment. Lenders and equity
investors are unfortunately not willing to provide funds under
conditions which make new investment unattractive and make uncertain
their ability to be repaid on time or earn an appropriate risk
adjusted return on their money. They have their own stakeholders to
answer to and cannot take into account matters of patriotism. And
unfortunately once they see a highly unattractive tax and regulatory
system put in place in a given sector, this will stay in their memory
for some time and it will be difficult to convince them that these
measures are temporary and that they can be confident an unfavourable
operating regime will not return in the future. So this creates a
vicious circle.
Does
this mean that Ukraine has ceased to be an attractive region for
investment because of government policies?
Certainly
in the case of the independent gas sector. Under the current tax and
regulatory regimes Ukraine cannot hope to compete with most countries
around the world for new investment into the gas sector. Staying
close to home, Ukraine’s neighbours like Poland and Turkey are now
actively developing their gas sectors with favourable tax and
regulatory regimes. Indeed, almost nowhere in Europe can one find
extraction tax rates in excess of 20%. Nowhere in Europe have we
seen governments requiring major industrial gas consumers to buy only
from state owned producers. So why would an investor choose Ukraine.
An example is the American major Chevron which has been reported to
have decided not to proceed with the development of major hydrocarbon
projects in the country. It has been widely reported that an
unfavourable tax regime was one key element of Chevron’s decision.
If Chevron will indeed not proceed, it will mean the loss of many new
jobs which would have been created by the projects and it will be a
major blow to Ukraine’s long established strategy to become energy
independent by fostering domestic production and reducing reliance on
imported supply.
If
the government returns to the prior tax regime for the sector, what
would the effects be?
The
effect would be to improve the prospects for investment in the sector
while at the same time providing greater funds to the state budget.
The math is simple. Under the previous tax regime every 100 million
cubic meters of gas produced resulted in UAH 300 million to the
budget. In 2015 the various independent gas companies were planning
to increase production by 500-600 million cubic meters. Instead,
companies are reducing investment rapidly because of the
unprecedented high extraction tax. Production will not grow and will
eventually start to shrink and the net effect to the budget is very
likely to be negative. Gas production companies are often
city-forming businesses for Ukraine, creating employment and support
for social programs at the local level. Reduction in investment will
not only hurt Ukraine’s budget revenues in the medium term but will
result in less local job creation and support for local social
programs. A return to the prior tax rates would result in more
investment, even under the otherwise difficult circumstances facing
Ukraine, leading to faster achievement of the country’s stated goal
of energy independence.
What
is the magnitude of investment required by independent gas producers?
In
order to increase production by 500 million cubic meters annually,
independent gas producers would need to invest an estimated $1.5
billion annually. Since today it is not possible for these producers
to borrow or find new equity investors, the source of this investment
would need to be own funds. But with an extraction tax of 55% and an
unfavourable regulatory environment, most independents will find this
hard to justify when they can produce much better returns from
investing elsewhere.
What
about perceptions that the independent gas producers make windfall
profits?
These
perceptions do not take into account the reality that natural gas
exploration and production is one of the most risky and capital
intensive businesses in the world. In Ukraine, the drilling of one
well costs $12 to $15 million and takes six to nine months.
Statistics show that in Ukraine only one of every four wells will be
successful due to the complex geology of Ukrainian deposits. As a
result the cost of production of one thousand cubic meters of gas
averages $200. At the current level of taxation, most projects
become unprofitable.
Have
private gas producers tried to engage in dialogue with the government
on the negative effects of the current tax and regulatory policies
for the sector?
Yes,
repeatedly. The largest private producers have proposed to the
government the setting up of an advisory body which would define
rules of the game to balance the interests of the government and the
independent producers and facilitate the ability to attract
investment into the sector, both from existing producers and new
entrants. Sadly the government has not reacted enthusiastically to
our attempts at dialogue. Particularly sadly because this lack of
constructive dialogue will impede the country’s desire for energy
independence.
What
is your forecast for private gas production in Ukraine? How quickly
could Ukraine achieve the real, not paper, strategy for energy
independence?
Energy
independence cannot be achieved overnight. It will require an
enormous amount of investment by the state, by existing independent
companies and new investors. It would also require political
stability, an end to the conflict in the east of the country and a
conducive tax and regulatory environment such as those prevailing in
many European countries seeking to foster energy independence. But
the private gas producers have an important role to play and have
already demonstrated their ability to rapidly increase production
under favourable operating conditions. What’s more – despite the
current difficult political and economic conditions that Ukraine is
facing – I am confident in saying that if the tax and regulatory
regimes were conducive to increasing production, the independent gas
producers would even today be making great strides towards helping
the country achieve energy independence.
What
are Burisma’s plans in response to the current tax and regulatory
regimes?
We
completed 2014 with a spectacular increase in production. Our total
production was 692 million cubic meters, over 50% more than we
produced in 2013. In 2015 we had planned to increase production to 1
billion cubic meters and launch more than 20 new wells. Under the
current environment we are not able to attract outside funding and
cannot justify the risk adjusted rate of return of these plans. We
will therefore have no choice but to scale back the investment
program or postpone its implementation until a more favourable
operating environment exists. The Board of Directors intends to make
a decision this month.
In
December Burisma announced a joint venture with the Kazakh national
oil and gas company “KazMunaiGas”. What type of projects does
this involve and does this mean that the company is actively working
to diversify its portfolio by region and/or products?
This
agreement was a major step for Burisma towards diversifying its
business geographically so that it is able to attract lenders and
potentially equity investors to ensure the growth of the business.
The agreement stipulates that Burisma will jointly with KMG conduct a
round of seismic and drilling operations for the exploration and
production of hydrocarbons, as well as explore the possibility of
building infrastructure in Kazakhstan. We have already reached the
stage of coordination of joint activities. And Kazakhstan is not the
only country where we see opportunities for business.
Burisma Holdings – the largest independent gas producer in Ukraine, founded in 2002. Holding comprises four operating companies that are engaged in mining and production of hydrocarbons – Energy service company “Esko-Pivnich”, “Pari”, “First Ukrainian Petroleum Company” and “Aldea”. In 2014, total natural gas production was 692 million cubic meters, is 50.4% more than in the 2013th. Burisma Holdings owns 20 licenses for hydrocarbon production in the major oil and gas basins of Ukraine. The entire volume of production is sold to the domestic market of Ukraine. #EnergySecurityUkraine www.burisma.com
