Parliament's failure to reduce choking royalty rates is taking its toll on private gas production.
Private natural gas producers and business associations say that exorbitant royalty taxes, which approximately doubled since December to 55 and 29 percent, depending on depth levels, are pushing them towards extinction, detrimental to boosting domestic output and scaring off new investments.
Private producers froze about $400 million in planned gas exploration and extraction projects this year, the European Business Association and Association of Gas Producing Companies in Ukraine said in an emailed statement on Nov. 5. Capital investments likewise were cut by 80 percent to 2014.
Already, combined gas production by state- and privately-run firms fell by 5 percent, or by 631 million cubic meters, in January-September on a yearly basis, according to the Energy Ministry.
Prime Minister Arseniy Yatsenyuk in December defended the policy as a way to fill the nation’s war budget.
Regardless of their purpose, the royalty rates are ill-conceived, said Robert Bensh, managing partner of Pelicourt LLC, a private equity firm with a majority stake in Ukraine’s third largest gas producer Cub Energy.
“This was extremely short-sighted poor legislation that continues, and everyone is to blame – the president, prime minister, energy minister, (and) finance minister,” Bensh said.
In July, Finance Minister Natalie Jaresko proposed lowering rates to their previous levels: 29 and 14 percent depending on the extraction depth. The cheaper royalty is for gas extracted at depths of more than 5,000 meters. Speaking at the U.S.-Ukraine Business Forum in Washington, D.C., she indicated that the tax rates would drop further starting on Jan. 1 to 20 percent and 10 percent, respectively.
Parliament has yet to pass such a bill.
Two competing draft laws – one backed by Jaresko and the other by lawmaker Yulia Tymoshenko, who made her fortune trading gas in the 1990s – have been reshuffled in parliament. Yet, it was Tymoshenko’s bill that was adopted in the first of two readings on Oct. 7.
Private gas producers criticized the bill for being populist, especially because it was voted on ahead of the Oct. 25 local elections.
The Kyiv Post hasn’t received a response from the Finance Ministry regarding the royalty tax rates on gas.
One reason why there has been a delay in reducing royalty taxes is that a large part of private gas production is non-transparent, said Yuriy Vitrenko, business development director for state-owned Naftogaz Ukraine.
Analysts say there are really only five to six purely Western gas businesses in Ukraine, among which are: Cub Energy, Kub Gas, Arawak, Eni and Cadogan. Overall, private companies produced nearly 3 billion cubic meters of gas last year, accounting for about 15 percent of total domestic production.
“Because of the high royalty tax that decreases the value of these assets” one can buy out many gas producing assets at low prices, Vitrenko said in an email response. “If then the royalty tax is drastically decreased, it will be a very profitable deal…one can suspect some ‘market cornering’ and ‘insider trading’ under the current circumstances.”
Mark Rollins, the new CEO of Ukrnafta, majority-owned by state-run Naftogaz, agrees that the taxes are too high.
“I do think that the royalty rates are too high… People are not going to come along and invest money where they are going to lose money. So you need to make it attractive,” Rollins said. “Ukraine is not the biggest oil and gas province in the world. You need to do something to attract companies to come here.”
Reverting to previous tax rates would be a good start, but investors would get very “excited” when the tax is closer to 10-15 percent, Bensh said. “That investment will increase production that reduces the reliance that the country has on Russia and on imported oil and gas.”
Alastair McBain, CEO of Arawak Energy, an oil and gas company that began to operate in Ukraine three years ago, said that progressive taxes would be an improvement and encourage trust and international competitiveness.
“That doesn’t mean paying lower taxes, it means paying taxes related to the reward we get from the business rather than a simple royalty tax which is like a tariff. In fact we see the reverse happening which is not what we hoped for,” McBain said.
Investors are already beginning to question what they see as inconsistency in tax rates. “These kinds of shocks, changes are just the sort of things which damage business, damage the reputation of the state and discourage investors,” McBain said.
Even though Arawak has experienced “millions of dollars” in losses in Ukraine, McBain will not leave the market if the taxes don’t change.
Bensh, on the other hand, is not so sure about staying if nothing changes.
“Will I invest in Ukraine? The answer is probably no if they can’t even get something like this passed,” he said.
Rollins said that if the government adopts lower rates it can actually make more money. “If production increases because of investment, the government will actually end up taking more money in the long run,” he said.
Otherwise, if nothing changes, private gas production will fall next year by 1.5 billion cubic meters if “the industry doesn’t renew investment to drill new wells,” the EBA stated.
Kyiv Post staff writer Ilya Timtchenko can be reached at [email protected].
