Oil & Gas sector: outcome of 2015

Gennadiy Kobal
Expert of NEWFOLK oil and gas consulting center
Review of oil and gas production in 2015
The results of the past 2015 may be deemed acceptable for oil and gas industry. 19.9 BCM were produced in Ukraine that is 1% less than in 2014. It is a good result, given the difficulties production companies faced. Oil and gas condensate production amounted for less than 2.5 mln. tons: the decline exceeded 10%.
The main outcome of the past year is a sharp decline in the performance of the largest gas producing company Ukrgasvydobuvannya, which produced 600 MMCM less. Further details thereof will be discussed below. On the other hand, private companies as a whole increased production. Here it must be noted that two companies Naftogazvydobuvannya (a subsidiary of DTEK) and Burisma Holdings produced 2 BCM of gas that is more than a half of total private-sector production.
Another outcome of the last year is a departure of foreign investors from Ukraine. What is involved here is the cessation of major projects within the framework of production sharing agreements (PSA). Both existing projects with Shell and Chevron were curtailed. In addition, Shell refused to continue joint activity with the state company Ukrgasvydobuvannya. Looking ahead, it should be noted that smaller companies working in the oil and gas in Ukraine might leave the country soon. The sale of 70% shares KUB-GAS, owned by Canadian Serinus Energy Inc, is at the final stage. Changes were also announced at Poltava Petroleum Company, a subsidiary of British JKX oil & gas.
Summing up the results of 2015, we may say that, despite an extremely unfavorable situation in the economy and detrimental government actions in oil and gas industry the latter has managed to maintain the level of production and keep the potential for further development.
State policy
We should note an extremely negative role of the state in oil and gas industry.
Taxation, mostly royalty, was the main problem for production companies. In August 2014 Arseniy Yatsenuyk’s Government with the filing of Ministry of Finance doubled royalty for gas production. It got up to 55% from above 5000 m depth production and 29% for under than 5000 m depth production. Denis Fudashkin, a Deputy Minister of Finance, was in charge of the reform. The rise of royalty affected private gas production companies. The Cabinet promised that duplication of royalty was a temporary step to be cancelled on 1 January 2015 with tax rates returning to the previous level. But the government at the last minute changed its position to enter 2015 with very heavy taxes or gas production companies. In fact, royalty was not even 55% but much higher. Its payments were calculated based on the price for gas stated by National Energy and Utilities Regulatory Commission of Ukraine (NKREKU). In fact, production companies were to sell gas for a cheaper price. Therefore, actual royalty sometimes exceeded 70% of gas price, not mentioning other taxes and payments. This situation led to the fact that gas production became unprofitable. Sometimes it was more lucrative to stop the production and, for example, workover wells to simply wait out the hard times. Obviously, in this situation, the was no space for development of the industry could.
Following royalty duplication for private companies, the government decided to complicate the operation of state-owned entities. In April 2015 royalty for the latter was increased from 20% to 70%. Consequently, Ukrgasvydobuvannya faced financial problems.
High tax burden was the main reason for the sharp decline of investments in production projects. Most of the companies simply decided to wait until tough times are over. In general, gas production declined slightly just by 1%. However, some private companies, firstly, Naftogazvydobuvannya and Burisma Holdings increased production significantly.
Another vital negative factor for the industry became a problem with realization of gas in early 2015. The government made it mandatory for major industrial customers to buy gas exclusively from Naftogaz of Ukraine in November 2014. Simultaneously, private companies lost almost entire market. Such steps of the government caused a shock and its effect was perceptible for several months after the cancellation of the decision.
Epic with royalty reduction dragged for the whole 2015. The proposal voiced by Ministry of Finance in July 2015 was the most feasible, but the Parliament did not provide enough votes for the bill. And only in the state budget for 2016 and under strong pressure from foreign partners, the Cabinet has made concessions to return previous royalty rate, which was in force until August 2014. Exception regards only joint venture activities. Entities involved in them will continue to pay royalty at a rate of 70%. Thus JV business is actually sentenced to death.
It is also necessary to mention the promising reform of gas market, which has not brought tangible relief for market participants to remain largely a fiction. Other legislative proposals of the Government, initiated by NJSC Naftogaz of Ukraine aroused many problems. What is involved here is an issue of formation of gas safety stock for traders. Attempts were made to force the gas sellers to form gas reserves in the amount of monthly sales volumes. In fact it was necessary to find 3 billion UAH to purchase gas and keep it in underground storage. For now the Cabinet has turned away from those plans but for how long?
This is not the whole story. Still the issues of the return of foreign investment remain unresolved. A ban on repatriation of funds abroad is still effective together with problems concerning updating special permits, importing equipment and much more.
In general, it shall be admitted that almost all initiatives of the Government of Arseniy Yatsenuyk in oil and gas industry only complicated performance of companies, both private and public. Confidence in public institutions fell though before it was low. Remaining investors are looking for opportunities to say goodbye to Ukraine.
State companies
State-owned companies Ukrgasvydobuvannya and Ukrnafta are among the outsiders of industry today. They are bulky and inert structures with more than 20 thousand employees in each. Thus, any changes are so hard to implement there. Frequent replacements of management, as is the case with Ukrgasvydobuvannya make any structural reforms of the company impossible.
Last year was the worst in terms of production volumes of Ukrgasvydobuvannya for quite noticeable reasons. The company produced 14.5 BCM of gas. The decrease amounted for 600 MMCM or 4%. Production of gas condensate and oil amounted for 510 th. tons having fallen by also 4%. Such a serious decline in performance of Ukrgasvydobuvannya was affected by many factors, but the main thing was lack of funds for its development. Since April, royalty for state-owned companies has grown from 20% to 70%. In parallel the purchase price for gas increased from 349 to 1590 UAH (excluding VAT) per 1 TCM. From the first sight Ukrgasvydobuvannya should have received more revenue and at the same time tax burden increased. But reality looks much sadder. Naftogaz of Ukraine which is the only buyer of Ukrgasvydobuvannya’s gas constantly delayed payments for its deliveries. Initially unpaid money for gas amounted for 3 billion UAH. In November-December the debt reached 10 billion UAH. Ukrgasvydobuvannya was forced to pay taxes in a timely manner and all deferrals of payments were subject to 38% interest.
For state-owned companies 2015 was marked by replacement of management. New leaders were designated at Ukrgasvydobuvannya (Oleg Prokhorenko in June), Ukrnafta (Mark Rollins in July), Ukrtransnafta (Nikolay Gavrilenko in November). Each appointment was accompanied by changes in the top management and companies’ policies. Much has been said about the reforms, but real and tangible changes are very little.
With regard to results of state-owned companies, there is an evident sharp deterioration as to their main indicators. If Ukrnafta’s production decline was predictable, then Ukrgasvydobuvannya’s performance in 2015 opened up to be the biggest failure for the whole nearly 20-year history.
Without serious investments in geological exploration, drilling and infrastructure it is impertinent to count on stabilization of production or its growth. Despite there are 130 licenses for gas production every year becomes more and more difficult. The deposits are exhausted and the largest ones are in the final stage of development. Park of drilling rigs (about 80 units) is completely out of date. The company has no modern drilling rigs. Today there are a lot of rumors about reforms at Ukrgasvydobuvannya. The first one is about creation of transparent procurement of goods and services, as well as effective realization of oil products of its own production. It is expected that the next stage of reform in 2016 will improve company’s material base. New drilling rigs are to be purchased together with fracturing units. Modernization of Shebelynka GPP is to be fulfilled that would allow to produce fuel in accordance with Euro-4 standards.
Purchase and modernization of company’s drilling fleet is among Ukrgasvydobuvannya’s reported plans. It is scheduled to leave 40-45 drilling rigs with drilling volumes to significantly rise. It is also schemed to acquire its own fleet for hydraulic fracturing (HF). A tender for modernization of two existing units will be held, as well as the purchase of two new modern ones. The plan for 2016 includes conducting 100 fracturing operations, which is more than the number of all fracs performed in Ukraine for the last ten years.
Regarding exploration, the company discovered a small field in Transcarpathian region with reserves in amount of 1 BCM in 2015. However, the lack of infrastructure does not allow for exploring the field quickly and effectively.
A sharp drop in gas production was also caused by aggravation of all JA projects. Royalty for gas production for JAs accounts for 70% erasing all the sense to operate further. In recent years a wide range of Ukrgasvydobuvannya’s projects were implemented under JAs. Karpatygaz (subsidiary of Swedish Misen Energy) was its major partner which accounted for 80% of the production under JA. Karpatygaz is preparing a lawsuit against the Government of Ukraine in the amount of 3 billion USD. The details are still unknown.
For other state-owned company Ukrnafta last year was full of tests. After a year of confrontations the company’s main shareholders represented by the state (51%) and Privat group (42%) reached an agreement as to replacement of leadership. In late July, British citizen Mark Rollins was appointed the company's CEO. Main condition of the Cabinet of Ministers during negotiation as to Rollins’ candidacy touched an issue of payment of dividends and taxes. The government expressed very little interest in oil and gas production. Privat group in its turn was trying to keep loyal management on key positions and also to solve the problem of gas for underground gas storages (UGS). For years Ukrnafta has been pumping gas into UGS without charge. None of the abovementioned was resolved. The Government threatened to revoke license in case of failure to pay royalty and dividends and Privat threatened to start litigation. For 5 months of Mark Rollins’ management Privat has been losing the control of the company to the Cabinet, but the struggle continues.
Plans of Ukrnafta include development of production (including gas) in which Mark Rollins has great experience.
As for state company Chernomorneftegaz, about a dozen of employees remained after evacuation of Crimea. The main goal is to return the state-owned property back to Ukraine through international courts. In Crimea, Chernomorneftegaz reduced production by the end of 2015 having produced 1.8 BCM that is 200 MMCM less than in 2014. Drilling in Odessa field was stopped. That field deposits the bulk of gas. It should also be noted that a problem with Strelkovoe deposit on Arabat Spit which is on the border of Kherson region and Crimea has been solved. But the deposit is connected to Crimean transmission system. Today development of the field is conducted by Ukrainian company Plast.
Private companies
The second half of 2015 and especially the end of the year was marked by a sharp rise in gas production. But, there were not enough preconditions for such development.
Naftogazvydobuvannya, a subsidiary of DTEK, is a leading company in domestic gas market. Last year, the company increased production up to 1.3 BCM against 750 MMCM in 2014, a 70% increase. Naftogazvydobuvannya became the first private company which reached the level of production of 1 BCM. The company surpassed Ukrnafta in terms of production and became the second largest company in Ukraine after Ukrgasvydobuvannya. The company's success was ensured by implementation of a drilling program commenced in June and July last year. Drilling of 6 new wells was finished at Semirenkovskoe field in Poltava region. However, the success of Naftogazvydobuvannya was marred by a number of unpleasant factors. Firstly, since April 2015 the company had been facing severe pressure from Prosecutor General's Office. Several times Naftogazvydobuvannya’s accounts and objects were arrested that negatively affected its performance. The company could not sell gas and had to pump it into underground storages. It is worth noting that at the end of the year the main problems of Naftogazvydobuvannya were solved. But, Naftogazvydobuvannya has huge outstanding payables (hundreds of millions UAH) to its contractors that include dozens of drilling, geophysical and service companies from all over Ukraine. Many of these companies now are on the verge of bankruptcy. In fact, Naftogazvydobuvannya holds Ukrainian market of service companies in hostage.
The second-largest Ukrainian company Burisma Holdings also managed to increase production by 13% to almost 800 MMCM. Production growth was achieved through pending completion of projects started before the tax increase in August 2014. In July, the company launched a well in Vodianovskaya area in Kharkiv region together with a temporary measuring separation unit (TMSU) and gas preparation unit. Depth of the new well is 5600 m. In addition, in October, one of companies incorporated in holding, PARI, started gas production at Sherementovskoe field in Chernivtsi region. It should be noted that last year Nikolay Zlochevskiy’s accounts were arrested in the UK. But the owner of Burisma Holdings and ex-Minister of Ecology has managed to settle the issue.
Geo-Alliance group of companies makes the top three. The group incorporates a range of production companies, largest of which are Pryrodny Resursy and East Geological Union. In 2015, Geo-Alliance slightly increased its gas production to 274 MMCM. The group has also become the largest producer of liquid hydrocarbons among independent companies having produced 50 th. tons. In June, Ministry of Energy has put into operation two fields of Geo-Alliance: Koshevoyskoe gas and condensate field in Poltava region and Yasenivskoe oil field in Sumy region. In the company explained that in each of the fields there is one well in bad condition. In the fourth quarter of 2015 Pryrodny Resursy drilled a new well at Lutsenkovskoe field. The planned depth is approximately 5300 m.
The fourth largest company is KUB-GAS company, which reduced production by almost 30% to 240 MMCM. In summer Serinus Energy Inc announced the issuance of a special permit for West-Olgovskiy oil and gas block in Kharkiv region valid for 20 years to a company controlled by KUB-GAS. However, in the autumn 2015 it was leaked that Canadian Serinus Energy (owns 70% of KUB-GAS) was looking for a buyer of its Ukrainian assets. Completion of the transaction is scheduled for the end of January 2016.
Another major private company with foreign investments JV Poltava Petroleum Company (PPC) (controlled by British JKX) cut its production by 10% to 213 MMCM. At the end of 2014 the company announced the revision of its drilling program because of the high royalty rate. PPC received a new special permit for West-Mashivskiy oil and gas field. However, the British said that under current taxation in Ukraine the start of work would be delayed. At the end of 2015 Victor Khrulenko, the company’s head, left the company to work at a processing unit of state-owned Ukrgasvydobuvannya.
In the western region Goryzonty group of companies stands out from all other oil and gas entities. Goryzonty became one of the most successful companies in 2015. Level of production is not high (about 3.5 MMCM per month) but the group has an ambitious development program to increase production significantly in coming years. Last year, drilling company Goryzonty purchased an Italian drilling rig to commence drilling. In July 2015 Goryzonty acquired three new licenses for Bunivskaya, Rudnikovskaya and Kolodnitskaya areas.
Among other news, it should be noted of emergence of a new company. Kharkiv regional Council agreed on allocation of Volodarskaya area to Yuzgaz. The company is associated with deputy Efim Zviagilskiy. He also relates to another gas company, Mine named after Zasyadko.
Foreign investments
Last year was also marked by departure of one of world's leading oil and gas companies from Ukraine. Chevron closed its Ukrainian office. Recalling, Chevron Ukraine and LLC Nadra Olesska signed a production sharing agreement (PSA) for Olesska Area (Lviv and Ivano-Frankivsk regions) on 5 November 2013. Representing company Chevron Ukraine BV was registered in January 2013.
Dutch-British oil and gas company Royal Dutch Shell also left Ukraine. The company withdrew from production sharing agreement previously signed for development of Yuzivska gas-bearing area in Kharkiv and Donetsk regions. Earlier Shell ceased cooperation with Ukrgasvydobuvannya at another project. Thus, there are no large foreign companies in Ukraine involved in hydrocarbon production except for Italian ENI. The company has a share at a joint venture which owns licenses in Western Ukraine. However, there is no production conducted at the moment.
Along with above-mentioned British JKX a range of foreign investors in Ukrainian oil and gas sector is ultimately narrow. But JKX is being slowly crushed by domestic financial and industrial group Privat. Arawak Energy (owns 50% of Geo-Alliance) is one of the largest investors in real production together with investors from Czech Republic that are minority shareholders in the companies incorporated in Goryzonty group.
Auctions and licenses
An attempt of State Service of Geology and Mineral Resources of Ukraine (Gosgeonedra) to start a mechanism of auctions for sale of special permits was completely failed. The first auction held in July can be called successful. 5 oil and gas blocks were sold, 4 of them are in Lviv region and Horoshivskaya Square is in Kharkiv region. The latter was bought by Neftegazrazrabotka (DTEK) for 16.5 million UAH.
Two subsequent auctions in November and December were just failed. Goryzonty company was the main contender for special permits. The company prepared oil and gas areas for the competition at its own expense only to be expelled from participation at the auction. As a result, some unknown companies bought all licenses.
Great resonance was driven by Gosgeonedra’s decision to withdraw more than 40 special permits for exploration and production of oil and gas areas in November. It was the biggest revision of licenses since 2004, when Mykola Zlochevskiy was a chairman of State Committee for Natural Resources of Ukraine. A period of his management is memorable for massive privatization of the fields during Orange Revolution.
Among companies that were deprived of (or threatened to be deprived of) licenses are state-owned Ukrgasvydobuvannya and private Tysagaz, Poltava Petroleum Company, Regal Petroleum and Delta. Ukrgasvydobuvannya has a risk of losing 15 licenses among including for a number of big fields such as Yablunivskoe, Abazovskoe, Bilche-Volitskoe, Opishnyanskoe and Novo-Mechebilivskoe.
But two weeks later Gosgeonedra stated that it allowed the companies to resolve issues. As it turned out, Gosgeonedra’s actions were taken to force companies to pay royalty debts to the budget.
In December, the same steps were committed against Ukrnafta. Prime Minister Arseniy Yatsenuyk sent a letter to Ministry of Ecology and Natural Resources of Ukraine laying down a requirement to revoke Ukrnafta’s licenses because of arrears in royalty payments. Thus, the company may lose 80 licenses together with entire production stop.
Repressive methods of state bodies for oil and gas market were especially evident in 2015. Thus rapid improvement of status-quo in the industry is hardly expected. The companies entered 2016 with cautious optimism.