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.