Progress in the Ukrainian oil and gas sector in 2019 and the outlook for 2020

Ukraine

In 2019, the Ukrainian oil and gas industry and the energy sector saw several important developments including: for the first time in several years, licensing rounds and production-sharing agreement (PSA) tenders for numerous new oil and gas blocks; the launch of an online information platform for the Ukrainian gas transmission system operator (TSO); legal changes that allow non-residents to store and trade natural gas in Ukrainian gas storage facilities while being exempt from import taxes and duties; the export of Ukrainian natural gas for the first time in 15 years; and the unbundling and continued efforts of the TSO to increase the efficiency of transportation and storage systems.

In general, the sector has shown positive development. More details on the upstream and natural-gas sectors and on government efforts to make the industry more attractive to foreign investors are listed below.  

Upstream

With few oil and gas licences auctioned in previous years, the government did not appear committed to achieving a significant increase in domestic hydrocarbon production, including from onshore non-conventional plays, the continental shelf and exclusive maritime economic zone of Ukraine, which is foreseen in Ukraine’s Energy Strategy Plan until 2035.

It seemed, however, that change would come in 2019 when in December 2018 the Cabinet of Ministers of Ukraine (CMU) published a decision to hold tenders for production sharing agreements (PSAs) for 12 large onshore blocks. This news, preceded by an earlier announcement to hold several rounds of subsoil auctions through the online public procurement platform ProZorro, whetted the appetite even of a few major international oil and gas players. However, despite the government has kept its promises, the experience would teach the government and industry valuable lessons.

Undoubtedly, the PSA remains a highly valued mechanism for subsoil operations in Ukraine. Although no previous PSA has come to fruition, it is not the instrument itself that failed. Unlike the regular licensing mechanism (subsoil permits), which are often more lucrative in terms of taxation (recent tenders have shown that investors are ready to compete for even less than 70% of profit production on certain blocks), a PSA offers better stability and makes it possible to organise operations with more efficiency. These factors play a decisive role in large greenfield projects with limited information about geology, like those currently offered in Ukraine.

At the same time, it is important to understand that PSAs do not provide quick solutions for either investors or the government. A PSA may take considerable time to complete from the nomination of an area until the negotiation of a well-balanced document. It is also in the best interests of the government to give international oil and gas majors enough time to scrutinise offers and submit bid proposals.

For one reason or another, few international players joined the PSA competition for nine onshore blocks in May. Another tender for a large offshore block with a total area of 9,496 sq. km. was cancelled after the quality of the bidders, which included few international players, did not meet the government's expectations. As a result, the government extended the bidding deadline for the remaining three PSA blocks for another three months (until 4 February 2020) and is considering re-tendering the Dolphin offshore block in March 2020.

In terms of subsoil auctions, in 2019 the State Geological Service of Ukraine finally held new licencing rounds, offering for the 20-year exploration and production of 34 onshore petroleum blocks. Out of 19 blocks, however, 14 were awarded to the state-owned Ukrgazvydobyvannia (UGV) and only one to a Ukrainian subsidiary of an international oil and gas company. Such low interest from international players is only partially explained by an imperfect investment environment, and appears to stem from internal factors, such as lack of information about subsoil areas, insufficient time to prepare for the auctions and flaws in the auction procedure that discourage foreign companies from participating in auctions directly via their non-resident entities. 

But after all the government has made that necessary step, which should give a chance for progress in 2020 and beyond. As a result, legislative and regulatory work should focus on at least the following: improving the PSA framework, in particular the mechanism of conversion of regular licences into PSAs (if such conversion is justified); improving subsoil permits auctioning procedure; enacting a new subsoil code to create new instruments for the industry, such as assignment, transfer, lease, pledge of special permits, farm-in and farm-out agreements, etc.; and implementing internationally adopted oil and gas industry standards, such as principles for evaluating reserves.

Fiscal policies must also remain stable, especially concerning projects to enhance production from mature and depleted fields. As the usual recovery rate from conventional reservoirs is 30% – 40%, there is great potential for new technology to increase efficiency. For instance, already now in Norway production rates reach 50% and this figure may be improved to 60% within the next five years as a result of digitalisation of oil and gas industry.

Speaking of digitalization, appropriate reforms are also highly anticipated at the institutional level. The newly appointed Head of the State Geological Service has already announced plans to introduce electronic document workflow, including creating personal online accounts for subsoil users, which should help improve transparency in both business and administration in line with the recently passed EITI-compliant law On Ensuring Transparency in Extractive Industries. Long-awaited reform in the State Geological Service will continue with implementation of a single-window system for obtaining regulatory permits, submitting work programmes and reports as well as simplifying access to geological data. Some of the relevant legislation has already been adopted to that effect and must now be applied in practice. The State Geological Service has also presented an on-line Investment Atlas containing basic information about subsoil areas nominated for the upcoming auctions.

In general, the forecast for 2020 looks optimistic. With new licensing rounds and other developments, however, the government must not forget about its current commitments to accomplish work started in 2019. In fact, completing negotiations on PSAs would be a litmus test for many international players who are keeping a close eye on Ukraine.

Natural gas market

The newly liberalised Ukrainian natural gas market was born during difficult times for Ukraine. It was forced to evolve quickly and often under resistance from various market players, which either were not up to speed with the tight deadlines or were reluctant to reform past practices. In 2019, the regulatory framework has become more stable and predictable after the TSO fully implemented an online information-exchange platform to enable "daily balancing" (i.e. determining differences between gas inputs and outputs to and from the transportation system in relation to each user).

Daily balancing was introduced by a Resolution of the National Commission for State Regulation of Energy and Utilities Sectors No. 1437 dated 27 December 2017, which was supposed to come into effect on 1 August 2018, but was postponed several times due to unreadiness of the information platform. As a result, daily balancing was launched on 1 March 2019.

What does daily balancing achieve? It allows traders and suppliers to manage gas portfolios more efficiently, reduce the cost of bank guarantees required by the TSO, simplify trading on VTP and in gas storage and provide the TSO with six times more accurate data on imbalances in the system. Daily balancing, however, did not solve the issues of payment discipline for negative imbalances and unauthorised withdrawal of natural gas from the system by distribution system operators for their technological needs.

Apart from the usual trading operations on VTP and in underground gas storages carried out by Ukrainian residents, in 2019 non-residents extensively used Ukrainian gas storage facilities for storing and trading of gas in the so-called customs warehouse regime (CWR). According to the Customs Code of Ukraine, foreign goods may be stored in CWR within Ukrainian customs territory under control of Ukrainian customs authorities for up to 1095 days with the conditional full exemption from the 20% import VAT and customs duties. Upon expiry of the statutory term, goods must either be cleared for import, subject to applicable taxes and duties, or re-exported from Ukrainian territory.

According to Ukrtransgaz, as of the end of September, Ukrainian gas storage facilities contained 6.7 billion cubic meters of natural gas stored by 32 customers in the CWR. While the regulatory framework had been in place since 2017, storage and trading of gas in the CWR became feasible for European companies only from 1 January 2019 after the state regulator decreased entry tariffs by half and approved exit tariffs from the Ukrainian gas transportation system via interconnectors at Beregdaroc (Hungary), Budince (Slovakia), Hermanowice (Poland), Lymanske (Romania) and Orlivka/Isakcha (Romania).

With the approval of exit tariffs, several Ukrainian companies have also tested export possibilities with small volumes of natural gas. This represented the first successful export of gas in 15 years, demonstrating how advanced the regulatory framework has become over a relatively short period of time. For 2020-2024 the regulator approved new tariffs, which additionally introduce preferential rates for shorthaul and transportation of gas to/from the CWR as well as a few new interconnectors, including Veľké Kapušany (Slovakia).

The Ukrainian gas sector, however, is far from a market since the majority of trading is carried out over-the-counter (OTC). Those few existing gas exchanges offer only limited instruments due to restrictions in the law or the absence of regulation. If the government wants to achieve transparent pricing, fair competition, open access and liquidity on the gas market, it must do the following: enable close-out netting, allow the TSO to procure gas in real time (free from public procurement requirements) for an efficient balancing, introduce a derivatives market and create incentives for market players to trade on the exchange, such as REMIT reporting standards for OTC trading.

On the other hand, market participants must promote trading under standard and transparent rules. Since 2015, the EFET General Agreement has become one of the main instruments for cross-border transactions, and this practice should be implemented for domestic trade as well. While the EFET General Agreement must be adapted to Ukrainian realities (i.e. close-out netting provisions, market-to-market principles, calculation of the termination amount, introducing transfer and acceptance reports), key players have already implemented various EFET features in their domestic trading and supply contracts.

It is also important to note that Ukraine is steadily moving towards market-level prices for households and heating companies, which is also one of the conditions of the free market. From 1 January 2020, the price of gas supplied by Naftogaz under its public service obligations is established on the basis of Naftogaz’s average prepayment gas price for the industry. The profitability margin of suppliers of gas to households are capped at 2.5% only until 1 May 2020.

New TSO and new energy regulations

2019 was marked by another important milestone for Ukrainian gas sector: unbundling of gas transmission system operator. According to the selected Independent System Operator (ISO) model all transportation assets, dispatching systems and personnel were transferred to the new TSO - LLC “Gas TSO of Ukraine”, a wholly owned subsidiary of JSC “Main Gas Pipelines of Ukraine”. The latter is managed by the Ministry of Finance of Ukraine and is fully independent from the Naftogaz group, which restructuring is an important commitment of Ukraine under the EU-Ukraine Association Agreement and programmes with the IMF, World Bank and EBRD.

The new TSO was certified in accordance with the Directive 2009/73/EC, licenced and on 1 January 2020 received full operational control over the gas transportation system. Gas storage facilities have, nevertheless, remained under the control of the Naftogaz group. The new TSO has also signed interconnection agreements with the operators of Hungarian, Romanian, Polish, Slovak, Moldovan and Russian transmission systems, which would allow transporting natural gas across the respective borders according to European rules.

On 6 June 2019, the Ukrainian parliament ratified the updated Annex XXVII Energy Cooperation including Nuclear Issues to the EU-Ukraine Association Agreement, which will affect regulation in the Ukrainian energy sector, bringing its legislation in compliance with EU law. In addition, any changes in EU law must be transposed into Ukrainian legislation and the government must consult with the European Commission when considering new energy legislation.

For more information on opportunities in the Ukrainian energy sector and how industry reforms could affect your business, contact your usual CMS source or local CMS experts: Volodymyr Kolvakh and Anatolii Doludenko.