Like the rest of the world, Ukraine has been affected by the crisis on energy markets caused by decline in demand caused by measures taken to combat COVID-19. There are also local conditions aggravating the energy markets decline, namely an extremely warm winter that affected both Ukrainian and European natural gas markets, that in turn responded with a fall in prices continuing so far.
Investing in new projects during downturn poses more risks for the investors as compared to the more flourishing times, yet it promises a larger profit in future. The Ukrainian government has again announced new measures to support both domestic and foreign investors; however, aside from the usual concerns about investment profitability, the investors are increasingly more sensitive to the investment climate in Ukraine, including consistency of the investment policy, predictability of reforms and stability of the rules and regulations upon which the investors rely to measure that profitability. The latest initiatives to revise the feed-in tariff give them less assurance in the future as well.
How can the Ukrainian government win attention and confidence of investors?
Though consumption and natural gas prices are still falling, the Ukrainian market needs to increase the domestic production. Ukraine has consumed almost 30 billion cubic meters of gas in 2019. Two-thirds, i.e. 20 billion cubic meters, were produced in Ukraine, while the rest was imported; 4.6 billion cubic meters of gas were produced by the private companies, and the state-owned companies produced the rest.
Thus, despite that the gas consumption is expected to continue declining in 2020, almost a third of the total gas market will still depend on imports from Europe, unless Ukraine develops its own production. A future investor has a chance to successfully enter the Ukrainian market at a point where there is stable demand for gas, solely on condition that the invertor's price of such gas is be competitive as compared to the import price.
On 27 May 2020, the government presented the Economic Stimulus Program to overcome the consequences of the COVID-19 epidemic. Despite its "quarantine" description, the program offers measures aimed at developing the energy sector in general.
As far as the extractive industry concerned, the Program provides for three changes in the rent tax rates by setting, inter alia, (1) an incentive rent rate for natural gas, oil and condensate within five years after starting drilling of a well – the exact amount of such rate has not been made public yet; (2) new rent rates for oil and condensate production at 12% and 6% (as compared to the current rates of 31% for production of oil and condensate at up to 5000 meters depth and 16% for production at over 5000 meters depth respectively); and (3) the new rent rate for unconventional hydrocarbon deposits, which is expected to not exceed 2%.
The five-year reduction in rent rates for gas, oil and condensate may serve as a significant economic incentive for investors since due to the crisis and the current rent rates (which are 29% for gas deposits up to 5000 meters deep and 14% for deposits over 5000 meters deep) investors are reviewing their economic models for scheduled projects. Yet those investors who intend to invest by entering into production sharing agreements (the "PSAs") remain active, since the PSA's profitability is much less dependent on the rent rate.
The incentive rate for unconventional hydrocarbon deposits may stimulate the developers' interest in the shale gas deposits projects, which were suspended in Ukraine due to the external aggression and petroleum prices falling on a global scale.
Currently, Ukraine has an incentive regulation for new gas wells, which is 12% rent for production at up to 5000 meters depth and 6% - at over 5000 meters depth. This incentive rent is effective from the beginning of 2018 till the end of 2022. Having introduced current incentive rate, the government expressly fixed by the due provision of the Tax Code that such rent rate may not be increased, nor any adjustment factors or other mechanisms may be applied to such rate if they lead or may lead to an actual increase in tax liabilities of the developers.
A similar principle should be applied to any incentive rent rate to be introduced in the future. If Ukraine explicitly commits to fix an incentive rent rate, the investors will have more opportunities to protect their rights whenever Ukraine is in breach of its obligations and potentially will be more secure of their investment.
The production sharing agreements are still an attractive tool for investments in oil and gas production, as such projects enjoy a lower rent rate, which is 1.25% for gas and 2% for oil and condensate. The state's profit from such projects is secured by the state receiving a share in the produced petroleum according to the rules defined in the PSA. In addition, a stabilization rule for production sharing agreements is currently in effect; it fixes that changes made to the laws after the PSA was signed do not apply to that PSA, with some exceptions. Ukraine is about to sign 12 PSAs – nine will be concluded following the results of the tender held around a year ago and three more will be signed with the winners of a second tender selected in late April this year.
Thus, the reduced rent rates for gas, oil and condensate may attract investors to the extractive industry since they may make the projects, that remain "up in the air", more profitable in view of the falling petroleum prices. In addition, energy prices may be expected to rise gradually after the quarantine measures are lifted, although lower gas prices may last longer in Ukraine and Europe due to a mild winter and remaining gas stored in the storages, which were filled more than usual in spring 2020.
Yet it is not favourable economic conditions alone that are necessary to attract investors but reducing the risks of losing profit or the investment entirely. The Ukrainian Government should communicate that all incentives are introduced for a clearly defined period and may not be rescinded or changed prematurely. For this, the new provisions in the relevant laws (changes must be made to the Tax Code if they relate to the rent) must clearly state that Ukraine undertakes not to change the incentive rates or other guarantees within a designated period of time.
Published: NV Business, 13 July 2020
Authors: Oleg Alyoshin, Tetiana Revutska