Ukraine’s energy sector never stops to buzz with super-important news. One day, Viktor Yanukovych arranges for gas cooperation with Turkmenistan’s president. The next –the government announces another effort to turn NJSC Naftogaz, EnergoAtom or UkrEnergo into joint stock companies as Russia cast its eye on them. Alternatively, the government proposes that foreign investors seeking to extract shale gas in Ukraine set up a joint enterprise with the obscure SPK-GeoService. On top of all this is the uncertainty of gas talks with Russia, where Ukraine has apparently exhausted all its arguments. “If you were to design an energy system that promotes corruption, it might look very much like Ukraine’s,” says Edward Chow, a well-known international energy expert, who has advised four different Ukrainian governments. In February 2012, he took part in “Ukraine at the Crossroads: What’s at Stake for the US and Europe?”, the latest hearing on Ukraine in the Subcommittee on European Affairs of the U.S. Senate Committee on Foreign Relations. The Ukrainian Week talked to Mr. Chow, who expressed his view on Ukraine’s energy problems.
U.W.: What was the key message that you delivered at the hearings on Ukraine to the Senate committee?
They wanted to hear about the energy situation in Ukraine, which is critical not only for Ukraine, but for the region at large. So, I gave them a briefing on where I think things are there. The fact is that the solutions are within the control of the Ukrainian government. I’m not just talking about this government but about any previous governments. The solutions are quite well-known to Ukrainian authorities. They have been discussed exhaustively with both the Europeans and the Americans over the last 20 years. What is missing includes the political will in Kyiv as well the organizational capabilities there to reform its energy policy. Once Ukraine makes the decision to conduct reforms, interested outside groups can offer the assistance that Ukraine requires. The first priority is to normalize its energy relations with Russia, which the president has clearly not done. In April 2010 the Kharkiv agreement prolonged the bad practices of the past, rather than striking a new path, that would lead to normalization and having regular business relations with Russia. It was related to other political issues that are not directly connected with energy, which can destabilize energy agreements rather than help them. In spite of the rhetoric of the gas price discount in relation to the Kharkiv agreement, this will never happen.
U.W.: Do you see increased domestic gas extraction as a solution?
Investors need to understand what gas pricing is going to be based on. Right now the gas pricing system is disadvantageous for the producers of domestic gas, which is why Ukrainian gas production has remained stagnant for the last 20 years. The gas produced in Ukraine is at a disadvantage compared to gas that is imported, which is the exact opposite of what the case is in most countries. The latter actually discriminate against importing gas and favor of domestic gas. So, Ukraine, particularly in view of current gas prices, should be producing a lot more gas than it does today. And all geologists inside and outside Ukraine tell me that Ukraine can easily be producing 50 % more gas than it is at present. The price of domestic gas is in the neighborhood of USD 40-50 per thousand cubic meters. At the same time Ukraine is importing gas at USD 400 per thousand cubic meters. So, the domestic producer does not have an incentive to invest money in gas production because it is getting less than the market price.
U.W.: A popular viewpoint is that foreign or national investment in domestic gas production and a parallel increase in price will not solve the problem. There is a ceiling for raising utility fees. According to First Vice Premier Valeriy Khoroshkovsky, even if raised, they would not cover the full original price of gas. Moreover, the government would have to subsidize a big part of the population.
I think that this is a false argument. Today your economy is subsidizing highly priced imports from Russia. You don’t need a USD 400 domestic gas price. You can allow yourself a price of USD 100 for it, which will lead to increased domestic gas production. If the domestic production price is allowed to increase, it won’t go up to USD 400. This does not have to be done before providing more incentives to people to re-invest in the production of even more gas. As an energy expert I’m very concerned about the fact that domestic gas prices are regulated at too low a price, which is causing domestic production to decline or stagnate. In theory, this gas should go to the population and state entities. In reality it is creating a ‘grey market’ for domestic gas. And it is the route and cause of large-scale corruption in the gas sector. If you price domestic gas at, for example, USD 50 and allow the import of gas at USD 400, then very quickly some enterprising people will appear, who will magically transform domestic gas into imported gas and trade it to individual people with the “right” political connections. There are a lot of people who do not want the current system to change because they are making a lot of money from it. Of course, these reforms are not going to be easy. You will need to have three- to five-year programs to get to the position of having market prices for domestic and imported gas. But Ukraine has to want to begin to move down that path.
U.W.: EBRD and EIB are not rushing to give new loans to Naftogaz as they are waiting for its corporatization. But, the previous attempt ended in failure. And what could happen if such a government monopoly runs out of credit resources?
I never believed that the EBRD and EIB would invest in the Ukrainian pipeline system, no matter who is in power, Yushchenko, Tymoshenko or Yanukovych. None of these development banks take business risks. It was just empty talk from the very beginning by both the Europeans and the Ukrainian governments supporting them, since Naftogaz and Ukrtransgaz will never be able to execute the conditions being imposed, even if they are corporatized. The conditions set forth would essentially be a sovereign guarantee on the part of Ukraine. At present, Ukraine is experiencing difficult relations with the IMF. So, in the last two years, the Ukrainian government has put itself into a position whereby it has barely any lending capacity left. Ukraine goes to Russian banks to borrow money for Russian gas. The Russians are happy to accumulate Ukrainian debt. One day they will come to collect. And Ukraine won’t have the means to pay. The only thing left is for the Russians to decide what assets they want in order to have this debt repaid. So, this government is digging itself a very deep hole, particularly in the energy sector. It sounds like a joke that Ukraine is going to import gas from Slovakia, Romania or Turkey. And the fact that authoritative news services are reporting this, is very indicative of the poor understanding of the subject. It does not help your government and, more importantly, Ukraine. The LNG Terminal in Odessa and shale gas will not help Ukraine in the short-term either. These solutions, even assuming that they are possible, will take five to ten years to accomplish.
U.W.: Recently, the Ukrainian government decided that foreign companies seeking to explore shale gas in Ukraine have to enter into a joint venture with Nadra Ukrainy, (Ukraine’s Deposits), a state-owned company, and a little-known local company called SPK-GeoService. Is that an acceptable approach in international practice?
Let’s go back to the very beginning. Every country can decide that a foreign investor can be the partner of a state-owned company, for example, Naftogaz. The state provides a foreign investor with a license to hopefully explore the resources that belong to the state. The fact that there is state participation through a national energy company is quite normal. When a state involves a specific local private partner, this is most unusual. In the case of a state company, the state is setting a condition to get license. And a foreign company understands what a state is contributing and providing. A foreign investor is going to invest technical capacity, money, managerial capabilities. What then is this private local partner providing? Does it have technical capability that applies to this project? If the project costs, say, USD 100mn, can it contribute an equal share? Would it contribute USD 10mn into the project in cash or in another form, or do things that a foreign investor cannot do itself? A foreign investor that is going to come in would be concerned about this. This is too messy. They don’t know who these people are. They might be subjecting themselves to accusations of corruption in their own country.
U.W.: Could Ukraine take advantage of promoting the Trans-Caspian Pipeline that could be connected to one of the European pipelines along with Turkmenistan?
A short answer is no. The objective of those who are seriously considering building pipelines, including Europeans talking about Nabucco and other pipelines, is to bypass Ukraine, not enter Ukraine. So, this is more political theater as far as I am concern. There are a lot of hurdles facing the Trans-Caspian Pipeline, connecting Turkmenistan with Azerbaijan. But Ukraine has the advantage of geographic location. Even if these projects are implemented, it will be in the future. The government has to attend to the things that are within its control right now, instead of worrying about things that may or may not happen ten years from now. I can understand that Ukrainians want to participate in construction projects there. But I strongly doubt that the Trans-Caspian Pipeline could rescue Ukraine’s dire gas situation.
Edward Chow, a senior fellow in the Energy and National Security Program at CSIS, is an international energy expert with more than 30 years of experience in the oil industry, including 20 years at Chevron. He has worked in Asia, the Middle East, Africa, South America, Europe, and the former Soviet Union. He has developed policy and business strategy and successfully negotiated complex, multibillion-dollar international business ventures. Mr. Chow specializes in oil and gas investments in emerging economies.