12. UNTYING AN INFERNAL FUEL KNOT

ANALYSIS & COMMENTARY: By Serhiy Nikolayev
Ukrayinska Pravda web site, Kiev, in Ukrainian 21 Dec
BBC Monitoring Service,UK, in English, Thu, Dec 29, 2005

There are three practical ways of solving the current energy crisis in terms
of rising world prices and problems in gas talks with Russia, a Ukrainian
website has said. One option is to create a vertically-integrated energy
company, while others include ensuring the same rules for all energy
producers and getting rid of bureaucracy in the process of issuing licences
for developing wells, the article said.

The following is the text of the article by Serhiy Nikolayev entitled
“Untying an infernal fuel knot”, posted on the Ukrainian website

Ukrayinska Pravda on 21 December; subheadings are as published:

This year’s rise in the price of energy sources and the crisis in gas
negotiations with Russia have clearly highlighted the knot of problems which
has been blowing wind on the neck of the Ukrainian fuel and energy sector.

However, now is the time when, under pressure from insurmountable
circumstances in the fuel crisis, the Ukrainian authorities have a chance to
untie this knot and to optimize the work of the oil and gas sector. As US
President John Kennedy used to say, the wise Chinese write the word “crisis”
with two hieroglyphs at once: “catastrophe” and “opportunity”.
OPPORTUNITY 1. ESTABLISHMENT OF VERTICALLY-

INTEGRATED COMPANY
Indeed, catastrophes in Ukrainian fuel and energy sector happen with obvious
regularity: twice a year, in April-May and in September-October. For some
reasons, both sowing and harvesting campaigns always turn out to be a great
surprise for Ukrainian authorities. This is why growing demand for fuel
almost usually transforms itself into price rises. Following the notorious
“ratchet rule”, the price does not fall any more.

Twice a year, having stepped on the same rake, the state resumes playing
administrative games: it tries to regulate prices, bans oil production
experts, searches for ones guilty of incompetence and wages an exhausting
fight to get cheap fuel for agricultural works.

But neither of these “steps” produces important results because officials do
not understand the most important point: it is much more effective for the
state not to press on the market, but to have it own major player on this
market.

Of course, the State Committee for Material Reserves of Ukraine might have
been a player of this kind: it might have entered the market with fuel
interventions to drop the price. But we can recall a quotation from a
classical cat [from Russian animated film]: “For selling something we don’t
need, it is necessary to buy something we don’t need first. But we have no
money.”

The 2005 state budget envisages just 625m hryvnyas [about 125m US dollars]
for the State Committee for Material Reserves, while according to the former
committee’s chief Yevhen Chervonenko, the State Committee for Material
Reserves needs at least 2.7bn [hryvnyas] to fulfil all its functions.

There is a different way: to establish a vertically-integrated oil company
(VIOC) with the controlling interest in shares belonging to the state. It
should also have a completely closed cycle of production and distribution of
its produce: borehole – oil refinery – refueling station. According to
experts’ calculations, taking into account the possible elements of this
company, the VIOC might control about 30 per cent of the fuel sales market
and substantially influence its retail price.

Not only the majority of Russian oil companies (in particular, Lukoil and
TNK), but also Russian officials have understood the benefits of this model.
It is no accident that the Russian Gazprom, whose controlling interest in
shares is owned by the state, is building up its muscles in oil extraction,
refining and sales (in particular, this concerns recent purchase of Sibneft
[Russian oil company] by Gazprom).

For developing a VIOC, not a single penny from the state budget funds is
required. All funding can be carried out within the limits of bank loans. In
particular, a loan for formation of the third “segment” of the mentioned
“chain”, i.e. purchasing refueling stations, has been provided to [Ukrainian
state oil company] Ukrnafta by Deutsche Bank (240m dollars).

Taking into account credit interest rates, profit rate (the average profit
of a Ukrainian refueling station is up to 15,000 dollars), the number of
planned refueling stations (947 stations which are being purchased with the
existing customers’ basis), taxation rates, etc., experts have calculated
that the purchase of refueling stations will pay for itself in four years.

Meanwhile, the state will get its powerful player on the fuel sales market
in one or two years, and it will be able to influence the price level and
stability in practice.

However, the groups which currently control oil refining and the sales
market are unlikely to be happy with this news. Despite the fact that nobody
will take the risk of doubting the establishment of a VIOC (as the former
President [Leonid] Kuchma and the incumbent President [Viktor] Yushchenko
have clearly stated that this kind of VIOC is necessary for the state), but
small spokes are already being put in its wheels.

In particular, MP Ihor Yeremeyev, who controls 41 per cent of the Halychyna
oil refinery, and has close ties with the oil trading entity Continuum
(owning the Western Oil Company which, in its turn, controls a chain of fuel
stations) has already launched a public attack against VIOC. Ukrnafta
reportedly buys its fuel stations for an extremely high price.

Another MP and Yeremeyev’s colleague from the People’s Party faction, Vasyl
Nadraha, came to saying that 120,000 dollars for building a fuel station is
just a pittance (in general, it is surprising for a member of the
parliamentary Committee for Pensioners’ Veterans’ and Disabled People’s
Affairs to assess oil issues as an expert).

Having heard this comment, oil traders whom I know smiled skeptically and
immediately promised “to make an order to this ‘expert’ for building several
dozen fuel stations for this price.”

Meanwhile, according to calculations by experts, the cost of building one
fuel station (including purchase of land) is from 700,000 to 1.2m dollars.
By the way, when Deutsche Bank accepted purchased fuel stations as a
mortgage (as a rule, the mortgage price is 50-60 per cent of the actual
price), made an evaluation of 600,000 dollars for each one.

The second offensive line against a VIOC goes through the Halychyna oil
refinery. The point is that the auction to sell 32.86 per cent of
Halychyna’s shares has been scheduled for 25 January 2006. Ukrnafta is very
likely to take part in the contest, as the company needs an enterprise for
refining extracted oil.

On the other hand, Ukrnafta’s board decided to abstain from participation in
the mentioned auction as early as on 19 October, because, first, purchasing
the mentioned stockholding does not guarantee the company’s participation in
managing the enterprise, and second, there are questions with regard to the
relationship between the Halychyna oil refinery and Ukrainian taxation
authorities: statements with regard to the refinery’s failure to pay taxes
on a large scale have been made).

Yeremeyev makes accusations again, and accusations are related to prices
again. The initial price of the package is allegedly three times higher.

There is information that, in response to this, Ukrnafta is ready to offer
Yeremeyev to buy his own package according to the proposal he has announced.
The desire to purchase Yeremeyev’s package has been indirectly confirmed by
the fact that one of Ukrnafta’s shareholders, Ihor Kolomoyskyy, said after
the shareholders’ meeting on 20 December that it would be feasible for the
company to take part in the refinery’s economic activities if it had a
controlling stake of shares, very preferably 60 per cent and more.
OPPORTUNITY 2. INTRODUCTION OF UNIFIED AND STABLE

RULES OF THE GAME FOR ALL EXTRACTORS
What do the Russians, the Romanians or the Turks do when the world price for
oil and gas grows? Regardless of the volumes of their own prospected oil
stocks, they cautiously begin to increase extraction (in order not to scare
the market, as happened in mid-1980s). This way they either save on
importing energy sources from abroad or increase income from exporting their
own fuel.

Everything is on the contrary in Ukraine: in the course of the first half of
2005, when the world price of Russian gas saw almost 20-per-cent growth and
when Russia began speaking about liberalization of gas prices, the growth of
Ukrainian gas extraction saw… [ellipsis as published] a 24-fold slowing
down in comparison with the same period of the previous year.

The situation with oil is similar. While contracted Russian oil prices for
Europe saw growth of 65 per cent (in nine months), Ukrainian oil extraction
growth was just 2.6 per cent, and extraction of gas condensate, which
accompanies, oil fell by 4.4 per cent.

In reality, these surprising statistical discrepancies have very clear and
understandable reasons. The most important of them does not lie in the fact
that we have insufficient reserves of prospected energy sources (even if
volumes of gas extraction are increased by half, and if new deposits are not
prospected at all, reserves of prospected deposits will be sufficient for
about 20 years).

As strange as it may seem, the main reason lies in the fact that…
[ellipsis as published] it is unprofitable to extract oil or gas following
the regulations in force for those enterprises where the state has a
controlling share interest (the share of Ukrainian gas extracted by them is
over 95 per cent, and the share of oil is over 97 per cent).

Let us take gas as an example. The average cost of extracting 1,000 cubic
metres of gas in Ukraine equals 197 hryvnyas. Being a state-owned
enterprise, the national joint-stock company [NJSC] Naftohaz [Ukrayiny] is
obliged to sell its gas primarily to the population and municipal
enterprises. Taking into account the fact that all of them taken together
consume larger volumes of gas than Ukraine extracts, the word “primarily” is
transformed into the phrase “almost impossible”.

Taking into account the fact that the Naftohaz sale price is 112 hryvnyas
(which is lower than the cost price), one can ask Naftohaz board members a
“very simple question”: why do they reduce the company’s profitability by
prospecting new deposits and extracting and selling more gas?

As reduction of the company’s profitability also results in a reduction of
the amounts of taxation revenues and state dividends, this “simple question”
can bring the Naftohaz board to criminal liability.

Meanwhile, gas companies which have obtained licences for gas deposits
supply gas to the chemical and metals industries not for 112, but for
440-450 hryvnyas per 1,000 cu.m. Therefore, it is obvious that,

[1] FIRST of all, it will be necessary to increase gas tariffs for the
population to the level of its cost price. The price of 1,000 cu.m. of gas
for the population is 22 dollars in Ukraine, compared to 38 dollars in
Russia, 70 dollars in Kazakhstan and 120 dollars in Moldova. Those who are
not able to pay the higher price should get direct aid instead of exhausting
the sector with price limits.

In addition, the actual gas price will promote energy saving.

[2] SECOND, certain standards for supplying gas to the population should

be developed, and they should not depend on the form of ownership of the
extractor.

As to oil, the situation here is not simple either. Ukrnafta extracts oil,
but it is not sure whether it will be able to sell it for the market price.
There were quite frequent cases in the course of the recent year when oil
refineries did not want to take part in auctions to sell oil, but in cases
when they took part, they were not in a hurry to bargain for oil and
demonstrated “a surprising coordination of positions”.

Consequently, Ukrnafta was forced to “request” other refineries to refine
extracted oil. Despite the fact that almost all of them do not work to full
capacity (Odessa and Kherson oil refineries were actually idle in the course
of recent months), and the state is a shareholder in three of them
(Kremenchuk, Nadvirna and Halychyna oil refineries), there are frequent
cases when oil refineries’ management refuses to work with Ukrainian oil.

The stance of the owners of Russian oil refineries is absolutely clear: they
are already vertically-integrated entities and are oriented at refining
their own oil. Even when oil refineries are out of work, their owners still
get profit through redistribution of incomes in the whole chain from
borehole to fuel station.

“Manual management” [presumably through administrative means] of rent
payments also prevents normal oil and gas extraction. Despite the fact that
the law “On rent payments for oil, gas and gas condensate” exists in
Ukraine, its legal force is suspended every year. The rent figure doubled in
2005 alone. There was not a single case when calculations were presented on
whether the sector would survive the new rent rates.

How can one calculate profitability, how can one develop a financial plan
for an extractor, how can one calculate the feasibility of developing new
deposits in the face of this uncertainty? There is no way. This is why
extraction growth is dropping. This is why prices are growing. This is why
the country’s energy dependence is growing.
OPPORTUNITY 3. OPTIMIZING PROCEDURE FOR ISSUING

PERMITS FOR DEVELOPING DEPOSITS
There is another problem which does not allow Ukraine to increase oil and
gas extraction volumes: it is the extremely bureaucratized procedure for
issuing permits for developing deposits and land allocation for them.

Just guess the time which, in accordance with Ukrainian legislation, is
needed for government entities to issue a permit for developing a deposit?
It is two years! However, this process could, objectively, last no more than
two months.

As for land allocation, the situation is even more complicated, as land is
allocated by local councils. Any person having relative powers in a region
(first and foremost, its governor) can block this process.

For example, one former governor of Sumy Region was so keen on trying to
appoint his man the chief of Okhtyrkanaftohaz [oil and gas company in Sumy
Region] that he blocked the process of land allocation for boreholes. As the
result, only half of the 70 boreholes planned in the region have been
developed.

Major questions also emerge with regard to transparency of the process of
issuing licences. The State Committee for Natural Resources issued 116
licences for developing oil and gas deposits last year. Over 80 of them were
distributed among private companies. A large number of these companies did
not deal with extracting natural resources at all previously.

The State Committee for Natural Resources allocated 22 wells without any
tenders or contests last year.

According to the NJSC Naftohaz Ukrayiny, gas extraction at many of these
deposits has not begun yet, though in accordance with the law “On oil and
gas” and the code “On mineral wealth”, licences for land plots should be
revoked if works fail to start in the course of six months from the date
when the permits come into force.

Consequently, the need exists to minimize the terms for obtaining permits
and land allocation at legislative level, having determined a limited list
of grounds for a refusal to allocate land for a deposit, along with defining
clear restrictive criteria for candidates for “purchasing” deposits and
increasing control over the process of their development. -30-

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