IHS CERA special report outlines policies that would help Ukrainian gas sector realize its full potential in partnership with domestic and foreign investors

KYIV, Ukraine (January 18, 2012) – Ukrainian gas production has the potential to more than triple to 70 billion cubic meters per annum (Bcma) by 2035 but would require gas sector investment to increase tenfold to some $10 billion per year, according to a new IHS CERA special report. Improvements to the country's investment climate are essential to achieving these potential increases in production, the report says.

The report, Natural Gas and Ukraine's Energy Future is the product of an intensive six-month program of research, consultation and analysis carried out by IHS CERA at the request of Ukraine's Ministry of Energy and Coal Industry. The report outlines policies for improving Ukraine's investment climate that could help it realize its full potential in partnership with domestic and foreign investors.

“Ukraine's ability to begin to achieve its potential will require implementing an attractive investment climate," said David Hobbs, IHS chief energy strategist. "This, in turn, will allow the application of the essential modern technologies—for seismic evaluation, drilling, completion, well stimulation and production management.”

Ukrainian gas production has the potential to increase to 70 Bcma by 2035—more than triple current production—if increased investment can be attracted, according the report's indicative gas production profile. This includes resources from new discoveries of conventional gas onshore and offshore, and considerable new resources from tight gas sands and unconventional shale gas and coal bed methane.

Although Ukrainian legislation affecting the gas sector has seen positive changes in the past 18 months, the overall regulatory environment for investors remains complex and extremely challenging:

The permitting process for exploration and production (E&P) has changed frequently in the past three years, creating the perception of legal and regulatory instability. The overall permitting framework suffers from flaws and ambiguities that risk allowing investors to conclude that full compliance is time-consuming and sometimes impossible

Customs clearance procedures for imported equipment are cumbersome and expensive and add to upstream development costs

The new Law on the Principles of the Functioning of the Natural Gas Market, adopted in July 2010 as a condition of accession to the Energy Community—a European Union-based multilateral organization—represents a step forward, but there is further to go

Policy Recommendations:

Natural Gas and Ukraine's Energy Future contains the following specific policy recommendations

Industry Structure

Ukraine can benefit from the vertical unbundling of the gas sector by restructuring the current integrated industry into distinct segments:

An upstream segment that will build on today’s semicompetitive playing field to become fully competitive in the context of stronger and clearer regulation

A downstream segment comprising distribution and marketing into which more competition can gradually be introduced

A midstream segment—transportation and storage—that could remain as a regulated monopoly for the time being (although storage could be spun off as well)

Upstream

A target of attracting up to $10 billion of investment annually into the upstream will likely require a revamp of the terms under which foreign or domestic investors can invest in the exploration and development of natural gas (as well as oil). This could include the following reforms:

Changes to permitting including greater duration and acreage for license awards, a strong preference for issuing combined special permits for E&P, and in general more streamlined permitting procedures

Strengthening the stability of properly obtained permits and introducing robust procedures for smooth conversion of existing exploration permits into production permits

Increasing significantly the time allowed for submission of bidding documents at license auctions

Developing special rules for unconventional gas E&P because of the inherent differences relative to conventional gas development

Making access to exploration data easier

Simplifying procedures for importing equipment and reducing customs duties on new technology for E&P

Downstream

In terms of the domestic gas market, full implementation of the 2010 Law on Principles of Functioning of the Natural Gas Market is a good first step, but there is a need to go further in some areas:

The principle of free choice of suppliers for consumers will provide strong leverage for squeezing costs out of the supply chain and ultimately lead to lower prices for end users

Secondary legislation will be required to implement the principle of nondiscriminatory access to the gas transportation system as well as storage facilities

Price liberalization will ultimately remove distortions caused by regulation. The extent of this liberalization should lie in a range of outcomes:At a maximum, this would include full price liberalization for all categories of customers, combined with financial support for vulnerable categories of consumers (which could be financed by upstream royalties).

As a minimum first step, regulated prices for sales to district heating utilities would be increased to reflect the actual cost of gas acquisition in order to make Naftohaz financially sustainable.

Natural Gas and Ukraine's Energy Future was commissioned by Ukraine's Ministry of Energy and Coal Industry. IHS CERA offers an independent assessment and is exclusively responsible for all of the analysis, content and conclusions contained in the study.