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Can Oil And Gas Save Europe’s Poorest Country?

Ukraine is now Europe’s poorest country (per capita), having overtaken the long-time leader Moldova in 2018. A country whose abundant coal reserves have spurred its transformation into the Soviet Union’s leading industrial and agricultural powerhouse has, over the course of the last 30 years, become Europe’s chronically underachieving appendage. The state of things in Ukraine’s energy sector reflects that of the economy at large – outdated infrastructure, lack of long-term investment and an unwavering penchant for poor management have created a triple whammy that Kyiv has so far been unable to resolve. At the same time, its eastern neighbor Russia has tangibly contributed to the chaos and confusion and it is against the background of a still-raging conflict in Donbas that the Ukrainian authorities are trying to resuscitate their oil and gas production. 

Struggling with gradually declining gas production from mature fields that were discovered back in the Soviet era of the 1960-1970s, Ukraine sees its national oil and gas company Naftogaz as the conduit towards higher domestic output and, consequently, increased energy security. Traditionally, Naftogaz would control almost four-fifths of Ukrainian gas production – this is certainly true for the average of the 2010s though it needs to be noted that in 2010 Naftogaz produced 89% of Ukraine’s aggregate compared to 76% in 2020. The main reason for this trend stems from the maturity of Naftogaz’s producing assets, the Shebelinskoye and Krestishenskoye fields’ depletion ratio had risen to 90% by the end of the decade, whilst there seem to be no new gas assets of equivalent quantity coming up in the pipeline.

Graph 1. Gas Production of Ukraine in Total and Naftogaz in particular in 2010-2020 (Billion cubic meters per year).

Source: Ukraine’s Energy Ministry, Naftogaz Ukrainy.

Keeping all the above in mind, it seems somewhat counterintuitive that Ukraine’s Prime Minister Denys Shmyhal announced that by 2025 Ukraine should renounce imported gas. One would often hear from Ukrainian politicians that Ukraine has become more self-sufficient in terms of its gas needs, however, the only reason this happened is that overall consumption in Ukraine has plummeted since 2014. It is only in the past couple of years that demand bounced back into its growth phase. Total gas demand in Ukraine has increased 8% year-on-year to 32.29 BCm in 2020 while gas output has been decreasing – at first glance everything seems to indicate that such tight deadlines foreshadow a surefire failure. 

Graph 2. Ukraine’s Monthly Gas Consumption in 2014-2021 (billion cubic meters per month).


Source: Ukraine’s Finance Ministry. 

Government intervention has been the main underlying cause of mismanagement in the modern history of Naftogaz – the temptation of easy money flowing in from Gazprom’s transit fees or the lure of murky schemes in gas import contracts was never easy to shake off. CEO Andrey Kobolev has tried to ease the government’s grip on how Naftogaz revenues are allocated and now, with his mandate extended into 2024 and no more elections on the horizon, he can finally enjoy a couple of “silent” years, focusing on the Ukrainian NOC’s primary role, providing energy. Concurrently, it needs to be said that state intervention might also have a beneficial side, as was demonstrated by recent moves within Ukraine’s Energy Ministry. Committed to counteract the tepid international interest towards the country’s first-ever international licensing round, the government has allotted Naftogaz several promising licensing blocks. 

Related: Oil Sees Biggest Single-Day Loss Since April 2020

These assets might provide the reserve base for future growth. The Dolphin block is Ukraine’s most promising offshore asset (the Ukrainian Black Sea is assumed to wield 150 BCm of gas), whilst the Yuzivska block is Ukraine’s most promising shale play, though located relatively close to the front line in Donbas. Naftogaz is confronted with a dual dilemma with regard to these blocks. Considering most of its currently producing onshore assets are of conventional nature, it lacks shale and offshore experience and know-how, however, perhaps even more importantly it lacks the finances to kickstart its ambitious drilling campaign. The COVID-induced market slump has stymied Naftogaz’s financial stature, dropping into negative territory following the profit-generating period of 2018-2019. At the same time, the Ukraine government maintains ambitious long-term goals for its largest national taxpayer:

  • Investing 21 billion USD into exploration in the 2021-2030 timeframe, of which 7.3 billion USD in 2021-2025
  • Tripling the company’s proven reserves base from the current level of 158 BCm to 500 BCm by 2025
  • Expanding into renewables, including the construction of wind farms in the Black Sea

Balancing these interests, especially in the tumultuous political climate of Ukraine, is no easy feat. For instance, the average price Ukraine pays for its imported gas has started to climb back again (see Graph 3) – and although it useful for Kyiv that Gazprom has ceased to publish its prices since the summer months of 2020, the cost would still fall on Naftogaz’s shoulders. Simultaneously, Naftogaz can no longer count on transit revenues boosting its financial standing. One of the key tenets of the Ukrainian NOC’s transformation into a market-driven company was the spinning-off of all its transportation assets into a separate entity, Main Gas Pipelines of Ukraine (Magistralniye Gazoprovody Ukrainy, MGU). 

Graph 3. Average European Gazprom Gas Price vs Cost of Ukraine's Reverse Gas Purchases 2015-2021 (USD per 1000m3).


Source: Ministry for Development of Economy, Trade, and Agriculture of Ukraine; Gazprom. 

By doing so, Naftogaz has rid itself of the gargantuan task of modernizing the entire country’s dilapidated gas transmission infrastructure, i.e. freeing up its balance sheet, as well as cleared one of the main geopolitical irritants of its operations – the seemingly endless Russo-Ukrainian gas dispute. On the other hand, transit revenues could have provided a temporary aid in financing Naftogaz’s upstream expansion. The Ukrainian government would still garner the transit income as MGU is a state-owned entity, however, Naftogaz would be excluded from that string of transactions. 

This need not mean that Naftogaz’s ambitious plans are destined for failure. Ukraine still has ample hydrocarbon reserves and despite talks of achieving carbon neutrality by 2040, Kyiv would be fully supportive of more oil and gas production, regardless of whether it is conventional onshore, offshore, or shale. Thus, the EU/IMF-sponsored changes will at some point allow Naftogaz to become more profitable in the future, though the effect of those changes will most likely play out in a much more protracted timeframe than the Ukrainian authorities envisage. Yet if there is a time to launch a production ramp-up, it is now. Gas wars between Moscow and Kyiv are unlikely in the upcoming years thanks to the 5-year transportation contract signed in late 2019 yet the conflict potential is still there, especially as we get closer to 2024-2025. 

By Viktor Katona

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