Where Would Increased U.S., EU Sanctions on Russia Leave Energy Investors in Ukr

The EU and the US say they will impose "further costs" on Russia over its actions in Ukraine, as unrest continues in the east of the country. Tension has been rising in eastern Ukraine, with pro-Russian activists occupying buildings in more towns. On 14 April White House spokesman Jay Carney warned that Russia's actions "will come with a cost,'' which has Western energy companies deeply invested in Russia, such as Exxon Mobil and BP, increasingly nervous.

While Russia denies stoking unrest in eastern Ukraine, British Foreign Secretary William Hague told reporters that he believed seizures of official buildings in eastern Ukrainian towns and cities "is something that is being planned and brought about by Russia."

From the Kremlin, Russian Foreign Minister Sergei Lavrov the same day denied allegations that Russian agents had been fomenting unrest in eastern Ukraine and added that he was seeking an explanation from the U.S. about a 12 April visit by CIA director John Brennan to Kiev.

So far, the limited European Union economic sanctions imposed because of Russia's annexation of Crimea do not cover Russian oil companies. President Obama has approved but not put into effect sanctions aimed at sectors of Russia's economy that include those of petroleum companies. Possible energy sanctions clearly worry the Kremlin, as oil and petroleum products represent more than two-thirds of Russian export earnings, and they finance just over half of the federal budget. The EU is also baulking at increased sanctions, as it is the world’s largest energy importer, buying from foreign sources 70% of its oil, 50% of its natural gas and 44% of its coal at an annual cost of nearly $830 billion.

Amid the rising tensions, there is one possible bright spot for foreign investors nervously eyeing Ukraine’s energy market – hydraulic fracturing, or “fracking.”

In 2011 the U.S. Energy Information Administration reported that Ukraine has an estimated 42 trillion cubic feet (tcf) of technically recoverable shale gas reserves, ranking its deposits as the fourth largest in Europe behind Poland (187 tcf), France (180 tcf) and Norway (83 tcf). Initial prospecting indicates that the most promising shale reserves are in the Lublin Basin, which extends from Western Ukraine into Poland, and the Dnieper-Donets Basin in the east Ukraine along the Russian border.

More than half of Ukraine’s primary energy supply comes from its uranium and coal resources. It is natural gas, which also plays an important role in Ukraine’s energy mix, which is at the heart of its disputes with Russian’s state-owned Gazprom. In 2012 Ukraine consumed approximately about 50 billion cubic meters of natural gas, while producing about 19 bcm, with domestic production accounting for approximately 37% of the total, with the remainder made up by Russian natural gas. Gazprom, which cut off its supplies in 2006 and 2009 in pricing disputes, is threatening to do the same again.

The economic reality of Ukraine’s vulnerability to Russian pressure over natural gas imports impelled the administration of former President Viktor Yanukovich to embrace the concept of fracking, especially as preliminary estimates by geologists of Ukraine’s shale gas in reserves ran as high as 2.10 trillion cubic meters. Accordingly, last year the Yanukovich administration put out to tender for sites for shale natural gas extraction: John James Hughes (Donetsk region), Olesky (Region), Slobozhanska (Kharkiv region), Poltava (Poltava) and the offshore Skifska Black Sea field. As Ukraine lacked the requisite technology, Ukraine sought foreign investment, and Royal Dutch Shell, Exxon Mobil and Chevron all expressed interest. Yanukovych eagerly courted Western energy firms even as he hedged his bets by signing a deal at the Kremlin for a major gas discount and Russian loans.

The first major oil firm to cash in on Ukraine’s potential natural gas bonanza was Royal Dutch Shell, which began negotiations with Yanukovich’s administration in 2011. On 24 January 2013 Ukraine's Cabinet of Ministers approved a production sharing agreement (PSA) with Shell and Ukrainian energy firm Nadra Yuzivska LLC for the 7,886 square kilometer Yuzivska field located in Kharkiv and Donetsk regions, with the PSA stipulating that the first 15 exploratory wells as part of the project are to be drilled by 2018. On 12 September Royal Dutch Shell signed the PSA in The Hague with Ukrainian Prime Minister Mykola Azarov to begin fracking activities in the Yuzivska field, which is estimated to contain over four trillion cubic meters of gas. Azarov told reporters, “Starting in 2015, Shell in Ukraine will be producing significant amounts of gas,” with the government expecting production to climb to 30 billion cubic meters a year, at a cost of $120-130 per thousand cubic meters. At the time Azarov was signing the PSA, Ukraine was paying Russian state-owned natural gas monopoly Gazprom $390-$400 per tcm, so the Shell deal appeared an extraordinary bargain.

Azarov added, "Of course, these difficulties that exist in the development of shale deposits must never be underestimated. We have difficult work ahead, but we and ‘Royal Dutch Shell’ are sure to be on the right track, and the agreement corresponds to our national interests, and it will eventually solve the problem of providing Ukraine with its own gas. It is very important. We will gain some energy independence, whereas Shell will earn their money. Shell is the largest company that has the latest technology for safe shale gas extraction."

Next to seize Ukrainian investment opportunities was Chevron, which on 5 November 2013 signed a 50-year Production Sharing Contract with the Ukrainian government to develop oil and gas in western Ukraine.

In reporting the contract the government announced that Chevron would spend $350 million on the exploratory phase of the project and that the Chevron’s total investment could reach $10 billion. In the initial phase Chevron said that it hoped to conduct seismic surveys and to drill exploratory wells on the 1.6 million-acre Oleska Bloc, where geologists found massive shale rock deposits. Then president Viktor Yanukovich was so enthusiastic about Chevron’s joint 50-50 PSC with Ukraine’s Nadra Olesko LLC that he said that hydraulic fracturing “will let Ukraine satisfy its gas needs completely and, under the optimistic scenario, export energy resources by 2020.”

While Azarov resigned on 28 January and Yanukovich fled Ukraine on 22 February, the new leadership has inherited the previous administration’s energy problems – how to pay for Russian natural gas exports. With the cosy arrangements that Yanukovich made with Putin, including a 30% discount on natural gas prices in return for rejecting closer ties with the EU now a distant memory, the transitional government in Kiev is, if anything, even more eager to embrace Western companies willing to enter the domestic market to produce shale gas.

Chevron has already said that it intends to continue to expand its activities in Ukraine.

The picture for Royal Dutch Shell is more complex, as its Ukrainians interests were not limited solely to shale gas. On 19 March Royal Dutch Shell said that it withdrew from negotiations as part of a consortium with ExxonMobil, Petrom and Nadra Ukrainy to develop the offshore Black Sea Skifska oil and gas field west of Crimea, having made the decision in January, a spokesman said, adding that Royal Dutch Shell would still pursue its shale gas onshore projects in Ukraine.

On 26 March Ukrainian Prime Minister Arseny Yatseniuk told his constituents that the price the country would pay for Russian gas would soar by almost 80 percent from April 1 as the seizure of Crimea had rendered a cheaper gas deal with Gazprom obsolete. Accordingly, Ukrainians will not see Western hydraulic fracturing firms as environmental despoilers, but as saviors.