To Prime Minister of Ukraine
A. P. Yatsenyuk
To Chairman of the Committee
on Fuel and Energy Complex,
Nuclear Policy and Nuclear Safety
of the Verkhovna Rada of Ukraine
To Chairman of the Committee
on Taxation and Customs Policy
of the Verkhovna Rada of Ukraine
Re: draft Law of Ukraine no. 4309
“On Amendments to the Tax Code of Ukraine
and Several Other Legislative Acts of Ukraine
(Re Improvement of Particular Provisions)”
29 July 2014
Dear Arseniy Petrovich!
Dear Nikolay Vladimirovich!
Dear Vitaliy Yurievich!
We, the undersigned companies and organizations, would like to express our profound respect and present to you our comments concerning the draft Law of Ukraine no. 4309 dd. 21.07.2014 “On Amendments to the Tax Code of Ukraine and Several Other Legislative Acts of Ukraine (Re Improvement of Particular Provisions)” (hereinafter referred to as the Draft Law). We appreciate your confidence and openness that you demonstrate in these difficult times for Ukrainian oil and gas industry, and therefore we are appealing to you in this collective letter.
We understand that the Draft Law aims to improve the Tax Code provisions, to increase the budget revenues and, among other things, to ensure fair taxation of oil and gas projects. In particular, it stipulates the following: 1) increase in the taxation base to determine the payment for subsoil use for the natural gas sold by the gas production companies otherwise than for the needs of population; 2) increase in the rate of payment for the subsoil use for the natural gas sold otherwise than for the needs of population, to 70% regardless of the extraction depth; 3) increase in the rate of payment for the subsoil use for oil and condensate. However, having analysed the Draft Law text in detail, we have come to the conclusion that the methods and measures suggested by the Draft Law will prove inefficient to achieve these goals. Instead, the Draft Law may result in a dramatic rise of the tax burden for the privately owned gas production companies, substantial decline in overall project profitability (down to the closure of projects as unprofitable) and general downturn in the attractiveness of Ukrainian market for foreign investors, whereas:
1. Projects of privately-owned gas production companies have low profitability
Ukrainian oil and gas industry is characterized by complex geology, low exploration maturity of most deposits, the need to carry out complex refining seismic surveys. In particular, according to the expert estimates, approximately 60% of Ukraine’s current conventional gas reserves occur at the depth more than 5 kilometres. Therefore, privately owned companies, before starting extraction of hydrocarbons, have to face high drilling risks, high probability of drilling dry wells and demand for substantial investments in seismic surveys. The prime cost of gas production varies for different privately owned companies and deposits; however, in any case, it significantly exceeds the costs of state-owned companies (operating the deposits explored previously in the Soviet period), in particular, due to the need to conduct geological surveys and explorations, to utilize up-to-date development methods and to stimulate exploitation of deposits. Therefore, the calculations of the gas production prime cost prepared by Ukrgasvydobuvannia of Naftogaz of Ukraine based on the financial indicators of state-owned companies (at the level of UAH 230–240) cannot be applied to quantify profitability of private extraction companies where the prime cost is substantially higher. Accordingly, the profitability of such private projects cannot be calculated based on the public companies’ data. Taking into account the exploration costs and average industry indicators of successful drilling probability (15–30% at the stage of exploration, and approximately 50% at the stage of development, including technological risks), private companies do not make excess profits (700–1,500%), and therefore rise of payments for subsoil use to 70% and cancellation of differentiated rates for extraction of deposits below 5 kilometres will render exploration and development of the oil and gas deposits unprofitable.
2. Adoption of the Draft Law will result in the unprecedentedly high industry taxation as compared to European countries
Today, the Government must focus on maximizing the country’s domestic gas production along with reduction of gas consumption and diversification of the gas sources. However, the Draft Law raises the subsoil use payment rates to the levels unprecedented in Europe. No European country from among gas importers (like Ukraine) has such a high gas production tax rate as is suggested by the Draft Law (70%). The tax rates for hydrocarbon production in these countries do not exceed 20%.
3. Oil and gas industry requires continuous investment made due to the reinvestment of private companies’ profits
Privately owned oil producing companies continuously reinvest their profits into further exploration and prospecting. Notable growth of hydrocarbons’ production in Ukraine is only possible through significant growth of capital investment, and according to some estimates, the private sector needs at least 300-500 USD million annually only to support the current production level. Increase in the tax burden and erosion of capital from the sector will definitely lead to a halt in the performance of private companies and will make it impossible to maintain such significant (re)investment flow.
4. Increase in tax burden will lead to the industry stagnation in general, to a stop of the adopted exploration programs and will make it impossible to develop new projects
Oil and gas industry requires planning of the project economy and stable long-term investment. Any change in the tax burden (upwards) fundamentally undermines the investment attractiveness of further hydrocarbon deposits’ development in Ukraine because of the unpredictability in economic justification of hydrocarbons’ production and calculation of the investment payback time. In the absence of profit, private gas producing companies will not be able to finance the exploration and development of deposits, drilling of new wells and fulfilment of additional studies. This will unavoidably lead to suspension of the industry’s development in general.
5. Increase in the tax burden will not lead to significant budget revenues and will lead to even higher reduction in the mid-term
Increase in the natural resource royalty rate will give only minor and short-term growth of the budget revenues as this innovation will only affect privately owned companies that account for only 11% of the produced gas. In the long-term, this will lead to the decay of the industry as a whole and budget losses in future periods. In particular, according to the estimates, increase in the royalty rate for oil (condensate) and natural gas will make it possible to raise budget revenues in the first year of the new regime, but later on will lead to significant losses due to the drop in production and growth in consumption of imported gas and imported oil products.
6. Radical change of the rules of the game in the oil and gas market will lead to closure of projects implemented by international investors
Over the last 5 years, Ukraine showed a stable trend of attracting significant investments into its oil and gas industry in particular. Investment of privately owned companies, in particular, ensured the growth of gas production in the country. Since 2010, the average annual growth rate of gas production by public companies was -4.4%, while for private companies it amounted to +21.8% over the same period. A challenge of increasing hydrocarbons’ production requires that the government creates and supports attractive investment climate, which presupposes stable and flexible fiscal system, basic legislation and regulatory framework that would be clear for international investors. The royalty rates stipulated by the draft law are unprecedented even for the European perspective. Today, the international community is very focused on the new initiatives of the Ukrainian government as never before since they will be taken into account when decisions about the financing of the Ukrainian economy and projects are made. That is why, any change in the tax legislation and increase in the tax payments can lead to phasing out of such investment projects and flight of international investors from the Ukrainian market in favour of other, more attractive neighbouring jurisdictions (Poland, Romania, Turkey) that compete with Ukraine for development of their own oil and gas industries, if to compare their fiscal and tax conditions (the above countries provide favourable conditions for stimulation of domestic production development) and systems for stimulation of hydrocarbons’ production with the Ukrainian ones.
We hope sincerely that the above comments will facilitate follow-on revision of the draft law as soon as possible. Please accept the assurance of our highest esteem, wishes of success and our expression of readiness for cooperation.
With best regards,
JV Poltava Petroleum Company
Geo Alliance Group
Burisma (Esko Pivnich, Pari, First Ukrainian Gas and Oil Company)