CEO of Smart Energy Sergei Glazunov: One Should not Expect a Boom in Drilling from 1 January

At the end of the last year, the Ukrainian parliament reduced the royalty rates for gas production from new wells to 12% and 6% depending on the depth, and pre-approved deregulation for gas producers. Importance of these changes, challenges of the gas producing industry, the necessary reforms, as well as the company‘s performance trend in general were recounted by Sergei Glazunov, the CEO of Smart Energy, a company managing energy assets of Smart-Holding, in the interview to Ukrainian News.

The parliament lowered the royalty for gas production to 6-12% for new wells. What effect will these changes bring for your 2018 drilling plans? Will the production forecast increase?

One should not expect a boom in drilling from 1 January simply because new drilling projects require a lot of preparation, including a fairly long approval procedure. Speaking about our company, in 2018 we will be able to implement only those projects that were planned in previous periods.

In 2017, we managed to increase our natural gas production by approximately 8.5%, i.e. to 226.3 million cubic meters in comparison with the previous year. We expect at least to preserve this trend in 2018.

At the same time, I believe that the adoption of the law that provides for a decrease in royalty for new wells will have a positive impact on investment in the industry, and, as a result, on the growth of gas production in Ukraine.

Could you please explain how this law will work: if, say, in January you start drilling a well, in spring you connect it and put into operation, during what period will 6-12% royalty for the gas produced from it be levied? In other words, how many years will this well be a "new" one?

According to the law, the royalty rates for gas production at the level of 12% and 6%, depending on the depth, apply to new wells. A well is considered to be new if its drilling from the surface started after 1 January 2018, which is confirmed by the drilling rig’s commissioning certificates. And there is a so-called stabilization clause, which says that these new rates for new wells are valid for 5 years. That is, the production from wells that were drilled after 1 January 2018 will be taxed according to these rates, at least until the end of 2022.

On the eve of the budget process, the Association of gas producing companies, including your company, actively supported draft law #3096-d on deregulation of gas production. What will its adoption give to the company?

One of the main factors for successful development of any market-based business is deregulation. This draft law, which was adopted in the first reading in December last year, provides for a number of deregulatory provisions. I hope it will be adopted in the second reading and in general at the beginning of this year. In particular, it provides for the reduction of a number of licensing procedures and approvals, which will make it possible to accelerate the deposits’ development and commissioning process. It also provides for streamlining of certain land-related issues, including the possibility to obtain properly arranged and clearly executed documents for land plots for new facilities, because at the moment there is great ambiguity in this process. In addition, it abolishes a number of archaic aspects that existed before and have nothing to do with the oil and gas sector. This is the first stage in terms of deregulation of the sector, which takes a big serious step towards simplifying business and increasing its investment attractiveness.

What other reforms are needed so that you could say: "That`s it, the state has provided all the conditions, nothing hinders the development of the gas producing industry"?

We see Law #3096-d as a certain first step in terms of deregulation. There are a number of issues that can be attributed to the same category of deregulatory ones and it makes sense to implement them.

In particular, it would make sense to consider initiatives that can lead to acceleration and mobility of drilling operations, to drastically reduce the time of drilling and well infrastructure development.

There is also a large scope of work in terms of simplifying and optimizing the licensing procedures. In this case, an option to introduce a "single window" could be considered, provided that transparent rules and regulations of regulators are established.

From the point of view of the sector’s investment attractiveness, I believe that much needs to be done to improve transparency of approaches to obtaining new licenses, in particular, transparency in tendering procedures to obtain new licensed sites. A big and extremely important issue to be solved is availability and quality of the geological information that is provided to a potential investor during the auctions.

Another point that, in my opinion, has a significant negative impact on the industry’s investment attractiveness now is the risks of an arbitrary suspension of licenses by the State Geology and Natural Resources Service.

In addition, much work has to be done to update the Natural Resources Code because now we use the code that was adopted in 1994 and mostly inherited the Soviet principles and mechanisms for the development of mineral resources, which do not correspond to modern world practices.

Over the past year, prices for hydrocarbons increased significantly, therefore, gas producing companies should have more funds. How have your investments increased and has your company reached the pre-crisis 2013 year level by the scope of investments?

Now, gas is sold at about $285 per a thousand cubic meters (without VAT), which is approximately 65% of the price that was in 2013 and, accordingly, the company's earnings per a unit of output in currency equivalent are of approximately the same proportion. That is, if we compare the current situation with 2013 and the amount of own funds that the company earns and can reinvest, it objectively makes up approximately 70% of the earlier contemplated investment volume.

The hardest year was 2015. That was an increase in the royalty, monopolization of the sales market, the overall difficult situation in the country, and a reduction in consumption.

In 2016, certain positive changes were made – the royalty returned to its previous level, which allowed companies to think about the resumption of their investment cycle. Therefore, for example, in 2017, we invested about UAH 450 million in the development of our fields, which is significantly more than in 2016 and is many times higher than in 2015.

In fact, we are gradually reaching the pre-crisis level. The royalty reduction for new wells and deregulation initiatives naturally increase the investment attractiveness of our projects. Accordingly, in the future the company is planning to increase investment in the development of its deposits.

What investment projects were implemented in 2017 and what is their result?

In 2017, we managed to put into operation well #109 of Mekhedovsko-Golotovshchinskoye field (Poltava region). Here we successfully applied technologies unique for Ukraine to complete a well using swellable packer scheme and hydrocarbon-based solutions.

We began drilling of another well, #28, on Ostroverkhovskoye field. Two major workovers were successfully carried out: well #2 was commissioned on Sviridovskoye field (Poltava region) and #5 on Ostroverkhovskoye field (Kharkiv region). In addition, we installed two compressor units, which allow for low-pressure operations.

These major projects led to an increase in the group’s average daily production by 25% at the end of 2017 compared to the end of 2016.

Regal Petroleum has rented a well of Ukrnafta located on its licensed site. Can you call this cooperation successful?

This is well #2, which is located on Sviridovskoye field. The well was put into operation, now it works at the planned production rates that were expected from this project.

Previously, you worked with "Natural Resources" for higher utilization of an LPG and stabilized gas condensate plant. Are you looking for new partners for additional loading of the plant?

Now, after the commissioning of well #109, the LPG production plant operates approximately at 80% of its capacity. Taking into account those projects that we are planning to implement on Regal Petroleum’s deposits in the near future, we are going to additionally load this plant to its full capacity. Therefore, most likely, we will manage with our own production resources. At the same time, given that we have a fairly successful experience in the technological implementation of such projects, we are considering similar projects and assessing potential opportunities in the regions of our presence.

Hydraulic fracturing is quite a popular topic now. Do you consider this method of production stimulation?

We have experience in hydraulic fracturing on our fields. At two wells: on Ostroverkhovskoye and Vasishchevskoye deposits. This experience was successful, the hydraulic fracturing operations made it possible to increase production from these wells several times. This is really the most effective method of production stimulation. Now we are looking at one of our existing wells in terms of the possibility of hydraulic fracturing.

Recently, the number of service companies increased in Ukraine. Have you felt the effect from the competition between these companies, have the prices for drilling, repairs and other services gone down?

Indeed, we see a growing number of service companies these days. In particular, the Belarusian company Belorusneft has entered the market, the Croatian contractor for drilling Crosco and other companies are considering this possibility. However, at the moment, the demand is still higher than the supply is. This is due to two factors. First, is the government program 20/20, where the main customer is the state-owned company Ukrgazdobycha, which has declared large volumes of drilling and other operations to stimulate production, as well as workover. Ukrgazdobycha accounts for about 95% of all orders. The second factor is the legislative changes that were adopted at the end of the last year, that is the decrease in the royalty for new wells, which should also cause increase in demand for these types of services from private companies. Until now, the market has been working as follows: service companies, including Ukrainian ones, were bringing additional equipment for specific orders, for specific contracts. Therefore, in order to get some service, you need to join the queue. Perhaps now, as the attractiveness of this market sector from the investment viewpoint is growing, this demand will be met with quite serious proposals from contractors to make this market really liquid one. Now, there is demand, but supply is not sufficient, so the prices have, on the contrary, slightly risen rather than fallen. Price reduction is now possible only for a large order. That is, if you are ready to offer a contractor a deposit development program, including drilling of several wells, then you can talk about price reduction and volume discounts.

The geological service declares that it will resume auctions to sell special permits for new sites. Are you planning to participate in those?

We are monitoring these auctions constantly. If there is something interesting and if high-quality geological information is provided, on which basis justified conclusions about the investment attractiveness of these facilities could be drawn, we will participate.

What are the group's estimated losses from blocked production on Ostroverkhovskoye field?

The halt was from 17 to 23 November 2017. We failed to produce 2.2 million cubic meters of gas and about 70 tons of condensate. If we talk about direct budgetary payments, which the state has not received, then this is more than UAH 4 million. In addition, taking into account the heating season, the country compensated for its own production shortage by import going into the corresponding expenditures in foreign currencies.

What was the essence of the claims from the Geological Service to Ukrgazvydobutok? Why did they coincide with the claims from other state bodies – the State Fiscal Service and the Prosecutor General`s Office?

Production suspension orders resulted from unjustified accusations of the prosecution office of the alleged sale of hydrocarbons "on the side", which in principle is not technically possible. If from their point of view there was an illegal sale, there must be underpayment of taxes to the budget. Based on these orders from the State Geological Service, director of Ukrgazvydobutok company was charged with allegedly illegal use of mineral resources and acquisition of property.

We believe that these are absolutely unfounded accusations and we will defend our right position. Our company operates absolutely transparently, within the legal framework, paying all taxes. We successfully develop Ukrainian gas production, that is, the energy independence of our country. It is noteworthy that in the State Fiscal Service’s rating Ukrgazvydobutok is one of the top 100 companies (it is ranked 16^th in 2016).

Is the pressure from the law enforcement agencies on the group persisting?

To date, there is a number of proceedings that are being pursued against our companies, some are at the stage of investigation and some are in courts now.

We are absolutely confident in our rightness in all these cases.

Considering these proceedings, we do not rule it out that we may undergo more searches or checks, as previous experience prompts. However, we expect that the law enforcement agencies have already got the idea of our core operating activities, and that the business is absolutely transparent. However, everything is possible.

Vin-Pellet: where do you export? What price do you sell at?

We now have three types of products that we produce at Vin-Pellet: bedding, feed and fuel pellets. At the moment, more than 90% of the output is cattle-breeding pellets, mostly as bedding pellets. This is because at the moment fuel pellets from straw are not very competitive in price if, for example, compared to pellets from sunflower husk.

Initially, the plant was planned for fuel agropellets, it was about large volumes with an understandable margin. However, over the past four years, the market for fuel pellets has significantly changed. Therefore, now our strategy has somewhat altered. We focus on random contracts where there is a positive economy.

At the same time, Vin-Pellet is the market leader in the production of pellets. Over the past several years, a number of enterprises have curtailed their production due to a significant drop in margins in the market for pellets from biomass.

We now occupy about 45% of the agropellet production market in Ukraine. We sell to countries of the European Union. We work with Germany, the Baltic states, Finland, Poland, Austria, Italy, Denmark. We develop the markets of the Middle East – Qatar, Jordan, Kuwait, Palestine, Israel, Saudi Arabia. Recognition of Ukrainian producers in the markets of the Middle East is growing, in spite of the fact that this growth is very slow.

The average price for the product line is approximately EUR 60 per ton.