• Unlike many European countries, Ukraine has the potential to completely abandon the import of gas and cover its needs exclusively from domestic resources. Ukraine ranks fourth in Europe in terms of production and third in proven natural gas reserves, behind only Norway and the Netherlands.

    Over the past 20 years, investments in the development of oil and gas fields in Ukraine were limited. This provides significant opportunities for increasing gas production through the use of new technologies for exploration and production. In 2015, Ukraine produced 19.9 bcm of gas (20.5 bcm in 2014) or 60% of the total volume of gas used by Ukrainian consumers. In 2015, Ukraine imported 16.4 billion cubic meters of gas. The volume of gas in underground storage for the year increased by 2.5 billion cubic meters. Gas production volumes reduced by 0.6 bcm or 3% in 2015 compared to 2014.

    Extraction of gas in UkraineThe volume of gas production by state company Ukrgazvydobuvannya (UGV) decreased by
    4% — from 15.1 to 14.5 billion cubic meters. These amounts also include volumes produced by joint ventures and gas used for UGV's own production and operating needs. Oil and gas company Ukrnafta reduced gas production by 13% in 2015 — from 1.7 to 1.5 bcm.

    Because of the occupation by Russia of Crimea and Sevastopol, last year Ukraine did not receive gas from another Naftogaz group company, Chornomornaftogaz. During the first two months of 2014, this company had produced 0.3 bcm of gas (in 2013 the total figure was 1.7 bcm).

    In the same time, private producers increased production by 17%, from 3.3 to 3.9 bcm. The government of Ukraine forecasts that gas production in Ukraine will increase to 27 bcm till 2020. The adoption in 2015 of a number of bills in the energy sector has opened up new opportunities to improve the situation in the industry, though more changes are required to achieve the stated objectives. 

    In particular, fiscal policy on royalty rates needs revision. Despite the reduction in 2016 of the royalty rates (they decreased from 70% to 50% for UGV), they remain a heavy burden for new projects. It is also important to adopt appropriate legislation that would allow local authorities to keep a proportion of rent payments in local budgets for investment in the needs of the region (currently 100% of royalty payments are directed to the state budget). Implementation of these changes will contribute to the cooperation between gas companies and the local community. The involvement of local communities is an essential factor for the successful build-up of gas production in Ukraine.

    In addition, it is necessary to remove existing regulatory barriers that hinder the development of the industry. These include complicated and non-transparent procedures for obtaining special permits, outdated rules governing oil and gas field development, the absence of a central geological information database, and the need to obtain rights for land in addition to obtaining special permits. At present, obtaining approvals and permits may take three times longer than actual drilling works at the site.Taxation policies of contractual production sharing also need revision. Naftogaz supports the implementation of the necessary regulatory changes that contribute to the development of the gas sector and help attract investments to gas production in Ukraine.

    UKRGAZVYDOBUVANNYA (UGV) 

    A subsidiary of Naftogaz, UGV is the most powerful player in the market of natural gas and gas condensate extraction in Ukraine. UGV accounts for 75% of total production of Ukrainian gas, with a share in the total oil and condensate extraction of 500 thousand tons or 20% of the market.

    The structure of the UGV production cycle

    At the end of 2015, the resource base of UGV was 285 bcm of proven reserves of gas. This is 3-6 times higher than the resource base of comparable companies in other post-communist countries (Petrom, PGNiG, Romgaz, MOL).

    UGV currently develops gas, oil and oil-gas fields in 11 regions of Ukraine, although exploration searches for new hydrocarbon deposits in recent years have been localized in the Dnipro-Donets Basin and the Carpathian region.

    All marketable gas produced by the enterprises of UGV is purchased by Naftogaz and used for the needs of the households at a price fixed by the state.

    The enterprises of UGV employ approximately 20 600 people.

     

    CRITICAL YEAR

    The reduction of gas production by UGV was particularly due to the temporary loss of control over assets located in the east Ukraine conflict zone (185 mcm), and also due to a significant shortfall in the exploration of new areas and field development during several preceding years.

    The company's resource base has been depleted: during seven years from 2007 to 2013 the UGV secured only one special permission to explore new areas instead of the approximately 100 needed. To ensure production growth, the increase in incremental reserves must be at least two times of the production volumes.

    During 2013-2015, UGV produced about 45 bcm of gas while its reserves increased by only 29 bcm.

    By 2015 the company produced 172 thousand tons of liquefied gas, 8% less than in 2014. At the same time, there was a slight decrease in sales of petroleum products. In 2014, 362.7 thousand tons of oil were sold, while in 2015 UGV sold 358.1 thousand tons.

     

    NEW TEAM, NEW STRATEGY

    In June 2015, following a recommendation from Naftogaz, the Cabinet of Ministers appointed Oleg Prokhorenko as the new head of UGV. Prior to his appointment to UGV, he worked at McKinsey in Ukraine and in other countries where he advised major private companies and government agencies on reform issues. From 2005 to 2007, Oleg studied at the Kennedy School of Public Administration at Harvard University (USA), where he received a master's degree in public administration and public policy.

     

    Over the course of several months a new management team was formed that came from private sector Ukrainian and international companies. In total, approximately 65% of key management personnel were changed. The primary task of the new team was preventing a critical reduction of UGV production. Reduced production had become inevitable because of the situation in which the company worked over the last decade.

     

    In 2015, UGV received 20 special permits, including four for new fields, and posted a fivefold increase in the volume of seismic work.

     

    By increasing revenues and measures to improve financial performance, the company was able to intensify the work of operating and exploratory drilling, and to commission three compressor stations.

     

    Priority program implementation allowed the company to avoid a significant drop in output in 2015. In 2016, volume of production was stabilized and began gradual growth.

     

    In addition to solving the most pressing problems faced by the company, the new UGV management has developed a long-term development strategy and action plan, conducted a major reorganization, substantially changed and strengthened technical staff, and involved international experts.

     

    Jointly with Naftogaz team, the new management has identified six key areas that will help introduce modern European standards to the work of UGV:

     

    • Fight against corruption;

    • Production and processing increase;

    • Increase of reserves;

    • Operational model optimization;

    • Reforms of internal processes;

    • Deregulation and improvement of legislation.

    STRATEGY 20/20

    List of JV agreements

    UGV is currently implementing its 20/20 Strategy program, which targets to bring volumes of gas production to the level of 20 bcm per year in five years. The total investment budget is estimated at more than UAH 80 billion.

    In order to develop the investment program, several technical audit projects have been initiated. In particular, geological reserves were audited by Ryder Scott, Deloitte examined key management processes and conducted an audit of terrestrial infrastructure. Petrad conducted an audit of emissions and capacity for their reductions.

    The majority of the existing operating deposits are considerably exhausted. Therefore, in order to carry on gas extraction from depleted fields, the company is focusing on intensifying production. This method relies on modern technologies including hydraulic fracturing (HF), allowing gas extraction at much cheaper rates compared to the cost of drilling new wells.

    Investments in seismic exploration in the second half of 2015 exceeded the previous four years' combined budget. The company plans to develop 3D models of 20 priority fields by the end of 2016 and conduct 100 hydraulic fracturing operations.

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    Ukrgazvydobuvannya is a vertically integrated oil and gas producer with a full production cycle

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    In order to implement the strategy of increasing production volumes, UGV needs to invest in technical upgrading, production intensification and exploring new fields, as well as drilling new wells.

    TRANSPARENCY IN PROCUREMENT

    By the end of 2015, the new team of UGV saved about UAH 500 million in procurement procedures. This was possible thanks to the elimination of corrupt schemes and resetting the entire procurement system. The overall effect of savings in procurement and financing totaled over UAH 1 billion.

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    UGV intends to increase volumes of gas production to 20 bcm per year by 2020 

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    In particular, all possible purchases since August 2015 were transferred to the ProZorro e-procurement system. UGV conducted nearly 300 tenders worth UAH 500 million by the end of the year. Savings through ProZorro for this period amounted to UAH 54 million.

    For purchases which could not be conducted through electronic auctions a new transparent procedure was used. By eliminating intermediaries on key supplies (pipes, chisels, methanol, etc.) the company saved over UAH 420 million for the second half of 2015. In addition, UGV implemented anti-corruption procedures that facilitated monitoring of contractors during the execution of contracts for compliance with anti-corruption practices.

    EFFICIENCY IN SALES

    Improving efficiency in sales is one of the priority tasks for the new UGV team. In 2015, the company conducted a transparent public tender to choose an exchange for the sale of its oil and began to sell products through electronic auctions. This allowed the company to increase competition among oil buyers and secure higher margins from sales. Previously UGV was required to sell its non-gas products via a designated exchange where the products were sold at artificially low prices and then resold by intermediaries at commercial rates.

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    By eliminating intermediaries the company saved over UAH 420 million in the second half of 2015

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    In addition, UGV stopped selling initially refined oil products, which was a source of raw materials for artisanal oil refining. The filtered products now undergo further processing, allowing UGV to receive high-octane components, which are the basis for the production of gasoline that meets Euro-5 standards.

    Furthermore, in 2015 UGV decreased the size of lots thus expanding the market to involve small private traders in auctions. UGV products are now sold through a competitive exchange trading three or four times a month. The company plans to establish daily online trading in its products.

    Subsoil royalty for gas from UGV

    Thanks to the simplified procedure of motor fuel sales, from September 2015 UGV began to supply low-octane petrol of domestic production for the needs of the Defense Ministry and State Reserve via direct contracts.

    UGV actively works with members of the Ministry of Energy and Coal on the issue of transferring LPG auctions to the electronic form. To enable this transfer it is necessary to amend the Cabinet of Ministers Resolution №570, which does not provide for electronic trading of LPG.

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    The market value of UGV non-core assets is estimated at over UAH 0.6 billion

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    Another important step was the expansion of export channels for finished products, from direct contracts with international traders to public tenders for export. In addition, a technology was introduced that allows for the comparison of prices on the domestic market and external hubs and lets the company choose the optimal option between selling in Ukraine and abroad.

    This strategy helped UGV sign direct contracts with major energy market traders who had been previously inaccessible for UGV because of shady intermediaries. In 2016, the first delivery took place to VitolGroup, the world's largest independent oil trader with a 2015 turnover of USD 167 billion. In this transaction, UGV sold motor gasoline through a direct contract. Today UGV exports to nearly a dozen of international traders via monthly spot contracts. Another important step finalized in 2016 was the modernization of UGV's Shebelynka gas processing plant. This project enabled the company to start mass production of gasoline meeting the Euro-4 standard. In the third quarter of 2016, UGV launched production of gasoline that meets the Euro-5 standard. It is expected that UGV will launch production of Euro-4 diesel fuel in Q4 of 2016.

    Most international companies outsource some production processes


    OPTIMIZATION OF OPERATING MODEL

    In addition to the production of gas, oil and condensate, the company currently has a number of non-core assets. These include subsidiary farms, holiday homes, medical and health institutions, shops, catering establishments, cultural centers, food items and more.

    Status of the trials asIn 2015, an inventory of non-core assets and property was conducted. According to preliminary estimates, the market value of the UGV's non-core assets is above UAH 0.6 billion. These assets generate a total UAH 30 million in monthly losses, with costs including maintaining assets and paying more than 1700 employees.

    UGV intends to divest a number of non-core assets and focus on its core business — increasing gas production.

    JOINT VENTURE CONTRACTS UPDATE

    Since the arrival of the new team, joint venture agreements (JVs) have proven one of the most challenging areas. JVs account about 8% of UGV"s total gas production.

    As of 2015, there were eight joint venture agreements with participation of UGV, concluded between 2002 and 2014, with 5 of them concluded in 2004. The official aim of creating these JVs was to ensure the necessary level of investment that was not available for UGV due to the fixed low level of gas prices.

    These joint ventures are organized in such a way that UGV has no operational control over assets. The UGV number of votes in the supreme governing body of all JV contracts is less than 50%, depriving UGV of opportunities to make decisions on JV operational activities. In many cases, the partners block UGV decisions. The agreements contain asymmetric distribution of rights and duties not in the interests of UGV.

    Under the terms of these contracts, the major UGV contribution is the right to use wells, while partners provide the majority of funding. UGV's partners were obliged to finance and provide for the overhaul of wells, with UGV contributing exploration rights. Partners were also obliged to install the components for the commercial metering of natural gas.

    The result of this joint activity should have been shared profits through the sale of hydrocarbons extracted from repaired wells.

    An audit of JV contracts conducted by the new management has found that UGV had completely fulfilled its obligations under all JV agreements, but none of the contractors fulfilled their investment and production commitments in full.

    In particular, the shortfall in production plans for 2015 totaled 360 mcm of gas (1.16 bcm was produced against planned 1.5 bcm). In some cases, UGV partners also did not fulfill their financial contributions in full, did not perform or fund the overhaul of wells, and did not implement commercial metering.

    In addition, some of the JV partners conceal their accounts from UGV. Almost all refused to adopt the IFRS accounting system and harmonize with UGV. Some JVs have arrears in payments to the state budget, while the current legislation provides joint liability of the participants of JVs for all the obligations of the JV. The audit of JV contracts found that a number of UGV partners performed sales of hydrocarbons extracted within the JV at unjustifiably low prices.

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    73 cases totaling UAH 1.5 billion were decided in favor of UGV during 2015

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    During 2015, the new management of UGV led pretrial negotiations with each of the partners to remedy the situation in each case. These negotiations have not led to improvements in the work of JVs. In late 2015, UGV initiated seven claims for the termination of JV contracts in order to regain control of its fields involved in the JVs.

    In addition, following lengthy pre-trial negotiations, UGV filed a claim to the arbitration in Stockholm in 2016 for breach of JV contract against Karpatygaz and MisenEnterprises AB.
    The new management currently has no plans to enter into new joint venture agreements for the production of gas as this format of partnership has proven to be problematic.

     

    STRENGTHENING OF THE TECHNICAL COMPETENCE OF STAFF AND OUTSOURCING

    In order to coordinate the intensification of production in 2015, foundations for reformatting of the technical team were laid. For the first time, the company managed to attract foreign professionals with significant experience in modern upstream technologies, including hydraulic fracturing operations.

    UGV performs internally many services that most international mining companies outsource. The company intends to determine which non-core production processes can be outsourced.

    The structure of UGV includes Ukrburgaz, Ukraine's largest drilling company. Following many years of underfunding, the technology and equipment used by the company are obsolete. UGV plans to employ external contractors to supply new equipment, materials and services where appropriate. The emergence on the market of a powerful new customer like UGV creates a new ecosystem of service companies and can reduce the cost of such operations in Ukraine with a positive spillover effect for private gas producers.

     

    ENVIRONMENTAL SAFETY

    UGV adheres to strict requirements for environmental safety of production and environmental impact. The company's processes are structured to ensure that all hydraulic fracturing operations meet modern emission standards and regulations and do not endanger the environment.

    The company is actively expanding and implementing several projects of cooperation with international and national organizations such as the EBRD, World Bank, Ministry of Foreign Affairs, the US DOE and others. These projects aim to implement the best international practices of production, engage international technical support specialists and to qualify to modern environmental standards to attract investments.

     

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