Failure to reduce gas royalty rates in 2017 impacts competitiveness of Ukrainian regime – GlobalData

05 April 2017, Sweetcrude, Lagos — Ukraine cheered some operators with 2017 tax legislation reducing the standard royalty rates for oil production from 45% to 29%. However, draft proposals to reduce royalty rates on new gas wells to 12% were not included in the final legislation.

With natural gas making up nearly 90% of Ukraine’s 2016 hydrocarbon production on a barrel of oil equivalent basis, a reduction in royalty rates on new gas production may be required in order to attract significant new investment to the country’s upstream gas sector.

A significant majority of Ukraine’s recoverable reserves are natural gas, so although recent oil royalty rate reductions are positive, existing gas royalty rates of 29% keep the Ukrainian regime uncompetitive.

Hungary, a regional peer producer with onshore gas production has applied standard rates of 16% in its recent bid round, while Romania applies royalties of 3.5–13% on gas and Poland will apply low royalty rates of 3% on gas after 2020.

With a royalty rate of nearly 30% on standard gas projects, Ukraine’s relatively regressive fiscal regime for gas fields imposes a significant front-loaded fiscal burden on project cash flows, resulting in relatively high levels of state take for gas developments at global average prices, as shown in the chart below.

Despite the imbalance in Ukrainian royalty rates compared to peer onshore producers, international oil companies with existing Ukrainian operations have seen reasonable investment returns. Relatively high realized gas prices, as well as lower capital and operating costs compared to Central European producers, have allowed independent producers to achieve solid margins.

The gas price paid by industrial customers, at which private Ukrainian producers sell most of their gas and set monthly based on average import prices, averaged US$6.22/thousand cubic feet (mcf) so far in 2017. These gas prices represent a small premium to European benchmark prices.

Additionally, Ukraine’s per unit capital and operating expenditure is lower than other producers in Eastern Europe.

A chart in the full version of GlobalData’s analysis shows the effect of a 12% royalty rate compared to the current regime on an operator’s netback on one mcf of produced gas, assuming the average 2017 imported gas price of US$6.22/mcf, and national average full-cycle capital expenditure of US$1.75/mcf and operating expenditure of US$0.85/mcf. Under this analysis, the margin before tax is around 30% on one mcf of produced gas, although the royalty rate reduction would yield a significant increase in the operator’s netback to almost 50%.

However, above-ground issues may mean that operators will require an additional premium in order to take on investment risk in the country. Ongoing fighting in Eastern Ukraine precludes new investments in conflict zones and creates uncertainty regarding the safety of operations in a significant portion of Ukrainian territory, while restrictions on foreign currency to support the hryvnia restrict operators’ ability to repatriate dividends. The doubling of royalty rates in August 2014 to 55%, which was later reduced to 29%, in response to government funding gaps, signals the potential for the government to sharply increase the fiscal burden in response to financial volatility.

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