September 04, 2015

Ukraine’s energy crisis may invite hydraulic fracturing and regulatory uncertainty

Since 2014, Ukraine has been in turmoil. An ouster of the Ukrainian president, disputes over Ukraine’s natural gas payments debt to Russia, and the annexation of Crimea, among other events, have culminated in a severe energy crisis in the country.

Traditionally, Ukraine has been a significant consumer and vital transporter of natural gas produced in Russia. Ukraine provides Russia with access to the European gas markets through an extensive network of Ukrainian pipelines, guaranteeing Ukraine a continuous supply of natural gas at discounted prices. Russian gas satisfies 40 percent of Ukrainian energy demand.

A domestic energy crisis leads to natural gas reform

Recently, Russian threats to shut off Ukraine’s natural gas supply and increase gas prices, combined with a drastic reduction in coal production in Ukraine (production declined 22.4 percent in 2014), has led to energy market instability. Ukraine has been forced to supplement its natural gas supply with product purchased from Europe. To satisfy domestic energy needs, Ukraine has begun taking major steps to reform its energy sector by reducing its energy dependence on Russian gas and seeking alternative energy sources.

In 2011, Ukraine pledged to reform its energy laws and officially joined the Energy Community, an international policy organization that works to extend the European Union’s energy market to South Eastern Europe and the Black Sea region. As one element in this strategy, in April 2015 Ukraine adopted its Natural Gas Market Law. This statute is designed to conform Ukraine’s natural gas pipeline infrastructure to the Energy Community standards. (Author’s note: The Natural Gas Market Law is currently available only in Ukrainian.)

The main purpose of the Natural Gas Market Law is to create a more efficient and competitive environment in the natural gas market. For example, it provides for nondiscriminatory access to gas infrastructure, in conformity with Ukraine’s commitments as a member of the Energy Community. Under the law, customers will be able to independently choose a gas supplier. Currently, a state-owned company known as “Naftogaz” extracts Ukrainian natural gas and through its subsidiaries also controls natural gas transmission and distribution. The new law separates Naftogaz’s production and distribution activities from the transmission of natural gas. Specifically, the law provides two models for unbundling the exclusive control that Naftogaz enjoys: the Ownership Unbundling model (control of transmission is separated from distribution and production) and the Independent System Operator model (independent operators manage a transmission network owned by other companies). Ukraine has to select which model it will follow by the end of 2015. Additionally, Ukraine is working to approve a new “Energy Strategy” designed to expand alternative energy sources and increase environmental protection.

Shale gas potential and hydraulic fracturing

Against this backdrop, industry is showing a strong interest in Ukrainian shale gas. According to the U.S. Energy Information Administration, Ukraine has Europe’s third-largest shale gas reserves at 128 trillion cubic feet. Since 2011, approximately 22 domestic and foreign-owned companies have been engaged in hydraulic fracturing in Ukraine.

But this growing industrial presence is bedeviled by a host of obstacles. At least one company has backed out of a deal to extract shale gas in Eastern Ukraine due to the threat of military action in that area. Yet setting aside this currently unstable climate, there are many other challenges to hydraulic fracturing in Ukraine.

Challenges to hydraulic fracturing

First, Ukraine lacks a regulatory regime for hydraulic fracturing, and it is hard to predict its official position on the issue. Certain EU countries oppose hydraulic fracturing; for example, France has banned the practice. As Ukraine changes its laws to meet the Energy Community standards, it may decide to adopt the antipathy toward hydraulic fracturing that is prevalent in the European Union.

Importantly, regulation of natural resources in Ukraine differs significantly from the approach used in the United States. In Ukraine, natural resources belong to the people with the government acting as a trustee. To extract natural gas, a private investor must execute a production-sharing agreement with the government. But no investor is entitled to 100 percent of its production. The investor is allocated only a share of it and the state receives the rest.

Another challenge to hydraulic fracturing in Ukraine is uncertainty about the extent of public objections. Preoccupation with the military activity in the eastern regions of the country could minimize citizen opposition to hydraulic fracturing. That said, more people in Ukraine than in the United States live in proximity to well locations. They are thus more susceptible to potential negative effects of hydraulic fracturing and to opposing the practice.

Finally, there is no guarantee that hydraulic fracturing will result in less expensive prices for natural gas than those that currently prevail on the market. Studies have shown that shale gas reserves in Poland that are similarly situated to Ukrainian reserves—which are located much deeper in the ground than those occurring in the United States—are more expensive to extract than their American counterparts.

Doing business in Ukraine

Before consulting clients seeking to engage in the natural gas sector in Ukraine, one must thoroughly understand the complexities of Ukraine’s longstanding bureaucracy, unfamiliar legal system, and unstable political climate. Reforms designed to achieve greater energy independence are underway and promise to offer a measure of regulatory stability. However, the process of fully implementing these changes will take time.