Yevhen Palienka: The only way to save Ukrainian gas production is to fight to reduce the cost of gas extraction

When the industry is unsteady at all levels, from local to global, and it’s not clear who to trust and listen to, the best a journalist can talk to someone who has the experience and can afford to keep an eye on the situation from the outside. Yevhen Palienka is the ex- financial director of the state company Ukrgazvydobuvannya. Before joining the public sector in 2018, he worked in finance and management in private international and Ukrainian gas production companies for over 20 years – JKX Oil and Gas plc (PPC and Yuzhgazenergy), Smart Energy Group, Regal Petroleum plc.

- Let's talk about the latest developments. According to the published results of the State Audit Service’s audit due to financial violations in Naftogaz, the loss of the state budget amounted to 75.5 billion hryvnias. The State Audit Service at first refused this data and then transferred it to the SSU. Naftogaz said everything was wrong – calculations and the results. In your opinion, who is right?

In terms of the accrual of stocks, we are not talking about any missing money. There is a discrepancy in methods and approaches. IFRS, which give the management of the company enormous freedom of action in defining accounting policies and in making decisions on reporting, have international accounting rules. On the other hand, all state-owned companies in Ukraine are required to conduct budgeting and accounting according to the regulations of the Ministry of Finance and the Ministry of Economic, take into account the specifics of tax requirements. And they, in turn, determine the approaches to the use of IFRS.

State-owned enterprises are expected to have results that will not differ by more than 10% from those set out in the annual financial plan. Logically, the report on the results should be prepared according to the same methodology according to which the financial plan was drawn up and approved. And in this case, accounting was carried out according to the IFRS methods in the understanding of management, and the financial plan did not include the accrual of the debt reserve. Perhaps there was no recognition of certain transactions as income, which the IFRS allows, but the Ministry of Finance standards and the Ministry of Economic – no.

There are four sides to this situation. There is the management of the NAK, as a party that makes financial statements. There are Deloitte auditors who check it, verify it. There is the Supervisory Board of the NAC, which approves the release of such reports. And there is a shareholder - the state - the user of the reporting. What really happened: the state audit that was carried out is an audit conducted by the shareholder. And the shareholder's conclusions do not coincide with the statements prepared by the management, confirmed by Deloitte, and for which the Supervisory Board voted.

Based on my experience working in public companies whose shares are listed on the stock exchange, the sequence of actions upon receipt of such a negative document from an audit of a shareholder or other government body should be different.

First, when such a document was received, the company should immediately report it and declare that it will study the document and give further comments after professional study. This is a rule of good manners and an element of openness. And the removal of such issues into the public sphere, according to the international business community's rules, should be done by the company itself before third parties publish the information.

The second point – the Audit Committee examines the issue and makes a report to the Supervisory Board. Based on the Audit Committee's report results, the Supervisory Board may invite these state auditors and ask them to make a presentation of the findings. To clarify the Supervisory Board, this is a discrepancy in shareholder accounting approaches and methodologies, or something severe. And the management should be able to defend its position. And after all points of view have been expressed, each member of the Supervisory Board must make and make public his decision: whether he or she considers the management's position to be correct, agree with state auditors' conclusions, or express their separate opinion.

- But Naftogaz is a state company. They could not help knowing that a state audit could come to them and would check them according to their standards. Why not make, for example, Ukrainian and international versions at the same time?

- I would not distinguish between Ukrainian and international options. IFRS accounting is standard. But there are certain nuances that are required by the Ministry of Economy and the Ministry of Finance, the rules of taxation. Why they did not consider this point, I do not know - here is the question of coordinating the work of the financial and accounting services, taking into account certain peculiarities of taxation when preparing an accounting policy. For example, the next problem could be separate gas metering for JI purposes. On May 1, the PSO regime for district heating companies may end, and by this time, NJSC should sell to district heating companies all the gas purchased as PSO gas with the corresponding tax features. If this does not happen, then, as far as I understand the legislation, the NJSC will not have the right to sell this gas on the free market since the rent for this gas production was paid to the GWL at a separate rate.

If we talk about the losses that the NJSC declared for 6 months, these losses are probably objective. But before the publication of the semi-annual report, it was possible to submit some information about the impending accrual of the debt reserve and the possible consequences, to prepare the public for the fact that the result would be negative. Showing such losses at once, without some informational preparation, is a little shocking to all stakeholders.

To what extent can the initiation of a criminal case on charges of treason against Naftogaz's leadership be connected with these events?

 - Opening a criminal case in Ukraine is a formal procedure for any inspection act that exceeds 1 million hryvnia. I would not consider it as a separate part of the verification procedure.

The company attracts a lot of interest – every citizen of Ukraine is its shareholder. Naturally, everyone is interested in what is happening there, so information is important. And when the reserves were accrued, these postings were made, probably it would be possible to give press releases in which to say: look, gas is taken from us, but we cannot receive payment for it, this is a government decision that we must supply gas without the hope of getting money, and the consequences will be such and such. And this is all the money that will be displayed in the financial statements with a minus sign. And then the expectations of the shareholder would probably be different.

- One of the consequences of the publication of the audit results, the NJSC called the failed bond issue...

- Raising debt capital, including the issue of bonds for mining companies, is a hazardous undertaking. It is possible to attract debt capital to finance infrastructure projects with minimal risks and a clear economy. Issuing bonds to replenish working capital or finance exploration drilling is extremely risky. Mining companies use such an expensive tool only in very extreme cases. For the same JKX, bond redemption has been one of the biggest and most dangerous problems and a brake on development over the past 4 years. So mining companies need to plan to finance high-risk drilling and exploration projects only with their own funds or with shareholders' funds, but not borrowed capital.

UKRGAZVYDOBUVANNYA

- For the last six months, the phrase "dropped the production" sounds very often. Naftogaz, in turn, claims that the indicators have been kept. So dropped or not?

- Here, it is necessary to define prey. Previously, everyone looked at the so-called gross production, which included the volume of gas produced and sold for money and the volume of gas consumed internally and was calculated, rather than counted by meters. Favorov's team managed to convince the NJSC to make a collective decision and now only the volume of gas that is sold is being monitored - commercial gas. Of course, it is smaller in volume than gross. From what I saw and see, it cannot be said that commercial gas production has dropped sharply. It is within natural fall, plus extra loot. But the deposits are depleted and the curve is going down. And there will be no miracle. The probability of discovering large new deposits in Ukraine is practically zero. Therefore, every effort should be made to optimize the development of existing reserves.

- Does the new project in Lviv region fit into this strategy?

- This is a production intensification project with the Romanian company Expert Petroleum. The field is given to a private investor and he, at his own peril and risk, can invest in the intensification of production. If he succeeds, UGV pays him certain bonuses for this gas. And if it doesn't work out, the investor will lose his money.

- Why is the Lviv region so attractive that the investor went there?

- Probably, it is the least attractive for Ukrgazvydobuvannya. There is minimal production there, and these fields and production volumes were not serious for the GWL. Therefore, they were given to the investor, maybe something will work out. The investor has a huge advantage: he can make purchases very quickly, almost instantly, and apply new technologies. And the UGV must go through Prozorro, through all competitions, and this is insanely long.

I have had situations in private companies when 72 hours passed from order to delivery to the site. At the UGV, subject to all procedures, it takes six months. And oil and gas technology sometimes requires instant decisions and actions.

Readers write to us that local residents are unhappy with this project; they are afraid that their houses will go underground due to the use of hydraulic fracturing technology.

- I do not think that hydraulic fracturing will be the main instrument for intensifying production there. If the geological structure suggests an increase in production using hydraulic fracturing, then the GWL would do this. Expert Petroleum has enough qualified specialists to avoid problems. UGV is a licensee; therefore, it bears responsibility in any case. I do not think that any mining company-licensee would support any work that may pose any threat to the environment. It's more a matter of emotions.

- How do you feel about the opinion that the UGV is going bankrupt on purpose? The company is not released on the stock exchange, and Naftogaz, striving to conquer the population's supply market, buys gas at the lowest price...

- I would not say that the UGV is bankrupt. From what I now read in the press, it is decided that not all UGV projects will have a positive economy, and other goals are being set. But this means that there must be some external, non-returnable source of funding. And for me this is rather strange, because there is simply no such source in business. Nobody is ready to just give money and get something in return.

And with regards to gas prices - a good question. If UGV and Ukrnafta would fully enter the market with their gas volumes, perhaps the price of gas would be lower in Ukraine. Then it would be a real competitive market. And so the price of gas for the population (UAH 4700/thousand cubic meters excluding VAT, excluding transportation – ed.) was lower than the price for the PSO of the same NJSC for heat and power in October (UAH 5374.1/thousand cubic meters), excluding VAT and transportation – ed.). The question arises – what is the market: 4700 or 5374? In general, it would probably be very useful if UGV and Ukrnafta competed with each other both for a gas buyer and for production efficiency. This would be very healthy for the industry.

- Both figures are far from the level of prime cost for gas companies. Last year, when the price was at the level of 5200 hryvnias, gas-producing companies' representatives said they were no longer reaching payback.

- It is not entirely correct to use the concept of prime cost. This is an accounting term. Gas production companies consider the cost of lifting gas - this includes the cost of the license, and the cost of exploration, dry wells, the whole complex of costs that do not always fall on the cost of accounting, but are borne by companies, and sometimes immediately refer to a loss.

The cost of lifting gas in Ukraine ranges from $ 50 to $ 120 per thousand cubic meters. And this does not include rent and VAT. With such a cost, Ukrainian gas producers are beginning to lose to alternative supplies from Qatar and the United States.

And the only way to change the situation is to start fighting to lower this cost. You need to think about how to apply new technologies that are more expensive but can reduce costs per unit of production.

It is necessary to revise the entire process of field development fundamentally, and precisely from the economic point of view, in order for Ukrainian gas to become competitive in price with the world market.

This is a very frustrating task for miners. I received a lot of criticism on my Facebook, and I was told in my face that you want people to reduce their earnings, etc. I say, look, if gas from Qatar, which costs less than $30 on the spot, is transported to Europe, then at the entrance to Ukraine it can cost $120. And in Ukraine, only the cost of the gas itself will be 100, plus 29% of the rent - already 130. And some margin is needed.

In this situation, gas producers and service companies are in the same boat. They both want to survive and want to work. My understanding is that you need to combine orders so that service companies have a clear order plan for the next year, two, three. And with such a plan, they could give lower prices for their work. In turn, the customers very clearly organized the work so that there was no downtime to reduce the cost of gas production.

- Can't it happen that only large foreign service companies will remain in Ukraine, which have their own working capital to update equipment and operate at affordable prices. Ukrainian companies, having no such opportunity, will be forced to leave the market?

- Attraction of any funds is associated with the presence of projects with a positive economy. If there are such projects, then both Ukrainian and international companies will participate in them. And if the projects have a negative economy, then no one wants to participate in this. Although Ukrainian companies may remain, Westerners have certain marginality requirements for profitability, and they will leave. And ours will try to work even in such conditions.

- And, nevertheless, from your point of view, will UGV ever enter the open market? “I would like UGV to become a company with shares listed on one of the leading stock exchanges. This would be useful not only for UGV, but also for other Ukrainian companies if they entered international capital markets and sold their shares there. Markets bring certain work standards, rules, and policies that are very useful for working in a company, both in terms of their openness and the fight against corruption. It would be very cool.

- In what direction is Ukrgazvydobuvannya moving today?

- In my opinion, the UGV is now moving according to the plan laid down in the Trident program. After all, there were not three, but four directions of development. Base "Trident" - this is the existing fields and the optimization of current production. Its main project is the immediate modernization of infrastructure. About 40% of the base production depends on the infrastructure's stability: compressor stations, pipelines. Some of them are in a supercritical condition, and in order not to lose current production, they need immediate replacement and modernization, and this is a serious investment.

To make the right decision, it is necessary to make an independent technical and economic assessment, the so-called feasibility study, which would confirm the correctness of the technical solution, economic parameters and would remove the potential corruption risk when purchasing equipment. After that, the project itself is already underway.

I think my colleagues are doing this, and have already made infrastructure a priority. As far as I know, they are working on this issue very seriously. Concerning Tryzub – one of the directions for superdeep drilling was misinterpreted in the media. Deep drilling is carried out both in Ukrgasvydobuvannya and in private companies.

There are wells 6000 m and deeper; they were drilled and drilled. This is a normal process. However, the program was about considering the prospects for great depths in depleted fields, where production was carried out from depths of up to 4 thousand meters. Such as Shebelinka, in the first place. This technically requires a more serious approach - you will have to drill through the seated pressure. Well 888 is currently being drilled at the Shebelinka field. As for me, this is not even a well drilling project, but research work, which will provide very serious information about the field and suggest how to develop further not only the Shebelinka field, but the rest deposits of the Donetsk-Dniprovska depression region.

The second part of Tryzub is dense gas.This requires more serious capital investments, hydraulic fracturing, and more complex technological approaches. Such gas is usually more expensive to produce because the costs are higher and production is falling faster than usual.

The third direction is the shelf, on which there could be potential deposits. But here, one must understand that offshore production is much more expensive than onshore. And the investment is risky. JKX drilled a well in the Dolphin field in the 1990s and did not receive commercial gas production. Experienced partners should be wisely recruited for such projects.

From what I see in the public domain, colleagues are moving in all these directions, and quite actively, sincerely, I wish them success.

- With regard to the need to update and develop the gas production infrastructure. Today, some experts blame your team for this, claiming that new equipment in such volumes was not needed and that purchases were made in certain oligarchs' interests. And now only the lease of warehouses for storing pipes washes out more than 2 million hryvnias monthly from the company's funds.

- When I came to the UGV, the warehouses had a large amount of leftovers, sometimes very old. Not all of them were effectively used. At the group level, Naftogaz took severe steps to fix this. There were projects that were related to the optimization of balances and proper management. But I don’t remember that something was bought that was simply put in the warehouse and lay there like a dead weight. There was a large purchase of 20 drilling rigs, and almost all of them are working. Whether it should have been done or not is another question. Drilling rigs are purchased when they have a work plan for the next 20 years. Their download may be questionable today. I was taught that a mining company should not buy drilling rigs. It is easier to hire companies that specialize in drilling. But such a decision was made. And these machines are a huge investment that you need to think about how to return, and some of the machines still have to be paid for.

Now it's easy to criticize decisions that were made earlier. But at that time there was an expectation for reserves, expectations for work programs. And machines were purchased under these expectations. The situation has changed, Brent is trading at about $ 40, and the world has the least number of drilling rigs in the past few years.

If we digress from Ukraine, how do global trends affect our gas production industry from your point of view? What awaits it in the near and medium term?

- It is important to clarify that now gas has become a commodity absolutely independent of oil. If earlier gas was historically traded in relation to oil quotations, now oil and gas are separate commodities with different trends.

The world's oil companies agree that the peak in oil consumption has either passed or is passing. And then we will only see a decrease in oil consumption. The oil price is expected to be in the range of $40-60, not higher.

Accordingly, there may be no need to increase production.

But natural gas has become a global product thanks to LNG technology, which allows gas to be liquefied and transported by sea. If earlier, there was nothing without a gas pipeline, Qatar can now safely supply gas to Europe and America and China, India, and Japan. The gas market has become global; it develops according to its own rules. Moreover, the combustion of gas does not lead to serious air pollution.

And if Europe reduces gas consumption under the pressure of green technologies, then India and China will increase it or somehow balance. But you need to understand that the gas price will range from $100 to $200.

In Ukraine, we now have a unique situation when it is possible to bring gas to both Ukraine and from Ukraine to Europe. That is, Ukraine has become part of the European gas market. An important role in this was played by the possibility of storing gas as a customs warehouse in a storage facility. The world has changed, this has already led to the fact that the price of gas in Ukraine will be formed taking into account the reserves in storage facilities in Ukraine, it will no longer always be Hub +, it may be Hub-. If gas is already in Ukraine, and the price is falling, then it is more profitable to sell it to Ukraine than to pay for transportation to Europe and sell it there.

And this also needs to be taken into account by the mining companies. You can't just look at futures in Amsterdam, build a curve, add transportation and say - here's a gas price forecast in Ukraine, it doesn't work that way. The models should be more complex.It is indisputable to take into account futures for the main hubs, but also take into account the cost of transportation to Ukraine, and gas reserves in Ukraine's storage facilities, understanding how much of these reserves can be supplied only in the JI mode until May 1, 2021, the impact of the structure of gas reserves in storage on pricing in the coming months. And we must not forget that gas production in Ukraine is greater than consumption from May to September. That is, there are many risks and mining companies must be very careful with forecasting and modeling.

GAS MARKET

- The open gas market for the population has been operating in Ukraine for the third month. At the same time, government officials continue to make statements "there are no grounds for raising tariffs." Is this political rhetoric, or is there a possibility that "manual control" will return?

- It is essential that this happened. The gas market for the population is up to 10 billion cubic meters of gas per year, which is almost a third of the Ukrainian gas market. A super-competitive struggle has begun, and I really hope that this struggle will result in two things.

The first is that the price of gas for the population, and potentially for the heat and power plant, will be fairly market prices. And the second, that the population will receive a service for gas consumption.

Service is lacking on the market now. I would like it to be possible to pay for gas quickly and simply, so that someone would instantly answer my call to the gas company there, that they quickly checked the meter for me, etc. The fact that competition for the consumer has appeared is a super healthy phenomenon for the economy - competition will be formed both in price and in the quality of the service provided.

 - But Naftogaz has Ukrgasvydobuvannya and it is impossible to compete with it.

- UGV and Ukrnafta can sell all of their gas on the exchange, on a prepayment basis, or using bank payment guarantees. And already Naftogaz or others will buy it and compete for the consumer with the service's help, not just with the price of gas. Without this, it isn't easy to talk about the real market price of gas in Ukraine.

It is important that the population has now become a part of the market, and this market is evolving very quickly; I really hope that in 2021. District heating companies will also join this market.

The logic of the gas market development is that the gas producers must go about their business, produce gas and sell it. And the supplying companies have to buy gas and add a service to it. And due to this, compete for the consumer.

ABOUT THE DIFFERENCE IN APPROACHES AND PHILOSOPHY

- You have worked in private companies for twenty years. And then they decided to come to the state-owned enterprise. Will you take another risk with a state-owned enterprise, or now only in private business?

- What upset me in a large state-owned enterprise is that you very quickly begin first to analyze some political issues, criminal liability, and then talk about business. And I have worked for 20 years in a private company, where it is important to talk about business decisions directly, very quickly, and not worry who it may offend. At the UGV, I supplemented my practical work experience in a large-scale state enterprise, but now I need to recover in business and business thinking.

- But even in private companies, the business philosophy can be different. Both Favorov's team and those who replaced it have decades of work in private foreign companies behind them, but even in the public field, it is clear how different they are.

- I think, yes. The approach that Andrei Mikhailovich and Executive Director Steve Baldwin had is such an absolutely American openness. It was said publicly, it was said openly about the problems, the same commercial gas and the situation with the difference between commercial gas and gross production.

Large companies have a number of internal procedures for any public statement, and these procedures deter employees from commenting. Different people must answer different questions to be answered correctly.

In my opinion, it is necessary to strengthen educational work, to explain certain information to people. Oil and gas production is associated with the population, with the lease of land, with the same hydraulic fracturing. Besides, mining companies, including UGV, are major payers of taxes and dividends. You can tell in simple, accessible language and explain to people that if you or regional gas companies have not paid for gas, this money will not end up in the budget.

Tags: gas, Naftogaz, legislation, Top management, gas production, price

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