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May 11, 2022

Subsoil Use Rights in Ukraine: Exploration & Production Licenses, Production Sharing Agreements and Production Enhancement Contracts

To the list

Iaroslav Cheker,

Counsel

Dmytro Melnik,

Associate

Alina Kriuchkova,

Paralegal

 

Abstract

 

This article provides a detailed description and analysis of existing oil & gas subsoil use mechanisms in Ukraine. Comprehensive characteristic of exploration & production licenses, production sharing agreements and production enhancement contracts with procedures and terms of their receipt/signing (including for investors with foreign capital) is provided, its features, pros and cons are highlighted. In addition, the main legislative initiatives to improve the existing mechanisms of subsoil use designed to solve a significant part of highlighted industry issues are analysed and summarised.

 

Additionally, the article provides a general description of Ukraine's oil and gas industry. Inter alia, production over the past few years based on the reserves statistics, key market players (both with Ukrainian and foreign capital) and technical capabilities of the industry: the gas transmission and oil pipeline systems, capacity of underground gas storage facilities in mainland Ukraine. Special attention is paid to historical aspects of Big Oil activities in Ukraine.

 

Introduction

 

The National War is taking place in Ukraine. The War against the enemy, who has been cynically and insidiously encroaching on Ukrainian lands and its independence for eight years.

 

Footages of the bombing by the Russian militaries of peaceful Ukrainian cities have spread around the world. The European continent has not seen such atrocities since the World War II. Against all the odds, the Defence Forces of Ukraine repulse the enemy's attacks. We do not see any hints of the end of the War, notwithstanding, we are all convinced that the day of the end of Russian aggression will be painted yellow and blue - the colours of the Ukrainian flag.

 

On the day when the War ends, the Great Reconstruction of Ukraine will indisputably commence. The Ukrainian Government is already declaring comprehensive and structural changes in the economy aimed at attracting investors to Ukraine. It is clear to the Ukrainian authorities that the fast recovery of Ukraine requires investment which, in its turn, cannot be attracted without swift and full-scale reforms. That is why we look at the future of Ukraine cautiously, but still with reserved optimism. We are confident that oil and gas production will be one of the key engines for the recovery of the Ukrainian economy.

 

We realise that investments in Ukrainian oil and gas production are impossible nowadays. Nonetheless, we are pretty sure that the investors who decide to invest in Ukraine after the end of the War will make the right choice. In addition to the moral and value aspect to help Ukrainian people cope with the consequences of excessive geopolitical ambitions of the "northern neighbour", such investors may count on significant profits. It appears there are all the prerequisites for this.

 

Ukraine has a long history of hydrocarbon production. At the end of 2021, Ukraine celebrated its own anniversary of the oil and gas industry: 250 years since the beginning of hydrocarbon industrial production. Kerosene lamp was invented in the Ukrainian city of Lviv. At the beginning of the XX century western Ukraine was the third largest region in the world in terms of oil production volumes. In the middle of the last century Ukraine supplied gas to Russia, and other nations. It is a good opportunity to bring up intermediate results of the energy formation of Ukraine, which restored its Independence 30 years ago, and to talk about potential investment opportunities in the field of "blue fuel" and "black gold" of Ukraine in order to increase awareness of foreign audience of Ukrainian upstream sector.

 

Consideration of this topic is also relevant in connection with potential (we hope, future) embargo on Russian hydrocarbons, a trend for refusal of coal and with a role of natural gas as the most environmentally friendly fossil fuel, which the gas might play in relation to this trend.

 

In 2017, the Cabinet of Ministers of Ukraine (hereinafter referred to as the "CMU") adopted the Energy Strategy of Ukraine, which outlined the strategic guidelines for the development of the fuel and energy complex for the period up to 2035. According to the approved strategy, Ukraine is and, in the future, strives to remain one of the largest producers of hydrocarbons in continental Europe and a reliable transit country for energy resources (first of all, natural gas and oil), ensuring reliable and safe supplying for domestic and neighbouring markets. Therefore, we see that production, transit and supply of hydrocarbons, as well as energy sector in general, remain a focus for the Ukrainian authorities.

 

Moreover, achievement of energy independence by Ukraine is one of the most important goals set by the new National Economic Strategy for the period up to 2030. Energy has been remaining one of the priority sectors of Ukraine's economy, which independently forms more than 14% of state's GDP. At the same time, given the available potential of the industry, the corresponding share of energy in Ukraine's GDP can be significantly increased in the short and medium term.

 

Before we proceed to the existing mechanisms of subsoil use in Ukraine, we would like to draw your attention to the Ukrainian oil and gas production in terms of statistics and other characteristics of the industry.

 

Reserves, Production Volumes and Technical Capabilities of Ukraine

 

Reserves

 

According to BP, Ukraine ranks second among European countries in proven gas reserves. Ukrainian gas reserves comprised 1.1 trillion cbm, which is 32% of all natural gas reserves in Europe. Pursuant to the International Energy Agency, gas condensate and oil reserves in Ukraine are estimated at 400 and 850 million tons, respectively.

 

Production Volumes

 

Ukraine consumes approximately 30 billion cbm of gas per annum. About 2/3 of these volumes is covered by domestic production: most of gas in the amount of 13,7 billion cbm is produced by the state company JSC "Ukrgasvydobuvannya" (hereinafter referred to as "UGV"); another part of production in the amount of 6 billion cbm is covered by private sector companies and PJSC "Ukrnafta". The rest of gas is imported from European countries.

 

Technical Capabilities

 

According to the Baker Hughes Rig Count index, in July 2019, in the peak of drilling activity in Europe, when 200 rigs operated in the European countries, almost half of the rigs worked in Ukraine. Even during COVID-19 pandemic period the biggest amount of drilling rigs in Europe has been working in Ukraine (39 rigs as of December 2021).

 

Ukraine really has impressive oil and gas reserves, which in the nearest future might be sufficient to meet not only the country's own needs, but also the needs of neighbouring European markets. As the above figures show, Ukraine has not only large reserves of hydrocarbons, but also the technical ability to increase volumes of produced oil and gas in the short and medium term.

 

Gas Transmission and Oil Pipeline Systems, Gas Storage Facilities and Refineries

 

Gas Storage Facilities

 

Ukraine is a country with tremendous potential for natural gas storage. This is, among other things, an undoubted advantage for ensuring the energy security of the European countries.

 

In addition to the direct function of gas storage, Ukrainian underground gas storage facilities (hereinafter referred to as "UGS") are used to secure transit gas supplies to Western Europe, to cover seasonal fluctuations in consumption in Ukraine and Europe, and to create long-term and operational reserves of natural gas.

 

Ukrainian UGSs are the largest in Europe and the third largest in the world. There are 13 UGSs, located throughout Ukraine (two of them locate in Crimea and certain areas of Luhansk region which are temporarily not controlled by Ukrainian Government), the majority of which were created on the basis of depleted fields. Capacity of Ukrainian UGSs allows storing more than 30 billion cbm of natural gas.

 

Volume of Ukraine's UGSs in the total volume of European gas storages is 21%. One more positive thing is that Ukrainian UGSs are in considerable demand by foreign companies. For example, in 2020, gas reserves created by foreign companies comprised 10 billion cbm, which is four times higher than in 2019.

 

Gas Transmission and Oil Pipeline Systems

 

Ukraine has well-developed gas transmission and oil pipeline systems. Ukraine's gas transmission system (hereinafter referred to as "GTS") is one of the most powerful and extensive networks of main gas pipelines in the world. GTS input capacity is 281 billion cbm/year, output - 146 billion cbm/year.

 

The main oil pipelines system of Ukraine includes 19 oil pipelines with a total length of 3,506.6 km, 28 oil pumping stations and the Pivdennyi Sea Oil Terminal. The capacity of the input system is 114 million tons/year, at the output is 56.3 million tons/year. The total nominal capacity of the tank farms of the main oil pipeline system is 1,083 thousand cbm.

 

Refineries

 

Yet another important feature for Ukrainian oil and gas industry characteristic is the refinery industry, and more precisely, available operating oil refineries in the country.

 

Production of Euro-5 light oil products in Ukraine is carried out by: Kremenchuk Oil Refinery Plant (PJSC "Ukrtatnafta", Poltava Region), Shebelynskii Gas Refinery Plant (UGV, Kharkiv Region) and small refineries - up to 15 plants of different capacity. These plants produce fuel for carburettor (aviation and motor gasoline), jet (aviation kerosene), diesel (diesel fuel) engines, boiler fuel (fuel oil), motor oils, various bitumen, paraffin, coke for the electrode industry, lubricants, etc.

 

Although Kremenchuk Oil Refinery Plant was attacked by Russian missiles, there are also 5 other large refineries in Ukraine; unfortunately, for various reasons, the relevant plants are not currently operating.

 

Investment Climate and Key Market Players

 

Foreign companies started actively investing in Ukrainian extraction industry in the 1990s. Oil and gas were identified as the most attractive objects for investment at that time. Today, hydrocarbons remain one of the most attractive and invested sectors of the extractive industry in Ukraine. It resulted in attracting many players with both domestic and foreign capital.

 

At present, a large number of companies with foreign capital operate in Ukrainian oil & gas production market, including the following:

 

  • Cadogan Petroleum – a British independent oil and gas extraction company with assets in Ukraine since 2006. Currently, the company is engaged in geological study, development and production of hydrocarbons in Lviv region, Western Ukraine. Over 11 years of operation, Cadogan Petroleum has invested about UAH 4 billion (circa USD 146,5 million) in Ukraine.
    • JV Poltava Petroleum Company (JV PPC) – a joint Ukrainian-British venture, successful investment project in Ukrainian oil and gas industry. It was established in 1994. The owner of JV PPC is the British oil and gas company JKX Oil & Gas PLC. JV PPC holds six production licences in Poltava region (central Ukraine).
    • Smart Energy – is a group of companies, one of five leading independent gas producers in Ukraine. The group is represented by British company Enwell Energy plc. owning assets in Poltava and Kharkiv regions (central and eastern Ukraine). Since 2014 Smart Energy group companies have allocated almost UAH 6 billion (circa USD 219,7 million) in taxes to state and municipal budgets and allocated almost UAH 3,3 million (circa USD 121,000) in social investments only in 2019. In 2021, Smart Energy group companies paid a total of UAH 2,2 billion in taxes, which is almost two and a half times more than in 2020 (UAH 948.0 million).

     

    Ukrainian leaders of the oil and gas industry are the following:

     

    • UGV is a 100% subsidiary of National Joint Stock Company "Naftogaz of Ukraine" (hereinafter referred to as "Naftogaz of Ukraine") and one of the largest gas production companies in Central and Eastern Europe. The company specializes in the production of natural gas and gas condensate and produces about 2/3 of the total volume of Ukrainian "blue fuel". UGV has hundreds of exploration and production licenses in central, eastern and western Ukraine, Shebelynskii gas refinery plant and signed several production sharing agreements with the State of Ukraine;
    • DTEK Oil&Gas is a subsidiary of DTEK, the largest private energy holding in Ukraine. Proven natural gas reserves of DTEK Oil&Gas fields amount to over 30 billion cbm;

Esco-Pivnich LLC is a private gas company with seven exploration and production licenses in Ukraine;

  • Kub-Gas LLC - is a private gas production company founded in 2000. The company conducts geological study, development and production of hydrocarbons in five licensed areas;
  • MC Ukrnaftoburinnya PrJSC is one of the largest private gas production companies in Ukraine. The company produces natural gas, gas condensate and oil. The company operates 28 gas condensate and oil & gas wells;
  • Zakhidadarservice – group of companies, established in 2014. Zakhidadarservice is engaged in exploration, drilling and oil & gas production in western Ukraine. Total daily production of natural gas within the group is 700 thousand cbm and annual production of 204 million cbm. The group discovered 10 gas and one oil field, drilled 56 wells, among them 44 productive wells are arranged and put into operation, five gas preparation plants and one oil collection and preparation station were built, more than 110 km of gas pipelines were laid, 16 successful overhauls of wells were made;
  • The Geo Alliance Group – is one of the largest producers of gas and gas condensate in Ukraine. In 2020, the group produced 203 million cbm of natural gas and 32,000 tons of oil and condensate; and others.

 

Before start of the war, Ukrainian companies had been actively increasing their capacity and opening new horizons for cooperation with world leaders in the oil and gas market. We do hope that relevant tendency will resume after Ukrainian Victory.

 

In October 2021, the largest Ukrainian energy company, Naftogaz of Ukraine signed memoranda of understanding with foreign companies, which formed the basis for future partnerships within new strategic projects like development of Black Sea areas and tight gas deposits, increasing the efficiency of production in depleted fields, etc. These memoranda were signed with Dragon Oil (UАЕ), SOCAR AQS (Azerbaijan), Helmerich & Payne, Inc. (“H&P”) and with Seas Energy (USA).

 

Both Ukrainian and foreign companies believed in the prospects of Ukrainian oil and gas production. During the first 9 months of 2021, significant capital investments were attracted in the field of crude oil and gas production, amounting to circa UAH 12.7 billion (circa USD 465 million). Investments in the provision of ancillary services in oil and gas production for the relevant period amounted to UAH 218 million (circa USD 8 million), gas supply (including electricity, steam and air conditioning supply) - UAH 26.2 billion (circa 960 million USD), gas production and gaseous fuels distribution – 1.4 billion UAH (circa 51 million USD).

 

Unfortunately, oil and gas production is not growing as fast as Ukrainians would like it to. There are several reasons for this, in particular:

 

1)   Aggression of the Russian federation towards Ukraine, which made impossible to explore and produce significant oil and gas deposits on the Crimean shelf, as well as threats to the stable operation of oil and gas companies in the east of Ukraine and the part of the shelf under the control of Ukrainian state;

1)   Insufficient efforts of Ukrainian authorities to improve the investment climate: incomplete judicial reform, the need to further ensure the protection of property rights together with stability and independence of anti-corruption bodies' work, etc.;

2)   Depletion of existing fields, insufficient investment in exploration of new oil and gas deposits;

3)   Necessity to attract new advanced technologies, etc.

 

Notwithstanding that, Ukraine takes steps to improve the investment climate: a new stage of judicial reform was launched, improvement of extractive legislation is on the march (set out below), cooperation with the International Monetary Fund is ongoing, and so on.

 

Oil & Gas Trading Platform

 

One more positive characteristic of the Ukrainian oil and gas market is the availability of exchange platforms that provide electronic trading in many Ukrainian energy resources, including oil and gas.

 

The Ukrainian Energy Exchange (hereinafter referred to as "UEEX") is the most popular. It was established in 2010 with the aim of creating a reliable, transparent and efficient mechanism for market trade in energy resources in Ukraine and the formation of national benchmarks.

 

According to the Energy Club, over the past three years, more than 25,000 deals, with total sales of more than UAH 65 billion (circa 2,3 billion USD) have been concluded on the UEEX. Currently, there are more than 900 companies that wholesale energy resources on the UEEX. There are small market participants, big international production companies, large global traders and state-owned enterprises among them.

 

Nowadays, UEEX is a centre of organised trade in energy resources, which continues to operate stably even in war conditions, attracting more and more new entrants from around the world.

 

To summarise the above, considering significant hydrocarbons reserves, production volumes and technical capabilities, transmission, storage and refinery infrastructure, various market players and availability of quite-developed energy trading platforms, we see rather good prospects in attracting new investments and market players in Ukrainian oil and gas sector right after the war is ended.

 

Mechanisms for Obtaining the Subsoil use Right in Ukraine

 

As of now, Ukrainian state offers several mechanisms for obtaining the right to use oil and gas subsoil, which we suggest to review in more detail:

 

1)      Exploration & Production license (hereinafter referred to as "E&P license").

2)      Production sharing agreements (hereinafter referred to as "PSA").

3)      Production enhancement contracts (hereinafter referred to as "PEC").

 

E&P license

 

E&P license is a document which is issued by State Geologic and Subsoil Survey of Ukraine (hereinafter referred to as "Ukrainian Geological Survey") and grant a right to use oil and gas subsoil during the time, within the subsoil area and under conditions provided for in the license.

 

As of February 2022, there are 586 valid E&P licenses issued for the oil and gas subsoil use. In particular, in 2021 Naftogaz of Ukraine obtained more than 30 combined E&P licenses for work on the Black Sea offshore area controlled by Ukrainian Government.

 

An E&P license has the following features:

 

1)      It can be issued to both Ukrainian and foreign companies.

2)      There are several types of E&P licenses, which are issued for different periods depending on the method of subsoil use and type of natural resources. There are the following oil and gas E&P licenses:

 

  • for geological study and pilot development, provided for 5 years (on the shelf – for 10 years);
  • for oil and gas production, provided for 20 years (on the shelf – for 30 years);
  • combined license: for geological study and oil and gas production, provided for 20 years (on the shelf – for 30 years);
  • for the construction and operation of underground oil or gas storage facilities, provided for 50 years.

 

3)      Area for geological study of oil and gas subsoil cannot exceed 500 square km (sq. km), and for the Black Sea area cannot exceed 1000 sq. km.

4)      It is impossible to sell or to pledge E&P license. Mainly, transfer of E&P license is carried out by selling a company owning the license.

5)      Generally, the license is issued via an electronic online auction.

6)      It is possible to return E&P license in case of obtaining the negative environmental impact assessment conclusion (which makes it impossible to produce oil & gas on a relevant area). In that case, E&P license price and other related payments shall be returned to a company.

 

It is worth to add that some temporary changes in the approaches to the calculation of rent rates for gas production were introduced.

 

From 1 March 2022, when calculating the sale price of natural gas for rent rate calculation purposes, the arithmetic mean of gas prices for the reporting month on the Dutch gas hub (TTF) will also be taken into account, and the rent rate will depend on the gas sale price for the respective period.

 

For example, if the gas was extracted from the new wells at a depth of more than 5,000 meters, the rent rate will be 3.00 % (gas price is USD 150 per 1000 m3 or less), 6.00% (gas price is more than USD 150 and not more than USD 400) and if the price is more than USD 400 - 6.00% of the actual gas price of USD 400 and 18.00 % of the actual sale price of gas exceeding USD 400 per 1000 m3.

 

Notwithstanding that the state leaves in effect the reduced rent rates for the new wells, new rent rates are higher than previous rates. Considering that Ukraine needs to support its economy and military expenses during incessant Russian attacks, this step seems unpleasant but necessary for state budget.

 

At the same time, the abovementioned rent rates will be effective only during the martial law period. We think that after the war is finished relevant rent rates will be diminished.

 

In addition, a stabilisation clause on rent rates regulation until 2032 is established. It means that the corresponding rent rates cannot be abolished, increased, or revised for ten years (but can be reduced).

 

We will also describe the mechanism for obtaining E&P license in more detail: we believe that it is a competitive advantage of Ukraine in comparison with other countries from the "oil and gas club".

 

Starting from October 2020, Ukraine introduced a new, more efficient, and transparent procedure for obtaining E&P license via online auctions in electronic bidding system "Prozorro.Sales". It differs a lot from the previous bidding model – thus, auction organizing and conducting procedure is precisely regulated, a human factor is minimised, the procedure is transparent and competitive, no participant has an advantage over other participants, everyone has an opportunity to follow the auction online.

 

An investor who would like to obtain an E&P license can initiate an auction for the desired area on his own before Ukrainian Geological Survey. To do so, an investor should submit an application and additional materials to the Survey. To enable such initiation, Ukrainian Geological Survey created Atlas of Investment Opportunities. The Atlas includes a plethora of promising areas of natural resources offered for sale via electronic auctions.

 

The following features of the procedure for obtaining E&P license should be noted:

 

1)      An auction for E&P licenses sale is conducted within 90 calendar days from the date of its announcement.

2)      Foreign companies can participate in auctions on its own, without establishing a subsidiary or representative office in Ukraine.

3)      A guarantee fee for participation in the auction is 20% of the initial price of E&P license. Fee must be paid by a participant before the auction day.

4)      The auction is conducted in an electronic bidding system in three rounds in interactive real-time manner.

5)      A winner of the auction signs a sale-purchase agreement of E&P license (SPA).

6)      If a foreign company with no representative office in Ukraine wins the auction, such company is obliged to register its own representative office in Ukraine within four months from the SPA signing date (condition precedent).

7)      Issuance of E&P license is carried out within 30 working days in accordance with the SPA terms (in case of concluding of SPA with condition precedent – within 30 calendar days from the date of its occurrence).

8)      In case E&P license is not sold, it is proposed for a repeated auction with discount. Initial price of a repeated auction lot is 50 percent of initial price of this lot.

 

Although the mechanism of electronic online auction for E&P license was introduced recently, we can already confirm its effectiveness. From 2019 to 2021, 27 oil and gas E&P licenses for the amount of more than UAH 1,55 billion (circa USD 56,7 million) were sold in Ukraine.

 

It should be also noted that in Ukraine there is no fee for "dormant" licenses, i.e., the licenses under which oil and gas are not produced in the relevant subsoil area. The introduction of such a fee has been discussed for the last few years; however, the Ukrainian parliament is not currently considering passing the relevant laws.

 

In 2018, the State estimated quantity of "dormant" E&P licenses in the amount of 158 licenses.

 

It should be said that Ukrainian legislation prescribes instruments that enable Ukrainian Geological Survey to fight against unfair subsoil users who do not produce oil and gas production without reasonable grounds.

 

Ukrainian Geological Survey has the right to suspend and revoke E&P license. Ukrainian Geological Survey has a right to suspend E&P license validity exclusively upon the results of conducted audit on its own initiative or at the request of the state mining and technical, environmental and sanitary control bodies and municipal authorities in the case of:

  • violation by subsoil user or its contractor of the terms of E&P license or agreements on the oil and gas subsoil use conditions.
  • endangering the life or health of subsoil user's employees or other people.
  • repeated violations of legislation on environmental protection and rational use of oil and gas subsoil.
    • performance of the works not stipulated by E&P license, except for searching and exploration of new oil and gas deposits within the plot.

 

E&P license revocation is carried out in court, inter alia, in the following cases:

 

  • withdrawal of oil and gas subsoil area provided for use;
  • recognition of E&P license as invalid;
  • suspension of the license and failure of a subsoil user to eliminate the grounds for said suspension;
  • if subsoil user has not started without reasonable grounds subsoil using within 180 calendar days from the date of start of E&P license validity;
  • misuse of oil and gas subsoil.

 

If a subsoil user refuses from E&P license or the subsoil user company is liquidated, Ukrainian Geological Survey revokes the license extrajudicially.

 

The Ukrainian government pays sufficient attention to the efficient subsoil use. For example, in March 2021, President Volodymyr Zelenskyy of Ukraine enacted the decision of the National Security and Defense Council of Ukraine (hereinafter referred to as "NSDC") "On the state of affairs in subsoil use sphere". By the relevant decision, Ukrainian Geological Survey was instructed to conduct unscheduled audits of some extracting companies, which, inter alia:

 

1)      obtained E&P license without of the auction;

2)      have E&P license for oil and gas production, but have not started production within two years after obtaining the license;

3)      have combined license and have not started production within two years after the approval of hydrocarbon balance reserves;

4)      have not started production within 10 years after the obtaining of combined license.

 

In 2021 Ukrainian Geological Survey revoked 38 oil & gas E&P licenses.

 

According to another NSDC decision enacted by the President of Ukraine in July 2021, CMU was instructed to prepare a draft law, which will expand the Ukrainian Geological Survey's powers in terms of extrajudicial suspension and revocation of E&P licenses. The Ukrainian Geological Survey should have such powers in the following cases:

1)      The E&P license was obtained out of auction, based on the results of approbation of mineral resources reserves without the E&P license.

2)      Oil and gas subsoil user has not started using oil and gas subsoil within 180 calendar days without reasonable grounds.

3)      Oil and gas subsoil user within 180 calendar days did not take measures to eliminate the reasons of E&P license suspension.

4)      Subsoil use causes poisoning, radiation damage, persistent loss of working capacity, disability or death of people.

5)      Subsoil use is carried out using methods and techniques that lead to significant environmental pollution or caused negative consequences for the environment.

 

As far as we know, such a draft law has not been submitted to Ukrainian parliament yet. We have doubts that such a draft law will be considered by the parliament even after the war is ended.

 

PSA

 

The next mechanism for obtaining of the subsoil use right in Ukraine is PSA.

 

PSA is an agreement under which the state authorises an investor for a specified period to search, explore and produce minerals (including oil and gas), and an investor undertakes to perform the works at its own expense and risk.

 

An investor is entitled to compensate for the costs related to PSA at the expense of part of extracted products ("cost petroleum"). A share of cost petroleum cannot exceed 70% of the total production output until full compensation of investor's costs.

 

The rest of the products ("profit petroleum") are distributed between the investor and the state in a manner prescribed by the PSA.

 

Until recently, the PSA mechanism was not popular in Ukraine. Four PSAs for Ukrainian oil and gas production were concluded until 2020:

 

  • PSA with Vanco International Limited for the Prykerchenska area was signed on 19 October 2007 (Crimea shelf of the Black Sea). The PSA was terminated in May 2008; however, this decision was cancelled later;
  • PSA with ENI Ukraine Shallow Waters B.V., EDF Shallow Waters SAS, Waters of Ukraine LLC, JSC NJSC Chornomornaftogaz for the Subbotina, Abiha, Mayachna and Kavkazka areas (Crimea shelf of Black Sea) was signed on 27 November 2013. The project's investment was estimated at USD 4 billion;
    • PSA with Shell Exploration and Production Ukraine Investments IV B.V. and Nadra Yuzivska LLC for the Yuzivska area (eastern Ukraine) was signed on 24 January 2013. The amount of investment planned to be attracted was estimated at USD 10 billion;
    • PSA with Chevron Ukraine B.V., Nadra Oleska LLC for the Oleska area (western Ukraine), signed on 5 November 2013. The amount of potential investment was also estimated at USD 10 billion.

     

    Signing of the PSA for the hydrocarbons production in the Black Sea shelf at the Scythian area with a consortium led by Exxon Mobil was also scheduled in 2013. According to the Minister of Energy of Ukraine, industrial production by 2017 should have reached 8-10 billion cbm of gas per year.

     

    Unfortunately, for various reasons (mainly due to the temporary occupation of the Crimean Peninsula and military aggression in eastern Ukraine by the Russian federation), hydrocarbon production in the relevant areas has not started. Nevertheless, attempts to revive some of the above-mentioned projects have been made.

     

    In December 2020 Naftogaz of Ukraine became the beneficiary of the Yuzivska area project. In 2021 the company was entitled to develop the Scythian area in the Black Sea shelf and has already started the exploration.

 

As for Oleska area in western Ukraine, the Ukrainian government is actively looking for interested investor to join the project. The block has a large area, more than 6 thousand km, and significant prospective resources:

 

  • conventional hydrocarbons -27.0 billion cbm;
  • shale gas -1.6 trillion cbm;
  • tight gas -1.4 trillion cbm.

 

We are pleased to note that the PSA mechanism recently got a second wind: about ten new agreements were signed. On 31 December 2020 seven PSAs for the development of oil and gas fields with a total square of over 10,000 sq. km and a minimum investment of about USD 400 million were signed. Both national and foreign companies concluded such agreements with the State of Ukraine for a period of 50 years:

 

1)   State company UGV (Naftogaz Group):

  • Balakliiska area (eastern Ukraine):
    • square: 1119,25 sq. km (larger than Hong Kong area);
    • minimum investment – UAH 800 million (circa USD 29,3 million);
    • drilling of at least 2 exploration wells;
    • 3D seismic.
  • Ivanivska area (eastern Ukraine):
    • square 841,61 sq. km (larger than the area of Madeira)
    • minimum investment – UAH 800 million (USD 29,3 million).
    • drilling of at least 2 exploration wells;
    • 3D seismic.
  • Buzivska area (central-eastern Ukraine):
    • square: 669,65 sq. km (slightly smaller than the area of Singapore)
    • minimum investment – UAH 600 million (USD 21,9 million);
    • drilling of at least 2 exploration wells;
    • 3D seismic.
  • Berestianska area (western Ukraine):
    • square: 286,38 sq. km (slightly smaller than the area of the Maldives)
    • minimum investment – UAH 450 million (USD 16,4 million);
    • drilling of at least 2 exploration wells;
    • 3D seismic.

 

The Canadian company Vermilion Energy took part in tenders for the first two PSA projects together with UGV. However, the Canadian company refused to enter into the PSAs due to economic downturn, the coronavirus pandemic and significant reduction in oil and gas prices compared to 2019.

 

1)   Ukrainian Geo Allianсе Рartnership LLC and Geo Allianсе Рartnership B.V.– Sofiivska area (north-central Ukraine):

  • square 2 715,95 sq. km (larger than the area of Luxembourg);
  • minimum investment – UAH 1 billion (USD 36,6 million);
  • drilling of at least 3 exploration wells;
  • 3D seismic on the area of at least 500 sq. km.

2)   Ukrainian WELL СO LLC – Uhnivska area (western Ukraine):

  • square 967,44 sq. km (larger than joint area of the Granitic Seychelles and Barbados);
  • minimum investment – UAH 600 million (USD 21,9 million);
  • drilling of at least 3 exploration wells;
  • 3D seismic.

3)   Oil & Gas Overseas Trading B.V (Netherlands) and Oil and Gas Exploitation LLC

– Zinkivska area (north-central Ukraine):

  • square 571,4 sq. km (the area of the Isle of Man);
  • minimum investment – UAH 500 million (USD 18,3 million);
  • drilling of at least 2 exploration wells;
  • 3D seismic.

 

On 13 January 2021, PSA with American Aspect Energy was signed. The company became the first US PSA investor after Chevron left Ukraine in 2014. The agreement was concluded for a period of 50 years for the Varvynska area (north-central region of Ukraine):

 

  • square – about 3 471 sq. km (larger than the area of Samoa);
  • minimum investment – UAH 1 billion (USD 36,6 million);
  • drilling of at least 3 exploration wells;
  • 3D seismic on the area of at least 500 sq. km.

 

On 8 November 2021, two PSAs were signed with energy holding EP Holding for the development of the Grunivska and Okhtyrska areas (north-eastern Ukraine):

  • square – 1750 sq. km (larger than the area of Guadeloupe);
  • minimum investment – UAH 1,6 billion (USD 58,6 million);
  • drilling of at least 18 exploration wells;
  • 3D seismic on the area of at least 500 sq. km.

 

PSA with the British York Energy (Alpha Energy Group) for the development of the Ichnianska area (northern Ukraine) is expected to be signed:

 

  • square– 2086 sq. km (slightly smaller than the area of the Comoros);
  • minimum investment – UAH 900 million (USD 32,9 million);
  • drilling of at least 3 exploration wells;
  • 3D seismic on the area of at least 500 sq. km.
  • Consequently, we see that the PSA mechanism is actively used in Ukrainian oil and gas production these days.

 

The procedure for concluding PSA covers the following steps:

 

1)      Decision to hold an auction. It is made by CMU on the proposal of the Interagency Commission on Organization of Signing and Execution of PSAs (hereinafter referred to as the "Interagency Commission"). Relevant decision indicates terms and conditions of the auction, PSA area, minimum investment, tender documentation list, participation fee, etc.;

2)      Auction announcement. It is conducted by the Interagency Commission within two months from CMU decision date. The announcement prescribes more technical information: address for applications submitting, bank details for participation fee payment and list documents to be submitted;

3)      Submission of applications. The term for submission is indicated in CMU decision and cannot be less than one month;

4)      Review and evaluation of applications. It is carried out by the Interagency Commission according to a list of criteria, including the most effective work program, the most attractive investment conditions, sufficient financial security and international experience, etc.;

5)      Interagency Commission prepares and submits conclusion to CMU;

6)      CMU determines a winner. The stages 4-6 could not last more than three months;

7)      Announcement of the results;

8)      Conclusion of the PSA. The parties have 12 months to conclude the agreement; this term could be prolonged for 6 months at the request of investor.

 

Below we enumerate the main aspects of the PSA mechanism in Ukraine:

 

1)      The process of competition holding and PSA concluding is administrated by a special body mentioned above, the Interagency Commission. The commission consists of representatives of state authorities (the Ministry of Energy, the Ministry of Economy, the Ukrainian Geological Survey, State Tax Service, etc.), municipal authorities and Ukrainian MPs.

2)      If a foreign investor is a PSA party, the investor must register its representative office in Ukraine within three months from the PSA concluding date.

3)      As a general rule, the PSA draft is prepared by an investor.

4)      A list of essential conditions that must be regulated in the PSA is determined by law. The list includes provisions that apply to all PSAs (not just oil and gas) and as well as those related to PSAs in the sphere of hydrocarbons and deposits with significant mineral reserves.

 

General conditions, which must be provided in any PSA include the following:

 

  • names of the parties of the agreement and its details;
  • characteristics of the subsoil area (mineral deposits), including geographical coordinates and restrictions on the depth of industrial development of subsoil;
  • land granting conditions and land recultivation project;
  • types of subsoil use; list, volumes and terms of works performance; quality work requirements;
  • rights and obligations of the parties;
  • obligations of an investor on giving preferences to the products, goods, works, services of Ukrainian origin (under equal conditions in terms of price, term of performance, quality, compliance with international standards) and hiring predominantly Ukrainians as the workers to perform works under PSA in Ukraine;
  • the procedure for determining the value of produced minerals;
  • rent payment procedure;
  • conditions for determining the volume of cost petroleum;
  • a list of costs to be compensated by cost petroleum;
  • a procedure and conditions of the profit petroleum distribution between the state and an investor;
  • a procedure for transferring of property ownership from an investor to the state;
  • PSA implementation monitoring procedure;
  • obligations of the parties under the agreement;
  • dispute resolution procedure, etc.

 

The special conditions that must be provided in the PSA in the sphere of hydrocarbons and deposits with significant mineral reserves include:

 

  • a procedure for the use of geological, geophysical and other information;
  • the procedure and peculiarities of cost accounting for industrial and technological needs;
  • a procedure and terms of assessment of the level of land plot environmental pollution at the moment of PSA concluding;
  • a scope and timing of environmental protection activities;
  • a procedure for coordination and approval of work programs;
  • conditions of property risk insurance, etc.

 

5)      The maximum PSA validity term is 50 years. The term can be extended at investor's request.

1)      Special rules for termination of PSA. The agreement can be terminated:

 

1)      In cases provided by the PSA;

2)      By the state, if an investor does not begin implementing the agreement within the prescribed timeframe;

3)      By CMU, in the event of an imminent threat to the human lives and health or the environment (it could be decided to restrict or temporarily prohibit the subsoil use without terminating the agreement);

4)      By CMU, if based on the results of a conducted complex audit significant violations of the terms of the agreement were identified.

2)      The maximum square of the area provided to an investor is not limited by law.

3)      The rent rate for oil and condensate is 2%, for natural gas - 1.25%.

4)      Stabilisation clause: guarantees for the stability of legislation (is not applicable only to changes in defence, national security, public order ensuring and environmental protection legislation).

5)      Possibility of disputes settlement in arbitration.

6)      Possibility of waiving the state's immunity.

7)      Currency restrictions do not apply to an investor.

8)      Simplified procedure for equipment importing, etc.

 

To summarise, we see that an investor under PSA could obtain more guarantees from the state than under E&P license. On the other hand, the procedure for buying the E&P license is faster and simpler in comparison with the PSA concluding mechanism.

 

Improvement of legislation

 

Ukraine strives to improve subsoil use legislation by implementing the best international standards. This position of the state in law-making is traced through the prism of the draft laws submitted for consideration to the Ukrainian parliament or developed in the professional environment and proposed to be submitted to the parliament.

 

We would like to highlight the following three legal drafts:

 

1)      New Subsoil Code of Ukraine.

2)      The Draft law No. 4187.

3)      The Draft law No. 4344.

 

New Subsoil Code of Ukraine

 

This is a comprehensive document designed to implement into Ukrainian legal system the provisions of European Union law, especially the Directive 94/22/EC of the European Parliament and of the Council on the conditions for granting and using authorizations for the prospection, exploration and production of hydrocarbons.

 

The draft of the New Subsoil Code was developed by the working group at the Ministry of Ecology and Natural Resources of Ukraine together with a team of the project “New Subsoil Code of Ukraine” funded by the European Union and implemented by the Consortium of experts Projekt-Consult (Germany), MinPol (Austria) and Better Regulation Delivery Office BRDO (Ukraine).

 

Currently, the legal framework for subsoil use in Ukraine is represented by a large number of regulations. Sometimes, the provisions of such regulations do not correspond to each other or even contradict each other.

 

The New Code should become the sole unified legal act that will regulate the subsoil use in Ukraine. In case of adoption of the new Subsoil Code of Ukraine, current Subsoil Code of Ukraine, the Law of Ukraine "On Oil and Gas", the Law of Ukraine "On Production Sharing Agreements", etc. will become invalid.

 

Among the other things, the draft of new Subsoil Code of Ukraine provides for the following changes:

 

1)      Introduction of a fee for "dormant" licenses;

2)      Deregulation (cancellation of agreement on the terms of the subsoil area use, etc.);

3)      Possibility of alienation of rights under the E&P license (sale, pledge, contribution to the share capital, etc.);

4)      Exemption from participation in the auction for the sale of E&P license for areas located near the enterprise;

5)      Lifting of import duties on new equipment and its components;

6)      Incentives for subsoil users who reinvest in production development and / or implement leading modern technologies;

7)      To encourage companies to purchase Ukrainian mineral raw materials, it is planned to establish the State Credit and Insurance Agency;

8)      Introduction of a land reservation mechanism, etc.

 

The draft of new Subsoil Code is yet to be submitted to the Ukrainian Parliament.

 

The Draft Law No.4187

 

The main purpose of the draft law is to create a transparent, convenient and understandable system of subsoil use, to reduce excessive state influence on the industry, as well as to increase competition and legalise relations in subsoil use sphere. This document, inter alia, introduces the following amendments:

1)      individuals and companies subject to sanctions cannot be subsoil users (in case with companies - also if their beneficiaries are subject to sanctions);

2)      subsoil use unified information system will be created. Its data will be displayed on the web portal "Interactive map of subsoil use and geology of Ukraine". In addition to the existing functionality (for example, providing access to the state register of E&P licenses), the system will provide convenient online access to information on subsoil areas offered under E&P licenses or PSA terms; protocols of State Commission of Ukraine on Mineral Resources (SCMR) on conducting of state expertise and assessment of mineral reserves; geological information catalogue, etc.;

3)      improvement of the procedure for initiating an E&P license auction;

4)      cancellation of the E&P license for geological study and pilot development;

5)      an exhaustive list of the grounds of the E&P license granting out of the auction procedure is determined by law;

6)      Possibility to use E&P license as collateral or otherwise alienate the rights under the E&P license (including its transferring to the subsidiaries and contributing to joint activities). State companies will be able to transfer the E&P license only to other state companies;

7)      more clear and precise grounds for revocation of the E&P license are established;

8)      a use of international standards (UNFC-2009, CRIRSCO, PRMS) and transition to the WGS 84 coordinate system, etc.

 

Relevant draft law was passed in the first reading.

 

The Draft Law No.4344

 

It was scheduled for consideration by the parliament in the first reading. The main purpose of this draft law is to improve the competition procedure for PSA conclusion.

 

One of the authors of this article participated in the work on improving the legal regulation of the competition procedure for the conclusion of PSA in Ukraine. The results of this work formed the basis of the draft law No.4344.

 

In particular, the draft law proposes the following amendments:

 

1)      Improving the regulation of SPV participation in PSA conclusion competition.

2)      Increasing the minimum term of the competition from one month to three months for land subsoil area and to six months on the shelf. It will provide participants with sufficient time for detailed analysis of proposed lots and preparation of qualified and competitive applications and the documents hereto.

3)      The criteria for evaluation of the proposals of PSA competition participants are becoming clearer, its list is fixed by law. CMU can envisage additional criteria for determining the winner of the competition; at the same time, the share of such additional criteria cannot exceed 10 percent of the total weight of all criteria for determining the winner of the auction.

4)      CMU decision to hold a competition for the PSA conclusion should clearly provide for the share of each criterion for determining the winner of the competition and the  criteria for determining the winner, which have the greatest weight among other criteria.

5)      The criteria for determining the winner of the competition are divided into quantitative (for which it is possible to establish objective measures) and non- quantitative (for which it is impossible to establish objective measures). For example, quantitative criteria include: the attractiveness of proposals for the distribution of cost and profit in favor of the state, the amount of guaranteed investment, the level of financial securities of the proposed program of work.

6)      The weight of quantitative criteria cannot be less than 70 percent of the total weight of all criteria for determining the winner of the competition.

7)      The share of criteria for evaluating the applications of participants and determining the winner is established in the decision on holding the competition. The scoring method for the participants of the PSA competition will also be known in advance.

8)      Possibility to involve independent experts by the members of Interagency Commission during the consideration and evaluation of applications and attached materials. Precautions to avoid the conflicts of interest of experts are determined. The findings of independent experts will be of a recommendatory nature.

9)      Online broadcast of the Interagency Commission meetings. The maintaining of records of such broadcasts and free access to them for at least three years.

10)      Prohibition to be a PSA investor to persons related to the Russian federation (citizens, residents, etc.). The same rule applies to individuals and companies subject to sanctions by Ukraine and their related persons, etc.

 

In summary, the draft laws analysed above will significantly improve the regulatory and legal environment for doing business by oil and gas companies.

 

PEC

 

Finally, we would like to describe the mechanism that is just gaining momentum in the Ukrainian oil and gas market - PEC.

 

The nature of the PEC contract is deviated from the described above mechanisms of E&P license and PSA, since the PEC is rather more of a service nature.

 

In common practice, the purpose of concluding PEC contract is to increase the efficiency of hydrocarbon production in depleted fields.

 

Nowadays, Ukrainian legislation does not provide a special legal framework for PEC contracts.

 

Until recently, this type of agreement has never been concluded in Ukraine. Nevertheless, in 2019 UGV initiated a project to conclude a PEC contract to work on 13 depleted fields in western Ukraine. According to the results of the competition, the Romanian Expert Petroleum became the winner. The company was founded in 2005 and has worked on more than 1,300 wells during its existence.

 

The PEC contract between Expert Petroleum (operator) and UGV was concluded in 2020.This agreement was even shortlisted for "The 2020 CEE Deal of the Year Awards", which nominates the best deals on the European market.

 

Intensification of works, increase of volume of taxes and other budget allocations to be paid in the result of the partnership will allow accumulating over UAH 4 billion to the GDP of Ukraine and Lviv region.

 

Regarding the terms of the concluded PEC contract, the following provisions should be noted:

 

1)      PEC contract was concluded for 15 years with the possibility of its prolongation for 10 years.

2)      The contract prescribes minimum amount of capital investment that the company has to invest in increasing of hydrocarbon production in the fields. Accordingly, Expert Petroleum has committed to invest at least UAH 1 billion (USD 36,6 million) and increase production by 300 million cbm over five years.

3)      Expert Petroleum is obliged to establish a subsidiary in Ukraine for obtaining environmental and labour safety permits, which can only be issued to Ukrainian company (it has already been done).

4)      UGV will approve the development plans, annual work program and budget proposed by Expert Petroleum at these fields.

5)      Expert Petroleum will receive a fixed fee for support of the baseline production (at the level of current operating costs of UGV, taking into account inflation) and for achieving incremental production.

6)      The full ownership of the extracted products and fixed assets that the contractor will use to perform works and provide services in accordance with the PEC contract belongs to UGV. It was also planned that Expert Petroleum will have the right to use hydrocarbons produced in the PEC area for technological needs and will be obliged to transfer all assets acquired to fulfil its obligations under the terms of the PEC contract, as well as assets created to increase the production (for example, recently drilled wells, etc.), in exchange for a "transfer value" agreed by the parties.

7)      As the work and services are carried out by Expert Petroleum and E&P licenses belong to UGV, which is responsible as their owner, the parties have provided for the possibility of establishing a coordination mechanism (for this purpose a coordination committee which consists of 100% of UGV representatives has already been established), etc.

 

Therefore, we see that the lack of special legal framework for PEC contracts is not an obstacle to conclude such types of contracts in Ukraine.

 

At the same time, the preparation of such contracts requires considerable volume of legal work to avoid or eliminate potential risks (qualification of PEC contract as a joint activity, unprecise distribution of duties and responsibilities of the contract parties, non-compliance with labour protection rules or labour legislation of Ukraine, etc).

 

Conclusions

 

Ukraine has excellent preconditions for large-scale oil and gas production:

 

1)      Favourable geographical location;

2)      Huge reserves;

3)      Qualified personnel;

4)      Developed infrastructure: oil and gas pipelines, oil and gas storage facilities, oil and gas refineries, etc.

 

The E&P license is a fairly clear and understandable mechanism for the access to oil and gas subsoil in Ukraine. The license cannot be alienated for now, but this issue should be resolved (the draft law No.4187, the new Subsoil Code of Ukraine).

 

The PSA mechanism provides more guarantees for an investor than the E&P license mechanism. The disadvantage is that the competition procedure and the PSA concluding process is quite a long and, in separate aspects, a little bit ambiguous. Despite this, the drawbacks mentioned will be eliminated by the draft law No.4344.

 

The PEC contract mechanism is not directly regulated by law in Ukraine. It entails some positive aspects, like discretion and the ability to settle the interests of the parties in the best and most comprehensive manner. In the meantime, negative consequences may arise in case of insufficient attention during preparation of the relevant types of contracts.

 

Ukraine has no choice but to develop rapidly after the end of the war. That is why we are confident that the improvement of Ukrainian oil and gas production legislation will be carried out as soon as possible and the Ukrainian State will be one of the most attractive countries in terms of investing in oil and gas.

 

In the wake of it, E&P licenses, PSA and PEC contracts in Ukraine will be more popular than ever.

 

Special for OGEL Journal

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