Ukraine's war on two fronts

Ruth Green, IBA Multimedia JournalistFriday 7 August 2015

As Ukraine contends with a precarious security situation and dire economic outlook, Global Insight assesses the local and transnational energy wars shaping the legal and business landscape.

Over the past 18 months, Ukraine hit the international headlines time and again as it battled months of widespread demonstrations, bloodshed, the annexation of Crimea, snap elections, the downing of Flight MH17 and a tumbling currency, the beleaguered hryvnia. The country’s long-running spat with Russian state-owned gas giant Gazprom, which has a monopoly over the European gas market, has also been well documented since the feud first began ten years ago.

Ukraine is still largely reliant on gas from Russia and disputes over payments have crippled supply numerous times over the past decade as the two countries continue to come to contractual blows. The pipeline that transits the country also carries around half of Gazprom’s exports to the rest of Europe, meaning that the problems have also been felt much further afield.

Over the years, contracts between Russia and Ukraine have been signed, amended and restructured in an unregulated and often arbitrary way. This finally came to a head last year when Gazprom launched a case against Ukraine’s state-owned gas utility, Naftogaz, in the Arbitration Institute of the Stockholm Chamber of Commerce (SCC), claiming the Ukrainian company owed it billions of dollars in unpaid debts on gas delivered since 2009.

Although the hearing isn’t expected to take place until early 2016, with the ruling scheduled for next June at the earliest, Jonathan Stern, Chairman of the Natural Gas Research Programme and a Senior Research Fellow at the Oxford Institute for Energy Studies, says the case’s potential ramifications could be extraordinary. ‘This is not the first arbitral case between Russia and Ukraine – there’s just been endless argy-bargy – so this is well-trodden arbitral ground,’ he says. ‘The thing about an arbitral tribunal, particularly in this type of case, is it’s a “nuclear option”. You’ve no idea what the result will be and the consequences may be devastating. The real big thing about this case is it concerns huge amounts of debt and, of course, huge amounts of money.’

Sure enough, Naftogaz hasn’t taken the claims lying down and, in May this year, filed its own claim at the SCC, alleging it is owed as much as $16bn by Gazprom for losses stemming from amendments to its gas purchase and gas transport contracts.

Stern says the complexity of the case will make it very difficult to arbitrate. ‘It is a massive can of worms in contractual terms, which is why we’ve had these dragged out arbitration proceedings on all these issues in Stockholm,’ he says. ‘There are disputes all over the place, there are disputes on prices, on “take or pay”, disputes on who did or did not supply when they were requested or not requested to supply. What the tribunal has to do is sift through the evidence and look at the contracts and decide out of all the things that are alleged to have happened by the parties, which are the ones that are contractually sound.’

Separate to this legal challenge, the European Commission (EC) has charged Gazprom with abusing its dominant market position in Central and Eastern European gas markets – another claim Gazprom strongly denies.

And, while these very public contractual disputes continue to play out elsewhere in Europe, a number of controversial changes imposed by the Ukrainian government are causing their own legal rifts back on home turf. Last August, the government announced it was increasing royalty payments on private natural gas producers in the country from 28 per cent to 55 per cent for gas produced from depths of more than 5,000 metres, and from 14 per cent to 28 per cent for gas produced at depths of less than 5,000 metres.

The move was purportedly to aid the country’s fledgling economy. But, Vladimir Sayenko, a partner at Sayenko Kharenko in Kyiv, says the plan clearly backfired and has succeeded in discrediting the government. ‘The increase in royalty payments for private natural gas producers was presented to the public as an element of justice, an attempt to finance budget deficit from the local oligarchs’ pocket,’ says Sayenko. ‘Yet, this populist move was not justified economically and has had a negative impact on the investment climate in Ukraine.’

Consequently, a number of private companies have resorted to taking the government to court over the move. ‘As the fiscal pressure is being raised by the government, more and more oil and gas companies are ending up in courts trying to challenge claims from the tax authorities,’ says Vitaliy Radchenko, a partner in CMS Cameron McKenna’s energy and projects practice in Kyiv.

After lengthy out-of-court discussions, the government finally conceded to decrease royalty payments for natural gas and also passed a bill reinstating the two-year royalty relief period for new gas wells. While the announced changes have come as good news to some, Sayenko says natural gas produced by joint venture companies would still, for now at least, be subject to extremely high royalty rates. ‘Royalty payments in relation to natural gas produced by joint ventures will stay at 70 per cent,’ he says. ‘They may be decreased later this year when the new methodology of taxation applicable to oil and gas producers is developed to stimulate domestic production pursuant to the “action plan on gas sector reform”, approved by the Resolution of the Cabinet of Ministers in March.’

Besides royalty hikes, another change has drawn the ire of foreign gas companies operating in the country. In November, the government passed a resolution stating that all industrial gas buyers in the country must purchase gas exclusively from Naftogaz until March 2015.

The Kyiv District Administrative Court has since declared the government’s resolution illegal and invalid. Nevertheless, several companies are turning to the courts for compensation. One example is London-listed JKX, which was forced to postpone its 2015 capital investment programme due to the government’s actions. The company is currently seeking repayment of more than $180m in rental fees that it says its Ukrainian subsidiary paid on the production of oil and gas in the country since 2011.

In January, emergency arbitrator Professor Rudolf Dolzer, who was appointed under the Arbitration Rules of the Stockholm Chamber of Commerce, issued an interim award to JKX. It ordered the Ukrainian government to refrain from imposing royalties on gas produced by JKX’s Ukrainian subsidiary that were in excess of 28 per cent – substantially less than the 55 per cent rate currently applicable under Ukrainian law – while the claim is pending.

In February, JKX announced it was suing the government under the Energy Charter Treaty for breaching its bilateral agreement with the UK government and is seeking orders from the Charter’s Tribunal to force Ukraine to comply with the award. While the interim award is binding under international law, if Ukraine refuses to comply then JKX will have the option to pursue the claim in the Ukrainian courts. CMS’ Kyiv office is advising JKX on Ukrainian law issues, while a team from Allen & Overy’s London office, led by Mark Levy, is acting for JKX in arbitration proceedings.

‘If JKX is successful in this case, this would have paramount impact, as all other companies are equally suffering from the 55 per cent royalty tax these days,’ says Radchenko. ‘Ukraine will then have to re-consider whether the increased tax pressure is a wise policy.’

There is also a chance that, if successful, JKX Oil & Gas may set a precedent for others to take similar action. ‘A positive award in favour of JKX may indeed inspire others to bring similar claims against the government,’ says Joseph Tirado, a partner at Winston & Strawn and Co-Chair of the IBA Mediation Committee.

For Stern, the case could have significant implications both for the country’s foreign investment climate and its oil and gas market. ‘It would be foolish if the state allowed this case to progress very far,’ he says. ‘It’s kind of a bellwether – whether it wins the legal case or not is another matter – but, for JKX, which everybody knows has been through really difficult times through a range of different governments, if this company can’t make it, given how well-established it is, there is no chance that anyone coming in can make it. It would be very wise for the state to actually settle and improve the situation. If the state chooses not to or is unable to, there is no chance for any investment in this country.’

Although Sayenko agrees the government is likely to settle, he believes much still needs to be done to recoup the country’s business image in the eyes of international investors. ‘The Ukrainian government will probably try to settle such disputes,’ he says. ‘In general, we believe that the Ukrainian government will learn from these mistakes and will be careful to avoid similar precedents in the future. The government is trying to implement various reforms that are supposed to improve the investment climate, but actions speak louder than words and short term gains, such as increases in tax revenue, do not justify the damage that is being done to the business image of the country.’

JKX is not the only company that has been affected by the government’s actions. Canada’s Serinus Energy initially suspended drilling and development at its operations in eastern Ukraine last year over security concerns. However, the company recently revealed its overall production continued to be significantly below par due to ‘the lingering effects of Ukrainian government legislation’.

Elsewhere, Australia-listed Hawkley Oil and Gas, which saw production halted at its Sorochynska Well-201 in November 2014 due to a suspected water influx, said the government’s decision to increase royalties has been a ‘significant factor in assessing the economic prospects of potential well workovers’.

Both Hawkley and JKX have reportedly been in talks to sell off their Ukrainian assets. Although neither deal has come to fruition, the potential sales are indicative of the difficulties facing even established names in Ukraine’s gas market right now.

Domestic Production

Although spats between the government and foreign producers like JKX have made the headlines in recent months, Simon Pirani, a Senior Research Fellow at the Oxford Institute, says their operations are relatively small in the context of the wider Ukrainian gas market. ‘There are a small number of British and other foreign companies operating in Ukraine,’ he says. ‘You tend to hear a lot about their legal problems, whereas some of the issues relating to transit and import are actually far more important.

‘To put a figure on it, last year Ukraine consumed only 42 billion cubic metres [bcm] when the industry was in a state of collapse and they were trying to save gas and money. Of this, Ukraine produced 20bcm and about 3.5bcm of that was produced by all of these private companies put together, so they’re a small part of the overall picture.’

However, Pirani recognises that the right investment climate would guarantee these producers a larger share of the market. ‘Of course, if the legal framework for investing in oil and gas projects in Ukraine was better, more people would do it.’

As Pirani notes, production sharing agreements (PSA) in Ukraine’s oil and gas sector have a chequered history. US firm Vanco International learned the hard way in 2008 when its 30-year PSA to explore near Kerch on the Crimean peninsula was suddenly withdrawn by Yulia Tymoshenko’s government, allegedly to protect state interests. Vanco was eventually forced to appeal to the SCC. It was only after a change in government in 2010 that things were smoothed over and the dispute was eventually settled out of court.

Despite these setbacks, other major companies have continued to chase gas assets in Ukraine. In January 2013, Royal Dutch Shell signed a landmark $10bn 50-year PSA with the Ukrainian government to develop untapped shale gas resources in the Yuzivska gas blocks in the eastern Kharkiv and Donetsk regions.

However, the ongoing security situation in the east of Ukraine has brought promising projects like this to a standstill. ‘This project is now on hold in large part because the asset is where the military conflict is taking place – it’s a tragedy for all concerned,’ says Pirani.

‘There were other PSAs that were about to be signed when the change of government took place last year, namely one with Chevron, and there was one in the Black Sea by a group of companies headed by Exxon Mobil. They were very close to being signed, but then war broke out.

‘These offshore Black Sea projects need to be operated out of Crimea, but nobody is going to do business there at the moment. However, it’s not practical to do those offshore projects from somewhere else unless you’re really desperate and want to reorganise everything. These big companies aren’t really desperate, so they can go somewhere else to do their business.’

Radchenko agrees that the government has much more to lose from the situation. ‘I do not see significant legal ramifications for the companies – force majeureand various termination provisions were always there in the PSAs,’ he says. ‘For the state, however, this means that the planned projects, investments and taxes in millions of US dollars will not flow into Ukraine, which is much more dreadful for the country.’ Markian Malskyy, Head of Arbitration at Ukrainian law firm Arzinger, points out that ‘the Ukrainian government, in fact, provided Chevron with formal grounds for avoiding implementation of its contractual obligations’ by raising rates for the use of subsoil. ‘The PSA concluded with Chevron prescribing that the foreign investor has the right to universally pull out of the contract in the event that the Ukrainian government does not fulfil the preliminary conditions,’ he says. ‘Those conditions, inter alia, stipulated amending Ukrainian legalisation, in the part of taxes [or] duties.’

Radchenko agrees that the government’s actions are proving inimical to progress. ‘The government has declared the idea of Ukraine’s energy independence, but its actions are in no way motivating oil and gas companies to invest money into Ukraine – which just shows that the government is not trying hard, or it is just being hypocritical. We will see whether the government will change its views and actions, or there won’t be any investors left and gas production will not rise.’

For Stern, if the Ukrainian government is to maintain the interest of foreign investors, then its prerogative has to be to get these companies’ operations up and running again. ‘If it is true that Ukraine really wants to encourage investment, then the first step is to get companies like JKX and Shell back in business drilling and producing,’ he says. ‘If that doesn’t happen, nothing else will.

‘The country also has massive potential for reducing its gas consumption even lower than it is now. And there’s no reason why in ten years this country couldn’t be self-sufficient in gas, but [if things stay as they are] that’s not going to happen.’

Although Pirani says the government’s recent decision to pass a gas market reform, bringing it into line with the EU’s Third Energy Package, certainly showed willing, he thinks practically there is still much more that can and should be done.

‘Passing a law is one thing, but implementing it in a country with a military conflict ripping its industrial area in the east to bits is a whole other matter,’ he says. ‘It will take time and it will not alter the physical reality that they import gas from Russia and as long as that is the case – and it will be the case long beyond 2020, and Russia is going to transit gas long beyond 2020 – they’re going to have to somehow agree about how those things are going to happen.’

There is some hope for Pirani, however. ‘Remarkably, in October, the European Commission, Russia and Ukraine agreed on how the gas imports and transit would be done over the winter and that’s been reviewed to take us over the summer,’ he says. ‘This is a glimmer of hope in gas terms in what is politically an absolutely dark situation.’ .

Ruth Green is a freelance journalist and can be contacted at ruthsineadgreen@gmail.com