Publication: Prism Volume: 3 Issue: 13

Recent developments in Ukraine’s fuel complex: Coping with the legacy of Soviet planning

By Sergei Kolchin

Ukraine has few energy resources of its own and is obliged to import much of the primary fuel it needs. In the Soviet period, Ukraine’s primary fuel production was made up of heavily subsidized coal extraction, plus nuclear power plants that included Chernobyl, and some hydro-power. Downstream, there was the refining of oil acquired from Russia at prices way below world market levels, and the generation of electricity at artificially low prices from coal, oil and gas, as well as from the highly problematic nuclear power stations. When Ukraine achieved independence and began the transition to a market economy, these arrangements had to change. The issues in the electricity industry — how much nuclear capacity should be retained, and what new power sources should be developed — are still not resolved. There are also fundamental difficulties in the primary fuels sector.

In the new climate, Ukraine’s coalmining industry has proven uncompetitive and has, like Russia’s, entered into a profound crisis. Schemes for extensive pit closures have been put forward by foreign advisers, together with further development of hydro-electricity, but progress on these fronts has been slow. As for oil and gas, Ukraine’s efforts are now concentrated on guaranteeing a stable supply from foreign suppliers. Political tensions between Ukraine and Russia — Ukraine’s main supplier of oil and gas — have exacerbated the problems that Ukraine faces on the energy front.

Extraction of Hydrocarbon Resources

Ukraine does not produce enough oil and gas to satisfy its own needs. Moreover, output has fallen in recent years. In 1996, the country produced 4.1 million tons of oil and 18.4 billion cubic meters of natural gas. In 1997, output is projected at 3.9 million tons of oil and 17 billion cubic meters of gas.

Ukraine has adopted a widely publicized program of oil and gas development up to the year 2010, but many independent experts think the program is too ambitious and could be implemented only with wasteful subsidies. In their opinion, the goals set forth in the program — to extract up to 7.5 million tons of oil and up to 34 billion cubic meters of natural gas by 2010 — are unlikely to be achieved, at any rate in a cost-effective way.

Most of the already-known oil and gas reserves have been worked out, or are difficult to extract. Implementing the program would require from $10-$15 million in investment. Great hopes are placed on discovering new oil and gas deposits on the shelves of the Black Sea and the Sea of Azov, but only the first, rather modest, projects have been launched so far. Royal Dutch/Shell won the first tender to explore and develop oil and gas deposits on the Ukrainian Black Sea shelf. It was followed by British Petroleum, which signed an agreement with the Ukrainian government on exploring and developing oil deposits in the eastern part of the country. In the first stage, BP intends to invest $2 million; only later will it decide, on the basis of these results, how much more money to invest. The Ukrainian government is considering the possibility of setting up a joint venture with British Petroleum, in which the Ukrainian side would have a 51 percent share.

On the whole, however, Western companies have shown little interest in Ukrainian oil and gas extraction or oil refining projects. In oil refining, there has so far been only an agreement to create a joint venture on the basis of the Kherson Oil Refining Facility, with the participation of the "Production and Trading Group," registered in the Cayman Islands.

Oil Refining

Six large refineries — the Lisichansk, Kremenchug, Kherson, Odessa, Drogobych and Nadvornaya refineries — make up the bulk of Ukraine’s oil-refining industry. But their capacity is now severely underutilized. Only 13 million tons of oil were refined in Ukraine last year — no more than about 20 percent of the country’s capacity. For example, the Lisichansk refinery, which has an annual capacity of 21 million tons, refined only 2.1 million tons in 1996. This spare refinery capacity does however provide opportunities for deals with those crude oil producers elsewhere in the former Soviet Union (a minority) who are looking for refinery outlets.

Thus the Kremenchug refinery, which is now part of the Ukrainian-Tatarstan "Ukrtatnafta" company, has been faring rather better than Lisichansk. Its future prospects do not, however, appear bright, for Tatarstan’s Tatneft has said that it plans to reduce its usage of Ukrainian oil refineries in the future.

At the end of 1996, Yury Shafranik, chairman of the Tyumen Oil Company and a former Russian energy minister, signed a protocol with the governor of Odessa oblast on setting up a transnational group in partnership with the Odessa refinery. The group came to nothing, however. This is partly because most Russian oil companies have underutilized capacity in their own oil refineries and are therefore uninterested in buying into Ukrainian oil refineries. It is also caused by Kyiv’s reluctance and, in particular, the reluctance of the Ukrainian parliament, to allow Russian oil companies to bid in auctions for Ukrainian oil refineries.

This was seen most recently when the Lisichansk oil refinery was auctioned. According to a protocol signed by Russian prime minister Viktor Chernomyrdin in Kyiv, Russian oil suppliers were to be allowed to participate in the auction if they guaranteed to supply the refinery with a minimum of 6 billion tons of oil over seven years. But when the relevant legislation was adopted, it stated that only Ukrainian-based companies with a maximum of 25 percent foreign ownership might take part in the auction.

Relations with Russia

The overriding aim of Ukraine’s energy policy at present is to diversify its sources of energy and free itself from fuel dependency on Russia. So far, little headway has been made with this. In 1996, Ukraine purchased (or at any rate received — payments problems remain acute) 7.6 million tons of oil and 49 billion cubic meters of natural gas from Russia. In 1997, shipments of 53 billion cubic meters of Russian natural gas were planned, and 2.8 million tons of oil were to be supplied to the republic’s refineries, which is five percent more than in the same period last year. In the event, deliveries in the first half of this year fell one third short of the level of the corresponding period of 1996, and the difference has been made up from Kazakhstan — via Russia.

Ukraine’s debt for Russian energy remains an acute problem. On June 1, 1997, it amounted to 3.7 trillion rubles (almost $6 billion), 3.3 trillion rubles of which was for natural gas. Of the approximately 90 billion cubic meters of gas consumed by Ukraine, 60 percent was supplied by Russia’s Gazprom.

The Ukrainian parliament has blocked a number of efforts by the Ukrainian government to resolve this problem. Proposals for creating a Russian-Ukrainian "Gaztranzit" corporation were accordingly buried, as were attempts to pay Gazprom with property in Ukraine (gas storage facilities, pipelines, etc.).

The Russian government is, in turn, concerned about its dependence on Ukraine in the area of transit. Construction on the "Yamal-Western Europe" gas pipeline, which goes through Belarus, is going ahead full swing while Russia’s federal energy commission is drafting proposals for a "Saratov-Novorossiisk" oil pipeline that would skirt Ukraine.

Transportation of Energy

The transportation factor looms increasingly large in Ukraine’s oil and gas policy. On the one hand, some 4000 kilometers of oil pipelines pass through Ukraine, carrying Russian oil to the west; also passing through Ukraine is the only pipeline through which Russia exports natural gas to the west and the Balkans. Since becoming independent, Ukraine has been able to use this to exert pressure on Russia. On the other hand, Ukraine’s export orientation, which dates from Soviet times, has had a negative effect on independent Ukraine — its port terminals are not adapted for receiving oil and petroleum products from other countries.

Ukraine’s disagreements with Russia are not merely political but also financial and economic: Ukraine has sought to raise transit charges to what it claims are international levels (for gas, it is demanding $2.28 per thousand cubic meters per 100 kilometers); as has already been noted, it has not been paying regularly for the Russian oil and gas that it receives; and there have been diversions of "transit" fuel from pipelines for local use.

As a result, both sides are looking for a way out of their mutual dependence. The steps Russia has taken have been described above. Ukraine is, for its part, actively seeking alternative suppliers of oil and gas and lobbying for the particular transport scheme for Caspian Sea oil that would be most favorable to itself. Several rounds of negotiations have been held between Ukraine and Uzbekistan on the issue of shipment of Uzbek oil and gas. Uzbekistan has agreed to let Ukraine use part of its territory for the exploration and extraction of hydrocarbon resources. Negotiations over payment for Turkmen natural gas are proceeding with some urgency (in 1997, 20 billion cubic meters are to be supplied to Ukraine, 47 percent of which will be paid for in hard currency, and 53 percent in barter trade). However, payment problems have already arisen with Turkmenistan. Ukraine has also indicated its interest in buying Iranian oil, also, for the most part, on a barter basis. And an agreement has been signed with Turkey under which Middle Eastern oil could be brought in to Ukraine via the Black Sea and a pipeline from Ceyhan to Samsun.

But the main direction of Ukraine’s oil policy in recent times is lobbying for a method for transporting Caspian (and in the future, Iranian and Iraqi) oil along a route bypassing Russia. Ukraine has worked out its own proposal, which envisages building an oil pipeline from Yuzhny to Brody (670 kilometers) and a terminal in Odessa, at a cost of $1.3 billion. Ukraine promises to have a port terminal in Odessa, able to pump 12 million tons of oil a year, ready by 1998. Ukrainian experts maintain that transportation costs for shipping one ton of oil from the Tengiz oil field in Kazakhstan by their proposed route would be $33-37, and $25-29 for one ton of Azerbaijani oil. So far, however, the Azerbaijani International Operating Company (AIOC) has shown no interest in Ukraine’s proposal, arguing that the initial investment costs would be too high.

Institutional Changes in the Fuel and Energy Complex

Ukraine’s participation in international fuel and energy cooperation has been hobbled by the slow rate at which Ukraine embarked on the denationalization and privatization of this sector of its economy. Recently, however, there has been some progress in this area. According to recent reports, Ukraine intends to follow the traditional path of creating vertically-integrated oil companies. The first such company will be created on the basis of "Ukrnaft," which will assume control of the Nadvornaya and the Kherson refineries and a number of other petroleum enterprises. The second will probably become "Ukrshelfnaftagaz," a company created in 1996 to develop the oil fields on the shelves of the Black Sea and the Sea of Azov which also includes the "Chernomornaftagaz," "Ukrnaftakhimpererabotka" and "Ukrnaftaprodukt" companies. The weakness of the future Ukrainian vertically-integrated oil companies is the absence of their own extraction base.

At the same time, the process of transforming Ukraine’s oil refineries into corporations is speeding up. In April 1997, Ukraine’s State Property Fund announced its intention of putting up 61 percent of the shares of the Kherson refinery and 52 percent of the Odessa refinery up for investment tenders. A tender for sale is being prepared for shares in the Lisichansk refinery. According to the plans to distribute shares in those of Ukraine’s oil industry enterprises which are to be privatized, four of them — Cherkassynaftaprodukt, Chernigovnaftaprodukt, Khmelnitsknaftaprodukt, and Yenakievonaftaprodukt — are to remain entirely state-owned while another six are to be largely (41-93%) state-owned. In the remaining six, which include the oil refineries in Rivne and Ivano-Frankivsk, the state will retain only a minimal stake.

In short, organizational change is under way in the Ukrainian fuel sector, and some restructuring of trade and production has begun; but the unsolved problems are still daunting.

Translated by Mark Eckert