Firtash Arrested in Austria

Dmitro (Dmitry) Firtash was arrested in Vienna today on an FBI warrant for organized crime stemming from a 2006 investigation.

Readers of this blog (from five years ago, at least) are well aware of his role in Ukraine’s energy sphere.

He is most well-known perhaps for being the central Ukrainian behind RosUkrEnergo, a gas middleman from back in the day.  Before being outed as the Ukrainian businessman behind the venture, he was notoriously camera shy.  Since then, he has worked to burnish his image (though the creepy corporate shot above is a bit weird) and expand his Group DF assets.

Some reports link Firtash with infamous gangster Semion Mogilevich, though he has disputed this connection.  When Mogilevich was surprisingly arrested in Moscow in 2008, some thought that it might resonate down to Firtash and others.  However, Mogilevich was released on bail, despite being listed as one of the FBI’s top 10 most wanted, and Firtash continued to grow his business.

He and Tymoshenko have a long-standing feud. As she emerges more powerful in the latest round of Ukrainian leadership, it could be expected that he may suffer as a result, especially given Ukrainian politicians’ propensity for retribution. His arrest is also being viewed as a means of putting pressure on Russia, sending a message to oligarchs with ties to the country that they could be targeted as part of the Washington’s frustration with Putin’s moves in Crimea.

I haven’t written here in a long time (clearly), but upon seeing the big news, I decided to take a break from finals studying and post something.  Maybe I’ll follow up with more later.  Follow me on twitter if you want: @hansstege

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Top 4 energy issues Ukraine’s new president will face in 2010

New year celebrations at Kyiv's central square, the Maidan - from unian.net

Happy New Year!  Celebrating 2010 and my return to blogging, I present the top four energy sphere issues that Ukraine’s new president — likely to be determined on a February 7th runoff election — will face in the coming year.

• At #4, modernizations across the board. Ukraine’s coal mines are notoriously unsafe, its gas transportation system is in need of investment, and its refining sector is facing massive technological deficits.  Modernizations at an industrial level can improve energy efficiency and boost the competitive positioning factories facing difficult times.  How the government incentivizes locally-based investments and how it finds the money and partnerships for large-scale modernizations (particularly for the gas pipeline system) will be key.
• At #3, inflation and gryvna depreciation. While not specifically energy-related, the potential for continued inflation and further depreciation of the gryvna have a range of implications to Ukraine’s energy sphere.  In particular, the majority of Ukraine’s energy sources are imported and bought with dollars while they are sold domestically on a gryvna basis.  For institutions like Naftogaz that are based on relatively strict gryvna-based budgets, any increase in the exchange rate makes payment for gas imports that much more difficult. ¶ For consumers, this is most evident with the price of gasoline, given Ukraine’s high reliance on crude imports.  Oil is bought with dollars, largely refined locally (where companies must pay gryvna wages) and the products are sold in gryvna terms.  As the exchange rate weakens, the nominal price of gasoline increases for consumers, a trend that can be particularly vexing if they notice global oil prices not rising in a similar fashion.

• At #2, oil supply issues to refineries. Ukraine’s refining capacity is woefully underutilized and hampered by problems in securing adequate crude supply.  Kremenchug no longer receives Russian crude after Privat seized it in late 2007.  Neither of the two Privat-owned western refineries get Russian crude either, and both are operating at very low utilization rates due both to the supply issue as well as low complexity hampering the quality of product output.  Lisichansk gets fairly stable crude deliveries from TNK-BP, but is still only at about 40% of its potential capacity.  Odessa was near full utilization until a dispute with Ukrtransnafta forced a disruption and a new pipeline supply scheme in October 2009. ¶ If crude supplies stabilize, particularly for the key refineries, then an important industrial segment will have a stronger operating environment to push the recovery, and will be better prepared to make the investments in order to transition to higher fuel specification (see above).  Also, on a macroeconomic basis, the country’s current account balance should strengthen as oil product imports decline.  It would likely also represent a step towards more genial energy cooperation with Russia, since that is the most likely source of crude for Ukraine.

• At #1, recalculating gas tariffs. Ukraine’s government needs to fix Naftogaz’s finances so it no longer relies on cash injections from the central bank or IMF funds.  The only way for this to happen is to bring revenues more closely in line with costs.  While the NERC (the regulating body) has been willing to pass along increases to industrial consumers, sometimes even at unjustified levels, pushing them onto residential and “budget” users has been more difficult.  It’s been impossible to do politically, with Tymoshenko being unwilling to take on the damage to her popularity such increases would bring.  Meanwhile, the IMF is screaming down Naftogaz’s door, essentially demanding a more realistic tariff for the currently subsidized users. ¶ While technically under the purview of the Prime Minister, how the new President (and likely the new PM) handles this issue will be very important for bringing Ukraine out of perpetual “crisis” mode, particularly given the monthly account settling Naftogaz faces with Gazprom.  A few different tactics need to be pursued, including increased energy efficiency to lower demand (current demand drops are relatively temporary due to slowed economic activity), a push toward individual gas metering to better measure consumption, and a shift away from blanket subsidies to a system of income-based assistance.  No one wants babushka to freeze, but that doesn’t mean that the middle-class family living three doors down should get the same discount that she does.

Gas war reignites in a big way

A couple friends have mentioned my lack of blogging, and its absence is particularly notable now during the latest iteration of the Ukraine-Russia gas spat.

I’ve been working on the conflict at work (which has kept me busy, and away from this blog) and following it quite closely.  However, at this point I don’t feel I can put the time and effort into a post that the current situation would deserve.  Hopefully I’ll be able to do a “postmortem” roundup, though that of course has to wait until it’s actually more-or-less resolved.

I say more-or-less because there’s no way that any agreement reached in the next weeks (and it could stretch that long to get something relatively concrete) will solve the underlying issues, just as none of the past contracts since the breakup of the Soviet Union have.

Here’s the deal though.

Gazprom has announced that they will be buying Central Asian gas at essentially netback European prices, as opposed to the rock-bottom prices that they’ve gotten historically.  (Whether or not they actually are paying what they say they are is another matter though.)  Europe obviously pays European prices.  The only cogs in the system that don’t pay “European” prices then, are Ukraine and Russia (internally) itself.

Russia was apparently willing to continue “subsidizing” Ukraine by passing along a set price for the year of $250 per mcm, so long as Ukraine froze transit fees, ceded more of the internal industrial market to its local marketing arm Gazprom Sales Ukraine (GSU), and opened up some strategic infrastructure within the country to ownership by Gazprom. Late in 2009 would bring more negotiations for the price in 2010, before moving to a formula indexed off of gasoil and heavy fuel oil prices in 2011.

Ukraine balked, and Yushchenko ordered Dubina home from negotiations in Moscow right before the deadline.  The two sides made good on their posturing, and have ground the gas flow westward to a halt.

Putin has grown angry, suggesting Ukraine move to the “market” rate of about $450 / mcm immediately.  Yushchenko came back with his own $201 figure.  Based on the lag time in gathering the average oil product prices incorporated in Gazprom’s sales contracts, gas prices would be pretty much reaching their peak around now (corresponding to the all-time oil price highs in July and August 2008).

So if Ukraine were using a formula to determine their prices, they’d be stuck with a figure roughly corresponding to Putin’s threats.  But that price is adjusted quarterly, and because of the rapid fall in oil prices at the end of 2008, it is guaranteed to go down by about $50 by the time it’s recalculated in April 2009 — that is, if Ukraine moved fully into this “European”-style arrangement, which doesn’t appear to be likely.  If they did however, and if oil product prices stayed at about the same levels they are at now partway into this year, by 3Q2009 the gas price would drop nearly $100 and by 4Q2009 it would even be below the $250 / mcm originally offered.

Gas pricing is a tough job because it lacks the market drivers and signals of other commodity exchanges.  It’s particularly obtuse when two monopolies are the buyer and seller.  Add in the political back-story behind each country and their historical relationship, and you have a rather complicated situation.

P.S.  Check out the coverage by LEvko, Taras, and Adrian for more regular news updates.  The Oil Drum also has been posting about it, as has the local press (once they came back from their New Year’s breaks).

Gas talks on hold

In the US, John McCain is suspending his campaign to address the country’s distressful economic situation.  In Ukraine, Yulia Tymoshenko has suspended key natural gas price negotiations due to the country’s distressful political situation.

From Monday’s Kommersant:

On Friday Prime Minister Yulia Tymoshenko communicated that negotiations with Russia on the price of gas in 2009 have been halted because of the political crises.  Naftogaz intends to use this pause to wait out for the December lowering of world hydrocarbon prices, which theoretically allows it to get gas at a more advantageous price.  Analysts figure that this expectation is not unfounded — if oil quotes, to which gas prices are connected, will continue to drop, than the cost of gas could end up being lower by 25%.  But if the pricing market isn’t favourable, it threatens to be a significant loss.

The head of the government, Tymoshenko, announced to journalists that because of the political instability in Ukraine, negotiations with Russia on the supply of natural gas have stopped for the time being.  “Without question, when there is an uncertain situation in Parliament, an uncertain situation with the coalition, holding negotiations doesn’t work out [не получается],” noted Tymoshenko.  A highly-placed source in Gazprom confirmed to Kommersant that the Ukrainian side has for the time being halted consultation on the price of gas.  “Next week representatives of Naftogaz were supposed to arrive to reach agreement on the pricing fromula and concrete points in the agreement.  But the visit was put off for an unspecified amount of time without explanation,” said the source.

Oleg Dubina, the head of Naftogaz, explained the delaying of negotiations not as political, but with completely comercial justifications.  According to him, the later that a contract is reached, the less the price of gas for Ukraine could be.  Based on the price-setting formula that Gazprom uses, the price of gas is connected to the price o oil, which gets lower as we approach December, asserted Dubina on Friday.  Correspondingly, gas for Ukraine also would become cheaper.  Therefore, Naftogaz figures that “it’s not worth it to rush into signing [an agreement].”

Should give Naftogaz a bit more time to try to secure another loan to buy the fuel it needs for the upcoming heating season.

There’s more to it than just relying on this “December price drop”…

More seeps out on Vanco’s partners

Update (9/21/08): A bit more on Khmelnitsky, the alleged figure behind Integrum, is appended below.

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A very intriguing article in today’s Eurasia Daily Monitor by Myroslav Demydenko digs into possible organized crime connections to one of the investors in the Vanco-led Black Sea oil and gas project.

Through an offshore subsidiary, the US-based Vanco makes up about 1/4 of the joint venture established to run the development of the 13,000 square km offshore tract.  The other partners were revealed to be the Rinat Akhmetov-owned DTEK, the anonymous Austrian investment firm Integrum Technologies (more on them later), and Shadow Light Investments, owned by Evgeny Novitsky–who, according to Demydenko’s article, has connections to a Russian mafia outfit:

According to a number of reports in the press and the book Darkness at Dawn-The Rise of the Russian Criminal State by David Satter (Yale University Press, September 2004), Evgeny Novitsky is alleged to be a member of, or very close to, Russia’s Solntsevo organized crime gang.

Satter wrote that Solntsevo had close ties to a Russian company called Sistema [I would classify being “director” as having “close ties”], which is linked to Moscow Mayor Yuriy Luzhkov and to the IVK, the information technology company, of which Novitsky was director. Solntsevo, working through the company SV-Holdings, eventually came to own a large share of IVK.

… Kommersant wrote on July 22, 1997, that an unnamed official of the FBI had revealed the names of three individuals suspected of being “shadow bankers” for the Solntsevo mob, one of whom was Evgeny Novitsky.

There are more connections and citations listed by Demydenko to reiterate Novitsky’s supposed connections to the mob, including tantalizing references to infamous gangster Semyon Mogilevich, who some claim is in deep with RosUkrEnergo.

As for Integrum:

Integrum Technologies has refused to disclose its main investors, and Vanco executives have admitted on a number of occasions that they do not know the identities of the owners of Integrum…Evidence suggests, however, that Kyiv Investment Group, a company owned by Ukrainian oligarch Vasyl Khmelnytsky, is one of the hidden partners of Integrum.

Update (9/21/08): Khmelnitsky is a former Tymoshenko supporter who has since switched over to the Party of Regions.  However, their separation was reportedly relatively amicable and without scandal.  Khmelnitsky’s main investments are within the Kyiv property sector.

…

Meanwhile, the Cabinet of Ministers passed a resolution to divide up another large Black Sea shelf plot into 33 smaller sections, rather than license it off as one large structure.  OMV had reportedly early expressed interest in the project, but it’s unclear how this–and the ongoing scandal surrounding Vanco–could affect their viewpoint…

Gas and Politics

So it seems that I have left Kyiv just as things are getting interesting.

My Fulbright scholarship ended this summer and I have moved to Washington DC to begin working in the energy consulting field. Events in Ukraine’s energy and political fields continue to draw my attention, though, and I hope to keep this blog updated—certainly more frequently than I have for the past month.

Perhaps the key issue in the energy sphere now is how the deepening political crisis will affect the ongoing talks between Naftogaz and Gazprom concerning the price of imported natural gas for Ukraine. Last year’s negotiations happened between the transition of the Party of Regions-led Rada and the tenuous Democratic Coalition (headlined by Tymoshenko at PM). PoR deputy Yuri Boyko negotiated the deal in October 2007, but Tymoshenko immediately voiced objections and began pulling strings to put her own stamp on the agreement. That led to rounds of protracted and contentious negotiations that lasted well into 2008 before a key deal was signed in mid-March. Until then, in an unstable and imperfect arrangement, gas was being supplied to Ukraine without a contract.

Negotiations for next year’s contract began months ago, tied in with Tymoshenko’s goal for a long-term deal with Gazprom. While a multi-year contract is unlikely at this point, progress is continuing on next year’s deal. This big question is the price charged to Ukraine, guaranteed to rise from the current $179.50 per thousand cubic meters (mcm). Predictions run from $250-450, and they tend to be connected to various “concessions” granted to Russia, running from the status of the Russian Black Sea Fleet in Crimea to maneuvers for Ukraine’s 2009/10 presidential elections.

The fracturing political landscape affects the mandates of the various actors involved. As I mentioned, last year’s deal was principally negotiated by Boyko, who was then the Minister of Fuel and Energy. This year’s negotiations have mainly been conducted by Oleg Dubina, the head of Naftogaz, a position beneath the ministerial level. Both positions, though, ultimately report to the Prime Minister, Tymoshenko.

She herself has gotten involved in the negotiations, and one of the issues raised is how she accepts directives passed on to her from the president. Yushchenko has traditionally given the Ukrainian negotiators instructions for their meetings with the Russian side, but as he and Tymoshenko continue their drift apart, it seems more and more unlikely that the two will be able to cooperate. They had already bickered about this issue last winter, with Tymoshenko proudly proclaiming that she had talked with the Russian delegation “without directives,” only to be confronted with the list of instructions passed to her from the President after it was posted on the Presidential Secretariat’s website.

Yushchenko himself is not a good negotiator for natural gas deals. His former nickname within Gazprom upper management was reportedly “The Artist” because of his finicky and aloof manner. During meetings following the Orange Revolution he gave no indication of understanding the complexities of the gas business, and did not appear to be too invested in the outcome.

Since then, Yushchenko has taken the task more seriously for a variety of reasons.

• He witnessed the effect of unpopular deals after outrage at the 2005 agreement helped contribute to the split of the Orange Coalition.
• He recognizes the boost in popularity gas deals can bring to the figures involved, and seeks to capitalize it—or at least prevent Tymoshenko from solely benefiting from it.
• He resists ceding any more authority to the Prime Minister, using his directives to emphasize the political pecking order he is trying to maintain.
• He respects the economic impact of gas deals and, drawing on his background as a successful economist, positions himself as more in touch with the realities of the financial ramifications. (This economic experience is generally contrasted with Tymoshenko’s aggressive social spending plans.)

The two sides have both asserted that they will be able to present a unified front in the ongoing negotiations, and keeping the talks at company-level (i.e., between Dubina of Naftogaz and Alexei Miller of Gazprom, rather than Tymoshenko and Putin or even Yushchenko and Medvedev) should theoretically help keep the political fallout at arms length.

In reality, there is no way to completely divorce the maneuvering of Ukraine’s politicians with the natural gas negotiations, and every twist and turn will be used as “proof” of Tymoshenko’s alleged deal with Putin or Yushchenko’s rumored affinity to RosUkrEnergo. Politics has been deeply intermingled in Ukraine’s natural gas relations with Russia and Central Asia since the breakup of the Soviet Union, and it is unlikely to cease being so at this point.

As a footnote, I expect the price to be between $300 and $350 per mcm, though this is of course speculation at this point. A lot depends on how the costs are derived, as I explained in an earlier post.

—

Also worth mentioning is that Ukraine’s main stock market, the PFTS, has declined over 60% since January 1st, 2008, making it the worst performing stock market in the world. The PFTS performed extremely well last year, perhaps leading traders to feel that it was over valued at the start of 2008. Unhealthily high inflation, poor regional financial performance, geopolitical worries exacerbated by the Georgian conflict, and the upswing in domestic political instability have all contributed to the decline.

A pattern…

Update (8/8/08): I’ve appended a quote from today’s Ekonomicheskie Izvestia article on Marathon’s quiet exit from Ukraine.  The article also includes a funny caricature featuring Tymoshenko…

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Gas production from independents is flat

The Vanco situation is pretty well documented.  Other stories are less so.

Following its London IPO in June, Cadogan Petroleum saw its share price plummet when two of its licenses were called into question last month by the Ukrainian courts.  (In 2007, the EBRD had purchased a 5.2% stake in Cadogan as a way to help promote independent oil and gas production in Ukraine.)

In July, the Naftogaz subsidiary Chornomornaftogaz announced the annulment of offshore agreements with CBM Oil and Shelton Canada Corp, two other small-scale oil and gas producers.

A similar announcement was made in June regarding cooperation between the US-based major Marathon Oil and Chornomornaftogaz.  Now Marathon is packing up its Kyiv office and leaving Ukraine.

In all, 73 subsoil licenses have been revoked by the Ministry of Environmental Protection, with another 83 still under threat.  The majority of these were granted in 2006-7, under former PM Viktor Yanukovich’s government.  Back in December, the new Yulia Tymoshenko-led government announced plans for a major check of all licenses, in an alleged attempt to root out “speculators” who were sitting on valuable reserves but not investing into their development.

When Tymoshenko came to power in 2005, she made a similar push.  By February 2006, 504 licenses granted between June 23rd and December 31st, 2004 (again, under Yanukovich), had been revoked.

Rooting out corruption is one thing; shooting yourself in the foot is another, a point that President Yushchenko seems to be trying to make as he cites problems with foreign investor relations at Kryvorizhstal and the new terminal at Boryspil airport.

Ukraine seems to be struggling at reaching a balance between making the country attractive for foreign investment, preventing corruption from spreading, and engaging in revenge by attacking past moves made by political opponents.

Meanwhile the oil major Shell continues to have a presence in Ukraine, both with downstream retail and a exploration and production joint venture.  The company has committed $100 million for developing a project in the Dnieper-Donets basin, but it remains in the early stages (seismic surveys are expected to be completed by next summer, last I heard).

Successfully implementing this project, with potentially a couple hundred million tons of oil equivalent at stake, would be a huge boon to Ukraine’s foreign investment climate, and might make up for some of the pummeling it’s been getting lately.

Update (8/8/08): From today’s Ekonomicheskie Izvestia article “Marathon left on the sly“:

An industry specialist within the Ministry of Fuel and Energy structure told Ekonomicheskie Izvestia that, “Marathon decided to close their Kyiv office and leave the market without any extra noise in order to not attract any extra attention to the event. They got tired of waiting for progress in negotiations with the Ukrainian government for further cooperation and decided to end the study of their posible perspectives within the country. Marathon’s mood was also negatively affected by the problems with the license of the American company Vanco for work on the Prykerchenskaya section of the Black Sea.”

Ukraine suggests talks with Vanco even as government prepares its case

Ukraine’s government has expressed willingness to hold talks with Vanco, so long as the oil exploration company drops its international arbitration suit. At the same time, an analysis by Kommersant of the government’s case against Vanco suggests that Ukraine’s argument, which includes accusations of corruption, may hold up in court.

According to Deputy Justice Minister Yevgeniy Korniychuk speaking on July 30th:

“Our position is that we will immediately hold consultations with Vanco Prykerchenska Ltd., as soon as they suspend their suit.  We have turned to Vanco with a request – if they want to continue talks, at first it is necessary to suspend the suit for 60 days, and than we will talk.”

This suggestion is similar to one delivered by mail to Vanco right before the company became eligible to file arbitration proceedings.  At the time, the letter had been sent to Vanco International Ltd (VIL).  Korniychuk’s direct address to Vanco Prykerchenska Ltd. at his press conference on Wednesday may be a concession aimed at pulling both sides to the negotiating table.

However, it is clear that the government is against any involvement for VPL–which includes in its ranks VIL, Rinat Akhmetov’s DTEK, and two investment firms–in the future of the Black Sea shelf development.  According to Korniychuk, in the event of a amicable resolution, they would be willing to allow VIL to take part in some sort of project:

“We are not arguing the right of Vanco International, which won the competition [to sign the PSA], to develop the shelf.  They can return to it, though maybe with some other commecial terms.  But the shelf certainly won’t be developed by Vanco Prickerchensaka.”

In the past Vanco has stated its openness to hold negotiations, both during the 60 day period necessary before filing for arbitration, as well as during the beginnings of the proceedings themselves.

While Vanco may acquiesce to this pause for talks, they will likely grumble about it as well.  After all, the government was rather quiet during previous 60 day period, which was initiated by an official letter of complaint sent by Vanco to the government and meant to begin a dialog.

Should no settlement be reached and the case proceeds to the Stockholm arbitration court, it appears that Ukraine has a fairly solid argument on its side, according to Kommersant.

The government’s case, which was prepared in March by the law firms Astapov Lawyers and Barlow Lyde & Gilbert, has two prongs: the first concerns violations of Ukrainian law; the second alleges corrupt elements within the deal.

The first prong concentrates on the relationship between Vanco International and Vanco Prykerchenska, alleging that the transfer of the PSA from the former to the latter was against the law.  Indeed, this point has been one of the more questionable acts in the saga — how could VIL win the tender, negotiate and sign the PSA, and then pass off the deal to a separate entity that contains three new players?

Vanco has asserted it was within its rights to do so.  Ukraine’s case argues that this is against the law, saying that a separate agreement had to be reached first.

Other issues within this branch of the argument:

• While Vanco International of Houston registered to particpate in the PSA tender, Vanco International of Deleware won it.  This allegedly violates article 7 of Ukraine’s law on production sharing agreements. Delaware has a listing for Vanco International Ltd in its corporations databse. Texas has a Vanco International Inc.  From what I’ve heard, Vanco has admitted that VIL is registered in Delaware, despite press reports placing it in Bermuda (the location of VPL) or the Virgin Islands.
• Vanco International’s application was not submitted in full, violating a regulation concerning the tender.  This apparently includes “providing contradictory information regarding its whereabouts, ownership, jurisdiction and financial status.”  Besides the confusion over locations mentioned above, VPL was created with only $12,000 in initial capital, while pledging to invest about $330 million.  Vanco secured a letter from Citigroup saying the company would attract necessary funds by holding an IPO, but it turns out that this move was planned for VIL, not VPL.  Therefore, “in reaching the decision on determining the winner of the tender, the inter-agency commission was relying on misleading information, a violation of part 1, article 230 of the civil code.”
• According to the PSA regulations, the company was apparently not allowed to have a stake higher in the production than 50%; the PSA signed by Vanco has it receiving 70% during one phase of production.
• Part of the area granted to Vanco overlaps with the military training ground Chauda.  As such, Ukraine’s Defense Department should have been involved in the deal.  While the agreement apparently stipulated that Vanco would pay $37 million for the relocation of the training ground, the situation is still “inconsistant with the law on ensuring security of the state.”
• According to point 34.13.1 of the PSA, which concerns double taxation, Vanco could avoid paying any taxes to Ukraine, thus dropping the government’s share of production.

The government appears to be slightly worried over how these violations will be accepted by the Stockholm court.  There is also the possibility that the joint investment protection agreement reached between Ukraine and Britain may be enacted, due to Bermuda’s status as a British protectorate.  This agreement is investor-friendly, shifting additional burden onto the government’s case.

In response to these worries, there is a second line of argument based on corruption within the deal.

After it emerged that DTEK is involved in the project, observers immediately began questioning if illegal influence could have affected the outcome.  (Actually, ever since the relatively little-known company Vanco won the tender, beating out some other heavy hitters, there have been suggestions that something has been going on behind the scenes.) DTEK is owned by Akhmetov, who is a member of the Party of Regions in parliament — the same party as Viktor Yanukovich, Prime Minister at the time the PSA was signed with the government.

The government’s case calls for two past employees of Vanco International, former vice president John Gorman and former head of production Gabor Tari, to give evidence in favor of Ukraine.  It’s fairly easy to guess the gist what that evidence may be, but for now, it’s just conjecture…

Tymoshenko, Vanco offer wildly different stories on Black Sea project

(Note – 5/16/08: Updated with Vanco’s revelation of the involvement of Akhmetov’s DTEK and other investors below.)

Ukrainian Prime Minister Yulia Tymoshenko and American independent petroleum company Vanco Energy both held press conferences today outlying sharply contrasting images of Vanco’s Black Sea hydrocarbon development project and throwing the future of Ukraine’s deep-water oil and gas production into question.

Vanco signed a landmark production sharing agreement (PSA) with the Ukrainian government in October 2007 granting the company access to the 13,000 square kilometer Prykerchenska region off the Crimean coast. Tymoshenko and her government have been critical of the deal, however, asserting that the company lacks sufficient means to cover the necessary investment. That criticism culminated last Thursday when the Ministry of Environmental Protection revoked Vanco’s subsoil permit for Prykerchenska.

Vanco, in turn, has sent a formal letter of complaint to Ukraine’s Cabinet of Ministers, alleging that the government has been negligent in holding up its side of the PSA. If a mutually satisfactory resolution cannot be reached within 60 days, Vanco will be able to open arbitration proceedings against the government in Stockholm court.

In a press conference today, Tymoshenko stood by her previous assertion that Vanco’s representation in Ukraine, Vanco Prekerchensa Ltd. (VPL), is in fact an offshore structure registered to four female college students. She also asserted that VPL has only tens of thousands of dollars at its disposal, far from the billions eventually necessary for investment into a large-scale Black Sea project. Tymoshenko used the opportunity to lay blame at the feet of President Yushchenko, saying that the crooked deal happened under his watch and amounted to a “RosUkrEnergo-2.” She further justified her the revocation of the permit by suggesting Vanco was in current negotiations to sell off its activities to other companies, including Gazprom.

At a press conference earlier in the day, Vanco’s senior vice president Jeffrey Mitchell dismissed claims about the four students and expressed frustration at the government’s unwillingness to discuss the situation directly with the company. “Gene Van Dyke is absolutely the owner of Vanco,” he said. The practice of assigning a project to a country-specific subsidiary is “absolutely normal,” he added, pointing to the same practice in its African offshore projects. All such subsidiaries are connected by Vanco International Ltd. (VIL), itself a subsidiary of Vanco Energy.

Mitchell declined to expressly describe the ownership structure of VPL, but presumably its main shareholders are VIL and London-based JNR, the private investment vehicle for Nathaniel Rothschild. Vanco and JNR put forth a joint bid during the tender process in 2006 that resulted in the PSA after a year and a half of negotiations. JNR is likely playing the role of financier for the project. (Updated – see below.)

The only instance of four college-aged people associated with the deal, according to Mitchell, were the signatures of four accountants with Ernst & Young that helped with registration services–they are otherwise unconnected to any of Vanco’s activities.

As for questions about financial viability, Mitchell pointed out that the company was drilling two wells in Africa this year, one for about $65 million and the other for $40 million. The company is planning on investing $87 million in the Prekerchenska project this year, with about $60 million of that covering over 4,000 sq km of 3D seismic data collection. Following an open bid process, Vanco is currently negotiating with a seismic mapping firm with the aim of starting this fall. Collection and interpretation of the data is expected to take over a year and any delays could interfere with the company’s drilling plans.

Mitchell said Vanco was expecting to sign a contract for a drilling ship within the week, a process which includes a $30 million letter of guarantee. Drilling of the two wells is expected to cost about $140 million (about $1.2 million / day, 60 days per well), with the first one scheduled for the first quarter of 2010. Vanco is in the process of coordinating with Turkey and Petrobras, who will also be using the same ship for drilling in the Turkish section of the Black Sea. This cooperation is necessary to justify the expense in getting the ship, which will be the largest such drill rig in the world after it is completed in December 2009, through the Bosporus.

Should the government continue with its attempts to strip Vanco of its ability to work on the project, the company is prepared to use legal action to recoup sunk costs. This could potentially cost the Ukrainian government around $100 million. It would also delay any production in the Black Sea for years, as high demand for technically capable drill rigs complicates scheduling.

Tymoshenko also allegedly criticized the terms of the PSA, which she claimed gave Vanco a 90/10 revenue split. Vanco asserted that the ratio for the first phase of the project (until the company recoups its investments) is only 70/30 in favor of the company. Following that point, revenues will be split 50/50, though taxes and royalties are likely to shift that the figure closer to 35/65 in favor of the government. Mitchell claimed the terms of the PSA are more “pro-government” than about 70-80% of comparable deals worldwide and suggested that Ukraine’s inexperience with such agreements is leading to unfounded accusations.

Vanco is also frustrated that the government, by not seating its half of the inter-agency PSA coordinating committee, is interfering with progress on the project. The company is still awaiting approval from the government for its 2008 work program, submitted in February. Vanco has yet to receive even an acknowledgment of its receipt.

The company expressed further frustration that the battle against its activities is being waged through the press–Vanco only learned that its permit had been revoked through mass media reports. It is hoping that the formal complaint and threat of a lawsuit will finally force the government to confront the company with its issues and begin a discussion.

To me, four things suggest Tymoshenko’s crusade against Vanco is much more about publicity and popularity than on sound business sense:

1. Her reliance on the press for communication as opposed to direct talks with the company.
2. The current government’s obvious intention from the beginning to not cooperate with Vanco on the project, as suggested by the lack of an attempt at fulfilling any parts of the PSA.
3. Tymoshenko drawing Yushchenko into the conflict, blaming him for much of the trouble despite the fact that he had absolutely nothing to do with the deal other than to be present when it was signed. The PSA was completely the result of Yanukovich’s cabinet.
4. Her attempts to connect the issue to corruption in the gas sphere (another of her pet issues) by mentioning Gazprom, RosUkrEnergo and shadowy foreign-registered companies.

The sad part is, if they cannot reconcile, both Vanco and Ukraine will end up the eventual losers in this episode.

Update (5/16/08) – From today’s Kommersant (my translation):

Mr. Mitchel said [at a press conference yesterday] that JNR Eastern Investment Ltd. had intended to participate in Vanco Prykerchenska Ltd., but because the granting of the license and the signing of the PSA lasted 18 months, the company [JNR EIL] lost interest in the project.

[Instead] Mr. Mitchel explained that the composition of Vanco Prykerchenska Ltd is made up of his company [Vanco], Rinat Akhmetov’s Donbass Fuel and Energy Company [DTEK], Russian entrepreneur Evgeny Novitsky’s Shadowlight Investments Ltd, and the Austrian investment company Integrum Technologies Ltd [represented at the press conference by Gerhard Eckert], all on a parity basis.

While Integrum wouldn’t divulge whose interests it served, a UralSib analyst Kirill Chuiko told Kommersant that Integrum had in its time acted in the role of an investment intermediary for the Austrian oil [and gas] company OMV. [Edit: An OMV spokesperson responded to my inquiries regarding a possible connection by saying that “There is no connection between OMV and Integrum Technologies Ltd. at all.”]

And from UkrRudProm (my translation):

“Deutsche Bank (fulfilling the role of an intermediary) approached us, suggesting we participate in the project in the role of a financial investor,” explained Maxim Timchenko, general director of DTEK.

The government denied that the annulling of the license was aimed strictly against DTEK [a long-standing rival of Tymoshenko, including in the Dniproenergo affair]. The Minister of Environmental Protection Gregory Phylypchuk responded that, “Independent of which groups will be the investors, a beneficial investment climate will only appear when all the main players legalize their relations with the Ukrainian power [government].”

The government is still refusing the return the license to Vanco. The revelation of investors is seen as a way for Vanco to strengthen its position should the dispute go to court, depriving Ukraine of a “gotcha” moment.

The composition of investors is certainly interesting and it’s too bad that I missed this press conference…

Government revokes Vanco’s Black Sea hydrocarbon license

Vanco faces the revocation of its Black Sea shelf hydrocarbon project – From vancoenergy.com

On May 8th, Ukraine’s Ministry of Environmental Protection announced it was revoking Vanco Energy’s offshore exploration and production license for the Prykerchenska region of the Black Sea.

Vanco had signed Ukraine’s first ever hydrocarbon production sharing agreement (PSA) last October after a year and a half of intense negotiations, but growing criticism from Prime Minister Yulia Tymoshenko and her government had led to speculation that the deal may be canceled.

Ukraine is apparently willing to allow Vanco to reclaim its license should the terms of the deal be restructured. The company is refusing to reexamine the agreement, however, and is likely to take the issue to international courts.

Revoking the deal will likely push back any Black Sea production for years, while worsening an already jittery mood among international investors.

There is a press conference scheduled for Monday afternoon featuring Tymoshenko and her Ministers of Economics and Environmental Protection, with the revocation of the license as the likely topic. (I have requested permission to attend and will update accordingly. Update: I’m not enough of a journalist for their tastes, so cannot attend. However, I will be going to Vanco’s press conference earlier in the day. Updates from that to follow.)

The Houston-based Vanco was the surprise winner of a 2006 tender giving them exclusive rights to negotiate for the license on the 13,000 square kilometer Prykerchenska region off the Crimean coast. Ukraine’s Black Sea offshore zone is believed to contain massive amounts of hydrocarbons, with Vanco estimating its region alone potentially holding 2-4 billion barrels of oil equivalent. Development of these reserves would help Ukraine wean itself from reliance on Russian oil and gas.

However, production in this deep-water region is complicated by Ukraine’s offshore inexperience and technical limitations. Chornomornaftogaz, the Crimean subsidiary of Naftogaz, lacks the means to drill beyond depths of around 100 meters, while the Prykerchenska zone ranges from about 500 to over 2,000 meters deep. Full-scale production (should the region be fruitful) would likely take tens of billions of dollars.

The combination of these technical and financial hurdles led Ukraine to call for outside investment and employ a PSA to coordinate the project. The process of reaching the agreement was a drawn-out and affair complicated by the government’s inexperience. The final agreement (discussed below) was signed as the Viktor Yanukovich-led government was on its way out of office, to be replaced by Tymoshenko’s cabinet.

In March of this year, the Minister of Environmental Protection criticized the PSA, saying that the tract was too large to give away, especially to such a relatively-unknown company. His calls to reexamine the license were picked up by various Verkhovna Rada Deputies and were later echoed by Tymoshenko herself.

On April 11th, Tymoshenko publicly criticized the PSA, intimating that foul play was involved in the deal and announcing the government’s intention to look into the situation with the aim of restructuring the license.

“Ukraine gave all this wealth away to one company,” she reportedly said. “Meanwhile, the State Finance Monitoring Agency has figured out that this company, it has become clear, is registered in an offshore zone by four female students between 20 and 22 years old.” This off-shore structure, along with the grand size of the area, led her to equate the awarding of the license to a “global crime.”

On April 15th, Vanco’s 80-year old founder and chairman, Gene Van Dyke, gave a press conference in Kyiv to give his company’s side of the story.

Vanco’s founder Gene Van Dyke emphasized his company’s experience in deepwater drilling.

One of his central messages was iterating a desire for openness and clarity throughout the process, and he backed up that goal by clarifying terms of the company’s bid, the PSA, and its work schedule. He also expressed frustration at the government’s comments and lack of support as the company has attempted to move forward in its development plan.

Indeed, Vanco asserted that the Ukrainian government had not contacted them privately regarding its criticisms, instead relying on accusations through the press. This comes even as the government has failed to fill its half of the inter-agency PSA coordinating committee that is supposed to be overseeing the work of Vanco on the offshore project.

Just before the mid-April press conference, the government announced that first deputy PM Alexander Turchynov (Tymoshenko’s right-hand man and candidate in Kyiv’s pre-term mayoral elections) would lead the committee. This position was supposed to be filled by the second of two first deputy PMs, whose duties cover the fuel and energy complex, but Tymoshenko has not filled this role (though at one point Vitaly Gaiduk from the Industrial Union of Donbass was rumored to be tapped for the position). The other spots on the government side of the committee, however, were not filled.

The absence of this committee forced Vanco to essentially proceed with its business plan without explicit approval. This has led to delays and trepidation from the company that they may come under additional pressure.

Van Dyke also emphasized his experience in the oil industry and background as a “wildcatter.” He spoke of the significant potential of the region due to its geological characteristics, while at the same time stressing that there remains critical risk–all of which is being borne by the company, as versus the Ukrainian government.

Van Dyke, an 80-year old “living legend,” is a sharp contrast to the co-eds described by Tymoshenko.

Here’s a rundown of the situation, as described by Van Dyke at the press conference last month:

• Vanco’s bid in the initial tender outlined a three-year initial stage, with the committee committing to investing around $200 million during that time frame. This expenditure comes in the form of at least 3,000 square km of seismic data (budgeted at $60 million) and the drilling of two wells, regardless of the results of this data (at $70 million per well). Van Dyke believes this pledge to sink two wells within the first three years pushed Vanco’s bid above others, which apparently included more conditional language. “We had the most aggressive work program,” he said.
• The plan for the next three years included an additional 1,000 sq km and drilling another two wells.
• Three years after the start of the deal, Vanco is required to release a quarter of the land back to the government. At the end of the nine-year exploration period, the company has to give back everything except for the land surrounding any fields they discover. The government can then give out the returned acreage to other companies through new license agreements.
• The PSA calls for a 70-30 revenue split in favor of Vanco until the point when the company recoups is losses. From that point on, it will be a 50-50 division. However, adding in the 2% royalty and the 25% corporate income tax results in about a 65-35 split in favor of the government, according to Vanco.
• This year’s work program calls for $87 million in investment from Vanco. They aim to complete 4,200 sq km of 3D seismic mapping (above the 3,000 sq km required). After receiving seven bids, they expect the task to cost about $50 million. They hoped to begin in September, expect the mapping to take about seven months, and then plan eight months for reviewing the data.
• Vanco expects to begin drilling in 2010. Turkey’s national oil company and Brazil’s Petrobras are also coordinating in potential Black Sea development. Vanco has agreed to jointly contract a drilling rig with them. The rig, MPF01 (multi-purpose floater) is currently being constructed in China. The topside will be built in Spain, and it is expected to leave the docks in December 2009. Passing through the Bosporus will require a partial de-construction of the large rig. Once in the Black Sea, Petrobras gets to drill the first well, followed by Vanco, followed by Turkey’s oil company, with the pattern then repeating itself.
• The ship costs about $1.2 million per day. With wells expecting to take 60 days, that results in about $70 million per well. If Vanco can get cooperation from the government, by 2010 “we should have some major discoveries off the shore of Ukraine,” Van Dyke said.
• All resources extracted are to be sold in Ukraine (unless the government refuses, and decides to export them). All oil extracted will be sold at world market prices. The price of gas will be pegged to the current import price for Russian / Central Asian gas. (No one knows exactly what will be down there–the geological formations are very suggestive that something is there, though.)
• Vanco has no intention to sell off its license. While Van Dyke admitted that they have been approached, he said they are firmly committed to their work program and developing the area. He also strongly denied the rumor that they would sell off to Gazprom, saying he had never hear anything from the Russian company and wouldn’t sell to them anyway. (Gazprom has no offshore experience anyway, so that idea is rather impractical).

I’m off to Vanco’s press conference, more later.