Ukraine: conflict and regulations weigh on oil sector

03 April 2018

Armed conflict in the Donbass region and a volatile regulatory environment will weigh on Ukraine’s oil and gas sector in 2018, as foreign investors are deterred from entering the country. Rebounding economic growth in 2018 will moderate the impact of elevated government spending on sovereign credit risks, although long-term debt sustainability will be contingent on implementing International Monetary Fund (IMF) reforms.

Security Environment

Armed conflict in Donbass continues to weaken Ukraine’s security environment. Fighting between the government and separatist militias has largely stabilised along a line of contact.

The intensity of fighting varies, in line with Russia’s strategic objectives, although there are numerous violent incidents daily. Grenade launchers, guns and mortars are the primary weapons used in the conflict, although during periods of escalation, heavy artillery and tanks have been used. In October 2017, the Ukrainian parliament approved a law on reintegration of separatist area. However, this is unlikely to significantly de-escalate the conflict, as Ukraine’s proposals will not be acceptable to separatists.

The weak security situation will weigh on Ukraine’s energy sector. Many oil majors have suspended operations or withdrawn from the country entirely. In 2016, Royal Dutch Shell withdrew from a shale gas exploration project in eastern Ukraine, having declared force majeure on some of its obligations at the Yuzivska natural gas field in 2014. Oil and gas assets have also been targeted in attacks by militias on both sides, and industry infrastructure will remain a target in 2018. In June 2014, the Urengoi-Pomary-Uzhhorod pipeline in central Ukraine was damaged by an explosion in a suspected terrorist attack. The attack did not disrupt gas flows.

Trading Environment

Government spending is expected to rise in 2018, as the current administration seeks to bolster its position ahead of elections in March 2019. The minimum wage rose by 16.3% in January 2018, whilst a further 10% rise is earmarked for 2018. Defence spending is also forecasted to rise from USD 4.9 billion in 2017, to USD 6.1 billion in 2018. Elevated spending levels will place pressure on Ukraine’s budget deficit, which is anticipated to reach 3.1% in 2019, from 2.5% in 2017. However, this will not immediately elevate sovereign credit risks, as rebounding economic growth enhances tax receipts on goods and services. Real GDP growth is expected to reach 3.0% in 2018, up from 2.1% in 2017.

However, in the longer-term outlook, Ukraine’s sovereign creditworthiness is likely to be weakened by slow reform progress. The country’s short term position is supported by a USD 17.5 billion IMF assistance package. However, payment of a USD 2 billion tranche of loans, initially expected in Q1 2018, will now be delayed by the IMF, as the government has failed to create an independent anti-corruption court. IMF withdrawal from the country would have significant implications for Ukraine’s fiscal stability, as Eurobond debt repayments will reach USD 1.8 billion in 2019, from USD 0.7 billion in 2017.

Investment Environment

The regulatory environment remains volatile for the hydrocarbons sector in Ukraine. In November 2014, the government decreed that major industrial companies could only buy gas from state-owned Naftogaz, forcing a number of foreign gas producers to suspend investment in the country.

Whilst the decree was invalidated in 2015, the government continues to routinely adjust taxes and regulations in the sector. Contract alteration risks are also elevated in Ukraine. For example, in November 2017, Naftogaz had 3 licences revoked for exploration and development of gas sites in Budyschansko-Chutivsky, Obolonsky and Pysarivsky. This followed lobbying by the Poltava Regional Council.

The outlook is more positive for the renewable energy sector, as Ukraine looks to reduce its reliance on Russian gas imports. In 2015, the government amended feed-in tariff rules, which will now be paid in euros, and removed local content requirements for solar projects. As a result, non-hydropower renewables generation capacity is expected to grow by 4.1% in 2018. However, the sector will remain a small part of the overall power mix at below 2%.

Ukraine: conflict and regulations weigh on oil sector
* Pricing would be dependent on the location and type of asset. Underwriters would avoid any risk in the east of Ukraine.
In this month's Risk Outlook, we also provide a detailed forward looking assessment of developments within the security, trading and investment environments for Democratic Republic of the Congo, Bahrain, Cuba and Guyana all of which have been the subject of recent enquiries from JLT's client base.

CPS April 2018

The monthly Risk Outlook is supported by JLT’s proprietary country risk rating tool, World Risk Review (WRR) which provides risk ratings across nine insurable perils for 197 countries. The country risk ratings are generated by a proprietary, algorithm-based modelling system incorporating over 200 international sources of data. 

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