Ukraine discloses new tax legislation initiative for gas producers

Ukraine’s Finance Ministry submitted on July 15 a draft bill outlining changes in the taxation regime for private natural gas producers. According to the draft that might be considered by parliament as soon as today, the production tax for gas will decrease from the current 55% of the natural gas price (and 28% for those mining gas from deposits deeper than 5km) to 29% (14%) as of 4Q15.

The law also stipulates changes to the taxation base for the production tax as of 4Q15. Now being the so-called marginal price of gas (maximum allowed gas price for industrial producers), the tax base will become the average import price of natural gas. 

On top of that, the draft proposes a special tax regime for new gas production projects that are approved after January 2016. For such projects, the government would offer a 20% (10%) rate of production tax, but at the same time introduce a “surcharge-to-profit tax”, which is in fact a tax on unleveraged free cash flow. A 30% tax rate will be applied to, roughly speaking, the maximum of [0.3 x EBITDA] and [EBITDA less exploration and production CapEx for the period], given our understanding of the bill. This regulation will take effect in 2016, according to the draft.

Alexander Paraschiy: The reduction of the tax rate to 29%/14% is a long-awaited initiative from the government, which is in fact a return to the taxation regime that existed before August 2014 (when rates were 28%/15%). If such an initiative is approved by parliament, it will allow gas E&P companies to unfreeze their investment projects that they halted after the prohibitive taxes were introduced. The key problem is that this rollercoaster, in which the tax regime for gas companies has changed three times over the last 15 months, has completely destroyed the sector’s confidence in the sustainability of any positive initiatives. The temptation of the government to impose new taxes on gas producers has not disappeared, in our view, even if this bill is approved.

In any case, this initiative will be beneficial for JKX Oil & Gas (JKX LN) and Serinus Energy (SEN PW), as well as for deep gas producers Regal Petroleum (RPT LN) and DTEK (DETKUA).

Regarding the special tax regime for new projects, we see no benefits for producers of gas from deep wells and only minor (if any) benefits for those producing gas from shallower wells. Theoretically, such an initiative could be beneficial for those producers having extremely high gas production costs (e.g. producers of shale gas, which are non-existent in Ukraine). For sure, such an initiative could be attractive for those gas producers who will be able to inflate their production costs (last year, average production costs for private gas producers were USD 40/tcm, we estimate).  

To illustrate the uselessness of this initiative, consider a deep well producer that currently pays 28% production tax (USD 70/tcm at a gas price of USD 250/tcm) and has production costs of USD 40/tcm. Under a lower rate, it will pay USD 35/tcm in tax. If it chooses to initiate a new project with the new tax regime, it will pay USD 25/tcm in production tax and USD 17-56/tcm in “surcharge-to-profit tax”, thus paying a total of USD 42-81/tcm in production and surcharge taxes.