Oleh Prokhorenko, CEO and Chairman of UkrGasVydobuvannya (UGV) since 2015, was brought in to turn Ukraine’s gas production sector around. At the start of his tenure, production was in decline and Ukraine’s gas sector was overly reliant on expensive Russian gas. Over the last three years, thanks to energy sector reforms and Prokhorenko’s result-oriented management, the transformation has been staggering. UGV, Central and Eastern Europe’s largest gas producer, has now dramatically increased production and revenues, even setting its sights on exporting its product once it helps Ukraine become self-sufficient in gas. Here, Prokhorenko explains the before and after of Ukraine’s gas sector and how international partners can get involved in its future growth
Previously, you had been working at McKinsey. How has your experience in international business consulting helped you take the company in a new direction?
My background has prepared me perfectly for the transformation of the largest natural gas producer in Ukraine and one of the country’s largest public sector companies. My master’s degree was in public policy and my work at McKinsey focused on the transformation of public and private sector organization. I got to experience and lead rapid transformations that were focused on results and meeting ambitious targets. That’s what we’ve been doing here, implementing international best practices in terms of corporate governance, management and oil and gas production. I am also bringing in the values that I adopted while working in the West – zero tolerance to corruption, a focus on value and maximizing shareholder value. It’s really an economical approach to resource allocation and utilization. As an example, this company had previously lacked, among other processes, rigorous investment decision-making procedures. We’ve implemented that. A lot of things we’ve done have brought in operational processes and technologies that we were missing, such as hydrofracking operations, the use of coiled tubing operations, improving the operational efficiency of drilling, compression stations, and so on. We’ve done all of this while focusing on the economic efficiency of the operations. We are a commercial company and that’s the mindset I am installing. It is owned by a state company, at the moment, but that doesn’t mean we shouldn’t set economic targets.
Why did you choose to get into the energy sector?
It’s a combination of two things. One, in my McKinsey work I focused on several sectors and one was energy. I did a lot of work in energy in the Middle East and the former Soviet Union, including Ukraine. So I understood how the sector operates and what was missing in this particular company. Energy is one of the critical priorities for the transformation of Ukraine. The slow pace of reforms prior to 2014, was one of the reasons why Ukraine found itself with large state budget deficits, unreformed energy prices, declining energy production and overreliance on imports. Turning that situation around is one of the main targets for Ukraine as a whole. One illustration is Naftogaz, whose group we are part of. Before 2014, it was a kind of black hole for the state budget; every year the government would have to subsidize the losses it was incurring because it was importing energy and selling it in Ukraine at unreformed prices. Today, Naftogaz Group is the largest contributor to the state budget. However, many of these reforms take time to be fully felt and now we’re at the point, going into 2019 and 2020, where we will really begin to see the reforms affect Ukraine’s economic situation. Gas production will increase, finances will be more balanced, and the sector as a whole will become more and more attractive to investors.
What have you achieved so far since you joined the group in 2015?
The main achievement is the growth of gas production. When I joined, the company was in a situation of declining production. Between 2014 and 2015, UGV lost about 600 million cubic meters in gas production. Part was related to losses in the military zone, and some was related to the decline of joint activity agreement productions within UGV. In the past, there were joint activity agreements made to increase production, but what happened was that those agreements turned out to be corrupt in most cases and production dropped. Moreover, systemically, this was a company that has suffered from underinvestment for over 20 years. This meant the equipment was largely outdated. For example, the average age of drilling rigs was 25 years old. If you look at the industry, the normal age is 9-10 years. And our largest compressor stations are 40 to 50 years old. Why? Because Ukraine hadn’t implemented the reforms in the gas sector that it needed in the past. Prior to 2014, Ukraine was paying one of the highest imported gas prices in the world, while UGV, the domestic producer, was getting only 10 percent of that price. It may sound absurd but that’s exactly what was happening. Our calculations show that between 2009 and 2014, Ukraine paid about $50 billion to Russia. That’s astronomical. Over the same period, only in Russia, there were 218 new drilling rigs that were bought. In Ukraine? Zero. That means that Ukraine, under the previous regimes, was financing the gas production industry in Russia, but not in Ukraine. Ukraine was Russia’s single largest market for gas and Russia was corrupting public officials to keep it that way. Fortunately, that has changed. The government has started increasing the gas price and brought in new management. Since 2015, we have achieved nearly seven percent growth in production, and even more in terms of revenue.
How important was the hydrofracking program in that production increase?
We began our hydrofracking program because it’s one of the basic techniques that is used in oil and gas internationally. It increases production and allows us to develop unconventional reserves. Between 2010 and 2015 there were no hydrofracking operations in Ukraine. To me, that’s an indication that either the previous management was bad or they had no desire to increase production. Hydrofracking is a cheaper operation than drilling. So, that was one of our first focuses and has been one of the most successful things that we’ve done. In two years, we added more than 240 operations, which added 2.2 billion cubic meters of gas. Net, Ukraine now buys at least 1 billion cubic meters less, so that equals around $350 million annually. Now, the money is staying in Ukraine. Calculations show that $1 invested in oil and gas production adds to $2 in GDP because of the multiplier effect. So, we are contributing to GDP growth, and I’m quite confident that we’ve had a significant impact.
UGV plans to invest around $4 billion by 2020 and ramp up extraction from 15.25 billion cubic meters in 2017 to 20 billion by 2020. What is your investment strategy?
Yes. In 2016, we developed a strategy called 2020 which envisions this increase in production and investment, and today we are on track. Between this year and last year, we’ve invested about €1.2 billion. The investment goes to several areas: maintaining and increasing the production program, investing in drilling, oil workovers (repairing old and dysfunctional wells), stimulation (programs like hydrofracking and others) and building modern compressor stations. A big part also goes toward modernizing and replacing outdated equipment. One of our largest projects is modernizing drilling rigs. We operate 65 drilling rigs that are based on old Soviet technology, so we have a project to replace some of those rigs. Eighteen months ago we had a competitive tender, in which three companies participated. The tender was won by Bentech, a German company which is now building and supplying five drilling rigs. This is a much greener and more efficient technology. We also have other programs to modernize equipment. In three years we have replaced half of our specialized equipment fleet. Some of this equipment is Ukraine-produced, but other elements come from countries like Germany. It’s a large capital program that includes both production and refining. We do have a refining unit within the country, which is the second largest in Ukraine. In the last two years, we had multiple tenders signed for equipment, which is continuously being delivered.
Are there any tenders open right now?
They’re ongoing. We reach out to foreign companies, including German producers. The more international suppliers, the better as it increases competition, transparency and technology. We are working with German companies Katt, Bentech, BASF and SAP.
And are you open to partnerships with German financiers?
Absolutely. We’re looking for sources of competitive financing. We currently work with the European Bank for Reconstruction and Development (ERBD) and the European Investment Bank (EIB). But we’re actively looking for opportunities to work with foreign financial institutions and foreign partners. When we developed the Bentech project, we contacted several German banks to help finance the deal. It hasn’t worked out so far, but we remain hopeful that it will. We’re also open to more foreign oil and gas companies entering Ukraine. We invite competition. As the largest company, we drive change in the sector, and our programs have led to an increased number of suppliers and contractors coming to Ukraine. There are several new companies who have recently entered the market. One project in particular that we’re looking for international partners on is called PEC Production Enhancement Contract. We’re looking for international oil and gas operators or service companies to come here and invest in our fields to increase production. Essentially, what we offer is an opportunity to invest in a long-term contract (10 to 15 years) so they can recover that investment by developing our sources.
Why should investors and companies come to Ukraine now?
I think Ukraine has done a great job in terms of the regulatory environment. The government is fully aware and understands the importance of the energy sector. The government has been liberalizing the gas prices for the domestic sector. For the industrial sector, it had already been totally commercial. If you invest in the oil and gas sector, you would sell at the European price. I imagine that within two to three years, Ukraine’s domestic consumption will be at market prices. Ukraine also has some of the lowest royalty rates in Europe for companies that drill new wells. Already, the private sector has seen a 70 percent increase in new wells commissioned compared to last year. There have also been a number of deregulation initiatives that have been implemented. For example, one law eliminated about 14 different licenses and permits that were previously required. There was also a separate law on distributing the royalties to the local communities, which has helped align their economic interests with ours.
Will Ukraine start exporting gas?
We will once we reach self-sufficiency in energy supply, which should happen within two to three years. The exact timeline depends on how fast we can increase supply and reduce domestic consumption. Then, we’ll be able to supply to European gas transit systems and we can start supplying countries like Germany, Austria and Poland. We already have European prices here, so it will be relatively easy. We’re very well connected to the gas transportation network – the largest gas transportation system passes through Ukraine. So the infrastructure is ready; it’s only a matter of time before we start exporting.
How important could UGV become to Europe’s energy security?
I think we can have a sizeable role. Not on the scale of competing with Russian companies because we don’t have such reserves. But, within the European context, certainly. We are indeed the largest producer in Central-Eastern Europe, so what that means is that we can have sufficient influence in the regional context. I imagine that UGV and Naftogaz Group as a whole will be regional and European players to be reckoned with in the future.
Martial law was just implemented in Ukraine. Does that affect you?
We see no interruption in our day-to-day business. We are very confident about that. We see this as an opportunity to strengthen security and provide assurances to outside investors that they are safe. We will continue growing gas production uninterrupted.