As prepared for delivery
Remarks by John E. Herbst
U.S. Ambassador to Ukraine
Energy Sector Reform and European Integration
at the NaftoHaz-sponsored Conference
"Oil and Gas Industry of Ukraine: On the Way to European Integration"
Wednesday, November 9, 2005; 10:00
International Exhibition Center, 15 Brovarskyi Prosp.
Thank you, Mr.Chairman, for moderating this forum, and thank you to the organizers and participants of this conference for coming together today to discuss the European integration of Ukraine's oil and gas industry.
Ukraine has made a strategic commitment to European integration. Integration will bring greater foreign direct investment, as Western producers discover Ukraine as a manufacturing center for the European market. Integration will bring higher standards of living for Ukraine's population, and it will strengthen Ukraine's commitment to democracy, freedom of speech and of the media, and good governance.
Integration will also create challenges for Ukraine. Ukraine will need to open up its business practices and markets to European partners, and it will need to increase the competitiveness of its industries. As integration progresses, Ukraine will need to manage a gradual rise of input costs to European levels.
Key to Ukraine's successful integration will be energy sector reform. Today, Ukraine has significant additional operating costs due to energy inefficiency. Reliance on a small range of foreign energy sources limits competitiveness in pricing and hinders a gradual move to world prices. For any country, energy reform precludes such a high degree of dependence on a single foreign supplier.
Key to Ukraine's future energy reform will be the rational use of its oil and gas transit systems, positioned as they are between Russia and the Caspian on one side and Europe on the other. Ukraine will also enhance its energy sector by improving energy efficiency and by increasing domestic production of both onshore and offshore hydrocarbon reserves. U.S. companies and investors have potential roles in all three of these areas.
A realistic and commercially viable pipeline project
Congestion in the Bosphorus and declining North Sea production make bypass options around the Bosphorus Straights to Northern Europe increasingly attractive to international companies. Ukraine, as the world's largest energy transit country, can be a part of a possible bypass route by using its Odesa-Brody pipeline or other pipeline routes. Any pipeline project in Ukraine, or extension of an existing project, of course, should be done on a commercially viable and transparent basis.
Such a project should identify the array of upstream producers who own the oil, the transit companies to ship the oil, and the midstream refiners to process the oil at the other end. All links in the chain should be in place before the project begins, with an agreed market tariff rate that makes the project profitable. Government-to-government negotiations may play a role in project development, but the key ingredient will be the commercial contracts with private businesses to produce and refine the oil.
By bringing online a new pipeline route, the government of Ukraine would gain not only the revenues from the transit fees, but also valuable experience in transparent, western-style business practices. Success breeds success; once one commercially-viable transport project is accomplished in Ukraine, Western investors would be more willing to enter into similar agreements in the future.
I stress that any pipeline project must be commercially viable and transparent, because any effort to shortcut market forces in order to achieve greater energy integration with Europe will fail. Market forces should determine pipeline routes; oil should flow to where there are buyers. The price differential between Russian Urals and Caspian crude will of course be a factor in any rational business plan. And, if for domestic consumption Ukraine decides to use higher-cost Caspian crude, Ukraine must decide how it will pay for this price premium.
Increasing energy efficiency
In recent weeks the Government of Ukraine has recognized that any balanced plan for energy reform must address energy efficiency. Prime Minister Yekhanurov has announced plans for a 60% reduction in industry's dependence on natural gas. Part of this reduction will come from increased energy efficiency, and part from a switch in energy sources. President Yushchenko announced that Ukraine's Energy 2030 plan would feature a new component on energy efficiency.
The need for energy efficiency in Ukraine cannot be overstated. For every dollar's worth of industrial production, Ukraine consumes about two and a half times as much energy as does Poland. This addiction to energy is a symptom of the availability of cheap energy. The age of cheap energy, however, is over. As Ukraine moves toward Euro-Atlantic integration, it must also move toward world prices. World prices will bring greater transparency to the energy sector and force industry to modernize. These higher prices will encourage increased domestic energy production, and will justify investments in infrastructure to decrease energy loss.
Industrial modernization is overdue. Ukraine's metallurgy and heavy industry sectors rely on Soviet-era energy-intensive technologies, such as open hearth blast furnaces in steel mills. Open hearth furnaces were last used in the United States in the 1980s. Ukraine's old factories with their old technologies are not competitive with global industry that has been gaining efficiency over the last quarter century. In the long run, energy saving technologies will decrease operating expenses and increase net profits for Ukrainian industry. By consuming less energy overall, Ukraine will be better able to control its energy future.
Energy efficiency policies need to be developed using market mechanisms and incentives to save and modernize. Efficiency should not be state-administered.
Opening up Ukraine's energy sector to Western investment
American and other energy companies are very interested in Ukraine's hydrocarbon reserves, both onshore and offshore. Given the right set of commercial and government assurances, a range of companies are ready to launch deep water exploration in Ukraine's Black Sea, as well as onshore exploration, new field production, and enhanced recovery from existing fields.
A major find in the Black Sea would significantly improve Ukraine's energy security by lessening its dependence on foreign suppliers. While there is now exploration underway off the coasts of Turkey and Georgia, Ukraine's continental shelf remains unexplored. Nothing is known, therefore, about the potential type and amount of hydrocarbon reserves it may contain. Since this summer, the Ukrainian government has postponed plans to hold a tender on exploration licenses. Even if the tender is held soon, it may not attract investors effectively because it is expected to issue only limited-term exploration licenses, rather than the industry standard combined exploration and production license. Only stronger guarantees of investment and property rights, along with a more transparent tender process can attract the technologies, expertise, and investment capital Ukraine needs to explore its potential Black Sea reserves. Several American companies are ready to assume the risk of exploring and possibly developing Ukraine's offshore sector, once these conditions are met.
Regrettably, Ukraine's Communist faction recently registered draft legislation in the Rada that limits foreign investment in offshore reserves by requiring 60% of offshore ventures belong to state-controlled companies. The Verkhovna Rada's Fuel and Energy Committee has endorsed the legislation. This is a big step in the wrong direction if Ukraine is serious about attracting foreign direct investment in its energy production. Ukraine's parliament can show its commitment to open markets by stopping this legislation.
U.S. companies also can contribute to energy development and security in Ukraine by launching onshore enhanced recovery projects and new production projects. New exploration and drilling technologies have resulted in better data at the exploratory phase and longer lasting and more efficient drilling operations once production begins. But as in offshore exploration, Ukraine needs to provide transparent licensing procedures and guaranteed property and title rights if it wants to attract U.S. companies and technology to the onshore sector.
Alternative technologies -- many of them American -- will play a role in Ukraine's energy reform program. President Yushchenko has announced plans to focus on renewable energies and micro hydro-power stations as sources of clean, alternative energy. In my opinion, methane gas capture should also be on this list, since Ukraine has announced that its Energy 2030 plan will include increased use of Ukraine's 37 billion tons of coal reserves. Methane gas, the potentially dangerous by-product of coal production can be captured and safely used for pipeline injection, power generation, or local uses such as on-site boiler fuel, mine heating, and hot water generation. The U.S. is helping already with development of this new domestic Ukrainian source of energy. In September 2005 the U.S. Trade Development Agency awarded a nearly six hundred thousand dollar grant to Ukraine to fund a feasibility study on the development of Coal Bed Methane in the Donetsk Region.
Concluding Point
A diversity of foreign energy suppliers and routes, improved efficiency, and increased domestic supply will facilitate Ukraine's energy integration into Europe as an independent transit country, supplier, and consumer of energy. Transparent and market-based processes are critical for all three areas' development. The U.S. supports Ukraine in this effort, and we look forward to continuing dialogue on this issue and to supporting American business as they partner with Ukrainian counterparts.