UKRAINE KILLS DOMESTIC

Ukraine is facing a huge energy-security challenge. It is dependent on Russia supplying most of its natural gas as well as uranium fuel for its nuclear reactors.

Under these circumstances, a responsible government would develop a policy aimed at encouraging domestic hydrocarbon exploration and production. Instead, the government of Ukraine is doing the opposite: It is promulgating ill-conceived, anti-market policies that are set to kill domestic production.

After Russia's seizure of the Crimea and the war in the country's east, the Western majors, including Shell, BP, Chevron and VITOL, ceased exploration and production or have left. The more risk-tolerant among the smaller companies have remained, including JKX, Arawak, and Cub Energy TPNEF -64.29%.

On my recent trip to Kiev to address the Adam Smith sixth annual energy conference, I learned that due to the need to raise revenue to pay back the forthcoming International Monetary Fund's $17.5 billion loan, the government of Ukraine has imposed exorbitant taxes on local oil and gas producers. The companies are forced by law to sell their output to the government-owned monopoly.

Kiev's new tax is a royalty, which taxes output sales, not just profits. The rates are 70% for state-owned companies; 55% on wells under 5,000 meters depth, and 35% on wells over 5,000 meters. The government views upstream as a cash cow.

This is hare-brained: The local production of oil and gas will be increasingly depressed, billions of dollars a year will continue flowing to Gazprom OGZPY +4.56%, and Ukraine will borrow from the IMF to pay Russia.

To make matters worse, half of Ukraine's energy is produced at its aging Soviet-built power stations. The uranium fuel for these is supplied by Rosatom, the Russian energy monopoly. This further deepens Ukraine's strategic dependence on Russia and opens it to energy blackmail.

This lack of strategic overview and leadership may also be explained as a move by Kiev to punish hostile oligarchs who are partners in some of the exploration and production companies. The punitive taxation is likely to force the Western-owned independents to sell out to oligarchs who are friendly with the cabinet.

Over the years, top Ukrainian oligarchs and politicians have benefited from subsidized gas prices, which kept their gas-guzzling, inefficient industries running. Russian oligarchs close to Putin still have their business partners in Kiev.

Ukraine cannot continue its dependence on Russian gas for geopolitical reasons. It can only thrive by increasing local production. Deterring Western investors would be suicidal.

The government of Ukraine needs to lower its punitive tax rates. Royalty fees need to be replaced by a reasonable corporate income tax. Ukraine state-owned companies should be privatized, and not into the hands of Russia and its allies. Ukraine must reform its oil and gas sector before investors abandon it—and before its dependence on Russian energy increases further.

wsj.com