Russia's production sharing law--a foundation for progress

David R. Nelson
Wavetech Geophysical Inc.
Denver

Landmark legislation on production sharing agreements (PSAs) passed the Federation Council of the Russian Federation on Dec. 19, 1995, and was signed by President Boris Yeltsin on Dec. 30.

This long anticipated body of law will provide the framework for completing several of the PSAs that are currently under final negotiations and begin the process of bringing new areas up for tender.

While some in the industry have expressed concerns that the new law does not supply all of the necessary protections and procedures needed to attract investment, it is clear that passage of this law provides the basis for energy companies to cautiously proceed with projects that have been awaiting a legal basis.

The new law, in combination with the existing Law of The Russian Federation On The Subsoil ("Underground Code") provides for the following:

• Procedures for the offering and award of blocks.

• Guidelines for PSA negotiations and signing.

• Approval by federal law for agreements covering the continental shelf, exclusive economic zones, and zones of state interest.

• Framework for fiscal terms including profit tax calculation, local and value added tax ("VAT") reimbursement, exemption from other taxes, provisions for cost recovery ceilings, and flexibility in setting levels of royalty and profit hyrdocarbon share.

• Equal application of the law to foreign and Russian companies.

• Stabilization against adverse changes.

• Transfer and collateral rights.

• Term of the agreement and extension mechanisms.

• Standards for the protection of ecology and safety of personnel.

• Investor title to share of hydrocarbons and property acquired in performance of the project.

• Access to storage, processing, and transportation facilities on a nondiscriminatory basis.

• State guarantee of investor rights.

• Immunity waiver by the state on rulings of judicial and arbitration bodies.

The law as signed contains some terms that are of concern to energy companies. One of the main points of contention is that the law has a non-conflict clause in relation to the Underground Code, which was passed long before PSA legislation was considered. The Underground Code takes a different view of some issues as compared to the PSA law.

Even though in most cases these two pieces of legislation provide cross enabling language that supports each other and allows the individual agreements to set procedures and specific terms of project operation, some provisions of the Underground Code do contradict the spirit of the PSA law-in particular, an administrative ability of state entities to revoke the license. While there are provisions in both the Underground Code and the PSA law for resolution of these types of disputes, the potentiality of the need for frequent legal actions in response to claims against the license holder is undesirable.

Some provisions in the law itself are cause for concern such as the ambiguity in the stabilization clause. Such provisions will hopefully become the subject of amendments in the year near future. It would appear from Clause 1 of Article 17 that either party may effect changes to the terms of the agreement based upon a "significant change in circumstances in accordance with the Civil Code of the Russian Federation." This erodes some of the guarantee of rights to the investor provided in the Underground Code and other Articles of the law.

It is clear that some amendments will be necessary in order to mitigate these problems. From our recent experience of working closely with Russian energy officials at various levels, it is also clear that they are rapidly becoming comfortable and fluent with the detailed concepts of production sharing. We are hopeful that in the near future they will apply their knowledge to introduce the necessary amendments to the newly elected Duma.

History of PSA

The course of developments that has led to the current PSA legislation closely follows the political changes that swept the Soviet Union starting in 1985. The process of Perestroika, which the government of Mikhail Gorbachov initiated, opened the doors to the first oil and gas joint ventures (JV). While a significant development, the JV structure did not address many issues critical to the oil industry. The most important of these were taxation, freedom of export and transportation, and the question of government participation. Without national legislation, these issues overwhelmed some joint ventures, causing economic failure despite adequate reserves and production rates.

The decree of President Boris Yeltsin in December 1993 led to the beginning of the PSA era in the Russian oil and gas industry. This decree laid the groundwork for production sharing, including for the first time the concepts of cost recovery and profit hydrocarbons, thus somewhat clarifying the mechanism for government participation. However, the decree was not federal law and was therefore insufficient as a guarantee for large scale projects. It also left unresolved many important PSA issues.

As the initial PSA negotiations progressed, the idea of legislative approval of the agreements was put forth as a mechanism for giving the provisions of the individual agreements the force of law, thereby removing any ambiguity left from the presidential decree. From this, the push began to take the concept of production sharing one step further by writing and approving PSA legislation. The process of writing and passing adequate PSA legislation provided on one hand, an opportunity to bring together the progressive efforts of the various political, governmental, and industry groups in the Russian Federation, and on the other hand, it illustrated some of the inadequacies of the legislative process and politicization of this economic issue by some groups.

After a few well documented rounds of failed votes and changes to the law's text, it was finally passed in the final days of the old Duma.

Procedural issues

The law, along with the Underground Code, details the steps that are necessary in order to initiate and conclude a PSA. Plots of the subsoil will be nominated by both the local administrations and the federal licensing authority, Roscomnedra, and approved by the Federal Assembly. All announcements of upcoming tenders and the results will be published.

The government will form a tender committee that will direct each tender. The committee will consist of representatives of the federal executive authorities, including the federal authority of state subsoil fund administration and (or) its territorial subdivision and the executive authority of the local administration.

The committee will oversee the creation of terms and conditions for the tender, including a model agreement. The committee will also review the submitted bids, and then carry out negotiations with the winner leading up to the final signing of an agreement.

The committee and the tender winner will have up to 1 year from the date of the announcement of the results of the tender to conclude the agreement on production sharing. The agreement will be concluded between the investor and the state as represented by both federal and local authorities. If the agreement area included in the license lies in the continental shelf or in an exclusive economic zone, the agreements are subject to approval by federal law. Areas of special state interest and agreements concluded without a tender will also require ratification.

Agreements already sign- ed before the effective date of the law will be considered to have met the provisions of the law. Agreements currently under negotiation will be allowed to continue but will be subject to the 1 year time limit for conclusion.

The relevant license for use of the subsoil plot must be issued within 30 days of the signature of the agreement. Fig. 1 details the progression of PSA agreements from submittal through implementation.

Fiscal terms

The law defers the question of definitive fiscal terms to the individual PSA but spells out the basis for royalties, bonuses, and rentals, leaving the exact amounts and methods for payments to be specified by the individual PSA. This method is also provided for in the Underground Code. The ability to set specific terms for each agreement gives some flexibility to design appropriate fiscal terms to meet the economic needs of the specific project. However, obligatory terms and conditions that were set out in the original tender under which the blocks were awarded cannot be changed.

Profit tax will be determined on the basis of the investor's share of profit oil less deductions for financing costs, rentals, bonuses, and any other costs that are nonrecoverable from cost hydrocarbons. This approach solves some of the earlier problems associated with deductibility of certain expenses. The agreements will detail the expenses that can and cannot be cost recovered. Those that cannot will be deductible from the share of profit oil to arrive at taxable income. The exact tax rate to be applied will be that rate in effect at the time of the signing of the agreement.

Article 13 of the law clearly states that with the exception of profit tax and payments for the use of the subsoil (rentals and royalty), all other payments including local taxes are to be satisfied with the hydrocarbons received by the state under production sharing. The VAT that the investor pays for goods and services, and any local taxes the investor may be required to pay, will be credited against the VAT collected from the sale of hydrocarbons owned by the investor and by increasing the investor's profit oil share in the amount of the excess tax collected.

The law also requires that the agreements make clear provisions for the creation and funding of a plan of abandonment and site restoration.

The law does provide a stabilization clause to bring the overall economic benefit to the investor back to the original intent of the parties should new laws or regulations come into effect that would adversely affect the investor's economic position. This stabilization does not apply to cases where new rules are adopted for the protection of the environment or the safety of personnel, and it suffers from the ambiguous clause discussed earlier that needs to be clarified with future amendments.

Economics

The structure of the Russian PSA is simlar in many respects to other international contracts.

Elements such as signature bonus, exploration commitments, rentals, royalty, cost recovery, and profit sharing are commonly used. However, as stated earlier, in the case of the Russian PSA, the exact terms of production share percentage, royalty, rentals, and cost recovery ceiling percentage are left to be determined on a case by case basis. This provides flexibility to design a package of terms to fit the sometimes extreme exploration, operating, and marketing conditions that exist in some areas of Russia.

Fig. 2 details the economic flow of the Russian PSA.

More analysis

It is important to note that the law provides for equal rights for both foreign and domestic firms. This will allow international firms to compete on an equal basis with the newly created, reserve rich, integrated Russian oil companies.

While these Russian firms do not as yet have the capital resources to undertake risky, large scale projects, that time is rapidly approaching, especially considering that some of these companies may become valuable alliance partners to some of the international firms. The move by Arco to purchase a significant block of Lukoil shares is indicative of that tendency and in our view represents a strategically wise move.

By placing all potential investors on equal footing, the law has provided an atmosphere of fair and open competition that will result in PSA terms that are acceptable to the investors and at the same time ensure the protection of Russia's economic and sovereign rights.

The new Russian Federation Law on production sharing is certainly not perfect. A few significant problems and a number of relatively minor ones remain, and these need to be addressed either in amendments to the law itself or in related legislation or normative acts. However, it is important to recognize its significance, especially considering that as recently as 2-3 years ago, even the idea of a modern production sharing agreement was not given serious consideration by Russian lawmakers.

A major step has been taken that furthers the cause of investment in the Russian energy industry.

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