Russia's Petroleum Progress Improvements In Progress For Russia's New PSA Law

Lucian Pugliaresi, Anna C. Hensel
LPI Consulting Inc.
Washington, D.C.

Russian legislation making production sharing agreements (PSAs) fully legal under Russian law passed the upper house of the Russian Parliament (Federal Council) on Dec. 19, 1995, was signed into law by President Boris Yeltsin on Dec. 31, 1995, and took effect on Jan. 11, 1996.

While PSA legislation remains the central legal basis for large scale investment in the Russian petroleum sector, company views towards investment in this sector are tied to much more than the extent of legal guarantees. Investor attitudes are also shaped by expectations regarding political stability, behavior of Russian regulatory authorities, and prospects for the Russian economy. Furthermore, Western investors in the petroleum sector have some experience in dealing with the Russian government and existing frameworks for investment, particularly the joint venture (JV) deals with Russian entities and the often changing regulatory and tax treatment of these ventures.

Clearly, the more worried investors become about arbitrary and capricious behavior by the Russian government on such issues as taxes and regulations, the more investors become convinced that they require greater legal protections before making major commitments in Russia. Some Western companies are seeking a very high degree of protection largely because they do not have confidence in the stability of the Russian government and the stability of the Russian tax system. As a result, these more cautious investors are seeking a level of legal protection which they might not require in some other countries.

It is our view that attitudes among some Western companies in Russia on the political and economic environment may be too pessimistic and shaped more by press reports than actual conditions. News reports on violence, political instability, and a disastrous economy are not entirely borne out by the facts. Russia, of course, faces serious political and economic problems which must be carefully evaluated, but the overall outlook is much more complex, and some positive developments are under way.

Politics and economics

On Dec. 17, 1995, the lower house (Duma) conducted parliamentary elections representing two important developments in Russia.

The first is that democratic processes are in fact under way. The elections were held in a relatively free and fair manner-and, most importantly, did take place. Voter turnout was high (estimated at 65%), indicating people want change and influence over the political landscape.

The election resulted in a strong showing for the opposition to the current Russian government. The Communists and Liberal Democrats gained the most votes, with the centrist "Our Home is Russia" led by Prime Minister Viktor Chernomyrdin, and liberal Yabloko group coming in third and fourth.

Only four out of the 43 parties in the race cleared the 5% hurdle to qualify for the 225 Duma seats open to proportional representation. As a result, only about half the votes cast by the electorate succeeded in placing candidates under proportional representation in the Duma.

On a political level, the entry of the Communists into a prominent position in the Duma is hardly good news, but the most recent election represents the first time in Russian history that two consecutive elections have taken place. Democracy is taking root. More importantly, the Communists are not seeking a return to central planning and have on the whole been supportive of PSA legislation.

The likely contenders for the June 16 presidential elections are Boris Yeltsin; Gennady Zyuganov, chairman of the Communist Party; Vladimir Zhirinovsky, leader of the Liberal Democratic Party; Grigory Yavlinsky, leader of the Yabloko movement; and retired Gen. Alexander Lobed, a leader of the Congress of Russian Communities. Although it is true that Zyuganov is leading in the Russian polls, it is impossible to predict the outcome of the elections, and even a Yeltsin victory cannot be ruled out.

Economic outlook

Russia in January 1992 instituted a radical reform package with economic liberalization and privatization as the main foci.

In 1995, the International Monetary Fund (IMF) Stand-By Agreement was granted in conjunction with a comprehensive stabilization program. This loan led to a program of curtailing inflation, government spending, and the money supply.

The past year has seen substantial improvement, much of which can be attributed to economic requirements under the IMF loan program. The Russians can claim some success. Inflation has fallen from 17.8% in January 1995 to 3.2% in December 1995 and 4.1% in January 1996.

Through a combination of tight monetary and fiscal policies the Russians have been able to hold the value of the rouble against the dollar within a corridor of 4,300-4,900 roubles, although modest upward adjustment is expected this year. Currency reserves have expanded significantly with $1 billion in the beginning of 1995 and finishing the year with $12 billion. This performance is one indicator of the government's commitment to stabilization.

The 3 year decline in industrial production is finally bottoming out. In 1995 the volume decreased by only 3% vs. 21% in 1994. Since May 1995 production levels have increased by 1-2%, although production is still only 54% of its pre-reform levels.

There are other signs of improvement. As mentioned earlier, inflation has receded, the rouble has stabilized in its exchange value with the dollar, the decline in industrial production has bottomed out and appears to be on the verge of a recovery, and the Russian budget deficit continues to meet stringent IMF targets. Fig. 1 [73647 bytes] presents recent trends in each of these categories. These trends do not indicate that the Russian economy will be free of turmoil, but that the current news certainly does not suggest that the economy is on the verge of collapse.

The ratio of incomes of the richest and poorest segments of the population reached 1:13 in the past year. This number may be indicative of the dissatisfaction with the current government and largely accounts for the Communist and Nationalist showing in the past election.

Oil production outlook

Although the Russian economy is in the early stages of stabilization, the long term outlook for Russian oil production remains bleak. There may be short periods of stable output, as has been the case over the last year, but massive investment is needed to turn the industry around.

Production for 1995 was approximately 6.2 million b/d, down from 10.4 million b/d in 1987 (Fig. 2 [37910 bytes]). Russian officials recognize that to end the production slide they must quickly improve infrastructure and well rehabilitation work in the oil producing provinces. Many of the problems causing the downturn in production-such as inadequate well stimulation, bad cement, paraffin buildup, casing leaks, failure of mechanical pumps, and limitation of drilling depth-can be addressed quickly with adequate foreign investment and appropriate technology. We estimate that a minimum of $7-9 billion/year in new investment is needed just to maintain production at current levels (Fig. 3 [46971 bytes]).

A positive factor for the oil industry is recent progress in easing controls on domestic energy prices. The domestic price of oil has risen to 50-60% of the world price (around $9/bbl in October 1995) from 20% of the world price in 1992 (Fig. 4 [50528 bytes]). This trend offers some promise for increased revenues for domestic producers, which concurrently offers positive news for their foreign partners. Increasingly, foreign JV partners will not have to look abroad for sales to gain sufficient revenues to recover their investments.

PSA law needed

Investors considering JVs face a wide array of overlapping and confusing laws, which fall under both administrative and commercial law. Capricious lawmaking has deterred several Western companies from even looking at prospects in Russia.

Although many companies are carefully pursuing opportunities and specific projects, several are pulling out of Russia. Elf Aquitaine SA of France considered two projects in the Volgograd and Saratov regions and actually held two licenses to explore fields in these regions. Fed up with the lack of progress in its deal, however, Elf finally gave up the licenses.

Saga Petroleum AS of Norway is another company that decided to forgo Russia because of the lack of legal guarantees and the inability to reach closure on its opportunity in the Timan Pechora region. Saga also encountered too much resistance from local authorities.

Even with the problems faced by Elf and Saga, many major oil companies remain in Russia but are holding out for a proper PSA law before actually making capital investments. These investors are divided into two camps.

Investors in the first camp have a positive outlook and have shown considerable flexibility in the kind of PSA legal framework that may be necessary to proceed with their projects. Members of the second camp, on the other hand, continue to take a very strict posture, including arguing that the law must be written in a highly protective manner for PSAs.

Both of these investor groups have been a significant force within the Russian oil and legislative arena in educating and lobbying Russian government and legislative authorities on the merits of PSA legislation. Both domestic industry sources and prospective foreign investors made a strong and convincing case on the need for PSA legislation, and to a large extent the Russian Parliament responded, even if the final result was considerably less than expected.

The PSA law

The signing of three production sharing contracts, Sakhalin II in June 1994, Sakhalin I in April 1995, and Total's Kharyaga in December 1995, provided strong impetus for the Russian Parliament to reach a compromise and complete legislation for a PSA law. Essentially, foreign investors were seeking a legal basis which would provide the following:

• The foreign investor would sign a PSA contract with state officials (regional or federal governmental authorities) to develop, produce, and sell from a specific block.

• The investor would take on all the risk.

• The investor would split production with the state using a sliding scale formula ensuring increasing production went to the state, especially if the project became profitable.

• The investor would have the right to sell its own share at world market prices and be free to do as it wished with the revenues.

• All current taxes, duties, and fees not called for in the PSA contract would be eliminated.

• The investor would be obligated to pay a royalty fee for use of the resource, a profit tax, and the share of production owed to the state according to the individual contract.

• Any dispute concerning the contract would be dealt with in a neutral forum-international arbitration. Russian law would apply to the investor's conduct.

The "investor-friendly" draft PSA law passed its first reading on Feb. 22, 1995, and passed the second and third readings in the Duma on June 14, 1995. The Federation Council voted against the law for political reasons and for lack of understanding the law. The reasons the Federal Council gave for opposing the law were as follows:

• The draft PSA law provided for no Russian Parliament approval of individual PSA contracts.

• Regions would not be adequately involved in the negotiations of the contracts.

• The law provided tax privileges or "exemptions" in conflict with Russian law.

• The law was in conflict with other legislation such as the Underground Resources Law (URL).

• The law should not prevail over other federal laws, and international arbitration should not be an automatic right.

Final passage

The PSA law that eventually passed, after almost 2 years of a stormy legislative effort, is not as investor-friendly as the original version passed by the Duma in June 1995. Although this law, as compared to the earlier Duma version, has curtailed investors' rights in several essential areas, its passage is a positive starting point from the perspective of the oil and gas industry.

In fact, those who strongly opposed the PSA law are no longer in the Federation Council and Duma. The chairman posts of the committees have been confirmed, and reports indicate that Alexei Mikhailov (PSA supporter and original drafter) of the Yabloko group will chair the Natural Resources Committee and the Budget Committee will be chaired by Mikhail Zadornov of the Yabloko. The Property and Privatization Committee will be chaired by Pavel Bunich of Our Home is Russia, while the Economic Policy Committee will be chaired by Yury Maslyukov of the Communist Party.

Previous PSA supporters in the Duma who did not win re-election are trying to become key staffers, which will be a positive development for Western industry.

Key provisions

The new PSA law represents a substantial step forward for investors considering major commitments to the development of Russian oil and gas resources, particularly in the Russian Far East.

Many in the Western oil industry have presented their concerns to the Russian government that the law does not provide all the necessary protections and procedures needed to attract investment. Nevertheless, this law does provide a basis for carefully moving forward with projects which need the legal basis for a PSA to proceed.

The PSA law also provides specific procedures for converting existing JVs to a PSA. Article 6 of the new PSA law details the conversion process. However, the process appears lengthy and in fact seems to deter a JV from converting to a PSA.

If a JV converts to a PSA, the Russian partner must give up exclusive control over the license to operate a field. Also, the specific field must be on a list of fields to be approved by the Parliament. It is quite likely that the fields to be included on this list drafted by the government will be those giant and supergiant fields or other prospects requiring sophisticated technology and large capital commitments-both of which are too expensive to develop without Western investors. If the Parliament approves the field in question, a production sharing contract or agreement must be drafted and endorsed by a special negotiations commission established by the federal and regional government (as specified in the PSA law).

After an agreement has been made, the PSA must then be approved by the Duma because in most cases the JVs were given licenses without undergoing a competitive bidding or tender process. Another complicating factor is that local authorities may oppose JV conversion to a PSA because taxes cannot be collected as easily as before. Rosneft would have to issue through rebates any collected revenues to the local authorities.

Concerns and interpretations

Foreign investors in Russia working through various organizations continue to evaluate the PSA legislation and are working closely with the Russian government to make their views known. Western oil companies in Russia are in general agreement that modifications to PSA legislation are necessary either through legislative amendments or through so-called normative acts, which are a form of government regulatory edict. The major concerns of Western companies on the PSA law are as follows:

• The right to international arbitration in a neutral jurisdiction needs clarification.

• Other laws, particularly the Tax Code and the Subsoil Law, need modification to be brought into conformance with the PSA law.

• The right to export one's own oil should have no restrictions.

• Clarity is needed on the issue of customs duties exemptions for imports and exports.

• Clear rules are needed for cost recovery, profits tax calculation, and accounting procedures.

• Grandfathering provisions in the PSA law need further clarification.

Western industry has raised its concerns with Russian authorities and legislators at such forums as the Gore-Chernomyrdin Commission meetings, Petroleum Advisory Forum, the Congressional U.S.-FSU Energy Caucus, and other institutions. A key recommendation is the formation of an inter-ministerial group to prepare the much-needed normative acts, regulations, laws, and amendments and submit these to the Duma.

For the most part, Western oil companies have informed the Russian government that the new PSA law is not sufficient for them to commit funds for development. Much of the disappointment among these investors is that the Duma had originally passed a bill that was viewed by the industry as highly favorable in protecting their investment.

The earlier bill provided such measures as access to international arbitration, the right to export all of one's own production to hard currency markets, clear exemptions for customs duties for exports and imports, clear rules on cost recovery, profits tax calculation and accounting procedures, and others.

Western companies are also concerned with regard to administrative procedures, such as a licensing requirement, which might undermine the status of the PSA as a preeminent legal document. Such a license would fall under a different legal regime (administrative rather than commercial).

When responding to Western concerns over problems with licensing requirements, some Duma members take the position that a license more clearly establishes the status of the foreign entity, including the type of activity to be implemented. Note that Roskomnedra (Russian Federation Committee for Geology and Underground Resources) is the issuer of licenses and is regulated by the URL, which is viewed as inconsistent with PSAs.

The Duma has been working on an extensive list of legislation to encourage investment and sound business development. This list includes the Tax Code, Law on State Immunity, Law on Amendments to the Law on Profit Tax, Law on Amendments to the Law on VAT, and others. Other laws related to the PSA law which must be passed or amended include the laws "On Subsurface," "On the Continental Shelf," "On the Fundamentals of the Tax System," "On Production Sharing Agreements," "On Foreign Investments in the RSFSR," and "On the State Regulation of Foreign Trade Activities."

Western investor groups have asked the Russians to coordinate development of these laws under a single coordinating body, the proposed inter-ministerial group.

Russian response

While the new PSA law clearly raises concerns, Russian authorities believe that prospective Western investors have overreacted and presented a too pessimistic interpretation of the law. Nevertheless, during the recent Gore-Chernomyrdin meetings (Business Development Committee Meeting Jan. 7 in Washington, D.C.), Deputy Minister Shatalov addressed industry concerns and committed to working with Western oil companies to arrive at a solution.

We believe the Russians are serious about proceeding with the necessary changes so that investors will have sufficient legal guarantees to proceed with their projects. Russian authorities genuinely are committed to getting some of the large scale oil and gas projects under way this year, but must do so under an environment where power is now shared between the government and the Duma. Russians do appear to be acting in good faith and have set a schedule for completing the necessary regulations and amendments.

Chernomyrdin signed an instructional decree on Jan. 19 setting a term of 2 months for completing Item 2 of Article 26 of the PSA law, which states: "The government of the Russian Federation and the Bank of Russia shall, within a period of 3 months, bring their normative legal acts into conformity with this federal law as well as submit, in accordance with the established procedure, to the State Duma of the Federal Assembly of the Russian Federation, proposals concerning the introduction of amendments and supplements stemming from this federal law to the legislative acts of the Russian Federation."

The decree directs the various ministries, Roskomnedra, Rosleshkoz, Roskomdragmet, GosComOboronProm, along with the Central Bank to conclude all the work called for in PSA Item 2, Article 26, as well as related tasks, within 2 months. The decree also requests that the list of fields and deposits to be approved under the law be submitted to the government within 2 months.

The Ministry of Fuel and Energy issued an order on Feb. 13 detailing a work schedule to implement the PSA law and setting specific dates for completion. All work in conjunction with the PSA law is to be concluded by June, with deadlines as early as March. In addition, a "group of experts" has been named to work on the normative acts and amendments to legislation.

To date several Western companies have indicated they are pleased with the dedication of the Russian government to resolve the PSA issues. The Russians appear committed to get a workable and reasonable PSA law in place as soon as possible so investments can go forward.

Next steps

There is no doubt that Russia poses serious risks for any company considering a major development commitment. Risks of these types, however, are part of the international petroleum business. Furthermore, there are genuine differences in company evaluations of risk and company strategies to mitigate them.

For example, Total will be working for improvements in the PSA law and accompanying regulations, but according to trade reports is proceeding with its PSA project with the view that grandfathering provisions in the PSA law can be strengthened sufficiently over the next few months.

In a different approach, ARCO joined forces with the Russian integrated firm Lukoil through an equity investment. Essentially, ARCO has chosen a strategy to become "Russian," which is likely to prove to be an extremely effective approach for dealing with a broad range of risks in Russia as well as opening up new opportunities.

Other companies have also shown remarkable abilities to work through the maze of government regulations and approvals and educate Russian authorities on what it takes to attract capital over the long term. For those companies that have the patience and staying power, Russia is likely to yield the benefits to justify the effort.

Company concerns over the delays in getting the necessary protections in place represent a legitimate reason to be cautious. This year may prove to be pivotal in terms of industry commitment to Russia. However, given the massive transformation facing Russia and the distance the nation has traveled towards a Western style economy in such a brief period, the accomplishments to date are remarkable.

The Authors