Would Russian oil companies really like to have a PSA regime in Russia?

Dec. 23, 2002
The establishment of the Russian state system in the early 1990s and its transition to the new circumstance of running the economy on market principles required the formation of laws to regulate subsurface usage issues in the Russian Federation.

The establishment of the Russian state system in the early 1990s and its transition to the new circumstance of running the economy on market principles required the formation of laws to regulate subsurface usage issues in the Russian Federation.

At the time, the unsettled situation surrounding subsurface usage issues during the transition from free usage to paid usage was accompanied by a severe shortfall in financial resources of the domestic producing companies—brought about by the state's refusal to fund the fuel and energy complex companies during privatization.

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This in turn necessitated the search for new mechanisms to attract investments—then predominantly foreign—as well as for organizational and legal forms of conducting the business of extracting mineral resources in Russia.

On the basis of the Federal Law on the Subsurface, adopted in 1992, the legal status of subsurface usage was structured within the framework of administrative law. However, frequent changes in legal standards governing subsurface usage and the absence of a stable and favorable tax regime for long-term investments did little to assist the inflow of capital investments into the Russian mining and oil and gas industries.

PSAs arrive

So there emerged new investment mechanisms in the area of subsurface usage as an alternative to the license regime. Among such mechanisms and forms for attracting investments in practice internationally, production-sharing agreements were first on investors' lists, essentially creating "enclaves of stability" in unstable econ- omies.

The advantages for foreign investors stemmed from the fact that the PSAs ensured the internal stability of contractual relations within the sphere of the agreement itself and against the backdrop of overall instability in the receiving state's economic and legal systems—due to the intensive process of creating such a system in the state.

Also, under the conditions of nonconvertibility (or partial convertibility) of the ruble, the PSA mechanism ensured for investors reimbursement of funds invested in a project in the form of a fungible product (exported minerals and hydrocarbons).

For the domestic companies and the host state, PSAs had a number of advantages compared with other mechanisms for expediting investment in upstream activity under the prevailing conditions of that time. Primarily, these advantages entailed relieving domestic enterprises or the state of the need to attract internal funds, which were in deficit at that time.

Therefore, given the conditions of the total structural economic depression in the state at that time, the introduction of PSAs was expected to start a number of investment projects that would have direct and indirect (associated plus multiplying) macroeconomic effects.

Initially the PSAs were welcomed by the government and legislative circles, except for the left-wing opposition and some other forces that considered the PSAs as "selling out the motherland." These opposition forces managed via a number of high-ranking officials in the Federal Assembly to organize a response and delay the process of passing the PSA through the Federal Assembly. Then the PSA opponents were joined by the representatives of newly emerging and growing Russian capital, who had become stronger in their ambitions (both in the upstream and downstream industries). These new capitalists, however, then could not possibly have participated on an equal and competitive basis with the foreign companies in implementation of the large-scale investment projects, which were referred to in the aggregate as PSA projects. Instead, they sought to reserve for themselves a place in the future market of these export-oriented projects (the PSA project investors were granted the right of 100% export, while the average export share granted to oil producers in the state was around 30%) and thus their participation in the associated contracts.

An incentive to the state was that the PSA projects ensured the stable and payable demand for the products of associated industries.

Legal changes

As a result of a broad effort by all parties, the federal law on PSAs was adopted early in 1996. This law, as the result of a compromise, turned out to be not quite perfect and required further improvement, although it was better than existing laws regulating investments in the mining sector—including oil and gas.

Twenty-seven projects that were allowed to be developed under the PSA regime were governed by a series of List Laws. Amendments to these 11 laws were adopted, bringing existing legislation into compliance with the norms of the PSA Law. At the same time, besides three functioning PSAs signed prior to the PSA Law coming into force (Sakhalin-1, Sakhalin-2, and Kharyaginskoye), just one more PSA has been signed—covering Samotlor field, for which activity has not started yet.

Divergent attitudes

The main reason for the divergence of attitudes toward PSAs among Russian vs. foreign companies working in Russia comes from the structure of the oil assets that these companies have in Russia and from the competitive considerations and specific properties (including drawbacks) of the PSA legislation itself. Among these considerations:

Foreign companies do not have oil reserves under their control in Russia and are seeking to get access to them. And in Russia, all more easily exploitable (cheaper) resources or reserves of crude oil in the state are already under control (entered into the balance sheet) of the Russian oil companies. Therefore, foreign companies may claim, as a rule, marginal reserves located in remote areas that are often outside the framework of the existing oil-specific and general economic infrastructure. To ensure their profitable development within the framework of the license system of the subsurface usage is practically impossible—the risks are too high, mainly because of the instability of the economic and legal environment in Russia. Only the PSA, which is an alternative to the license regime, can make development of such reserves profitable. Thus, the formation of an efficient PSA regime in the state is a vital, rather than an ancillary, task for foreign companies.

Accordingly, foreign investors are interested in working in the Russian oil industry only under the PSA terms. This is the official position of the Petroleum Advisory Forum, comprising the Western oil companies operating in Russia.

The situation of the Russian companies is different. In the early 1990s, in the course of privatization of the oil industry, all fields under development or prepared for development—as well as considerable reserves under prospective categories (on the basis of so-called "historical characteristics")—were transferred practically free of charge to the balance sheets of Russian oil companies that were then being formed. Russian companies currently carry out 100% of their production in the state under the terms of the license system. So acquiring the right of subsurface usage under the PSA terms normally means for the Russian companies the acquisition of assets referred to under the "third level" of prioritization—or those in addition to resources that have been already developed or prepared for development. In other words, the PSA regime has for Russian companies only a prospective meaning and is not as vital for them as it is for the foreign companies.

This is why the majority of the major Russian companies do not share the optimism of foreign companies regarding the advantages of the PSA regime: They carry out their evaluations under a different set of parameters.

No mass transition to the PSA regime among the Russian companies has occurred (however, many of them have preferred to "book for themselves" areas of the subsurface eligible for the PSA regime) and couldn't have occurred. Why? Because they are quite well stocked with reserves, including those under active categories, and they open for themselves under the PSA regime only an additional possibility related to the development of new prospective fields located, as a rule, in more harsh environments compared with the existing reserves of their producing assets.

Foreign companies as evident competitors are not needed by the domestic companies to carry out independent implementation of the new projects in the Russian market. The exceptions here are the projects in which the Russian companies already owned the licenses to subsurface usage rights but did not have at that time the required financial resources for their development. Therefore, the Russian companies considered foreign companies as potential investors invited solely to perform the role of "guided" partners (keeping the right of control in Russian companies' hands), serving more to broaden their own portfolios rather than to act as strategic investors. Independent entry into the Russian market by foreign companies under PSA terms means the aggravation of competitive battles in that market for new assets, in which foreign companies have evident advantages. So support of the PSA regime means, for the Russian companies, creating conditions for aggravating the competitive struggle, while delaying it means protecting their competitive positions in the market.

Establishing administrative limitations on the PSA application, in particular that of the 30% "resource" quota allocated for production sharing. Under such conditions, Russian companies have to spend much more in the way of resources (financial and administrative) on the receipt of the right to subsurface usage under the PSA terms, compared with a license system under which there is no related artificial demand for "agiotage" (stock market speculation) demand. However, the Russian companies, having at their disposal considerable administrative resources, have preferred to "book" for themselves subsurface areas eligible for PSAs. In many such instances, these companies do so without having in mind the possibility of starting negotiations for the purpose of commencing commercial development of these areas. Instead, as with the case of getting subsurface usage rights under the license system terms, they have in mind just entering the resources of those areas into their balance sheets with the purposes of increasing their corporate investment ratings and thus reducing the cost of borrowed funds meant for financing their current operating costs.

Maintaining, until the recent establishment of a severance tax (OGJ, June 24, 2002, p. 22), the corporate (transfer) pricing system for crude oil allowed Russian vertically integrated companies (VICs) to artificially underestimate the remittance for subsurface usage rights for crude oil produced under the license system. But that is not the case with the PSA regime, because within the PSA framework the pricing mechanism is fixed in the agreement itself, and its application requires the consent of the state as the second party to the PSA. In addition, various noncash tax payments became quite widespread among Russian VICs (barters, tax offsets, etc.)—and, eventually, nonpayments. All that allowed, under the conditions of overly exaggerated nominal fiscal pressure on investors working with the license system, to ensure, using less effort, a lower actual tax burden on the VICs vs. achieving, with greater effort, an optimum tax pressure on investors within the PSA framework.

The PSA application requires higher transparency in the activity of the companies on one side and in that of the state on the other side, i.e., efforts by both parties to the agreement on any matter specified by either were supposed to be explicitly detailed in the agreement itself. At the same time, much of the results generated by optimizing taxation of VICs in the mid-1990s was achieved due to "nontransparent" zones of subsurface usage, investment, and tax legislation (due to lack of details in the relevant sections of such legislation). So while the Russian companies were transforming a significant part of their revenues into net profit using loopholes in the legislation (in other words, acting legally but in "gray areas"), they were not interested in the development of mechanisms for expediting investment that called for the elimination of such loopholes or that envisaged only "clean" entrepreneurial activity.

The interest of the Russian companies in the PSA changes depended upon the level of international crude oil prices: the higher the price, the lower the interest. That's because a high price allows companies to receive sufficient profit even under the conditions of excessive taxation typical of the Russian license tax system. And, conversely, the lower the crude oil price, the higher is the need for the tax mechanism to ensure optimum sharing of gross revenues between the state and the companies. The smaller the gap between costs and prices, the more stringent are the requirements put forward by the companies regarding accuracy, flexibility, and transparency of the mechanism of gross revenue-sharing between them and the state. Thus, all positive achievements in the development of the PSA Law after it came into force were accomplished during a span of low oil prices following the Asian economic crisis (1998-99).

A number of Russian companies (OAO Yukos, for example) think that the existing Russian PSA regime is worse than similar regimes for subsurface usage rights abroad. They contend that it is less attractive than its foreign counterparts because, in Russia, the ratio of profit oil averages 30:70 in favor of the state, while the world average is 40:60 (OGJ Online, Mar. 13, 2001).

Let us note that this argument against PSA application in Russia is based on a widespread delusion and incorrect economic comparison: The proportions of sharing the profit oil production do not correspond with the proportions of allocating gross proceeds among costs, taxes, and profit.

At the same time, certain essential characteristics of the Russian PSA legislation really do suffer in comparison with those of foreign PSAs and need to be rectified. For example, in the area of streamlining legislative procedures for drafting and signing PSAs, excluded from the PSA Law are the requirements for legislative approval of separate agreements, detailed provisions on exploration requirements, and allowances for entering into state balance sheets mineral resources through increasing or cancelling the production quota. There is also a need to bring the Russian PSA legislation into compliance with the World Trade Organization norms under TRIMs, or the WTO Agreement on Trade Related Investment Measures, and with the Energy Charter Treaty regarding elimination of administered parameters of the use of the domestic workforce and equipment and for specifying the time limit for drafting the agreements and responsibility for their delivery.

The procedure of preparing and signing the PSA has not been finalized and is extremely complicated, bureaucratic, and time-consuming. Experience shows that such a process takes 5-7 years, while the PSA adoption procedure takes less than 1 year in other countries—normally 3-6 months.

The absence until now of a full package of the normative and legal documents that would apply in full the provisions of the PSA Law. The current PSA legislation does not provide full guarantees against changes in tax legislation. The investor is put under the pressure of making a case in domestic courts that the changes proposed by the state deteriorate the economics of the project.

Absence of the judicial practice of resolving disputes related to PSAs in Russia.

The state today mostly takes into account the voices of major domestic businesses (which mainly, according to the reasons cited, range from neutral to negative regarding PSAs). Therefore, a voice in support of the PSAs of small and medium-sized, nonintegrated companies developing mineral resources with difficult extraction properties is almost not heard by the state. Or the state just does not want to hear them—reflecting the current position of the Ministry of Economic Development and Trade, which has been responsible for PSAs in Russia since 2000, towards "small" PSAs (see chart).

At the same time, implementation of PSA projects for small fields (the practical use of Article 2.5 of the PSA Law) represents a considerable unused reserve for incremental growth of production and of the economic growth at the regional level.

Acknowledgment

The views expressed in this article are the author's own and do not reflect the official position of the Energy Charter Secretariat nor the position of any Energy Charter member state.

The author

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Andrei A. Konoplyanik is the newly appointed deputy secretary-general to the Energy Charter Secretariat in Brussels. Previously, he was president of the Moscow-based Energy and Investment Policy & Project Financing Development Foundation. Since 1993, he has held a number of advisory positions with the Russian Federation government, including the Russian Ministry of Energy, and has served on state Duma committees. During 1996-99, he was executive director of the Russian Bank for Reconstruction & Development in Moscow. Konoplyanik received his PhD in energy economics at the Moscow Institute of Management and earned a doctorate of science from the State Academy of Management. He has published more than 300 articles in Russia and abroad.