Russia aims targeted stimulus at tough oil and gas resources

The action is playing out on six main fronts to be addressed by this article:

• The mineral extraction tax (MET) and export customs duty (ECD).

• The Yamal gas and LNG fiscal incentive package.

• The offshore fields fiscal incentive package.

• Shelf and other frontier fields licensing, possibly beyond the national oil companies (NOCs).

• Regulation of shelf operations, including application to nonlicensee operators, liabilities, local content, and other aspects.

• Gas-export liberalization.

MET and ECD

The Russian government's biggest claims on wealth generated by hydrocarbon development are the MET and ECD.

MET amendments

The MET applies to production. For crude oil, the rate is based on a formula that takes into account price, reserves volume, and degree of exhaustion of the deposit. Special deduction formulas apply to oil produced in Tatarstan and Bashkortostan.

A fixed rate applies to production of natural gas and condensate by Gazprom and its affiliates. Independent producers pay a percentage of the Gazprom rate. Associated gas production, to which flaring limits apply, has a 0% MET rate.

Changing the MET for incentive purposes requires an amendment to Russia's Tax Code. Many such amendments have been enacted since 2009, most taking the form of 7-15-year holidays for oil production—but not gas or condensate—up to thresholds of 10-35 million tonnes. These amendments apply in the Sakha Republic (Yakutia), Krasnoyarsk, and Irkutsk regions; the Nenets Autonomous Region; and certain areas of the Yamal-Nenets Autonomous Region. Those areas include the Yamal Peninsula; fields in the Caspian, Azov, Black, and Okhotsk Seas; and fields north of the Arctic Circle within internal and territorial waters (within 12 miles of shore) on the continental shelf.

A 0% MET rate applies to high-viscosity crude meeting physical specifications, without production volume or year limits. A governmental directive of May 2012 calls for work toward enactment of more-sweeping tax, tariff, and other benefits to encourage development of oil difficult to produce because of high viscosity or low reservoir permeability.

An MET holiday, subject to volume and year limits, also applies to Yamal Peninsula natural gas and condensate used for LNG. Similar MET holiday proposals are under consideration for gas produced from East Siberia and the Far East. Gas reinjected for pressure maintenance and condensate production also receives a 0% MET rate.

Conflict over a proposal to raise the MET rate for independent producers to Gazprom's rate has been resolved for now by an amendment enacted late last year that phases in rate increases for Gazprom and its affiliates and gradually shrinks discounts from the Gazprom rate for independents. The move has prompted Gazprom to consider selling shares in some of its gas ventures to independent producers in order to lower its ownership below the 50% + 1 share threshold that determines whether the full or discounted MET rate applies. De facto control over these ventures may not pass from Gazprom in any event.

The ECD for oil

Since its reintroduction 14 years ago when oil prices began rising rapidly, the ECD has come to take the biggest single fiscal bite.

Calculation of the ECD for hydrocarbons differs from the general Customs Tariff Law rule of discretionary rate-setting by the executive branch. For crude oil, the ECD is assessed on the basis of a formula tied to the Urals crude price, subject to government decrees. The current rate is 401.5 roubles/tonne of crude or condensate.

Adjusting the ECD to encourage oil projects has been difficult because the formula on which the rate is based is established by law, which defines crude oil as a particular commodity for this purpose. ECD reductions have occurred via governmental decrees that define (perhaps artificially) separate categories of crude. Winning this type of incentive have been Rosneft's Vankor field and about 20 other fields licensed by Surgutneftegaz, Slavneft, TNK-BP (now part of Rosneft), and Gazprom Neft and others in East Siberia. Gazprom's Prirazlomnoye field in the Pechora Sea has received ECD incentives, as have Lukoil's Korchagin and Filanovskoye fields in the Caspian.

Application and use of these ECD incentives are further complicated by their temporary nature and uncertain terms. The Ministry of Finance monitors projects with an eye toward cancelling them when internal rates of return are deemed to have reached acceptable levels, as it has with the Vankor and Korgachin fields.

The ECD regime for crude oil and oil products has been the subject of recent economic and political debate. The current approach is referred to as 60-66-90 because for crude oil it is set at 60% of the difference between the monitored world market price and a certain price passmark threshold; for light and heavy oil products the rate is 66% of the rate for crude; for gasoline it is 90% of the rate for crude. The aim of this system has been to encourage the manufacture and export of oil products while addressing a domestic shortage of gasoline. This approach is under constant review and reassessment; most recently, there has been talk of moving to a 45-90 model.

The ECD for gas

The ECD for gas differs from that for oil. It is 30% of the customs sale value, per government decree.

For pipeline exports, so far the only relief granted has been for Gazprom and its foreign partners in connection with investment in the Blue Stream pipeline crossing the Black Sea between Russia and Turkey. The relief was part of a 1999 bilateral treaty protocol, which prevails over Russian general law and was stated to last until full investment recoupment or 2015.

For LNG, the ECD was set at 0% by decree in 2005. But so far Russia's only exports of LNG come from the Sakhalin 1 project, which has a special exemption. For unclear reasons, the 2005 decree was rescinded in 2007, leaving no general exemption for LNG as a technical matter.

Recent ECD changes

The ECD regime gas changed fundamentally with enactment of amendments to the law enacted last year and effective as of Apr. 1 this year. Now the government:

• Has the general power to determine the formula for calculating the duty on crude and oil products but not to exceed per-tonne levels fixed by the Customs Tariff Law.

• Can set the ECD for specifically defined high-viscosity crude at 10% or less of the standard crude rate. The incentive can be set for a maximum of 10 years and until 2023 at the latest.

• Can set the ECD at or below established per-tonne incentive ceilings for a wide swath of frontier and shelf areas. The area includes any fields in the Sakha, Irkutsk, Krasnoyarsk regions and the Nenetsk region north of 65º N.Lat., and in the continental shelf, territorial sea, inland waters, and Caspian Sea zone. The ECD area of coverage substantially but not totally overlaps the regional MET incentives in the Tax Code.

A new, complex set of sliding-scale formulas enacted with these changes generally preserves the 60-66-90 ECD approach for crude oil, oil products, and gasoline. But debate continues on that subject.

Yamal Package

The first fiscal breakthrough for new gas development came in the Yamal Package, a crop of important legislative and executive measures now enacted foremost in support of the Yamal LNG project (OGJ, Apr. 15, 2013, Newsletter). The package would benefit other license-holders—most prominently Gazprom—that also could produce gas for liquefaction in the Yamal-Nenets (Yamal Peninsula) area.

The package sets MET at 0% on as much as 250 billion cu m of natural gas produced for liquefaction for no more than 12 years from the start of LNG production. Condensate production of up to 20 million tonnes also receives the 0% rate, subject to the same time limit. The package also sets the ECD at 0% on LNG and condensate, subject to enactment of a suitable decree.

The package further recommends relief from regional and local taxes on gas and LNG production. The Yamal-Nenets government responded in December 2010, lowering the general profit regional take by the maximum amount permitted by law (to 13.5%) and lowered the property tax to 0% from 2.2%, keyed to the same volume and time thresholds as in the broader law package mandate.

New deal for offshore

In April 2012, the Russian government essentially extended the basic Yamal LNG incentive framework, with further elements, to the newest wave of proposed exploration and production projects in tough offshore frontier areas. This Offshore Package aims at benefiting projects that Rosneft is pursuing in partnership with several IOCs and that Gazprom similarly might pursue under the restrictive current policy on shelf access. The general aim is reported to be to provide investors in these projects with an internal rate of return of 16.5-22%, calibrated to project difficulty by four defined categories. As with the Yamal Package, the Offshore Package itself enacts nothing but instead calls for legislative and executive measures to implement the intended stimulus.

The package applies to commercial production beginning after Jan. 1, 2016, of oil, gas, or condensate in internal waters, territorial sea, or the continental shelf, excluding offshore projects developed with horizontal wells drilled from land. For a field to be eligible, a government decision on granting an ECD concession or holiday must not have been made as of the date of enactment.

The Offshore Package exempts producers from the ECD with no time or volume restrictions, although these might be added later. It also establishes ad-valorem MET for offshore projects as a percentage of the crude oil, gas, or condensate sales prices, differentiated by degree of difficulty into these categories:

• First category (base level) projects, including in the Azov or Baltic Sea, 30%.

• Second category (heightened level) projects, including Black Sea shallow water (up to 100 m), Pechora or White Sea, and southern part of the Okhotsk Sea (south of 55º N.Lat.), including the Sakhalin shelf, 15%.

• Third category (high level) projects, including Black Sea deep water, the northern part of the Okhotsk Sea, and southern part of the Barents Sea (south of 72º N.Lat.), 10%.

• Fourth category (Arctic level) projects, applicable to the northern part of the Barents Sea and eastern Arctic (Laptev, Eastern Siberia, Chukotskoye, and Bering Sea), 5%.

The package sets the rate of profit tax at 20%, the same as the standard rate, and assures tax stability for specific periods by category: first category, 5 years from start of commercial production until 2022 at the latest; second category, 7 years until 2032; third category, 10 years until 2037; and fourth category, 15 years until 2042.

It also calls for a series of other incentives, such as deductibility of abandonment expenses, assurance that general fiscal conditions won't deteriorate if tax rates change during the stability period, reduced MET rates and other incentives to protect project economics if world crude oil prices fall below $60/bbl, and others.

Ministries were to have proposed laws and initiatives to implement the Offshore Package by last October, but the process is taking longer. Officials recently have indicated drafts might be submitted to the parliament soon, allowing enactment with effect next Jan. 1. A January 2013 directive from Prime Minister Dmitry Medvedev indicates Lukoil may receive an extension of the Offshore Package to cover its Caspian Sea fields, to be treated under the second category of incentives. Another sign of activity is circulation within the government of a draft strategy for full shelf projects to encourage local production of equipment and development of service providers.

Shelf fields license access

Little has occurred to broaden access to offshore licenses. Current law makes Rosneft, Gazprom, and their affiliates the only companies able to hold continental-shelf licenses, requiring state control and 5 years of Russian shelf experience. Technically, other Russian companies and IOCs could acquire 49% direct interests in a Rosneft or Gazprom affiliate having the requisite experience, subject to approval requirements. So far, however, Rosneft and Gazprom, with Kremlin approval, have offered only nonequity, joint-operatorship participation.

Efforts nevertheless have been made or suggested to at least diminish the shelf-license monopoly in the interest of accelerating offshore development.

The Ministry of Natural Resources, for example, has floated Subsoil Law amendments that would allow companies other than Rosneft and Gazprom to acquire exploration-only licenses and, in the event of discovery, join one of the shelf licensees as minority partners. Under a recently proposed variation, the license would allow only limited prospecting. Another suggestion has been to make licenses relinquished by the favored state companies available to other producers. No such reform has yet been enacted. The same fate so far has greeted efforts by state-owned Zarubezhneft to be allowed direct shelf access, whether by legislative amendment or interpretation.

Lukoil, meanwhile, has been pressing for Subsoil Law amendments that would make shelf licenses available to it and other Russian national companies that are not state-controlled. There might be better chances for short-term success by Lukoil and others in gaining access to the territorial sea. The company appears to be making headway in its effort to acquire more Russian blocks or convert exploration to production licenses (alone or in venture partnerships with Rosneft) in the Caspian and Azov Seas, which the government most recently seems to be treating as no longer equivalent to the continental shelf. IOCs might also soon be allowed to play a more-active exploration and production role in the Caspian and Azov basins as well.

On another possible reform front, the government might decide to allow companies not controlled by the state—Russian and even foreign—to acquire licenses to new strategic-size blocks in East Siberia and Far East onshore frontier regions and be unhindered in their development. There have been indications that this modest reform might occur because Rosneft and Gazprom can't do everything on their own.

For strategic onshore fields—defined as those having reserves exceeding 70 million tonnes of oil or 50 billion cu m of gas—a December 2012 amendment to the Subsoil Law bars tenders for development rights, thus allowing only auctions. This means the highest qualifying bidder automatically wins. Still, all continental shelf and strategic onshore gas fields will remain the exclusive domain of Rosneft and Gazprom. And those giants are wrangling over the "common space" in their offshore fields, with Rosneft seeking fields presumed to be mainly gas and thus previously reserved for Gazprom but Gazprom resisting vigorously and with some recent success on Arctic fields grants.

Shelf operations

Quiet progress has been made toward recognition of the role of nonlicensee operating companies, such as those working with Rosneft and some likely to do so with Gazprom or its affiliate Gazprom Neft on new shelf projects. Also developing are rules for shelf operations generally.

Russian law doesn't explicitly recognize the role of nonlicensee operators, notably those working essentially on a risk-service basis. The risk-service agreements now taking effect are to be governed by English law. Refinement under the Russian Civil Code would be useful in order to distinguish the intended risk-based relationship from straight fee-for-service. This would clarify the industry-standard apportionment of risk and provide comfort about enforceability of agreed terms in all circumstances.

A hopeful sign is the attention to nonlicensee operators that has appeared in several recent initiatives.

Nonlicensee operators are included with subsoil licensees in amendments enacted late last year to the Continental Shelf Law (CSL) and Inland Waters and Territorial Sea Law. The amendments, effective from July 1 this year, specify requirements for oil-spill prevention and response obligations. They include strict financial-security requirements.

Other amendments, now slowly progressing through the Duma—the lower house of the Russian parliament—will clarify exploration and production operations on the Russian shelf in positive ways.

Among them, CSL amendments would affirm that licensees may create and use artificial islands, facilities, and other structures if allowed by the subsoil license. Nonlicensee operators under contract to licensees now would receive such permission by simple governmental directive without further authority needed. The amendment also includes a provision stating that property rights to any such offshore structures may pass between operator and licensee. This clarification is needed to support the finance structure for the new Rosneft (and probable Gazprom) projects with IOCs.

The Shipping Code also is to be amended to allow vessels owned by a foreign company to be operated under the Russian flag if the company is more than 50% owned by a Russian person or company, if it has a branch registered in Russia through which the vessel is managed, and if the vessel is being used for shelf exploration and production or related support services. This amendment, too, will benefit the new Rosneft and Gazprom projects. Several other amendments will accommodate a growing non-Russian role in marine transportation related to exploration and production on the Russian shelf.

Part of the same multiprong draft law would provide a blanket exemption from the 2.2% property tax for property on Russia's shelf in the Arctic being used for development of gas or condensate reserves. This measure accomplishes one of the Offshore Package directives in a way that bypasses a requirement applicable to onshore fields for regional legislation.

Although Russia traditionally hasn't imposed strict local-content requirements in oil and gas outside of production-sharing agreements, of which only three are in force, recently issued offshore licenses contain a general obligation to purchase and use Russian-made vessels, installations, and equipment unless they are not available.

Also, last November the Ministry of Industry and Trade circulated a draft strategy for "localization of production of equipment and development of the oil and gas service sector for shelf projects to 2020." Details remain uncertain.

Gas-export freedom?

Gazprom's monopoly on gas exports is rooted in the Gas Export Law enacted 7 years ago. As interpreted to date, the law requires Gazprom or a 100%-owned affiliate—essentially Gazprom Export—to be the exporter, as owner or agent, of all gas leaving Russia in any form, including LNG. Some loosening has emerged in contracts with a few Russian independent producers for Gazprom to act as export agent.

Novatek and, more recently, Rosneft have been lobbying for removal of the Gazprom monopoly, even as agent, to support financing and development of the Yamal and other possible frontier gas and LNG projects. This might occur gradually, starting with only LNG exports aimed at the Asia-Pacific basin to avoid harming Gazprom's European and anticipated Chinese markets for pipeline exports of gas.

The law exempts exports of gas and LNG from grandfathered production-sharing agreements. LNG exports from the Sakhalin 2 project fall under this exemption as well as an express right in the agreement itself. Possible Sakhalin 1 pipeline exports to China would qualify as well but have met Gazprom resistance.

President Vladimir Putin is reported to be pushing Rosneft and the ExxonMobil-led Sakhalin 1 group to supply a desired expansion of the Sakhalin 2 LNG plant instead of Rosneft's building another LNG plant. The Sakhalin 2 project is led by Gazprom. Another Gazprom LNG project, at Vladivostok, also is receiving attention. Thus, even in the Far East, Gazprom's control won't relax easily.

Acknowledgment

A longer version of this article appeared in the April 2013 edition of the Association of International Petroleum Negotiators Advisor. The authors believe that the content of this article is accurate as of the end of May 2013. But this is a dynamic area. In general, and for this reason in particular, this article is for general briefing and orientation purposes only. It is not intended and should not be taken as legal advice for any particular project or set of facts. Qualified legal advice should be obtained for any such particular project or set of facts.

The authors

Jon Hines is a partner in Morgan Lewis's Moscow office, heading the firm's Russia/CIS oil and gas project practice. He has 25 years of experience representing private and state-owned companies from around the world on transactions in this region. His work focuses mainly on large-scale oil and gas (including LNG) and mining development, as well as merger-and-acquisition projects and related financings in Russia, Kazakhstan, Turkmenistan, Ukraine, and other members of the Commonwealth of Independent States. Hines has also assisted clients in connection with a number of Russia-related arbitration proceedings in Moscow, Stockholm, London, and Paris. He is currently serving his third 5-year appointed term on the Panel of Arbitrators of the International Commercial Arbitration Court at the Russian Federation Chamber of Commerce and Industry.

Hines earned his JD, with distinction, from the University of Virginia School of Law and his BA, with distinction, in international affairs and Russian studies from Princeton University. He is admitted to practice in New York.

Alexander Marchenko is a senior associate in Morgan Lewis's Moscow office, specializing in energy-sector transactions. He has 10 years of experience representing private and state-owned companies from around the world in Russia and other CIS countries on matters related to the oil and gas and mining sectors, including merger-and-acquisition projects, related financings, and regulatory advice. Marchenko earned his JD from Moscow State Law Academy and an LLM from the University of Toronto Faculty of Law. He is admitted to practice in Russia.