PROBLEMS PLAGUE RUSSIAN UPSTREAM VENTURES

Several upstream Russian oil and gas joint ventures (JVs) with foreign partners have begun operations and are producing and exporting oil. But continuing political unrest, inadequate energy laws and policies, and a burdensome tax regime continue to delay formation of upstream projects large enough to slow the rapid decline in Russia's oil and gas production.

May 24, 1993

4 min read

Several upstream Russian oil and gas joint ventures (JVs) with foreign partners have begun operations and are producing and exporting oil.

But continuing political unrest, inadequate energy laws and policies, and a burdensome tax regime continue to delay formation of upstream projects large enough to slow the rapid decline in Russia's oil and gas production.

George Hardy, a principal in the law firm Butler, Hardy & Stevens who directed the University of Houston project that helped revise Russian mineral and commercial laws, said frequent changes of Russian ministry officials disrupt continuity. Constant political turmoil discourages development of effective, integrated oil and gas policies.

Several measures have been proposed that would ease the tax burden in Russia on privately funded oil and gas enterprises. While some JVs involving foreign partners have received exemptions from the export tax others still await final approval of exemptions promised many months ago.

Observers agree that Russia's economic needs are deep and wide. But combined disincentives to foreign companies could delay redevelopment of Russia's oil and gas industry and put off broader economic recovery.

MEASURE OF STABILITY

Hardy said Russia in 1992 appeared to create some stability for oil and gas investors when it approved the republic's law on subsurface resources and implementing regulations.

The law adds stability by requiring that licenses for oil and gas exploration and development must be awarded through competitive bidding in tenders or auctions. Also, the law discourages monopolistic behavior by all entities, including government enterprises.

But Hardy said the subsoil law contains several flaws:

By failing to account for situations in which direct negotiations could be the best method of awarding acreage, the law discourages foreign investors from bidding for projects with marginal reserves or economics or other fiscally unattractive features.
While the law grants federal and regional governments joint jurisdiction over licensing, some republics and automonous regions have ignored the central government and adopted their own petroleum policies. As a result, continuing tension between central and regional authorities adds to political instability.
The law treats upstream oil and gas licenses as personal contracts or administrative allocations rather than statutory rights to underground resources, a financially -important distinction.

Instability also persists because of erratic progress of proposed petroleum legislation.

Russian lawmakers in April were reviewing two competing drafts of proposed petroleum legislation. One proposal was submitted in August 1992 by a group of Russian and foreign experts-including the University of Houston team led by Hardy assembled by Russia's Supreme Soviet. The other was submitted in March 1993 by the Interministerial Commission (IC) organized by the Russian Ministry of Fuels and Energy.

Hardy said the IC draft, from the perspective of experienced international investors in petroleum projects, is the less satisfactory of the two proposals, with the sections on transportation almost unworkable.

OTHER DISINCENTIVES

While political and legal uncertainty endure, Hardy said Russia's tax and fiscal regime is the biggest barrier to foreign companies seeking to form upstream ventures in the republic.

Major Russian tax and fiscal elements include royalties, a corporate income tax an inventory tax on property owned by enterprises, a value added tax (VAT) on property, equipment, and machinery imported by ventures, and a proposed superprofits tax.

The Russian VAT rate recently was reduced to 20% from 28%. Also, recent measures reportedly approved would permit petroleum production ventures to calculate the export tax on the basis of Russia's internal oil price, rather than the price received on exported volumes.

Among other factors deterring foreign investment in Russia, Hardy cited:

Lack of adequate processes for administrative appellate review.
Absence of accepted standards of due process.
Judicial system evolution inadequate to make judicial processes reliable ways of resolving disputes.

While it is hard to generalize about foreign company attitudes resulting from perceived political and economic chaos, the dearth of available financing indicates global lending institutions regard investment risks in Russia as too high, Hardy said. In fact, petroleum investor interest appears to have shifted to Central Asia, a development that doesn't bode well for project financing in Russia.

The effect of Russia's widespread chaos also is reflected in the decline of foreign investment. Hardy said direct investment in Russia in fourth quarter 1991 was slightly more than $52 million. In second quarter 1992, the comparable amount fell to $5.2 million.