No. 1, 2010

New amendments to the Russian legislation on the subsoil encourage Russian companies to increase their overseas investment portfolio

The amendments introduced over the last few years into the legislation of the Russia on Subsoil use can affect how the leading Russian oil and gas companies review their strategy and tactics for replenishing their resource base in favor of overseas upstream operations.

Legal reality

By participating in overseas projects, Russian companies gain extremely valuable experience of operating in a fiercely competitive environment. At the same time, apart from positive stimuli, there exist many factors "forcing" Russian oil and gas companies to do this.

This situation is largely connected with the amendments and addenda made recently to the Law On Subsoil. In April 2008, for instance, amendments were introduced that determined the legal framework for using subsoil plots of federal significance. The new version of article 2.1 of the Law on Subsoil classes as subsoil plots of federal significance all internal waters, territorial seas and the continental shelf of the Russian Federation, as well as subsoil plots located on the territory of constituent entities of the Russian Federation and containing, among other things, recoverable reserves of oil in a volume of 70 million tons and gas in a volume of 50 billion m³. The procedure for official publication of the list of subsoil plots of federal significance was determined by resolution of the Government of the Russian Federation in November 2008. The current list includes about a thousand subsoil plots and is subject to regular updating as new geological information becomes available.

At the same time, article 9 of the Law On Subsoil establishes that subsoil users on plots of federal significance may be legal entities set up in accordance with the Russian legislation, unless the Government has established additional restrictions on access to participation in tenders or auctions for the right to use such subsoil plots for Russian legal entities with foreign investors.

More stringent requirements have been set for subsoil users on plots of the Russian continental shelf, which must not only be set up in accordance with the legislation but also have at least five years' experience of developing subsoil plots of Russia's continental shelf. The stake in their authorized equity capital directly or indirectly controlled by the Russia must be more than 5%. As of today, however, there is an extremely limited number of local companies with any experience of working on the Russian continental shelf. The majority of Russian companies with the requisite experience, potential and financial status for implementing projects on the shelf (such as LUKOIL, Surgutneftegaz and TNK-BP) are not formally under government control.

The predominant licensing regime for subsoil use in Russia does not fully meet the interests of the government and current reality. A countrywide transfer to a contractual system of subsoil use and a transparent system for awarding such contracts are needed.

Not by chance has there been a substantial increase recently in activity by Russian oil and gas companies in other countries. As practice shows, they are showing the greatest interest in Kazakhstan and Uzbekistan.

Borrowing progressive innovations

It should be noted that the Russian legislators are also studying attentively the leading CIS countries' positive experience in this sphere. In 1999, the licensing system for subsoil use currently prevalent in Russia was abolished in Kazakhstan and the subsoil started to be provided to investors for use on the basis of subsoil use contracts concluded between the investor and the Republic of Kazakhstan, represented by the competent authority (Ministry of Energy and Mineral Resources).

Today, Kazakhstan simply has no need for any broad application of the PSA system. Relations between the government and subsoil users were transferred on to the civil law basis back in 1999, when licensing of subsoil use was abolished and the subsoil use contract, which is a civil law contract in nature, become the only document regulating relations between the investor and the government.

Kazakhstan has apparently reached the level of development at which it no longer needs a full PSA law, since the basic PSA concept - stable conditions throughout the term of the agreement - conflicts with the nation's current requirements. Over the last 15 years, Kazakhstan has managed to attract such a volume of foreign investment that any further inflow of such investments might have an adverse effect on the country's national security.

As a result, since the early 2000s, the leadership of Kazakhstan has been pursuing a policy designed to make the foreign investment framework more stringent and to strengthen the role of the government in the energy sector. Also connected with this is the sharply increasing activity and the rise in the capitalization of the national oil company KazMunaiGaz.

The innovations in the legislative sphere should be viewed on the same plane. In January 2003, for instance, a new Law on Investments was passed, its main innovation being elimination of any differences in status between foreign and national investors.

The government's desire to strengthen its participation in the country's energy sector was realized in October 2005, when, in article 71 of the Law On Subsoil, a rule was introduced securing the priority right of the government to acquire the subsoil use right or a participatory share in a subsoil user company being disposed of on conditions not worse than those offered by other buyers.

The next serious step in strengthening the government's presence in the oil and gas sphere consisted in the amendments introduced into the Law On Subsoil in October 2007, in particular into articles 45-2 and 45-3. These articles deserve closer attention since they constitute a unique case of state protectionism on the part of the government.

Article 45-2 envisages the right of the Republic of Kazakhstan, represented by a competent authority, to demand from a subsoil user, in relation to deposits of strategic significance, changes to the terms and conditions of contracts in order to restore the economic interests of the Republic of Kazakhstan if the actions of the subsoil user engender a material change to the economic interests of the Republic of Kazakhstan.

Moreover, whereas article 45-2 envisages the need for a negotiation process to change or terminate the contract, article 45-3 does not, if the material change to the economic interests of the Republic of Kazakhstan jeopardizes national security.

For about two years, the above-mentioned rules lay "dormant," since the list of strategic deposits in the country had not yet been determined. This gap has now been closed. In August 2009, a resolution of the Kazakhstan Government approved such a list, including 231 subsoil plots.

Active work is now under way in the Republic of Kazakhstan to draft a new Law on Subsoil and Subsoil Use to replace the current laws On Subsoil and on oil production.

For Uzbekistan, an important stage in development of the legislative framework in the sphere of subsoil use was the adoption, in December 2001, of the Law of the Republic of Uzbekistan on Production Sharing Agreements, this constituting a major landmark in development of the legislation of the Republic of Uzbekistan On Subsoil Use. The new PSA law demonstrated a clear desire and readiness on the part of Uzbekistan to build relations with foreign investors on an equal, mutually beneficial basis and in consideration of generally accepted international norms and rules.

In general, the passing of the PSA law may be seen as a timely and progressive step toward improving the legislation of the Republic of Uzbekistan on the subsoil. The beginning of serious investment activity in the country may be linked with the adoption of this law.

The experience of LUKOIL, which concluded its first production sharing agreement with the Republic of Uzbekistan in accordance with the new PSA law in June 2004, shows that PSA as a new civil law institution, incorporated into the country's legal framework, may be considered as having taken root.

At the same time, Uzbekistan does not stand aside from the PSA discussions that have been ongoing throughout recent years in neighboring countries, above all Russia and Kazakhstan. There have been increasing calls recently within the Uzbekistan's government circles for the PSA system to be applied only in the most exceptional cases. The opinion is heard that subsoil exploration and development should be governed by the ordinary licensing regime as matter of priority.

LUKOIL is today the leading foreign investor in the oil and gas industries of Kazakhstan and Uzbekistan. The choice of these countries is largely explained specifically by their understandable and predictable subsoil use regimes, plus the commercial appeal of the local upstream projects.