With this installment, we turn to an article that was first published in the Project Finance Newswire in April 2005.
Doomed to Invest in Russian Oil?
At a major oil and gas industry conference recently, Lukoil
president Vagit Alekperov was asked about the prospects for
foreign investment in Russia’s petroleum sector. This
question followed only five days after a public statement by
Russian Natural Resources Minister Yuri Trutnev that
auctions to develop certain major Russian oil, gas and
mineral fields would only be open “to those companies in
which not less than 51% of the share capital belongs to
Russian participants.”
No wonder then that Alekperov’s response beginning
with “[y]ou are doomed to invest in Russia”was greeted with
appreciative laughter.
A very brief look at the recent legal history of foreign
investment in the Russian oil and gas industry, as well as a
look at a preliminary draft of a new law on underground
resources, suggests that the conditions for such investment
have not particularly worsened over the past decade.
Meanwhile, the macroeconomic fundamentals suggest that,
despite a flawed investment climate, international oil
companies are indeed “doomed” to invest in the Russian
petroleum sector, just as Russia is doomed to seek such
foreign investment, at least in the medium term. Compared
to other major oil-exporting nations that have shunned
foreign investments in their petroleum industries, Russia has
neither the historical imperative nor the geological luxury of
going it alone.
Background
After the Soviet Union dissolved in 1991, international oil
companies were keen to invest in Russia, figuring that Russia
would welcome their capital and technology, and the oil
companies were eager to add oil reserves to their balance
sheets. Russia had significant potential to export more oil.
Production peaked in 1988 and was falling due to lack of
investment and declining domestic demand tied to the
collapse of the Soviet economy.
While there had been no foreign investment in the Soviet
petroleum industry, the Russian Federation had a variety of
models to choose from. It could merely pay for foreign oilfield
services and allow no foreign participation in the production
itself (like Saudi Arabia or Mexico). It could license concessions
(like Canada). There were various other forms of participation,
including splitting the production with investors by
means of production sharing agreements like those used in a
variety of countries as disparate as Angola, Indonesia, Libya
and other parts of the CIS.
A country’s policy on a strategic resource like oil is rarely
made on purely economic grounds, and specific historic
factors are always at work. For example, both Saudi Arabia’s
and Mexico’s oil industries were created from the nationalized
assets of mostly American oil companies, in 1976 and
1938 respectively. Since then, both Saudi Arabia and Mexico
have continued to develop their petroleum resources on their
own, but in very different circumstances. Saudi Arabia’s oil is
relatively cheap and technologically simple to produce, much
of it coming from the single enormous Ghawar oil field.
Moreover the Saudis claim that production from this and
similar fields could be easily increased if the market justified
it.Mexico also produces the majority of its oil from one large
field (Cantarell), but that field is offshore in the deep waters
of the Gulf of Mexico, as are Mexico’s more prospective undeveloped fields. There is a constitutional prohibition in
Mexico on foreign investors having a participating interest in
petroleum projects, although economics and geology might
warrant otherwise. Saudi Arabia has a greater ability than
Mexico to go it alone in the future. Saudi Arabia is also more
heavily dependent on the petroleum sector.
In contrast, Russia’s original great petroleum region in
western Siberia was only discovered in Soviet times (excluding
the Baku oil fields in what is now Azerbaijan, even
though this was part of the Russian empire when the fields
were discovered in the 19th century). If Russia’s original
petroleum region was developed under challenging climactic
and geological conditions, then Russia’s new prospective
petroleum regions — in the Arctic, in eastern Siberia and
offshore Sakhalin Island — are even more challenging.
In February 1992, as a transition from the Soviet
command model, Russia adopted the current “underground
resources law” that introduces a licensing regime. Under this
law, the government owns all of the country’s oil, gas and
minerals, and licenses third parties (including state-owned
Russian and foreign companies) to explore and produce
them in return for payment of a fee to participate plus royalties,
taxes and duties. The underground resources law does
not prohibit foreign participation in tenders or auctions for
licenses, but it contemplates that foreign investors may be
excluded by other laws, such as the laws governing the
maritime continental shelf or national security, or even local
laws. Licenses can be transferred to related parties under
limited conditions, but they cannot be sold or used as collateral
to secure debt. By law, licenses are not property and are
not protected, for example, from changes in the tax laws.
Russian domestic oil consumption continued to fall into
the mid-1990s as did Russian oil exports. Some of the decline
in exports was due to Russia’s changing commercial relations
with former socialist nations that had not paid for oil in
convertible currency in Soviet times.Without a stable, transparent
legal regime, it was argued, Russia would not be able
to attract the investment needed to jump start production,
much less to develop new prospects in remote and technically
difficult areas, such as offshore Sakhalin Island. As a
result, various experts, both Russian and foreign, joined with
the oil companies in advocating that Russia adopt a new
regime based on production sharing agreements.
A production sharing agreement— or “PSA”— is essentially
an agreement between the government and an investor under which the investor agrees to risk
its money to explore and develop a prospective field, and if
“commercial” (i.e., enough) oil or gas is found, then the
produced petroleum is shared between the government and
the investor according to an agreed formula. Usually, a PSA
provides that the first amounts produced (sometimes called
“cost oil”) are allocated to the investor to cover its costs. The
balance, or “profit oil,” is what is shared.
While debate about a PSA law dragged on and Russian
companies snapped up licenses, Russia eventually signed
three ad hoc PSAs with international oil companies: the
Sakhalin I project in June 1995, the Sakhalin II project in June
1994 (but which came into force after Sakhalin I) and the
Kharyaga project in northeastern Siberia in December 1995.
Not surprisingly, all of these PSAs concerned expensive and
technically difficult projects outside the original western
Siberian oil district. President Yeltsin signed the new PSA law
in late December 1995, a few days after the Kharyaga PSA
was signed and before any of them had come into force.
Far from accelerating the pace of foreign investment in
the Russian oil sector, the new PSA law arguably slowed it, as
oil companies complained that the new law was inconsistent
with the tax code and lacked other provisions needed to
secure the economics of PSA projects. The oil companies
withheld investment in the hope that the PSA law would be
amended. The PSAs for Sakhalin I and II (which came into
force in mid-1996) and Kharyaga (which came into force in
early 1999) were negotiated directly with the Russian government
before the new law was written, and were thus “grandfathered,”
or protected from later changes in taxation and
other economic parameter.
Other projects did not have the option of copying the
PSAs for these three projects since their agreements had to
be governed by the new law. Calls to revise the new law
were countered by opponents, including domestic Russian
majors such as Yukos, that lobbied against the PSA law on
the ground that it unfairly favored foreign investors over
Russian oil producers. Gradually the opponents prevailed.
The PSA law was amended in 2003 to limit PSAs to a short
list of fields approved by the
Russian parliament, or Duma
— and only where a licensing
auction for the same field had
already failed.
Russian production and
exports of crude oil have
increased significantly since
the passage of the PSA law in
1995, despite the fact that not
a single PSA has been entered
into since its passage.
There are several reasons
for this increase. One is
skyrocketing oil prices. However, foreign investment in the
form of portfolio and debt investment in Russian oil companies
as well as mergers and joint ventures with Russian
companies have also played an important role.
The future?
The story of Russian production in the past decade has been
increasing production, often by Russian companies making
relatively inexpensive “brownfield” investments in existing
oilfields. The era of increasing production through such
brownfield investments is drawing to a close. Most analysts
agree that the biggest barrier to Russian exports today is not
production but export capacity, or the lack of pipelines and
port facilities needed to transport the oil abroad.
There is reason to believe that neither the remarks by the
natural resources minister about limiting foreign investment
to minority positions in Russian oil projects, the new draft
version of the underground resources law, nor the Yukos
affair are likely to stem this flow of investment. Although the
current underground resources law permits foreign licenses, most major project licensees are nevertheless Russian
entities,with ultimate majority ownership by Russians. A big
exception is TNK-BP, which is ultimately 51% owned by BP
(with licenses held by subsidiaries).
In his remarks, the natural resources minister referred only
to a specific group of fields, including Sakhalin 3 and some
fields in the Barents Sea, as well as some mineral deposits. In
the case of the oil fields he named (although not necessarily
the mineral deposits), it has long been expected that those
projects would be developed in partnership with Russian
companies. In the case of Sakhalin 3, for example, subsidiaries
of Mobil (now ExxonMobil) and Texaco (now ChevronTexaco)
won the right to negotiate a PSA for that project in 1993.They
were negotiating with Rosneft to form an alliance to develop
the project 10 years later when the PSA law was undermined
by the Duma. A new auction for the Sakhalin 3 project— for a
license or a “right to use underground resources” as it is
termed in the new draft underground resources law and not
for a PSA — will determine how it is developed. In contrast,
work has already begun on the Sakhalin 5 project, where a
Russian company that is ultimately owned 51% by Rosneft and
49% by BP is the licensee.
This is not to suggest that the new draft underground
resources law, at least in its present form, will be rapturously
welcomed by potential investors. Some unwelcome changes
for foreign investors are that the new draft underground
resources law explicitly limits licensees (now called “users of
underground resources”) to Russian entities or individuals,
and it explicitly grants the government the right to restrict
the use of “strategic” assets. This was the likely basis of the
natural resources minister’s comment that certain fields will
be restricted to minority foreign participation. Moreover, the
liability of users for non-compliance is broad, with exceptions
only for illegal acts of the government or due to force majeure.
Russian users of underground resources may be owned by
foreign investors (with some exceptions), and foreign investors
may welcome other provisions of the draft underground
resources law, such as classifying the right to use underground
resources as a form of “real property” that can be pledged or
assigned (albeit only with governmental permission) and limiting
the grant of the right to use underground resources
outside of auctions. Existing licenses will remain valid, or may
be converted to contracts to use underground resources (the
new term), at the existing licensee’s option.
So why are the IOCs “doomed” to invest in Russia’s petroleum
sector? Why shouldn’t Russia follow Saudi Arabia’s or
Mexico’s model?
Whatever the ultimate profile of the anticipated
Gazprom-Rosneft merger, the new state-owned behemoth
will not compare to a Saudi Aramco or Pemex, in the first
case because Russia does not have one enormous and easily
exploited oilfield as its cornerstone asset and in the second
case because Russia is developing, and gives every indication
of continuing to develop, its difficult offshore and remote
reserves with the help of foreign capital and technology,
whether through the existing grandfathered PSAs or through
joint ventures such as the Sakhalin 5 project.
It is no coincidence that the head of the Russian Federal
Energy Agency — former Rosneft executive Sergei
Oganesyan — said recently about the slowing pace of
production increases that the lack of significant investment
in developing production must be reversed if Russia is to
continue increasing oil output at a steady rate. In Russia, a
variety of private companies continue to function well,
many with substantial foreign ownership. The PSA law,
however disabled, remains on the books and could be
revived for the appropriate project, while the new draft
underground resources law does not represent a significant
departure from present practice. Russia will continue to
need capital and technology, not to mention additional
export capacity, to maintain and increase the increasingly
important income it derives from oil exports, while the oil
companies will still want to add reserves wherever they are
available. Taken in context, neither the natural resources
minister’s remarks nor the Yukos affair gives any indication
of changing that situation.