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.
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 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.