Doomed to Invest in Russian Oil

At a recent industry conference, LUKoil President Vagit Alekperov was asked about the prospects for foreign investment in Russia’s petroleum sector. The question came only five days after a public statement by Natural Resources Minister Yury Trutnev that auctions to develop certain major oil, gas and mineral fields would only be open “to those companies in which not less than 51 percent of the share capital belongs to Russian participants.”

No wonder that Alekperov’s response beginning “you are doomed to invest in Russia” was greeted with appreciative laughter. Taken as a whole, the legal history of foreign investment in the petroleum sector in post-Soviet Russia suggests that international oil companies are indeed “doomed” to invest in the sector, just as Russia is doomed to seek such foreign investment. Compared to other major oil exporting countries that have shunned foreign investment, Russia has neither the historical imperative nor the geological luxury of going it alone.

After the Soviet Union dissolved in 1991, international oil companies, or IOCs, were keen to invest in Russia and add significant oil reserves to their balance sheets. Russia had the potential to increase exports with the help of foreign investment, as production continued to decline and domestic consumption fell.

Russia had a variety of models to choose from. Some countries, like Saudi Arabia and Mexico, merely pay for foreign oil field services and allow no foreign participation in production itself. Some, like Canada, offer licensing concessions, and some offer various other forms of participation including sharing the oil produced with investors by means of production-sharing agreements, or PSAs, which are used in countries as disparate as Angola, Indonesia and Libya, as well as other CIS countries.

Of course, a country’s oil policy is made as much on political as on purely economic grounds. In February 1992, Russia adopted the current Underground Resources Law. Under the law, the government owns all of the country’s oil, gas and minerals, and offers licenses on auction or tender to third parties to explore and extract them in return for royalties, taxes and the like. While the law does not prohibit foreign companies from holding licenses, foreign investors may be excluded by other laws. Licenses cannot be sold or used as collateral; they are not property and are not protected from changes in the tax laws, for example.

Yet Russian crude exports continued to fall until the mid-1990s. Some of this decline was due to former Soviet allies that were not used to paying for oil in convertible currency, but falling production was also a problem. 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 develop new prospects. As a result, both IOCs and various experts recommended a PSA regime. The PSA is essentially an agreement between the government and an investor enshrined by law, under which the investor risks money to explore and develop a prospective field, and if enough petroleum is found, it is shared between the government and the investor according to an agreed formula.

While discussion and formulation of a PSA law dragged on, Russia eventually signed three ad hoc PSAs with IOCs: the Sakhalin-1 project in June 1995, the Sakhalin-2 project in June 1994, which came into force after Sakhalin-1, and the Kharyaga project in northeastern Siberia in December 1995. Not surprisingly, all concerned expensive and technically difficult projects outside the original western Siberian oil district. After they were signed, but before any of them had come into force, President Boris Yeltsin signed the new PSA law in late December 1995.

Far from accelerating the pace of foreign investment, the new law arguably slowed it. International oil companies complained that it was inconsistent with the Tax Code and lacked other provisions needed to secure the economics of PSA projects, and withheld investment in the hope that the PSA law would be rectified. Opponents of the PSA law, including domestic Russian majors such as Yukos, lobbied against it on the grounds that it unfairly favored foreign investors over Russian producers. Gradually, the opponents prevailed, culminating in 2003 with amendments limiting PSAs to a short list of fields approved by the State Duma — and only where a licensing auction had already failed.

Meanwhile, production and exports of petroleum have steadily increased, despite the fact that not a single PSA has been created since 1995. There are several reasons for this, including a natural lag before the grandfathered PSA projects began production. Foreign investment in Russian oil companies, as well as mergers and joint ventures with Russian companies, has also played an important role. Yet much of the increase in Russian production in the past decade has been due to Russian companies making relatively inexpensive investments in existing oil fields.

Despite the difficulties, neither Trutnev’s remark nor the apparent denoument of the Yukos affair is likely to stem the flow of foreign investment. Trutnev’s remark referred to a specific group of fields, including Sakhalin-3. It has long been expected that they would be developed jointly 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. But well before the PSA law was effectively neutralized 10 years later, those companies were already negotiating with Rosneft to form an alliance to develop the project. A new auction for this project — for a license and not a PSA — will determine how it is developed. A joint venture between Russian and foreign companies would not be a surprising result.

This is not to suggest that the new draft law on underground resources will be rapturously welcomed by potential investors. The bill explicitly limits “users of underground resources” to Russian entities and explicitly grants the government the right to restrict the use of “strategic” assets. Moreover, the liability of users for noncompliance is broad, with exceptions only for illegal acts of the government or due to force majeure. But most Russian subsidiaries owned by foreign investors can participate, and foreign investors may welcome other provisions of the bill, such as classifying the right to use underground resources as “real property” that can be pledged or assigned with governmental permission, and expanding the use of auctions. And existing licenses will remain valid, or may be converted to contracts to use underground resources, the new term introduced by the bill.

So why are international oil companies doomed to invest in Russian petroleum? 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 be comparable to Saudi Aramco or Mexico’s Pemex. Unlike Saudi Arabia, Russia does not have one enormous and easily exploited oil field as its cornerstone asset. Unlike Mexico, with its constitutional prohibition on foreign capital participating in the oil industry — though its reserves are mostly found in the very deep waters of the Gulf of Mexico — Russia is developing, and gives every indication that it understands the need to develop its difficult offshore and remote reserves with the help of foreign capital and technology. Russia not only has multiple petroleum regions and dozens of oil fields, but also an established working relationship with foreign capital. A variety of private oil companies continue to operate, many with substantial foreign ownership. The PSA law, however hobbled, remains on the books and could be revived for the appropriate project, while the new law does not represent a significant departure from present practice.

Russia will continue to need capital and technology to maintain and increase the ever more vital income it derives from oil exports, while IOCs will continue to seek to add reserves wherever they are available. Taken in context, neither Trutnev’s remarks nor the Yukos affair gives any indication of changing this situation.

Shane R. DeBeer is a partner with the international law firm Chadbourne & Parke, and is based in its Moscow office. He contributed this column to The Moscow Times.

Original at The Moscow Times.