Oil and gas regulations in practice: a lawyer’s review

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Sofiya Zhylkaidarova
Signum Law Firm, Almaty
ssz@signumlaw.com

Kazakhstan is rich with natural resources. The government’s main source of revenue is the export of commodities, with oil accounting for about 60 per cent of its total exports each year.

As a result, close attention is paid by the local and international community to legislative developments in the field of oil and gas exploration and production. The global economic situation, oil prices, the operations of foreign investors, project implementation and social problems in the industry are the main triggers for a response through legislation or social initiative.

Since its independence, and after the signing of the main production sharing agreements (PSAs) in the early 1990s, Kazakhstan’s oil and gas industry has witnessed a phased development of legislation, ranging from the establishment of favourable conditions within the framework of coherent and welcome investment legislation in the 1990s to a situation where Kazakhstan has mainly recovered, formed its own National Fund and begun to strengthen government control measures and to increase requirements for investors, some of which are very questionable.

In this article I will briefly analyse the main legal issues facing the industry, with conclusions detailing how it is possible to achieve comfort and positive law enforcement for investors, and where legislation still needs to be significantly improved. To discuss this in more detail, I will focus on recent trends in the industry and red flags for investors.

Improvements: achieved key project indicators (KPIs)

Given the maturity of the market as well as its players, there is a pressing need to increase liberalisation of legislation, decrease government intervention and change economic conditions to revive the market and make it more appealing to investors. How do present laws and practices address these needs?

Entry of investors into projects

Present legislation clearly defines and clarifies conditions for tenders regarding the signing of new concession agreements, as well as details regarding the procedure for buying and selling interest in existing projects. Kazakhstan has changed the procedure for obtaining state permits, established a clear and coherent process (documents, deadlines) and removed the state’s pre-emptive rights of acquisition of small and medium-sized projects (non-strategic projects), making the procedure for acquiring interest in projects more straightforward and faster.

Are PSAs no longer challenged?

Several years ago, previously concluded PSAs were actively challenged by attempts to waive their tax stability, convert them into regular contracts or change their meaning and interpretation. We are now witnessing a more or less established process of their recognition and application.

Taxation

Today, contracts can be conditionally divided into those that have fixed tax stability as of a certain date (as a general rule as of the signing date) and contracts that have no tax stability. Under the latter, the investor is subject to tax legislation. The tax burden is not as high as in many developed countries; however, constant changes in the legislation detract from the stability and clarity of the tax regime.

Reporting and project documentation

At present, there are no big questions outstanding about which project documents are needed and where they are to be submitted, how they should be drawn up or where to look for experts. The processes for reporting and the preparation and approval of project documents seem to be settled and are comprehensive and straightforward.

R&D expenses

A formal list of nominated organisations has been established as to which oil companies transfer a certain percentage of their working capital budget for research and development to improve exploration and production technology. However, it would make real impact and clarify things if the formal transfer of money to entities ‘authorised to accept money’ would provide some transparency about the relevant results and outcomes. Kazakhstan could spend this money to acquire technologies, patents or innovations for disruptive businesses other than commodities production to diversify the economy.

Environmental matters

The Environmental Code establishes processes and environment compliance rules. The rules have become increasingly transparent. However, issues raised by the industry remain in relation to ‘economics v ecology’, for instance, compensation for excess emissions or gas flaring.

Local talent training

In the past, there was a shortage of local talent. The establishment of contractual obligations for the training of personnel and the replacement of foreign personnel led to an increase in local employment. Active training of local specialists and their promotion to management positions is now visible. This is due to the commitment of oil companies and their corporate culture to train local staff and internal talent development programmes.

KPIs to target

Stabilised v current legislation on concession agreements

PSAs and contracts approved by the President of Kazakhstan now have a certain level of security and stability against legislative changes; however, the economy is still developing with constant legislative revisions and it is important that investors are assured of a certain level of stability.

At the same time, stability should not be equated with rigidity; it should not mean refusing to improve legislation, but rather guaranteeing clear and consistent rules to predict long-term results of investment activities. When planning an entry into a project, an investor must be able to make economic predictions based on coherent and calculable data. Therefore, Kazakhstan should consider how to reduce the ‘shocks’ to investors by announcing longer-term policy planning.

Local content

Contracts now set various thresholds for local content, for example, the percentage of locally produced materials and equipment in the total budget spent for purchasing goods and equipment for operations. The same normally applies to purchase of services and staff hiring. The goal is obvious: to increase domestic production and national product. However, it is often necessary to adopt an individual approach, for example, for goods and equipment due to the non-diversified economy of Kazakhstan and the limited production and availability of local goods and equipment.

Procurement

Procurement rules are in constant flux. There is at present an innovative online platform that marks the beginning of transparency; however, this system does not allow an accurate determination of the compliance of price-range qualification requirements. Moreover, competition between potential suppliers at a fixed price cannot be applied to projects with special sensitivity or the need for complex technologies and qualifications.

Oil export quota

Most contracts require that a subsoil user supply the local market with a certain percentage of oil produced and then be allowed to export the rest (the export quota). However, in practice there is frequent non-compliance with the quota in the contracts. For example, the contract may require supply to the local market of up to 30 percent of the volume of oil produced, allowing more than 70 percent to be exported, but in practice government agencies often only permit smaller export volumes. Creation of a transparent mechanism and compliance with guaranteed export volumes is the most important KPI to convert an ambiguous oil sales economy into a transparent, corruption-free system.

Customs export duty

Customs export duty was introduced as an instrument of state influence on excess profits of oil companies as a response to years of high oil prices. It is directly dependent on world oil prices. However, the government’s bureaucratic mechanisms to update the rates often delay a prompt response to the volatile oil prices market and, therefore, to the economics of the investment projects.

Regional social response

Given the general economic situation – the lack of diversification in the economy and the concentration of basic income around oil exports – the negative social response in the ‘oil patch’, which should be properly managed by local government to avoid risks to investors, has intensified. An increase in public awareness and the engagement of local communities should also be seen as important KPIs for collaboration between national governing bodies and investors.

Government management and cooperation

Today, the competent authority, the Ministry of Energy, plays a dual role: that of the party to the civil contract (E&P contract) and that of the controlling state body. However, this does not always work due to the different legislation regulating these roles. As the common objective is to ensure the safety of projects and improve their economics, the mechanism of state management and regulation of oil operations would be significantly improved, for example, by introducing into the management structure self-regulatory organisations, agencies or institutions without the status of a state body, following the example of many Western countries that represent the state’s interests in dealings with investors. This allows the development of real cooperation, increases the efficiency of project implementation, takes into account the specifics of projects and changes the nature of the relationship from ‘punitive’ to ‘collaborative’.

Recent trends

Litigation: rule of law or rule of state interests?

When representing the interests of oil companies in court disputes with state bodies, we are faced with persistent bias by the courts towards the interests of the state. How should courts be guided? By rule of law or rule of state interests? Without getting into political theory, a solution must be found.

One solution could be the pre-trial (peaceful) settlement of disputes. This is not done at present due to the dual status of the competent authority. Legislation sets out a peremptory norm: public authorities cannot conclude amicable agreements with private companies. This directly contradicts the nature of a civil law contract – a subsoil use contract. Peaceful resolution of disputes, the search for compromises between the parties to civil law contracts, especially in long-term relations, should be the basis of cooperation between investors and the state since it directly proceeds from the essence of contractual legal relations.

An extrajudicial and pre-trial settlement of disputes analogous with tax disputes can also be a good alternative. There is already a positive example: an appeal commission to hear complaints of tax assessments (decided not only by the relevant government body, but also by the Atameken National Chamber of Entrepreneurs).

Although this option is not ideal, it is definitely a step towards improving the process of dispute settlement. At present the claims against the competent authority are appealed directly to the court, in the absence of any alternative. The competent authority may also immediately file a lawsuit against the subsoil user in court. A buffer between the dispute and its consideration by the court is necessary. In terms of judicial review of disputes, a good option is to consider disputes in non-state courts, for example, the Astana International Financial Centre court of arbitration.

Finally, during a hearing itself a reconciliation between parties is possible. After all, the competent authority’s claim to recover the penalty under the contract is not a public law matter. A voluntary agreement by the competent authority and the subsoil user to enter into a mediated negotiation process to resolve the conflict through compromise helps to maintain a balance of interests between the parties and the possibility of further joint activities.

Breach of contract

Last year a number of companies were sued for breach of contract and ordered to pay fines. The violations were:

• violations of the deadlines for the start of exploration or production;

• failure to fulfil obligations under the work programme;

• violations of obligations regarding Kazakh personnel, goods, work and services, and maintenance; and

• failure to train Kazakh specialists and finance social programmes.

For bona fide investors, which are still the majority, the non-fulfilment of contractual obligations arose in most cases for reasons beyond their control, for example, untimely (protracted) signing of documents by the competent authority (permission for additional issue, altering of the contract, affecting the fulfilment of contractual obligations). At the same time, in almost all claims, court decisions were made in favour of the state.

Without analysing the specifics, in those cases we reviewed, the subsoil user’s fault was ambiguous, often directly due to inappropriate action by the competent authority. As a result, due to the improper fulfilment of obligations by the competent authority acting as the state regulatory body, the same authority, but acting as a party to the contract, sued the company for defaulting on its obligations.

Model contracts

As a measure of the unification and ‘modernisation’ of subsoil use contracts, the latest Subsoil Code, after exploration, envisages the conclusion of new production contracts in the form of a standard contract. This is a logical step in light of the new regulations in the field of subsoil use.

Despite the fact that this is the right of the subsoil user, the competent authority in most cases insists on concluding a new contract. The first model contracts are already being concluded and a paradox within this process has already arisen. The tax authorities’ position is that these are ‘new contracts’ and, accordingly, accumulated exploration expenses under the ‘old contracts’ cannot be counted as costs against future production.

Is this a ‘cold shower’ for the investors? It is nonsense. On the one hand, the state is in favour of creating conditions to attract investment in subsoil use and, on the other hand, it frightens investors by legal inconsistencies or their interpretation, which do not favour subsoil users. An investor may invest in exploration, taking huge risks with the expectation of recovering the investment through production, only to lose this opportunity.

Given the aforementioned, we believe that there is a real need for negotiations between the State Revenue Committee, on the one hand, and subsoil users, with the assistance of the competent authority, the Ministry of Justice, and the bodies regulating investment activity on the other. A transparent and fair approach to the taxation of hydrocarbon exploration and production should be developed. Otherwise, irreparable damage will be caused to the investment climate in Kazakhstan.

Tax stability v tax creativity

The state has also found creative ways to increase profitability from projects, even from under-stabilised contracts. In our practice, we observe repeated cases of refusal to return value added tax (VAT), the amount of which is sizeable as the accumulated VAT is often almost fully refundable.

Companies may not receive VAT refunds due to errors made by their suppliers, such as problems with documents or a supplier reporting on the fourth stage in the total supply chain. Yet the investor cannot influence the actions of this supplier in any way as they do not have a contractual relationship with the supplier. And so the investor is punished. The government aims to create a transparent system for the supply chain and VAT, but why must this be done at the expense of a bona fide investor?

Transfer pricing

In Kazakhstan, control of oil export prices, even in transactions between independent parties, is included in the concept of transfer pricing. Despite regular changes (introduction of price monitoring with the submission of regular reporting and establishing an agreement on prices), there are still additional assessments of oil revenues; yet a clear practice still does not exist for both tax and judicial authorities. There are often cases in which companies, with an absolutely transparent mechanism for selecting oil buyers and all the documents confirming the costs associated with the transportation and sale of oil, accrue millions of dollars through the use of ‘convenient’ sources of information.

Summary

With the development of oil and gas legislation and maturity of the industry, it is necessary to introduce new institutions and mechanisms to cooperate with oil and gas investors so that the state’s profits from projects is expressed not only in material benefits, but also in a meaningful balance of economic interests and collaboration with oil companies.

This collaboration should sustain the short-term receivables as well as increase investment in future gains by acquiring new technologies and human and social capital, and overall to improve Kazakhstan’s reputation in a challenging and changing global economic arena.

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