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. Last Updated: 07/27/2016

Making PSAs Work

Production sharing agreements have been applied in many oil-producing countries as a highly efficient mechanism to attract foreign investments into under-developed oil industries. The concept of a PSA is very simple: Normal tax treatment is replaced with a split of production. At the same time, the major impetus for PSA development in any country must be the civil and legal foundation that ensures the stability of the PSAs by guaranteeing that fundamental rules won't change arbitrarily. Such stability and the superior financial terms available under a PSA are the major attractions luring long-term investors into the sector.

To date, Russia has concluded just four PSAs and only three of them are operational. The first exploratory well has been drilled at Sakhalin-1, and production has commenced at Sakhalin-2. The third PSA field that is operational — the Khariaga field located in the Komi republic — also sets a good example because its reserves had been practically explored before the PSA was concluded. As a result, production commenced fairly quickly. The fourth PSA concerns the Samotlor field, and production under this PSA has not yet started.

Until recently, the main reason why Western companies showed little real interest in Russian PSA projects has been the absence of necessary legislation. Although negotiations on the Sakhalin projects began when the Soviet Union still existed, the present law on PSAs came into force only in 1996. The tax legislation necessary to implement any agreements under the 1996 law was introduced only in 1999. So far, no "sub-legislative" acts have been adopted to guide the practice of a PSA operation with respect to accounting and customs clearance of products extracted. Even now, a number of amendments are necessary to currency legislation and many other regulatory documents.

Analysts have long noted that the "side effects" of a PSA (increased orders to local industry, contracts with Russian companies, extra jobs and increased tax revenue) may be more important than any income gained directly by sale of oil by the state. This is particularly true during the initial stage of field development, which requires massive investment while generating virtually no income. Keeping this observation in mind, Russia needs to exert particular effort to adopt measures that will steer the maximum number of contracts and orders generated by PSAs to Russian companies.

Existing PSAs seem to support the idea that the side effects of such agreements deserve special attention. The offshore drilling platform for Sakhalin-2, for example, was not retooled in the West or in South Korea, but in Komsomolsk-on-Amur.

However, the fact remains that Western investors tend to deal with familiar suppliers, while Russian companies have not yet established a stable reputation on the world market. Therefore, they face obstacles even when they can offer competitive equipment and prices. The government must keep this in mind in developing tender rules that conform to global practice.

Under such rules, state agencies should be directed to provide assistance to domestic producers such as information with respect to all issues relating to bidding for a tender and consulting in filing necessary documents and meeting deadlines. The state can also assist Russian companies in complying with necessary international certification requirements, since no Western investor will purchase equipment that lacks such certification.

The state should also seek ways to encourage consortium arrangements between Russian and foreign companies in cases when Russian suppliers are not capable of competing directly. Such arrangements can be used to ensure that the maximum possible benefits of PSAs remain in Russia and that as much of the monies spent on such projects as possible will be used to develop Russian industry. Such arrangements can introduce Russian producers to advanced technologies and production management, while simultaneously enabling them to increase their capital.

PSA development in Russia is also seriously hampered by bureaucratic red tape. Wandering through an endless chain of offices at numerous ministries to obtain the multiple approvals and decisions necessary to launch a PSA project can take months or even years. It often takes a huge amount of time simply to determine which ministry or official even has the authority to make the necessary decision.

Nonetheless, the PSA remains the only effective instrument for attracting significant foreign investment directly into the energy sector of the Russian economy. As such, it would certainly make sense to give one ministry complete authority over all aspects of PSA implementation based on the country's long-term economic development strategy. The obvious candidate for such authority is the Economic Development and Trade Ministry. At present, though, it is not possible to develop a PSA without the active participation of the Energy Ministry (which handles technology issues), the Natural Resources Ministry (which handles all information and licensing regarding subterranean development) and the Finance Ministry (which must approve the terms and conditions of any PSA).

Obviously it is imperative to consolidate these powers as soon as possible and it is fully within the competence of President Vladimir Putin and his government to do so. They must give priority to developing fair decision-making processes on PSA matters and clear-cut coordination principles to guide the work of relevant governmental agencies. The government must move quickly, keeping in mind both the need for measures that will stimulate new PSAs and the need for mechanisms to implement existing PSAs. Until these measures become a priority for the government, PSAs will never be able to live up to their true potential as a tool for economic development.

Mikhail Klubnichkin is a tax partner at PricewaterhouseCoopers in Moscow. He contributed this comment to The Moscow Times.