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 KAZAKHSTAN International Business Magazine №4, 2004
 Draft Law on Offshore PSAs: Merits and Drawbacks
Draft Law on Offshore PSAs: Merits and Drawbacks
Daniyar Tenelov, Senior Lawyer, Sayat Zholshy & Partners Attorneys at Law
Daniyar Tenelov is the Senior associate of Sayat Zholshy & Partners and Member of Kazakhstan Petroleum Lawyers Association. Prior to joining Sayat Zholshy & Partners, in November 2003, Daniyar was a senior associate at a large transnational energy company. He specialises in oil & gas, corporate law and taxation.
Analyzing Kazakhstan's subsoil use legislation has shown that today, when making subsoil use contracts, production sharing agreements are, as a rule, most preferable. For example, the Republic of Kazakhstan's Tax Code, effective since January 1, 2002, even contains a section directly addressed to PSA taxation. Moreover, in compliance with the Tax Code provisions, since January 1, 2004, the tax stability of subsoil use contracts has been provided just for production sharing agreements. As continuation of this tendency, a draft law On Production Sharing Agreements at Offshore Oil Operations1 has been submitted for consideration of the Majilis of Parliament.
1. The Resolution of the Government of the Republic of Kazakhstan #969, dated on September 16, 2004.
In the Republic of Kazakhstan Prime-Minister's explanatory note to this draft law it is said that the law will be aimed at further improvement of the current legislative framework with respect to PSAs, taking account of the necessary progressive implementation of the Caspian Sea Kazakhstan Sector state program (CSKS).
On reviewing and analyzing this draft law, we, in turn, should like to highlight a number of issues we consider to be important and problematic.
First. Based on the title and on Article 1 of the draft law, one can draw a conclusion that it regulates relations connected with entitlement to perform oil operations in the CSKS and Aral Sea when concluding, executing and terminating PSAs. This means that the additional requirements established by this draft law will legislatively cover no on-land production sharing agreements. Analyzing its provisions, however, shows that they are not purely offshore-related and can be applied to any PSAs. In this connection, the reason for such a difference between offshore and on-land PSAs is not clear. Sure enough, if we judge from the latest data, CSKS projects are very promising, and probably just because of their attractiveness in terms of investments the Republic of Kazakhstan's Government has put forward the additional requirements. But the draft law also covers the Aral Sea Kazakhstan Sector, where forecasts are still not as much optimistic. Moreover, attractive fields are quite available on land too, or they can be discovered there in the future. Thus, we believe that the scope of this draft law might have been spread over all PSAs, not just over offshore ones.
Second. Section 2 of Article 2 of the draft law makes provisions that if laws establish rules of PSA conclusion, implementation and termination other than this Law provides for, the rules of this Law will be applied. However, in compliance with the Republic of Kazakhstan's Law On Statutory Enactments, laws, according to their hierarchy, are classified into laws that introduce additions and amendments to the Constitution, constitutional laws and codes, and to laws of the Republic of Kazakhstan. Since, according to its status, the draft law under review is an ordinary act, this may mean the laws that introduce additions and amendments to the Republic of Kazakhstan's Constitution, constitutional laws and codes will take priority over it, and they may not be affected by section 2 of Article 2 of the new draft law. Hence, it should be expressly formulated therein that it will have priority only over laws of the same level.
Third. Section 1 of Article 3 of the draft law reads that in pursuance of state programs as well as international contractual and other commitments of the Republic of Kazakhstan, the government approves a list of sea blocks (sections) in Kazakhstan's sector of the Caspian and Aral Seas subject to bidding on PSA terms. At the same time, the Republic of Kazakhstan President's Decree On Subsoil and Subsoil Use (hereafter the Subsoil Decree) provides that the government shall annually approve a list of Subsoil Sections (Blocks) subject to open and negotiated bidding with respect to investment programs. This effective Decree is, however, an act of the same level as the draft law under review, and hence, this provision may not be applied to sea block list approvals. Although Article 8 of the new draft law does provide that the competent government authority should annually prepare and submit for government approval a list of sea blocks (sections) subject to bidding on PSA terms, the question of the time during which the government will approve this list is not settled in the draft law under review.
Fourth. Section 1 of Article 4 of the draft law provides that the National Company is entitled to at least 50% share holding as a contractor to all offshore PSAs concluded by Kazakhstan. Thus, we proceed to the worldwide common practice of joint subsoil use with national company participation. This participation is, however, a National Company's right and not its obligation, that is it may be declined.
Fifth. Article 4 regulates liability issues in relation to participants of the consortium being a party to a production sharing agreement. According to the draft law, consortium participants have joint rights and bear joint liability under PSAs. Currently, consortium participants' liability is regulated by the Republic of Kazakhstan's Civil Code, in conformity with which they bear joint liability for commitments connected with consortium activities, unless otherwise stipulated by their consortium agreement. That is, consortium participants may provide for independent liability in relation to any issues. The new draft law limits this individual liability right to issues related just to disclosure of information recognized as confidential; untimeliness and incompleteness of payment of taxes and due charges from participants' revenues (including transfer pricing); as well as the observance of tax accounting regulations and administration procedures. In relation to all other production sharing agreement issues, participants shall bear joint liability, which reduces the attractiveness of such an organizational form as consortium.
Sixth. Article 5 of the draft law, for the first time in Kazakhstan's legislation history, provides a definition of PSA, which is one of the most important innovations, as emphasized in the explanatory note to the draft law. We agree with such an appraisal, but at the same time we should like to note that nothing is said in the draft law about the civil nature of production sharing agreements, which, according to civil law classifications, fall under contractor's agreements. This observation is made in connection with the discussions currently underway in Kazakhstan in relation to the legal nature of subsoil use contracts. While some refer them to civil agreements, other people say about their different, special status. This difference in approaches is both of great theoretical and practical importance. And though this problem had been already elucidated by scholars and practicing lawyers, the draft law has still failed to clarify this issue. Moreover, to a greater extent it supports the advocates of the civil nature of subsoil use contracts, which will undoubtedly produce disputes and disagreements in the future.
Seventh. Article 6 of the draft law provides for decreasing subsoil use periods under offshore PSAs, which is explained by their strategic importance for Kazakhstan. Now the term of agreement will be set by the parties in accordance with the legislation of the Republic of Kazakhstan effective on the date of signing the agreement. But it will not exceed 25 years for extraction operations, 35 years for combined exploration and production, and 40 years when developing fields with unique reserves. On expiration of these periods, a new production sharing agreement may be concluded.
Eighth. The draft law contains serious innovations related to subsoil use rights tenders. Article 12 provides for a two-step procedure of their implementation. The terms of bidding include additional commitments, which are determinants in selecting the winner. To obtain the right to use subsoil on PSA terms, the following order of priority is established for additional commitments:
1.high technology proposals, which will be differentiated by the following disciplines and priorities: petrochemistry, petrochemical products follow-ups; works related to or associated with primary activities in hydrocarbon exploration and production; providing services to subsoil users;
2. proposals on creation and use of new refining facilities as well as trunk and other pipeline facilities;
3. proposals on construction and joint use of infrastructure and other facilities.
In the event of relatively equisignificant contents of bidders' additional commitment proposals, as indicated in section 5 of this Article, the tender committee is entitled to make a short list of bidders (two bidders at the least). To decide on the final winner, the committee has the right to ask the short list participants for more proposals or explanations related to their bids. The short list participants are entitled to improve their proposals within the time established by the tender committee. Based on the improved bids, the committee decides on the tender winner and the participant whose proposal is recognised as the best after the winner's proposal.
At the next stage, a commission formed by the competent authority for PSA preparation negotiates with the tender winner on the basic provisions of a draft PSA, including the possibility to improve the previously specified uniform criteria. The said commission is set up in accordance with the established procedure no later than one month from the publication of the tender results, the PSA having to be signed no earlier than one year after the setting up of this commission.
These innovations are explained by the fact that during the Soviet period Kazakhstan used to develop basically as a USSR agricultural and raw materials supply base. Today, an obvious bias in industry towards the raw materials sector may be seen as well, whereas the international experience shows that this way is ineffective. Hence, the republic has chosen a strategy of developing processing/refining industries and high technologies. The draft law provisions mentioned above provide for just this line of development of the oil and associated sectors.
At the same time, it should be noted that the draft law provides no criteria to define high technologies, which in the future may lead to disputes and disagreements on the issue.
Ninth. Articles 23 and 24 set forth guarantees of PSA stability and government guarantees to subsoil users. At this, the guarantees of stability are formulated here in a way different than in the Subsoil Decree currently in force, where it is said about inapplicability to Subsoil Use Contracts of additions and amendments to legislation, which enter into force on its signing and which deteriorate the subsoil user's status. In such cases, the new draft law proposes to make PSA amendments that guarantee commercial results to the contractor, which he might have achieved when applying the legislation current at the time of signing the agreement. Nonetheless, as practice shows, subsoil users have certain difficulties in achieving their first commercial results. For instance, in the event of changes in tax legislation, in connection with which historical costs could not be charged to corporate income tax deductions, the Republic of Kazakhstan's Ministry of Finance proposed to compensate for this change through repealing payable historical costs and increasing the royalty rate. At the same time, historical costs are a fixed amount, and royalty consists of two variable components (the amount of oil produced and its price), therefore, in this case, nothing can be said about some adequate substitution. Similar problems also arise in relation to other legislation additions and amendments. Correspondingly, we believe that guarantees of stability should be formulated in the draft law in the same way as in the Subsoil Decree.
So, in spite of the fact that the reviewed draft law has reflected many important and essential aspects of production sharing agreements, it also contains quite a lot of disputable and unclear provisions. In case of its adoption as it is, these provisions can in the nearest future bring about serious disputes and disagreements between subsoil users and the Republic of Kazakhstan.
We hope that the article will draw subsoil users and lawmakers' rapt attention to this problem, and a more in-depth analysis of the draft law will become a prerequisite for its harmonization and improvement.

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