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 KAZAKHSTAN International Business Magazine №1, 2005
 Changes in Kazakhstan’s Local Content Rules for Oil Operations
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Changes in Kazakhstan’s Local Content Rules for Oil Operations
 
Abai Shaikenov, Partner with SALANS International Law firm
Anthony Cioni, Senior Associate with SALANS International Law firm
 
In December 2004, the President of Kazakhstan signed an amending bill that brought about a number of changes to Kazakhstan’s subsoil legislation, including some amendments designed to further encourage the development of the Kazakhstan oil service sector (the New Changes). These New Changes were significant and have generated much discussion in the investment community.
 
We will focus on the effect of the New Changes in this article. We will also briefly address the application of the same in the face of the various stability guarantees under previous legislation and contracts and current bi-lateral treaties. 
 
Legislative History of Kazakhstan Content Rules
Before explaining what changes are afoot in Kazakhstan law, it is useful to explain that the Subsoil Law and Petroleum Law were first brought into existence in 1995/96 (the Original Versions) with a large overhaul in 1999 (the 1999 Versions). Therefore, when one is discussing changes to the law it is useful to explain the relevant benchmarks.
 
Under the Original Version, an Operator was obliged to use:
·          materials and equipment produced in Kazakhstan, provided they were competitive in terms of ecological, technical, pricing, delivery and operational considerations; and
·          the services of Kazakhstan businesses to the extent the same are competitive in terms of price, effectiveness and quality.
 
The above requirements were tightened by the 1999 Versions. Under the amended version of the law, Operators were obliged to purchase materials and equipment produced in Kazakhstan, "if they meet the standards and other requirements by holding a tender in Kazakhstan in accordance with the procedure established by the Government". The vague reference to "standards and other requirements" was seen by the petroleum community as a step backwards, which took the view that the tender requirement was an unnecessary (and potentially meddlesome) layer of regulation.
 
The situation for the procurement of services was similarly altered. As a result of the 1999 amendments, Operators were obliged to "involve" Kazakhstan businesses in the procurement of services for oil operations provided that the services "meet the standards and other requirements by holding a tender". Along with the need for a tender, the investment community had concerns over the vague wording of the amended law.
 
Following on these changes in 2002, the Government passed a regulation setting out specific rules for the conduct of tenders in respect of materials and services (the Tender Rules), the effect of which is further discussed below.
 
The New Changes
The final step in the above legislative trail is the New Changes. The recent amending bill brought in a number of new concepts, including the term "Kazakhstan Content". This term is broadly defined as a declining percentage of:
·          Kazakhstan personnel providing services relative to oil operations, the number of which should increase each year as a result of training programs; and
·          goods, works and services of ‘Kazakhstan Origin’ purchased by the Operator or its subcontractors.
 
Under the amended laws, field operators must now:
·          use equipment materials and finished products manufactured in Kazakhstan, provided that they meet state and/or international standards;
·          involve Kazakhstan organizations in the performance of services relative to oil operations, so long as they meet "the standard, price and quality characteristics of similar work and services provided by non-residents" of Kazakhstan;
·          give preference to Kazakhstan personnel during the performance of oil operations; and
·          finance training and re-training programs for Kazakhstan citizens in accordance with the subsoil use contract.
 
All tolled these changes would not appear to effect drastically the rights and obligations of existing field operators in Kazakhstan. However, these concepts are coupled with an amendment that is causing great concern in the international oil sector investment community. 
 
Generally speaking, Article 63 of the Subsoil Law requires operators to procure the bulk of oil service goods, works and services through a tender. However, this Article now requires the operator or the "tender organizer" to "notionally reduce the price offered by a Kazakhstan producer by 20%, provided that its goods, services and work meet the tender conditions and stated standards". This is the crux of the amendment and issues abound as to its application.
 
Firstly, there is the general concern of operators on price certainty. The decision to develop or shelf an oil field can often turn on as little as one or two percentage points difference to the company’s internal rate of return. It is difficult to predict the effect of a potential 20% cost rise across the board. This clearly seems to erode the financial position of subsoil users.
 
Secondly, there may often be a question as to whether a local producer’s goods, services and work meet the tender conditions and "stated standards". In the case of the latter term, it is unclear what constitute 'stated standards'. Given the potential health, safety and environmental concerns regarding inferior goods, works and services, these vagaries are less than desirable. This is especially true when one considers that, as a matter of law, an operator is liable to third parties for the negligence of its contractors. This could pose a serious problem in the event of an accident or spill caused by substandard goods or services; especially if the Kazakhstan producer does not have the financial wherewithal to repay the operator for the damages paid out to the public. In this sense, the rules seem to be wrongly oriented; de-prioritizing health and safety matters to the benefit of a select number of local providers.
 
Thirdly and most broadly, the regulatory enforcement of the above tender rule will likely go hand in hand with the monitoring and enforcement of the percentages listed under the 'Kazakhstan Content' definition. Many, including the writers, believe that this will simply represent an added layer of regulation designed to extract further concessions from operators and their contractors.
 
Interaction of New Changes and Tender Rules
When addressing the above enforcement concerns, one must recall that the State already purports to regulate the tender of goods, works and services relative to oil operations under the Tender Rules.1 This not only reiterates the above issues, but also brings in a new set of provisions under the Tender Rules, thereby further muddying the waters.
1. Government Decree No. 612 On the Rules on the Purchase of Goods, Works and Services for Oil Operations
 
For example, the Tender Rules mandate Kazakhstan content requirements by percentage. By illustration, a service does not qualify as the Direct Performance of Services in Kazakhstan if more than 30% of the costs are allocated to the use of foreign employees. Similarly, if more than 50% of the costs of work performed in Kazakhstan are allocated to foreign raw materials, then that work will not constitute the Direct Performance of Work in Kazakhstan.
 
As a first observation, this places a great administrative burden on oil producers and oil service sector players to keep sufficient records to evidence their compliance with these thresholds.
 
If the thresholds are not met (or not evidenced by proper recording keeping), goods, works and services may fail to qualify as 'Kazakhstan Origin' for the purposes of considering ‘Kazakhstan Content’ requirements. In this event, the State may try and take steps to remedy what it views as a breach by the operator or the 'tender organizer' of the subsoil legislation.
 
Application of the New Changes to Operators and Oil Service Companies
All subsoil use grants occurring after the New Changes will be subject to the above regime. In this instance, investors will need to consider whether this regime, combined with other factors such as recent tax changes, affects the price they are willing to pay for new blocks.
 
For existing players in Kazakhstan, the situation is more complicated. Subsoil users may be able to resist the application of some or all of the above changes, depending on the year in which they procured their subsoil use right grants from the State. The various iterations of the Petroleum Law, Civil Code and Investment Law over the years have included so-called ‘stability clauses’. Similar clauses were included in some subsoil use contracts; particularly for the larger projects.
 
These clauses were designed to 'freeze' the laws applicable to a given oil field to those laws that were on the books on the day that the subsoil use contract was signed up. If any legislative changes were made after this date and if those changes have a negative economic impact on the operator, then arguably these legislative changes do not apply to that operator.
 
In the present case, there are a number of arguments to support the proposition that the New Changes would, in fact, have a negative economic effect on various field developments. The negative impact is likely to be felt by the additional administrative burden placed on the operators and their 'tender organizers'. It is also likely to manifest itself in the increased cost of retaining local producers and service providers, possibly by as much as 20%. Given the foregoing, it is important for operators and their service companies alike to think about whether the field is stabilized against the New Changes.
 
Abai Shaikenov is a Partner in the Salans Almaty office. Mr. Shaikenov is the author of many articles published both internationally and in the domestic market. He graduated with honors from Kazakh State Legal Institute, the Asia-American Institute in Transnational Law under the auspices of Duke University School of Law & the University of Hong Kong Faculty of Law. Mr. Shaikenov has extensive experience in oil and gas law, corporate, energy, banking, foreign exchange control, environmental, tax and securities regulations. His work extends to advising on multilateral institution financing, structuring of transactions, foreign investment, intellectual property, and various corporate matters related to doing business in Kazakhstan. He speaks fluent Russian, English, and Kazakh.
 
Anthony Cioni is the Senior Solicitor in the Salans Almaty office. Mr. Cioni is a Canadian Barrister and Solicitor (Alberta) and is a fully qualified and registered UK Solicitor. He concentrates on energy and natural resources matters with a particular emphasis on petroleum sector matters dealing with upstream and midstream issues. Anthony’s practice also extends to oil sector related financing matters, including the negotiation of loan and pre-export finance facilities. Mr. Cioni is a regular contributing author to many business journals and international publications. Anthony is a member of the International Bar Association and the Association of International Petroleum Negotiators. He speaks English, French, Italian, Russian, and has studied Spanish.
 


Table of contents
Oil in the CIS: Economic and Sovereign Rating Implications  Special Report of Fitch Ratings Agency 
The Science of Selling  Harry Frisch, Michael Bang 
All People Are Different  Fatima Chapkhaeva 
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