Production Sharing Agreements in Kazakhstan: Problems and Means of Improvement
Aizada Akkaisiyeva, Master of Economics, Deputy Head of the Agency for Foreign Aid Co-ordination at the Investment Policy Department of the Ministry of Economy of the Republic of Kazakhstan
Today, despite Kazakhstan’s natural desire to diversify its economy, the outlook for its social and economic growth is still dependent on an efficient exploitation of its available resources. Due to tough competition in the mining development investment market, the country has to constantly revise the conditions offered to investors. One of the few mechanisms which provide certain guarantees of a stable investment climate to investors is field development under Production Sharing Agreements (PSAs).
Many countries practice production sharing in the development of fields, since a PSA is more beneficial for states possessing large resources, but lacking funds for their development. Under a flexible taxation regime, a large share of the final profit is received from the sale of raw materials, i.e. most of the revenues for the budget are made in a convertible commodity – oil. As a special regime, a PSA permits a more precise calculation of the economic efficiency of projects, thanks to a considerable reduction of unknown factors, and it guarantees an acceptable degree of risk and stability for investors. This is why a PSA is preferred by foreign investors.
The idea behind the PSA is that an investor and the state sign an agreement under which the investor develops a field. After the royalties have been paid, a certain portion of the products extracted by the investor (compensatory production) is transferred to its ownership to recover expenses. The remainder is considered profitable production, and is shared between the investor and the state. The investor pays from its share of the profitable production a profit tax and other taxes specially established under the tax regulations.
At present, the legal framework for PSA development in Kazakhstan is insufficient. A PSA as one of the subsoil contracts is described in Chapter 5 of the Law on Oil1 and in Article 94-1 of the tax law, which states that the taxation of subsoil users is carried out according to two models, based on the main types of contracts. The first taxation model is applied to all types of contracts, except Production Sharing Agreements, to which the second model is applied.
Despite the lack of a legal framework, nine PSAs on oil and gas production have already been signed and put into effect. These include one of the largest oil and gas projects – the development of the Karachaganak oil and gas condensate field. For comparison, only three PSAs (Sakhalin-1, Sakhalin-2 and the Khariaginskoye field) have been signed in Russia where the Federal Law On Production Sharing Agreements was passed as early as 30th December 1995.
Taking into account the fact that many large foreign investors prefer PSAs, and that PSAs will be widely applied in the future due to the discovery of large oil and gas fields in the Caspian shelf, some practical aspects should be considered. This is especially important today when various terms and conditions of several draft PSAs are being discussed with investors. The article will mainly touch upon problems which are the most acute from the standpoint of the state, and which, as it seems, have not been stressed before.
Specialists carrying out feasibility studies and experts with ministries and departments considering PSAs have encountered many problems. These typically arise due to the lack of limitations on the scope of feasibility studies, delays in passing the necessary legal acts, and the peculiarities of PSA application in Kazakhstani fields.
The mechanism of PSA fulfilment can be divided into two large components – economic and legal.
The economic mechanism of a PSA should be understood as a composition and a rate of all payments made by the investor, a limitation of compensatory production and reimbursable expenses, and their dependence on the current economic indicators of the project.
An agreement must establish the following components of the PSA economic mechanism:
• the maximum allowable amount of compensatory production;
• the composition of expenses incurred by the investor and subject to reimbursement from compensatory production;
• the proportions of profitable production sharing;
• the payment of royalties to the state;
• the taxation of the investor’s profit (profitable production) and exemption from other taxes and duties;
• the reduction in the tax base by taking into account interests paid on credits, one-off payments for the use of subsoil, and all other payments subject to reimbursement;
• one-off payments;
• the investor’s obligations to give preference to Kazakhstani legal entities (with other equal conditions) in carrying out operations under PSAs;
• the liquidation of the consequences of the project implementation;
• the inclusion of various types of insurance in the cost estimate;
• the acquisition by the investor of a certain portion of required process equipment in the territory of Kazakhstan;
• the transfer of property, the cost of which has been reimbursed, to the state’s ownership.
All other components of the economic mechanism should be established during the preparation and negotiation of the agreement.
A feasibility study into a PSA defines the investor’s final economic parameters, such as profitability (IRR), the net discount income (NPV), the period of investment recoupment, and others. These parameters are calculated based on the cash flows related to the project.
The IRR is especially important, for it serves as a measure of the investor’s interest in the project implementation. Out of all the parameters, it is the only tool which allows the investor to define the profitability of its investment in the course of the project’s implementation.
When negotiating a PSA and the parameters of production sharing (changes in which always affect the IRR achieved for an estimated period), the investor will always object to changing the scale of production sharing in favour of the state, arguing that this reduces the profitability of its expected investment.
In many cases, PSAs provide for a condition (a so-called «uplift») which allows the investor to include in its expenditure accruals on their not reimbursed portion in each period of the project’s implementation (usually on a quarterly basis). This is explained by the necessity for the payment of interests on credits required for financing the prospecting, the exploration, and the development of fields.
As a rule, the amount of such accruals is fixed at the LIBOR floating rate plus fixed percentage (two to four, in accordance with the agreements concluded and offered in Kazakhstan).
It should be noted that using the uplift in the feasibility study «worsens» the investor’s economic parameters. The higher the interest rate under the uplift is, the lower the NPV and the IRR become, the longer the investment recoupment period is, and the higher the maximum negative cash is. For example, with a 10% uplift, the IRR in a PSA will fall from 20%, desired by the investor, to «modest» 15%.
However, none of PSAs which provide for an uplift have calculated an actual interest on the invested capital, irrespective of whether the capital is borrowed or owned (share capital). It is possible that representatives of the government, negotiating with investors, may hold the impression that the latter agree to a rather small remuneration for their services.
This gap in the feasibility study into PSAs should be liquidated by including in the relevant regulations the necessity for calculating the economic parameters of the project with and without the uplift, and by including the received interest in the investor’s income. This would facilitate the comparison of projects in tenders, which is crucial for the selection of winners.
It should be taken into account that all the parameters of an investment project in many respects lose their initial economic purport when the uplift is used. It is well known that a positive NPV shows the profitability of an investment project and its acceptability for the investor. When the uplift is used, however, this basic provision of the theory of investment efficiency evaluation does not work, and the NPV is no longer an equivalent of the excess income received in the course of the project’s implementation.
The situation is similar with the internal profitability rate, which is usually compared with the bank rate in order to evaluate the possibility of attracting borrowed capital. When the uplift is used, the IRR is no longer the maximum allowable interest rate required for the complete financing of the project, and the profit for the project operating company is zero. The actual investment profitability is the annual interest on the invested capital, irrespective of whether it is borrowed or owned. The uplift considerably reduces profitability.
The analysis of feasibility studies into PSAs, already signed or proposed by various companies, has been carried out based on various technical approaches and scenarios of hydrocarbon market development and the inflation process. The situation is the same with algorithms for calculating basic economic parameters, which reflect the interest of both the investor and the state in the fulfilment of such agreements, and with the principles of selecting the PSA economic mechanism. This may result in an incommensurability of proposals considered by the tender commissions, in mistakes during the selection of partners, and in decisions being made groundlessly.
It is obvious that the state authorities should develop legal acts relating to PSAs in order to successfully fulfil the existing and future PSAs, and to enable the following:
• to achieve uniformity in the methods of calculating and producing the basic economic parameters of PSAs;
• to define a degree of uncertainty in the volume of recoverable reserves and in future expenses for their development, at which a PSA is possible to be signed;
• to eliminate the possibility of hidden reductions in the investor’s efficiency factors during the approval of the PSA economic mechanism;
• to correctly compare proposals from oil companies for PSAs and to make well-grounded decisions on the winners of tenders;
• to develop and offer to subsoil users PSA terms and conditions which are a reasonable compromise between subsoil users and the state.
Without such acts, the fulfilment of PSAs in Kazakhstan would be imperfect and incomplete.
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