Extractive Sector: Time for Action

Editorial Review

The UNCTAD published its annual report on investment last autumn. The 2007 report titled “Transnational Corporations, Extractive Industries and Development” analyses new trends in the sphere of foreign direct investment. We are publishing an abridged version of the first part of the report, which is traditionally devoted to the distribution of FDI by economies and regions, in the current issue of our magazine. As for this article we would like to discuss the topic indicated in the headline.

Think Global…

According to UNCTAD experts, the share of foreign direct investment in the oil and metal sphere in global investment has been falling since the 1970s, while the share of other sectors has been growing. However, as a result of price hikes (oil prices grew by 10 times between 1998 and 2006), the share of the mining sector has grown significantly, although it lags behind the services and processing sectors.

UNCTAD experts believe that prices have gone up because of demand for oil, gas and ores from developing countries whose economies are growing rapidly above all from China. Specialists say that the cost of developing new fields will grow. This will keep prices high in the near future. As a result, this will boost investment in the mining sector. For example, investment in non-ferrous metal exploration grew from $2bn in 2002 to $7bn in 2006, while oil and gas drilling doubled and the coefficient of using drilling facilities went up to 92%.

Reserves, production and consumption of mineral resources are not distributed evenly in terms of geography. Some developing countries are regarded as the main producers and exporters of mineral resources, while developed countries are main consumers of them. This situation creates imbalances: importing countries are worried about their supplies while exporting countries are concerned about access to markets. Multinationals can play an important role here for both. Multinationals provide capital, knowledge and access to markets to countries which have no own capacities to develop their mineral resources. For countries where they are based they can service as an instrument of access to foreign sources of raw materials. A number of the world’s major multinationals are actively operating in the extractive industries; moreover, several new players have emerged from developing and transitional economies in the past decade.

At the same time, multinationals’ share is uneven in different extractive subsectors. For example, in 2005 23 out of 25 major multinationals specialised in the mining sector were private, and only two corporations were controlled by the state. In the oil and gas sector, most of the 50 largest producers belonged to the state, especially those from developing countries. For example, the Saudi Aramco company’s capacities were double the capacity of the major private oil and producer ExxonMobil in 2005.

In connection with this, the UNCTAD report paid special attention to the growth of new mining multinationals. Although multinationals remain leaders in terms of foreign assets, a number of state-run companies from developing countries are quickly turning into global players. For example, the combined foreign production of seven major state-run companies – CNOOC, CNPC, Sinopec (all three are from China), LUKOil (Russia), ONGC (India), Petrobras (Brazil) and Petronas (Malaysia) – exceeded 528 million barrels of oil equivalent in 2005 against 22 million barrels a decade ago.

Despite the fact that all countries to a certain degree rely on multinationals in developing their natural resources, poor countries depend on foreign companies to a greater extent.

The instability of the raw materials markets influences both government policy and investment decisions of multinationals. UNCTAD experts note that a favourable price situation has prompted many governments to try to increase their shares in profits through changing mining legislation, tax regimes and contracts. Recent regulatory changes both in developed and developing countries point to the fact that historic regulations were perhaps too generous towards foreign investors.

… Act Local

Kazakhstan where, according to UNCTAD, multinationals’ share in the metal mining sector was about 63% (in 2006) and in the oil and gas industry about 50% (in 2005) is no exception in this regard. Worried about liquidity problems in the banking sector and a threat of economic slowdown, official Astana is increasingly actively “optimising” its policy in the mining sector. One of its latest achievements is an increase in the share of the state in the Kumkol and Kashagan oil fields, as well as the Bogatyr coal mine.

Delivering the state-of-the-nation address on 6 February, President Nursultan Nazarbayev said: “The main vector in the oil and gas sector is to strengthen the state’s positions as an influential and reliable player on the global oil and energy markets. For this we are consistently strengthening the state’s influence in the strategically important energy sectors.” Later, the head of state ordered the management of the Samruk holding company for managing state-owned assets and regional social entrepreneurial corporations to take specific measures to efficiently develop and increase the competitiveness of the metal mining sector. In order to do this, they need to sort out problems in managing state-owned stakes in existing metal mining companies and obtain licences to develop prospected ferrous and nonferrous metal mines. In addition, a national metal mining company whose functions will be similar to those of the KazMunaiGas national oil and gas company is expected to be set up. Another instruction given by the Kazakh president to the government is to develop a new Tax Code, which should ensure a reduction in general tax burden in the non-extractive sectors and for small and medium-sized businesses. Mr Nazarbayev openly stressed that the expected budget losses should be compensated for by the mining sector.

The day after the state-of-the-nation address, Prime Minister Karim Masimov ordered the checks of the observance of contract provisions by all mining companies. At a Ministry of Energy and Mineral Resources meeting he said that “contracts on all mines where contract liabilities have not been fulfilled, in pursuance of the head of state’s order, should be terminated” and mines should be returned to the state, dividing them between Samruk and social entrepreneurial corporations.

According to the Ministry of Energy and Mineral Resources, there were 822 mining contracts of national significance in Kazakhstan as of 1 January 2008. In 2007, the observance of contract obligations was checked on 831 mining facilities in 2007. However, only 454 of them implemented 100% of their financial obligations. As a result, 97 contracts where less than 30% of obligations had been were terminated. Notifications on violations of contract obligations and licence conditions were sent to a further 182 companies.

Moreover, the Prime Minister ordered the suspension of all negotiations with foreign investors on concluding mining contracts until the adoption of a new Tax Code which should come into force in the beginning of next year. A working group headed by Deputy Prime Minister Yerbol Orynbayev has been set up to draft it.

Kazakhstan intends to abandon Production Sharing Agreements as a model for mining contracts. The Ministry of Economy and Budget Planning has proposed this to the government as early as in November 2007. Backing this position, the head of the mining taxation division of the Ministry of Economy and Budget Planning’s tax policy and forecasting department, Galymzhan Zhakupov, has explained that taxation under Production Sharing Agreements in Kazakhstan now “is extremely complicated and non-transparent, because of the application of a system of triggers which declaratively aims to guarantee stable special payments to the state but actually makes it possible to minimise taxes through regulating recoverable expenses”. Moreover, sizes of special payments and taxes of mining companies, including Kazakhstan’s share, are set while concluding contracts on Production Sharing Agreements. This “does not rule out an element of subjectivism and creates conditions for corruption”, given that the initial level of tax burden should be the same for mining companies.

Simultaneously, the government is studying the issue of imposing a tax on extracting raw materials, similar to the one adopted in Russia. Its rate will depend on the output of raw material and its price on the world market.

However, the government assures that the new Tax Code will not concern those major mining companies that are already working under Production Sharing Agreements. In line with Kazakh legislation, tax provisions of oil contracts concluded before 1 January 2004 should be stable. This means the provisions of these contracts can only be changed by the consent of both sides, however, “if an investor fulfils its obligations”. We should remember that Astana which has become “experienced” after battles of Kashagan is becoming increasingly sophisticated in its arguments and “persuasions”. Investment projects in the extractive industries have high operating, technological and environmental risks, which is why “skeletons in the cupboard” can be found in any mining company.

Another initiative which is actively being discussed by experts is the ministry’s proposal to impose a duty on exports of oil and petroleum products from 1 January 2009. The ministry estimates that this move may raise $2.2bn in net revenue, if oil prices stand at $88 per barrel next year. Minister Sauat Mynbayev has said this duty will be imposed on those mining companies whose contracts do not envisage stability in customs payments. “Individual negotiations” will be held with other companies.

Although this customs duty is only being discussed, the mining companies have already emerged in Kazakhstan that have experienced the “costs” of the planned innovation. However paradoxical it is, the matter is not about a Western multinational but the Kazakh national company. The president of the KazMunaiGas national company, Uzakbay Karabalin, told a Samruk meeting on 31 January that the London Stock Exchange had reacted to the possible imposition of the duty by a slump in the price of shares of its subsidiary KazMunaiGas Exploration and Production (KMG E&P) by $2.70 or 9.5%. As a result, the capitalisation of KMG E&P fell by $1.2bn. It is not surprising that the head of Samruk, Kanat Bozumbayev, whose task is to increase the value of assets under management, has warned against hasty decisions on this issue.

The Russian experience shows the ambiguity of the efficiency of this duty. LUKOil Overseas Service Ltd’s former country director in Kazakhstan, Boris Zilbermints, believes that this measure has reduced the competitiveness of Russian companies on global markets and their abilities to invest in developing new fields.

What Is the Result?

Kazakhstan’s desire to increase revenue from developing its natural resources through direct budget collections is very logical. Even the argument about the great social and knock-on effect of multinationals’ activities cannot be an important counterargument. This is also confirmed by UNCTAD experts, who note that the specifics of the extractive sector are that the possibility of setting up new jobs in large-scale projects, as a rule, is limited and, as a result, these projects have almost no effect on employment. This is especially true about projects fulfilled with the involvement of multinationals because in comparison with local enterprises these companies use more capital-intensive technologies and processes. The possibility of establishing feedback in the extractive industries is also generally small. Moreover, foreign branches often employ foreign suppliers and subcontractors. As a result, the highest direct benefit is produced by raw materials extraction only in the form of increasing revenue of the host country, especially as budget collections. However, the general benefit from generated revenue is defined by how the government regulates, distributes and spends revenue created for the host country and how they help achieve development goals and satisfy the needs of the current and future generations. Experts warn that in some cases easy access to revenue from mineral resources may make the government less accountable to its population and to a greater extent inclined to protect and strengthen the interests of the ruling elite.