The battle is not over, Alexei Melnikov, member of the State Duma Budget and Tax, assured RusEnergy. "No private meeting at that level can annul the results of the enormous work done to introduce PSAs in our country. Even if the government retreats somewhat, it will be a tactical loss that will not affect the fate of PSAs in Russia," he said.

Mikhail Subbotin, one of the authors of the original PSA legislation and an ardent supporter of that tax regime, considers some of the arguments of the enemies of PSAs.

Under the Carpet

The Russian media directly or indirectly affiliated with oil companies have been campaigning against production-sharing for several months, and this offensive may be a prelude for strangling PSAs in this country. The headlines are far from impartial: "Under-the-Rug Battles with Lethal Outcome for Economy," "Share and Starve," "Bribe Power," "Does Russia Want an Oil Offshore Haven?" The same set of quotations, distorted figures and weak arguments are used by various publications. Here are a few samples of anti-PSA reasoning.

Several editions at once quoted Kakha Bendukidze, CEO of United Machinery Plants, who addressed the January hearing on PSAs at the State Duma saying: "We've got a tax regime today that is practically the same as in Canada or Norway. According to the estimates of economists at oil companies, if a barrel of oil sells for $12.50, they have to pay 27.3% of their earnings in taxes. But when the price exceeds $22.50 per barrel, taxes on each earned dollar amount to 40.4%, and at over $30.00 per bbl, the tax burden is more than 60%. According to various estimates, the taxation faced set for PSAs is one-fourth to one-eighth of those levels. Russia does need PSAs, which resemble offshore havens that do not bring any investments to the national economy."

Defenders of PSAs have to remind their opponents that investors in large oil and gas projects have to endure negative cash flow for 7-10 years without obtaining significant, if any, income, and can start paying the host government its share of profit at a later stage. Taken as a whole, a PSA-based project yields more revenues to the state than regular tax schemes.

Three ongoing PSAs in Russia - Sakhalin-1, Sakhalin-2 and Kharyaga - are in that preliminary period: however, the quoted figures are an exaggerated even for these companies. According to Bendukidze, PSA investors pay about 7.5% of their income in taxes when one barrel of crude sells for $30.00 and less than 5% when the price is $23.00 per barrel. Is that possible?

Comparing Taxes

In real life, Sakhalin investors pay royalties equivalent to 6% (Sakhalin-2) or 8% (Sakhalin-1) on each ton of produced oil. They also have to pay the corporate profits tax at the rate of 32% to 35% on their share of profit production. Domestic companies, after the cut in the profits tax last year, are charged 24%, but the investors in Sakhalin still have to pay at the rate fixed in their PSAs. Add rentals for leased acreages, signature and start-of-production bonuses, payments to the Sakhalin development fund, etc.

It should also be borne in mind that PSA investors pay taxes for specific projects at the place of their operations. Companies operating under the regular fiscal regime and paying taxes where they are registered can reshuffle their taxes by switching revenues from one project to the development of other projects.

PSA investors cannot minimize taxes through methods that are perfectly legitimate for other companies, such as the registration of subsidiaries in quasi-offshore havens in Russia (Chukotka, Mordovia, and Kalmykia) or Baikonur in Kazakhstan. It is also impossible for them to cut taxes by fictitiously hiring the disabled. Yukos, Lukoil and other Russian players generously apply these tricks, and Sibneft managers declare in public that such methods of tax minimization are their duty before shareholders.

Yukos chairman Mikhail Khodorkovsky, one of the most vociferous critics of production sharing, asks: "What is going on with PSAs? For the first nine years their taxes are just one-quarter [of regular ones]. Does our nation want money today or in nine years?" Well, if PSA operators evade taxes, why Yukos is unwilling to use the same regime? The company minimizes taxes by other means, such as branches registered in the Mordovia offshore haven.

Royalty Obliges

In many cases anti-PSA publications are based on incompetent analysis of existing projects. Readers are fed figures taken out of context. Some analysts, for example, quote the allegedly low royalty rate in Sakhalin, saying that such terms make PSAs unprofitable for Russia. Grigory Vygon, a senior expert at the Institute of Financial Studies, writes: "In the USA, the royalty rate is twice as high. The sacrifice was not justified."

It is hardly possible to judge the tax burden from one tax alone. The investor has to pay for many things: previous geological and geophysical studies; the host government's share of profits; various bonuses; contributions to local funds for social development, etc. But even if we deal with the royalty alone, it should be remembered that the Russian Ministry of Finance took the 8% rate as the average value for calculating the rate of the new severance (mineral extraction) tax in 2002, which is exactly what PSA-based Sakhalin 1 has to pay.

This is what Russian oil companies pay on average, even though they operate mostly onshore and in areas with a well-developed infrastructure. It is not clear why this rate appears low when it is applied for an offshore project in a seismic zone complicated by seasonal ice and other climatic hardships. When the Sakhalin PSAs were signed, the law placed the royalty rate between 6% and 16%.

Investment Component

The fiscal component, however, is not as important as the investment one. Three ongoing PSAs have already attracted over $4b in investments, and the flow is growing. In 2003, two Sakhalin projects involve expenditure of almost $3b, about one-third of all annual direct investments in the Russian fuel and energy sector.

The Russian machinery manufacturers' frustration is understandable. They get far less contracts than they would like to. But suggestions that the basic PSA law is violated are groundless. Only three PSA-based projects are currently underway, and all of them had been signed before the current law came into effect in 1995. They were covered by the grandfather clause. The law stipulates that contracts signed earlier will be implemented according to their original terms. It is worth mentioning that the provision requiring PSA operators to allocate a specific percentage of contracts for Russian suppliers was only included in the law in early 1999. Thus, the critics of PSAs accuse them of violating a legal norm that does not concern them at all.

It is also unclear why PSAs have become the target of allegations to the effect that PSA operators discriminate against Russian suppliers. Prior to the financial crisis in August 1998, domestic contractors met only 55% of the Russian oil industry’s requirements, and nobody seemed to notice. Today, some domestic companies, such as Sibneft, prefer to buy foreign-made equipment and services, but only PSAs are subject to criticism.

The hysterical propaganda may usher in another period of delays for new PSAs. The struggle against production sharing is more than it appears to be.The real purpose is the re-distribution of property. Oil companies are trying to weaken or eliminate competitors and prevent the launch of major new projects. The idea is to buy additional reserves that would become available without new PSAs at minimal prices and raise the market capitalization.

The state is obviously on the side of the attackers who are playing by the existing rules. The rules are rotten, but only the state can change them. Unfortunately, the government is in no hurry to do so, and investors have reconciled themselves to the dictate of Russian companies. If the situation persists, PSAs may become an extinct species of business relations in Russia.

See also:

the original at
www.rusenergy.com

Production Sharing Agreements

RusEnergy, February 14, 2003