Mikkelsen A., Langhelle O. (eds.) Arctic Oil and Gas. Sustanability at Risk?

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246 E. N. Andreyeva and V. A. Kryukov

In the political sphere, the emerging Russian state system is drifting towards a

rigidly vertical power and away from the federative model declared at the beginning

of the 1990s. The federative model was based on regional and municipal rights

and powers, including the federative units’ right to manage the natural resources

on their own territories. The social political sphere is handicapped by the complex-

ity of the transition to new civil society institutions and the search for an efficient

model of their functioning. In the economic sphere, new economic institutions are

still to be formed; and foremost, procedures for dealing with the after-effects of the

earlier system are still to be invented. It is rather a complicated task as:

To form a new system, the countries implementing transition should not only

eliminate the old system and replace it with a new one, but they should also

correct the consequences of functioning in the framework of the old system

during a long period of time.

Such consequences include both technological infrastructure (above all, the

inter-regional one) and the network of settlements created within the system of

centralized planning and management.

The Russian model

Several factors have contributed to determining the strategy of oil and gas develop-

ment in the Arctic, both offshore and within the bounds of the Northern territories

of Russia. These are crucial for understanding the principles and assumptions

behind what is already referred to as ‘the Russian model’.

First of all, the political processes of the emerging Russian state system empha-

size the accumulation of all decisive functions and powers at the federal level,

including those relating to hydrocarbon resources development. Additionally, the

corporative and bureaucratic role of governmental structures’ procedures is

strengthening, owing to Russia’s weak juridical system and lack of supervision.

Finally, the need for corrective measures to dealing with the after-effects of the

planned economy is still apparent; in particular, there can be no rapid change to

the system of settling people in the North.

Consequently, a distinctive Russian model of hydrocarbon resources develop-

ment has emerged over the past ten years. Its distinguishing features are centralism,

corporatism and paternalism. Centralism refers to a growing concentration of

decisive and legislative powers at the federal level (including oil and gas revenue

flows; see Table 10.2).

Corporatism refers to the existence and dominance of one large state company

or a quasi-state corporation taking over the development of significant areas of

the Northern sea shelf, as well as territories on land. Paternalism refers to a top-

down process of providing solutions to social problems in the regions according

to the priorities and directions as defined by the state government bodies and

corporations (the Arctic territories and their inhabitants are increasingly taking on

the role of passive ‘recipients’).

The Russian model 247

The state as a powerful stakeholder

In addition to stakeholders such as the dominating corporation owners (mostly

financial institutions acting as representatives for private individuals’ shares), the

Russian state is the most powerful stakeholder. Oil has been produced in Russia

for over 100 years and, during the entire existence of the Soviet Union, the oil and

gas industry, like all other industries, belonged to the state. The present Russian

authorities see the oil and gas sector of the economy as the basis of the Russian

state’s power within the world economy. Many states that produce oil and gas for

sale to other countries declare their energy resources as national property, and

take control of the income from exports. This is done not only by taxing exces-

sive income from private companies, but by taxing the production capacity itself.

A similar process can be observed in Russia.

This is why Russia has used various methods – ranging from taking

Yuganskneftegaz away from YUKOS for its tax debts to buying Sibneft from its

shareholders at market price – to raise the state share in oil and gas production to

one-third, and simultaneously regained the controlling share in JSC Gazprom,

which produces 90 per cent of Russia’s natural gas. The state’s long-term plans

most likely include increasing control over oil production to half of the country’s

production volume.

Watch out, the pipes are closing

All active major oil pipelines in Russia, except the KTK Pipeline (Caspian

Pipeline Consortium; the state control over it was legally lifted), are owned by

Transneft. In 2002, YUKOS, LUKOIL, Sibneft (now – Gazprom Neft), TNK

(now – TNK-BP) and Rosneft planned to build a private major oil pipeline from

Western Siberia to Murmansk for supplying oil to the US. The Prime Minister at the

Table 10.2 Russian oil and gas revenue flows (federal/regional as of 2006):

primary distribution of revenues

Tax base assignment Federal Regional

1. Extraction tax

Oil 95% 5%

Gas 100%

Oil and gas shelf and offshore 100%

2. Export duties

Oil and gas 100%

3. Excise tax (petrol, diesel) 40% 60%

4. Corporate income tax 27% 73%

5. Royalties SPA

Gas 100%

Oil 95% 5%

6. Corporate income tax SPA 20% 80%

Source: Art. 50 ff. Budget Code RF.

248 E. N. Andreyeva and V. A. Kryukov

time, Mikhail Kasyanov, had said earlier it was legally allowed, but added that a

private pipeline is out of place in Russia. He explained that the principle of equal

access for all oil companies to any pipe in Russia could not be broken. His succes-

sor, Mikhail Fradkov, was more precise in 2004: private pipelines cannot exist in

Russia at all.

However, private major pipelines in Russia do exist, including the Shell

pipeline within the Sakhalin-2 project, and the TNK-BP pipeline in the Kovykta

deposit. The law does not demand the nationalization of these pipelines; however,

every new major pipeline can only be state-run (Butrin, Vesloguzov and Rebrov,

2006). Recently, Shell announced that they will turn over the controlling share in

Sakhalin-2, the largest oil and gas project on the Russian continental shelf, to JSC

Gazprom. Analysts consider that the company gave in to pressure from Russian

authorities.

Striving for monopoly over new deposits

In November 2006, Russian Cabinet of Ministers made a forecast for natural gas

production in Russia by 2015. They predict that independent producers would

have only a 17-18 per cent share in gas production, despite owning 24 per cent of

the resource base. Gas production experts say this forecast will be correct if JSC

Gazprom keeps acquiring major gas deposits of Russia, including those already

belonging to private companies. According to its energy strategy, Russia will be

extracting between 742 and 754 billion m

of natural gas by 2015. This increase

will be mostly due to developing the Yamal Peninsula and Shtokman deposits,

those in the Irkutsk region, including the Kovyktinsk gas-condensate field, and a

number of deposits in the Far East (Grib, 2006).

In December 2006, there was an unexpected announcement that offers from

Western partners concerning participation in the Shtokman field development

could be considered again. First Deputy Prime Minister Dmitriy Medvedev

declared at the Davos Economic Forum that Arctic resource development would

be a joint activity with various countries.

During negotiations with potential partners, Gazprom was aiming at the access

to end users of natural gas in Europe and in the United States in exchange for

participation in development of this Europe’s biggest field. But the topic hasn’t

been finally closed yet. It could be raised again if some interesting offers are

received from foreign partners.

On the same day, Putin’s aide Igor Shuvalov in Washington and the Industry and

Energy ex-Minister, Viktor Khristenko, in Moscow spoke about possible and

desirable involvement of foreign companies in the Shtokman project ‘as suppli-

ers of equipment’ or ‘in some other form’. Russia will independently develop the

first stage and provisions for joining the project have remained the same. Of the

five Western bidders that reached the final stage of the Shtokman tender in June of

The Russian model 249

2006, spokesmen for three companies (Total, ConocoPhilips and Statoil) confirmed

they had noticed nothing new in the attitude of the Russian authorities (The Energy

Shtokman Therapy, 2006).

The licenses were revoked by the Russian Agency of Sub-soil Resources

(Rosnedra) because of alleged mismanagement of the license conditions. Experts

believed federal authorities might transfer the licenses to the state-owned Rosneft

company. The licenses might be in the field of interest for the companies Rosneft

and BP, which recently signed a cooperation deal committing companies to

cooperate in the Arctic.

The principal decision was made at a meeting in the presence of Mr V. Putin:

rights to develop all fields within the Russian continental shelf should be allotted

to state-owned companies – JSC Gazprom and Rosneft.

Legislative and institutional challenges for Arctic projects

in Russia

The European North of Russia plays an important role in the ‘Energy Strategy for

Russia towards 2020’ that was approved by the Russian Government in May

2003. The strategy document estimates that the Arctic shelf of Russia and Yamal

Peninsula will become the most important regions for Russia’s gas production

strategically. However, the document also recognizes that, in order for this to

happen, a stable investment framework and foreign expertise will be required.

Several oil and gas fields have been discovered and a lot of prospects have been

mapped seismically in the Russian part of the Barents and Pechora seas

(Map 10.2). However, the area is large, and it is also considered an undeveloped

exploration province. The key success factors for exploration in this area will

include the size and concentration of reserves, the reservoir parameters with high

well productivity and predictions of oil (light versus heavy) as opposed to gas.

The area is also undeveloped with respect to production. The first projects, ‘opening

projects’, will also need to develop the necessary infrastructure in order to sustain

the development of large fields with high profitability. This will in turn benefit

other projects and will inspire exploration activity on a long-term basis.

Prirazlomnoe and Shtockman will be such ‘opening projects’ for oil and gas in

the Arctic offshore region. Experts from JSC Gazprom and their partners

assume that several small discoveries along with known structures individually

are too insignificant to be stand-alone projects. Area planning supported by the

authorities along with cooperation between license holders will help to make

many of these fields commercially viable.

Mineral legislation – how to make it stable and predictable?

A distinctive feature of the development of oil and gas resources in the Russian

Arctic is that the main participants are large companies – the oil companies JSC

LUKOIL and JSC Rosneft, as well as the gas company JSC Gazprom. In 2006,

250 E. N. Andreyeva and V. A. Kryukov

Map 10.2 Oil and gas fields and hydrocarbon-bearing structures of the Russian Arctic shelf.

another leading Russian oil company, JSC Surgutneftegas, also declared its inter-

est in the work offshore. It signed an agreement with the Norwegian company

Statoil on cooperation in the sphere of development of oil and gas resources

offshore.

In this way, the company will significantly expand its participation in

the Northern projects, in addition to the ongoing development of the fields in the

North of Eastern Siberia (Talakanskoye and four leases in the territory of

Republic of Sakha).

The principal legislation covering the approaches to the

development and use of hydrocarbon resources in the Russian Federation (RF)

comprises: the RF Constitution (1993); the RF Federal Subsoil Law (1992); the

RF Federal Law on the RF’s Continental Shelf (1995) and the RF Federal Law on

the Production Sharing Agreement.

The legal and commercial framework is very important for determining the

level of activity in the region, owing to the large investment required, the risks

involved and the slow return on investment. During the 1990s, in the Russian

mineral legislative sphere, an attempt was made to combine public law and civil

law approaches. The Federal Subsoil Law was based upon public law principles

(i.e. dominance of the state in the decision-making process, as in determining

license conditions). Such an approach protects the company against any changes

in tax or conditions. A more stable and predictable approach is based upon civil

The Russian model 251

law principles (i.e. agreement between the state and the company) – a production

sharing agreement – where any changes have to be discussed by both sides before

they can be approved. This is why nearly all Russian oil companies formed with

foreign investors lobbied for the civil law approach. The process of formation

started in 1993; it was not until 1994–1995 that Russia and its oil and gas sector

experienced a great investment shortage.

Thomas Walde, Professor at the Center for Energy, Petroleum and Natural

Resources Law at the University of Dundee, observed the functioning of Production

Sharing Contracts (PSCs) in the initial stages of the oil and gas development in the

new market economy conditions:

We had lately several references to the dissatisfaction in Russia with the

PSCs concluded with several major oil companies. From my own, minor, role

in Russian oil–gas law reform I have some observations. First, this history

started with the ‘Houston’ project in the 1990s; I considered this a largely

illusionary project by the US oil community to ‘take over’ the Russian oil

industry. I remember a very weird tax law professor calling me in 1991 at

night urging me to make him visiting professor in Dundee so he could learn

how to run the Russian oil industry. Second, at one time the idea emerged that

PSCs were the right instrument for Russia to organise foreign investments.

PSCs, one has to remember, have been used exclusively in developing countries;

their particular feature is that they are very opaque on who runs and controls

the operation. They can be something like a service contract under the

control of the state company, but they can also in effect simply continue

foreign control like a traditional concession/license contract, but give the

impression the host state now owns and controls the operation. That opacity

was the first main advantage and reason for PSCs, the other one was, and is,

that it operates an in-built tax stabilisation mechanism by way of the cost

recovery system (and that mechanism–diluted in Russia–is I understand now

a major issue in Russia). Cost overruns lead simply to faster and more exten-

sive cost recovery and that seems currently a major criticism of the Sakhalin

contracts (notwithstanding that the costs in the oil industry have seriously

inflated everywhere–as is normal in any industry experiencing a sudden ups

and down) and we have a prior, low-oil price induced shrinkage of capacities

(facilities, human resources).

Unfortunately, the development of a production sharing agreement (PSA) regime

makes it more uncertain and difficult to obtain PSA terms for projects. This is

problematic for both Russian companies and their foreign partners. Suggestions

for simplifying the procedure have been submitted for consideration to the state

Duma and it is hoped that the regime position can be revised.

Another issue is

the pending overhaul of the Subsoil Law. The final edition failed to gain govern-

ment approval, which makes the outcome of the important changes unclear.

Nevertheless, the great potential of the hydrocarbon reserves (the Shtokman field

252 E. N. Andreyeva and V. A. Kryukov

Textbox10.2 Legal framework

The principle of joint jurisdiction (Article 76 of the

RF Constitution)

The principle of joint jurisdiction presumed actual participation of both the

regions and the federal center in granting the rights to use subsurface

mineral resources. However, practical implementation of this principle was

not clearly formulated. This led to a number of serious problems in inter-

relations between the companies – users of subsurface resources and

regional authorities. Finally, in 2004 the principle was suspended. Several

amendments revoking the principle were introduced to the Underground

Resources Law.

Underground Resources Law (1992)

The fundamental legislation on use of subsurface resources includes the

following:

– subsurface resources are a state property and are granted to compa-

nies–land users for a certain period of time for the purpose of survey,

exploration and development of mineral deposits;

– entitlement for the use of subsurface resources should be carried out

on a payment basis;

– subsurface resources are jointly owned by the federation and

constituent entities of the federation, apart from the fields located on

the shelf and in the closed seas that are under the federal jurisdiction.

One of the main problems is execution of the law, which contains several

reference rules. A new edition was, therefore, submitted for revision in

June 2006 by the Minister of Natural Resources. In addition to clarifying

the role of the Federal Center in regional subsurface management, this

edition attempts to integrate the civil law propositions into the resource

management frame.

alone is considered to be larger than all the Norwegian gas fields discovered

during the last 30 years) and the expected long-term production (more than

50 years) attract foreign companies to participate in this project.

The ‘two keys’ principle

In compliance with the RF Constitution (Article 72, Item 1) in Russia, the issues

of oil and gas resources located onshore are to be solved under the joint jurisdic-

tion of the Federation and its constituent entities (see Textbox 10.2), which implies

The Russian model 253

they have to reach a certain consensus. The issues include the possession, use and

management of land, subsurface, water and other natural resources, as well as

management decisions concerning nature, preservation of the environment and

environmental safety control and use of natural resources within specially

protected natural territories (Moe and Kryukov, 1998).

The principle of joint jurisdiction presumed (Article 76 of the RF Con-

stitution), that:

on the issues of joint jurisdiction of the Russian Federation and constituent

entities of the Russian Federation: Federal laws, as well as RF constituent

entities laws, and other statutory legal acts are issued, and accepted in

compliance with the Federal ones.

The ‘two keys’ (joint jurisdiction) principle arose as a result of the political

processes that prevailed in Russia in the beginning of the 1990s. The principle

reflected the aspirations of the territories to solve the social problems they inher-

ited after the collapse of the old system, and to meet the social challenges of the

future. Initially this principle was based on the Subsoil Law (1992) and later

became one of the cornerstones of the new Constitution (1995). Among the key

stakeholders affected by the formation of the principle of joint jurisdiction are the

population of the oil and gas territories (including the native peoples of the North),

oil and gas companies, state institutions and other bodies at both the federal and

regional level. During this period, the oil and gas companies – as their formation

was at the initial stage – were not active participants in the discussions over grants

for the rights to use subsurface resources. The main concern was on the issues of

ownership of the companies’ assets, as well as access to export infrastructure.

The process of the companies’ formation was basically completed by the end

of the 1990s. As this process was coming to an end, the position of the major

companies on the issues of subsurface management began to change. This was

mostly due to the reappearance of the real proprietors, who were interested in

receiving payment for their assets purchased during privatization. The companies

supported the cancellation of this principle, as the presence of two participants on

the part of the state, in their opinion, created additional complexities.

However, this was not without a controversy. Victor Orlov, Chairman of the

Committee on natural resources and preservation of the environment under the

Production sharing agreement (or contract) (PSA; 1995)

An alternative legislation, in the form of production sharing agreements,

was a response reaction of Russian and Western companies to investment

instability in new development projects. Procedures accompanying

implementation of PSA are extremely complicated: about 28 different

coordination and agreement stages have to be passed through.

254 E. N. Andreyeva and V. A. Kryukov

Council of Federation of the RF (in the 1990s, Minister of Natural Resources),

pointed out that ‘the regions deprived of any interest in subsurface management,

may become opponents and not supporters of the reforms being carried out’.

Orlov’s opinion, in Russia’s emerging democracy, the ‘two keys’ principle

provided stability both to the companies’ economic activity and life in the

regions.

The subsurface management agencies, which were created in the

resource regions and were made responsible for ‘the second key’, appeared to be

more consistent and stable. Up until 2002, the regions actively participated in

investment of the mineral resources base. Moreover, investments in geological

prospecting exceeded the volume of federal investments by 2-3 times.

The conflict of Vladimir Butov, Governor of the Nenets Autonomous Okrug

(NAO), with the ‘oilmen’ became one of the catalysts for facilitating changes to

the Underground Resources Law. From December 2001 for a period of two years,

the head of NAO neglected to sign 43 permissive documents on the work of the

affiliated company PC LUKOIL. As a result, the company was declared to have

infringed license agreements.

The Archangelsk regional assembly directed

amendments of the Underground Resources Law to the state Duma, prepared by

experts of the company. The essence of these amendments was to deprive the head

of the regional authority of the right to dispose of the natural resources in the

region. However, the NAO governor acted not so much in the interests of the local

population, but rather in his own interests – he created ‘the petroleum company

of regional development’ – the Nenets petroleum company. Therefore, the posi-

tion of the company JSC Arkhangelskgeoldobycha (an affiliated branch of the

JSC ‘LUKOIL’) was based on the assumption that the law in its 1992 edition

impeded the development of oil and gas complexes, as the general director of the

company Oleg Moldovanov noted. The governor of another oil-producing region –

the Tomsk region – Victor Kress stated ‘it is much safer for the state when “the

key” belongs to two, rather than to one owner’.

Nevertheless, on August 3, 2004 the deputies of the state Duma ratified

amendments to the RF Ministry of Natural Resources to the Underground

Resources Law in the second reading and actually deprived the governors of the

right to ‘the second key’.

The Underground Resources Law

The management of subsurface resources of the Russian Federation continental

shelf was assigned to the RF authorities for regulation (Article 3, the RF URL –

Underground Resources Law). There are several fundamental points that provide the

framework for legislation on subsurface resources. Thus, the subsurface resources

are considered to be state property, and are granted to companies/land users for a

certain period of time for the purpose of geological survey, exploration and develop-

ment of mineral deposits. Furthermore, entitlement for the use of subsurface

resources should be carried out on a payment basis. Also, the subsurface resources

are jointly owned by the Federation and its constituent entities (apart from the fields

located on the shelf and in the closed seas, which fall under federal jurisdiction).

By the time the administrative reform began in 2001, a number of conceptual

changes were introduced to the Underground Resources Law. Many of those

directly affected the interests of the regions. Hence, some of the amendments

accepted in 2001 fundamentally changed the system of payment for land use.

Instead of royalties and deductions for mineral replacement, a tax on production

was introduced. Distribution of oil and gas production tax between the budgets

has changed drastically since that time. From 2007 onwards, it has been totally

directed to the federal budget.

The balance and distribution of power between the federal and regional level of

the state system changed fundamentally with respect to control and management

of subsurface resources in 2004. The changes were introduced by the Federal Law:

On introduction of changes and amendments to the RF Underground

Resources Law of August 22, 2004, # 122-FL (Federal Law). These amend-

ments reflected the need to bring the RF Underground Resources Law in

compliance with the Federal Law.

‘On general principles of legislative (representative) and executive public

authorities organization in the Russian Federation’ of July 4, 2003, # 95-FL.

Proxies of the federal body of the state subsurface resources fund control

significantly has been expanded; the earlier existing principle of the ‘two keys’ –

joint decision-making at the federal and regional levels on the issues of use and

management of subsurface resources – was replaced. From that time on, all the

important decisions concerning oil and gas projects were supposed to be made at

the federal level.

In our opinion, the ‘two keys’ principle most profoundly ensured accommoda-

tion of both the State’s own interests and the interests of the regions where the

leases and land users are located. The principle was directed at smoothing

economic, environmental and social conflicts connected to geological survey,

exploration and development of subsurface resources. It also created incentives

for regional participation and encouraged the regional bodies to create a socially

oriented system of natural resources management.

During the 1990s, the Underground Resources Law contributed to obtaining

significant financial and social–economic advantages from the implementation of

subsurface resources management projects in the producing regions, including

the Arctic. Thus, rental income received by the regional budgets from hydrocar-

bon production at that period, enabled significant increases in the living standard

of the population in the corresponding constituent entities of the Russian

Federation.

More importantly, the Underground Resources Law allowed investment flows

that were directed at implementing large infrastructure projects at regional level.

The construction of bridges and roads of inter-regional and national significance

in Yamal-Nenets Autonomous Okrug and Khanty-Mansi Autonomous Okrug may

be an illustration. These projects were the first positive experience among

structural reforms to be implemented in practice at the regional level.

The Russian model 255