1 Introduction to production sharing agreements
One of the most common types of contractual arrangements for the exploration and production of natural resources, production sharing agreements (PSAs) are very complicated and often cause disputes between states and exploration companies. PSAs in Kazakhstan have their own history, characterised by both success and failure. This chapter reviews the evolution of the PSA in Kazakhstan, briefly describes the most ambitious projects and summarises the issues encountered along the way.
1.1 History of PSAs
PSAs have been widely and successfully employed in more than 60 countries around the world for decades. They balance out the interests of the state in regulating access to its natural resources and those of extraction companies that possess various resources.
The fundamental principle that underpins the PSA is the distribution of the extracted oil between the government of the resource-rich country and the oil extraction company, which allows the latter to recover its capital and operational expenditures. The oil extraction company assumes all risks of exploration, pays taxes on its share of the extracted oil and transfers its proprietary rights to constructed infrastructure to the host state under the respective legislation and the terms of the PSA. This model is often used in countries that have fairly favourable resource potential, but a dearth of financial and technical assets.
The first PSA was developed in the early 1950s in Bolivia. However, the modern form of the PSA, as it still known today, was implemented for the first time in 1966 in Indonesia. The PSA diverged considerably from the existing models of oil and gas contracts at the time, under which oil companies carried out oil operations at their own expense and at their own risk, but received no rights to the subsoil.
At the time the PSA emerged, nationalistic sentiments prevailed which prevented the Indonesian government from granting rights for subsoil use and concluding the traditional types of concession agreements with international oil companies (IOCs). At the same time, the government could not afford to let its oil and gas sector stagnate, as national companies did not have the necessary expertise and capital to develop the industry. Thus, the concept of the PSA was introduced, and a precedent was established and was subsequently taken up in other developing world countries.
Although the main concept of the PSA remains unchanged today, the individual characteristics of these agreements may differ from country to country; and even the terminology is not necessarily consistent. Straddling both public and private law, PSAs have a controversial legal nature which is often the subject of intense debate among the legal community, the general public, governments and IOCs.
This chapter discusses the history, legal nature and current situation of the PSA in Kazakhstan. Section 2 outlines the history of the oil and gas sector, the introduction of the PSA, its relationship to the Kazakh petroleum regime and the latest developments.
The following sections discuss the legal nature and main features of PSAs and the regulatory bodies that govern them. They aim to provide the reader with a comprehensive understanding of the legal nature and essence of the PSA in Kazakhstan.
The final sections of this chapter discuss the main clauses of the PSA - such as terms of operation, taxation, applicable law and jurisdiction - as well as environmental protection. Finally, the conclusion summarises the main points discussed.
2 History of the oil and gas sector
2.1 Before the introduction of PSAs
According to BP's 2020 Statistical Review of World Energy, the world's total proved oil reserves were estimated at more than 1.73 trillion barrels as of the end of 2019. Kazakhstan ranks 12th in the global rankings, with 30 billion barrels of proved oil reserves.
The first activity in the Kazakh oil and gas sector began in 1899, in the Karachunul field. At first, oil was extracted using the fountain method. This was a cheap and easy way to extract oil, but it was inefficient. The wellhead had to be sealed and the total pressure inside the well had to be guaranteed. As time went on, companies began to extract oil using depth pumps and compressors, and later rotary drilling. During that period, and until Kazakhstan gained independence, the subsoil and the lands of the Kazakh people were owned by the Communist Party. The Soviet government built some pipelines and, instead of rotary drilling, began to use rapid turbine drilling, which increased oil production. The Communists were extracting millions of tonnes of oil and gas each year. However, the profits did not remain in Kazakhstan, but instead went directly to Moscow. The most significant discoveries were made in 1979, during the Soviet period: the Tengiz and Karachaganak fields in western Kazakhstan.
After the collapse of the Soviet Union, Kazakhstan gained independence and the right to use its subsoil, which had previously been the exclusive prerogative of the Communist Party. The question thus arose: how should the subsoil be used and regulated?
Although Kazakhstan lacked experience and resources, it still had a strong regulatory base. However, improvements to this legislation were needed in order to attract more international investors to the country, as the Soviet Union was no longer providing money and expertise. These legislative amendments and improvements resulted in a very weak position for the state. As a result, the government adopted the new Code of the Republic of Kazakhstan on Subsoils and Processing of Mineral Raw Materials dated 30 May 1992, which was the first of many laws in the oil and gas sector. This law was generally favourable for foreign investors, but less so for Kazakhstan. Two years later, the government adopted the Regulations on the Subsoil Use Licensing Procedure dated 8 August 1994, which required that subsoil use contracts comply with the respective licences. During the 1990s, Kazakhstan ratified several international conventions and treaties, including the Energy Charter Treaty, signed in Lisbon on 17 December 1994. At the time, the Kazakh government was keen to develop the legislation governing the subsoil. Accordingly, Kazakhstan adopted the Law of the Republic of Kazakhstan on Oil dated 28 June 1995 and the Law of the Republic of Kazakhstan on Subsoils and Subsoil Use dated 27 January 1996. These laws were significant and governed the Kazakh oil and gas sector until July 2010. They provided for a system of licences and contracts to use the subsoil, and a stabilisation statute guaranteed that the licences awarded and contracts concluded would remain unaffected by any legislative amendments or new laws which could potentially worsen the positions of investors in the future.
2.2 The PSAs in Kazakhstan and their relationship with the petroleum regime
As Kazakhstan lacked the necessary expertise, machinery and funds, it could never develop the full potential of its oil and gas sector without foreign investment. The introduction of the PSA was the only possible way to attract significant foreign investment to the country and develop vast oil fields such as Kashagan, Tengiz and Karachaganak.
According to some commentators, the PSA is the most favoured model of field development contract among foreign investors. As the conditions of the PSA establish a special regime, the agreement facilitates the proper calculation of the economic efficiency of specific projects by reducing the number of unknown variables in the equation and guaranteeing investors an acceptable level of risk and stability. Before the start of the project, the investors conduct a feasibility study of the PSA, in which the most important indicators are the internal rate of return, the net present value and the period of compensation for their investments. Given the complexity and the size of the Kashagan, Tengiz and Karachaganak fields, foreign investors agreed to enter into these projects only on the basis of the PSA.
At present, 11 projects are still operating under the PSAs. For the purposes of this chapter, we will consider the three largest and oldest of these:
- the Karachaganak project;
- the North Caspian Project; and
- a joint venture called Tengizchevroil LLP, established by the first president of Kazakhstan, Nursultan Nazarbayev, and Chevron Corporation. This has all the features of a PSA, but the contract and their terms have not been disclosed to the public.
(a) North Caspian PSA
The North Caspian PSA (NCPSA) was concluded between Kazakhstan and the international consortium in November 1997, with a contract term of 40 years. According to the official website of North Caspian Operating Company BV (NCOC), the current operator of the project is NCOC and the consortium consists of the following oil and gas companies:
- NC KazMunayGas JSC (KMG) - 16.88%;
- ENI SpA (Agip) - 16.81%
- Exxon Mobil Corporation - 16.81%
- Royal Dutch Shell plc - 16.81%
- Total SA - 16.81%
- China National Petroleum Corporation (CNPC) - 8.33%
- INPEX Corporation (Inpex) - 7.56%
In the course of time, an enormous oil field - the Kashagan field - was discovered in the northern part of the Caspian Sea in 2000. The oil reserves of the Kashagan field are estimated at 4.5 billion tonnes.
The parties to the NCPSA have also discovered:
- the Kalamkas Sea field (284 million tonnes of oil);
- the Aktoty field (156 million tonnes of condensate gas);
- the Kairan field (112 million tonnes of oil); and
- the Southwest Kashagan field (20 million tonnes of condensate gas).
(b) Karachaganak Field Final PSA
In 1979, the Soviet government discovered one of the largest oil fields and one of the largest gas condensate fields in the world - Tengiz and Karachaganak respectively. The condensate reserves of Karachaganak are estimated at 9 billion barrels, while the gas reserves are estimated at 14 trillion cubic metres (m3).
In 1997, the government of Kazakhstan and IOCs signed the Karachaganak Field Final Production Sharing Agreement (KFFPSA), with a term of 40 years.
According to the official website of Karachaganak Petroleum Operating BV (KPO), the operator of the project is currently KPO and the consortium consists of the following IOCs:
- KMG - 10%
- Agip - 29.25%
- Chevron Corporation- 18%
- Shell - 29.25%
- Lukoil Oil Company JSC - 13.5%
By 2019, KPO had extracted 18 million tonnes of oil production and 8.7 billion m3 of gas production. Half of the gas produced was reinjected to maintain reservoir pressure.
(c) TengizChevrOil joint venture
On 2 April 1993, a joint venture called TengizChevrOil LLP (TCO) was established by the first president of Kazakhstan, Nursultan Nazarbayev, and Chevron Corporation. This project has all the features of the PSA, but the contract is not a classic PSA. The parties to the contract have concluded numerous agreements, but the terms of those agreements are not disclosable to the public. The licence for exploration and production was issued for a period of 40 years.
According to the official website of NC KazMunayGas JSC, which is currently the operator of TCO, the following IOCs are participants in this project:
- Chevron - 50%
- Exxon - 25%
- KMG - 20%
- Lukoil (through LukArco) - 5%
The oil reserves in the Tengiz field are estimated at 3.4 billion tonnes. By 2017, oil production by TCO had reached 28.697 million tonnes.
(d) Law on PSAs
Kazakhstan had great strategic plans to use the PSA to further the development of the Caspian Sea and attract IOCs to build infrastructure, discover and extract oil, and use local content at their own expense and risk. To realise these ambitions, the government adopted the Law of the Republic of Kazakhstan on the Production Sharing Agreements in Offshore Oil Operations dated 8 July 2005 ('PSA Law').
However, the PSAs also resulted in damage to the state economy and losses to the national budget. In a speech in 2008, former Prime Minister Karim Massimov stated that Kazakhstan needed to increase the tax burden for subsoil users and revise the procedure through which they paid taxes; he also highlighted the importance of excluding the PSA as a type of subsoil use contract. He assured investors that Kazakhstan would continue to fulfil its obligations under existing PSAs, but would not conclude any new PSAs because times and Kazakhstan - had changed. Thus, the PSA Law was abolished in 2009.
2.3 Current situation
(a) Kashagan and the NCPSA
The commencement of commercial oil production in the Kashagan field was initially scheduled for 2008, but was postponed first to 2013 and then again to 2016. According to the consortium of IOCs, the delays were due to:
- problems with pipelines, machinery and equipment;
- the technical difficulties of the project;
- the harsh climate;
- the ecologically sensitive environment of the Caspian Sea; and
- strict regulatory requirements.
In November 2016 the NCPSA finally commenced commercial oil production in Kashagan; by the end of 2018, this had reached 22.5 million tons of oil, 13 billion m3 of gas and 2.6 million tonnes of sulphur. As yet, however, this has not yielded dividends for Kazakhstan. Under the terms of the PSA, for the time being, the IOCs will retain almost 90% of the profits as compensation for their investments; Kazakhstan will begin receiving adequate profits and revenues in approximately 2027-2029.
There are several problems connected with Kashagan, as a result of which the government of Kazakhstan now regrets signing the NCPSA.
First, the government appreciates that oil extraction from the seabed is more complicated than on land. As previously mentioned, Kazakhstan did not have - and still does not have - the necessary resources to exploit the Kashagan field by itself. In order to extract the oil, the consortium must build artificial islands, bring machinery to those islands and endure the harsh winters of the Caspian Sea - not to mention addressing the related environmental issues. We also understand that NCOC made a number of engineering mistakes, which caused delays and budget increases. This means that Kazakhstan will not see any profits in the immediate future.
Second, the PSA concept requires the consortium to be compensated for its investments by the state. The state must thus strictly control the investors' expenses; if it does not, the investors may deliberately increase their costs. However, in the late 1990s and early 2000s, the government was poor in controlling these expenditures; and even today, it cannot adequately control the costs of the project. This has allowed the investors to export as much oil as they wish. Once again, this means that Kazakhstan will not see any profits for the foreseeable future.
The third problem is the controversial participation of KMG in the project. Between 2004 and 2008, KMG invested a stake of 16.81% in the project. KMG is the national company, which is owned by the government. As the state had always been a party to the NCPSA, this meant that the government was now represented on both sides of the PSA. As previously mentioned, this project has abundant potential, but has also required huge investments. NCOC has made large cash calls, which are quite acceptable for IOCs but not for KMG, which can barely pay them.
(b) Karachaganak and KFFPSA
Since development started in 1997, the IOCs have invested more than $14 billion in the Karachaganak field. In 2015, a dispute arose with the government over the costs of the project. The issue was resolved through arbitration in 2019, with a decision in favour of Kazakhstan. According to that decision, the consortium was ordered to pay an initial $1.305 billion to Kazakhstan and an additional payment of $600 million by 2037. Consequently, both parties to the KFFPSA approved the expansion of the Karachaganak field with an investment of $1 billion.
(c) Tengiz and TengizChevrOil LLP
On 5 July 2016, the participants of TCO reached agreement to finance the Future Growth Project/Wellhead Pressure Management Project. Under this project, TCO will build a refinery and crude gas reinjection facilities, a well-stream gathering system, pressure-boosting facilities, infrastructure and auxiliary facilities. The estimated cost of the project is $36.8?billion.
The participants in TCO have increased the budget and delayed the schedule several times. Currently, Chevron claims that the cost of the project is $45.2 billion. However, the government believes that the increased cost for Tengiz is too high and wants the investors to recalculate it.
In 2020, TCO planned to renovate the machinery used in the Tengiz oil field. However, due to the Covid-19 pandemic, the renovation was postponed to 2021.
3 Legal nature of PSAs
As previously mentioned, it is vital to understand the legal nature of the PSA. The PSA is a type of contract with specific features which are essential to investment agreements. In Kazakhstan, the PSA does not specifically indicate the counterparty as a foreign entity. The participation of a foreign investor does not imply that international law will apply; in fact, the state only applies local law under the PSA. Moreover, sometimes the local company (KMG) participates alongside the investors. Thus, we would argue that the PSA is not specifically regulated by international public and/or private laws.
As some commentators point out, all public elements of the PSA - such as taxation issues, environmental regulations and production sharing procedures - are resolved before the PSA is concluded. The investors have the right to choose whether to enter into the contract. Once the PSA has been concluded, both parties have equal rights and mutual obligations to perform the contract. Accordingly, we consider that the PSA is a civil contract.
4 Main features of PSAs
4.1 Cost oil versus profit oil
When an oil field is discovered, the state and investors negotiate on the proportions in which the oil will be shared. Once they have reached an understanding, the investors can start developing the oil field. As previously mentioned, the investors bear all capital and operating costs, and receive compensation in return. The investors calculate all of their investments and define the costs of the project, which the state must compensate by sharing oil with investors. It is thus very important for the state to monitor these costs; otherwise, the investors can increase the costs and can even provide fake invoices.
Once the oil field has been developed, the investors commence oil production. The start of commercial oil production means that investors can retain the produced oil as compensation for their investments. The proportion of this compensation is agreed between the investors and the state. This compensation is called 'cost oil', as it only compensates the investors for their investments. The remainder of the oil produced is called 'profit oil', and is divided between the parties in a certain proportion as agreed between the state and investors before the conclusion of the PSA.
5 Role of the authorised body
The history of Production Sharing Agreements Limited Liability Partnership (PSA LLP) - the authorised body for PSAs in Kazakhstan - begins in 1997, when the NCPSA and the KFPSA were concluded. Kazakhstan needed an authorised body in order to enter into these PSAs. Kazakhoil JSC was designated as the authorised body from 1997 to 2001, in accordance with a decree of the Kazakh government.
In 2001, the Ministry of Energy and Mineral Resources took over this role for one year. Then, in 2002, in accordance with a decree of the president of Kazakhstan and a decree of the government of Kazakhstan, NC KazMunayGas JSC was established, which assumed this role until 2010.
In 2010, the Ministry of Oil and Gas became the authorised body. That same year, KMG also transferred a 100% participation interest in the charter capital of PSA LLP to the Ministry of Oil and Gas.
In 2014, the Ministry of Oil and Gas was restructured as the Ministry of Energy, which then became the authorised body for the PSAs. Two years later, under Government Decree 355/2016, PSA LLP was appointed as the authorised body, and it continues in this role today. The main task of the authorised body is to make decisions on behalf of the state regarding the transfer of cost oil and to monitor the invoices submitted by investors.
As previously mentioned, it is very important that the state monitors costs closely; otherwise, investors could increase the costs and could even provide fake invoices. For example, an investor could buy drilling equipment abroad for $1 million and resell it through an affiliated third company for $2 million. As a result, the investor could report that it has invested $2 million in the state economy. Thus, the amount of the cost oil doubles, which is negative for the state economy.
In this regard, it is questionable that KMG has certain shares in the Kashagan, Karachaganak and Tengiz projects, while an affiliated company, PSA LLP, is the authorised body in the respective PSAs. This presents a risk of corruption in the national oil company. We would argue that the authorised body of the PSA should be completely independent from the PSA operator that incurs the costs under the PSA, as a conflict of interest is otherwise inevitable.
6 Analysis of the main clauses of the PSA
6.1 Exploration, development and production
Once the investors have signed the PSA, the government approves the list of blocks/sections in order to implement the PSA. After accepting the designated contract area, the investors carry out the geophysical surveys. These operations should take place only within the designated blocks. Under the PSA in Kazakhstan, the investors bear all risks and receive compensation through sharing in the oil produced. Without oil, there is no compensation. Based on the results of the survey, the investors choose a drilling site for the purpose of well exploration. If this is successful, the investors will announce the discovery of oil.
Technical and economic feasibility studies are then carried out. Based on the available data, the government will approve the field development programme. The development then begins: the investors commence construction and develop infrastructure and transportation networks. Once the necessary preparations have been made, oil wells are drilled, the development stage ends and the commercial production stage begins.
6.2 Local content
As the budgets of Kashagan, Karachaganak and Tengiz kept expanding, the government decided to impose a minimum 50% local content obligation on investors. In response, NCOC, the operator of the Kashagan field, increased its share of local content to 46.2% in 2014, 27.7% in 2015, 27.8% in 2016, 32% in 2017 and 48% in 2018. These fluctuating figures suggest that there is little stability or sustainable growth. Meanwhile, TCO, the operator of the Tengiz field, declared that in 2018 it purchased $2.5 billion of Kazakh goods and services. However, the percentage of local content that this represented was not disclosed. KPO, the operator of the Karachaganak field, issued a report in 2018 which stated that its share of local content was 56%.
However, operators do not treat local workers in the same way as they treat expats. Several incidents have resulted from these unequal work conditions. Workers have gone on strike numerous times, but the issues remain unresolved.
Under the PSA, the operator is responsible for the respective project and for all working processes. Usually, investors create a special legal entity for operating purposes. Although the operator is a separate legal entity, the investors bear joint responsibility to the state for the operator's actions under the PSA.
The operator usually does not possess funds itself. In order to maintain the project and working processes, the operator makes cash calls to the investors.
The operator of the Karachaganak field is a foreign legal entity, KPO. Similarly, the operator of the Kashagan field is also a foreign legal entity, NCOC. In Tengiz, the investors created a limited liability partnership, TCO, under Kazakh law.
In order to reduce environmental pollution, IOCs endeavour to upgrade and modernise their equipment and machinery. However, environmental disasters still frequently occur. Kazakhstan needs to rethink its attitude towards its natural resources. The most badly affected area is the Caspian Sea, which includes the Atyrau and Mangistau regions. The anthropogenic impact in these areas is catastrophic, encompassing millions of hectares of technogenic zones and degraded pastures, and millions of tonnes of spilled oil.
The companies that operate under PSAs in Kazakhstan experience similar problems, such as sulphur utilisation. The increase in sulphur reserves in Tengiz and Kashagan is another red flag. TCO and NCOC claim that they cannot utilise the amount of sulphur produced and thus most of it is blown away by the wind. Environmental specialists argue that the actions of the IOCs are insufficient. TCO and NCOC would rather pay billions of dollars in fines to the government than find a way to utilise the sulphur produced without environmental consequences.
The North Caspian Sea is a delicate ecological zone. Its flora and fauna are very sensitive, and there are a lot of rare species - such as sturgeon fish and the Caspian seal - which are included on the International Union for the Conservation of Nature Red List of Threatened Species. The development of the Kashagan field is proving difficult due to the limits of the existing technical capabilities.
However, KPO always fulfils its obligations to ensure safe working conditions and protect the environment in the region in which it operates.
According to the United Nations Convention against Corruption and the Organisation for Economic Co-operation and Development, 'corruption' is the abuse by officials of their state powers for their personal benefit by pursuing the interests of third parties. According to Article 2, part 1 of the Anti-corruption Law, 'corruption' is:
- the acceptance of property benefits and advantages not provided for by law, in person or through an intermediary, by persons who perform state functions, and persons equated with them, through the use of their official powers and opportunities linked to them, or such other use of their powers; and
- the bribery of such persons by individuals or legal entities through the illegal provision of benefits and advantages.
In the PSA context, corruption mainly arises in relation to oil extraction, tax collection, ecology protection, land use and goods procurement. Oil extraction is hard to control, as it involves ongoing examinations of licences, ecological indicators, land use, labour relations and tax payments.
6.6 Royalties and taxes
Under the existing PSAs in Kazakhstan, the tax burden on investors is inadequate. Currently, investors need only pay corporate income tax and value added tax. They do not pay property tax, land tax, excess profit tax, royalties, customs fees for exported crude oil and gas condensate, or excise duties for crude oil and other minerals. Moreover, the PSA members of the Kashagan, Karachaganak and Tengiz projects need not comply with the current Tax Code, as this does not have retroactive effect.
6.7 Applicable law and dispute resolution
As previously mentioned, the PSA in Kazakhstan possess no features of international law. As the subsoil has economic and strategic significance, the only applicable law is the law of Kazakhstan.
With regard to dispute resolution, we would suggest that the PSA is a civil contract. Disputes under such contracts may be addressed in accordance with the agreed conditions in the contract, whether through the Kazakh courts or through international arbitration. In general, such disputes are resolved through international arbitration, given that one party to the PSA is the state itself.
The PSAs currently used in Kazakhstan appear to have facilitated the effective colonisation of the country. Kazakhstan cannot cancel the existing PSAs and investors continue to operate based on them. According to these PSAs, Kazakhstan receives a small share of the profits from the exploitation of its natural resources once the investors have been reimbursed for their investments. IOCs purposefully overestimate their expenses. Investors are aware that the Kazakh government does not have the necessary expertise to check the implied costs.
On the other hand, Kazakhstan also does not have the necessary expertise, funds and technologies to exploit its natural resources itself; and without the IOCs, it would be unable to produce oil and exploit large oil fields such as Kashagan and Tengiz. For these reasons, the PSA is both a blessing and a curse.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.