Production Sharing Agreements as the Most Efficient Legal Regime for Subsoil Use in Ukraine

In 2012 the Ukrainian Government held 3 tenders on execution of production sharing agreements (the PSA) for hydrocarbons to be recovered at 2 onshore and 1 offshore blocks. As a result of these tenders, Shell won the tender for the Yuzivs'ka block (Eastern Ukraine), Chevron — for the Oles'ka block (Western Ukraine) and the consortium consisting of ExxonMobil, Shell, OMV and PJSC NAK Nadra Ukrayny — for the offshore Skifs'ka block (the Black Sea). On 24 January 2013 the PSA regarding the Yuzivs'ka block between Ukraine, Shell Exploration and Production Ukraine Investments (IV) B.V. and Nadra Yuzivs'ka LLC was executed in Davos. PSAs regarding the other blocks are expected to be finalized and executed in the first half of 2013.

Legislative stability as an incentive attracting investors

Participation in the 2012 PSA tenders of major international oil & gas companies is a clear indication of substantial interest on the part of investors in the exploration and production of gas and oil in Ukraine. Many investors agree that after a train of recent legislative developments in this area regulation of production sharing agreements in Ukraine results in rather favorable legal regime. The principal rules are included in the Production Sharing Agreements Act No.1039-XIV, of 14 September 1999 (the PSA Act). One of the most significant incentives in the PSA Act is the stabilization clause pursuant to which during the PSA term (i.e. maximum 50 years) an investor's rights and obligations will be governed by a legal regime existing on the PSA execution date and by subsequently adopted legislation benefiting the investor, i.e., reducing or canceling taxes, simplifying regulation of exploration and production of minerals, easing supervising and regulatory procedures, such as customs, currency, tax and other types of controlling activities, or decreasing investor's liability. Such benefiting future legislation must apply from its effective date. Under the PSA Act, the stabilization clause does not apply to the legislation regulating defense, national security, public order and environmental protection. These exceptions are of a great concern to foreign investors as they preserve uncertainty in rather sensitive legal areas, such as environmental protection and relevant investor's liability. However, it is important that even in case of negative legislative changes outside of the stabilization clause affecting investment under the PSA, a foreign investor may resort to compensation of the incurred damages based on Ukrainian law applicable to protection of foreign investments or relevant international treaties ratified by Ukraine, such as the Bilateral Investments Treaties, the Energy Charter Treaty. As a result, the Ukrainian PSA mechanism appears to provide investors with sufficient legal protection from the future negative legislative changes.

Freedom of contract under the PSA mechanism

Unlike the heavily regulated and in many respects investor-unfriendly legal regime other than the PSA applicable to oil and gas exploration and production, the PSA Act allows parties to the PSA to establish their own rules applicable to the PSA activities, including production sharing, transportation, treatment, storage, processing, use, sale of minerals, construction and operation of related industrial facilities, pipelines and other facilities. In particular, under the PSA Act, an investor and the State may contractually agree on: the procedure for determining the investor's recoverable cost in compliance with requirements set forth in the PSA Act; the terms and procedure for sale (disposal) of produced minerals (hydrocarbons) and Operator's payments to the PSA's other parties; the investor's right and terms to use property transferred into ownership of the State; the parties' liability for a default on their respective obligations under the PSA in addition to relevant mandatory provisions of the PSA Act; the procedure for (a) suspension and early termination (including through invalidation) of the special permit for subsoil use and (b) restriction, temporary prohibition (suspension) or termination of subsoil activities in case of imminent threat to human life and health or environment; and the procedure and conditions for early termination of the PSA.

Other investor friendly provisions

In addition to the noted broad implementation of the freedom-of-contract principle, the PSA Act provides investors with a number of other important incentives and privileges including, inter alia, the following:

a) Privileges in obtaining governmental approvals

The State ensures issuance to investors (including operators under the PSA) and facilitates issuance to their contractors and subcontractors of all approvals, quotas, special permits for subsoil use and licenses to carry out exploration and use of mineral deposits, issuance of mining allotments, land use rights documents and other authorizations related to subsoil use and performance of works under the PSA (the Governmental Approvals). Such approvals are issued following the statutory approved procedures.

The State also ensures issuance of work permits and service cards (applicable to employees of investors' representative offices) to investors' foreign employees and facilitates the issue of such documents to foreign employees of the investors' contractors and subcontractors.

b) Privileges in importing goods

The investor and its contractors are not subject to licenses and quotas for importation to Ukraine of their own or leased equipment, materials and other assets required for performance of works under the PSA.

c) Investor's right of free disposal of hydrocarbons

The investor may freely dispose its share of minerals (hydrocarbons) produced under the PSA to any chosen buyer on contractually agreed terms. Such hydrocarbons are not subject to any export licenses and quotas and any other limitations for disposal on the territory of Ukraine. Limitations may apply only if they were expressly established in the PSA tender terms.

d) Currency and payment privileges

Under the PSA Act, the investor is entitled to freely convert into Ukrainian or foreign currency and expatriate funds received under the PSA. The PSA may also contain specific currency and payment terms.

The State ensures that currency control restrictions under Ukrainian law do not apply to the investor's operations within the PSA (including those related to purchase of equipment, materials and other goods, works and services required for operations under the PSA) with respect to the following transactions:

(a) payments under export and import transactions, including relevant statutory deadlines;

(b) obtaining loans in foreign currencies from, and their repayment to, Ukrainian residents or non-residents, including applicable registration requirements with the National Bank of Ukraine and limitations concerning interest rates;

(c) foreign currency wires to other investors under the PSA and the State, including any requirements to obtain an individual license of the National Bank of Ukraine;

(d) foreign currency wires to non-residents as payment for goods, works, services and intellectual property rights, including any requirements as to (i) mandatory expert price evaluation confirming compliance with market prices and (ii) documentary evidence of actual performance of works, services or transfer of intellectual property;

(e) sales and purchase of foreign currency for settlements with non-residents and repayment of loans in foreign currency; and

(f) placement of currency values on foreign accounts, including requirements to obtain an individual license of the National Bank of Ukraine.

e) Tax incentives

Under the Tax Code of Ukraine the PSA investor (operator) shall pay only value added tax (VAT), income tax and subsoil use fee. Payment of all other state or local taxes and mandatory charges are substituted by sharing of minerals (hydrocarbons) between the State and the investor on the terms of the PSA. Under the Tax Code the subsoil use fee for the PSA investor is established at a discounted rate of 1.25% for natural gas, and 2% for crude oil.

Conclusion

As shown above, the current Ukrainian PSA regime appears to be investor-friendly. Many of its current provisions have been introduced as a result of international investors' proposals submitted directly or through international business associations in Ukraine, such as the American Chamber of Commerce and European Business Association.

Notwithstanding these legislative improvements, there is still room for further development of the PSA regime reflecting the best international practices and experience to be obtained through implementation of the Ukrainian new PSA projects. Based on legal analysis there is hope that the PSA regime will be successfully used by many investors in the oil and gas industry and other subsoil sectors with positive economic results.