Legal and Political Risks of Investing in Russia

1. Legal and Political Risks of Investing in Russia Karl Brown, Cathy Bundy, Randy Cubriel, and Mike Dombroski

2. Background Statistics • World’s largest natural gas reserves • 2nd largest coal reserves • 8th largest oil reserves • Largest exporter of natural gas • 2nd largest oil exporter

3. Brief History of Russian Oil • State owned under the Soviet Union regime • High of 12.5 million bbl/d produced in 1988 • Worlds largest producer • 1991 production dropped to 6 million bbl/d with collapse of Soviet Union • 1999 privatization of industry boosts production • By 2005 production increased to 9 million bbl/d • 2nd largest producer of crude oil

4. Current Industry Makeup

5. Major Companies • Lukoil • Largest independent producer • 14% state controlled • Yukos • “The Yukos Affair” • State owned • Gazprom • Controls Russia’s natural gas industry • 38% state owned • Rosneft • State owned • 2nd largest company • TNK-BP • Result of British Petroleum merger with Tynmeh Oil company

6. Sakhalin-2 and Shell • Island off the east coast of Russia • Estimated 14 billion barrels & 96 trillion cubic feet natural gas • Developed by Shell, Mitsubishi, Mitsui • Operate as Sakhalin Energy • Foreign investment accomplished though PSA contract

7. Methods of Operation • PSA • Operate without any special arrangements • Invest in Russian companies • ConocoPhillips owns 10% in Lukoil • TNK-BP

8. Operation without a PSA? • Subsoil licensing rules are inconsistent • Tax rates fluctuate greatly without PSA • Foreign companies have limited ability to operate or gain mineral rights

9. What is a PSA? • PSA (Production-Sharing Agreement): contract between the state and an investor • Defines the terms and condition for exploration and taxes • Terms defined in the PSA supersede laws defined in the status quo • Makes many long term, typically high risk projects possible

10. History of PSAs in Russia • PSAs in Russia were created under Yeltsin (law signed in 1995 and took effect in 1996) • Three PSAs operating currently • Sakhalin 1 – ExxonMobil • Sakhalin 2 – Shell • Kharyaga – Total • PSAs used in other former Soviet countries (Azerbaijan and Kazakhstan)

11. PSA Structure • Government retains the rights and ownership of the oil and gas resources • Company provides all capital • Payments at specified points in the project and royalty payments (6% in Sakhalin) • After the capital investment is recouped, profit is shared between the government (Russian federation and regional Sakhalin Oblast) and the company • The government share increases as the project progresses (up to 70%) • The company pays tax on the profit that it makes

12. Community Involvement • Western companies spend money on community projects and infrastructure building • Shell’s spending will be $1.5 Million in support of the Sakhalin indigenous population • Shell also built power plants on Sakhalin

13. Legal & Political Problems Western Companies face with a PSA Risk of Government or Court Intervention Provisions must comply with Russian Federal Law Government’s Ability to Amend the PSA Requirements Assume Adequate Resources

14. Risk of Government or Court Intervention • Court Intervention: On Sept. 18, 2006 a Russian Court ordered Sakhalin II to shut down for one month because of alleged environmental violations. • Government Intervention: • Art.2: legislative overlap between federal and local authorities

15. Article 2 § 6 • Within the limits of their power established by the Constitution of the Russian Federation and federal laws, the Russian Federation subdivisions shall perform legislative regulation of their involvement in production sharing agreements for the use of subsoil areas within their respective territories.

16. Risk of Government or Court Intervention • Court Intervention: On Sept. 18, 2006 a Russian Court ordered Sakhalin II to shut down for one month because of alleged environmental violations. • Government Intervention: • Art.2: legislative overlap between federal and local authorities • Pull license(s) • Renegotiate PSA’s • Nationalization

17. PSA Provisions Must Comply With Russian Federal Law • Liability. Parties are liable for non compliance in accordance with Russian civil legislation. Art. 20 § 1. • Term. PSA terms (time-span) must be in compliance with legislation of the Russian Federation. Art. 5 § 1.

18. Article 20 § 1 • Liability. The parties shall be liable for non-fulfillment or improper fulfillment of their obligations under the Agreement as provided for by the Agreement in compliance with the civil legislation Federation.

19. Article 5 § 1 • The term of the Agreement shall be defined by the parties in compliance with the legislation of the Russian Federation applicable…

20. PSA Provisions Must Comply With Russian Federal Law • Liability. Parties are liable for non compliance in accordance with Russian civil legislation. See Art. 20 § 1. • Art. 5: PSA term (time-span) must be in compliance with Russian Federation. • These are but two examples.

21. Government’s Ability to Amend the PSA • Art. 17 § 1: Amendments to the Agreement may be made only by consent of the parties, as well as by demand of one of the parties in case of a significant change in circumstances in accordance with the Russian Federation Civil Code.

22. Requirements Assume Adequate Resources • Art. 7 § 2: to employ citizens of the Russian Federation, their portion being no less than 80 per cent of all employed personnel… • to acquire manufacture machinery, engineering equipment and materials of Russian origin in the amount of at least 70 per cent of the total cost of acquired manufacture machinery… • …at least 70 per cent of engineering equipment in value terms to be used for extraction of minerals, their carriage and processing (where it is provided for by the agreement), acquired and (or) used by an investor for carrying out works under the agreement, have to be of the Russian origin.

23. Issues Dealing With PSA Disputes • Possible Avenues for Dispute Resolution: Litigation, Arbitration, or Mediation • Sovereign Immunity • Enforcement

24. Art. 22: Court, Arbitration, or Mediation • Art. 22: Disputes between the State and the Investor relating to implementation, termination and invalidity of the Agreements shall be settled in court, by arbitration (including in international arbitration institutions) or by mediation ... • Choice of Venue • Choice of Law

25. Sovereign Immunity • Sovereign Immunity-A judicial doctrine which precludes bringing suit against the government without its consent. • Art. 23: The Agreements … may provide for the waiver by the State of its sovereign immunity in court, immunity in connection with preliminary security of the claim and execution of judicial and (or) arbitration judgment in compliance with the Russian Federation Law.

26. Enforcement • Assuming a Western Company is successful in court, arbitration, or mediation, who enforces the judgment/award?

27. Sakhalin-2 Current Issues • In Fall 2006, Natural Resource Ministry (NRM) says project violating multiple environmental standards • Project must be reviewed and approved before work is continued • Could result in suspension of project, which will add to overall costs

28. Was it Really Environmental? Analysts speculate that the actions weren’t motivated by environmental concerns Motivated by government desire to give Gazprom a bigger share In 2005, Shell offered 25% of share to state-run company Gazprom for a 50% share in Gazprom field Government and Gazprom not content

29. Cost Overruns • Large cost overruns associated with project • Original budget: $12 billion • Current budget: $20 billion • Reasons for cost overruns • New frontier for development • Sourcing of materials and labor was more costly than originally expected • Cost overruns delay the government receiving its portion of profits

30. Review of Sakhalin-2 • Review currently being conducted by NRM • Expected to last one month • Sakhalin Energy claims that they did not violate any standards and have cooperated with NRM • Russian government denies any claims of political motivation and says there is evidence of ecological damage

31. Possible Impacts of Review • If the review finds environmental problems • Project will be suspended or license revoked completely • Additional costs will be incurred • Damage costs could be up to $50 billion • Delay Project completion • If the review finds no fault with Sakhalin Energy • Production will go on as originally planned

32. Future of Foreign Investment • Only 3 PSA agreements issued • Natural Resources Ministry wants IOC’s to surrender more control of projects to local companies and Russian Government • Includes BP, Total, Exxon Mobil and Shell • Illegal for foreign investment to hold more than 51% of strategic reserves • Putin favors nationalization • Call for PSA revisions

33. Future Contracts • PSAs signed during a different political era • Russian control a primary emphasis • Ideal contracts: Recent contracts in export infrastructure and LNG • Foreign capital invested • Local control maintained

34. Conclusions • Lots of political uncertainty surrounding operating in Russia • Uncertainty surrounding licensing and subsoil rights will continue • Russia must continue to look for foreign investments to meet its growing energy demand • Investments will likely be co-operating agreements with Russian companies

35. Questions?