General Overview of the Existing Legal Framework for Hydrocarbon Exploration and Production in Ukraine
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This article reviews Ukrainian law on the exploration and production of oil and gas and considers, in particular, certain issues related to the issuance of special permits (the Ukrainian term for oil and gas licenses) and the entering into of production sharing arrangements.
Special Permits for Subsoil Use
In general, in Ukraine, the exploration and production of oil and gas, including shale gas, are based primarily on special permits, which are usually issued separately for either exploration or production (special permits for both exploration and production are also sometimes used in practice).
Exploration special permits, which usually allow trial commercial production (often referred to as pilot production), can be issued for up to five years. Production special permits can be issued for up to 20 years, provided that the relevant reserves of natural resources have been proven (with certain exceptions). The duration of special permits may be further extended subject to meeting certain conditions and following specified procedures.
As a rule, a special permit is awarded based on an auction, where the bidder that offers the highest price wins the auction and receives the special permit.1 As a practical matter, an auction for the sale of a special permit can be announced at any time, requiring all applications by auction bidders to be filed within 15 days after its announcement in order to qualify to participate, with the auction then held within one month after its announcement. Typically few potential bidders can prepare applications to participate in an auction within such 15 day period, giving the initiator of the auction a significant advantage.
In certain cases, special permits may be granted without an auction, for example: (1) for production special permits where the subsoil user, after conducting works under an exploration special permit at its own expense has proved the reserves (which is an important right, as otherwise no reasonable investor would engage in exploration in Ukraine); (2) provided the adjacent area has not already been transferred into use, for (a) the extension of a subsoil area, for which a special permit has previously been issued, by up to 50% of the size of the area covered by the original special permit, where such extension is for geological study or for the placement of underground storage, or (b) the extension of the subsoil area covered by an original special permit for production, in order for minerals to be produced in an amount not exceeding 50% of the deposits covered by the original special permit; or (3) for geological studies (exploration), including for trial (pilot) development and production, of minerals by a business enterprise where at least 25% of its shares (or participation shares) belong to the State.
Just like special permits put up for auction, obtaining special permits without an auction also requires approval from a number of state authorities, including the local self-government authorities having jurisdiction over the areas covered by the special permit.
The relevant legislation provides for certain cases, mostly related to the violation of oil and gas and environmental laws and the terms of the special permit, where a special permit may be suspended or permanently terminated (annulled) and financial sanctions may be imposed.
Production Sharing Agreements
On Production Sharing Agreements Act of Ukraine of 14 September 1999 (the PSA Act) provides, as an alternative to basing the exploration and production of oil and gas on an application for a special permit (on either an auction or non-auction basis), that a foreign investor may enter into a production sharing agreement (a PSA) based on a competitive tender2 (or, in certain limited cases, on a negotiated basis). Unlike for an auction, the winner of a PSA tender is determined based on how well, in the subjective view of the appointed tender committee, the specified criteria are met by each bidder, including those concerning which bidder presents the best financial possibilities and the greatest value for the proposed investment.
Under a PSA, which can be entered into for up to 50 years, subject to further extensions, the investor’s expenses are to be reimbursed in production (referred to as Cost Compensation Production). The production remaining after the distribution of such Cost Compensation Production is then shared between the investor and the state.
It is noteworthy that all of the investor’s expenses related to the performance of works and other activities under a PSA incurred after the publication of the notice on the investor’s success in the tender (or in the case of the entering into of a PSA without a tender, after the issuance of the respective Cabinet of Ministers of Ukraine decision permitting this), can now be compensated with the Cost Compensation Production, unless otherwise provided by the PSA. Moreover, disputes arising out of PSAs may be referred to Ukrainian commercial courts or, if agreed by the parties, to international arbitral institutions or for ad hoc arbitration.
A PSA may include any number of domestic or foreign parties as investors, provided that if there is more than one investor, they must appoint one investor to be the operator to represent their interests before the State, as the other party to the PSA, which is represented by the Cabinet of Ministers of Ukraine. Where a foreign legal entity contracts for a PSA, it has an obligation to register a representative office in Ukraine within three months after entering into the PSA. Such representative office is then entitled to make payments of revenues and export production abroad to the foreign legal entity that it is part of and acts for, without the Ukrainian withholding tax that would otherwise apply. Special permits for the relevant subsoil areas are also required for operations under a PSA. However, for PSAs, they are, by law, issued without the need for auctions and for the duration of the PSA.
According to recent amendments to the PSA Act, a PSA investor’s operations carried out for its PSA (including those in connection with the purchase of equipment, materials, services, works and products for the PSA) are now expressly exempted from the rather strict Ukrainian exchange (currency) control regulations.
In addition, a number of other advantages apply for PSAs, including tax benefits, simplified procedures for the issuance of many necessary authorizations and the right to land use allocations by the state. The right of state and local government bodies to impose regulations conflicting with a PSA is also very limited. Furthermore, Article 27 of the PSA Act, known as the so-called “stabilization clause”, guarantees that the rights and obligations of the parties established in a PSA shall be governed for the duration of the PSA by the legislation of Ukraine that was effective at the time of the conclusion of the PSA. The only exceptions to this special rule are for changes in law for matters of national defence and security, the maintenance of public order and environmental protection. Recently, the PSA Act has been amended so as to create further benefits for foreign investors, by exempting from the application of the “stabilization clause” those laws that (1) decrease the rates for or cancel taxes and duties, (2) simplify the state regulation of exploration and production works, (3) reduce the procedures for state regulation (control), in particular for customs, currency and tax regulation or (4) decrease the liability of investors in comparison with the laws effective at the time of the entering into of the PSA.
As an option, the holder of an already issued special permit is entitled to back into a PSA without a competitive tender, and then enjoy all the benefits thereunder, subject to the approval in each case by the Cabinet of Ministers of Ukraine.3 We believe that this move to a PSA should be of benefit to most special permit holders, in particular to ensure longer terms of subsoil use and to avoid burdensome exchange controls.
1 The relevant Ukrainian statutes allow a foreign legal entity or individual to directly apply for a special permit in Ukraine. However, as a matter of practice, the procedural regulations governing the process for special permit applications are drafted in such a way that they can generally only be met by Ukrainian legal entities. Therefore, from a practical standpoint, a foreign investor should structure its investments in the exploration and/or production of oil and gas based on special permits in Ukraine through a Ukrainian company (unlike for a PSA, as discussed in general).
2 Three tender based PSAs have been entered into so far with the Ukrainian government, being with Vanco for an area in the Black Sea (which was then unsuccessfully contested by the Tymoshenko-led government), Shell for an area in eastern Ukraine and Chevron for an area in western Ukraine. A PSA with an Exxon Mobile-led consortium for a western Black Sea area is presently under negotiation.
3 A PSA awarded without a tender has recently been signed with ENI and EDF for an area within the Black Sea shelf.