Precipitating A New Age of Oil & Gas Investment

Unprecedented turbulence has impacted the global oil and gas industry over the past five years. In supply terms, new sources of production flowed from US shale and tight oil and gas formations, Iranian sanctions were lifted, OPEC maintained production volumes, North America experienced geopolitical, economic, and environmental shocks, and the Middle East and Africa boosted and restricted global oil and gas supplies. In demand terms, China’s slowing economy, linked to sluggish global growth and economic activity, reduced its demand, adding to supply-side pressures.

Notwithstanding Kazakhstan’s widely publicized strategies targeting economic diversification, income from mineral and oil and gas resources will dominate state revenues.

Drill-down Into History

Kazakhstan’s post-Soviet oil and gas landscape encompassed fields transferred into private—local and international—ownership and new joint ventures between the national oil and gas company (and its predecessor organizations) and major oil and gas groups making new, major plays. Throughout the decade following the new millennium, global prices trended steadily upward to a peak in excess of USD145 per barrel until a sharp decline precipitated by the global economic crisis began in late 2008, reducing prices to around USD30 per barrel.

In 2009 Kazakhstan revisited its subsurface use frameworks to replace the prevailing PSA-based taxation regime with the current Excess Profits-based system set out in the Tax Code, Petroleum Law, and Subsurface Use Law. The key associated differentiator between these two taxation bases was the elimination of the tax stability concept in the original Production Sharing Agreements concluded by the government of Kazakhstan, retained in a limited number of cases after 2009. While this shift was directed at enabling the state to participate in higher returns during increased global prices, the elimination of tax stability also reflected the state’s confidence in its resource reservoirs as available global reserves moved toward a perceived downward curve of increasing scarcity.

Since 2009, accepted perspectives regarding global reserve stocks have dramatically shifted as the US shale industry and other global sources of unconventional oil and gas supply have been brought online and made economically viable as new extraction technologies evolved.

The altered landscape of international oil and gas investments profoundly impacts Kazakhstan’s oil and gas industry.

Core Principles of Oil and Gas Taxation

Oil and gas companies aim to maximize profits and, when considering where to invest capital, assess the stability, clarity, and predictability of the local fiscal, legal, and regulatory environment.
Oil and gas fiscal frameworks have four key characteristics:
– The resource base is not infinite and the state must be adequately compensated for the depletion of these resources;
– Substantial up-front investments are needed to explore, develop, and extract resources;
– Significant project risks exist in terms of geological, pricing, political, and technical factors impacting the “risk premium“ attached to any project or jurisdiction;
– The revenues from extractive industries dominate state income. Amendments to fiscal regulations governing these industries (or revenues flowing from such regulations) may exponentially impact public finances.
The fiscal terms applied to extractive industries must appropriately allocate financial risks and benefits between sovereign governments and private companies. Conceptual conflicts exist between oil and gas companies and the state regarding the appropriate division of risk and reward from a petroleum project; each party seeks to maximize rewards and shift risk to the other. The right fiscal regime can improve the trade-off between each party’s interests.
Oil and gas agreements and associated fiscal rules establish resource prices regarding bonuses, royalties, taxes, or other payments an investor will make to the government over a project’s life. Designing fiscal arrangements that encourage a stable fiscal environment and efficient resource development maximizes the overall total realizable value of the revenues to be divided. Since returns are eroded by excessive taxation in times of price volatility—if the fiscal regime taxes by production or turnover rather than profits, or investors are not suitably compensated for up-front investment risks—this will inhibit the inward flow of new international oil and gas investment.
There has been a lack of new investments in Kazakhstan by international oil and gas companies, excluding new Chinese investment or additional investments in subsurface projects with stabilized fiscal regimes.

Increasing new investments in Kazakhstan

Provided that Kazakhstan continues to retain reservoirs and potential projects that are of interest to international oil and gas companies, what must the state do to facilitate new investments? Investors seek to maximize returns by understanding, evaluating, and managing the multi-faceted risks of such investments.
Oil and gas projects are capital intensive and involve investment that runs over an extended timeline. Any oil and gas company investing in a foreign jurisdiction also becomes exponentially exposed to risks once an investment is committed because exiting is impossible without triggering adverse financial consequences. Companies are concerned about investing in countries where fiscal legislation is in constant flux, as this reduces a potential investor’s ability to forecast expected cash flows.
Investors faced with this perceived elevated level of fiscal risk resulting from a financial system and tax regime subject to frequent and material changes reduce the value placed on future income streams—as higher discount rates are used when evaluating likely returns—to compensate for exposure to increased risks. This inhibits new oil and gas investment.

Striking a Balance

Governments need the technical and financial capabilities of international oil companies (in addition to their willingness to bear “downside risk“) to successfully develop and exploit national mineral resources. The state wishes to capture upside rewards when commodity prices are high by asserting control over their natural resources.
Creating a fiscal environment that allows investors to generate profit and positive investment returns at low prices, but also providing scope for investors and the state to generate acceptable and equitable returns as commodity prices begin to rise, is important. These objectives may be achieved by focusing on available fiscal concepts:
– Stabilization
– Progressivity
– Taxing profit or project returns rather than taxing extraction and volumes
A stabilization clause is a contractual risk-mitigating device protecting investments from variations in the fiscal, legal, and regulatory environment, combining local laws and international treaties. From a government perspective, stabilization is an attractive and inexpensive mechanism through which investor risk may be mitigated. Stabilization potentially limits the government’s future fiscal flexibility, i.e. where applicable legislation is “frozen“ and remains constant through the duration of the contract in question.

Stabilization may be implemented while retaining the state’s ability to align applicable taxation policy with future economic goals, albeit with investors’ mutual consent. Fiscal regimes may be retained in a stable form (i.e. less pressure to be amended/reformed) since they contain progressive factors that provide the state with an increasing share of returns as project profitability increases. This progressivity could be achieved using various mechanisms including progressive income or profits taxation, windfall and excess profits taxes and dynamic-rate royalty structures, as opposed to taxing extraction.

Currently, the Ministry of National Economy is working on a new tax code for the extractive industries with the objective of improving the subsurface use taxation regime in Kazakhstan. In order to maximize the level of potential new subsurface investment in Kazakhstan, the stakeholder community must, however, be properly engaged in the tax reform process to arrive at a fiscal framework that benefits the state and investors alike.