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Production Sharing Agreements in Ukraine: Who Will Win the Battle

Production Sharing Agreements in Ukraine: Who Will Win the Battle

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The PSA law, despite its comparatively rare usage, complies with the best industry practices and provides the parties with enough instruments to ensure, that the signed PSA will suit their needs. At the same time, the PSA industry receives less attention from the State and, therefore, is less successful in Ukraine, especially comparing to the recent concession reform, which drew an unprecedented amount of foreign investments into Ukrainian seaport infrastructure.

1. It’s not how you start, it’s how you finish

Years 2019-2020 became remarkable for Ukrainian oil&gas industry because of 12 tenders on production sharing agreements (“PSA”) execution. These are the first successful PSA tenders since 2012.

These tenders were aimed to attract foreign investors. Still, this goal was partly achieved, since foreign oil&gas companies won only five tenders (two of which were won by Vermillion Energy, a Canadian oil&gas company, in cooperation with Ukrainian state-owned company Ukrgasvydobuvannya). However, winning the tender was only half of the battle.

On 13 Jan 2021 finishes a one and a half year period for the PSAs execution of the first wave of tenders. It is still unclear whether the Government aims to actually sign the PSAs, or just waits when this period will finish refusing investors in PSAs execution based on the impossibility to reach a consensus in the negotiations. In the latter case, we really doubt that investors will be able to compensate anything from the state for the “inability to agree” on some PSAs provisions. Moreover, it goes without saying that the success of these PSA tenders will transform into a fiasco.

Such uncertainty amplified by the global COVID-19 crisis and oil price fall made Vermillion Energy quit the negotiations process leaving Ukrgasvydobuvannya on its own in Nov 2020.

The situation with PSAs of the second wave of tenders is even cloudier. On 8 Aug 2020 finished the deadline for the State to provide foreign winners of these tenders with a first PSA draft for negotiations. Given that the Government failed to perform its obligation even until Dec 2020, foreign investors prepared and registered with the Ministry of Energy of Ukraine their own draft PSAs. It is unclear whether even God may guess the State’s approach to the negotiations of these draft PSAs.

At the same time, the winners, especially the foreign investors, expect to see a well-rounded PSA, compliant with the best oil&gas industry practices and containing certain unconditional guarantees that are widely accepted in other jurisdictions.

Below we elaborate on the most important PSA provisions for investors. If treated poorly during the negotiations these provisions may become the deal-breakers.

2. Six circles of hell

  • Cost production and costs recovery

Under PSA the investor recovers certain share of its costs, according to the pre-specified rate. Under Ukrainian law, the cost production share may not exceed 70% of the total production. In practice, this rate is usually in-between 60 – 70%. This is common for industry cost production rate.

Under the general rule, the investor should completely recover the incurred costs. Any segregation of certain costs by the State is likely to be unacceptable for the investor. Besides, the investor will seek to include in the cost recovery not only expenses directly linked to PSA performance but also any ancillary costs such as training. Therefore, it is important for both the State and the investor to clearly determine the list of expenses to be recovered, to avoid any conflicts in the future.

  • Profit production

State’s share of profit production in Ukraine is usually set at 10-15%, which is also customary. In practice, investors often apply the R-factor to gradually increase the State’s share of the profit production. Since Ukrainian law does not address this matter, investors are free to offer any method of the production share change, which they find reasonable. The key obstacle here is, of course, whether the parties will find the middle ground on this matter.

But there is another issue to consider when dealing with profit production. The Government’s default approach is that the investor should sell the Government’s profit share and transfer receive revenue to the specified bank account. At the same time, the investor may find the distribution of share in kind to be the most appealing option. While such disagreement might not be as deal braking as other matters, it is still an important aspect of the PSA that should be kept in mind.

  • Work programme and investments

Ukrainian PSA tenders require that the investor performs certain scope of geological exploration, such as seismic surveying and drilling of appraisal wells. For this purpose, the investor is also required to finance the field development. The term for such works and investments is often five years from the date of the PSA execution.

When dealing with work programme, the parties should agree on the moment, when the investor’s obligations are deemed satisfied (for instance, when certain depth of drilling is reached). As well they should determine if such completion releases the investor from investment obligation regardless of whether the actually incurred costs are less than the guaranteed amount.

The investor may also seek to include a mechanism of simultaneous performance of geological works and production of hydrocarbons. There are many pitfalls to avoid when negotiating these terms. For example, differentiation of production shares depending on the type of works, agreeing on separate work programmes and specifications for different simultaneous works.

While the abovementioned issues do not sound very tough to negotiate, in practice, they may prove to be quite an obstacle to overcome.

  • Assignment

Ukrainian law allows the assignment of rights under the PSA subject to prior approval of the State. There are no exceptions for the cases when the assignee is a company, affiliated with the investor. If the State does not provide such approval within 90 days from the date of the request, it is considered as granted. Ukrainian law provides only a general description of the requirements to the assignee, namely, the sufficiency of financial, technical resources, as well as having the relevant experience in the industry.

While the Ukrainian law does not address change of control provisions of the PSA, the State’s current view on this matter is that any change of control of more than 50 percent should require prior State’s approval with no carve-outs for affiliates. Obviously, the investor would want to have some exceptions from such State’s approach.

  • Stabilisation

The stabilisation clause is crucial to ensure that the investor’s legal and financial burden is not increased throughout the PSA’s term and that the economic conditions negotiated at the PSA’s execution date remain the same. Under Ukrainian law, stabilisation guarantee protects the investor from the negative changes in Ukrainian laws, except for changes related to defence, national security, public order, and environmental protection.

One of the major fears of the foreign investor is that the State may interpret certain unfavourable changes as falling in these exceptions and apply them to the investor. Reasonably, any investor will want to limit the exceptions from the stabilisation clause before the PSA is signed and introduce a mechanism of damages compensation.

  • Permits and licenses

The special permit for subsoil use determines both exploration and production phases as well as sets the term for performance of and specifies the scope of works to be done under the PSA. Such special permit depends on the PSA’s terms and conditions. If the PSA provides for the extension of the geological exploration period, after the parties agree on the specific term of such extension, the special permit should be changed respectively.

The State has a general obligation to assist the investor in obtaining any licenses, permits, and/or rights required for the PSA performance. At the same time, the State may be left with no influence on some important matters, such as land plots’ allotment, given that generally the State is not entitled to dispose of the land plots for subsoil use.  

Although, if the private owners of the land plots in question are non-cooperative, the State should resort to expropriation procedure through court.

In this regard, the investor should ensure that (i) the allotment of the land plots is a condition precedent for the beginning of works under the PSA and (ii) the investor has a walk-away right if it does not obtain use rights to the land plots.

3. Conclusions

The core issue of why PSAs execution takes so long in Ukraine lies not in the legislation. It is caused by lack of political will, inconsistency, and lack of transparency of the State’s position in PSAs negotiations, and, most importantly, absence of so-called “one-stop-shop” approach when dealing with PSAs. Lack of coordination between the State and other state and municipal authorities, involved in the PSAs execution and performance processes, makes the whole procedure less effective and hard to streamline. Despite that, we believe that the winners of the PSA tenders will reach an amicable solution with the State on all the mentioned key terms and will sign the agreements in time. This will prove that PSA is a reliable and mutually beneficial instrument for the development of the oil&gas industry in Ukraine.

By Maksym Maksymenko, Counsel, Head of Real Estate and Infrastructure, and Rostyslav Mushka, Associate, Avellum

Ukraine Knowledge Partner

AVELLUM is a leading Ukrainian full service law firm with a key focus on Finance, Corporate, Dispute Resolution, Tax, and Antitrust.

Our aim is to be the firm of choice for large businesses and financial institutions in respect of their most important and challenging transactions.

We build lasting relationships with our clients and make them feel secure in new uncertain economic and legal realities.

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Firm's website: www.avellum.com

 

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