Kazakhstan, Russia Heading in Different Directions on Oil Taxation Policy

One Way…

The economies of both Russia and Kazakhstan are heavily dependent on the extraction and export of natural resources, and revenues from the hydrocarbon sector form the backbone of the state budget in the two ex-Soviet countries. Over the course of the past two years, the rise, then collapse, then partial recovery of global oil prices has taken both countries on a rollercoaster ride, and the global economic downturn has forced them to dip into their respective rainy-day national oil funds to help prop up their economies during the crisis. The risk of such heavy reliance on oil has thus been driven home, giving further impetus to efforts to diversify each country's economy, but with a modicum of oil price stability returning to the market, the two governments are now reassessing their dependence on oil revenues, looking specifically at how the sector should be taxed to best benefit the state.

Kazakhstan introduced a new tax code in January 2009, geared to increase the overall tax burden on the hydrocarbon sector, and with the expectation that other economic sectors would benefit. The new code abandoned tax stability for all pre-2004 contracts, replaced the export duty with a sliding rent tax, introduced a mineral extraction tax in place of the previous royalty, and alternated the excess profit tax and corporate income tax rates. The problem—at least as far as the government's recent policy pronouncements indicate—was that the new tax rules did not apply to certain oil companies and projects. Indeed, since the country's three largest hydrocarbon projects—Tengiz, Kashagan, and Karachaganak—are all being developed under fixed-tax regimes (either via long-term concessions or production-sharing agreements, PSAs), the changes had no real impact on the foreign consortia that hold the rights to those fields. In an ironic twist of fate, the company most affected was state-owned Kazmunaigaz.

Kazmunaigaz Exploration & Production (KMG E&P), the London-listed upstream arm of Kazmunaigaz, complained loudly about the lack of fairness, lobbying the government for an exemption. At the same time, the fact that the tax changes did not affect the consortia operating Kazakhstan's "Big Three" projects meant that, overall, the government's accumulation of tax revenue from the hydrocarbon sector did not materially improve. In the meantime, the government has had to tap into the national oil fund to stimulate the Kazakh economy, while development costs for the "Big Three" again appear to be on the rise. Since their contracts allow them to recoup investment costs before paying revenues to the government, these higher up-front costs delay revenue inflows for the government, proving a further irritant.

Last month, President Nursultan Nazarbayev signalled that enough was enough, saying that all oil companies operating in Kazakhstan should be subject to the same tax rules, with no preferences or special rules for those working according to long-term contracts (see "Related Articles"). Kazakh officials have long chafed at the idea (or at least the perception) that the country's largest hydrocarbon deposits were effectively licensed to Western multi-nationals for pennies on the dollar in the 1990s, when the Central Asian state's economy was at its weakest point in the early post-Soviet transition years. Now, having trebled oil production (to 1.5 million b/d) over the past 15 years and looking to repeat this over the next 10 years, Kazakhstan is in a much stronger position vis-à-vis the foreign oil companies (at least compared to 1996, if not 2006). The government has made periodic noises about wanting to revise the "sweetheart" terms of those 1990s deals, only to stand down, but this time the government seems determined to follow through on its rhetoric. Prime Minister Karim Masimov yesterday called on his government to draft new tax rules that would abolish the exemptions that the foreign consortia working on the "Big Three" projects enjoy.

...Or Another

North of the border, however, the Russian government is taking a very different tack. Having already decided to stop issuing PSAs for new projects back in 2003, then introducing one of the harshest oil tax regimes in the world in 2004, Russia is actively considering easing its tax regime for the oil sector, aiming to stimulate needed investment in exploration and production. Russia put the squeeze back in 2006 on the Sakhalin-2 consortium, prompting the foreign companies operating the project under a PSA to sell control of the project to state-run Gazprom, thus allowing Russia to have more of a say in controlling costs and also ensuring more of the revenues from the project—which launched LNG exports in 2009—to flow to state coffers. Since then, however, the government has subtly taken its foot off the throttle, particularly with the domestic oil sector, as the slowdown in production growth over 2005–07 was followed by an overall annual output decline in 2008.

The oil sector's production stagnation prompted the government to introduce some minor tax cuts, returning the industry to modest growth in 2009. Along with raising the taxable threshold according to which the mineral extraction tax was applied, the government took steps late in 2008 to modify its oil export tariff-setting system, reducing the lag time between when prices are monitored and when tariffs are adjusted. The moderate success of these initiatives in resuscitating the sector in 2009 has spurred calls from the domestic oil industry for more tax breaks and incentives, including a shift to profit-based taxation and a change in the methodology in determining oil export tariffs (in order to reduce the overall tax percentage relative to the oil price). The government's launch in December 2009 of tax exemption on oil production and exports from Eastern Siberia has helped provide incentives for producers operating in that frontier region as well, although companies such as Rosneft and TNK-BP have called on the government to clarify how long the current system will remain in place amid calls by the Finance Ministry to end the tax breaks.

Outlook and Implications

Russia's approach to taxing its oil sector has evolved over time, with some officials in the administration now calling for a rollback of restrictions on investment by foreign and privately owned Russian companies in "strategic" hydrocarbon deposits and offshore blocks. The "success" of the government's stabilisation of the oil industry over the past two years has come at a cost to the state, however, as tax breaks have diverted more money to the companies for investment, with less going to Russia's budget coffers. Hence the Finance Ministry's determination to re-institute taxes on producers in Eastern Siberia, as the loss of this tax revenue—and potential additional losses to state revenue from an eventual shift to a profit-based taxation system—is forcing the government to seek to fill this budget gap in other sectors. With Russia continuing to prop up other ailing sectors of its economy, the government can ill afford at this point to provide additional tax breaks to an oil sector that it has already stabilised. Ironically, the government's reliance on tax revenue from the oil sector has made the state unable (or perhaps unwilling) to reduce this revenue further, even if it would—in the long run—help to diversify the economy and make the state less dependent on oil sector taxes.

Kazakhstan is effectively at an earlier state of development in the evolution of its oil sector and its tax policy, with the government still not yet satisfied with the state's limited role at present. Kazakhstan's apparent determination to scrap the tax stability enjoyed by the foreign consortia operating the "Big Three" projects emanates from the government's dissatisfaction with the original terms that it agreed on more than a decade ago. Thus, it is not until the government satisfies this urge to redress these perceived past wrongs that it will be content to let these projects progress without additional state interference. A stake in the Karachaganak project for Kazmunaigaz is just a start, as the government has now made it clear that it is ready to pick a fight with all three consortia at once in order to advance its national interests. For Kazakhstan, increasing the state's say in the development of its oil sector is not merely about getting a stake in each of these projects (although it has been argued that by doing so, the state will ensure more of the revenues from the output), but also about boosting tax revenue by discarding the exemptions from changes in oil taxes that the "Big Three" enjoy under their existing contracts.

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• Russia: 27 January 2010: Government Mulls Early End to Eastern Siberian Oil Export Tariff Exemption
• Kazakhstan: 27 January 2010: Energy Minister Reiterates Plan to Impose New Tax Rules on All Oil Firms in Kazakhstan
• Kazakhstan: 26 January 2010: Kazmunaigaz Says Karachaganak Phase III Cost Estimates are Growing; Kazakhstan Seeks Increased Role
• Russia: 21 July 2009: Russian Government Suspends Oil Export Tariffs on Key Eastern Siberian Oilfields
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• Russia: 19 September 2008: Government Moves to Ease Burden on Russian Oil Firms with Huge Reduction in Export Tariffs
• Kazakhstan: 15 July 2008: Karachaganak Consortium Begins Paying Kazakh Oil Export Duty; TCO May Be Next
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