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    Russia's Upstream Draws The Line [NGW Magazine]

Summary

The complex system of tax relief and special discounts for strategic projects has to be paid for by new taxes elsewhere, and the whole industry is squealing. [NGW Magazine Volume 4, Issue 22]

by: Joseph Murphy

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Featured Articles, Europe, Premium, NGW Magazine Articles, Volume 4, Issue 22, Corporate, Exploration & Production, Political, Tax Legislation, Russia

Russia's Upstream Draws The Line [NGW Magazine]

Russia’s oil and gas industry has reportedly pushed back against government plans to impose a tax on the production of associated petroleum gas (APG).

The levy, proposed by the finance ministry, is seen as setting an unwelcome precedent, as it would place a greater burden on the industry as a whole in order to fund tax breaks for a single project operated by state-owned Rosneft and Gazprom Neft.

As NGW reported on October 14, the finance ministry has suggested applying a mineral extraction tax (MET) of rubles 385 ($6)/’000 m3 of APG, released as a by-product of oil extraction. The tax is aimed at raising more than rubles 30bn ($470mn) annually to cover around half of the tax relief recently granted to Rosneft and Gazprom Neft at the Priobskoye oilfield in Western Siberia over the next 10 years.

Priobskoye was discovered and developed in the 1980s and has now grown mature. Rosneft and Gazprom Neft claim the support is necessary as the field’s oil is increasingly difficult to recover, especially given the high water-content in its reservoirs.

Industry backlash

The proposal has been met strong criticism from the energy ministry and the country’s oil producers.

“This is impractical,” the energy minister Alexander Novak told reporters at the Tass news group on November 5. “It can lead to serious consequences in terms of the cost of associated petroleum gas for consumers.” The finance ministry has hit back saying that as APG is a mineral, the fact it is not subject to MET is “unacceptable.”

Rosneft, despite being the main beneficiary of the funds raised from the levy, has also expressed opposition.

“We believe that this initiative does not serve the best interests of the industry; the interests of Rosneft,” its vice president Pavel Fyodorov said during a conference call on November 6.

Rosneft CEO Igor Sechin is understood to have signed a joint letter with the heads of Lukoil, Surgutneftegaz, Tatneft, Gazprom Neft, Russneft and Irkutsk Oil addressed to the president, Vladimir Putin, asking him to block the proposal. Assoneft, the association of independent Russian producers, has similarly written to the energy ministry, the federal antimonopoly service and the deputy PM Dmitry Kozak, asking them to prevent it, Russia’s RBC news agency reported on November 7.

Russia’s leading petrochemical producer Sibur, which relies on APG as its primary feedstock, has also railed against the move, according to RBC. The company buys around 22-23bn m3 of APG each year – equivalent to a quarter of national output – and the levy would drive up the cost of these purchases. 

Impact

The potential impact of the tax is difficult to determine until its details are fleshed out.

MET typically applies to all minerals that are extracted rather than only those that are sold. Rosneft and other signatories of the letter to Putin claim this could mean that APG that is re-injected into reservoirs to maintain pressure could potentially be taxed multiple times, every time it is released again. But it is doubtful that this is the ministry’s intention, as natural gas that is re-injected into reservoirs is not currently subject to MET in Russia.

The financial effect on producers is likely to be fairly small, according to Fitch Ratings analyst Dmitry Marinchenko, who told NGW he did not expect its introduction to knock off more than 1% of most producers’ pre-tax earnings (Ebitda). VTB Capital said in a research note on November 1 it expected a drop in large integrated companies’ Ebitda of 0.1-1.1% as a result of the levy, with Surgutneftegas suffering the most and Tatneft the least.

Russia’s biggest APG producers are Rosneft and Gazprom Neft, which together extracted 54bn m3 of the gas last year, while Lukoil produced 11bn m3 and Surgutneftegas 9bn m3.

Non-integrated producers may be hit harder, as they are less able to handle the added cost.

But costs would also rise for refiners and petrochemical producers that use APG as feedstock, eroding their margins. Refiners are already under pressure from stricter IMO rules on sulphur emissions coming into force in maritime shipping next year. The rules are driving down the price of high-sulphur fuel oil – produced in abundance at less sophisticated refineries.

Speaking with NGW, Vienna-based JBC Energy warned that oil producers could also be motivated to flare more gas, undermining Russian efforts to raise APG utilisation to 95%, up from 89% last year.

A bad precedent

JBC Energy said it was unlikely the new tax would be introduced, pointing to its economic impact and the strong opposition from the oil industry. But the ministry’s proposal is more alarming for what it signifies.

 “The new tax would set a bad precedent, when tax rebates provided for some companies are offset by an additional tax burden on the whole sector,” Marinchenko told NGW.

The landscape of Russia’s oil industry taxation has grown increasingly complex. Russia’s use of MET and export duties does not take into account specific project operating and capital costs. This means that projects that are more expensive – whether because they are in remote areas or are geologically challenging – need tax relief to be realised. Over the years more and more oil and gas fields have been granted this relief – a process seen as subject to how much lobbying power a company has. As such they have become the norm rather than the exception, steadily eroding the industry’s tax base.

The finance ministry’s proposal to fund support for Rosneft and Gazprom Neft with a new levy suggests a growing concern that the situation is unsustainable. The government even sought to impose a temporary ban on the award of new tax breaks in July, excluding support at Priobskoye, citing their impact on the federal budget.

Russia is having to rely increasingly on remote and unconventional projects to support growth, as fields in more developed areas that are easier to recover become mature. Producers are drilling into deeper Achimov and Bazhenov oil and gas formations in Western Siberia, while expanding in emerging basins in the Arctic and Eastern Siberia. But so far these projects have only made progress because of tax relief. For example Novatek’s $27bn Yamal LNG hub – a lynchpin in Russia’s drive to become a major global LNG producer – will not pay any export tax, MET or property tax during its first 12 years of operation, and is also subject to a reduced profit tax.

As the share of oil and gas production from remote and challenging fields grows, Russia’s tax revenues will continue to shrink unless the industry can manage to cut costs to the point where tax breaks are no longer necessary. Russia could well forgo making this effort in the event of a bullish rebound in oil prices to levels seen before the 2014 crash. But few forecasters predict this necessary surge.