(A) Changing the Rules of the Game

Ukraine’s PSA Regime was often praised by the investment community as being liberal and investor-friendly, and in particular letting investors conclude PSAs directly with the State without the need for a local partner.  In practice the only PSA Tender so far held in Ukraine for the Prikerchenska area was won by an IOC that had no local partner.  Then, the GOU repeatedly warned the investment community that it was not happy that local partners were not imposed on investors in the PSAs, citing the example of Turkey where the national company Turkish Petroleum Corporation (TPAO) has 50% stake in every project.

Finally in 2011, GOU changed the rules of the game, enacting Amendments to the PSA Law that in effect allow GOU to impose a local partner on the winner of the PSA tender, with the presumed obligation to fund the involvement of such local partner.  The investors are not required to bid with the local partner, they can bid alone or in a consortia, with the local partner conveniently waiting for a winner to impose its involvement.  An interesting aspect is that this local partner is not identified in the law.  It is vaguely defined as “commercial partnership [company], 100% of the authorized capital of which belongs to the State, or commercial partnership [company] created with its participation”.  This awkward formula means that any company with any State-owned stake can qualify as the local partner.

The above Amendments to the PSA Law do not establish the size of the interest of the local partner in the PSA, but provide that the investor, which won the PSA tender, not the local partner, will be the operator of the PSA.  Other than that the Amendments lack crucial details on how the relationship with the local partner will be structured.

These Amendments to the PSA Law also undermined one more essential right of an investor, which was granted under the original PSA Law: to freely use its share of production, including exporting it outside of Ukraine.  This right was important to investors because Ukraine is known to impose restrictions and price controls on domestic sales, in particular of natural gas. Amendments to the PSA Law, however, provide that “in selected instances” the PSA tender conditions may contain the investor’s obligation to sell its share of production exclusively at the domestic market.

(B) Other Amendments to the PSA Law: stabilization clause restored; the PSA List removed.

Two other important Amendments to the PSA Law were also enacted in 2011.

• The so called “stability clause” allowing the investor to rely on the legislation in effect at the time of signing the PSA throughout the term of the PSA, which was removed from the PSA Law in 2010, was restored back. This development was unanimously welcomed by the investors, which consider guarantees against changes in the legislation for the duration of the PSA essential for such long-term and high-cost investment.
   
• The PSA Law contained a requirement that the Subsoil areas eligible for PSAs must be included in the list adopted from time to time by the Cabinet of Ministers (the “PSA List”). The PSA List had to be agreed in advance with local authorities, which were not always happy to unconditionally grant their agreement.  In practice the GOU reportedly encountered strong resistance from the local authorities when it was trying to include the Olesska Shale gas area located across several regions in Western Ukraine into the PSA List. In response, the Amendments to the PSA Law were enacted eliminating the PSA List altogether.  This may seem as a liberalization measure, removing an extra approval, but although the local authorities can be removed from the stage of tendering Subsoil areas, which will make this stage easier for GOU, in practice they are not going anywhere.  The investor will face them immediately as soon as it signs the PSA and starts its activities in the area, and will have to deal with them directly and find a compromise.  Basically GOU shifted the burden of dealing with local authorities from itself to the investor.

(C) Practical Opportunities for PSAs: tenders for Yuzivska and Olesska Subsoil areas

Although the PSA Regime may be applied to any subsoil areas on-shore and off-shore, in practice it is understood that the PSA mechanism will be offered mostly for Black and Azov Sea Shelf (both shallow-water and deep-water) and for some Shale gas areas.  The current GOU chose to prepare the PSA tenders first for two on-shore areas, Yuzivska and Olesska (“PSA Tender Areas”), aiming at exploration and production of primarily Shale gas.  Two relevant GOU Resolutions on preparing PSA Tenders were adopted on 30 November 2011 (“PSA Tender Resolutions”) and the Tenders were announced in February 2012.

In fact originally GOU planned to designate these PSA Tender Areas strictly for Shale gas, depriving potential investor of an opportunity to develop other types of hydrocarbons.  The investors, however, convinced the GOU otherwise, and the PSA Tender Resolutions provide for development of various hydrocarbons that may be found in these areas (Shale gas, natural gas, CBM, crude oil and condensate), with the common understanding, however, that Shale gas would remain a priority.

Not surprisingly the GOU took advantage of the recently enacted Amendments to the PSA Law (described in sub-Section (A) above) on local partner and included the provision in the PSA Tender Resolutions imposing a local partner on the winner of the PSA tender.  The GOU went further by requiring the winner to fund the involvement of such local partner and establishing its stake at 50%.

This “local partner” was later identified through a two-level tender process: first a tender determined the State company: NAC Nadra of Ukraine, and then another tender was held among private companies, which was won by a small geological company SPK Geoservice.  A joint venture between NAC Nadra of Ukraine and SPK Geoservice (in which NAC Nadra of Ukraine has a 90% stake) became the “local partner” to the winners of both PSA Tenders.  As it is known, Yuzivska tender was won by Shell, and Olesska tender by Chevron.

These winners will have 120 days to conclude with the local partner a joint operation agreement or another agreement based on international oil and gas exploration/production practices.  It is not clear what happens if the parties fail to reach an agreement within this timeframe, or in general.  Moreover, such an agreement appears to be a pre-condition for concluding the actual PSA with the State, so the winners will have to negotiate on two fronts: with the local partner and with the State.  It should be kept in mind that the PSA Law establishes the 12-months term (with one possible 6-month extension) for negotiating the PSA with the State, and negotiations with the local partner may deduct 120 days (4 months) from the 12-months timeframe for the actual PSA negotiation with the State.

The PSA Tender Resolutions stipulate that the bidders must propose the ratio for the production sharing with the State in their applications, but do establish some parameters: the cost-recovery production is limited to 70%; the State share in the profit production must be at least 15% for Olesska area (16.5% for Yuzivska) of the total production, which if calculated together with the 50% share of the local partner, leaves the investor with 42.5% share in profit production (out of 100% of the total profit production the first 15% goes to the State, and the remaining 85% is evenly split between the investor and the local partner).  The PSA Tender Resolutions also contain the minimal scope of investment required separately for the exploration and production stages.

The above terms and conditions of the PSA Tender Resolutions caused protests from the investment community and relevant letters were sent to the GOU, simultaneously listing the industry’s other requests, such as international arbitration, waiver of the sovereign immunity by the State, etc.

The Olesska and Yzivska PSA tenders and the subsequent process of negotiating and concluding PSAs (including handling the “local partner”) are an important test of how serious GOU is in terms of attracting investors and what level of GOU-favored conditions investors are willing to tolerate.