Legislation on Subsoil and Oil: Problems and Prospects (M. Suleimenov, Director of the Scientific Institute of Private Law under the Kazakh State Law University, Corresponding Member of the National Academy of Sciences of the Republic of Kazakhstan, Doctor of Law, Professor)

Legislation on Subsoil and Oil: Problems and Prospects

Subsoil and petroleum legislation is in a state of rapid development. The next set of amendments and additions to certain legislative acts pertaining to subsoil use and petroleum operations has been prepared and its adoption is expected soon. The Government passed the Law "On Investments" dated 8 January 2003 and Law "On the State Control over the Production and Turnover of Certain Types of Oil Products" dated 7 April 2003.

Before commenting on amendments to the Decree of the Republic of Kazakhstan, having the force of law, "On Subsoil and Subsoil Use" dated 27 January 1996, I would like to address certain problems arising from the laws previously issued.

1. Problems

1.1. Grandfathering clause

The core of the problem is to ascertain whether the so-called grandfathering clause or the clause on the stability of legislation which was set out in Article 6 of the Law "On Foreign Investments" still exists.

Let us analyze Article 4.3 of the Law on Investments, which states the following:

"The Republic of Kazakhstan shall guarantee the stability of terms of contracts concluded between investors and state agencies of the Republic of Kazakhstan, except for cases where amendments are made to a contract by agreement between the parties.

These guarantees shall not extend to:

amendments to the legislation of the Republic of Kazakhstan and/or the coming into force and/or amendment of international treaties to which the Republic of Kazakhstan is party which change the procedure or conditions for the import, manufacture or sale of excisable goods; or

amendments and additions which are made to legislative acts of the Republic of Kazakhstan for reasons of national security, or for the protection of the environment, health or morality."

If we literally interpret the second part of Article 4.3 of the Law "On Investments," it appears that guarantees extend to cases which are not listed in that part. In other words, in the event of changes to legislation, the Republic of Kazakhstan guarantees the stability of terms of contracts concluded between investors and state agencies of the Republic of Kazakhstan, except for cases where amendments are made to a contract by agreement between the parties. Therefore, if a petroleum contract is concluded for 20 years, and amendments to legislation which influence the terms and conditions of the contract are introduced in 5 years after its execution, the guarantee of the stability of terms of contracts shall apply. Amendments shall not apply; the then-existing laws that were in effect at the time of execution of the contract shall apply. This is a grandfathering clause which is even more favorable for an investor because there is no need to prove that the investor's position was adversely affected as the result of changes in the contract.

1.2. Definition of contract

Article 23 of the Law "On Investments" refers to the stability of contracts. It states that "benefits conferred on the basis of contracts concluded with the authorized state agency for investments before this Law enters into force shall remain in effect until the expiry of the periods established in such contracts."

I have come across the interpretation of this article in the sense that it secures the stability of contracts for all investors including subsoil users (1). This is wrong.

It should be remembered that the section of the Law on Investments on the state support for investments does not relate to petroleum operations as it applies to preferred activities which require support (e.g., agriculture, production infrastructure, construction of Astana, processing industry, housing, social and tourist facilities). Oil exploration and production do not fall into this category.

However, I would like to address the definitions of "contract" and "agreement" as they are used in this Law.

The Law specifies the definition of "contract" as an investment contract which provides investment privileges. (Article 1.8)

At the same time Article 4.3 of the Law refers to contracts concluded between investors and state agencies of the Republic of Kazakhstan.

This means that the Law applies two different terms: the "contract" refers to relations between the authorized investment agency and investor on granting preferences, while the "agreement" refers to all relations between investors and state agencies including those which are not related to granting preferences.

Definitions of state agencies are also different: with regard to granting preferences, the "state agency" means an authorized state agency on investments (currently, Investment Committee under the Ministry of Industry and Trade of the Republic of Kazakhstan); with regard to agreements both related and non-related with preferences, the "state agencies" mean any state agencies with which investors enter into an agreement (for example, with respect to agreements to carry out petroleum operations, it is the Ministry of Energy and Mineral Resources).

This is a very important provision. This implies that those provisions of the Law on Investments that refer to the conclusion and termination of contracts, as well as those that refer to the stability of contracts do not apply to agreements without preferences, in particular, to subsoil use agreements.

The definition of "contract" under the Law on Investments should be distinguished from the definition of "contract" under the Laws on Oil and Subsoil and Subsoil Use. For example, Article 1 of the Law on Oil refers to the definition of "contract" as an agreement between a contractor and the competent agency on carrying out petroleum operations (similarly, Article 1.6 of the Law on Subsoil and Subsoil Use).

Thus, the definition of "contract" depends on whether it refers to priority investments or ordinary investments, including oil investments. Therefore, Article 23 of the Law on Investments cannot apply to subsoil use contracts.

In recent years the Government of the Republic of Kazakhstan has been reviewing some of the provisions of subsoil use contracts. In doing so, the Government is guided by Article 6 of the Law on Foreign Investments which states "Should a foreign investor's position be improved as the result of changes in legislation and/or the enactment and/or amendment of the terms and conditions of international treaties, certain terms of the contracts between the foreign investor and the authorized state agency representing the Republic may be amended with the mutual consent of the parties in order to achieve a balance of the economic interests."

A similar provision is stipulated in Article 285 of the Code of the Republic of Kazakhstan No. 210-II "On Taxes and Other Obligatory Payments to Revenue" (the "Tax Code") dated 12 June 2001 "In the event that there is an improvement in the conditions of taxation for a subsoil user resulting from changes in the tax legislation, an adjustment shall be made in the conditions of taxation in subsoil use contracts with a view to restoring the economic interests of the Republic of Kazakhstan."

Considering that in 2000 the amount of some types of taxes (value added tax and social tax) was reduced, the Government declared that the balance of the parties' economic interests in subsoil use contracts has changed and foreign investors' position has improved and suggested that subsoil users should enter into negotiations concerning contract adjustments. It must be admitted that that attempt have not been successful. Negotiations are under way but the Government has not undertaken any coercive actions in this regard.

1.3. Retroactive force of law in connection with adoption of the Law

on Investments

The force of a legislative act does not extend to relations occurred prior to its enactment (Article 37 of the Law of the Republic of Kazakhstan No. 213-1 "On Legislative Acts" dated 24 March 1998). Therefore, the Law on Investments does not apply to relations which occurred prior to its enactment. In particular, it does not apply to contracts concluded before this Law entered into force. The Law on Foreign Investments, Article 6 in particular, applies to such contracts. Thus, the legislation which was in effect at the moment the contract was executed shall apply until the expiration of the term of the contract.

This is an important provision. It allows avoiding the effect of the so-called continuing relations. This principle implies that if a relation occurred before the law entered into force but allows being in effect after its enactment, the new law shall apply to those rights and obligations which will occur after the enactment of the law (please refer, for example, to Resolution of the Supreme Court of the Republic of Kazakhstan No. 269-XIII "On the Introduction of the Civil Code of the Republic of Kazakhstan (General Part) dated 27 December 1994). If Article 6 of the Law on Foreign Investments had not been in effect, the Law on Investments would not have applied to contractual relations which were in effect prior to enactment of the Law on Investments and would have applied to relations which continue under the contract.

The norms of subsoil laws apply to subsoil use contracts. Article 71 of the Law on Subsoil and Subsoil Use and Article 57 of the Law on Oil establish that "amendments and additions to legislation which adversely affect the subsoil user's position shall not apply to contracts which were issued and concluded prior to such amendments and additions."

1.4. Application of transitional provisions on licenses

The matter under discussion is about Article 2 of the Law of the Republic of Kazakhstan dated 11 August 1999 which annuls licenses. However, licenses previously issued shall remain in force. As for suspension, revocation, termination and invalidation of subsoil use licenses, the norms of the Law on Subsoil shall apply in the version which was in effect prior to the introduction of amendments.

In this context, a dispute arose in a certain situation when following the changes in subsoil users' composition, subsequent amendments to the contract were made. The question of making amendments to the license came up. Two law firms which advised the contract's participants on subsoil use came to different conclusions. One firm believed that amendments to the license needed to be made, while the other had a different point of view.

The point is that according to Article 2 of the Law dated 11 August 1999, the former (old) legislation applies to suspension, revocation, termination and invalidation of licenses. This list is comprehensive and does not provide for changes to a license. Therefore, one might think that changes to the license are not included in the list of issues which are resolved in accordance with the former laws. All the more so, as the licensing agency is the Government and now it is impossible to have changes to the license made.

Therefore, pursuant to the new legislation amendments are made to a contract rather than a license. That will do.

Nevertheless, interpretation of this law is rather disputable. A draft subsoil law deals with this easily: all matters associated with licenses shall be dealt with by a competent agency. It is suggested that Article 74-1 be included in the Law on Subsoil as follows: "The functions of a licensing agency (Government of the Republic of Kazakhstan) in relation to previously issued and valid subsoil licenses shall be performed by a competent agency."

1.5. Law on the state control over the production and turnover of

oil products

On 7 April 2003 the Government passed a law "On the State Control over the Production and Turnover of Certain Types of Oil Products."

Initially, this law was drafted by a working group under my leadership under the auspices of the Ministry of Energy and Mineral Resources but then the draft law was transferred to the Ministry of Finance. As a result, state interference in oil producers' operations increased. The Ministry of Finance was designated to be an authorized agency. The Ministry of Energy was referred to other state agencies.

Licensing for the production of oil products was introduced. The requirement as to the minimum volume of production of oil products is being introduced subject to approval by the Ministry of Energy and Mineral Resources of the volume of supply of crude oil and/or gas condensate into the Kazakhstani internal market. A unified database on the production and turnover of oil products will be available as of 1 January 2004.

As of 1 January 2004, sale of oil products at filling stations and oil products storages shall be permitted if a computerized recording system is in place and information on the volume of purchase and sale of oil products is transferred to the authorized agency. Other measures aimed at strengthening the state control over the production and turnover of oil products are also being introduced.

The policy of greater government control also applied to the production and turnover of oil. In addition to the base law, a law of the Republic of Kazakhstan "On the Introduction of Amendments and Additions to Certain Legislative Acts of the Republic of Kazakhstan Pertaining to State Control over the Production and Turnover of Certain Types of Oil Products" was passed on 7 April 2003. Also, amendments were made to the Law on Oil.

Article 1 was supplemented with the definition of a unified database to keep track of the production volume and/or turnover of oil. This database shall be formed on the basis of information supplied by a contractor in a manner established by the Government of the Republic of Kazakhstan.

The competence of the Government of the Republic of Kazakhstan was expanded. Four new subclauses were added to Article 5. In accordance with the new provisions, the Government of the Republic of Kazakhstan shall:

6-1). regulate oil exports, including by way of approving (amending) excise rates, customs, protection, antidumping and compensation duties, and quotas for oil export;

6-2). establish quantitative restrictions (quotas) for oil transportation by various means of transport;

6-3). establish the procedure for maintaining a unified database of oil production and turnover;

6-4) organize control over the observance of safety instructions as to technological process of production, storage and turnover of oil.

Authorities of a competent agency (Ministry of Energy and Mineral Resources) were also expanded. Now, the Ministry exercises the state control over oil exploration in accordance with the project of oil exploration and turnover.

Thus, there might be new government resolutions with respect to strengthening control and state regulation of the production and turnover of oil and oil products.

Amendments (subclauses 6-1)-6-4)) made to Article 5 of the Law on Oil contradict to the purposes and objectives of the Law on Oil; they are irrelevant to the subject of regulation of this legislative act and in certain cases are clumsy.

For example, the matters of export and import refer to the subject of regulation of the Law on Licensing; quoting being ungrounded violates provisions of the Law on Licensing and Energy Charter Treaty which establish that such restrictions are permitted only on the grounds of state security, state monopoly, enforcement of law, environmental protection, protection of property and population health.

The same can be said about quotes on transportation. This contradicts the principles of free disposal of property, banning of unwarranted restrictions of transfer of goods, works and services (Article 2.3 of the Civil Code and Article 13.3 of the Law "On the Protection of and Support for Private Entrepreneurship").

The same can be said about control over the turnover of oil.

Adoption of these amendments to the Law on Oil create the conditions for state interference in business operations of subsoil users, which conduct petroleum operations, by way of imposing quantitative and price restrictions on sale of produced oil in the internal and external markets, determining oil transportation routes and means of transport, as well as by regulating subsoil users' operations which are not associated with petroleum operations, sale and/or processing of oil. The Law also creates the basis for lobbying interests of certain transportation organizations which will ensure full utilization of their transport capacities by way of having state agencies set restrictions for subsoil users on oil transportation by other means of transport (for example, imposing restrictions on using pipelines and rail will lead to maximum utilization of automobile transport though it might be disadvantageous for a subsoil user. These state agencies' departmental and group interests in the interference in operations of contractors conducting oil operations are aimed at supplying Kazakhstani refineries with crude oil. However, this contradicts Article 13.3 of the Law "On the Protection of and Support for Private Entrepreneurship" which prohibits state agencies from instructing entrepreneurs (including entities conducting oil operations) to deliver goods (carry out works and render services) to certain consumers (including certain refineries).

2. Prospects

Currently, a law "On the Introduction of Amendments and Additions to Certain Legislative Acts of the Republic of Kazakhstan Pertaining to Subsoil Use and Petroleum Operations in the Republic of Kazakhstan" has been prepared and is expected to be adopted.

Preparation of a draft law has been long and complicated. At first, the draft law was prepared by the National Legal Service in November 2001. However, it did not satisfy the Government and the Ministry of Energy and Mineral Resources of the Republic of Kazakhstan. Having been instructed by them, the Scientific and Research Institute of Private Law formed a working group consisting of M.K. Suleimenov, group head, Yu.G. Basin, E.B. Osipov, B.V. Pokrovsky, and O.I. Chentsova, who prepared a new draft law. That draft was discussed many times in the Ministry and Government and underwent many changes. Unfortunately, the legislative part of the draft law was not good and it was not our fault in many of the drawbacks because, firstly, our opinion was not always taken into account (according to a vice-minister, you serve as consultants, and not vice versa), and secondly, we were dismissed from the project at the last stage.

2.1. Changes in the text

The draft law does not contain revolutionary changes in legislation on subsoil use and does not affect the existing concept of subsoil use based on the contractual system of granting of subsoil for use which was introduced in 1999.

Many amendments were made, and those imperfections that were introduced by the 1999 law were eliminated. In particular, the words "Decree of the President" were replaced with the word "Law," the contradiction between the Law on Subsoil (which employs the definition "subsoil section") and the Law on Oil (which employs the definition "block") was eliminated. Therefore, the Law on Subsoil employs both terms: "subsoil section (block)". The Law on Oil amended the term "block" which was defined as any territory on land or water designated as a block on a specially prepared map of blocks. The draft law defines the "block" as a part of the subsoil to be granted to a subsoil user to carry out petroleum operations and to be designated as a block on a specially prepared map of blocks (Article 1.1 of the draft law).

2.2. Processing of mineral raw materials

Processing of mineral raw materials was at the center of debates. Article 20.1 of the Law on Subsoil stipulates that the processing of mineral raw materials shall not be deemed as subsoil use operation. The Committee on Geology of the Ministry of Energy and Mineral Resources of the Republic of Kazakhstan insisted that this provision should be excluded. At the same time, the definition "mining" was expanded to include "technological operations on primary treatment (primary processing) of mineral raw materials."

We protested against inclusion of processing in the Law on Subsoil. The Law deals with only prospecting and exploration while processing is a different term. These terms cannot be regulated in the same article. There must be a separate law if it is necessary at all.

It should be noted that these provisions on processing concern mainly solid raw materials. The Law on Oil did not amend the definition of mining. However, inclusion in the law of relations on processing might influence the relations on exploration and processing of oil.

2.3. Liquidation fund

Another matter to which we opposed is the creation of a liquidation fund. Firstly, this is the freezing of working capital. Secondly, volumes and exploration difficulties at deposits differ, and therefore, of particular importance are the principles of formation of the liquidation fund and the role of a contract therein. The draft Law on Subsoil defines the liquidation fund as a fund to be formed by a subsoil user, in accordance with the legislation of the Republic of Kazakhstan and terms of the contract, to eliminate the implications of subsoil use operations carried out in the Republic of Kazakhstan (Article 1 of the law). The procedure for creation and use of the liquidation fund are established by the Government of the Republic of Kazakhstan. The amount of and procedure for allocations to the liquidation fund are stipulated in the contract (amendments to Article 48.3 of the draft Law on Subsoil).

Unification of methods of determining the procedure for formation of a liquidation fund is dangerous because it might lead to additional restrictions on subsoil users' operations. The requirement for each subsoil user to freeze cash in the deposit account as is envisaged by the draft law is too severe.

Therefore, the procedure for creation and disposition of the liquidation fund (if established) must be stipulated by the contract.

Also, the provision on the establishment of a liquidation fund contradicts the Tax Code. Article 97.1 of the Tax Code refers to contributions to be deducted from subsoil users to the fund to eliminate the implications of subsoil use operations (the reserve fund) relating to completion of subsoil operations at the given deposit. The amount of and procedure for making deductions to the fund to eliminate the implications of operations are established by the subsoil use contract.

In light of this, the introduction of and procedure for the formation of the liquidation fund are equivocal.

2.4. National companies

National companies are the most important matter in the Law on Oil.

The definition of the national company was clarified. The existing law provides that the national company is a closed joint-stock company, with one hundred percent of stock belonging to the state, created by the Decree of the President of the Republic of Kazakhstan for managing petroleum operations directly in the Republic of Kazakhstan as well as by shared participation in the contracts (Article 1 of the Law on Oil). In the draft law, the national company for carrying out petroleum operations is understood to mean a legal entity, with one hundred percent of stock belonging to the state, established for conducting petroleum operations on terms specified by the Law on Oil, i.e. it can be founded in any form, especially as a closed joint-stock company no longer exists. The definition is given in a general form. The only distinct features are one hundred state participation and the term "national."

However, nobody knows the meaning of "national." The legal status of a national company is not clear. On the one hand, it is a joint-stock company and must comply with the norms of corporate law; on the other hand, it is endowed with authority to perform the state functions.

This raises the problem of delimitation of authority between the National Company KazMunaiGas and Ministry of Energy and Mineral Resources, and a special government resolution was adopted on 20 June 2003 to address this problem.

These matters are resolved in the new draft Law on Oil. The major task of the national company is to represent state interests in the contracts with contractors which provide for the national company's shared participation in the contracts.

The national company retains its public powers such as participation in strategic development of reproduction rates and further increase in petroleum resources; implementation of the single government policy in the petroleum sector; preparation of annual reports to the Government of the Republic of Kazakhstan on the status of the performance of contracts; monitoring of hydrocarbon exploration, development, production, refining, sale and transportation as well as of designing, construction and operation of oil and gas pipelines and oil and gas field infrastructure.

The Government Resolution No. 707 dated 20 June 2003 designates KazMunaiGas as a working organ of the Ministry of Energy and Mineral Resources of the Republic of Kazakhstan.

Mixing different functions within one body is far from being impeccable (from a legal point of view) and effective (from the point of view of industrial process control). The situation where managerial authorities prevail in business relations will inevitably impact the equilibrium of business entities (KazMunaiGas, on the one hand, and other oil producing companies, on the other hand) and will lead to ungrounded interference in the companies' operations.

The national company is a commercial organization, a joint-stock company. State interests must be represented by way of independent development of deposits, shared participation in contracts, and disposal of the state shareholding in oil producing companies. In my opinion, it is impermissible to grant the National Company the right to carry out monitoring and control over activities of other companies. This must be in the competence of the Ministry of Energy as a state organ.

The legal status of a national company is so vague and contradictory that needs to be defined in a law on national companies rather than in amendments to the Law on Oil.

The law on national companies must establish the criteria of delimitation of powers between the state agencies and national company and limit the national company's public functions. When the national company enters into civil relations, in particular, by way of concluding investment contracts, the law must specify:

a) whether this entering is on behalf of the national company or of the state;

b) which respective rights and obligations the national company and the state shall obtain; and

c) who will be liable for the failure to comply with contracts (as well as to whom, in which manner and to which extent) (2).

The Conception of the policy of law of the Republic of Kazakhstan states:

"... it is necessary that the Civil Code and a separate law should define the status of national companies delimiting the spheres of responsibility of national companies, the authorized agency and state" (3).

A truer word was never spoken.

1 This interpretation is given, for example, in the "Research on Access to Investments in Exploration and Production of Petroleum Resources - Comparative Analysis of Legislation of Azerbaijan, Kazakshtan, Russia, Turkmenistan and Uzbekistan" presented for discussions by the Energy Charter Investment Group on 26-28 May 2003 (page 16).

2 Yu.G. Basin National Company. - in the book Yu.G. Basin Selected Works on Civil Law, Almaty, AYu-Adilet Law School, Scientific Institute of Private Law under the Kazakh State Law University.

3 Kazakhstanskaya Pravda, 3 October 2002.

M. Suleimenov,

Director of the Scientific Institute of

Private Law under the Kazakh State Law University,

Corresponding Member of the National Academy of

Sciences of the Republic of Kazakhstan,

Doctor of Law, Professor