13 june 2012

Prime Minister Dmitry Medvedev chairs a meeting on taxation of the oil and gas sector at Gazprom Mezhregiongaz

According to the Prime Minister, “the tax policy in this sector should be aimed at encouraging more investment.”

Transcript of the beginning of the meeting:

Dmitry Medvedev: Good afternoon, colleagues,

We have met here at Mezhregiongaz today to discuss issues that are important for everyone present: taxation of the oil and gas industry. I can say without exaggeration that, whether we like it or not, Russia’s oil and gas sector is of crucial strategic importance for our country. It is well known that Russia is a leading global producer of crude oil and natural gas. The products of the national fuel and energy industries account for the bulk of Russia’s exports (72.5% of exports to countries outside the CIS), and the customs payments from this sector are of tremendous importance for the federal budget, accounting for over half of federal revenue. Therefore, the well-being of our oil and gas companies is essential for meeting a wide range of important goals.

The Presidential Budget Address set the task of improving taxation of the oil and gas sector. These rules should encourage the development of greenfield projects as well as stimulate deeper conversion of raw hydrocarbons in Russia. At the same time, certain recent trends in the oil industry are hindering its growth. You are well aware of this: I am referring to the declining production in West Siberia, which is a traditional oil and gas producing area in Russia, as well as the slow pace of modernisation of domestic refineries. In this context, the government has passed a series of decisions of which you are also well aware – the so-called 60-66 special customs regime was introduced starting from September 1, 2011, which reduced the maximum crude oil export duty to 60% and harmonised the export duty for light and heavy refined products at 66% of the export duty on crude oil. This policy was aimed at increasing the efficiency of the brownfield oil projects by optimising taxation, attracting investment, and consequently boosting production. It was also introduced in order to stimulate an upgrade of Russian oil refineries by increasing the profitability of secondary distillation units. These decisions have had some effect, but it probably was not the effect we had expected. In any case, the Ministry of Energy and the Ministry of Finance should ensure further monitoring of the results of the sector’s work in consideration of the new customs regime. Oil companies should ensure the implementation of the plans for updating refining capacities; these plans envision the renovation and construction of 122 secondary distillation units by 2020. According to expert assessments, companies’ investment for the purpose is considerable, totalling some 1.2 trillion roubles. I’d like to instruct the Federal Service for Supervision of Environment, Technology and Nuclear Management, the Ministry of Energy, the Federal Antimonopoly Service, the Federal Agency on Technical Regulation and Metrology to continue to monitor the upgrades to refineries and ensure adequate oversight of the implementation of relevant agreements.

Next. Currently, more flexible mechanisms are being formed, including fiscal mechanisms that improve investment attractiveness of the projects involving offshore field development, including on the Arctic shelf, and so-called hard-to-recover oil. First and foremost, investors need stable and predictable rules. I spoke to some colleagues before this meeting – I suppose that was the motivation for our meeting – and they asked me to ensure stable conditions for their work. For these conditions to be really stable for five years at least, this should look like a final decision. This is necessary for capital intensive, long-term projects which are generally able to ensure considerable growth of hydrocarbon production in the future, creating new high-paying jobs. Also, such project can bring in orders for innovative products produced by Russian industry.

The gas industry and gas companies need the same rational and measured approach. According to the general plan for the gas industry’s development, it is planned to increase gas production by 50% from the current 670 billion cubic metres to 1 trillion cubic metres per year by 2030. New gas producing centres will appear in the Yamal Peninsula, East Siberia and the continental shelf. Of course, these projects should also be economically efficient and understandable, justified for investors, therefore taxation in the gas industry should stimulate investment.

I will stop here and give the floor to the Minister of Energy, Mr Novak, to make a few introductory remarks. Go ahead please.

Alexander Novak: Thank you, Mr Medvedev. Colleagues, as the prime minister said, the oil and gas sector is critically important to the Russian economy. On the one hand, taxation and fiscal regulation should provide for a sustainable increase in budget revenues; on the other hand, taxation should create incentives for investment and attract global technologies.

Mr Medvedev, I’ll begin with the situation in the oil industry. There is a presentation, and as part of the presentation I’d like to brief you primarily on our vision for tax policy in the oil industry. As the slides show, oil industry production indicators have remained at a high level in recent years; we have overcome the trend of declining oil production that began with the global financial crisis in 2008. The timely stimulative measures taken by the government allowed us to reach maximum production for the post-Soviet period, or 511.4 million tonnes by the results of 2011. According to the general plan for the oil industry’s development, this level of production will remain stable until 2020. Oil refining has also grown in recent years, reaching a maximum of 256.5 million tonnes in 2011. Currently, the oil refining industry completely meets domestic demand. In the period to 2020, we expect investment in the industry, the construction of a number of new installations and the modernisation of obsolete ones. I’d like to say that we see two major threats hindering the attainment of the goals set by the general scheme.

First is the decline in production caused by insufficiently flexible tax policy. Second, there is the shortage of high-quality oil products in the domestic market as a consequence of the failure to carry out large-scale modernisation of domestic oil refineries on schedule. I will comment in more detail on the tax system with respect to the oil industry as compared with other oil and gas economies. As of today, the level of fiscal pressure on Russia’s oil industry is the highest not only in relation to other industries but also in comparison with other countries (you can see this on the slides). The key problem in the existing tax system is that taxes and duties are levied on the absolute figures of company earnings rather than on the financial result. Even though this approach helped to simplify tax administration and fiscal performance, it fails to take into account the industry’s economics and actually impedes investment. For example, existing tax regulations make large-scale production at both new and existing fields unprofitable. As I see it, we should again consider transitioning to an added earnings tax. If we don’t do that, we could cause a drop in production quite soon. As a result, only 11 billion tonnes of oil (the green column on the slide) out of 22 billion tonnes that we now have as reserves may be produced within the next 20 to 30 years. Conscious of how acute this problem is, the government of the Russian Federation has adopted a number of tax regulatory measures, including with regard to the mineral production tax (MPT). We have introduced tax holidays on MPT for fields in new oil producing areas. Coefficients have been reduced for depleted fields, new small fields, and for the export duty on new fields in new oil producing areas.

To stimulate development of hard-to-recover oil reserves, a government resolution was signed on May 3, 2012 that rated projects by the degree of difficulty on the basis of geological conditions. The resolution provides for reduced MPT rates based on the degree of difficulty and a reduced export duty rate for extremely viscous oil. We intend to draw up the relevant amendments to the Tax Code before October 1, 2012. These tax innovations are ultimately aimed at moving an additional 2.5 billion tonnes of reserves into active production.

In order to encourage new offshore projects, a government resolution was signed on April 12 that provides a degree-of-difficulty gradation of projects pegged to geographical location. Companies producing hydrocarbons in new fields have been exempted from the export duty, and an ad-valorem MPT rate has been introduced for new offshore fields depending on their category of difficulty. We intend to draft the relevant amendments to the Tax Code before October 1 of this year as well. We see as our ultimate goal in this regard the beginning of active geological exploration in a region with projected hydrocarbon reserves amounting to 100 billion tonnes of reference fuel.

Mr Medvedev, the main problem today is how to create incentives for developing new fields with higher operating and capital costs and more complicated geological conditions, the fields that are located far away from the markets and need new infrastructure. Clearly, the current MPT breaks are not enough to pay for such a development effort. It’s already clear that stimulating new projects through the introduction of lower crude oil export duty rates, which has been used since 2009, proved its effectiveness in East Siberian fields, such as the Vankor, Verkhnechonsk, Talakan and others, but has not so far been codified in law. This leads to a situation where oil companies are postponing their investment decisions with regard to major new projects, such as the Vostochno-Mesoyakhskoye, Kuyumbinskoye, Yurubcheno-Tokhomskoye and Russkoye, which could trigger a drop in production, which I showed on the slide highlighted in green.

We propose preparing a uniform method for cutting duties on oil produced at offshore and land-based fields and specifying the criteria for forming a list of new fields for further consideration by the Government Commission on the Fuel and Energy Complex and approval by the Russian government. We will need to decide on a number of investment projects based on this methodology before the end of 2012. I would like to underscore that this methodology must be adopted before the end of 2012. Decisions on possible tax relief should also be made before the end of 2012.

Now, with regard to oil refining. I have already mentioned the growing refining volumes. However, the production of petrol grew by only 14.4% from 2005 to 2011, while the production of fuel oil, consumption of which is falling in Russia, increased by 29.4%. There’s an obvious disproportion here which is due to the fact that export duties that were in place from 2005 to 1 October, 2011 had a rate for black oil which was 2.5 times lower than the rate for crude oil and nearly half of the rate for light oil. As a result, oil companies were encouraged to increase the output of products of primary refining and fuel oil. In fact, lower duties subsidised export-oriented output of petroleum products of low refining depth. These subsidies are estimated at about $7 billion a year. Oil companies had no incentive to modernise their equipment. We know the results: in 2011, Russian refineries were not prepared to produce Environmental Class 3 or higher fuels in the amounts required to saturate the domestic market. Then, we had to change technical regulations and postpone the ban on selling low environmental class fuels. The amended terms of the ban on trading in lower class fuels were introduced in 2011 based on the analysis of plans to modernise refineries voluntarily submitted by oil companies and on forecasts of demand for the main types of petroleum products. As a result, Class 2 fuel sales will be banned beginning on January 1, 2013, Class 3 on January 1, 2015 and Class 4 on January 1, 2016.

Mr Prime Minister, you have already mentioned that in order to comply with technical regulations, we will need to commission and retrofit 122 secondary distillation units (by comparison, we commissioned and retrofitted only 20 units over the course of the past three years), and to invest more than 1 trillion roubles in 2012 prices (by comparison, we invested only 170 billion roubles during the previous period). We should be able to produce Class 5 environmental fuel by 2020. The production of petrol is expected to increase from 600,000 tonnes in 2011 to 38 million tonnes in 2015, whereas the production of the diesel fuel should go from 11.9 million tonnes in 2011 to 77 million tonnes.  In order to be able to achieve these goals, we will implement policies aimed at strict observance of technical regulations and prevention of oil shortages on the domestic market. To do so, we will conduct quarterly monitoring of upgraded oil revenues, synching scheduled repairs and conducting annual updates of short- and medium-term balance of supply and demand by major types of petroleum products.

We also believe that the introduction of differentiated excise rates based on fuel classes, levelling duties on light and dark petroleum products, levelling duties on fuel oil and crude oil beginning January 1, 2015 will serve well as economic incentives for upgrading refineries. We also propose instructing the Ministry of Economic Development, the Energy Ministry and the Finance Ministry to analyse the effectiveness of the customs and tariff regulation "60-66" and to report back to you with the results of oil and gas industry performance in 2012. Summing up the taxation of the oil industry, I would like to emphasise that a large number of tax, tariff and technical regulations have been drafted in recent years, but we are now facing new challenges that have to do with the adoption of laws and regulations that must ensure the achievement of the earlier announced strategic goals, the adoption of procedures and incentives, and attract investors to the industry. That concludes my report with respect to the oil industry and tax administration.


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