Since 2001, when the function of monitoring so-called production-sharing agreements (PSAs) was transferred from the Ministry of Energy to the Ministry of Economic Development and Trade, the government has been giving the issue increased attention. Since then, a law on direct production sharing was adopted, state-run companies Rosneft and Zarubezhneft were appointed to represent the Russian government in PSAs and a VAT compensation mechanism was worked-out for the Sakhalin-1 project. The absence of functional legislation still remains to the main problem plaguing the potentially effective projects that are planned or being implemented on PSA terms. Two PSA-related draft laws are currently on the State Duma's waiting list: one on taxation and one on the mechanism of compensation of investor's expenses.

A total of 28 deposits are seeking PSA status today, and only three of them are being developed – Sakhalin-1, Sakhalin-2 and Kharyaga. In effect, the three functional PSA projects owe their existence to presidential decrees issued by former President Boris Yeltsin.

The list of complaints voiced by potential investors is quite long, and its main points they desire are legal guarantees for tax breaks, a clear distinction between reimbursable and nonreimbursable expenses, abolition of limits on the number of deposits that can be developed on PSA terms and the regulation of the problem concerning the role of Russian Federation member republics and territories in PSA. Moreover, investors demand that some relatively recent PSA-related legislative acts should be amended, including the law "On Direct Production Sharing," which was adopted by the State Duma in May 2001 and aimed to simplify the system of operating for existing PSA projects. The problem is that, while introducing a simplified mechanism of production sharing, the law simultaneously placed foreign investors under double taxation: The profit tax payable in Russia in oil supplies is not taken into account by tax services in the investor's home country.

It is well-known how PSA legislation is imperfect in its description of the spheres of competence and powers of local administrations. Suffice it to recall that litigation has been under way since August 2000 on the issue of transferring a 20 percent stake in the Kharyaga deposit to LUKoil. The companies, TotalFinaElf and NorskGydro, that have been developing the deposit since 1995, decided to find another Russian partner (in addition to the Nenets Oil Company, which holds a 10 percent stake and is controlled by the local administration) and to transfer a 20 percent stake to it. They chose LUKoil because it was also involved in Kharyaga development. The transfer of the stake to LUKoil was affirmed by Prime Minister Mikhail Kasyanov, but met with opposition from local Governor Vladimir Butov. Moreover, a minority shareholder of the Nenets Oil Company, who suddenly emerged on the scene, filed a legal claim protesting the transfer of the shares to LUKoil. The governor maintains that the stake (20 percent) should be put for a tender or competitive bids. In a letter he sent to Kasyanov, the governor offered, on behalf of the Nenets Oil Company, to buy the stake for $50 million. The conflict has not been regulated by now.

"A situation where regional authorities are refusing to comply with the prime minister's orders is absurd and undermines the prestige of the state," analyst from investment and brokerage group Nikoil Gennady Krasovsky said.

The draft Tax Code (Chapter 24) the Finance Ministry submitted to the State Duma in December 2001 will considerably complicate conditions for PSA investors. Under the PSA law currently in effect, investors pay only VAT, profit tax, tax on using natural resources and the unified social tax. But, if the draft is adopted, PSA investors will be made liable for paying almost all taxes that exist in Russia. Also, the draft will introduce a much less favorable (for investors) mechanism of reimbursement of expenses.

The oil lobby put forth an alternative draft in which PSA investors are guaranteed stable conditions of operation. Now a battle is under way with both sides experiencing ups and downs. Incidentally, head of the State Duma Budget Committee Alexander Zhukov, who used to support the oil lobby's draft, made a public speech on March 18 calling for complete abolition of the PSA system as a vestige of the dark period of Russia's history.

"The point is not whether our PSA-related tax legislation is good or bad," Alfa Bank analyst Konstantin Reznikov said. "The problem lies not in the present tax rates and conditions of operation, but in the fear of their possibly changing in the future. Besides, with the present level of oil prices, the PSA scheme does not lead to any significant increase of efficiency. YUKOS, for example, decided not to wait for PSA and started to work with its Hungarian partner according to an ordinary scheme."

In an interview given in November 2001, a department head at the Ministry of Economic Development and Trade, Oleg Koshikov, said that, in a situation in which oil prices are high, there is little motivation for companies to operate on PSA terms.

According to Mikhail Armyakov, analyst at the Russian Investors company, for investors, predictable conditions of doing business are most important, while oil prices only determine how long an investor will have wait for first profits.

"Investment in the main capital of Russia's oil companies increased dramatically and exceeded $6 billion in 2001," Armyakov said. "This made it possible to achieve a major increase in oil production. The fact that the production-sharing mechanism is still skidding in Russia only serves to confirm the unwillingness of the government and the oil companies to give foreign competitors access to Russia's natural resources."