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What to Expect in Regulation of Foreign Investment in Russia in 2016: Outlook for the Oil and Gas Sector

Natalya Morozova, Vinson & Elkins, Russia

The Russian legal framework for the national security control over foreign direct investment in business entities which have strategic importance for the defense of the country and the security of the state emerged in 2008, shortly before the crises. The key laws in this area have undergone some revisions and amendments since then, but their fundamental principles have not been modified. Of primary importance law is the Law on the Procedure of Foreign Investment in Business Entities Having Strategic Importance for the Defence of the Country and the Security of the State–often referred to as the "Strategic Law".

Under the Strategic Law, many foreign investment proposals in more than 40 industry sectors or types of activities, which are determined to have an effect on national defense and security, are reviewed by the Strategic Investment Government Commission headed by the Prime Minister. The Commission's prior approval is generally required for the acquisition by a private foreign investor of control over a target company operating in any of the relevant sectors, with 'control' generally stated to include:

  • Acquiring (directly or indirectly) more than 50% of the voting shares,
  • Obtaining more than 50% of the seats on its board or other management body,
  • Acquiring the right to appoint its chief executive officer, or otherwise determining the target's operations through a management or similar agreement,
  • Acquiring any voting interest below 50% also requires prior approval in cases where a target has multiple minority shareholders, if the acquisition would give the foreign acquirer de facto control over the target company, and
  • Acquiring (directly or indirectly) more than 25% of the voting shares, if the acquirer is a foreign state or an international organization or a legal entity controlled by a foreign state or an international organization. This threshold also applies to the aggregate acquisition by several such acquirers, even if they are unrelated.

Geological research and/or exploration and development of certain natural resources–deposits "of federal significance"–fall under the Strategic Law. In terms of oil and gas, a field of federal significance is any deposit with recoverable reserves of at least 70 million tons of oil or 50 million cubic meters of gas, or any deposit that is located in Russian internal or offshore waters or on the continental shelf.

Russian law is especially restrictive in relation to foreign participation in companies which are involved in geological research and/or exploration and development of deposits of federal significance. The acquisition by a foreign investor of "control" in such companies requires the prior approval of the Commission.

For these purposes, "control" is generally deemed to exist where a foreign investor (or all foreign investors taken together if such investors are controlled by foreign states):

  • Controls (directly or indirectly) 25% or more of the voting shares or participating interests in the strategic company, or
  • Is able or has the power to appoint 25% or more of the directors (and/or other management body) of such company, or
  • Is entitled to appoint the chief executive officer of such company, or
  • Has the power to make decisions relating to the business activities of such company (including by means of joint voting arrangements), or
  • Acts as the management company of such company.

However, where the acquiring party is a foreign state or a company controlled by a foreign state:

  • The acquisition of over only 5% of such a company requires the prior approval of the Commission,
  • The acquisition of production assets equal

to or greater than 25% of the book value of such a company's total assets is prohibited, and

  • The acquisition of control over such a company is prohibited absolutely. The Strategic law does not allow for a waiver of such prohibition or for such prohibition to be relaxed in the event of approval by the Commission.

Notably, according to the most recent amendments to the Strategic Law, the above prohibitions now apply where the aggregate interest of one or several foreign states, or of separate companies controlled by one or several foreign states, exceeds the required thresholds (until recently, the law could be interpreted to look at the states' or companies' interests on a separate basis).

Until recently, the Commission has been relatively busy reviewing applications by foreign investors. Its work load has significantly reduced now due to the worsened geopolitical situation and the sectoral U.S. and EU sanctions.

Russia is the second-largest producer of oil and gas (according to the BP Statistical Review of World Energy 2015), and Russia's economy is heavily reliant on revenues derived from its oil and gas exports. It has been negatively affected by the dramatic drop in the price of oil in 2015 and further decline in oil prices in the beginning of 2016. According to the Bank of Russia, the hard currency export revenues reduced by 1/3 in 2015. In the same year, the cost for Russia of the global oil and gas prices' decline was about USD 160 billion.

In addition, Russian companies need to explore for, discover, and develop significant new oil and gas deposits in order to maintain or grow current high production levels. Sanctions that are specifically targeted at the ability of Russian banks and oil and gas companies to access external financing will likely have an additional negative impact on Russia's ability to develop its energy sector as a driving force of its economy. It has been recently reported that some major Russian companies, such as Rosneft, Gazprom and NOVATEK have requested postponement of the launch of several new oil and gas deposits with the total potential annual peak production of approximately 26 million tons.

The above makes the task of attracting foreign direct investment in the Russian oil and gas sector of significant importance. Historically, Europe has been the major market for Russian oil and gas companies. With the problems in this market, Russia has increased its focus on the Chinese market as a destination for its abundant supplies of energy and raw materials. Russia's Energy Strategy looking forward to 2035 reportedly provides, specifically for the diversification of its export markets, an almost tenfold increase in gas shipments to the Asia Pacific region by 2035, and double the growth of oil production in East Siberia and the Far East. Offering upstream interests to Chinese state-owned oil and gas companies is also seen as a means to obtaining access to the Chinese market. In 2015, the Deputy Prime Minister said that Russia is prepared to consider allowing Chinese investors to acquire a controlling interest in its strategic oil and gas projects and there are no political obstacles to that.

However, there have been fundamental legal obstacles to foreign state-controlled companies (which would primarily include most likely candidates for investment from China or India) acquiring control in the Russian strategic upstream companies, as the Strategic Law absolutely prohibits such investment.

Interestingly, the Russian government has found a way around the prohibition. The first known example of this is the Yamal LNG project in the Russian Arctic. In 2014, the China National Petroleum Corporation (CNPC) acquired a 20% interest in the project. Simultaneously with this acquisition, the Chinese and the Russian governments signed a treaty for cooperation in the development of the Yamal LNG project. In late December 2015, the Russian government approved the protocol to the above treaty, which provides, inter alia, that the Chinese Silk Road Fund will acquire a 9.9% interest in the Yamal LNG project, which will bring the total state-controlled investment in the Russian strategic company to a 29.9% level which is prohibited by the Strategic Law. However, according to the Russian Constitution, international treaties supersede national laws. If the protocol is ratified by the State Duma (the highest legislative authority), it will become an international treaty of Russia that will supersede the Strategic Law to the extent the protocol will allow a higher threshold as opposed to the Strategic Law. Obviously, the same legal mechanism can be used in other potential projects to overcome the Strategic Law prohibitions. It remains to be seen whether Russia will continue to use such mechanism and will indeed offer controlling stakes in its strategic oil and gas fields to the major state-controlled Chinese companies and perhaps state-controlled companies from other states.