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Kazakhstan Legislation Could Mean Unilateral Cancellation of Energy Contracts

October 3, 2007

On September 26, 2007, the lower house of the Kazakhstan Parliament voted unanimously to amend an existing law regarding subsoil use.  If the amendment is approved by the Senate and signed by the President, it would grant the government the unilateral right to modify or cancel production sharing agreements and contracts for underground resources (“Energy Contracts”) in order to “protect the national interests…and safeguard the economic security of the Republic of Kazakhstan.”

The amendment to Article 45-2 of the Law “On Subsoil and Subsoil Use” does not spell out the conditions under which such action could be taken, other than to say that it could occur “in the event that a subsoil user’s actions, when carrying out operations on subsoil use, lead to essential changes of the economic interests of the Republic of Kazakhstan.”  Apparently those definitions may be interpreted rather widely by the courts or in arbitration, especially when they relate to strategic subsoil resources like oil.  Foreign companies will have the right to dispute the government’s cancellation action, but only by trying to prove that their action has not caused “essential modifications of the economic interests of the Republic of Kazakhstan which create a threat to the national security.”

Observers believe that the amendment is a response to the long-running controversy over the development of the strategically important Kashagan oilfield.  Located in the Kazakh section of the Caspian Sea, Kashagan is considered to be the largest oilfield outside the Middle East in terms of reserves.  It is being developed by such multinationals as Exxon Mobil, Royal Dutch Shell and Total SA. The development has been plagued by cost overruns of more than 50%, and delays that have pushed to 2010 the original 2005 target for pumping oil. 

Kazakh officials have expressed their displeasure over Kashagan by temporarily halting operations due to “environmental violations,” as a means to get the consortium’s attention.  However, this did not provide the investors or the market with the proper information or signals to understand the government’s concerns.  It left Kazakhstan open to criticism that it was following the path of Russia, by not making the “rules of the game” clear – in other words, that living up to commitments, and not environmental issues, was the government’s concern.  Accordingly, the government under the leadership of Prime Minister Massimov is using the new legislation to clarify Kazakhstan’s concerns over strategic properties that they rely upon third parties to develop.

The new legislation gives the Kazakh government the right to determine which soil and subsoil sites (primarily relating to energy development) are “of strategic importance,” and specifies that soil and subsoil use contracts can be cancelled:

  • Within two months following the day on which notice is received that the subsoil user does not consent in writing to negotiate modification and/or addition of terms and conditions of the contract, or refuses to negotiate, with the government;
  • Within four months following the day on which, in the event of negotiations, the parties and the government do not come to any agreement;
  • Within six months following the day on which, following agreement on changes that meet the country’s “economic interests, the parties do not sign the contract changes.

The net result of these provisions is to give foreign investors one year to start and to complete negotiations on amendments to a contract.  We understand that no compromises are envisioned relating to these terms.

The new legislation sets forth two basic concepts for termination of subsoil contracts:

  • An agreement may be terminated (i) under the consent of both parties and (ii) under the request of one party if a court rules to this effect. Therefore, if in the above periods a contractor fails to act as required (consenting to negotiate, coming to an agreement or signing contract modifications) the government will have legal right to apply to a court and require termination of a contract by its request;
  • One party may unilaterally refuse future performance of a contract agreement. Such refusal is possible without applying to a court.  The new legislation strengthens unilateral termination provisions already in the Civil Code and the laws by specifically applying them to subsoil use contracts. The draft amendments do not contain any details about the consequences to a foreign contractor if the government unilaterally refuses contract performance, but they may mean that the government by refusal will stop providing a deposit to a contractor for exploration and production. Any contractor will have right to appeal unilateral refusal to a court, which will review the grounds for refusal under an agreement or law. 

These rights of the government may be applied to both new and existing subsoil use contracts. The new amendments shall enter into effect from the date of their official publication. The intent of the amendments appears to contradict Kazakhstan's Civil Code, which allows cancellation of contracts under limited circumstances, but does not allow cancellation for economic reasons and can be considered nationalization.

The Government argues that the intent of the new legislation is to make it clear to foreign investors that companies must keep their commitments if the investors want the government to do the same by respecting all contract terms.  For this reason the law does not necessarily increase foreign investors’ political and economic risks of doing business in Kazakhstan.  It does, however, make it essential that investors work diligently to make it clear to the government that they are living up to their contractual obligations.

There is no definite timetable for approval, but press reports of a late October deadline for the government to reach an accommodation with the Kashagan consortium may indicate that action could be taken in the next few weeks.