vk.com/id446425943

Mineral Extraction Tax (MET)

In place since 2002

Federal Law No. 126-FZ of 8 August 2001 (which took effect on 1 January 2002) amended the previously existing regime of mineral resource restoration payments (Mineral Replacement Tax [MRT]), royalties, and excise taxes on the production of oil and gas condensate, and replaced all such taxes with the MET. The original 2002 formula to calculate MET, measured, and collected, in roubles per tonne produced was:

MET = Base rate x (Urals – cut-off rate) x exchange rate ÷ dollarising denominator + temporary surcharge1

The base MET rate for crude oil was originally set at RUB340/t, multiplied by a coefficient based on changes in worldwide oil prices. This coefficient was equal to the average perbarrel dollar price of the Urals blend in the relevant quarter minus cut-off rate of $8/bl, multiplied by the average rouble/dollar exchange rate for the quarter, and divided by 252 (the result of multiplying $8/bl times the base exchange-rate assumption of RUB31.5/$).

Since 1 January 2002, no royalties have been charged for the extraction of oil, except for oil produced in the course of the exploration and appraisal of oil reserves. Tax-code changes approved by the State Duma in 2003 increased the base rate for MET modestly, to RUB347/t, effective 1 January 2004. When first introduced, the MET scale was declared a temporary measure, and the tax was due to be imposed at 16.5% of the wellhead value of crude oil from January 2005. However, we have always believed that the scale system would continue to operate for the foreseeable future due to the difficulty of fairly establishing wellhead prices. Moreover, in May and November 2004, the State Duma approved further changes to the calculation methodology, which took effect on 1 January 2005.

These initially entailed raising the base rate to RUB400/t, and then to RUB419/t to compensate for the abolition of VAT levied on oil & gas exports to non-Customs Union CIS countries; raising the (Urals) crude price above which the tax kicks in to $9/bl from $8/bl; and raising the dollarising denominator, which climbed to 261 ($9/bl times RUB29/$), from 252 previously ($8/bl times RUB31.5/$). In July 2008, the State Duma approved a further increase in the cut-off rate to $15/bl from $9/bl, which took effect on 1 January 2009. In November 2011, the State Duma approved adjustments to the baserate, which increased to RUB446/t for 2012 and RUB470/t for 2013. These were raised significantly in the following years to RUB493/t in 2014, RUB766/t in 2015, RUB857/t in 2016 and RUB919/t in 2017 as part of the so-called tax manoeuvre that took place in 2014-2017 and was aimed at the rebalancing the tax burden between upstream and downstream, and between export duty and MET. This increase in MET rates was accompanied by a reduction in export duty rates and excise taxes, as discussed in the corresponding sections on this report.

After a one-year pause, the government has decided to proceed with the final phase of the tax manoeuvre, which involves the gradual elimination of the oil export duty, offset by a corresponding increase in the MET rate. We summarise the key parameters of the tax manoeuvre in Figure 132.

1 In effect from 2017

Renaissance Capital

20 June 2019

Russian oil & gas

Essentially, a sliding-scale royalty

Tinkered with since 2002

2014-17 saw the start of the tax manoeuvre…

… which is now slated for completion over 2019-2024

146

vk.com/id446425943

Renaissance Capital

20 June 2019

Russian oil & gas

Figure 132: Key parameters of the oil tax manoeuvre

	2012	2013	The start of the tax manoueuvre				Pause		The final phase of the tax manoueuvre
			2014	2015	2016	2017	2018	2019	2020	2021	2022	2023	2024
Upstream taxes
MET for crude oil, base rate (RUB/t)	446	470	493	766	857	919+	919+	A higher calculated rate to offset lower export duty
Export duty for crude oil, maximum rate	60%	60%	59%	42%	36%	30%	30%	25%	20%	15%	10%	5%	0%
MET for gas condensate, coefficient	na	na	1.0	4.4	5.5	6.5	6.5	A higher calculated rate to offset lower export duty
Export duties on oil products (as % of crude export duty)
Diesel	66%	66%	65%	48%	40%	30%	30%	30%	30%	30%	30%	30%	na
Gasoline	90%	90%	90%	78%	61%	30%	30%	30%	30%	30%	30%	30%	na
Other light oil products	66%	66%	66%	48%	40%	30%	30%	30%	30%	30%	30%	30%	na
Naphtha	90%	90%	90%	85%	71%	55%	55%	55%	55%	55%	55%	55%	na
Lubricants	66%	66%	66%	48%	40%	30%	30%	30%	30%	30%	30%	30%	na
Fuel oil	66%	66%	66%	76%	82%	100%	100%	100%	100%	100%	100%	100%	na
Excise tax, RUB/t
Gasoline Euro-4	6,822	8,960	9,916	7,300	13,100	13,100	13,100	13,100	13,100	13,100	13,100*	13,100*	13,100*
Gasoline Euro-5	5,143	5,750	6,450	5,530	10,130	10,130	9,463*	12,314	12,752	13,262	13,792*	14,344*	14,918*
Diesel Euro-4	3,562	5,100	5,427	3,450	5,293	6,800	6,498*	8,541	8,835	9,188	9,556*	9,938*	10,335*
Diesel Euro-5	2,962	4,500	4,767	3,450	5,293	6,800	6,498*	8,541	8,835	9,188	9,556*	9,938*	10,335*

*Reflects a reduced rate

**Renaissance Capital estimates

Source: Russian government, Renaissance Capital estimates

In addition, in 2016 the State Duma approved a “temporary” increase in MET rates for crude oil for the period 2017-2019 by increasing the rate by RUB306/t in 2017, RUB357/t in 2018 and RUB428/t in 2019. This additional rate should have reverted to zero by 2020, but the subsequent versions of the Tax Code, approved by State Duma in 2017 and 2018, have extended the duration of the RUB428/t surcharge for another two years, first until end-2020, and then until nd-2021. According to the current version of the Tax Code, this surcharge will disappear from 1 January 2022, but this deadline is subject to further adjustments, we understand. When it comes to Russian oil taxation, there is nothing more permanent, than temporary.

The commencement of the final stage of the tax manoeuvre (which involved the need to offset gradual reduction in export duty rate with a gradually higher MET), as well as the new approach to the regulation of the domestic product prices, from 1 January 2019, has resulted in the significant complication of the MET formula. It now has 30 different parameters and we reproduce the full formula below, untranslated, purely to highlight its complexity.

НДПИ = 919 x (Ц–15) x P/261 – (КНДПИ x (Ц–15) x P/261 x (1 – (3.8 – 3.5 x N/V) x

(0.125 x Vз + 0.375) x КД x (3.8 – 3.5 x Nдв/Vдв) x ККАН) – КК – (НАБ x ИАБ + НДТ x ИДТ) – (0.3 x (Ц–182.5) + 29.2) x Р x Ккорр – (П – (0.3 x (Ц–182.5) + 29.2) x (1 –

Ккорр)) x P) x СВ

If this was not enough, there are 18 different exemptions to this formula, discussed below and summarised in Figure 134.

MET exemptions

Following amendments to the Tax Code during 2006, effective 1 January 2007, MET rates vary depending on the geographic location, development and depletion of a particular oil field. Many of the changes to MET exemptions were made from 1 January 2015 to coincide with the introduction of the so-called tax manoeuvre, which saw a reduction in the export duty and a corresponding increase in MET rates in 2015-2017. Similar adjustments were made from 1 January 2019 to coincide with the start of the final phase of the tax manoeuvre, which will result in the eventual abolition of crude export duty

Many MET exemptions are available to stimulate investments

147

vk.com/id446425943

from 2024. These amendments were made to ensure that MET exemptions are not excessive, as well as to allow oil companies to retain their historical benefits associated with the export duty breaks. The full list of the current exemptions is below:

▪The tax rate is zero for extra-heavy (or highly viscous) crude oil with viscosity in excess of 10,000 cP, with a reduced rate for fields with viscosity between 20010,000 cP (prior to 2015, the MET rate was zero for all fields with viscosity in excess of 200 cP).

▪A MET holiday was introduced from 2007 for crude oil produced in East Siberia (in Krasnoyarsk, Irkutsk and Sakha-Yakutia). This applies for the first 10 years (measured from 1 January 2007) or 25mnt of production, whichever comes first. This was replaced with a reduced MET rate from 2015.

▪Further MET holidays were introduced from 2009 in three other regions: 1) on the continental shelf, where similar limits have been set (for 10 years starting 1 January 2009, or 35mnt of production) for all oil fields north of the Arctic Circle; 2) 12 years starting 1 January 2009, or 10mnt for the Azov and Caspian seas; and 3) seven years starting 1 January 2009, or 15mnt for new oil fields in the Nenets Autonomous District (Northern Timan-Pechora), the Yamal-Nenets Autonomous District and the Yamal Peninsula. This was replaced with a reduced MET rate from 2015.

▪A MET holiday was introduced from 2012 for crude oil produced in new developments in the Black Sea (for 10 years starting 1 January 2012, or 20mnt of production), the Sea of Okhotsk (for 10 years starting 1 January 2012, or 30mnt of production) and the northern regions in the Yamal-Nenets Autonomous District (to the north of the 65th parallel but excluding the Yamal Peninsula) for 10 years starting 1 January 2012, or 25mnt. This was replaced with a reduced MET rate from 2015.

▪For crude oil produced in all other regions, the relevant MET rate (calculated as above) is further multiplied by a depletion coefficient. This equals 1x for fields that are less than 80% depleted. Each 1% increase in depletion above 80% results in a 0.035 decrease in the coefficient, down to a minimum level of 0.3. The depletion rate is based on crude oil production and reserves information reported to the Russian government. The depletion coefficient (D) is calculated as follows: D = -3.5 x depletion + 3.8. This means a discount of about 40% for 90% depleted fields, rising towards 70% for almost fully depleted fields.

▪For small oil fields (with recoverable oil reserves of less than 5mnt), a MET reducing coefficient was introduced from 1 January 2012, which is calculated as follows: K = 0.125 x initial recoverable reserves +0.375. This means a discount of 50% for a 1mnt oil field, and a maximum discount approaching 60% for a very small property.

▪MET discounts of 20-100% for 10-15 years were granted for hard-to-recover reserves from 1 January 2014, depending on the field’s permeability, width and the location of the producing horizon, with the biggest discount (full exemption for 15 years) set for shale oil produced from the Bazhenov, Abalak, Khadum and Domanik suites. Discounts of 80% and 60% for 10 years are applied for oil produced from low-permeability (less than 2mD) reserves with the width of the producing horizon less than 10m, and greater than 10m, respectively. Finally, a discount of 20% for 15 years is applied to oil produced from the Tyumen suite.

▪In addition, various MET discounts were introduced from 1 January 2014 for existing oil fields located on the continental shelf of the Russian Federation or in its internal seas, with current discounts ranging from 60% to 90%, depending on their complexity (see page 168 for a discussion of the specific tax regime applied for hydrocarbon production in offshore areas). Simultaneously, a full MET

Renaissance Capital

20 June 2019

Russian oil & gas

148

vk.com/id446425943

Renaissance Capital

20 June 2019

Russian oil & gas

holiday for up to five years is provided for newly discovered hydrocarbons in these geographical areas, assuming a discovery is made after 1 January 2016.

▪Following the government’s decision to launch the final phase of the tax manoeuvre from 2019 and the resulting gradual reduction in the absolute levels of the export duty rates (until the abolition of export duty from 2024), all corresponding benefits, outlined on page 152-154 and previously related to the export duty, now also apply to increased MET in such a way that their combined effect is equal to the intended benefit under the pre-2019 tax regime.

▪Finally, reduced MET rates are applied under EPT regime as discussed on pages 155-157.

Different rules for the taxation of gas condensate

Prior to 2004, the MET rate for gas condensate was set at 16.5% of the value of gas condensate produced (at the wellhead) from gas condensate fields, and at a base rate of RUB340/t for gas condensate produced from oil and gas condensate fields, as is the case with crude oil. This has been revised subsequently in line with changes in the base rate. From 2004, gas condensate, irrespective of the type of field it originates from, was taxed at a single rate of 17.5% of the value of gas condensate produced. From 2012, a flat rate of RUB556/t was introduced, which was raised to RUB590/t from 1 January 2013.

From 1 July 2014, a new formula-based approach was applied to the taxation of gas condensate, which is correlated with the profitability of natural gas extraction and is differentiated between Gazprom and non-Gazprom producers. The structure of the formula as it applies to MET for natural gas and gas condensate is essentially the same, while coefficients are different. We discuss this formula in the gas MET section of this report, on pages 165-167. The formula includes many variables and differs on a field-by- field basis so it is impossible to accurately calculate for an external observer. In addition, starting from 1 January 2019, the formula for gas condensate MET is adjusted to offset the lower level of export duty in accordance with the final phase of the tax manoeuvre. We note, however, that our estimate of a headline rate shows a 46% discount in gas condensate MET, compared with that of crude oil, for 2019, before adjustments.

Gas condensate is additionally subject to two MET exemptions: a MET holiday for up to five years for gas condensate production from newly discovered fields on Russia’s continental shelf or in its internal seas (with the discovery made after 1 January 2016); and a MET for 12 years or 250bcm (whichever comes first) for gas condensate produced in the Yamal (from 2012) or Gydan (from 2015) peninsulas associated with the production of natural gas that is used exclusively for LNG.

Next steps?

With the final stage of the tax manoeuvre now in place, MET has become the dominant tax for the Russian oil producers. However, the calculation of MET has become exponentially more complex. While we see a sound mathematical logic behind the calculation of various new coefficients, kickers, exemptions, balancing and counter-balancing mechanisms, we believe the end result brings overcomplexity that will reduce regulatory transparency and compliance (the MET formula now includes 30 parameters, not to mention 18 different tax exemptions) and reduce competition as the government continues to attempt to ‘link the unlinkable’. From 2019 onwards, the profitability of the upstream sector is now affected by

MET rates for gas condensate are similar to gas MET, not oil

149

vk.com/id446425943

Renaissance Capital

20 June 2019

Russian oil & gas

the downstream margin. A new investor developing an oil field in West Siberia may find its MET rate go up because Russian refiners are demanding compensation for keeping retail petrol prices low. Domestic retail price controls are now effectively in place, with any deviation from target levels either severely punished by the government (if prices are too high) or used to prop up tax revenue for the budget (if prices are too low). This approach mirrors the 2013 decision to link gas transportation tariffs to gas MET rates (i.e. combining what should be separate fiscal and regulatory decisions in one law), which has brought nothing but stalemate to the now all-but-forgotten reform of the Russian gas sector. Market reality will bring new challenges, and we can expect the formulas will continue to evolve. Will we see 30 parameters becoming 40 or 60? The case in point is the yet-to-be-approved initiative to further increase MET rates to compensate for the proposed amendments to the damper mechanism, discussed on pages 162-163. This mechanism has already shown the increasingly more complex and less predictable tax regime, which requires simplification. Deputy prime minister Kozak has said that the government will take stock of existing tax regulations and exemptions in 2019, although there have been no concrete initiatives as of the date of this report.

150