The unconventional hydrocarbon resource boom that hit the US and Europe had gone relatively unnoticed in Russia until recently. Ignoring the world’s fascination with the potential of unconventional resources, Russia repeatedly downplayed their importance and maintained its focus on the development of its rich conventional reserves.

That was until in the Fall of 2012 when Russia suddenly re-engaged in intensive drafting of legislation on tax incentives for tight oil. The proposed tax incentives are rumored to have been an off-spring of the burst of Arctic deals between Rosneft, the state oil company, and foreign investors.

While the political will appears to be behind the legislation and the economic benefits are promising, the question, however, remains whether this reform will grow into a comprehensive regulation for unconventionals in Russia or remain a one-time, partial solution as a piece of the larger Arctic deals.

Russian Legislation: The First Attempt

Although Russia has acted outwardly coolly to unconventional development, the 2012 drafts are not the Russian legislature’s first attempt at tackling the economic hurdles of unconventional development. The first attempt to establish regulations dates back to 1998 when Russia introduced certain economic incentives to encourage the development of tight oil. The 1998 measures provided for tax relief with respect to oil reserves qualifying as “hard to extract.” The determination as to whether an oil reserve was “hard to extract” was made by the State Reserves Committee on a case-by-case basis upon an application from a subsoil user. In reaching its determination, the State Reserves Committee relied on certain, non-exclusive “temporary criteria for qualifying oil reserves as hard to extract” developed by the Ministry of Natural Resources for that purpose.

However, the 1998 measures were abolished by 2002 in the course of tax reform that replaced various mandatory payments related to subsoil use by a unified mineral extraction tax. Since then there were not any significant legislative developments with respect to Russian unconventional reserves until the end of 2012.

Russian Unconventionals: Lost in the Fog

The lack of legislative development with respect to unconventional reservoirs in Russia creates a number of obstacles for the potential development of these high-cost plays. Among other things, at the most basic level, Russia does not have a commonly agreed legal definition of what constitutes an unconventional reserve. It has remained largely debated whether such definition should be based on geological, technological, or economical criteria. In the absence of a general definition, Russian legislation relies on various criteria, which differ in their interpretation of what resources should be treated as unconventional.

For example, the Russian PSA Law, adopted in 1996, provides that a product sharing agreement can be granted, among other things, “when development of a field requires application of special costly technologies for extraction of significant volumes of hard to extract subsoil reserves in difficult geological conditions.” Nevertheless, while the PSA Law provides this possibility, this definition has never been put into use for an unconventional reservoir development. All product sharing agreements currently in operation in Russia were granted for conventional reserves prior to the PSA Law’s entrance into force.

Furthermore, in many cases, these “difficult” reserves have not been recognized as recoverable reserves and, therefore, are not included in the State’s official calculation of national reserves. In such case they are not included as “discovered” reserves in the individual subsoil licenses for blocks in which the unconventional reserves are located. This means that the respective subsoil license holders do not have the right to develop such reserves until they go through the process of exploration and discovery. In order to develop such unconventional reserves that not included in the State's calculation of reserves, a subsoil user must provide detailed evidence of a reserve’s existence to State authorities and apply for their registration in the State balance of reserves, which requires (i) an expert opinion of a special commission within the Federal Agency for Subsoil Use and (ii) a formal decision of the Federal Agency for Subsoil Use on inclusion of reserves in the State balance of reserves.

In addition, as unconventional reserves are not legally differentiated from conventional reserves, it makes it difficult to split rights for the development of conventional and unconventional reserves. Such an option might be desirable during the licensing process or after a subsoil license is issued if the company holding the subsoil license would like to diversify the cost and risk of developing the unconventional reserves by partnering with other companies, while maintaining its sole right to develop the conventional reserves in the license area.

Russian Legislation: The Recent Events

In 2012 the Ministry of Finance produced a draft law that establishes tax breaks for development of fields with tight oil. The tax breaks have been elaborated in pursuance of an order issued by then-Prime Minister Vladimir Putin in May 2012, that directed the development of a package of stimulus measures for unconventional oil. The provision of tax breaks for fields with tight oil was the centerpiece of the package. The draft law is now being reviewed and discussed among various Russian ministries. The draft law was initially targeted to enter into force in mid-2013; however, Prime Minister Dmitry Medvedev indicated at the latest economic forum in February 2013 that it is now expected to come into force no earlier than the end of 2013.

The announced tax breaks envisage lower subsoil use tax rates for mineral extraction tax. The fields are to be divided into three categories as per the level of oil viscosity and rock permeability. The draft currently envisages that for the most “difficult” fields, a subsoil user will be accessed from 0% to 10% of the total mineral extraction tax; for the “mid-range” fields, a subsoil user will be accessed from 10% to 30% of the total mineral extraction tax; and for the “easier” fields, a subsoil user will be accessed from 30% to 50% of the total mineral extraction tax. The tax breaks are to be awarded for ten, seven, and five years respectively starting from the field’s date of commercial production.

Catching Up: Environmental and Technical

Despite the legislative obstacles, in addition to the sheer size of Russia’s potential unconventional reserves, one advantage that Russia has over many other regions with unconventional reserves (such as Europe) is that its unconventional reserves are located mainly in vast, undeveloped, and unpopulated acreage and are primarily owned by the State. Therefore, the town hall proceedings and lease negotiations with hundreds to thousands of individual land owners that often occurs in unconventional developments in the U.S. and Europe will be less of a challenge for unconventional development in Russia.

With respect to the environmental challenges and movements surrounding unconventional development, Russia has used hydraulic fracturing (fracking) for many years for the extraction of conventional oil reserves. While fracking, in general terms, is occasionally referred to in Russian industrial safety and labor safety regulations, no legal definition or specific requirements are established by Russian law in this respect.

To date there have not been any legislative initiatives announced with respect to establishment of special regulations for fracking in Russia. However, if unconventional development becomes more wide-spread in Russia, we would anticipate that a debate around the need to regulate fracking operations would occur in Russia as it has been elsewhere in the world.

However, before fracking operations of a large unconventional development can become wide-spread in Russia, the industry will need to resolve a question as to where to source the equipment. There are a number of international and Russian oil field service companies active in Russia; however, the current equipment inventory in Russia is unlikely to meet the demand of a large unconventional development (let alone the possibility of more than one unconventional development).

With these needs in mind, due to the planned development of the Arctic and Russia’s unconventional resources on the horizon, the Russian government has initiated the development of legislation to establish greater domestic equipment manufacturing capacity and ensure growth in the oil field sector. However, this legislation is still in relatively early stages of development and short-term needs will likely need to be sourced from equipment manufactured outside of Russia.

Will Russia’s Unconventionals come out of the Fog?

Although implementation of Russian legislation governing unconventional resource development still has a way to go, this initiative is regarded by many as evidence of a new trend in State policy encouraging the development of unconventional reserves. That being said, Russia’s primary focus has been on tight oil reserves and there has been no visible legislative developments with respect to the potential development of Russian shale gas reserves. So it appears that Russia’s shale gas is likely to stay outside Russia’s unconventional play at least in the near future.