Russia: The Last Frontier?

Take one look at a map of the vast, largely untapped land mass that is Russia, and the country’s staggering mineral potential becomes obvious.

However, not too many mining companies are rushing to take advantage of this potential. Memories of the harsh treatment of oil multinationals Royal Dutch Shell (RDS. A-N) and BP (BP-N) in the hands of the Russian government are still fresh. After acrimonious disputes, the two companies were forced to cede interests in large oil projects.

And former Yukos CEO Mikhail Khodorkovsky, currently serving eight years in prison on fraud and tax evasion convictions — his prosecution largely seen as punishment for his standing up to then-president Vladimir Putin — is facing now new charges that could extend his sentence.

Aimed at addressing these and other fears that miners may have regarding working in Russia, the Canada-Russia Mining Conference was held during the Prospectors and Developers Association of Canada (PDAC) convention in Toronto in March. Organized by the Canada Eurasia Russia Business Association (CERBA), which promotes trade and investment between the three regions, the message that emerged was that despite its risks, Russia offers considerable investment opportunities in the resource sector.

The Russian government, for its part, is doing its best to attract investment dollars to the sector, and the Russians’ presence at the conference was clearly aimed at presenting the investment case to foreign mining companies.

Presenting the legal framework governing foreign investment in the resource sector was a senior Russian official, Denis Khramov, director of the department of state policy and regulation in geology and subsoil use in Russia’s Ministry of Natural Resources and Ecology.

Khramov set the stage by pointing out that Russia has sizable resources in coal, diamonds, palladium and nickel. Gold and silver resources are also substantial.

Strategic Sectors Law

Last May, Russia introduced the law of the strategic sectors, which regulates foreign investment and the acquisition of stakes in Russian strategic industries. With mining considered a strategic sector, investment in the sector is regulated by the new law.

Under the law, an acquisition of more than 5% of the shares in a company in the natural resource sector by foreign interests requires notification to the government. Advance government approval is requred when foreign interests acquire a majority stake in any company in the sector.

When the resource is considered strategic, as is the case for diamonds and uranium, for example, advance government approval is required prior to acquiring a stake greater than 10% in the Russian company, or when increasing a stake that is already greater than 10%.

Advance government approval is also required for any transaction or agreement to establish or acquire a voting control or de facto control by foreigners of a strategic resource or company.

One of the most onerous, and controversial, provisions in the strategic law concerns what happens when an exploration company discovers a resource deemed strategic. Any deposit of nickel, cobalt, tantalum, beryllium, lithium, platinum, niobium, uranium, diamonds, rare earths or high-purity quartz, regardless of size, is considered strategic.

A deposit exceeding 50 tonnes gold or 500,000 tonnes copper is also considered strategic, as is a deposit near a defence installation or in a frontier area. Oil fields with more than 70 million tonnes and gas fields with more than 50 billion cubic metres, or offshore gas fields, are also strategic.

Should an exploration company discover such a deposit, the Russian government may expropriate the deposit, but this is not automatic.

“I emphasize that the government may take a decision not to terminate the exclusive licence,” Khramov said.

And what does the company get for the expropriated minerals? The government will pay back the cost of exploration, plus a reward. The law does not specify the size of the reward, but Khramov assured delegates that it would be considerable.

“The amount of such reward, which is extra to the compensation, is being discussed by the government,” Khramov said.

He stressed that the law is not intended to deny access to resources.

“The main idea of the law in the field of strategic resources is to establish clear rules in terms of production licence and termination, and to guarantee fair reward that should compensate for investments and access restrictions to strategic resources.”

Another option is for the foreign company to participate in the development of the strategic resource as a minority partner, with a Russian company as a majority partner and operator.

While mining companies are unlikely to be satisfied by such vague assurances of fair compensation when a deposit is expropriated, or by the prospect of playing second fiddle as a junior partner to a local operator, Khramov said that the legal regime for foreign investors might be improved.

On the positive side, the law seems to imply security of tenure where the resource is not deemed strategic, and if a company is in line with its licence.

The strategic law does not apply to transactions completed before the law was enacted, nor transactions governed by a special law or treaty.

A company wishing to be granted government approval for an acquisition has to file an application with the Federal Anti-monopoly Service (FAS). Approval is subject to agreement of the Commission for Control over Foreign Investments, headed by Prime Minister Vladimir Putin. The process typically takes up to three months, provided the application is prepared correctly, but can take up to six months.

Sometimes approval is conditional. For example, the mining company may be required to refine or process the minerals in Russia.

Falling investment

Russia’s interest in attracting foreign mining investment is understandable, but the urgency felt by Russia is underscored by the fact that private exploration investment declined to 115 billion rubles last year ($4.3 billion at today’s exchange rate) from 144 billion rubles in 2007.

“This threatens our plans regarding exploration and development of natural resources,” Khramov says. In turn, this also makes it difficult for the Russian government to meet its targets for economic growth and social development.

This fall-off in investment is happening against a backdrop of a shrinking domestic economy. The Organization for Economic Cooperation and Development (OECD) is forecasting that Russia’s gross domestic product will contract by 5.6% this year, and according to a projection by the National Post, industrial production will fall by 15.9% in 2009, while exports will decline by 18%.

The global financial crisis is one major cause for the falling investment in exploration, but Khramov also blames deficiencies in the tax system, which does not stimulate exploration.

Another negative is the lack of incentives for regions to develop resources, since the federal government, and not the regional government, owns the resource and controls mining. Excessive and complicated bureaucracy does not help.

The government is working to address these negatives. On the tax front, it is introducing tax credits and tax deductions for exploration expenses. It is introducing incentives to encourage regions to invest in exploration, and it is working to improve the legal framework for subsoil use, while simplifying administration and bureaucracy.

The government is also working with two consultative groups made up of foreign companies: the Foreign Investment Advisory Council, and the Petroleum Advisory Forum, in order to improve the legal and administrative regime for mining.

The Russians are receptive to ideas of foreign companies on natural resources. “We will make our investment planning more favour-able to foreign investors,” Khramov said. But
while improving the subsoil legislation, the government will maintain Russia’s national interests.

Khramov’s department runs regular auctions and tenders for exploration and mining projects, and interested companies can bid. But Khramov suggested that bidders may seek local partners in advancing projects.

Beside the strategic sectors law, there are a number of other laws that govern mining, for example the subsoil law, as well as other laws and regulations, and, of course, mineral extraction tax.

“If you want to discuss specific issues, (you are) welcome in Moscow. We are ready,” Khramov concluded.

–Next week: Part 2.