The Legal Aspects of Hydrocarbon Production in Accordance with the Product Sharing Agreements Within Ukraine’s Exclusive Economic Zone

Bohdan USTYMENKO, M.J., Attorney at Law
Tetiana USTYMENKO, S.J.D., professor,
Department of Civil Law and Procedure
National Academy of Internal Affairs

Recent geological, geophysical and drilling operations in various regions have proved the offshore areas and continental slopes to host a wide range of mineral resources, including oil and gas, thus, confirming both the feasibility and the economic value of shelf exploration [1]. In particular, exploration of the Ukrainian shelf of the Black and Azov seas has yielded considerable mineral reserves, including up to 1583.5 billion cubic meters of natural gas and up to 409.8 million tons of crude oil, or more than 30 percent of Ukraine's total hydrocarbon reserves. At the same time, only 4 percent of them have been extracted, compared to almost 70 percent of the explored coastal hydrocarbon deposits.

Meanwhile, taking into account Russia’s propensity for anti-competitive practices and monopoly schemes, one of its reasons for occupying Crimea was getting access to the peninsula’s energy resources. The earlier forecasts of the American IHS CERA consulting firm on Ukraine’s prospects in traditional and non-traditional natural gas production clearly hadn’t gone unnoticed in the RF. According to the IHS CERA, by 2030, Ukraine could reach the mid-1970s gas production levels, which meant that besides fully meeting the domestic demand, the country would be able to export natural gas to Central and Eastern Europe, thus, squeezing out the Russians. The northwestern sector of the Black Sea between Crimea and Odessa region was believed to be particularly promising — the assumption reaffirmed by ExxonMobil and OMV’s successful offshore explorations of the neighboring Romanian sector [3, p. 152].

Needless to say, energy security is given special attention in the current National Security Strategy of Ukraine [4].

As far back as 1996, the Cabinet of Ministers of Ukraine (CMU) approved the Program of Development of Hydrocarbon Resources of the Ukrainian sector of the Black and Azov Seas [5]. However, given the current occupation of not only Sevastopol and the Autonomous Republic of Crimea, but also, the waters around the Crimean peninsula, the Program certainly calls for an update.

In the meantime, let’s take a closer look at the provisions of international maritime law in the area of sovereign rights and the jurisdiction of a coastal state over the extraction of minerals, including hydrocarbons, within its exclusive economic zone.

Article 56 of the United Nations Convention on the Law of the Sea [6] (UNCLOS) states that in its exclusive marine zone (hereinafter referred to as the EEZ), a coastal state, inter alia, has sovereign rights over the exploration, development and conservation of both living and non-living natural resources in the waters covering the seabed, on the seabed and in the subsoil, as well as over the management of these resources. In addition, according to the relevant UNCLOS provisions, within its EEZ, the coastal state has jurisdiction over the construction and use of artificial islands, installations and structures, marine scientific research, protection and conservation of the marine environment, as well as other rights and obligations under the Convention.

At the same time, Article 50 of UNCLOS stipulates that in its EEZ, the coastal state has the exclusive right to construct, authorize and regulate the construction, operation and use of:

• artificial islands
• installations and structures for the purposes provided for in Article 56 and
• other economic needs
• installations and structures which may interfere with the exercise of the
• rights of the coastal state in the EEZ.

Also, the coastal state has exclusive jurisdiction over such artificial islands, installations and structures, including jurisdiction with regard to customs, fiscal, health, safety and immigration laws and regulations. Artificial islands, installations and structures do not possess the status of islands. They have no territorial sea of their own and their presence does not affect the delimitation of the territorial sea, the exclusive economic zone or the continental shelf. (Article 60, Paragraph 8, UNCLOS).

Meanwhile, on the basis of UNCLOS, Ukraine has adopted its own legislation in regard to the EEZ. Thus, in accordance with the provisions of Article 4 of the Law of Ukraine On the Exclusive Marine Economic Zone [7], in its EEZ Ukraine has:

• sovereign rights for the exploration, development and conservation of the living and non-living natural resources in seabed and subsoil waters, as well as for the management of those resources and other economic exploration and development activities in the designated area, including the production of energy through the use of water, currents and wind
• jurisdiction provided for by the relevant provisions of the Law and the rules of international law for the creation and use of artificial islands, installations and structures, carrying out marine scientific research and protection and conservation of the marine environment
• other rights provided by the Law, other legislative acts of Ukraine and generally recognized norms of international law.

The sovereign rights and jurisdiction of Ukraine regarding the seabed of the exclusive (marine) economic zone and its subsoil are implemented in accordance with the legislation of Ukraine regarding the continental shelf and the Subsoil Code of Ukraine. For instance, Article 411 of the Economic Code of Ukraine [8] (hereinafter — the EC of Ukraine) also stipulates that in the marine EEZ of Ukraine, the state has exclusive right to construct, authorize and regulate the construction, operation and use of artificial islands, installations and structures for marine scientific research, exploration and development of natural resources and other economic purposes in accordance with the legislation of Ukraine.

Furthermore, Ukraine has adopted the Law on Product Sharing Agreements [9] (hereinafter — the Law on Product Sharing Agreements) that aims to create favorable conditions for investing in the prospecting, exploration and extraction of minerals, including hydrocarbons, within the territory of Ukraine, its continental shelf and the exclusive (marine) economic zone on the basis set out in the product sharing agreements. The Law regulates the relations arising in the process of conclusion, execution and termination of Product Sharing Agreements and defines the basic legal requirements for such agreements, as well as the specifics of legal relations regarding the use of subsoil under the conditions of product distribution (part two of Article 2 of the Law on Product Sharing Agreements). Relations arising in the course of prospecting, development and extraction of minerals, distribution of the resulting products, their transportation, processing, storage, processing, use and sale or disposal thereof in any other way, as well as construction and operation of related industrial facilities, pipelines and other infrastructure are governed by the product sharing agreement concluded under this Law (part two of Article 2 of the Law on Product Sharing Agreements).

Additionally, Article 4 of the Law on Product Sharing Agreements stipulates that in accordance with the product sharing agreement, one party — Ukraine (hereinafter — the state) — entrusts the other party (the investor) with prospecting, exploration and extraction of minerals in a certain area(s) and maintenance of contract-related work for a specified period, while the investor undertakes to perform the work entrusted at his own expense and at his own risk, with subsequent reimbursement of expenses and remuneration in the form of a product share. Part two of the said article stipulates that a product sharing agreement may be bilateral or multilateral, that is, several investors may be parties to it, provided that they are jointly liable for the obligations under such an agreement.

The state ensures and facilitates that the investors, including the agreement operators, their representatives, contractors, subcontractors and other involved organizations/persons, representatives of foreign contractors, subcontractors and their related organizations/persons obtain the respective quotas, subsoil permits and licenses for prospecting/exploration and exploitation of mineral deposits, mining permits, documents certifying the land rights and licenses related to the use of subsoil, the execution of works and the construction of structures provided for in a product sharing agreement (part three of Article 4 of the Law on Product Sharing Agreements).

The parties to the product sharing agreement are the investor(s) and the state represented by the CMU. For resolving issues related to the organization and conclusion of product sharing agreements, the CMU establishes a permanent interdepartmental commission (hereinafter — the Interdepartmental Commission) composed of the representatives of state and local self-government bodies and people's deputies.

The first paragraph of part 1 of Article 6 of the Law on Product Sharing Agreements stipulates that product sharing agreements under the Law may be concluded in respect to individual subsoil area(s) with clear special boundaries and coordinates, that contain mineral deposits or parts thereof of national and local importance, including subsoil areas within the continental shelf and the marine EEZ of Ukraine.

In accordance with part two of Article 6 of the Law on Product Sharing Agreements, an investor may apply to the CMU or the Interdepartmental Commission with a proposal to resolve an issue concerning the tender for concluding a product distribution agreement for a particular subsoil area. The investor has to be notified of the consideration results within three months.

The product distribution agreement tender contest in regard to a particular subsoil area must be conducted in accordance with paragraph 2 of part two of Article 6 of the Law on Product Sharing Agreements when any of the following is present:

• despite the mineral deposit site having a high yield potential, continuing the mining would entail losses for the users and the state, while its conservation or liquidation may have harmful social and financial/material consequences
• lack of state funding and technical capacity for the development of new large mineral deposits at the levels necessary for Ukraine’s social development and economic security
• the need for expensive specialized technology for developing the highly concentrated difficult to extract or residual mineral deposits, and for preventing losses of fuel and mineral raw materials
• the need to supply the regions with their own fuel and energy resources and create new jobs in the low-employment areas
• the need to introduce the latest technology and equipment for ensuring effective prospecting, exploration and mining of the underdeveloped mineral concentrations
• the need for developing mineral deposit fields in particularly difficult conditions, such as marine areas, fields with difficult to extract or depleted reserves or those located in the areas with undetermined hydrocarbon potential
• the need for additional or advanced subsoil exploration.

The distribution agreement must be concluded with the bidding winner and take into consideration the bidding conditions and the winner’s tender offer, while in the cases stipulated in paragraph 15, part one of Article 7 of the Law on Product Sharing Agreements — with the bidding winner and the entity specified in the paragraph (company). The contest is deemed to have taken place if at least one person/entity has applied for participation in the event, provided that he/it fulfilled all of the bidding conditions. The contest is deemed to not have taken place if there has been no applications for participation or if the CMU has not determined the winner (part six of Article 6 of the Law on Product Sharing Agreements).

The CMU’s decision to conclude an agreement without a bidding contest may be made on the basis of:

• a written request (application) of the subsoil user to the Interagency Commission with a proposal to conclude a bilateral or multilateral product sharing agreement with attached confirmation of the applicant’s legal status, financial capacity, special permit(s) for subsoil use and other relevant information
• Interagency Commission proposals on the prospects of concluding a product sharing agreement. A product sharing agreement may be concluded without a bidding contest on the decision of the CMU and the local self-government body on the areas of low mineral deposit concentrations, as confirmed by the relevant state authorities (part five of Article 6 of the Law on Product Sharing Agreements).

According to Article 7 of the Law on Product Sharing Agreements, within two months from the date of the decision to hold the bidding contest, the Interdepartmental Commission must publish the contest announcement in Ukraine’s official printed media and undertake other steps towards organizing the contest, within its competence as determined by the CMU. The contest term should not exceed three months from the bidding offer submission deadline.

The product sharing agreement must define a list of investor’s activity areas, a plan of required works with specific execution terms, amounts and types of financing, equipment and other indicators that cannot be below what has been specified in the tender offer, as well as other essential conditions (paragraph 1 of part two of Article 8 of the Law on Product Sharing Agreements). Part five of Article 8 of the Law on Product Sharing Agreements specifies that a product sharing agreement must stipulate an investor's obligation as to:

• giving preference to products, goods, works, services and other material values of Ukrainian origin, provided that their price, terms, quality and compliance with international standards are competitive
• per the needs specified in the agreement, for the works in Ukraine, hiring mostly citizens of Ukraine and facilitating their training to the extent stipulated by the agreement.

Pursuant to Article 9 of the Law on Product Sharing Agreements, the product sharing agreements concluded with respect to the prospecting, exploration and production of hydrocarbons, as well as the use of deposits with significant mineral reserves, except for the conditions specified in Article 8 of the Law on Product Sharing Agreements, must also include the following essential conditions:

• annual reporting on the well production qualities
• procedure for using geological, geophysical and other data
• specifics and procedure of bookkeeping on the relevant industrial and technological expenses
• procedure and terms of assessing the environmental pollution levels in the area of subsoil exploitation — land allocated for the needs related to the subsoil usage — at the time of the agreement conclusion
• environmental measures scope and implementation terms
• procedures for agreeing and approving the work plan, including oil drilling operation plans
• appropriate storage conditions of the state’s share of the extracted minerals before their transfer to the state
• conditions of insuring the property risks, including loss of the extracted minerals due to spilling, flooding or fire
• conditions of exceptional risk during the field development.

If a foreign investor is a party to a product sharing agreement, he is required to register his representative office in Ukraine within three months from the date of concluding the said agreement. If two or more investors are parties to a product sharing agreement, they must designate one investor as the agreement operator for representing their interests before the state. To this end, investors are required to enter into an operating agreement (hereinafter referred to as an operating agreement) that governs the relationship between the agreement operator and other investors (part two of Article 9 of the Law on Product Sharing Agreements). The term of the production sharing agreement is determined by the parties, but may not exceed fifty years from the date of its signing (paragraph 1 of part two of Article 14 of the Law on Product Sharing Agreements).

A special permit for the use of subsoil under the terms of product sharing agreements may be suspended or terminated (including by cancellation) only by the Cabinet of Ministers of Ukraine in the manner and on the grounds provided for in part two of Article 17 (paragraph 3 of Article 17 of the Law on Product Sharing Agreements). The right to use the subsoil while executing a product sharing agreement may be restricted, temporarily banned (suspended) or terminated by the Cabinet of Ministers of Ukraine in the event of an imminent threat to human life or health, or the environment in the manner provided for in such agreement. From the moment the investor amends the conditions that have led to the restrictions of his rights for the subsoil use, these rights become subject to full restoration (part two of Article 17 of the Law on Product Sharing Agreements).

Pursuant to Article 19 of the Law on Product Sharing Agreements, the products under a product sharing agreement are subject to distribution between the agreement parties, namely, the state and the investor(s), according to the terms of the agreement that, among other things, must include the terms and procedure for the transfer to the state of its share of the products in accordance with the agreement terms or its monetary equivalent.

Product sharing agreements for hydrocarbons may provide for the continuous distribution of hydrocarbons produced (paragraph 2 of part two of Article 19 of the Law on Product Sharing Agreements).

At the same time, the quarterly share of compensatory products may not exceed 70 percent of the total output produced during the billing period until the investor's costs are fully reimbursed (part three of Article 19 of the Law on Product Sharing Agreements).

Neither party to the product sharing agreement shall have the right to dispose of the products prior to their division under the agreement without the written consent of the other agreement parties (part four of Article 19 of the Law on Production Agreements). The procedure for determining the costs to be compensated to the investor with the compensatory products is determined by the product sharing agreement and the Law on Product Sharing Agreements (part five of Article 19 of the Law on Product Sharing Agreements).

However, prior to the moment when the products are divided at the measuring point, the state retains the products under the agreement (part one of Article 20 of the Law on Product Sharing Agreements). From the moment the products are divided at the measuring point, the investor acquires ownership of the compensatory products and a part of the profit products per the agreement, while the balance of the products remain the property of the state (part two of Article 20 of the Law on Product Sharing Agreements).

What is also worth noting for investors is that the state guarantees that the rights and obligations of the investor defined in the product sharing agreement will be subject to the legislation in force at the time of the agreement, except for legislation that reduces or abolishes taxes or fees, simplifies regulation of economic activity for prospecting, exploration and extraction of minerals, loosens procedures of state supervision (control) in the economic sector, in particular, those pertaining to customs, currency, tax, etc. or mitigate the investor’s liability applied from the effective date of such legislation. With that, part one of Article 27 of the Law on Product Sharing Agreements also stipulates that guarantees of the legal stability do not extend to the legislative changes in the areas of defense, national security, public order and environmental protection.

In addition, disputes between the parties to a product sharing agreement related to the execution, termination and invalidity of the agreement is subject to review in the courts of Ukraine, unless otherwise provided for in the terms of the product sharing agreement, as defined in Article 31 of the Law on Product Sharing Agreements.

In conclusion, we would like to stress that to create favorable conditions for the hydrocarbon production on the shelves of the Black and Azov seas and ensure Ukraine’s energy independence, the state should:

• beginning in 2020, intensify hydrocarbon production in the Ukrainian sector of the shelves
• in order to fulfill the regulations of the Marine Doctrine of Ukraine for the period up to 2035 approved by the Cabinet of Ministers of Ukraine, in 2020, adopt the Strategy for the development of hydrocarbon resources in the Ukrainian sector of the Black and Azov seas.

References:

1. Pro zatverdzhennya Zagalnoderzhavnoi programy rozvytku mineralno-syrovynnoi bazy na period do 2030 roku: Zakon Ukrainy vid 21 kvitnya 2011 roku № 3268–VI. (On Approving the National Program for Development of the Mineral Resource Base of Ukraine for the Period up to 2030: Law of Ukraine #3268–VI from April 21, 2011), URL: https://zakon.rada.gov.ua/laws/show/3268-17.

2. Pro zatverdzhennya Morskoi doktryny Ukrainy na period do 2035 roku: Postanova Cabinetu Ministriv Ukrainy vid 07.10.2009 r. № 1307 (On Approving the Marine Doctrine of Ukraine for the Period Until 2035: Resolution of the Cabinet of Ministers of Ukraine #1307 from October 7, 2009), URL: https://zakon.rada.gov.ua/laws/show/1307-2009-%D0%BF.

3. Viiny – XXI: Polihibressiya Rosii. - Kyiv: Tsentr globalistyky «Strategiya ХХІ», 2017.- 244 s. (Wars — XXI: Russia’s Polyhybression, Kyiv, Center for Global Studies «Strategy XXI», 2017, p. 244), URL: https://geostrategy.org.ua/images/wars21_UA_19.pdf.

4. Pro rishennya Rady natsionalnoi bezpeky і oborony Ukrainy vid 6 travnya 2015 roku «Pro Strategiyu natsionalnoi bezpeky Ukrainy»: Ukaz Prezidenta Ukrainy vid 26 travnya 2015 roku № 287/2015 (On the Decision of the National Security and Defense Council of Ukraine from May 6, 2015 “On the National Security Strategy of Ukraine”: Presidential Decree of May 26, 2015 No. 287/2015), URL: https://zakon.rada.gov.ua/laws/show/287/2015.

5. Pro programu osvoyennya vuglevodnevykh resursiv ukrainskogo sectora Chornogo i Azovskogo moriv: Postanova Cabinetu Ministriv Ukrainy vid 17 veresnya 1996 roku № 1141 (On the Program of Development of Hydrocarbon Resources of the Ukrainian Sector of the Black and Azov Seas: Resolution of the Cabinet of Ministers of Ukraine from September 17, 1996 No. 1141), URL: https://zakon.rada.gov.ua/laws/show/ru/1141-96-%D0%BF.

6. Сonventsiya Оrganizatsii Оb’yednanykh Natsiy z morskogo prava (ratyfikovana Zakonom Ukrainy «Pro ratyfikatsiyu Сonventsiya Оrganizatsii Оb’yednanykh Natsiy z morskogo prava 1982 roku ta Ugody pro implementatsiyu Chastyny XI Сonventsiya Оrganizatsii Оb’yednanykh Natsiy z morskogo prava 1982 roku» № 728-XIV vid 03.06.1999 r.) (United Nations Convention on the Law of the Sea (ratified by the Law of Ukraine # 728-XIV from June 3, 1999 «On Ratification of the 1982 United Nations Convention on the Law of the Sea») URL: https://zakon.rada.gov.ua/laws/show/995_057.

7. Pro vyklyuchnu morsku (economichnu) zonu: Zakon Ukrainy vid 16.05.1995 r // Vidomosti Verkhovnoi Rady Ukrainy. - 1995 r № 21, stattya 152. (On the Exclusive Marine (Economic) Zone of Ukraine: Law of Ukraine from May 16, 1995. Bulletin of the Verkhovna Rada of Ukraine #21, 1995, article 152.)

8. Gospodarskyi kodeks Ukrainy vid 16.01.2003 r. // Ofitsiinyi visnyk Ukrainy.- 2003 r., № 11, stor. 303, stattya 462. (The Economic Code of Ukraine of January 16, 2003. The Official Bulletin of Ukraine #11, 2003, p. 303, article 462).

9. Pro ugody pro rozpodil produktsii: Zakon Ukrainy vid 14.09.1999 r. (On Product Sharing Agreements: Law of Ukraine of September 14, 1999), URL: https://zakon.rada.gov.ua/laws/show/1039-14.