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Afghanistan's natural resources need investment

As Kabul offers the oil industry exploration acreage in the north of the country, Richard Devine and Ana Severova* look at the legal and other challenges facing potential investors

Afghanistan is once again approaching a critical juncture. Two significant milestones are scheduled for 2014: the next presidential election and NATO’s withdrawal of all of its combat troops. Both events are likely to affect Afghanistan’s course, but neither will change the critical need for significant investment in social infrastructure.

Afghanistan is seeking to address this need by attracting foreign investment into its natural resources sector. The US Geological Survey (USGS) estimated in 2006 that northern Afghanistan has undiscovered technically recoverable crude oil reserves of 1.6 billion barrels, comparable to those held by Equatorial Guinea, and 15.7 trillion cubic feet of undiscovered technically recoverable natural gas. Apart from hydrocarbons, a September 2011 USGS study estimated that Afghanistan has more than $900bn worth of mineral reserves including coal, gold, copper and rare earth elements.

The Afghan Ministry of Mines awarded its first hydrocarbon exploration and production sharing contract (EPSC) in late 2011 for the Amu Darya basin. In a key moment for the country, production from Amu Darya has recently begun.

The ministry is currently running its second hydrocarbon licensing round, which has generated interest from a number of international oil companies, including ExxonMobil. The ministry recently announced that it has selected a consortium of three international companies and a local Afghan partner as the preferred bidder.

Bidders compete on the basis of their proposed royalty rate and exploration programme. Where there is a tie between two bidders, the Hydrocarbons Law provides that the contract will be granted to the bidder with an Afghan partner. It is notable that the Amu Darya EPSC was won by a joint venture between China National Petroleum Corporation and and Afghan company Watan Oil and Gas. In its efforts to emphasise the transparency of the process, the Amu Darya EPSC has been published on the ministry’s website.

The Amu Darya EPSC is a typical production sharing contract with the winning contractor) bearing the risk of exploration. Certain features of the EPSC are particularly beneficial to the contractor. Under the Amu Darya EPSC, the first 15% of hydrocarbons produced are allocated to the government as royalty. Unless the government notifies it otherwise, the contractor is deemed to have purchased the government’s royalty oil at a prescribed formula price. The Amu Darya EPSC does not have different royalty rates for oil and natural gas. Similarly, there is no distinction between royalty rates for oil and gas in the Afghan-Tajik tender documents, although costs and revenues of non-associated natural gas projects will be ring-fenced from other costs and revenues.

It is a significant advantage to the contractor that the Amu Darya EPSC does not limit cost recovery to a certain percentage of available hydrocarbons. In this regard, the EPSC compares favourably to other PSCs in the region, such as Kurdistan PSCs which typically have a limitation on cost recovery of 40% for crude oil and 50-55% for non-associated gas.

The ministry’s profit share ranges from 50% to 70%, depending on an R-Factor (which is calculated on the basis of the contractor’s aggregate income divided by its aggregate expenditures on petroleum operations). In comparison to the allocation of hydrocarbons typically found in the Kurdistan PSCs, such terms are relatively generous to to the contractor.

Another interesting feature of the EPSC is the limited right of the gov- ernment to participate – the Ministry has no participating interest nor any back-in rights.

The Amu Darya EPSC provides for disputes to be settled by arbitration by the World Bank’s International Centre for Settlement of Investment Disputes (ICSID). The ICSID Convention provides important protection for investors through its limitations on the ability of host states to invoke immunity and court intervention in the arbitral process, and because it provides for the direct enforceability of a final arbitral award in favour of the foreign investor.

Given the country’s history, Afghanistan does not have a significant recent track record on foreign investment. To its credit, the country does have specific oil and gas legislation, both the Hydrocarbons Law and the Hydrocarbons Regulations were promulgated in 2009. The country is also taking steps to develop the institutions responsible for regulating the oil and gas industry.

Moreover, the government has recently proposed amendments to the Hydrocarbons Law with the intention of simplifying the licensing procedures and creating a more investor-friendly environment. The proposed amendments will also address unitisation and improve the terms applicable to the commercialisation of gas discoveries. While the revisions were initially rejected by the Afghan cabinet, they may still be implemented in time to apply to the contracts awarded by the Afghan-Tajik tender.

Afghanistan also has an Environment Law of 2007, which grants monitoring and enforcement powers to the National Environmental Protection Agency (NEPA). NEPA, together with the Environmental Protection Department of the Ministry, is responsible for ensuring compliance with environmental laws.

Afghanistan has (as yet, largely untested) bilateral, multilateral and domestic protections for foreign investors.

Afghanistan has entered into bilateral investment treaties (BITs) with Turkey, Germany and the Islamic Republic of Iran. These BITs offer dispute resolution mechanisms to qualifying investors as well as important investment protections. Afghanistan is also a full member of the South Asia Free Trade Area and the Organisation of The Islamic Conference’s Agreement on the Promotion, Protection and Guarantee of Investments, which provides certain protections for foreign investors.

With respect to domestic law, foreign investors generally benefit from Afghanistan’s Private Investment Law. However, investments in the natural resources sector need to be approved on a case-by-case basis and the government can apply terms that are more or less favourable than the terms applied to investments in other sectors.

Nonetheless, the Hydrocarbons Law contains provisions for protection of investors in the hydrocarbon sector. Contractor’s rights under hydrocarbon contracts and its assets (including its share of hydrocarbons) may not be expropriated directly or indirectly, except if authorised by a law and in times of public necessity. If the government expropriates, it must pro- vide fair compensation in accordance with principles of international law.

QEITs are also exempt from the business receipt tax and are eligible for accelerated depreciation and full carry forward of losses.Corporate entities in Afghanistan are generally liable for corporate income tax at a rate of 20% applied to income and a business receipt tax applied to gross revenue. However, a contractor under an EPSC will be treated as a qualifying extractive industries tax-payer (QEIT) under the Income Tax Law 2009. A QEIT has the option to stabilise income tax at a rate of 30% for the entire term of the EPSC, thereby insulating itself from any subsequent changes to income tax laws in Afghanistan.

Afghanistan is a dangerous, landlocked and mountainous country, which makes transportation solutions difficult and expensive. According to the ministry’s website, "no oil pipeline exists in Afghanistan other than the 3km, 6-inch line from Angot to the bottom of the hill nearby".

There is a very limited network of gas pipelines and only one oil refinery near the border with Uzbekistan. Save for a limited railroad route in the north, Afghanistan has never had a functioning rail network. As a result, investment in Afghanistan’s infrastruc- ture is critical.

The much discussed Turkmenistan- Afghanistan-Pakistan-India pipeline could, if constructed, diversify markets for Afghan gas. A potential alternative (or additional) pipeline from Turkmenistan via northern Afghanistan and Tajikistan to China has been recently discussed by the Afghan and Chinese governments.

Investment in the country’s infra- structure is related to the issue of security. Despite the recent surge in attacks, NATO has repeatedly reiter- ated its commitment to train and have Afghan forces fully in charge of security by 2014.

Nevertheless, while the govern-ment does provide a level of protection through its Mining Protection Unit, contractors will likely face challenges in securing their investments.

With the international interest generated by the hydrocarbon and mineral bid rounds on the one hand, and the worsened security situation in Afghanistan on the other,

Afghanistan’s position as the next frontier country ripe for investment hangs finely in the balance. It is hoped that with continued international support and the planned infrastructure improvements, things should be moving in the right direction for Afghanistan.

Ultimately, Afghanistan’s success will depend on its stability following the withdrawal of the NATO troops and the amount of international investment that Afghanistan manages to attract – two highly interrelated issues.

*Richard Devine is a partner in the Dubai office of Fulbright & Jaworski

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