Subsoil User’s Liability: Three Case Studies. VI Investors’ Voice Magazine: Oil and Gas Kazakhstan 2016: Strategies for the Future
This article concerns several interesting cases from the Signum Law Firm’s recent practice. At first glance, they appear to be common cases involving environmental damage compensation, damages from inappropriate mineral resource usage, and income owed from gas production. However, they all have certain common elements. This does not claim to be an objective, comprehensive analysis. We hope that the information on current court practices will be helpful when similar disputes arise.
CASE STUDY 1: Compensation for Environmental Damage from Mineral Resource Production
Introduction
The client’s deposit infrastructure development provides for oil platform construction, as well as for construction of associated access roads. In order to carry out this construction, the client hired contractors.
The work included sub-grade flooring and subsequent soil compaction and graveling. The project documentation stipulated use of either imported soil or “local” soil from side thrusts for the sub-grade compaction. During construction, the land was leveled (any protruding areas were leveled , and any concave areas were filled in, using soil left over from leveling the protrusions).
Based on the results of a survey on subsoil user activities, the Ecology Department (ED, or Claimant) filed a claim against the subsoil user asking for compensation for environmental damage caused by unauthorized production of COMR from 2012–2014. The claim is for .9 bln. tenge.
Claimant’s Position
The ED gave the following reasoning for their position:
(1) The contractors used “local” soil for their work, i.e., they produced COMR without a permit.
(2) ED does not deny that the alleged violation of the law, which resulted in environmental damage, was not perpetrated by the subsoil user himself, but by his contractors. Nevertheless, ED concludes that COMR production was carried out by the subsoil user’s contractors on the subsoil user’s contracted land with the user’s knowledge. They further assert that COMR was intended to meet the user’s needs. As such, ED believes that the subsoil user is responsible for his contractors’ production of COMR.
(3) The unauthorized COMR production resulted in environmental damage.
According to Article 108 of the Environmental Code, an economic assessment of the damage caused by illegal subsoil use has been determined in accordance with the rules for economic assessment of environmental pollution damage (under Resolution №535, 27 June 2007).
In accordance with Paragraph 16 of these rules, an economic assessment of the damages caused by unauthorized COMR production is ten times the COMR’s value. The cost of the COMR is officially based on the average market price for commercial product use (over a period not to exceed a quarter) starting from the date of the violation detection.
Subsoil User’s Position
The subsoil user stated the following:
(1) The damage should be compensated by the person causing the damage. ED does not deny that the subsoil user did not directly remove the soil, and every activity that ED considers be illegal subsoil use was carried out by a third party.
– According to Article 917 of the Civil Code, damages caused by illegal actions must be paid for by the person who caused the damage.
– According to Article 321 of the Environmental Code, the perpetrators of environmental offenses must pay for all the damage they have incurred.
(2) The subsoil user is not liable for actions of a third party, unless those actions were related to subsoil use operations that the subsoil users carried out themselves.
(3) Soil is not COMR. Accordingly, (1) there is no proof of illegal subsoil use; (2) the contractors’ use (removal) of the soil cannot be considered COMR production; and (3) ED was not authorized to calculate damages based on the soil price.
Court Findings
Who is liable for damages?
The court supported the subsoil user’s position regarding liability for damages.
Is the subsoil user responsible for the third party actions in the area specified in the contract?
The court resolved that soil removal by a third party (in the area specified in the contract) does not serve as grounds to hold the subsoil user materially liable.
Furthermore, the court indicated that, in accordance with Article 1,Paragraph 39 of the law “On Subsoil and Subsoil Use” (the Subsoil Law), the contract area is defined by the mining allotment on which the subsoil user has the right to carry out subsoil operations in accordance with the contracts. Consequently, the subsoil user is only responsible for activities related to subsoil use operations, as stipulated by the contract. Therefore, the court finds that the subsoil user shall not be held responsible for the actions of other subsoil users in his contract-specified area.
Can soil be considered COMR?
The court resolved that soil is not COMR. The court justified its finding as follows:
In accordance with Article 16, Paragraph 8 of the Subsoil Law, the list of substances considered to be COMR is determined by the Kazakhstani government. In the surveyed period (2012-2014), the Common Mineral Resources list was being used (as approved by governmental decree №397, 7 April 2011). This COMR list is exhaustive and does not include soil. Therefore, ED was not able to back up their assertion of illegal COMR production as they were unable to prove that COMR was produced.
The court further indicated that economic assessment of environmental damage caused by unauthorized production of COMR is defined as ten times the value of produced COMR, not soil. The court reasonably rejected ED arguments that soil is a composite of COMR.
It should be noted that there are further bylaws that do not list soil as a COMR, and the courts came to a similar conclusion.
Could soil removal be considered mineral production?
In our opinion, the court indirectly confirmed that soil removal cannot be equated with COMR production.
First, as soil is not a mineral, its removal cannot be regarded as production. In accordance with the Subsoil Law, “production” refers to a whole range of operations connected to the extraction of minerals from the subsoil to the surface. Consequently, “production” in this case only covers minerals.
Second, Kazakhstan’s Construction Rules 1.02-19-2007 indicate that building materials used for prospecting should not be subject to the requirements that govern exploration, development, calculation, or assertion of mineral deposit reserves.
It is possible that soil use should, in this case, be considered a construction activity and to some extent a land-use activity, as opposed to being classified as a subsoil use operation.
CASE STUDY 2: Damage Compensation for Excessive Oil Revenue Loss in Situ
For this court case, we would like to briefly describe the arguments of the respondent-subsoil user as presented in a court hearing. This court case was considered from every angle, and the verdict was in favor of the subsoil user.
Introduction
In 2013, Company А produced 100,000 tons of oil at the Zhol Oilfield. The development provided for the extraction of 140,000 tons of oil for that year. Zhol Oilfield’s ORF (Oil Recovery Factor) designed level is 0.25, with approved extractable reserves of 1,500,000 tons.
According to an inspection certificate issued by an authority for studying and using subsoil resources, the ORF performance in 2013 was 0.17 (ORF is calculated as ratio between the produced and projected volumes). Accordingly, divergence from the ORF is subject to compensation, as the extracting company is in breach of subsoil usage rules (calculation: 0.25–0.17=0.08 divergence). Thus, the ORF for the year was 1%=(1,500,000х1)/100=15,000 tons. That leads to a calculation of 15,000 tons х 0.8 = 12,000 tons with an average sale price of 350 US dollars per ton. Accordingly, the damage was tabulated at 5,250,000 US dollars. The authority for studying and using subsoil resources registered a court claim for reimbursement.
Discussion
To check calculation accuracy, what constitutes damage or harm must be established. In order to do that, are a few questions need to be answered:
What is ORF?
What are “excessive losses of oil in situ”?
Is it feasible to calculate and apply ORF to the volume of oil produced within a calendar year?
Will ORF noncompliance within a calendar year result in excessive losses of oil in situ?
Regarding the first question, ORF’s definition is described in the introduction; this definition is valid for natural resources found in deposits. Order No. 283 of the Ministry of Energy and Mineral Resources (27 October 2005) specifies that for oil recovery factors (gas and condensate), the portion of the existing reserves may only be extracted from the subsoil if it fits in with the plan to develop those natural deposits up to their economic efficiency limit, often by using approbated technologies and machinery to extract the oil. In other words, ORF means that oil in the approved geological reserves may only be extracted up to the economic efficiency limit— that is, up to the completion of the field’s commercial development.
Secondly, there is no definition for “excessive losses of oil in situ” in the legislation; therefore, the definition for normative losses of useful mineral resources in the subsoil will be used. This is understood to mean losses technologically related to methods and systems adopted for developing useful mineral resources at extraction, the level of which is based on technical and economic assessments (Article 1, Paragraph 13) of the Subsoil Law. Considering that technical and economic assessments serve as the basis for calculating ORF and that adopted development methods and systems are approved in the pursuit of reaching ORF at the end of the entire field’s economic efficiency, excessive losses of oil in situ mean that parts of the approved oil reserves remain un-extracted at the deadline for the field’s development.
Therefore, regarding the third question, as described above and based on the experience of developing oil and gas fields, the ORF should be calculated for the entire extraction period of a given field; ORF may not be applied within the scope of a particular period (one month, one year, two years, et cetera).
Fourth, based on the facts presented, ORF noncompliance over a year may not be used as proof of an excessive loss of oil in situ since: (1) the definition of excessive loss of oil in situ itself can only be used for the period in which the field operation is completed, (2) failure to reach an adequate production output in a given year does mean that this failure results in loss of overall volume because additional oil may be and will be extracted in the future, and (3) there is no option to calculate subsoil damage in legislation or in practice if there is a failure to cover production liabilities as approved by the work program.
In accordance with Article 917 of the Civil Code, damage caused by illegal actions must be reimbursed by the perpetrator. The above proves absence of harm is a legal fact and damage to the subsoil resources is unproven; therefore, an estimation of the damages is not possible, and the court is obliged to dismiss the claims.
CASE STUDY 3: Appropriate Subsoil Usage Breaches and Calculating Damages
Regulations for assessing the damage caused by noncompliance with appropriate subsoil use and resource legislation were approved by Order of the Minister of Investments dated 27 February 2015, No. 207— hereinafter Regulation No. 207— via references to examples of calculations referred to in the Appendix to Regulation No. 207. The absence of any explanation for the calculations and the use of ambiguous terminology has caused some confusion. Consider this example from Regulation No. 207.
Calculation Example:
The subsoil user produced 2,658,000 tons of oil during the accounting period. During this period, actual oil losses were 4,442 tons, including approved normative losses of 1,081 tons of oil.
The average price at the subsoil user’s oil realization (London Metal and Oil Exchange) for the accounting period was 50.49 US dollars, ie (4,442–1,081) х 50.49 = 169,696.89 US dollars.
Therefore, the calculation is 169,696.89 х (the official exchange rate of the Kazakhstan tenge for a foreign currency as set by the National Bank of Kazakhstan at the moment the damage was revealed) = amount of damage.
Discussion and Conclusions
As you can see, a formula that multiplies the difference of actual losses over normative losses by the average price at the time of the subsoil user’s oil realization (London Metal and Oil Exchange) during a given accounting period is used to estimate damages when a case is filed.
First, using the term “average sale price” is imprecise. Which sale price does this refer to—the subsoil user’s average weighted price for the last year, or for the last six months? Or, could it be a more definite period?
Second, to what extent are the applied prices grounded, fair, or objective? A number of subsoil users sell oil on the domestic market where the price is significantly lower than sale prices for exported oil. Obviously, when comparing the overall financial damages suffered from selling oil on the local market versus exporting oil, the exporter will bear less of a financial burden than the one exporting oil.
Third, there is a notation in parenthesis: (London Metal and Oil Exchange), as well as in the text in Paragraph 6 of Regulation No. 207 which states, “For useful mineral resources with official quotation prices, their average cost for the accounting period shall be used.” It is uncertain whether the use of quotations is mandatory or stylistic.
Fourth, when using quotations, should the difference in a reduction in price be applied? In other words, are quotations [necessary] for oil subject to their price in a particular world market segment, in which in order to supply oil, a subsoil user or a buyer will incur significant expenses? These costs start from the subsoil user’s well to its arrival on the world market, at which point the quotations are fixed. Are the current prices in the region considered?
In order to convert the calculation into the national currency, what date is the date on which the damage was revealed? Some breaches require certain future conditions for the damage to be acknowledged. In practice, the authorities indicate conflicting dates: an inspection certificate date, the year-end during which losses were specified, etc.
In conclusion, we’d like to stress that these examples show only one difference between actual losses and normative losses. They show lack of a specific calculation procedure, diverging in the cases of excessive formation oil losses, excessive gas burning losses, etc. Therefore, the examples disregard the extent and scale of damages caused to subsoil resources. Furthermore, it fails to highlight the environmental importance of these damages.
Subsoil users engage in various disputes and conflicts with government agencies resulting in ambiguous and inconsistent law enforcement practices in different regions. In this article we have presented recent case studies that we believe are the most interesting and topical. We are very pleased by the success rate of rulings in favor of subsoil users.
We hope that the creation of an investment court will allow consideration of cases with the participation of subsoil users whose disputes are mainly within the jurisdiction of the investment court. Moreover, the creation of this court will provide clear conditions for subsoil users’ work, taking into account the specifics of their activity and projects.
Information contained in this Client Update is of general nature and cannot be used as legal advice or recommendation. Please note that Kazakhstan is an emerging economy, and its legislation and legal system are in constant development. Should you have any questions or want to discuss matters addressed in this Client Update, please contact us.
