China Removes Restrictions On Foreign Investment In Upstream Oil And Gas.

On 30 June 2019, China’s National Development and Reform Commission (“NDRC”) and the Ministry of Commerce (“MOFCOM”) jointly issued three lists relating to foreign direct investment in China, namely the Special Administrative Measures for the Access of Foreign Investment (2019) (“Negative List 2019”), the Free Trade Zone Special Administrative Measures for the Access of Foreign Investment (2019) (“FTZ Negative List 2019”) and the Industrial Catalogue For Encouraged Foreign Investment (2019), all of which will take effect from 30 July 2019.

With these updates, China opens up more sectors to foreign investment, including upstream oil and gas (including CBM). The Negative List 2019 has removed the previous restriction that requires foreign investment in upstream oil and gas exploration and exploitation to be in form of equity joint venture (“EJV”) or cooperative joint venture (“CJV”). From 30 July 2019, in principle foreign investors may hold 100% interest in upstream oil and gas blocks in China. In this article, we would like to explore further the practical challenges that may still exist should foreign investors wish to participate into China’s upstream oil and gas sector under the new regime.

Background: Continuing Reforms in China’s Oil and Gas Sector

Traditionally, foreign investment in upstream oil and gas was limited to EJVs or CJVs (“JV Requirement”)1, partnering with legally designated Chinese national oil companies (“Chinese NOCs”). The regulatory regime was mainly set out in the Regulations on Sino-foreign Cooperation in the Exploitation of Onshore Petroleum Resources (“Onshore Regulations”)2 and the Regulations on Sino-foreign Cooperation in the Exploitation of Offshore Petroleum Resources (“Offshore Regulations”)3. The Chinese NOCs are China National Petroleum Corporation (“CNPC”) and China Petrochemical Corporation (“Sinopec”) under the Onshore Regulations4 and China National Offshore Oil Corporation (“CNOOC”) under the Offshore Regulations.

Despite that the Foreign Investment Catalogues (converted into the Negative Lists since 2017) provide for both EJV and CJV as allowed forms for Sino-foreign cooperation in upstream oil and gas, in practice such Sino-foreign cooperation has been in a form of Petroleum Contract (a.k.a. production sharing contract (“PSC”)).

In recent years, China’s upstream oil and gas sector has been undergoing certain reforms aiming at encouraging more participation of private and foreign investors.

The most significant moves include:

• In 2011, the then Ministry of Land and Resources (now the Ministry of Natural Resources (“MNR”)) recognised shale gas a new legal classification as an “independent mining resource” not included in the category of “conventional natural gas”; since then, the MNR launched two rounds of public tender for shale gas blocks but foreign investors were only allowed to participate by forming joint ventures that are majority-controlled by Chinese partners.

• In 2015 and 2017 Xinjiang Province, as a pilot, launched public tenders for conventional oil and gas blocks which were open to Chinese private investors but not foreign investors.

• In 2017, shale gas, shale oil and oil sands were expressly excluded from the JV Requirement.

• In 2018, the FTZ Negative List 2018 removed the JV Requirement for conventional oil and gas (including CBM) for foreign investors in Free Trade Zone.

The removal of the JV Requirement in the Negative List 2019 is in furtherance to the previous continuing reforms. More widely, since it published the Opinions on Deepening the Reform of the Oil and Gas System (关于深化石油天然气体制改革的若干意见) in May 2017, China has launched a number of reforms in the oil and gas sector in both midstream and downstream sectors.

The Implications of the Negative List 2019 and Key Legal Issues

The Negative List 2019 is generally welcomed by the market as a positive signal for China’s further opening up and reform and more opportunities for foreign investors in a fairer business environment.5 However, the pilot projects in unconventional oil and gas sector and in Xinjiang Province in recent years have shown that, the real opportunities for foreign investment after the Negative List 2019 depend largely on the availability of technically and economically viable blocks open to the market. In addition, as we analyse below, foreign investment in this area calls for a clearer regime for the implementation of the new rules from legal perspective.

Under the new regime, the options now available to foreign investors seem to include:

• PSCs or joint ventures with Chinese NOCs6;

• joint ventures with Chinese partners (other than Chinese NOCs);

• wholly foreign owned enterprises (“WFOEs”).

However, as the Negative List 2019 only provides China’s state policy and direction for foreign investment, there remains lack of implementation rules or amendments to existing legislations to address issues on how foreign investors may proceed with their existing and future investments in upstream oil and gas sector under the new regime. We highlight below a few issues which have been arising in our recent practice.

1. Changes to the PSC Regime

The PSCs have been used in China since 1980s, which are not unfamiliar to the international petroleum industry. So far we are not aware of any Sino-foreign cooperation in the upstream oil and gas sector in a form other than PSC7.

In theory, the Sino-foreign cooperation could take a form of EJV (i.e. a joint venture to be set up as a separate and independent legal entity in China). However, as it currently stands, the Onshore Regulations and the Offshore Regulations provide explicitly the Sino-foreign cooperation is in a form of “contract on cooperative exploitation” of onshore / offshore petroleum resources. In addition, under the two Regulations, the Chinese NOCs and other entities authorised by the State Council have the exclusive rights in the Sino-foreign cooperation in the upstream oil and gas sector. The removal of the previous JV Requirement in the Negative List 2019 per se may not provide sufficient legislative ground to address these two issues (let alone foreign investment in a form of WFOEs). In order for any new option to be feasible, either changes to the two Regulations or issue of new legislations will be required.

In addition to the legislative changes, the current widely adopted PSC regime may still dominate given its relatively mature practice in China8. However, we have seen appetite for and efforts to explore EJV as an alternative form of Sino-foreign cooperation. Detailed analysis is required in areas including but not limited to the following:

Cost recovery and profit sharing

One of the key features of the PSC regime is the cost recovery and profit sharing mechanism. The foreign party to the PSC (“Foreign Contractor”) are required to provide the investment to carry out exploration and bear all exploration risks, which essentially means to carry the Chinese NOCs during exploration phase. Chinese NOCs do not bear risk until they exercise their back-in rights after commerciality is proved. In a typical PSC, the annual gross production of petroleum products is allocated in accordance with sequence and proportions specified in the PSC.

If foreign investors wish to cooperate with Chinese partners but do not adopt PSC form, it will be important for them to formulate cost recovery and profit sharing mechanisms that are legal and workable under Chinese laws to achieve the different objectives of parties involved (including financial investors and industrial investors9), for example:

• Under the PSC regime, the value added tax (“VAT”) and resource tax (or royalties for PSCs entered into before 1 November 201110) are paid in kind through the Chinese NOCs to the relevant Chinese government authorities. “Tax petroleum” is sold simultaneously with the general petroleum, and the sales from such trading will be the taxes to be paid; filing and payment of such tax is handled by Chinese NOCs. The PSC also sets out detailed rules for determination of oil and gas quality, quantity and price. It is not clear whether in kind payment of VAT and resource tax will apply to EJV or WFOE, and if so, how they may handle tax calculation, filing and payment. Tax and financial advice is needed before foreign investors are to try EJV and WFOE.

• Under the PSC regime, after payment of VAT and royalties/resource tax, a fixed percentage of the annual gross production is used as recovery oil for both parties’ operating costs, the foreign investor’s exploration costs, and both parties’ development costs. The balance of the annual gross production after such allocation is called “remainder oil” which will be allocated between the Chinese NOC and the foreign investor in accordance with the mechanism provided in the PSC. Such cost recovery and profit sharing are all made in kind. For EJV, profits may be distributed in cash after the payment of taxes and statutory fund allocations, and such distribution is required to be made in proportion to EJV’s shareholders’ respective equity holdings. Therefore, the PSC’s fundamental risk allocation matrix does not exist for EJV.

• Under the PSC regime, funding is done through monthly cash calls. In a typical PSC, funding default results in (i) default interest accrued over the delinquency; (ii) non-defaulting parties’ obligation to make up the shortfall which will constitute a debt due from the defaulting party. The non-defaulting party is entitled to take and sell the defaulting party’s share of the annual gross production and apply the proceeds of the sale against all sums due and payable by the defaulting party. For EJV or other form of joint ventures, funding will most likely follow the rules and practice under PRC Company Law and PRC Partnership Law from 1 January 2020, and more complicated funding and funding default mechanism may be devised by the shareholders or partners. Regarding contribution by Mining Licenses, please see our discussion in point 2.

• The PSC includes an appendix of detailed accounting procedures to ensure the relevant petroleum operations are funded properly and cost recovery is made effectively. For EJV and WFOE, normally there is no need to have separate accounting procedures; rather they will follow the general Accounting Standards for Enterprises No. 27 – Exploitation of Petroleum and Natural Gas11 which is not as detailed as the accounting procedures.

Export and sales of petroleum

Under the PSC regime, Foreign Contractor is allowed to transport its entitlement oil to overseas (with carve outs of destinations which infringe on PRCs’ political interests) but need to pay crude export tax since 2007. However, if foreign investors are going to carry out exploration and exploitation activities via EJV or WFOE, in the same manner as domestic investors, they may face uncertainties in obtaining crude export qualifications, quotas and licenses if they wish to export crude overseas.

If, alternatively, foreign investors wish to sell their petroleum within China, they need to obtain the licenses for trading crude oil in China, and market and sell their petroleum to qualified traders on their own. As the Chinese NOCs are no longer partners in the blocks, the terms and conditions for sale of petroleum may be subject to heavy negotiation.

Ownership of data, and others

Under the PSC regime, Foreign Contractor’s data and samples maintenance and protection obligation is channelled via Chinese NOCs – Foreign Contractor hands original data and samples them over to the Chinese NOCs; and the Chinese NOCs have the right to give consent on export of data and samples. With the removal of the JV Requirement, we anticipate that Chinese government may raise concerns over data and samples from petroleum operations and formulate rules in respect of reporting and data transmission. In any case, the state secret laws will continue to apply. Foreign investors engaging in petroleum operations in the PRC should be alert to the potential risks in data transmission, as under China’s state secret laws, information relating to natural resources in the PRC (because of their impact on “national and social development”) are generally considered as being “high risk” areas in terms of state secret protection.

2. Mining Licenses

The PRC Mineral Resources Law and its Implementing Rules set out the general principles applicable to the licensing regime of natural resources (including oil and gas). Exploration and exploitation activities are subject to exploration licenses and exploitation licenses respectively (collectively “Mining Licenses”) issued by the MNR. Under the PSC regime, it is the Chinese NOCs who are entitled to apply for the Mining Licenses.

If foreign investors do not go for PSCs, the most important issue for them will be: how to obtain Mining Licenses? Under the current regulatory regime, the WFOE or the EJV needs to obtain Mining Licenses by themselves to carry out exploration and/or exploitation activities in China, either by (i) obtaining new Mining Licenses through a public bidding process (except for limited circumstances for transfer by agreement), or (ii) transfer of existing Mining Licenses held by Chinese license holders, or (iii) Chinese partner’s capital contribution.

• New oil and gas Mining Licenses may be obtained through a bidding process organised by MNR. The MNR will determine the scope of the blocks open for bids (including those open to foreign investors), publish the invitation for bids, set forth bidding rules, organise the evaluation of the bids and determine the winning bidder based on merit. The winning bidder needs to pay the licence fee and, in the case of a mining right resulting from a state-funded exploration, also pay the price determined through a valuation for that mining right, then complete the registration procedures and obtain the Mining Licences. We do not see explicit restrictions on foreign invested enterprises being awarded the oil and gas Mining Licenses, and the Foreign Investment Law provides for pre-establishment national treatment. However, the current regime authorises MNR to set out qualification and capability requirements in invitation to tender documents (as we have seen in the previous two rounds of public tender for shale gas blocks). It remains uncertain whether and how any JV requirements will be set out in the bidding process.

• New Mining Licenses may also be obtained through a transfer agreement with MNR. However, China is implementing a strict policy to control and regulate the transfer of Mining Licenses by agreement. Currently, Mining License can only be transferred by agreement in very limited circumstances (e.g. specific transferees or priority projects determined by the State Council) and such transfer is subject to approvals by the local governments where the mining rights are to be registered. It may not be a straight-forward procedure for foreign investors to obtain Mining Licenses via such method without Chinese partners’ involvement, even though there is no express restriction on foreign invested enterprises being the transferees.

• Transfer of existing oil and gas Mining Licences is subject to approval from MNR, and satisfaction of the conditions set out by relevant rules including, amongst others, passage of certain period and fulfilment of minimum investment obligation, prospecting or extraction permit holders can transfer their prospecting or extraction rights to other qualified entities. The transferee must meet the same qualification requirements as the applicant for the Mining Licenses. For Chinese state-owned enterprises, such transfer is further subject to the rules for transfer of state-owned assets.

• Contribution by Mining Licenses is generally allowed under PRC law. The process of evaluation and transfer of Mining Licenses is important in the case that the Chinese partner uses the Mining Licenses as capital contribution. Such capital contribution also involves transfer of the Mining Licenses to the joint venture and the same process and conditions for transfer as stated above apply.

In addition, since the exploration licenses for most of oil and gas blocks were already granted to the Chinese NOCs, the market is expecting a properly developed license relinquishment and transfer regime that can put the blocks held by the Chinese NOCs on to the market.

3. Establishment in the PRC and operational permits

The Negative List 2019 is an important supplement to China’s new Foreign Investment Law adopted on 15 March 2019, which shall become effective from 1 January 2020. Establishing a “pre-establishment national treatment and negative list” management system, all foreign investment will be treated the same as domestic investments if they are not listed in the Negative List 2019. The PRC Law on Sino-foreign Equity Joint Ventures, the PRC Law on Wholly Foreign-owned Enterprise and the PRC Law on Sino-foreign Cooperative Joint Ventures will cease to be in force, and all new foreign invested enterprises from 1 January 2020 will be structured under the PRC Company Law or the Partnership Law.

With respect to existing PSCs, there has not been any guidance whether the existing PSCs will need to be transformed and structured pursuant to the PRC Company Law or the PRC Partnership Law during the 5-year transition period. Although there are academic discussions whether PSC is a form of CJV, as PSCs are contractual arrangements provided for in the two Regulations, we view that transformation should not be required for PSC.

However, under the old PSC regime, Chinese NOCs are required to provide assistance in obtaining operational permits and licenses including accounts opening, foreign exchange formalities, customs formalities, personnel and visa, use of operational facilities. If the foreign investors are now going by themselves, they need to take into account the relevant time and costs for obtaining the operational permits by themselves – it may still be worthwhile to work with Chinese partners (not necessarily Chinese NOCs) to provide assistance and smooth the process.

Remarks

The Negative List 2019 represents Chinese government’s efforts to improve FDI environment, and the lifting of the JV Requirement for upstream oil and gas sector reflects China’s market-oriented reforms of the energy sector. However, in order to provide foreign investors with access to more opportunities in a fairer and more transparent business environment, additional regulatory changes are to be in place to implement the new regime, and let the market identify and evolve with opportunities in practice.