The Russian Federation Government and concerned ministries and agencies have been discussing a single export channel strategy for gas for a fairly long time. The implementation of this strategy began with the adoption of Federal Law No. 117-FZ «On Gas Export», dated July 18, 2006.In the environment that existed until recently, in which gas could be exported only through trunk pipelines of the unified gas supply system that belongs to OAO «Gazprom», the development of government mechanisms to coordinate natural gas export was not an urgent issue. Despite protracted conversations concerning granting independent gas producers access to export, the matter did not require immediate government intervention and was handled on the level of the owner of the unified gas supply system and the independent gas producers.

The rapid development of the worldwide liquefied natural gas market, the appearance in Russia of production sharing projects that specify export of natural and liquefied natural gas and the development of major natural gas production and export projects bypassing the unified gas supply system made it necessary for the government to develop and implement the single export channel strategy for gas.

The Federal Law «On Gas Export» adopted in mid-2006 may be considered as the establishment of the «boundary conditions» for export of petroleum gases.

Unfortunately, the provisions of the Federal Law «On Gas Export» give a fairly ambiguous definition of the target of regulation, which the owner of the unified gas supply system immediately took advantage of, trying unjustifiably to expand its interpretation. In addition to natural and liquefied natural gases, which export procedures are regulated by this law, OAO «Gazprom» tried to extend the law to gas condensate, natural gas liquids and liquefied petroleum gases. OAO «Gazprom»’s behavior caught both the authorities and the independent natural gas producers unawares and once again demonstrated its administrative clout.

On August 1, 2006, the RF Ministry for Economic Development and Trade issued OAO «Gazprom» and OOO «Gazexport» exclusive licenses (with no expiration date or quantity limit) to export liquefied gases assigned to the following foreign trade product codes: 2705 00; 2711 11; 2711 21; 2711 29; 2711 19; 2711 14; 2711 13 and 2711 12.

At almost the same time when these exclusive licenses were issued, the Federal Customs Service sent to customs agencies telegram No. TF-1821, dated July 31, 2006, which directed them, effective July 31, 2006, to carry out customs clearance procedures for exported gas produced from all types of hydrocarbon fields transportable in gaseous or liquefied form (foreign trade product codes from 2709 00, from 2711, from 2901) only if presented with an exclusive export license.

These actions stopped large amounts of condensate, liquefied petroleum gases and natural gas liquids at the border. The liquefied petroleum gas export situation is aggravated by the distinct features of government regulation of liquefied petroleum gas deliveries to the domestic market at government-regulated prices, specifically the linkage of liquefied petroleum gas exports to their deliveries under «balancing targets».

The study of possible scenarios identified the need to use a combined approach, i.e. to simultaneous use of the «agency» and the «administrative» options.

Further analysis of current law concerning the regulation of petroleum gas export demonstrates the need to develop subordinate legislation to define aspects of the interaction of gas producers with the company that has the exclusive license to export natural and liquefied natural gas.

Glossary

Acronyms

1. Current Russian Federation Classification of Liquefied Gases and Its Correlation to the Worldwide Classification

The list of terms used in world practice is fairly broad (see Glossary) and does not always coincide with terms and definitions used in Russia. This stems from traditions, the technological aspects of production and refining and the ownership structure of oil and gas producing and refining assets, which, for example, in the RF has led to the development of a separate kind of product called natural gas liquids (NGL), which are, essentially, feedstock for petrochemistry, but do not have clearly established hydrocarbon composition.

Despite the apparent similarity of names, liquefied gases vary substantially in their physical and chemical properties and in their hydrocarbon composition. For example, liquefied natural gas (LNG) may be liquefied under atmospheric pressure only at a temperature of -161°C. Its base is methane, while the primary components of liquefied petroleum gases are propane and butane.

In this report we will discuss only liquefied gases classified as alkanes. See Insert 1 for the classification of hydrocarbons.

Various approaches may be used to specify the terms and definitions used in Russia and worldwide and their correlation to one another. In this report, however, we will adhere to the «technological» approach, i.e. we will consider the origin of hydrocarbons from the time point they are extracted until specific marketable products are produced. Appendix E contains a flow diagram of the production and consumption of liquefied petroleum gases.

Appendix A presents the approximate correlation between petroleum gases.

Gases converted into fluid state for ease of transportation or storage may be classified among the liquefied gases mentioned in world and Russian literature devoted to the oil and gas industry.

Crude oil is one of the basic kinds of feedstock for the production of liquefied hydrocarbons. By its composition, crude oil is a blend of several thousand compounds, most of which are various hydrocarbons. When oil is extracted, associated gas and oil well gas are brought to the surface along with it. Associated gas means not only gas dissolved in oil, but also gas cap gas, free gas and the so-called gas well gas, which comes to the surface when crude oil is recovered. The content of liquid fractions in associated gas may vary widely depending on the field and stage of production. The RF Ministry for Economic Development and Trade Order No. 117 «On Wholesale Prices for Associated Gas Sold by Gas Processing Plants for Further Treatment», dated April 20, 2002, establishes the following relationship between the cost of associated gas and its liquid fraction content:

In addition to methane, associated gas contains more than 10% ethane, propane, butane and other higher hydrocarbons. The blend of these heavier hydrocarbons (C₃₊) extracted during processing of the associated is classified as a natural gas liquid (NGL). These hydrocarbons are valuable feedstock for the production of petrochemicals, including synthetic rubbers, tires, synthetic fibers and textiles, motor fuel components, polyethylene, polypropylene, derivative products and many more.

Associated gas containing a liquid fraction greater than 350 g/m³ is called associated wet (rich) gas.

The associated gas content in oil, the so-called «gas factor», may range from low — less than 200 m³ per ton of oil and 400-600 m³ per ton of oil, which is fairly typical for Western Siberia — to abnormally high — 2,500 m³ per ton of oil.

Field gas lines, compressor stations, gas drying and desulfurization units (where required) and gas processing plants equipped with gas product transport systems (gas lines, product lines, loading racks) are built for associated gas handing. The facilities and infrastructure needed to recover associated gas now in existence at most producing fields were erected in the Soviet period.

There are various ways to use recovered associated gas. If gas factor is low, oil companies may use drier gas without additional treatment as fuel gas for internal power plants or deliver it to regional heat power plants. Collected associated gas may be processed on site by being, injected into the formation, delivered to a gas processing plant (GPP) for further treatment or simply flared.

Processing at a GPP usually includes:

· chemical treatment and drying of the gas;

· separation of C₁ (methane) +C₂ (ethane) and C₃₊ by cooling.

The output of a GPP comprises residue gas (RG), which is almost analogous to natural gas, as well as liquefied hydrocarbon gases, gasolines and/or NGLs.

Properly speaking, the approach to associated gas treatment being traditional to Russia cannot referred to as complete gas treatment, and NGL is a purely Russian term found almost nowhere else in the world. The GPPs in Russia are rather «units for preparing associated gas for subsequent transport». In world practice, NGLs are usually subject to deeper treatment on site and then transported (and sold) as final petrochemical products.

When gas is recovered from gas condensate fields, gas condensate is extracted (condensed) right at the field. Gas is piped to treatment sites; condensate is either piped or transported by railway as a liquid. To transport gas condensate in a liquid state, light (volatile) fractions have to be removed from it. This procedure is called condensate stabilization, and it is usually performed near the site where the condensate is recovered. As a result of the stabilization process, stable gas condensate (which can be transported in a liquid state) and low-pressure stabilization gas, which contains more C₂₊ than natural gas, are produced from primary gas condensate. The preference is to use stabilization gas where it is produced, because additional treatment (primarily extraction of C₃₊) and compression are required to deliver it to trunk gas lines.

Fairly large amounts of hydrocarbon gases, from methane CH4 to butanes C3H8 inclusive, are produced during oil refining. The number one source is a straight distillation. The gas yield depends exclusively on the degree of oil stabilization in the fields or during transport.

Specialized enterprises have also been established to process gas supplied from purely gas fields. The natural gas is most often methane with minor inclusions of ethane. Sometimes helium, so necessary to many technology sectors, carbon dioxide and hydrogen sulfide are found as inclusions. Understandably, these «acidic» gases must immediately be removed from the main feedstock.

1.1 Liquefied Natural Gas

Liquefied natural gas (LNG) is a cryogenic liquid with a methane content of at least 86 % vol. and a boiling point of -161°C. On regasification, 1 m³ of LNG yields about 600 m³ of gas under normal conditions. LNG is a promising energy vector and is cost-effective and environmentally friendly compared to other kinds of fuels.

Economic analyses and practice show that LNG begins to compete with natural gas when it is delivered over long distances (more than 1500 km), to compensate for irregular delivery and to supply gas to small population centers. This is becoming relevant, especially now, when LNG trading under one-time contracts is becoming more and more common.

Since LNG is an entirely new kind of product for Russia, either there are no technical documents pertaining to it or they are at the early stage of development.

1.2 Liquefied Petroleum Gases

Liquefied petroleum gas (LPG) is the name given to a blend of hydrocarbon gases consisting of propane (C₃H₈), butane (C₄H₁₀), their isomers (normal-butane, iso-butane or pentane, propene, and butane), which are gases at ambient temperature and normal atmospheric pressure, but turn into liquid if pressure increases slightly (without a drop in temperature) (for reference, the working pressure of a residential LNG bottle is 1.6 atg).

The following are feedstock for producing liquefied gases in the Russian Federation: associated gas (recovered with oil), natural gas or gas condensate (recovered from gas fields), petroleum gases and other semiproducts produced when they are treated as well as (NGLs), and crude oil.

Propane (C₃H₈) and butane (C₄H₁₀) are the primary components of liquefied petroleum gases, but the ratio in which they are blended varies widely from country to country and depending on its use, domestic prices, production capabilities and climate.

The change in the composition of liquefied petroleum gases used for various purposes from country to country is governed by requirements for atmospheric emissions, mostly of CO. A high butane content reduces the level of NOx emissions, and a high propane content reduces the level of CO emissions.

The quality of liquefied petroleum gases and their content of various fractions are governed by the relevant standards in each country, e.g., the European standard EN589 defines composition of liquefied petroleum gases used in vehicles.

The assortment of liquefied petroleum gases produced at all types of enterprises on the Russian Federation domestic market is defined by the National Product Code OK 005-93.

Requirements for the quality of manufacture of liquefied gases are defined by national standards for household needs (GOST 20448-90, dated January 1, 1992, «Gases, Petroleum, Liquefied, Fuel for Residential Consumption»), for motor transport (GOST 27578-87, dated July 1, 1998, «Gases, Petroleum, Liquefied, for Motor Transport») and for export (GOST 21443-75, dated January 1, 1997, «Gases, Petroleum, Liquefied, for Export»).

Table 1 shows the grades of liquefied petroleum gases standardized in Russia.

Table 1. GRADES OF liquefied petroleum gases

Notes:

1) Mass fraction of sulfur content in gas must not exceed 0.01%.

2) PBA grade is used in summer; PA in winter.

According to the national standard, the percentage of propane in PA must be at least 85±10%; in PBA, 50±10%.

Table 2 presents the recommended uses of liquefied petroleum gas grades for household consumption.

Table 2. RECOMMENDED USES OF VARIOUS GRADES OF LIQUEFIED PETROLEM GAS

According to the national standard, the percentage of propane and propylene in PT delivered to the domestic market must be at least 75%; in SPBT, the percentage of butanes and butylenes cannot be more than 60%; in BT, the percentage of butylenes must be at least 60%. If liquefied petroleum gases are exported, the composition will look a little different: the percentage of propane in PT is at least 95%; the percentage of butane in BT is at least 98%, while there is at least 96% normal butane; and the percentage of butane in SPBT is not more than 60%; of propanes at least 40%.

On the whole, the GOSTs define liquefied gas grades and safety requirements for working with liquefied gases and set requirements for environmental protection, labeling and packaging, acceptance and testing methods.

In 2001 the Volga Petroleum Gas Research Institute (VNIIUS) developed, and the Russian Ministry of Energy endorsed, the «Classification of Liquefied Petroleum Gases, Light Hydrocarbons, and Natural Gas Liquids», which the RF Ministry of Energy and OAO SG-Trans (the main rail carrier of liquefied petroleum gases) now use. However, this classification has not attained official status (Appendix B).

The list of gases classified as liquefied petroleum gases established by the Unified Foreign Trade Product Code of the Commonwealth of Independent States used by member countries of the Commonwealth of Independent States for tariff and non-tariff regulation of foreign trade and its makeup, differ from the list established by the national standards and the classification codes.

As regards the breakdown of liquefied petroleum gases into converted gas and refined product, under the current customs law, if some of a product is the product of oil refining, this one and all the rest of products are subject to customs regulations as a refined product, regardless of its origin. Moreover, the National Code for Business Activities, Products and Services, OK 004-93 classifies liquefied petroleum gases as oil-refining products.

1.3 Natural Gas Liquids

As stated above, natural gas liquid is a purely Russian term related to distinct features of hydrocarbon processing. For this reason the term «natural gas liquid» appears in National Product Code OK 005-93,

and in the National Code for Business Activities, Products and Services,

but at the same time, this notion is not included in the Foreign Trade Product Code. This is why NGL exports, which are growing from year to year, are performed under the following Foreign Trade Product Code:

2. Existing System of Governmental Regulation of Liquefied Gas Export, Including the Existing System for Delivery of Liquefied Petroleum Gases to the Domestic Market

2.1. Regulation of Foreign Trade

Foreign trade in gas, including liquefied, is regulated in accordance with Federal Law No. 164-FZ, «On Governmental Regulation of Foreign Trade», dated December 8, 2003, and Federal Law No. 117-FZ, «On Gas Export», dated July 18, 2006.

Article 26 of Federal Law No. 164-FZ, «On Governmental Regulation of Foreign Trade» specifies the ability to limit the right to export by granting an exclusive right to export certain products, the list of which is defined by federal laws. The exclusive right to export certain products must be exercised on the basis of a license issued by a federal executive branch agency to which the Russian Federation Government has granted the right of governmental regulation of foreign trade. In section 2 of resolution No. 443, «On Approval of the Regulation on the Russian Federation Ministry for Economic Development and Trade», dated August 27, 2004, the Russian Federation Government specified that the mentioned ministry is the authorized federal executive branch agency regulating foreign trade, i.e. responsible for issuing exclusive licenses to export certain kinds of products.

Article 3 of Federal Law No. 117-FZ, «On Gas Export», dated July 18, 2006, states that the exclusive right to export gas is granted to the organization that owns the unified gas supply system or to a wholly owned subsidiary of that organization. This right is documented by an exclusive license to export gas by the procedure established by Russian Federation law on foreign trade. Article 1, Section 2 of that law gives a definition of the gas to which the exclusive export right applies, i.e. «gas extracted from all kinds of hydrocarbon fields that is transportable in a gaseous or liquid state».

Under the Federal Law «On Gas Export» and the Federal Law «On Governmental Regulation of Foreign Trade», the RF Ministry for Economic Development and Trade granted the exclusive licenses to OAO «Gazprom» and OOO «Gazexport» (with no expiration date or limit on amount) to export gases under the following Foreign Trade Product Codes:

— 2705 00 000 0 — gas: coal, hydrous, generator and similar gases, except associated gases and other gaseous hydrocarbons;

— 2711 11 000 0 — natural gas, liquefied;

— 2711 21 000 0 — natural gas, in a gaseous state;

— 2711 29 000 0 — other associated gases and gaseous hydrocarbons;

— 2711 19 000 0 — other liquefied petroleum gases;

— 2711 14 000 0 — ethylene, propylene, butylene and butadiene, liquefied;

— 2711 13 980 0 — other liquefied butanes for other purposes;

— 2711 13 930 0 — liquefied blends of butane and propane containing more than 50% but no more than 65% butane, for other purposes;

— 2711 13 910 0 — liquefied butanes more than 90%, but less than 95% pure, for other purposes;

— 2711 13 300 0 — liquefied butanes for chemical conversions in processes, except those listed in item 2711 13 100 0;

— 2711 13 100 0 — liquefied butanes for specific treatment processes;

— 2711 12 980 0 — other kinds of liquefied propane;

— 2711 12 960 0 — liquefied blends of propane and butane containing more than 50% but not more than 70% butane, for other purposes;

— 2711 12 940 0 — liquefied propanes more than 90%, but less than 95% pure, for other purposes;

— 2711 12 930 0 — liquefied propanes, other, for chemical conversions in processes, except those listed in item 2711 12 910 0;

— 2711 12 910 0 — liquefied propanes for specific treatment processes;

— 2711 12 190 0 — liquefied propane at least 99% pure, for other purposes;

— 2711 12 110 0 — liquefied propane at least 99% pure, for use as fuel.

In conjunction with the enactment of the Federal Law «On Gas Export», the Federal Customs Service sent to customs agencies telegram No. TF-1821, dated July 31, 2006, which directed them, effective as at July 31, 2006, to carry out customs clearance procedures for exported gas extracted from all types of hydrocarbon fields and transportable in gaseous or liquefied form (Russian Foreign Trade Product Codes from 2709 00, from 2711and from 2901) with an exclusive export license available.

At the same time, the RF Ministry for Economic Development and Trade received requests from OAO «Gazprom» to issue to its subsidiaries exclusive licenses to export gas condensate (Russian Foreign Trade Product Codes 2709) and petrochemical products (Russian Foreign Trade Product Codes from 2901). After reviewing the appeals of concerned companies, the Ministry for Economic Development and Trade, however, denied these appeals as found to be outside the scope of the Federal Law «On Gas Export» delivering an application to the Russian Federation Government and the Administration of the President of the RF requesting to rescind the Federal Customs Service’s telegram with the purpose of limiting exports to natural and liquefied natural gas only.

2.2. Customs Regulation of Liquefied Gas Export

The Russian Federation Government executes operational regulation of the foreign trade in accordance with Russian Federation Law «On the Customs Tariff» by setting rates for export customs duties and the list of products to which they apply, including liquefied gases.

To efficiently solve the problems of customs and tariff regulation of product import and export outside the Russian Federation’s customs territory, the RF Ministry for Economic Development and Trade Order No. 166 and the RF Ministry of Finance Order No. 154, dated June 17, 2004, established an interdepartmental commission on foreign trade protection and customs/tariff policy. The commission’s main objectives are:

1) review and prepare recommendations on setting and changing rates for customs duties;

2) review and prepare recommendations on customs/tariff regulation of goods crossing the Russian Federation customs border for noncommercial purposes;

3) analyze customs/tariff regulation in the Russian Federation with respect to its compliance with the World Trade Organization agreement;

4) review and prepare recommendations on modifying and expanding the foreign trade product list;

5) review and prepare recommendations on amending national trade preferences;

6) review and prepare recommendations on granting tariff preferences to goods originating in countries forming a free trade or customs union with the Russian Federation;

7) review and prepare recommendations on the introduction, application, extension, reconsideration and repeal of special protection, anti-dumping and compensatory measures when goods are imported

8) review and prepare recommendations on the advisability of responding to discriminatory and other actions on the part of other countries or their alliances that impair the Russian Federation’s foreign trade interests.

All matters pertaining to export customs/tariff regulation must be considered at a meeting of the interdepartmental commission before they are sent to the Russian Federation Government.

In current practice, the Russian Federation Government sets export customs duties for products derived from oil on a single listing. The only differentiation in export customs rates is between light and dark petroleum products. Export customs duties for dark petroleum products are much lower than those for light petroleum products, which include liquefied petroleum gases. This situation is determined by the current market basket of petroleum products and the need to supply the domestic market with gasolines.

Appendix C illustrates the trend in export customs duties for liquefied petroleum gases.

Because liquefied natural gas is not a refined product, its customs regulation differs greatly from that of the liquefied petroleum gases. Because there was no production and, therefore, no export of significant amounts of liquefied natural gas, neither the companies nor the government showed an interest in regulating it (Appendix D). Regulation was haphazard. That was the situation until late 2005, when OAO «Gazprom», as part of a tender for the development of the Shtokmansky field, asked the ministries and agencies to set a zero export duty on liquefied natural gas to encourage the interest of potential investors. The Russian Federation Government agreed, setting a zero export duty rate on liquefied natural gas in its resolution No. 855, dated December 30, 2005.

It should be pointed out that the efficiency with which the Russian Federation Government decides to consider export duties (averaging 1.5 to 3 months), on the one hand, facilitates a prompt response to a change in market conditions, but, on the other, gives investors no long-term guarantees that a particular export duty will be in effect for long.

The definition of liquefied gases is given in the Commonwealth of Independent States’ Foreign Trade Product Code (FTPC) approved by the Russian Federation Government Resolution No. 830, dated November 30, 2001 «On the Customs Tariff in the Russian Federation and the Product Code Used in Foreign Trade». According to the FTPC, liquefied gases include: liquefied natural gas (code 2711 11 000 0), propane (2711 12), butane (code 2711 13), ethylene, propylene, butylene and butadiene (code 2711 14), and other liquefied gases (code 2711 19). Liquefied petroleum gases may also include saturated acyclic hydrocarbons under the section «chemical industry products» (code 2901 10).

Because products are defined exclusively by the FTPC for purposes of applying export custom duties, and the short product name is given only for ease of use, duplicate codes introduce ambiguity when the export portion of liquefied petroleum gases is declared. The problem is aggravated by the fact that the Russian Federation Government reviews export customs duties under FTPC 27 every two months, while the export customs duties for FTPC 2901 10 is zero and is not reviewed. In fact, it has not been considered at all. This situation makes it possible to export up to one-third of liquefied petroleum gases from the Russian Federation duty free each year. The amount of liquefied petroleum gases exported duty free is rising from one year to the next.

2.3. «Balance-oriented» and Price Regulation of the Domestic Market for Liquefied Petroleum Gases and its Relationship to Exports

The Russian Federation Government introduced two-tier price regulation to supply the public with liquefied petroleum gases at acceptable prices (RF Presidential Order No. 221, dated February 28, 1995; Russian Federation Government Resolutions No. 239, dated March 7, 1995, No. 332, dated April 15, 1995; No. 88, dated February 6, 2001, No. 49, dated February 1, 2005; No. 726, dated December 5, 2005). According to these documents, liquefied petroleum gases for household purposes are supplied at regulated prices set on two tiers — federal and regional: wholesale prices for residential liquefied gas are approved by the Federal Tariffs Service with the endorsement of the Russian Federation Ministry of Finance, Ministry of Energy and Ministry of Justice; retail prices for liquefied gas for sale to the public for household purposes are approved by executive branch agencies of Russian Federation constituents (with allowance for the public’s social safety net). This large number of approvals for setting wholesale prices for liquefied petroleum gases effectively brought price regulation on the federal level to a halt. On a recommendation by the Russian Federal Tariffs Service, the Russian Federation Government therefore introduced changes to the procedure for setting wholesale prices for liquefied petroleum gases in its resolution No. 332, dated April 15, 1994. A decision by the Federal Tariffs Service is now sufficient to set them.

Table 3 presents data on the wholesale price for household-purpose liquefied gases.

Table 3. WHOLESALE PRICES FOR RESIDENTIAL LIQUEFIED PETROLEUM GASES

Retail liquefied gas prices are regulated by regional executive branch agencies and, if the relevant authority is delegated to them, by local governments or regional energy commissions (RECs). Regulated retail prices are normally differentiated depending on how the gas is supplied (bottled gas, group units), cross subsidies between network and liquefied gas, transportation distance to the consumer and terms of delivery.

Analysis of current law shows that gas prices can be regulated on the basis of Federal Law No. 69-FZ, «On Gas Supply in the Russian Federation», dated March 31, 1999, only for transactions that meet three conditions:

· the buyer is the end user, using the gas for fuel and (or) feedstock;

· the seller is an organization affiliated with a monopoly entity in the gas supply sector;

· the gas that is the subject of the transaction is transported by pipeline.

This conclusion implies specifically that transactions involving a liquefied petroleum gas that is not piped by gas transport and gas distribution organizations is not subject to price regulation. But price regulation is permitted when gas distribution organizations supply liquefied gas via group unit pipeline.

As for considering the procedure for setting liquefied petroleum gas prices as defining the cost of utilities, Section VII of the Housing Code specifies that local governments and executive branch agencies of Moscow and St. Petersburg set utility tariffs for residential buildings by the procedure defined by the Russian Federation Government. Utilities, according to the meaning given to this term by federal law, include gas supply which encompasses transactions involving liquefied petroleum gas, as noted above. That is, prices for liquefied petroleum gas sold to the public for household needs may be regulated.

Thus, we have a legal conflict, where several different laws set contradictory provisions for entities in the government-regulated market for liquefied petroleum gases.

The existing system for delivering liquefied petroleum gases for the public’s residential needs (the so-called system of «balance-oriented targets» or «delivery schedules») constitutes administrative regulation of mandatory liquefied petroleum gas deliveries to the domestic market at regulated prices, reinforced by the procedure for clearing their export outside the Russian Federation customs territory. Customs clearance of liquefied petroleum gases exported outside Russian Federation customs territory is handled in the region where the producer does business in accordance with the Russian State Customs Committee Order No. 832, dated December 1, 1999.

The Russian Federation Government introduced this system at the end of 1999 to guarantee liquefied gas deliveries to the public (Russian Ministry of Energy Order No. 405, dated November 1999; Russian Federation Government resolution No. 281, dated March 29, 2000). Later, in 2000-2002, the practice of balancing targets (delivery schedules) was extended for the next six months (Russian Federation Government Resolutions No. 555, dated July 25, 2000; No. 1022, dated December 29, 2000; No. 480, dated June 23, 2001; No. 910, dated December 29, 2001; No. 471, dated June 28, 2002; No. 15, dated January 8, 2003). After the Russian Federation Government approved the strategy for the development of the market for residential liquefied gas, it decided, in Resolution No. 426, dated July 15, 2003, to maintain the practice of setting delivery schedules for another year and a half (through 2004 inclusive).

At the same time, the RF Ministry of Energy (RF Ministry of Fuel and Energy) prepared and adopted a system of gathering information on production, transportation and deliveries of liquefied petroleum gases for consumers’ household needs. This system was implemented by the «Interim Procedure for Delivery Liquefied Petroleum Gases to the Russian Federation Consumers for Household Needs», approved by the Ministry of Fuel and Energy Order No. 405, dated November 30, 1999, «On Deliveries of Liquefied Petroleum Gases to the Russian Federation Consumers for Residential Needs», which was later amended by the RF Ministry of Energy orders No. 105, dated March 18, 2003, No. 344, dated August 6, 2003, No. 466, dated November 24, 2003; and the RF Ministry of Industry and Energy Order No. 16, dated February 1, 2005.

To increase the quality of reporting, improve government control of the fulfillment of targets for liquefied petroleum gases production and consumption and prepare for the liberalization of liquefied petroleum gas prices, the RF Ministry of Industry and Energy, in its Order No. 16, dated February 1, 2005, approved the «Methodology for Collection and Processing of Information for Reporting of Liquefied Petroleum Gas Production and Deliveries to the Russian Federation Consumers» (hereinafter referred to as «Methodology»). The Federal Energy Agency (Rosenergo) was authorized to gather and process information for submission according to the Methodology.

The duty to develop the so called «delivery schedules» of liquefied petroleum gas was assigned to the RF Ministry of Industry and Energy. The authority to develop draft monthly and quarterly delivery schedules was delegated to Rosenergo of Russia. It was also delegated the authority to manage delivery schedules on a day-to-day basis.

3. Major Areas in which Government Regulation of Liquefied Gas Export and the Domestic Liquefied Petroleum Gas Market Will Change

3.1. Foreign Trade Regulation

The situation with respect to the regulation of foreign trade as it evolved after adoption of the Federal Law «On Gas Export», may be characterized as «completed» with respect to legislation. The existing legislation encompasses all liquefied petroleum gases and implements the long-discussed single export channel.

Despite the existence of this legislation, however, a number of issues related to the specific implementation of the single export channel remain unclear. In particular, the interaction of the gas exporting company with gas producing companies has not been resolved, no procedure has been established for determining prices for gases exported through the single export channel, etc. While these issues are not so critical for liquefied natural gas because of lack of production and, therefore, export, the same issues pertaining to liquefied petroleum gas export required immediate resolution. For liquefied petroleum gases, the problem is only aggravated by government regulation of mandatory deliveries to the domestic market that are directly tied to export.

In our opinion, these problems can be solved by adoption of a Russian Federation Government resolution that would specify the status of the single export channel. We believe that it is in this direction that work toward improving foreign trade regulation will progress, but the timeframe for the development and adoption of this document will range from three months to a year, depending on how the single export channel is implemented and which regulated entities will be subject to the resolution.

3.2. Customs Regulation of Liquefied Petroleum Gas Export

Analysis of trends in export and domestic prices for liquefied petroleum gases, oil, and petroleum products shows that the linkage between the export customs duty for liquefied petroleum gases and the export customs duties for oil makes no sense. There is no question that a rise in export prices for oil results in the overall rise in prices on export markets for petroleum products and, therefore, for liquefied petroleum gases, as one of the energy resources. But one must take into account that liquefied petroleum gases are not a primary price-determiner for oil refining. Furthermore, the demand for liquefied petroleum gases is clearly seasonal, and the frequency of price fluctuations on the liquefied petroleum gas market is out of synch with prices for primary petroleum products, particularly gasolines, which requires proper consideration in regulation.

For this reason, concerned ministries and agencies have repeatedly raised the question of de-linking the establishment of liquefied petroleum gas export duties from the establishment of light petroleum product export duties.

The question of single-tier export customs duties for liquefied petroleum gases exported under FTPC 2711 and 2901 is also being discussed. But the solution to this problem is complicated because of the fact that, under the agreement between the RF and the EEC on Russia’s entry into the WTO, tariff regulation of petrochemicals, which include products classified under FTPC 2901, must be only at a zero rate.

Given the fact that the date for Russia’s entry into the WTO is once again being deferred for an unspecified time and because the licenses of companies exporting liquefied gases lack this FTPC, one might expect that the concerned ministries and agencies will have an increased interest in reviewing the current status of this issue.

3.3. Balancing and Price Regulation of the Domestic Liquefied Petroleum Gas Market and its Relationship to Exports

A substantial increase in the government-regulated prices for liquefied petroleum gases can be expected in the near future: to 2,700 RUR/ton (exc. VAT) as of September 2006 and to 3,500 RUR/ton (exc. VAT) as of January 2007. In the opinion of executive branch agencies, subsequent annual indexing of the regulated wholesale price of liquefied petroleum gases at rates up to 30% a year will make it possible to raise the price over three years to 70% of the average market wholesale market price by 2009. The only limit on the rate of increase in liquefied petroleum gas prices is the limit on the growth of utilities. Given the current structure of the retail price for liquefied petroleum gases for sale to the public, however, the planned change in the wholesale price as of August 1, 2006, will boost the ultimate price to the public by 5-10%.

Further, the possibility of gradually cutting public consumption of liquefied petroleum gases delivered at government-regulated prices is being considered to lower public subsidies for deliveries of liquefied petroleum gases at the regulated price. To this end, work will be done to amend Russian Federation Government Resolution No. 326, «On Approval of Procedures for Setting Standards for Consumption of Utility Services», dated May 23, 2006, with respect to applying procedures for setting standards for utility service consumption to liquefied petroleum gases, and a draft Russian Federation Government resolution on establishing the standard for public consumption of liquefied petroleum gases will be developed, with allowance for an annual reduction to be granted on government-regulated prices and to be used by Rosenergo in developing delivery schedules for the regions.

The ministries and agencies do not currently consider a contemporaneous repeal of the delivery schedules or balancing targets proposed in 2005 by the RF Ministry of Industry and Energy possible. The RF Ministry of Economic Development and Trade was named the leading ministry responsible for development of a plan to liberalize the liquefied petroleum gas market. It has proposed gradual liberalization using the mechanisms listed above.

3.4. Other Issues of Government Regulation

Other issues of government regulation might include improving the current procedure for distributing liquefied petroleum gases, i.e. clearly identifying the producer of liquefied gas and setting the necessary requirements for authorized companies. Authorized companies are defined as companies to which the regions have transferred the authority to obtain liquefied petroleum gases at plants at government-regulated prices for subsequent distribution to the public at prices set in the region. The Russian Federation Government resolution on deliveries of liquefied petroleum gases to the domestic market does not specify the entities to which it applies.

The lack of proper control over the quality of liquefied gases delivered to the domestic market has a negative impact on the market as a whole. The government will resolve this issue by developing the appropriate technical procedures.

4. Strategy Options for the Independent Gas Producer to Minimize Key Risks in the Change in Government Regulation of Liquefied Gas Export

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Appendix A

Appendix B

CLASSIFICATION OF LIQUEFIED PETROLEUM GASES (LPG), LIGHT HYDROCARBONS AND NATURAL GAS LIQUIDS

1. Liquefied petroleum gases

1.1 Industrial butane (BT)

1.2 Butane-isobutane

1.3 Isobutane

1.4 Normal butane

1.5 Propane

1.6 Industrial propane (PT)

1.7 Propane-butane-pentane fraction (other liquefied gases)

1.8 Blend of industrial propane and butane (SPBT)

1.9 Propane-butane fraction

1.10 Propane-propylene fraction

2. Light Hydrocarbons

2.1 Inhibited butadiene

2.2 Butylene (butene-1)

2.3 Hexene

2.4 Isoamylene

2.5 Isobutylene

2.6 Isopentane

2.7 Isoprene

2.8 Normal pentane

2.9 Waste butylene-isobutylene fraction

2.10 Piperylene

2.11 Propylene (propene)

2.12 Propellant

2.13 Butane-butylene fraction

2.14 Butane-isobutylene fraction

2.15 Butylene-butadiene fraction

2.16 Butylene-isobutylene fraction

2.17 Butylene-amylene fraction

2.18 Butylene-divinyl fraction

2.19 Butylene fraction

2.20 Hexane-pentane fraction

2.21 Hexane fraction

2.22 Isobutalene fraction

2.23 Isopentane fraction

2.24 Pentane-hexane fraction

2.25 Pentane fraction

2.26 Pentane-isopentane fraction

2.27 Piperylene fraction

2.28 Propylene fraction

3. Feedstock for liquefied gas production

3.1 Broad fraction hydrocarbons

Appendix C

EXPORT CUSTOMS DUTIES ON PRODUCTS DERIVED FROM OIL

Note 1. This Russian Federation Government resolution was effective only until September 30, 2002.

Appendix D

EXPORT CUSTOM DUTY RATES FOR LIQUEFIED GASES EXPORTED FROM THE Russian Federation Government OUTSIDE THE BOUNDARIES OF CUSTOMS UNION MEMBERS

Flow Diagram of the Production and Consumption of Liquefied Petroleum Gases

Appendix E