OREANDA-NEWS. A proposal to replace the revenue-based tax system for Russian oil and gas companies with a profit-based system could help avert a fall in output in the next few years, Fitch Ratings says. Russian oil production edged up 1% in 2013, but under the existing tax regime we expect production levels to stabilise at this level in 2014-2015 and potentially to start falling from 2016-2017.

Although the key parameters of the proposed regime are not finalised and the timing of its implementation is uncertain, we believe it could reverse the natural production decline from the traditional brownfields in western Siberia and the Volga-Urals, which account for over 90% of Russia's total oil output.

Russian oil and gas companies' two principal levies are the mineral extraction tax (MET), calculated on the physical volume of produced oil, and the export duty for volumes sold abroad. In Q413 the average price for Russian Urals blend was USD109 per barrel of oil, and the MET and the export duty were USD54/bbl and USD23/bbl respectively, totalling 71% of the Urals price.

While there are a number of MET and export duty tax breaks, such as for highly depleted fields, the main drawback of a revenue-based tax system is that it generally disregards production costs. Many other countries, including Norway and Brazil, tax the net earnings of oil companies, helping them maintain higher production. This is one of the reasons why the reserve life of a typical Russian oil company is higher, and its production level lower than that of similar-size international peers. For example, the median reserve life for Fitch-rated Russian oil and gas companies at end-2013 was 19 years, compared with 13 years for European and 12 years for US companies.

Russian companies are also facing challenges when producing from non-traditional oil deposits, such as viscous or tight oil. As production costs for heavy oil are much greater than for traditional oil, production from these deposits remains largely uneconomic under the existing taxation regime, even taking into consideration existing MET tax breaks. In our view, a profits-based taxation system could be a huge incentive for greater heavy oil production in Russia.

The government is considering piloting the profit-based tax on several new fields coming on stream, including LUKOIL's Imilorskoye and Surgetneftegaz's Shpilman fields, the largest untapped conventional oil fields, which should start production in 2015.