UPDATE 1-Papua New Guinea's A$1.2 bln loan for Oil Search shares faces probe

* Loan “frozen”, no impact on completed Oil Search share deal

* Probe follows questions raised by sacked treasurer (Adds PNG commission, UBS, source comments)

MELBOURNE, March 25 (Reuters) - An independent commission is investigating whether the Papua New Guinea government broke its own rules in taking on a A$1.2 billion loan to buy a key stake in oil and gas producer Oil Search, a commission spokeswoman said on Tuesday.

PNG’s Ombudsman Commission has frozen the loan while it investigates whether Prime Minister Peter O’Neill followed correct legal procedures in deciding to borrow the money, the commission said in a statement.

“The Ombudsman Commission is not asserting that there are irregularities involved nor does it want to interfere with any development initiatives of the National Government, but to ensure compliance with all the relevant laws,” it said.

In February, O’Neill approved plans for the government to buy new shares in Oil Search, giving it just over a 10 percent stake for A$1.2 billion. That allowed the government to gain a new stake in Oil Search after it gave up a bigger holding to Abu Dhabi in a A$1.68 billion convertible bond deal.

The move to borrow $1.2 billion from UBS has come under fire from former treasurer Don Polye after he was dumped by O’Neill earlier in March. Polye has said the deal breached budget guidelines and was done without approval from parliament.

However, others familiar with the transaction said the government did nothing wrong.

“This is a significant political beat-up and not about commercial reality,” a person close to the transaction told Reuters. He declined to be named due to political sensitivities in Papua New Guinea.

Oil Search sold the shares to the government to fund a $900 million acquisition of a stake in PNG’s biggest undeveloped gas fields, the Elk and Antelope fields.

The probe will have no impact on the share sale or the gas field deal, which were completed in March.

The company declined to comment on the investigation as it had nothing to do with the loan PNG secured from UBS.

Ombudsman Commission officials were not available to comment on how long the investigation would take or what “freezing” the loan meant. UBS said the financing arrangements remain confidential and declined to comment on the probe.

Oil Search shares fell 0.2 percent to A$8.53 on Tuesday, in line with the broader market. (Reporting by Sonali Paul; Editing by David Gregorio and Himani Sarkar)