OIL - STILL FUELING THE FUTURE

Despite the Russian government intention to diversify the economy, Oil is and will for some time to come remain the jewel in the crown of Russia's economic development. In fact, oil was one of the determining factors in the country's recovery from its 1998 financial crisis. True, plans have been put forward in Russia to diversify the economy away from the energy (oil) sector by shifting the tax burden from manufacturers to extractors by pumping up taxes on energy exports, but for the time being this is future talk.

In 2002, energy resources made up 56.4 percent of Russia's overall exports to Western countries. Russia is today's second-largest exporter of oil in the world. Total revenues from oil exports amount to no less than one quarter of Russian government revenues. Russian hydrocarbon production facilities such as the one in the Tyumen Oblast in West-Siberia, the oil fields in the Caspian Sea or the Far Eastern reserves are only a stone throw away from both the European and Asian markets. And, the United States' move to upgrade Russia from a second-rated player to vital ally surely has more than a few political reasons. True, Russia currently only accounts for a pitying 0.77% of US oil imports, but this is about to change. A start was made with the Russia-US "energy dialogue" launched in May 2002 when US President George Bush visited Moscow. The US is starting to realise that, next to the Middle Eastern huge, but increasingly unstable powerhouses, Russia has more oil reserves than any country or region can compare with. Russian oil reserves are estimated at 49-55 billion barrels or 9% of the world's proven oil reserves.

In fact, quarter one of 2002 saw for the first time since the 1980s, Russia overtaking Saudi-Arabia to regain its position as the world's leading oil producer. This however did not come naturally. During the 1990's, Russia's oil future looked bleakish with production volumes plummeting down from nine to six million barrels a day. With a steady stream of oil orders from the formerly planned economy coming to a standstill, reform of the industry was inescapable. The aim of the reform was the privatization of completely inefficient state-owned enterprises. This reform was accompanied by the much-needed change of the industry's structure. Several large, vertically integrated oil companies, like Yukos, LUKoil, Sibneft and Tyumen Oil Co. (or TNK), now dominate an industry formerly ruled by the Soviet Ministry of the Oil Industry.

Important was the separation of pipeline transport from potentially competitive activities, such as the extraction, processing and marketing of oil and oil products. In practice, there is room for competition only in the export of Russian oil and oil products. Exports to foreign markets are somewhat restrained. Today, Transneft is the state-owned oil distribution monopoly. The company has full control over pipeline transportation in Russia, but not for long if it is up to Russia's overtly productive and profitable oil giants. Very much against the will of OPEC, the non-member Russia's oil output is growing for the fifth straight year. The World Bank estimates that $6 billion to $10 billion in annual investment is needed to increase oil production to the levels Russia's energy policy foresees by 2010. Domestic oil producers cannot be expected to pitch in more than 50% of this amount, which did not prevent Russia from increasing its oil output by 9.9% in 2002 and the expected 10 per cent in 2003 from the current level of 8 million bpd. 4 million bpd is exported abroad through pipelines, ports, rail and other routes. Yukos Oil, which overtook its main rival LUKoil as No.1 Russian oil producer for the first time in monthly crude production, plans to boost exports by 40% in 2003, including to China and the US.

Contrary to their Middle Eastern rivals, however, pipeline bottlenecks are hampering Russian producers' oil export and causing cost increases. Transneft can only handle 3.5 million bpd and is not always willing to serve the producers' needs. The oil majors have to find alternative routes to lucrative western markets. Indeed, limited export facilities with an unbridled desire to boost exports to foreign markets are resulting in rising capital expenditures by the Russian oil majors. These expenses translate into investments in infrastructure and transportation, like the LUKoil-Conoco project to transport crude oil through the Arctic waters and Yukos' plan to build pipelines to China and through the Balkans to the Adriatic Sea.

Mikhail Khodorkovsky, CEO of Yukos Oil

Mikhail Khodorkovsky, CEO of the immensely successful Yukos Oil, stresses, "…the key component for any Russian company remains transportation costs and markets. Our marketing arm is able to maintain exports at a high level, and the fact that we have opted for a strategy of negotiating long term contracts has given us the opportunity to acquire some very attractive segments of the market".
In any case, despite government imposed export tariffs and cuts and so on, the advantages of exports are too high for Russian exporters. If the truth be told, Russia's oil industry benefited substantially from this crisis, which saw the devaluation of the rouble and consequently also a substantial lowering of production costs. The difference between domestic and export prices - the fact that Russian oil prices are indeed just over half of the global market prices - plus the guarantee of hard currency payment for exports are too tempting. Either they will export crude or refined oil products. According to Riabov, General Director of the Oil Refinery Association, it is important to process domestically, "and then export finished products in order to attract foreign currency into the country. This is why our tax legislation is now being improved to make it the same for domestic as well as foreign investors and to have a guarantee for raised funds."
How attractive then is the Russian oil industry to foreign investors? Well, certainly interesting enough for BP to strike a record $6.75 billion deal with TNK in February 2003. The deal created a global top 10 oil producer, valued at $18.1 billion. This landmark investment of the British giant, equalling some 1.5% of Russia's GDP, into Russian oil could easily ignite a rush of other global oil majors into the Russian Federation. Up until the BP/TNK deal was signed and brought serious competition to the Russian market (which had been dominated by LUKoil and Yukos), though, the level of direct investment in Russia's oil industry had been a mere $4.5 billion and much below what is needed for Russia to reach its future production objectives. In fact, this capital was primarily invested in high-risk and pricey offshore projects in the pacific and the Caspian Pipeline Consortium, which aims to connect Caspian fields to Black Sea ports. Russia's ailing service sector does provide opportunities to foreign technology, equipment and service providers. Some large international service companies (e.g. Schlumberger, Halliburton, Parker Drilling, Pride Foralsol) have recently signed major contracts with Russian oil majors. Still, a more interesting Russian oil investment climate will have to include a still missing fully transparent legal infrastructure, including a 'production-sharing agreement' law.