THE WASHINGTON TIMES: Russia rises on global oil demand

By Patrice Hill
December 18, 2006

Russia has emerged as an unrivaled energy superpower in a world thirsty for oil and gas, but the country’s recent moves to seize control of strategic parts of the energy industry have slowed growth in production and raised questions about the legal rights of investors and speed of future development.

The 10 percent annual growth in oil production that vaulted Russia into the top rank among suppliers in 2003 and 2004 slowed sharply to about 2.5 percent in the past two years in the wake of Russia’s breakup of its leading oil company, Yukos, and the jailing of its chief executive, Mikhail Khodorkovsky.

The slowdown in Russian production helped spur world oil prices to record highs by keeping a tight rein on global supplies.

Russia this year raised environmental and legal roadblocks to Royal Dutch Shell’s $22 billion project to develop huge oil and gas fields on Sakhalin Island in Russia’s Far East. Analysts believe it to be a bid to increase the state’s revenue and control in the largest foreign investment in Russia by insisting Shell include the state gas monopoly Gazprom as a partner. As a result, new investment by Western companies has dwindled.

Gazprom also shut Chevron, ConocoPhillips and other potential Western partners out of a major project to develop the gigantic Shtokman gas field in the Barents Sea, saying it will finance and manage the entire project on its own.

Yet despite Russia’s sitting on the world’s largest reserves of natural gas, a lack of timely investment in new drilling projects caused Gazprom to run short of fuel last winter to meet fast-growing demand for electricity in Russia.

Russian officials dismiss talk of energy shortages and say they are resolved to meeting their future commitments and are gearing up to do so. They point to the nation’s long history of being a reliable energy supplier to Europe, even during the Cold War, and note that other countries such as Venezuela also have been increasing control over their oil sectors.

Western investors showed little concern about their legal rights as they enthusiastically snapped up offerings of Russian energy stocks this year, Russian officials say. The first public stock offering of minority shares in the state oil company Rosneft in the summer was heartily received when it opened on the London Stock Exchange, despite questions about whether state control would impinge on earnings for investors. Russian electric utilities offerings last month also were oversubscribed by global investors.

But even as the world looks increasingly to Russia to satisfy its energy needs, the International Energy Agency is raising questions about whether growth in Russian oil and gas exports will be fast enough to keep up with rising demand in Europe and commitments Russia has made to deliver oil and gas to both Europe and Asia.

“Will the investments take place? Will they come on time?” asked William C. Ramsey, deputy executive director of the international agency. “These are costly projects. … We’re concerned that the investment climate now is not conducive to bringing those resources online.”

Russia in particular needs to start developing potentially immense deposits of oil in eastern Siberia that remain largely unexplored, he said. The country has just started work on a 2,500-mile pipeline from central Siberia to the Pacific coast that must be in place before the oil can be tapped.

“We need to devote money aggressively to the East Siberian fields,” Mr. Ramsey said. Because of the long time it takes to build transport and drilling structures, “we’re talking about 2017 before we see substantial resources coming out of East Siberia.”

Keeping prices high

Vladimir Milov, president of the Institute of Energy Policy in Moscow and a Russian deputy energy minister until 2002, said President Vladimir Putin’s goal in taking increasing control of the oil and gas industry since dismantling Yukos is to keep prices high, to feed the gusher of earnings from oil and gas exports that has lifted Russia’s economy and revived its international status.

Through the Yukos divestiture and other maneuvers, the government has exerted control over one-third of the oil sector and may be on course to gain control over another third within the next year, he said. The state retains near-complete control over the gas sector through Gazprom after Mr. Putin killed a plan to privatize the gas giant Mr. Milov said he had drafted before he left government.

While Mr. Putin has enjoyed public support in Russia for the re-nationalizations, “it was the private sector which caused our recent economic successes,” Mr. Milov said, including the fast growth in oil production that underpinned the country’s robust economic growth and surging incomes in recent years.

Despite increasing obstacles laid down by the government, the private sector continues to outperform state-controlled companies, he said, contrasting Gazprom’s anemic 0.1 percent output growth from 2000 to 2005 with the 12.5 percent growth from small independent gas producers and 8.4 percent growth from private oil producers.

Gazprom, at the state’s behest, has spent $18 billion recently acquiring the Sibneft oil company and other, unrelated entities and has announced intentions to pursue other acquisitions, while spending only $12.5 billion on the drilling and pipeline infrastructure needed to maintain and increase gas production to meet its future commitments, he said.
   
Gazprom has been relying increasingly on independent gas producers in Russia and producers in Central Asia to meet its commitments to European customers.

Faced with severe declines in Russia’s gigantic but aging gas fields in western Siberia, Gazprom needs to develop the huge fields to the north on the Arctic Yamal Peninsula — which alone would cost $70 billion to exploit, Mr. Milov said.

Private energy companies are eager to invest the tens of billions of dollars needed in new drilling and pipeline projects to tap into the energy riches in remote areas of the Arctic and Siberia. But the government’s stripping of corporate rights and assets has stultified such investment and instead funneled a flood of energy earnings into bubbles in the booming Russian stock and real estate markets, Mr. Milov said.

The lack of investment by Gazprom is hurting Russian consumers, he added. Gazprom had to cut off supplies to power stations in central and northwestern Russia for two weeks last winter when temperatures plummeted.

Promoting ‘national champions’

Mr. Putin also wants to increase the power and presence of Gazprom and Rosneft, the state oil company that obtained Yukos’ most prized oil-producing asset at a bargain-basement price under a sale arranged by the government in 2004.

They are the “national champions” through which the state now exercises strategic control. The state’s regulatory and legal apparatus have been galvanized to support the companies at every turn, Mr. Milov said.

The machinations over Shell’s Sakhalin II project illustrate the trend. While the government revoked Shell’s permit for the project, citing environmental problems and objections to cost overruns, the real reason for its action is it wants to alter the production-sharing agreement negotiated in the 1990s to include Gazprom as a partner, he said. The Shell project is a joint venture with Japanese companies and is the only foreign venture in Russia that does not include a Russian shareholder.

“This a selective case” showing an arbitrary use of the state’s regulatory powers to advance Gazprom’s interests, Mr. Milov said, contending that the devastation of forests and water quality cited by the state were potential problems from the beginning and did not prevent the project from going forward in the ’90s.

A top Russian oil executive, who requested anonymity, said Shell opened itself up to the government’s attack by announcing a year ago that its costs on the project had doubled. The announcement angered the government because it ate into the tax revenue Russia receives from the project and put Shell in violation of its contract. That gave the government an opening to renegotiate the terms.

“Russia is now a price-setter, not a price-taker,” the executive said.

The state also has threatened to revoke the license of TNK-BP’s joint venture to develop the giant central Siberian gas field of Kovykta in what analysts believe is a bid to ensure that Gazprom gains control over potentially lucrative gas exports to China.

ExxonMobil’s massive Sakhalin I project is being investigated for environmental violations, and questions have been raised about Gazprom’s role in controlling the project’s gas exports.

Russian Deputy Energy Minister Andrei Dementyev said complying with environmental laws is not negotiable. But he made no bones about the state’s intent to stand up for Gazprom in negotiations with Shell, Exxon and BP over gas projects.

“Our right and the right of Gazprom is to develop a single gas distribution system in the Far East and East Siberia,” he said.

He acknowledged that Gazprom has had trouble providing the gas needed by Russia’s electric utilities because of the country’s rapid growth of power use. But he insisted that Gazprom is prepared to meet its commitments.

“In the last 30 years, we have never given anyone a reason to doubt our competence,” he said. “Despite all attempts by the mass media to report problems, I honestly do not know of any gas contract that has not been honored, be it outside the Russian Federation, or inside the country.”

Gazprom recently said it is nearing an agreement with Shell to join the Sakhalin II project. If it ends up taking the lead from Shell, it would be the first time Russia has ousted a foreign player in its push to control the energy sector.

“This is a big mistake,” Mr. Milov said. The full participation of Western oil companies with sophisticated technologies and expertise will be needed if Russia is to exploit the energy wealth that lies in remote and inaccessible parts of Siberia and the Arctic.

Costly work ahead

Standard & Poor’s CreditWeek analyst Alison Dunn said the double-digit growth in Russian oil production early in the decade was due to a rebound from the depressed output levels of the 1990s and could not have been sustained.

But even to maintain slower growth, Russia will have to make more costly investments in remote fields and transportation networks, as all the “cheap” opportunities for increasing production have been used.

Russia is no longer dependent on Western companies to finance needed investments, she said. “As the Russian government has been able to collect most windfalls from high oil prices in recent years, it has accumulated massive liquidity reserves,” she said. “Russian oil companies generate substantial cash flows and, since 2002-2003, have adequate access to international capital markets.”

As foreign investment in Russia is “politically sensitive,” Ms. Dunn expects that it will be limited to minority stakes and shares and will need approval from the government. Nevertheless, because Russia possesses much of the world’s unexplored energy riches, interest in investment there remains robust in the West, despite the risks of state intervention and, in rare cases, confiscation of assets, she said.

Investors in Russian companies such as Gazprom, Rosneft and Transneft, the state oil pipeline monopoly, will have to keep in mind that there is a risk that powerful individuals and interests within the government will use the companies in political or economic power plays, according to Standard & Poor’s. But in the long run, the government realizes it is in its interests to be a reliable and steady supplier of fuel to its customers in Europe and Asia.
 
A study by Cambridge Energy Research Associates said the revival of oil production in Russia’s massive aging oil fields in western Siberia after the 1990s collapse was due largely to the application of oil-recovery technologies introduced by Western oil services firms such as Schlumberger and Halliburton. It expects the future of oil production in western Siberia — still the largest-producing region — to continue to depend on the work of those companies.

Some analysts and business executives charge that the state’s reassertion of control is aimed at enriching key government insiders who the Kremlin has placed at the helm of the companies it controls.

Perceptions of such insider dealing gave Russia a low ranking of 121 out of 163 countries in the 2006 Corruption Perceptions Index published by Transparency International. That ranking is below China and India and only slightly above Venezuela.

However, the World Bank’s measure of legal and institutional ease of access in 155 countries rates Russia higher at 79, ahead of China and India.

“By putting energy companies in the hands of rival bureaucratic factions in the Kremlin, profit is suppressed, investment is suppressed,” said Robert Amsterdam, attorney for jailed Yukos executive Mikhail Khodorkovsky. The biggest loss has been the rule of law, he said.

“The attack on the rule of law in Russia leaves casualties. Men are imprisoned. Journalists are killed,” and now Western oil companies are coming under attack, he said. The West deserves much blame for not forcefully condemning and trying to stop the state’s expropriation in 2004 of Yukos’ key assets, he said.

“The attack on Yukos was an attack on property rights,” he said. “That attack has left us reeling, has left BP reeling in Kovytka, Shell reeling in Sakhalin, and left Exxon under the gun.”

Andrei Illarionov, a former Putin economic adviser who declared that Russia was no longer free and who left the government after Yukos was dismantled, said the company was targeted because it was committed to openness and free markets in a way that was antithetical to powerful officials in the Kremlin.

It is symptomatic of the loss of freedom and transparency in Russia that foreign investors and observers have become confused by frequently changing rules and positions, he said.

As many as 15 theories emerged as to why Yukos was destroyed, he noted, and legions of analysts continue to scrutinize the Kremlin’s words and actions to try to guess its intent and to find clues about what is coming next.

“It requires a new kind of Kremlinology to figure out what’s going on — a science for understanding a nonfree country,” he said.

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