The Wall Street Journal: Russian Oil Firms Reap Little Benefit From Prices

By ALEXANDER KOLIANDRE
November 14, 2007

Despite high crude prices, Russian oil-production growth may be damped because the country’s tax regime deprives producers of the bulk of export revenue while rising costs mean companies struggle to invest in new fields.

“We don’t gain much from high oil prices,” said a spokesman for OAO Rosneft, Russia’s largest oil company by volume. His counterpart at second-largest company OAO Lukoil agreed: “High oil prices have only a marginal positive effect on the company. In reality it’s the Stabilization Fund which gains from the high price of crude.”

The state funnels most of the profits from oil prices above $30 a barrel through export and extraction taxes into its Stabilization Fund. Russian oil companies pay 24% income tax and then production taxes based on the market price of oil. As a result, the companies are left with about 10% of their upstream profits. Still, both Lukoil and Rosneft are better off than some, because they refine 40% of their output.

The strengthening of the ruble against the dollar is also denting companies’ profits. Oil producers pay their taxes and operating costs in local currency but sell oil on international markets in dollars.

In Lukoil’s case, production is rising at 4% a year, but its capital expenditure almost doubled from 2005 to about $9 billion this year.

However, profit can be better for those companies that also have greater refining capacities. With the tax burden highest on crude being exported, subsidies for domestic refineries leave companies with higher downstream capacity much better placed.

“Internationally, refinery margins have little to do with oil prices, but because in Russia export duties on crude and refined products are set differently, with a 30% gap, this gap goes up in dollar terms as oil prices go up,” said Ronald Smith, chief strategist at Alfa-Bank in Moscow. At $80 a barrel, the companies with refining capacity “are making $18 to $20 a barrel just out of the taxation differential. It’s four times higher than what would be considered good in the West.”

This differential divides Russia’s major oil companies into two categories. Lukoil and Rosneft, which refine about 40% of their oil, are much better positioned than Surgutneftegaz and OAO Tatneft, with BP PLC’s Russian venture TNK-BP somewhere in between. Even so, as the companies are working their refinery capacities flat out, they find it difficult to finance new projects.

The tax regime was developed many years ago, when oil was at $35 to $40 a barrel and the assumption was that it cost $2 to develop a barrel of reserves — a ratio of the total cost of oilfield exploration divided by the volume of reserves. With oil at $80 to $90 a barrel, it costs $7 to $8 to develop a barrel, Mr. Smith said.

“The only way the companies are still making money is by extensive development of existing fields, because this doesn’t require them to build oil fields from scratch,” said Mr. Smith. “Because the upstream profitability is so low, if you are going to develop a new greenfield project in, say, western Siberia, you are going to lose money whatever the oil price is.”

Sergey Donskoy, director of the Economy Department of Russia’s Natural Resources Ministry, didn’t agree. “The companies still have enough money to invest in new projects,” he said.

Last year, Russia gave tax holidays to the companies developing new projects in eastern Siberia, in order to fill a planned 1.6 million-barrel-a-day pipeline to China. The region’s crude production now stands at 20,000 barrels a day.

Mr. Donskoy also said the ministry is studying the possibility of easing taxation for oil deposits on the continental shelf. He pointed out that the current tax regime gives tax breaks for some depleted fields and heavy-oil projects, where oil production is more expensive.

Lukoil is already producing heavy oil, and Tatneft signed a deal with Royal Dutch Shell PLC in September to produce heavy oil in the Volga region.

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