May 2006
Whither Russia's Oil?
Second only to Saudi Arabia, Russia exported an estimated 7 million barrels of oil per day last year. Buoyed by the high prices and rapidly growing global demand, oil revenues have become the driving force of the Russian economy, while President Vladimir Putin promised to place “energy security issues” at the center of the agenda of the upcoming July G-8 meeting in St. Petersburg.
Yet since the sharp change of economic policy by the Kremlin in 2003--which affected transportation, taxation, domestic energy consumption, investments, and ownership--Russia’s oil sector has experienced a number of disturbing trends, including nationalization of independent companies, lack of long-term investment, and inefficiency of state-owned enterprises. The rate of production growth plunged in 2005.
Can Russia remain a reliable and stable producer? What are the long-term structural challenges to Russia’s ability to meet the world’s growing demand for oil? How does the ideological shift in economic policy affect foreign investment? What are the implications for Russia’s relationship with Europe and the United States?
On May 19, AEI brought together a distinguished group of leading scholars, policymakers, and industry experts from the United States, Russia, and Europe, to discuss these and other questions.
Clifford Gaddy, “Oil Rents and the Russian Economy”
Brookings Institution
The belief that oil is necessarily a “curse” or that Russian oil is hindering the country’s growth is simply a myth. Rather, as the Russian/Soviet case demonstrates, oil can be both a blessing and a curse. Under Brezhnev, for example, oil was a blessing, while under Gorbachev and Yeltsin it was a curse. For Putin, oil has undoubtedly been a blessing--it has allowed Russia to acquire $200 billion in foreign exchange reserves, and develop a stabilization fund estimated at $60-$70 billion. It has also allowed Russia to become a much stronger world player. Putin is reaping the benefits of history.
Yet there are also reasons for concern. Over the past several years, there has been a substantial decline in Russian oil output growth. This can be explained by three factors: China, whose demand grew suddenly and unexpectedly; the unchallenged continued market power of OPEC (by not expanding production when demand increases, the market becomes inefficient); and Russian brownfields of West Siberia which are old and overdeveloped. The other major future problem may be rent-seeking. A good analogy for rent-seeking in Russia is an iceberg in which taxes are the “formal” sector (that is, what you can see above the water) and rent-seeking is the “informal” sector (what is below the water). It is because rent-seeking is so ingrained in the Russian political/economic system that elements that challenge it have been obliterated by the state. For example, it was not enough just to imprison Mikhail Khodorkovsky, but rather YUKOS had to be entirely destroyed.
Julia Nanay, “Russian Offshore: Prospects for Investment”
PFC Energy
With onshore production growth falling in Russia, investors are turning their attention to the Russian offshore, composed of several regions including the Barents Sea, Kara Sea, Pechora Sea, Laptev Sea, East Siberia Sea, Bering Sea, Sea of Okhotsk, Caspian Sea, and the Black Sea. The Russian Ministry of Natural Resources, an increasingly powerful body in Russian politics which is responsible for oil and gas strategies in the country, has declared that by 2020, offshore production will account for 20 percent of Russia’s total oil and gas output at 1.9 million barrels per day and 150 billion cubic meters. A new subsoil law and differentiated mineral extraction tax, which are currently in front of the Duma, will define the future of oil and gas in Russia and the role foreigners will be able to play in this process.
Of all the offshore locations, the greatest hope is placed in the Barents and Kara Seas which are estimated to contain two-thirds of future offshore reserves. Yet the region is plagued with numerous challenges: legal (boundary dispute between Norway and Russia), environmental (deep water, ice, complex wave patterns), and technical (the future of subsea technologies). Sakhalin I and Sakhalin II are currently the most critical current offshore producers, with Sakhalin I expected to produce 250,000 barrels per day by the end of this year and Sakhalin II expected to produce 150,000-180,000 barrels per day by 2008.
International oil companies (IOCs) have a critical role to play in the future of Russian offshore production as they have the technology and management skills that are lacking in Russia; however, it is unclear if the Kremlin will allow IOCs into the market. The best option available to IOCs is to work with Russian state energy companies on joint ventures.
Marco Fantini, “Russian Oil and the Future of EU-Russian Relations”
Directorate General for Taxation and Customs Union
It is no secret that Europe is currently dependent on Russia for a tremendous amount of its energy needs (30 percent of its oil and 50 percent of its gas). By all indications, Europe’s dependence on Russia will continue. It is predicted that by 2030, 70 percent of Europe’s energy needs will need to be met by foreign countries. Europe has several concerns about its dependence on Russia--not least of which is a worry that Russia may use energy as a foreign policy tool or that production in Russia may slow down. The Russian energy industry needs between $170 and $200 billion in the short-to-medium future to meet Europe’s energy needs in 2020, and it is unclear if investors will have enough confidence in Russia. It is for this reason that Europe talks about diversifying. On the political front, however, European leaders continue to engage with Russia as evidenced by the EU and Russia Energy Dialogue, and the EU Green Paper on Energy Strategy which called for security of supply, competitiveness, and sustainable development.
Going forward, Europe is likely to continue to engage Russia in an energy dialogue and to try to create investment conditions which are favorable for both EU and Russian companies. Europe is also likely to push Russia to allow third-party access to pipelines in Russia (something which currently does not occur). Russia meanwhile is going to have its own set of concerns, including a fear that Europe will balk at signing long-term commitments and may bar Gazprom from certain European markets. At the end of the day, however, Russia and the EU are mutually dependent on each other--making it unlikely that ties will be severed. Partnership and communication will be necessary going forward to nurture this relationship.
Vladimir Milov
Institute of Energy Policy (Moscow)
Contrary to popular opinion about the damaging role of the oligarch-controlled oil companies, the restructuring of the oil sector in the 1990s was largely successful. Underestimated even by government officials, the spectacular growth in the oil sector is directly correlated to significant private initiative and private investment. This transformation would have been more successful if allowed to evolve further without administrative interference. Moreover, participation of foreign companies in joint ventures (the “transnationalization” option) should have been pursued instead.
Domestically, government interference only in the YUKOS case alone has slowed down the potential growth in production. Taking into account the output potential of YUKOS subsidies, instead of 2.4 percent growth in production last year, Russia could have easily achieved 5 percent growth. “Renationalization” is not an accurate term to describe the Russian case, as there was no specific legislation reclaiming oil companies as state property. Instead, many subsidiaries considered government-controlled are owned by daughter companies based outside of the Russian Federation. It is also fact, however, the state-owned companies, such as Gazprom, pay significantly less in taxes than private companies.
There is an evident trend since 2003 of oil companies investing abroad to secure their capital, rather than reinvesting in domestic oil production. As a result, the current period of stagnation is expected to continue, at least in the short run. Moreover, in order to keep up production, the Russian government will have to utilize the best international practices previously utilized by private oil companies (such as artificial lifts)--despite the fact that Mr. Putin himself criticized these practices (particularly, in regard to the YUKOS case) as “barbaric extraction.”
Government-controlled companies, such as Gazprom, are clearly not coping with recently added responsibility of managing oil companies, such as the case of Sibneft. In fact, it appears that the government may be preparing to add Rosneft to the conglomerate as well. Rosneft, which was groomed to be the new industry “champion,” has actually exhibited signs of stagnation since 2000 under current management. In addition, the punitive state taxation system--which does allow for adequate reinvestment in the development of the oil section--must change. Moreover, the new focus on Eastern Siberia is misguided -- all of the proven reserves are in Western Siberia, where the future of Russian oil production lies.
Andrey Ryabov
Institute of World Economy and International Relations (Moscow)
The so-called emerging economic model of the petro-state in Russia also reflects the political and social redistribution of power. This model is a radical departure from the post-communist path of other former Soviet states and is seen by the Russian authorities as an inevitable stage in political transformation of the country. This is an effort by the political elites to preserve the status quo and reinforce traditional paternalistic mode of governance, which is protected from competition.
This model was shaped not by Putin, but earlier in the 1990s, when Russian society failed to come to a consensus about the nature and direction of post-Soviet transformation. Unlike other Eastern European countries, there was no revolution in values. As a result, the new elite chose oil and gas as a way to integrate into the global elite, while the rest of the population was simply left to adjust to the new model.
There are three contributing factors to the political success of this model. First, the oil factor concentrated enormous resources in the hands of the state, and allowed dramatic improvement in the economic situation of the country, thus improving their legitimacy--especially as compared to the Yeltsin era. This, in turn, expanded the social base of support for the ruling elites through the process of redistribution to paternalistic/loyal social groups. Lastly, this resulted in virtual de-legitimizing and the disappearance of credible opposition groups. Thus, the petro-state model is not new; it is only strengthening previously established conservative trends in Russian political transformation.
The failure in implementing a number of broad social reforms of the Putin government leads to the conclusion that the goal of the government under the petro-state model is to cater to the interests of the elite only. In effect, the goal is to release the state from social responsibility--where the goal becomes not broader modernization of the Russian society, but optimization of this system of governance. This is the process of redistribution of property from one social group to another, which can only be achieved under authoritarian conditions, such as was achieved under tsarist minister Sergei Witte or under Joseph Stalin. In fact, a parallel can also be drawn between the modernization of Arab countries, such as Algeria or Egypt. As these cases demonstrate, the state operates autonomously from broad social support. In effect, it aims to constrict the economic and political activity of the middle class, while reinforcing the paternalistic model and the status quo.
William Browder
Hermitage Fund
The Hermitage Fund is the largest foreign investment fund in the Russian Federation, with over $4 billion dollars under management, with over 90 percent of that figure invested in Russian oil and gas. Since 1996, the fund has yielded a return of twenty five times the original investment. Unfortunately, in November of last year, I was denied entry by the Russian immigration authorities.
Part of the reason that I was thrown out of the country was my personal visibility as an ardent advocate of the rule of law in Russia, the implementation of strict anti-corruption measures, and institution of equal shareholder rights. Hermitage Fund has performed audits of Gazprom to expose fraud in the companies, has sued to cancel the flawed ownership scheme at Surgutneftegaz, and has called for an extraordinary meeting to prevent Anatoly Chubais from stripping the assets of Unified Energy Systems. As a result, I have lobbied extensively within the UK and Russian governments to reinstate my legal status in Russia.
There are currently two Russia’s that co-exist simultaneously: the reformist and modernizing Russia and the traditional Soviet-style, KGB-dominated state. The corporate example of “modernizing Russia” is Lukoil, which is largely a transparent public company with good management practices. Surgutneftegaz presents the opposite case, where the management has violated the rules of corporate governance and auditing practices. From a broader economic perspective, Russia is rapidly integrating into the global economy and hosting the G8, yet arbitrary tax rules and corruption issues persist. Sberbank, one of the largest government-owned banks, sued Hermitage for daring to suggest that cutting costs would increase profits.
In terms of the oil business, the market is exhibiting the “Russia is stuck in the past” scenario. The assets of the Russian oil companies trade at an enormous discount compared to their Western peers. While in the short-term, the picture for Russian companies may look robust, it will inevitably shrink in the future. The speed and magnitude of this process will and depend on resolution of investment risk issues, such as establishing transparency and rule of law.
AEI intern Ilya Bourtman and research assistant Igor Khrestin prepared this summary.
