No. 1, 2005

Konstantin Simonov,
General Director of the Center for Political Situational Studies


Mid-term prospects in Russia's oil and gas industry

Currently the press in Russia and elsewhere is active in discussing whether the economy in the Russian Federation should specialize in energy and raw materials or face structural reforms. What is certain, however, is that it is competent implementation of the state policies in the fuel and energy area that will largely determine energy security and economic prosperity in Russia.

The truth is in the middle

The fuel and energy complex (FEC) is currently the key industrial sector in the Russian Federation, accounting for one-fifth of the revenues on the national scale, three-fourths of which comes from oil production. This prevalence notwithstanding, the industry needs state support.

Today the Russian oil and gas industry is in a difficult situation, with many fields at the stage of declining production, while prospecting works proceed at anything but impressive rates. Most refineries are considerably below Western standards in depth of refining. On top of that, physical depreciation of capital assets at many Russian refineries is at a critical level.

Heads of many Russian oil companies believe that several years later the industry will reach the limit of its capability unless capital assets are renewed on a broad scale and new fields are offered for development. This is why they are adamant in opposing any tax increases that will affect the industry, as well as attempts to change the structure of the Russian economy at will. This is the case where the industry will be starved of investments after it "bridges the budget gaps", and this eventually will lead to a drop in state revenues. Innovations in the oil and gas complex, as suggested by a number of members of the governmental financial and macroeconomic bloc, may prove a very dangerous experiment likely to end in a huge budget deficit and a social disaster.

Representatives of the oil and gas complex believe it would be unwise to give up the existing source of budget revenues, FEC. Tax pressure might make the oil and gas industry unprofitable, while advancement in manufacturing industries will drag on. In consequence, the old basis of the Russian economy will be a shambles with nothing in the way of a new one in its stead. That will undercut taxable basis, impede timely foreign debt payments and curtail noninterest expenses, thus becoming a factor in political instability. The Government will be left without FEC's financial handouts at the height of foreign debt payments, because the country's economic policy pursued by the executive authorities will cause a plunge in production in the raw material sector.

At the same time, a number of liberal politicians are calling for structural reforms in the Russian economy, their aim being to take this country "off the petroleum needle" by reducing its dependence on hydrocarbon exports and thus on world oil prices. In their view, Russia's raw material orientation is a dangerous thing fraught with serious negative consequences in a situation of declining oil prices. On top of that, it tends to aggravate the country's technological lag in comparison with the leading world powers and perpetuates the archaic production structure. Thus, it becomes impossible to put an emphasis on manufacturing industries and high technologies.

In accordance with liberal suggestions, FEC should both drastically curtail its GDP share and pay for structural changes in the economy of Russia. By making the raw material sector pay higher taxes, they hope to ease fiscal pressure on the manufacturing industries and cause an outflow of investment resources to producers of finished goods.

The inefficient industrial structure and insufficient investment amounts are restraints on rates of economic dynamics. Given the exceptionally important short-term role of the energy and raw material sector in the Russian economy, the governmental long-term strategy plans to use its resource potential to deal with both current problems (in particular, to pay back the foreign debt) and mid-term ones. This resource ought to be used to create conditions necessary for faster development in sectors capable of producing competitive products with a higher share of added value.

Formally speaking, the supporters of liberal economic views are not against increased investments into the oil and gas industry. But the financial and macroeconomic bloc insists that the raw material industries should in the first place furnish the financial basis for structural reforms and current budget spending. Thus, it is suggested that oil and gas corporations scrape the bottom of the barrel in order to be able to invest into extended production. The more so that, as the "liberals" believe, far from all oil and gas earnings are reinvested in FEC.

The controversy between these two positions drags on for years. Neither can be recognized as the ultimate truth. It is not surprising, therefore, that yet another point of view has cropped up in recent years, implying that FEC's share in the structure of the Russian economy should decline, but the decline must not be radical. "landslide" structural reforms may only cause a crisis in the Russian economy, particularly against the background of rises in the price of hydrocarbon raw materials.

Looking for an efficient owner

The problem is not so much the structure of Russia's economy as efficiency of private and public property in the oil and gas complex. Many private companies demonstrate highly inefficient performance in live oil and gas fields; they would draw licenses for new fields and balk at investments. This results in consumption of reserves intended for future generations, as well as short-falls in taxes and investments in the industry. The whole thing is also preparing a soon-to-come production crisis.

A new state policy in the oil and gas complex comes to the fore in this connection. The state is interested in strengthening its role in the FEC, a viewpoint represented by JCS Gazprom, the biggest state-owned corporation. Not only does Gazprom produce growing amounts of natural gas, it wants to expand oil production and become a full-profile energy corporation covering the entire industrial cycle from production of raw materials to electric energy sales.

Yet, it is important for the development of the oil and gas complex to preserve independent oil and gas corporations as subjects of the Russian fuel market. The Russian economy would hardly benefit by Gazprom's expansion over the entire industry. Meanwhile, private companies ought to become sensitive to new requirements that are placed on the oil and gas complex. The situation in the industry is changing radically, and so it is necessary to measure up to the new tendencies. In the first place, oil companies ought to be increasingly active investing in new projects. But the main thing is to put into operation brand-new fields of hydrocarbons.

The new state approach is due to new conditions that are shaping in the industry. First, the "easy" oil fields are almost depleted, and thus large-scale investment projects have to be implemented and foreign investors have to be attracted. The oil and gas industry cannot go on developing in long-standing oil production areas. Oil and gas production should be promoted in such regions as East Siberia, in the Far East, and on the continental shelf. Second, the "free-for-all" period in FEC development is over, and the state is making a comeback. Third, the current oil export infrastructure has used up its potential, with slower export growth rates observed already in September 2004.

The dictates of the times

The state policy in the fuel and energy sector, if competently implemented, would help in dealing with a great deal of vital problems.

In the first place, this concerns the development of economically depres-sed territories and should be based on an inflow of investments to East Siberia and the Far East. Besides, social tensions will subside in East Siberia and the Far East as they accede to the unified gas supply system (UGSS). True enough, some 40-45 billion rubles in investments will have to be found for the purpose, 60% of these in the first few years of the program imdemetation.

Another important task is to guarantee that the growing Russian economy be provided with energy resources. Short of that, the Russian economy will lose one of crucial competitive advantages. In the mid-term, stable growth in oil and gas production may be secured by bringing into operation difficult oil and gas fields. Foremost in this sense are the Shtokman field, and oil and gas fields in Yakutia, Timan-Pechora province, the Krasnoyarsk Territory, the Irkutsk Region, Sakhalin, and the Yamal Peninsula.

The growing amounts of hydrocarbon production necessitate the expansion of the transport infrastructure and new large-scale pipeline and other export projects. In the first place, these are the Eastern oil and gas pipeline, the North European gas pipeline, terminals to export liquefied gas to the United States, and further expansion of the Baltic pipeline system.

We must create such conditions of work in the industry as would be clear to foreign investors. The "rules of the game" have to be clearly outlined. For example, projects to be implemented under difficult geological and geographical conditions require that favorable terms should be offered to foreign investments. This primarily concerns continental shelf development in the Far North and the Far East of the country.

Aside from that, it is necessary to attract foreign expertise to realize major technological projects such as the construction of integrated facilities to liquefy natural gas. It is absolutely necessary to develop new technologies for the production and refining of hydrocarbons, such as gas liquefaction technology. All of that should have a positive effect on a technological spurt in allied economic sectors, specifically iron-and-steel, engineering and petrochemistry. Their current internal situation is far from brilliant: companies are reluctant to invest in oil and gas refining, because crude oil exports are much more profitable. As a result, oil production grew 9.4% on previous year between January and September of 2004, while refining increased a mere 1.4%. It is important, therefore, to change this situation by building up production of finished products. In this connection, one can only welcome the decision to reanimate the plan to found a major petrochemical complex near the city of Surgut, as accepted by JCS Surgutneftegaz. Another case in point is JSC LUKOIL, which put into operation a deep crude refining complex in Perm, a development that will considerably increase the output of light petroleum products. Hopefully, projects of this kind will only multiply in future.

Russia's oil and gas potential can be used with success in the foreign policy area. LNG exports to the U.S. and Russian oil expansion in the U.S. market will be a weighty argument for strengthening Russian-American ties. Oil and gas export in the Eastern direction is increasing Russia's political weight in this promising region. Moreover, Russian natural gas purchases in Central Asia are an element of the effort to cement the post-Soviet space. It is in the interests of Russian oil and gas companies to expand the sphere of their activities outside of Russia, thus securing stronger international positions for the state. In this respect, Russia has the right to count on LUKOIL and its operations in Eastern Europe, primarily in Poland, Bulgaria and Romania.

High oil prices provide a fine chance for Russian oil and gas companies to restructure their activities, attract latest innovations, become more thrifty owners, change their attitude to mineral resources and refining, and join the group of real leaders in the world oil and gas market, both in production amounts and modern operational standards. The future of Russia's oil and gas complex and its would-be development model will depend on its success in this area.

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Oil of Russia, No. 1, 2005
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