PROSPECTS FOR INVESTMENT IN OIL PRODUCTION IN RUSSIA

By Sergei Kolchin

Many oil industry observers believe that Iraq will be the center of international and especially U.S. attention over the next few years. But BP’s stunning announcement in March that it was willing to spend up to US$6.75 billion to acquire the Tyumen Oil Company (TNK), Russia’s fourth largest oil producer, reminded investors that Russia is still a major player.

Despite a significant decline in oil production in the 1990s, Russia remains among the world’s leaders both in terms of the volume of oil it produces and the amount it exports to foreign markets. Russia also has huge oil reserves, so it can also look forward to a stream of investment projects in the future. Instability in the Persian Gulf can increase Russia’s attractiveness, although fluctuations in the general state of the world’s oil market also affect such plans.

The growing requirements for energy in China, Japan and the Asian Pacific region create a strong potential demand for Russian oil, but satisfying this demand will require that the necessary infrastructure be put in place. A program to supply oil to the United States via the far north has also been drawn up, giving added impetus to the development of trans-arctic oil transportation projects. This means that Europe could well lose its traditional standing as the largest customer of Russian oil.

Commercial factors rather than political ones now dominate the interests of Russia’s oil companies. If options to the east provide a more stable and solvent demand than do those in Western Europe, then Russian companies will start switching to the east, regardless of the Russian government’s political priorities. It is worth noting that, with regard to the formation of oil policy, the state plays a rather passive role in Russia. It does little more than exploit its monopoly position in pipeline projects (through the Transneft company) and employ certain tax levers.

Nonetheless, the symbiotic relationship between the state and Russia’s current oil elite remains strong. The results of the sale of the formerly state-owned Slavneft oil company in December of last year attests to this fact. At first there was talk of a broad swathe of candidates (there were twelve applications participating in the auction), and presentations were held abroad with a view to attracting foreign investors. One of these, the Chinese National Oil Company, responded to the call, offering somewhere between US$3 and US$4.5 billion. But the sale subsequently degenerated into a farce, with the company passing–via a prearranged deal–to Sibneft and the Tyumen Oil Company (TNK) for US$1.9 billion.

This confirmed once again the unique nature of oil privatization in Russia, in which the victor is typically not the party offering the most money, but the one which has the greatest lobbying potential.

RIVAL APPROACHES

From the very start, as the integrated Soviet economic system was breaking up, Russia’s energy sector in general–and oil production in particular–was assigned the role of a magnet, one employed to attract the foreign investment that the economy so desperately needed.

Initially, in the late 1980s, this investment took the form of joint enterprises, which used state-of-the-art oil extraction methods. For a while these joint enterprises accounted for up to 10 percent of all Russian oil production. But with the creation of nationwide oil holdings and the withdrawal of privileges and benefits from the joint ventures, they began to decline in number. Joint ventures began to be swallowed up by “parent companies” such as Lukoil.

After joint ventures, the mid-1990s saw the emergence of product-sharing agreements (PSA) as the new favored vehicle to attract foreign investment to Russia’s oil complex. PSAs guarantee the foreign investor a direct share of the revenues from the project, free of taxes, until the investor’s costs and an agreed profit are recouped. At first the PSA idea met with concerted opposition in Russia’s State Duma, especially from communists and nationalists who saw it as a surrender of Russian sovereignty. As a result of this opposition, the Sakhalin-1, Sakhalin-2 and Kharyaga projects are the only ones to have been developed on the basis of PSA. The subsequent battle to expand the list of oil projects operating under this system led nowhere, moreover, primarily because few Western investors were willing to try this procedure.

Recent debates in government and parliament on the chapter of the tax laws dedicated to PSAs demonstrate that Russia’s oil community is divided into two camps–those who support PSA and those who oppose it. The supporters of PSA think that investors should come in via individual agreements on specific oilfields. Opponents, on the other hand, believe that investment should be made through the share capital of Russian oil companies, a process which in fact began early this year.

Both sides agree that the energy sector needs foreign investment and technology. But they are also aware that a new law would only exacerbate the tension between joint ventures and PSAs as vehicles for the development of Russia’s energy complex.

THE TWO CAMPS

The main opponents of the expansion of PSA in Russia are Yukos, Sibneft, and TNK, companies that have been the leading players in oil production development in Russia over the past two years. These companies have achieved impressive results while working within the framework of the standard tax regime. Ranged against them are three other major oil companies: Lukoil, Surgutneftegaz and Rosneft. These are companies with a strong state sector orientation, which are run by managers who came originally from state administrative and production structures. They favor those forms of interaction with foreign investors (that is, international agreements and product-sharing agreements)that were traditional for the USSR and for Russia before the reforms.

At the same time, these companies also managed to amass considerable financial reserves during the period of high oil prices, a resource that they have used in varying ways. Although Surgutneftegaz and Rosneft have thus far hardly invested their reserves at all, Lukoil has been active using its reserves to acquire foreign assets. Lukoil owns refineries in Bulgaria, Romania and the Czech Republic. It also has stakes in various oil fields in Kazakhstan, including 12.5 percent of Caspian Pipeline Consortium pipeline, and has even acquired the Getty gas station chain in the United States.

The competitors of these companies–Yukos, TNK and Sibneft–are considered within the industry to have been the most active participants in the recent redistribution of Russian oil assets. They have initiated various projects abroad, ranging from transport projects to asset sales. Their financial resources amount to no less than those of the first three companies, but they have never stopped working at it, and are attracting foreign credits to boot.

The future prospects for investment in Russia’s oil complex depend to a large extent on the general state of the world oil market–that is, on whether prices remain at their current relatively high level, or whether a fall in oil prices looms with the end of military operations in Iraq.

In either case, it seems that Russian oil production will be quite attractive to foreign investors having a long-term perspective (the recent deal between BP and TNK attests to this in particular). However, the practice of simply earmarking oil reserves for themselves, as western oil companies have done in other post-Soviet states, is unlikely to work in Russia.

Unlike the state oil structures in other CIS countries, Russian oil majors have no desire to play a passive role in their relations with their western partners. They have their own clearly defined interests.

The 1997 deal whereby BP-Amoco acquired a 10 percent stake in Sidanco for US$500 million serves as a clear example of this. “Our company entered Russia five years ago, and we found it hard going at first,” said BP head John Brown. “But gradually our relations with our Russian partners have brought us a huge amount of experience in operating in Russia.”

THE BP DEAL: EXCEPTION OR THE SHAPE OF THINGS TO COME?

The new holding, which has yet to be named, will become Russia’s third largest oil and gas company. And it will be the first in Russia to have major participation by a leading international oil company.

BP will name half the members of the board. For its 50 percent stake in the joint company, BP will pay its Russian partners US$3 billion in cash. In addition, over the next three years Alfa Group and Renova, the two firms controlling TNK, will receive BP shares worth US$3.8 billion. To this end, the Anglo-American company is planning a new share issue. BP’s share of the oil produced by the new holding will amount to over 500,000 barrels a day, which is undoubtedly the key to its participation as a serious player in the Russian oil sector.

Government and oil industry analysts believe that this is some of the best news that Russia’s stock market has had in recent times. BP’s arrival in Russia has been heralded as a breakthrough in the strategy to attract foreign investment in Russia’s oil complex. In fact, however, the situation is not so clear cut.

One group of companies–TNK, Sibneft and Yukos–are evidently leaning toward selling their businesses to foreign investors. They are preparing the ground by normalizing business practices, adopting international accounting standards, reducing conflicts with minority shareholders and standardizing management structures. But a second group–Lukoil, Surgutneftegaz and Rosneft–are not ready to take this step, and indeed have no intention of doing so.

The BP deal aside, investment prospects for Russian oil production are linked primarily to the development of new markets. Russia lacks export infrastructure and currently exports only 45 percent of its oil production. Current projects being mooted include:

–The construction of an oil trans-shipment port in Murmansk, targeted at the North American market.

–Plans to construct an oil pipeline to the East (China or Nakhodka).

–The development of deposits in Eastern Siberia, a project that would include Gazprom, because of the mixed nature of local hydrocarbon resources.

As regards official policy, it can be assumed that the above-mentioned projects will receive state support, given the state’s interests in them (shares in the stock capital, export tariffs, and a monopoly on transportation).

In conclusion, it is quite possible that Russia’s energy sector will continue to grow, supported mainly by local investment, but also with the help of individual international projects, including some which involve a transition to mixed (international) control for some Russian oil companies. This would be a logical progression, given the way Russia’s oil complex has been developing over the past few years.

Sergei Kolchin holds a doctorate in economics, and heads the IMEPI Center for Macroeconomic Research at the Russian Academy of Sciences.