Russian Energy Review in 2012: Consolidating State Control in an Uncertain Market

Increased state control and consolidation of the oil and gas sector marked Russia’s energy developments in 2012, while the state budget remained heavily dependent on energy revenues. At the same time, Russia’s markets in Europe are shrinking due to the economic crisis and the “shale revolution” in the United States. European markets will remain vitally important to Russia as it exports more than half of its natural gas production to the continent.

Some successes in 2012 included rallying Eastern European countries behind the South Stream natural gas pipeline and the expansion of the Nord Stream pipeline to Germany. However, the Russian energy sector also exhibited profound inherent problems in 2012. One of the major blows was the indefinite suspension of its signature Shtokman natural gas project in the Barents Sea, which was jointly developed with Norway’s Statoil and France’s Total. The changed market situation and extremely high cost of production in the Arctic raised doubts as to the project’s profitability given its estimated cost of $40 billion.

In June, the Russian state budget was amended based on a higher projected oil price of $115 per barrel for Russia’s Urals oil export blend in 2012, changing it from the more modest prognosis of $100 per barrel (RIA Novosti, June 6, 2012). But oil prices then dropped to $93 per barrel in the summer followed by a slow recovery to $109 in December, which further affected state revenues.

Fifty percent of Russia’s budget revenue comes from oil and gas sales, as Putin admitted before the annual meeting of the Valdai Discussion Club in October (Komsomolskaya Pravda, October 2, 2012). Declining energy revenues have created a serious budget gap, prompting the Kremlin to announce in May an increase of the mineral extraction tax on oil and natural gas companies, which will double by the end of 2015. This will cost Gazprom an additional $3 billion per year. The Kremlin went even further in September by ordering its state oil company Rosneft to surrender 50 to 95 percent of its dividends to the state budget.

The year 2012 turned out to be very difficult for Gazprom, which generates 80 percent of the natural gas production in the country and has sole authority to export Russian gas. Gazprom was the world’s most profitable company in 2011, but the state-owned monopoly has seen drastically reduced revenues in 2012. The gas giant’s net profits declined by 33 percent in the first six months of 2012, with similar results expected in the second half of the year (Kommersant, December 24, 2012).

There are a number of factors contributing to the poor financial results of the company, including increased cost of production as Russia starts to develop new gas fields, and reduced demand due to the economic crisis in Europe. In addition, many European states are trying to diversify their gas supplies away from heavy dependence on Russian gas, which currently comprises 25 percent of the European market, but reaches more than 90 or 100 percent in certain countries, mostly in Central and Eastern Europe.

According to the Ministry of Economic Development, Russia will have problems selling gas to Europe as early as 2016. Nevertheless, Putin pushed for finalizing all investment agreements on the South Stream natural gas pipeline in 2012 and started construction in December. Gazprom will own 50 percent of the pipeline in most of the Central East European countries, except for Slovenia, where its share will be 49 percent. The pipeline will have the capacity to transport 63 billion cubic meters of gas per year, but doubts remain whether Russia will have such quantities available for export by 2015 or even later. Existing gas fields in Western Siberia are becoming depleted and the development of new fields in Eastern Siberia requires significant funding and new technology that Gazprom lacks. With the increased tax burden and expectations to pay for half of the $20.92 billion South Stream pipeline, Gazprom might be in a difficult position to invest in developing new gas fields.

Gazprom also ran into trouble with the European Union, which last year opened an anti-monopoly probe of the company’s pricing policies in eight Central and Eastern European countries. The probe is looking into Gazprom’s high tariffs linked to oil prices and the take-or-pay contract clauses that obligate the energy companies to pay for volumes they may not need.

The South Stream pipeline will also face difficulties complying with the EU’s energy regulations, which mandate that the energy producer cannot own the transmission network. In December, Russian Energy Minister Alexander Novak requested an exemption for the pipeline arguing that the functioning Nord Stream pipeline and the planned South Stream pipeline should receive special treatment because they straddle both EU and non-EU countries (The Moscow Times, December 17, 2012). The request is unlikely to be honored.

Meanwhile, state consolidation of the Russian energy sector continued in 2012 with the pending acquisition of TNK-BP by the state-owned oil company Rosneft. In October, BP agreed to sell its share in TNK-BP to Rosneft for $17.1 billion and a 12.84-percent share in the state firm. Simultaneously, Rosneft announced it has also bought for $28 billion the other half of TNK-BP from the AAR consortium owned by Soviet-born billionaires. The acquisition will catapult Rosneft into becoming the world’s largest publicly traded oil company. Rosneft, which now controls approximately 24 percent of the Russian oil market, is set to obtain control of more than half of Russian oil production. The oil industry has not seen such dramatic developments since the Yukos oil company owner Mikhail Khodorkovsky was jailed in 2003 and his company was effectively nationalized by Rosneft.

As Rosneft progressively becomes a monopoly like Gazprom, concerns are rising that greater state control will harm industry competitiveness and will make it harder to counter its endemic corruption. While Putin has vowed to deal with corruption in the energy industry, it is apparently more important to him to remain in charge of Russia’s energy resources that are essential for funding the state budget, maintaining the internal balance of power, and using them as diplomatic tools in relations with Europe.