Russias energy challenge

Russia does not stand in dire need of finding large-scale deposits of natural resources. Pumping out around 10 million barrels of oil every day and exporting around three-quarters of this amount, its output is currently surpassed only by Saudi Arabia. And it also has enormous untapped reserves, although estimates of the size of these deposits vary considerably. Analysts at BP estimate that it has around 80 billion barrels, giving it the world's seventh-biggest oil reserves, while a 2008 survey by the highly respected Oil and Gas Journal put the figure at closer to 60 billion barrels, most of which are located in Western Siberia, between the Ural Mountains and the Central Siberian Plateau. But many leading figures in the industry think that there could really be much more to unearth, perhaps as much as 100 billion more barrels, which would make it 'the biggest exploration prize in the world', in the words of Robert Dudley, the head of BP's joint venture with its Russian partner, TNK.7

Russia's problem is not the size of its existing reserves, but its ability to exploit them. It is true that for many years the dramatic, even stunning, rise of Russia's oil industry seemed to pay fitting testimony to the country's potential as a key global producer. Badly neglected during the political turmoil of the early 1990s, as the Soviet Union crumbled and fell apart, and then suffering badly from the depressed barrel price of the mid-1990s, the oil sector recovered sharply in 1999

and for the next few years its story was one of virtually unchecked growth. Companies like Yukos, Rozneft and Sibneft posted extraordinary profits and their share price soared as their pumps worked furiously hard to keep pace with the mounting strength of global demand.

However, by early 2008, things suddenly began to look less rosy for the Kremlin, even though the market price of crude oil was at this time starting to spiral to new heights. The business world was shaken in early April, when the International Energy Agency (IEA) announced that Russia's output had fallen for the first time in a decade. Having peaked in the first quarter of 2007, ran the IEA report, national production had started to tail off, already dipping slightly and looking likely to continue falling in the years ahead.

Even senior officials in Moscow had to admit that something was going seriously wrong. In an interview with an American newspaper, the president of Lukoil doubted whether output could continue to increase, while business analysts said that the growth experienced in recent years could 'no longer be taken for granted'.8 Other officials, such as the natural resources minister, Yuri Trutnev, spoke even more directly. 'Two years ago, we said the growth rate was falling, and we said this was bad for Russia, remember?' he asked in televised remarks after a government meeting in Moscow. 'But now we're saying the production rate is falling this year. This is not a bogeyman, unfortunately, this is real.'9

Scarcely could any spectre haunt the Kremlin so chillingly as the threat of diminishing oil revenues. The energy sector accounts for half of Russia's national income and 65 per cent of its foreign exchange earnings, and any shortfall would devastate its economy. Without these earnings, the country would run short of the foreign currency that services its external debt and run low on the emergency reserves that it has used in recent years to form an emergency economic 'stabilization fund'. In short, Russia's drastic economic growth since the late 1990s has been built by oil at a time when the market price of crude was climbing, just as since late 2008 analysts have expected its economy to contract sharply as a result of the drastic fall in barrel price.

There are a number of reasons why this output is deteriorating, but chief among them is the fact that the Russian government has regulated the industry very poorly. Desperate to make as much as money as it can from its prize commodity, the government levies a punitively high export duty, taking more than half the proceeds of any barrel that fetches a market price of more than $25. When all the other charges are taken into account - a variety of corporate, payroll and production taxes - then industry insiders complain that the state is taking as much as 92 per cent of profits made by international ventures such as TNK-BP. So the output from TNK-BP's fields in Russia, for example, accounts for one-fifth of BP's overall global production, but only one-tenth of its profits, and its officials have long argued that the oil industry is confronted by rising costs that will make many investments in Russia quite unprofitable unless the tax regime is drastically changed.

The government does offer oil companies some limited tax breaks, but these have made things worse rather than better because they only apply to production from older fields, and this has given oil firms an incentive to concentrate on squeezing as much oil as they can out of wells that are already in a state of decline. For a time, this approach helped to pump up production levels, since some old fields that had fallen into ruin after the collapse of the Soviet Union were revived relatively easily and cheaply. Using new pumps, and applying some basic engineering techniques to increase the flow of oil, a number of private firms were able to raise Russia's production from 6 million barrels every day to almost 10 million, and output jumped by 12 per cent in 2003 alone. But by 2008 this short-term strategy had started to yield rapidly diminishing returns as these older fields reached their natural limit: the reservoirs in the two largest producing regions, at Khanty-Mansi Autonomous Okrug in the west of Siberia and in the Volga-Urals, which together account for about two-thirds of the country's overall production, were both showing signs of exhaustion.

Solving this energy challenge should be relatively simple for a country with such voluminous quantities of petroleum as Russia. What is needed is a huge input of foreign investment, skills and expertise to exploit new fields in remote provinces, such as eastern Siberia and the Sakhalin region, and offshore. Russian companies have always been able to pump out oil from their existing wells, just as they did so successfully in the 1980s, by which time most of their main producing fields were discovered. But they completely lack expertise in two crucial areas. One is making the most of existing fields, squeezing everything they can out of them by using the latest, highly sophisticated methods of enhanced 'tertiary' recovery. The other is offshore drilling, particularly in deep waters. In both cases, it is Western companies - oil majors like BP, Total, Statoil and ExxonMobil, as well as minor service organizations like Schlumberger and Halliburton - that lead the way.

If Russia is to maintain its output in the years ahead, then it will have to exploit new fields and employ foreign expertise to do so.

But this will mean investing far more money into the wells than it is accustomed to because new fields, particularly those that lie offshore, require much more sophisticated technology and higher investment, which drives up production costs. This, in turn, means that profit margins fall, which is all the more painful if the price of crude oil crashes to the lows it achieved in 1986, 1998 and the early months of 2009.

These profit margins are generally likely to be much lower if Russian oil companies are forced to enlist the support of their foreign counterparts, which of course need to claw back the huge costs associated with developing a new oilfield. Above all, Moscow fears exploitation because it lost out so badly in the 1990s. This was partly because the privatization of its oil industry created a number of fabulously wealthy oligarchs who moved their assets abroad instead of investing in new wells and technology. But it was also because at this time Western companies like Shell, ExxonMobil and Total signed 'production sharing agreements' to develop oil and gas fields that Russia now claims were totally unfair. In the eyes of the Russian authorities, these deals demonstrate how foreign, particularly Western, energy companies are likely to exploit them, even when they have been invited there to work.

But this hostility is not just about money and profit margins, but also about national pride and security. Most countries dislike having to admit that they are dependent on foreign expertise to exploit their own resources and this is why most producers - notably those of the Middle East - have their own national oil companies that try to compete with Western 'Big Oil'. 'Can you imagine a politician in France saying I need help from the UK because they have expertise', as the president of Total, Christophe de Margerie, has said.10

For a country that has felt so humiliated in recent years by its loss of status since the heyday of the Soviet Union, national prestige is a big consideration. But it is also about security: if the production of its key export is dependent on foreign sources of assistance, then Moscow would feel vulnerable to threats and blackmail in the event of any national emergency. This is one reason why, in April 2008, Moscow introduced a new law that places severe restrictions on the foreign ownership of any company that operates oil and gas fields, as well as any other site 'of federal significance'.

Acquiring more reserves in the Arctic, or anywhere else, would solve none of these underlying challenges that confront Russia's own oil industry. Russia does not lack reserves of oil but the ability to exploit them, and any resources in the High North would be even more difficult to exploit than many of those that it already has in its possession. The same is equally true of its natural gas.

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