The Russian Oil Sector and the Global Oil Economy: A Prospectus

Quayat, David.
SAIS Review, Volume 23, Number 2, Summer-Fall 2003, pp. 1-22 (Article)

Published by The Johns Hopkins University Press DOI: 10.1353/sais.2003.0052

For additional information about this article

http://muse.jhu.edu/journals/sais/summary/v023/23.2quayat.html

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SAIS Review vol. XXIII no. 2 (SummerFall 2003)

The Russian Oil Sector and the Global Oil Economy: A Prospectus
David Quayat
Since the terrorist attacks of September 11, 2001, interest in the Russian oil sector has increased, particularly within the Bush administration. Russia is viewed as a potential buffer, if not substitute, for Americas dependence on Middle Eastern oil. This paper presents an overview of the Russian oil sector and suggests that this optimistic vision is unlikely to be born out in reality. Incomplete attempts at legal and political reform continue to deter foreign investors, and the profits that drove Russian oil companies production gains in the late 1990s have all but evaporated. Russia also suffers from export infrastructure problems that could hamper its ability to play a meaningful role in the global market. This does not mean Russia cannot play any role in the evolving global oil market. Rather, Russia should consider its development strategy carefully, and U.S. policymakers should accept that the Middle East will continue to dominate the global energy supply.

ince the terrorist attacks of September 11, 2001 there has been increasing interest in the Russian oil sector, particularly among American legislators and policymakers. The perceived importance of Russia to the future of the world oil economy and wider energy security has been reinforced by key members of the U.S. government, including President Bush.1 It has even been suggested that Russia could emerge as a challenger to Saudi Arabias dominance of the world oil market.2 Others, however, have been skeptical of Russias oil potential, arguing that Saudi Arabias spare capacity and extensive reserves make it essentially untouchable as the leading global supplier of oil.3 The Russian oil sector also faces interDavid Quayat completed his M.A. at the Johns Hopkins University School of Advanced International Studies (SAIS) in May 2003. Upon graduation he received the William C. Foster Award for scholarship, leadership, and distinguished service to SAIS. The author wishes to thank Dr. Wilfrid Kohl and Dune Lawrence for their comments and encouragement. This essay won first prize in the annual SAIS Review student essay contest.

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nal, interlinked obstacles to oil development that may undermine its future importance in the world market if unremedied, including lack of foreign investment, a convoluted regulatory scheme, a weak legal system, and transportation infrastructure in urgent need of modernization. Russia may not displace Saudi Arabia, but its importance to the global oil market merits close attention given increasing concerns over global oil security. This paper presents an overview of the Russian oil sector as it has developed since the end of the Cold War and the factors affecting its future evolution. It first surveys patterns of production and organization in the domestic industry, discusses the role of the government and private industry players, and then looks at the major obstacle to increased exports of Russian oiltransportation infrastructure. It concludes with an overall assessment, including recommendations for reform, as well as the outlook for achieving such reforms. Russian Production and Reserves For much of the 1980s, the Union of Soviet Socialist Republics (USSR) was the worlds largest producer of crude oil. Within the USSR, Russia led the Soviet republics in oil production.4 But, in the aftermath of its dissolution, the early 1990s witnessed a collapse in Russian crude production to levels not seen since the 1970s. Collapse has been followed by rebirth. Consistent gains in output over the last three years have brought Russia back to the top of global oil production, with much more of the oil being exported outside of the Former Soviet Union (FSU), a rebound that has made it the darling of American policymakers.5 In the context
Figure 1. Soviet Oil Production, 19731993

Source: Energy Information Administration Country Data

THE RUSSIAN OIL SECTOR AND THE GLOBAL OIL ECONOMY

Figure 2. Russian Oil Production, 1994Present

Source: Energy Information Administration Country Data

of Russian oil production, two questions press. First, can Russias production increases be sustained? And second, what are the longer-term prospects for reserve expansion or depletion? The Soviet Union hit its production apex in late January 1983, when output reached nearly 12 million barrels per day (mb/d). (See Figure 1.) The end of the Cold War, however, threw the Russian oil sector into disarray. Demand collapsed both within Russia and throughout the former Soviet satellites in the difficult transition to a market economy; the collapse in domestic demand and a lack of infrastructure needed to facilitate exports resulted in a major oil glut on the Russian market.6 Poor oilfield management and the scramble by Russias oligarchs to acquire assets as they were privatized by the Russian government compounded the problems.7 Soviet oil production returned to 1973 levels by 1993, and continued to decline well into the 1990s. In 1998, two events prompted the recovery of oil production in Russia. (See Figure 2.) The devaluation of the Russian ruble made Russian exports, including oil exports, more competitive in international markets. At the same time, world oil prices began to recover from OPECs disastrous decision to increase production just as the Asian financial crisis hit.8 This convergence of events allowed Russian oil producers, now mostly in private hands, to net higher profits, which allowed for greater capital investment.9 As a result, wells left idle since the early 1990s were brought back on line, and the life of older wells was extended. In 2000, over $4 billion was invested into the Russian oil sector, nearly a third in drill-

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ing,10 and capital investment rates have continued to increase owing to sustained high oil prices over the past year. The sustained capital infusions into developmental and exploratory drilling in existing oilfields has resulted in some positive developments for the Russian oil sector. In 1999, Russia experienced its first increase in the number of active wells in over a decade.11 However, as the International Energy Agency (IEA) notes, the number of idle wells in Russia continues to grow as well.12 In order to support sustained production increases, therefore, Russia has been forced to drill new wells. Many of these new wells are in Western Siberia, an already well-developed region that the IEA forecasts will decline in share of total Russian output.13 While new and exploratory wells have been drilled both in the north and far east, two-thirds of current production comes from these alreadydeveloped fields in Western Siberia.14 This concentration of new wells in well-developed fields raises several important questions. Chief among them is the future of Russian oil reserves, since new wells in developed oil fields do not add to Russias reserve estimates. Russian production in recent years has outpaced its addition of new oil reserves, a trend confirmed by Victor Kaluzhny, Russian special envoy for Caspian issues.15 Assessing Russias crude oil reserves is a difficult, if not impossible, task. First, despite the fact that all of Russias integrated oil companies publish reserve data, the official size of reserves remains a state secret. Second, Russian methodology for the calculation of its reserves differs for Western countries.16 Figures presented by Russian officials on reserve levels are often quite divergent. The Russian Energy Minister, Igor Yusufov, recently suggested that Russia possesses 12 percent of the worlds oil reserves, while other Russian officials and Western publications cite a figure of about 5 percent.17 Recent analysis by the U.S. Department of Energy places Russian reserves at about 6 percent of world proven reserves, while also suggesting that Russia will account for 18 percent of global reserve growth through 2025.18 The future of Russias reserves is also a source of much disagreement. The heads of two of Russias major oil companies, Lukoil and Yukos, eager to encourage foreign investment, offer an optimistic picture of potential discoveries, particularly in northern Russia, Eastern Siberia, and the Caspian.19 Others, however, have suggested that Russias reserves could be depleted before 2020, assuming continuing increases in production.20 No major new finds have been made since the announcement in 2000 that

THE RUSSIAN OIL SECTOR AND THE GLOBAL OIL ECONOMY

Russias sector of the Caspian contains approximately three billion barrels of new reserves. At current production levels, that only adds about one year of productive life to Russias oil sector. Exploratory drilling in new fields remains extremely weak in Russia, particularly in previously unexplored regions. Of the 135 exploratory wells Lukoil drilled in 2001, only thirteen were out- Overall, exploratory drilling has side of Russias remained quite low since the traditional or mature produc- collapse of the Soviet Union. In tion areas. 21 addition, approximately 60 percent Overall, exploratory drilling of Russias current reserves qualify has remained as difficult to recover. quite low since the collapse of the Soviet Union. In addition, approximately 60 percent of Russias current reserves qualify as difficult to recover.22 Major producers in Russia have focused on consolidating easily accessible reserves while higher cost fields have gone unattended. The cost structure of Russian oil production is a critical issue, particularly if long-term output increases are to be sustained. Production increases in Russia are coming from pushing existing infrastructure to its limits, while supplementing it with additional wells in existing fields. The average yield from Russian wells continues to decline and dependence on old reservoirs has required costly investments to net further oil, raising production costs to dangerously uneconomic levels. Russian oil typically costs $5 $7 per barrel to produce, compared to $1 $2 per barrel in Saudi Arabia.23 Costs will be even higher in many of Russias undeveloped oil regions, perhaps upwards of $15 per barrel.24 Just as high oil prices triggered the Russian oil recovery in 1998, sustained growth in output will also require sustained high prices. Technological advancements and modernization have reduced the production costs of some of Russias major oil producers,25 but Russias production increases might not survive a major downturn in oil prices. Forecasts for growth in Russias oil production over the next decade vary. Lukoil President Vagit Alekperov has suggested that Russia could reach production levels of approximately 9.1 mb/d by 2010.26 Deutsche Bank forecasts put Russian oil production at over 9 mb/d by 2007, consistent with figures offered by Eugene

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Khartukov, head of the International Center for Petroleum Business Studies.27 This growth potential provides Russia with an excellent opportunity to enhance its exports of oil and petroleum products. However, output growth will depend on one major variable: capital investment, particularly in underexplored regions of the country. While Russias oil producers have pursued a wise strategy of capital reinvestment and asset maximization, sustaining current production trends depends on greater foreign investment. Estimates of the necessary investment ranges from $5 to $35 billion a year over the next two decades, levels that cannot be met with only domestic capital.28 Recent years have not seen the levels of foreign investment called for, despite joint efforts by Russia and the United States to generate more.29 Foreign capital flows in Russias oil sector continue to be discouraged by an ineffective judiciary, a complicated tax structure, and incoherent production sharing legislation. These issues will be reviewed later in the context of Russian government policy. Private Actors The most significant development in the Russian oil sector over the past decade has been the transition to a market economy and the push to privatize oil production. Most of Russias oil production is now in private hands, and the Russian government continues to shed its remaining holdings. 30 In the process of privatization, wealthy business oligarchs scrambled to swallow as many of Russias oil producing assets as possible, sometimes through extra-legal means.31 Foreign oil companies have played a limited role in Russias private oil sector, and their experiences have often been less than positive.32 The privatization process has resulted in an industry dominated by a few vertically integrated companies (VICs). Ten of these companies control approximately 90 percent of oil output, with the remainder produced by Gazprom, Russias government-owned natural gas company, and independent oil producers with output of less than 650,000 barrels per year.33 Russias VICs are also involved with both upstream and downstream operations, including retail sales within the Russian Federation. The three biggest producers, Lukoil, Yukos, and Surgut, continue to increase their collective share of crude oil production. In 1998, these three companies produced more than 58 percent of output among Russian majors, and the five largest Russian oil

THE RUSSIAN OIL SECTOR AND THE GLOBAL OIL ECONOMY

companies produced roughly 70 percent of output. (See Figure 3.) If forecasts hold, Russias oil output will be concentrated in fewer and fewer hands, a trend reinforced recently by the merger Most of Russias oil production of Yukos and Sibneft. is now in private hands, and the By 2007, the five largest VICs in Russia Russian government continues could control 80 per- to shed its remaining holdings. cent of output among Russian ma- In the process of privatization, jors.34 (See Figure 4.) wealthy business oligarchs While Lukoil, Yukos, and Surguts share of scrambled to swallow as many production will conof Russias oil producing assets tinue to grow relative to total production as possible, sometimes through by Russian VICs, extra-legal means. their share of the overall Russian market is expected to decline owing to increased production from joint ventures and Gazprom. More important than the share of production is the share of reserves held by Russias largest oil companies and the ratio between reserves and output. Reserves are more evenly divided than production. Lukoil and Yukos lead the way with approximately 23 percent and 20 percent respectively of reserves held by Russias VICs. Four other firms hold 10 percent or more of reserves. (See Table 1.) The recent merger of Sibneft and Yukos gives the new entity the largest reserve base in Russia, indicating the potential for further reserve acquisitions by Russias largest VICs. Russian oil companies performance reflect a number of trends. Russian oil companies have made transition to western-style business techniques an important priority. They have established a corporate presence in the media and on the internet, and boast about commitments to transparency in corporate governance. Many now release financial information according to U.S. accounting standards, and auditing of proven and probable reserves has become common practice. Despite this, Russias oil industry continues to be dominated by a privileged elite, able to exert tremendous influence over government policy. President Putin came to office pledging, among other things, to curb the power of the oligarchs. According to some sources, this pledge has gone unfulfilled.35

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Figure 3. Russian Oil Production by VICs - 1998

Figure 4. Russian Oil Production by VICs - 2007

Source: Deutsche Bank, Oil Market Outlook: OPECs Balancing Act, 5 September 2002, 48. Note: in 1998, both Yukos and Sibneft operated as independent entities. In May 2003, they announced they would merge.

THE RUSSIAN OIL SECTOR AND THE GLOBAL OIL ECONOMY

Table 1: Reserve / Output Comparison Among Russian Majors

(Thousands of Barrels)

Company
LUKoil YUKOS TNK Surgut Rosneft Tatneft Sibneft Slavneft Bashneft Total

Reserves
14,280 12,500 8,200 6,990 6,415 6,140 4,720 2,820 1,350 63,415

% of Reserves
23% 20% 13% 11% 10% 10% 7% 4% 2%

Output
1,532 1,170 826 887 301 495 415 288 239 6,153

% of Output
25% 19% 13% 14% 5% 8% 7% 5% 4%

Source: Deutsche Bank, Prospect Investments

Recent financial data from Russias majors has shown that their financial performance began to slip in 2001. Lukoil and Yukos both reported a decline in profits of as much as 25 percent in 2001, and while this trend slowed in 2002, both companies continue to post losses.36 Three factors have contributed to weakening profits. First, the price for a barrel of crude has slipped from its high in 2000. Although the decline has not been drastic, increasing reliance on export revenues has intensified Russian oil companies exposure to price volatility. Second, increasing production costs have eaten into profits. As the earlier discussion of production indicated, older infrastructure is being pushed to the limit, with a resulting increase in capital costs. Finally, the rubles depreciation against the dollar has driven up the cost of imported equipment and materials. The overarching theme among private actors in the Russian oil sector continues to be asset consolidation, with the larger oil companies like Lukoil and Yukos purchasing smaller entities in order to exploit complementary asset and production structures.37 Some of this consolidation has come as a result of the sale of remaining state shares in the oil sector. Sibneft and Tyumen Oil Company (TNK) recently acquired the governments controlling

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interest in Slavneft, for example. The two companies will likely divide up the assets, paving the way for a possible Sibneft/TNK merger.38 Some analysts predict that the number of VICs will decline to five over the medium term if consolidation continues.39 As discussed above, foreign private actors have played a peripheral role in structuring Russias oil sector. British Petroleum is the most significant foreign player, with a minority stake in Russian producer Sidanko, an affiliate of TNK. This investment has proved problematic, even requiring intervention by U.S. political leaders to ensure its viability.40 The Chinese National Petroleum Company made a push to acquire Slavneft in December 2002.41 But many in Russia oppose foreign ownership of Russian companies, and the Duma even took up a resolution urging the government to ensure that the buyer was a Russian firm.42 Foreign participation has more typically taken place through joint ventures or production sharing agreements (PSA). ExxonMobil, for example, has been a major player in the development of oil reserves off of Sakhalin Island though a PSA.43 The Government Role Although the Russian government continues to divest itself of oil producing assets, it remains an important player in the domestic oil sector. Instead of controlling oil production through state ownership, the Russian government now influences it through regulation and taxation. Understanding the The Russian Duma has made absence of foreign insufficient progress in reforming investment in Russia requires an aplaws related to taxation and oil preciation of the production, leaving Russian regulatory and tax environment, often companies to exploit a system cited as the greatobstacles to rife with loopholes and foreign est further expansion investors loathe to risk capital in of production. The Duma has such an uncertain environment. Russian made insufficient progress in reforming laws related to taxation and oil production, leaving Russian companies to exploit a system rife with loopholes and foreign investors loathe to risk capital in such an uncertain environment.

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The Law on Underground Mineral Resources, passed by the Duma in 1992 provides the basis for the exploitation of petroleum.44 It grants the government exclusive ownership over mineral resources, permitting their use by state-owned or private corporations through licensing. The issuance of a license requires dual approval from federal and state authorities, ensuring that regional interests play a significant role in the development of hydrocarbons. The governor of the Nenets Autonomous Region recently threatened to block progress on the Kharyagansky oil project with TotalFinaElf because the federal government passed over the Nenets Oil Company, a regional oil company, as a potential partner in the deal.45 The Russian laws governing PSAs are perhaps the most criticized regulations. PSAs have been widely used within the Organisation for Economic Cooperation and Development to permit foreign companies to enter a country and exploit a natural resource. In a PSA, the foreign company and the host state negotiate a formula to settle the distribution of proceeds. PSAs usually supercede other local or federal regulations, particularly those relating to taxes and other liabilities.46 Other conditions may be included in PSAs, such as partnership with a domestic firm, or a supply requirement ensuring that a majority of the materials and labor used in projects comes from the host state. Currently twenty-seven PSAs have been approved in Russia, but only three have actually proceeded into the development phase.47 The main problem is the incomplete nature of Russias PSA law. First, foreign oil companies are limited in what oilfields can be exploited under PSAs. The government establishes a list of areas eligible for development (the latest list was approved in 1998), and foreign companies can request a PSA only from areas on this list. Since the passage of the PSA law in 1995 and subsequent amendments in 1998, foreign corporations have shown interest in only seven of the nearly twenty-seven project areas on the list, the majority around Sakhalin Island.48 The adoption of the PSA is then subject to ratification by federal and state authorities, who are free to impose further restrictions. Finally, the PSA law requires that 70 percent of the equipment used in a project come from Russian sources, an onerous condition that existing PSAs under development have failed to meet.49 The existing PSA law, beyond imposing these restrictive prescriptions, also contains several ambiguities that require legislative clarification. In terms of oil transport, the state-owned company

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Transneft continues to conduct all pipeline construction and operations. Construction of new pipelines to move oil and gas from the Sakhalin Island area has always been understood as an important aspect of the project. However, Transnefts role in the construction or operation of offshore pipelines remains unclear. Officials with the Sakhalin consortium have expressed the fear that the pipelines would fall under the national monopoly provisions that govern oil transportation,50 with negative tax and legal implications for the investors. The PSA law also permits the federal government to amend the requirements of a signed PSA unilaterally should a significant change in circumstance occur.51 The meaning of that phrase has yet to be tested or defined by either the Duma or Russian courts. Progress on further legal reforms has been slow. The Ministry of Economic Development and Trade is preparing to submit amendments to the Duma dealing with the tax status of PSAs.52 These amendments will clarify what costs are deductible when calculating the tax liability of a PSA. Drilling and exploration costs can already be deducted, but others, such as road and other infrastructure investment costs, cannot.53 Russian officials have been skeptical of reforms to the PSA law. They fear that further amendment will permit exploitation by Russian VICs acting through foreign companies they own or control, thus securing tax and regulatory advantages.54 The Russian tax code in general is in urgent need of reform. On January 2, 2002, a series of tax reforms went into effect, including reductions in corporate and personal income tax. But the sheer number of different state and federal taxes and the tax codes general bureaucratic complexity still deters further growth and longterm foreign investment. The government uses tax policy not only to generate revenue for the federal government, but also to control export levels and prices on the domestic market. The governments tax policy, combined with its management of the transportation system, has thus created huge disparities between domestic and international crude prices. The price gap had gradually closed over the 1990s, but the 1998 financial crisis that prompted the devaluation of the Russian ruble caused it to expand again.55 In addition, tax policy focused on volume of oil extracted instead of the revenues generated from the sale contributes to the lack of investment by penalizing projects with high upfront costs.56 Rejuvenated U.S. interest in the Russian oil sector since September 11 has caught the attention of the Russian government and

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led to the creation of high-level bilateral working groups. This U.S. interest has helped the Russian government to improve its relations with the West and given President Vladimir Putin new leverage in the international arena. These political considerations, when coupled with Russias continued dependence on the tax revenue generated from the energy sector, give the Russian government a vested interest in staying involved in domestic energy affairs. The outcome for oil companies, whether Russian or foreign, could be positive or negative. A Russia interested in maximizing tax revenues and international clout could pursue further liberalization and re- U.S. interest has helped the forms that encourage the Russian government to foreign capital needed to achieve higher output. improve its relations with Alternatively, Russia could the West and given President remain guarded about access to its resources, Putin new leverage in the shut out foreigners with international arena. unworkable PSA laws, and attempt to exert greater control over the private sector. Such a policy would appeal to nationalists within Russia who are most concerned with ensuring that Russian oil stays in Russian hands. Russian policies in the last two years have been positive, particularly progress on reforming the tax code and export regulations, but much more remains to be done to attract the foreign capital needed to expand Russias oil sector. Russian Oil Exports and Infrastructure Assuming Russia can overcome obstacles to enhanced production capacity, the road to becoming a major global oil supplier requires transportation infrastructure to support surging exports. Most of Russias existing oil pipeline and export network dates from the Soviet era, a system designed to bring oil to communist satellites of Eastern Europe.57 This network is gradually being converted to service other European and Western markets, but needs major renovation. Moreover, with existing infrastructure already operating at peak capacity in order to meet growing production, Russia can only accommodate growing production by expanding the capacity of existing routes or adding entirely new pipelines. As with

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Figure 5. Map of Russia

Source: Central Intelligence Agency

production expansion, Russias ability to move more oil to market requires serious investment, which so far has been limited. The collapse of the Soviet Union had serious consequences for the Russian pipeline system. Russia found itself with a significant portion of its pipeline system suddenly in foreign countries, including the Baltic ports of Ventspils and Butinge, and the Druzbha pipeline connecting central Russia to Central Europe. This means that Russian oil companies now face additional transportation tariffs charged by the former Soviet republics. For example, oil shipped to the Czech Republic or Germany via the southern branch of the Druzbha pipeline faces three or four sets of tariff charges for shipment, significantly raising its price. Russian exporters currently have limited alternatives to the pipeline system through Eastern Europe, the most significant transport facility options being the Black Sea ports of Tuapse, Novorossiysk, and Ozervka.58 In 2000, over half of Russias oil exports traveled through the Bosporus,59 and its Black Sea facilities are currently operating above their output capacity, with additional oil from the Caspian Pipeline Consortium further straining the system. Russia has seen little new pipeline construction over the last five years. The most significant project to date has been the Baltic Pipeline System (BPS), connecting Yaroslval to the Baltic port of Primorsk. Currently, the BPS pumps 240,000 barrels per day (b/ d), with an expansion to 360,000 b/d expected by the end of 2003.60 Transneft recently notified the government of its intention to proceed with the second phase of the BPS upgrade.61 The BPS has allowed Russia to avoid paying transit fees through Baltic States on

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the way to the Ventspils facility. However, while reducing Russias dependence on the old Eastern European routes, the BPS diverts, rather than expands, Russias export capacity. Other relatively minor pipeline projects have aimed to further reduce Russias dependence on foreign transit providers. The Ukraine bypass pipeline, for example, has reduced the tariffs faced by Russian oil flows through Ukraine on the way to the Black Sea ports.62 Several capacity-expanding pipeline projects are currently under consideration, most at least several years away from finalization. One ambitious proposal would link Russian fields to the growing Chinese market. Both governments are studying the project, with a final investment decision expected in the near future. The pipeline would allow Russia to transport approximately 600,000 b/d to China by 2010, and cost upwards of $6 billion.63 An alternative project to bring oil to the Pacific via a port at Nakhodka is also under consideration; this would allow Russia to export beyond China, and at a capacity of 1.2 mb/d.64 However, the Pacific project would require a much longer pipeline and the construction of new port facilities on Russias east coast, making it much more expensive than the pipeline to China. Transneft, Lukoil, and Yukos are collaborating on a pipeline and deepwater port facility at Murmansk in the Russian far north, which would permit easy access to European and U.S. markets, scheduled for completion in 2007, 65 though construction has not begun. Like its production, Russias crude oil exports have risen steadily since 1997. Forecasts for 2002 have placed total exports at approximately 5 mb/d,66 approximately 1.3 mb/d of that to the rest of the FSU.67 Of the remainder, about 3 mb/d finds its way into the Western European market, especially to Germany, France, the UK, and Switzerland.68 In the summer of 2002, Russia also made its first oil deliveries to the United States, though this was mostly a ceremonial gesture ahead of energy talks held in October.69 The steady rise in Russian oil exports makes it the secondlargest exporter behind Saudi Arabia. Analyses of Russias future export capacity run the gamut from conservative to optimistic. Energy Security Analysis (ESAI), an energy research firm, has put Russian export capacity to markets outside of the FSU at just over 3 mb/d by 2005 and 4.2 mb/d by 2010.70 However, Eugene Khartukov, of the International Center for Petroleum Business Studies, believes Russian exports outside of the FSU will reach 3.9 mb/d by 2005 and more than 6 mb/d by 2010.71 It is clear, however, that Russia will have to overcome

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its current transportation Russia will have to bottlenecks to further expand exports. Transneft and overcome its current the Russian government transportation bottlenecks should continue to pursue pipeline development indeto further expand exports. pendent of what happens to the price of oil. With demand growth in Asia expected to outpace growth in North America, and limited investment funds for the moment, Transneft should emphasize Asian export capacity. Russian Oil in the Global Context What does the above analysis of Russias upstream oil production, policy environment, and transportation system suggest about the broader role of Russian oil in the global market? As noted earlier, interest in Russian crude oil production has increased since the September 11 terrorist attacks, with many arguing that Russia could rival Saudi Arabia in overall production and exports. This optimistic assessment of Russias future role seems at best generous, at worst nave. Russias importance in the global oil market will no doubt increase over the next decade. But neither the realities of Russias transportation system nor, more importantly, the projected structure of global oil demand in the coming years, support the conclusion that Russia will be able to assert any form of dominance. In evaluating the significance of potential increases in Russias production and export capacity, it is important to keep in mind the forecasts for global oil demand to 2010. Deutsche Bank analysts have suggested that by 2005 global oil consumption will reach 81 mb/d, a 3.5 mb/d jump over 2002 levels.72 During the same period, Russias export capacity will probably rise less than 1.0 mb/d, potentially capturing one-quarter of new demand growth. But, because of infrastructure bottlenecks, exports far beyond Europe will continue to be uneconomic to 2005. Thus Russia will need to rely on its traditional European markets to absorb its exports. Demand growth in Europe through 2005, however, is expected to be weak, especially given the economic slowdown currently plaguing the region. Furthermore, increasing global supply and slow demand growth could exert downward pressure on global oil prices, affecting the ability of the Russian government and Russias oil companies to finance additional expansion of produc-

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tion or transportation. The recent decline in profitability of Russias majors makes the need for foreign investment even greater. Much of Russias success depends on higher global oil prices, but the Saudis may push oil prices down in order to defend OPECs market share.73 Over a longer time horizon, and assuming Russia completes some of the proposed Asian pipelines, as well as the Murmansk facility, prospects for Russias oil exports improve. Forecasts agree that Asia will be the largest source of demand growth over the next decade. Additionally, Chinese fears over energy source security are already prompting it to seek a diversified supply, giving Russia an excellent opportunity to expand its presence in the Asian market. However, optimism in the long term must also be tempered with the realities of Russias limited infrastructure. Assuming a best-case scenario for production and pipeline development, Russia could potentially export more than 1.0 1.5 mb/d new production to the Asian market by 2010.74 With oil demand in the region forecast to grow by 4.3 mb/d by 2010,75 even under this best-case scenario Russia would only be able to satisfy approximately 25 percent of the regions new oil demand. This stands in stark contrast to production trends in the Middle East, particularly in Iraq and Saudi Arabia. Whereas Russia requires massive investment in order to bring new production and exports to market, many OPEC members have already undertaken upstream expansion or have infrastructure that could support quick expansion into existing markets. Some forecasts have suggested that the Persian Gulf will account for over 50 percent of new supply to Asia, with Russia accounting for less than 10 percent.76 In North America, growth in Russian export capacity could play a more significant role. Forecasts through 2010 put U.S. demand growth for oil between 2.5 4.0 mb/d. Successful conversion of the Druzbha-Adria pipeline system, as well as expansions at Primorsk and completion of Murmansk would give Russia the ability to export between 1.0 1.5 mb/d to the United States, supplying as much as 50 percent of the new oil demand there. However, the United States would still be importing 10 mb/d from other sources, with significant portions of that continuing to come from the Middle East. Thus, while Russia could temper further dependence on Middle East crude, it is virtually impossible for it to make inroads against present U.S. dependence on Saudi crude oil, which currently supplies one-sixth of all U.S. imports.77 Additionally, Saudi Arabias swing capacity makes it a vital strategic partner to the United States, particularly in times of crisis.78

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In sum, Russias role in the global oil sector could grow over the next decade, but its role will be limited to making gains based on expanded global demand in key markets including the United States and Asia. Russia simply cannot keep While Russia may provide pace with Saudi Arabia some insurance against further either in absolute or in relative terms. While dependence on Middle Eastern Russia may provide or Latin American oil, it will some insurance against further dependence on do little to reverse existing Middle Eastern or Latin American oil, it dependencies. will do little to reverse existing dependencies. Furthermore, the best-case scenarios for expansion of Russian output depend on securing the necessary foreign investment and using it productively to add transport and export infrastructure. Russian Oils Future In concluding this analysis it seems reasonable to offer some observations on what Russia can and should do to maximize its role in the world oil economy. First and foremost, Russia needs to improve its investment climate to attract the investment necessary to expand production and distribution. Clarifying laws on PSAs and simplifying the tax code are essential in the short term to reverse stagnant foreign investment trends. In addition, the Russian oligarchs control over the sector makes even the most eager investors wary. The government needs to do more to curb their power. Given the resources at its disposal, the Russian oil industry would do well to plot a niche approach to development over the next decade. The Russian government will probably have to finance most major pipeline infrastructure development without the desired level of foreign investment, and consideration should therefore be given to picking a limited array of markets and developing the appropriate resources. China and Asia more broadly seem set to lead global oil demand growth over the next decade. Russia is already strategically placed to play a role here given developments in the Sakhalin region. Reinforcing this with export capacity in the east, whether through China or to Russias Pacific basin, would allow Russia to tap the biggest potential market in the world. Al-

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ternatively, Russia could pursue a fuel-America strategy. This would certainly bring Moscow politically closer to the United States and is probably faster and less costly to achieve than the Asia strategy. Right now, Russias oil sector very much remains a house divided, not moving decisively in either direction. The Russian oil sector and its potential future role in the global oil economy presents an interesting set of interactions between government and private actors, as well as strategic considerations. There should be no illusions about Russian potential: Saudi Arabia will continue to be the dominant player in the global oil market. Russia lacks both the surge capacity and the export infrastructure to battle Saudi Arabia successfully. Additionally, Saudi oil will continue to enjoy a comfortable cost and quality advantage over Russian crude. Yet, this should not prevent Russia from becoming a more significant player in global oil markets. A number of countries continue to have concerns about oil source security. Russia presents an excellent opportunity to diversify that supply. Whether Russia will be able to play that role is a question largely in its own hands; a little good luck from the markets in terms of higher prices certainly could not hurt. Notes
U.S. Secretary of Energy Spencer Abraham has publicly stated, Russia will play a pivotal role in ensuring global energy security. See Peter Baker, Russia Sees U.S. as New Market for Oil Reserves; Deals Could Ease Washingtons Reliance on Mideast, Create Windfall for Moscow, Washington Post, 8 September 2002, A25; See also Bush/Putin Joint Statement on New U.S.-Russia Energy Dialogue, 25 May 2002, <www.whitehouse.gov/news/releases/2002/05/200205248.html> (14 May 2003). 2 See generally Edward L. Morse and James Richard, The Battle for Energy Dominance, Foreign Affairs 81, no. 2 (March/April 2002): 1631. 3 Shibley Telhami and Fiona Hill, Americas Vital Stakes in Saudi Arabia, Foreign Affairs 81, no. 6 (November/December 2002): 168169; Adullatif A. AlOthman, The Reliable Supplier, Foreign Affairs 81, no. 6 (November/December 2002): 174175. 4 Matthew J. Sagers, Developments in Russian Crude Oil Production in 2000, Post-Soviet Geography and Economics 42, no. 3 (2001): 153. 5 Energy Information Administration, Russia Country Analysis Brief, April 2002, <www.eia.doe.gov/emeu/cabs/russia2.html> (5 October 2002). 6 See generally Robert Ebel, Russia: Breakthrough or Breakdown, Geopolitics of Energy 22 (February 2000): 812. 7 As the Russian economy was privatized, a small cadre of Russian businessmen accumulated an increasing amount of Russias wealth. These business leaders gathered power across industrial sectors and become known as the oligarchs.
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For a discussion of the role of the oligarchs in Russia see generally David Hoffman, The Oligarchs: Wealth and Power in the New Russia (New York: Public Affairs, 2002). 8 For a discussion of the decision to increase output see generally Wilfrid L. Kohl, OPEC Behavior, 19982001, The Quarterly Review of Economics and Finance 42 (2002): 209233. 9 EIA, Russia Country Analysis Brief. 10 International Energy Agency, Russia Energy Survey 2002 (France, 2002), 73. 11 Ibid., 74. 12 Ibid. 13 Ibid., 73. 14 Ibid. 15 Active Oil Reserves in Russia are Sufficient for 15 Years, The Russian Oil and Gas Report, 4 November 2002. 16 IEA, Russia Energy Survey 2002, 71. 17 See For Provision of Oil Production Growth in Russia it is Necessary to Invest $50 Billion, The Russian Oil and Gas Report, 4 October 2002, citing Russian reserves as 12 percent of global reserves compared with the 5 percent figure cited in British Petroleum, BP Statistic Review of World Energy 2001, <www.bp.com/centres/energy2002/2001inreview.asp> (14 May 2003). 18 Energy Information Administration, International Energy Outlook 2003, May 2003, <http://www.eia.doe.gov/oiaf/ieo/tbl_11.html> (17 June 2003). 19 CEO of Yukos Presented His Own Version of Russias Energy Strategy, The Russian Oil and Gas Report, 23 October 2002; Lukoil Head Posts Forecasts on Russian Oil Reserves, RosBusinessConsulting Database, 31 October 2002. 20 For Provision of Oil Production, The Russian Oil and Gas Report. 21 Lukoil, Annual Report for 2001 , 9, <http://www.lukoil.com/pdf/ LUKOIL2001Annualreportengl.pdf> (17 June 2003). 22 IEA, Russia Energy Survey 2002, 7476. 23 Active Oil Reserves in Russia are Sufficient for 15 Years, The Russian Oil and Gas Report. 24 Ibid. 25 Bill Powell, Russian Oil, Fortune, 13 May 2002, 88. 26 Lukoil Head Posts Forecasts on Russian Oil Reserves, RosBusinessConsulting Database. 27 Deutsche Bank, Oil Market Outlook: OPECs Balancing Act, September 2002, 48; Eugene Khartukov, Russias Oil Exports: Myths and Realities, (Presentation to the International Petroleum Executive Seminar, Johns Hopkins SAIS, Washington, DC, 1718 October 2002). 28 Ursula Hyzy, Russia Crucial to Energy Security in Coming Decades: IEA, Agence France Presse, 22 September 2002; Oil Prices Cast Shadow Over Russia, The Russia Journal Daily, 27 November 2002, <www.russiajournal.com> (15 June 2003); For Provision of Oil Production, The Russian Oil and Gas Report; Sagers, Developments in Russian Crude, 169. 29 IEA, Russia Energy Survey 2002, 87. 30 Eugene Khartukov, Russias Oil Majors: Engine for Radical Change, Oil & Gas Journal, 27 May 2002, 22. Recently, the government of Russia has liquidated its remaining shares in Lukoil (5 percent) and all of its shares in Slavneft. See Moscow Sells 5.9 percent of Lukoil for $775M, Global News Wire, 5 December

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2002; and Catherine Belton, Sibneft, TNK Snap Up Slavneft for $1.8Bln, Moscow Times, 19 December 2002. 31 Khartukov, Russias Oil Majors. 32 Barry A. Curtis and James R. Harrison, Rising Russian Oil Production Must Deal with Transportation, Business Issues, Oil & Gas Journal, 27 May 2002, 68. 33 Deutsche Bank, Oil Market Outlook, 48. 34 Andrew Jack, Russian oil rivals Yukos and Sibneft merge, Financial Times, 21 April 2003. 35 Peter Baker, Oligarchs Power Unfettered Under Putin, Washington Post, 14 December 2002, A18. 36 Yukos Released Financial Statements According to US GAAP Standards, The Russian Oil and Gas Report, 25 October 2002; Lukoil Says 2002 Profit to Shrink 5 percent to $2 Bln, Moscow Times, 22 November 2002; Surgutneftegaz Released Financial Statements for 2001 According to US GAAP Standards, The Russian Oil and Gas Report, 22 November 2002; Russian Oil Group Reports 11 Percent Profits Slide, Agence France Presse, 11 June 2003; Russia: Yukos Results Show Rising Costs, Global News Wire, 28 May 2003. 37 Consolidation of Russian Oil and Gas Industry Continues, The Russian Oil and Gas Report, 8 July 2002. 38 Belton, Sibneft, TNK Snap Up Slavneft for $1.8Bln. 39 Ibid. 40 Curtis and Harrison, Rising Russian Oil Production Must Deal with Transportation, Business Issues, 68. 41 Chinas energy giant CNPC withdraws from Russian oil sell-off: report, Agence France Presse, 17 December 2002. 42 Andrew Jack and David Stern, Chinese group pulls out of Russian oil sale, Financial Times, 18 December 2002, 27. 43 See generally Deutsche Bank, Big Oil in Sakhalin, December 2002. 44 IEA, Russia Energy Review 2002, 7879. 45 TotalFinaElf is Accused of Artificial Increase of Expenses on Kharyaginsky Project, The Russian Oil and Gas Report, 14 August 2002. 46 IEA, Russia Energy Survey 2002, 8183. 47 Ibid., 86. 48 Ibid. 49 Russian Deputy Premier Downbeat on Production Sharing Agreements, Global News Wire, 1 August 2002. 50 Sakhalin Energy Threatens to Suspend Developments of the Sakhalin-2 Project Worth $8.5 Billion, The Russian Oil and Gas Report, 22 November 2002. 51 IEA, Russia Energy Review 2002, 8485. 52 Duma to Debate Uniform Bill on Amendments and Supplements to Production Sharing Law, The Russian Oil and Gas Report, 13 November 2002. 53 Expert of Yukos on Experience Accumulated in Attempts to Sign Production Sharing Law, The Russian Oil and Gas Report, 5 July 2002. 54 IEA, Russia Energy Survey 2002, 84. 55 Ibid., 77. 56 Ibid., 80, 8283. 57 EIA, Russia: Oil and Natural Gas Export Pipelines, April 2002, <www.eia.doe.gov/emeu/russpip.html> (5 October 2002). 58 IEA, Russia Energy Survey 2002, 12, 9495. 59 Ibid., 12, 94.

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More oil to more destinations, Petroleum Economist, 19 August 2002, 24. EIA, Russia: Oil and Natural Gas Export Pipelines. 62 IEA, Russia Energy Survey 2002, 9899. 63 Projects aim to speed flow, Lloyds List, 9 December 2002. 64 Ibid.; Japan pipeline route still being considered: Russian official, Japan Economic Newswire, 5 June 2003. 65 Ibid. 66 EIA, Russia Country Analysis Brief. 67 Khartukov, Russias Oil Exports. 68 IEA, Russia Energy Survey 2002, 9192. 69 Peter Baker, Russia Sees U.S. as New Market. 70 Sarah Emerson, ESAI, World Oil Supply and Demand (Presentation to the International Petroleum Executive Seminar, Johns Hopkins SAIS, Washington, DC, 1718 October 2002). 71 Khartukov, Russian Oil: Myths and Realities. 72 Deutsche Bank, Oil Market Outlook, 3335. 73 Jamal Qureshi, The OPEC Conundrum, Petroleum Finance Company, (Presentation at Johns Hopkins SAIS, Washington, DC, 15 October 2002). 74 This assumes that major pipeline projects to Russias Far East or China are completed before 2010. 75 Deutsche Bank, Oil Market Outlook, 3335. 76 Emerson, World Oil Supply and Demand. 77 Jeff Gerth, U.S. Fails to Curb its Saudi Oil Habit, Experts Say, New York Times, 26 November 2002. 78 Ibid.