Rising Russian oil production must deal with transportation, business issues

May 27, 2002
After declining throughout most of the 1990s, Russian oil output is on the rise (OGJ, Apr. 29, 2002, p. 24). This oil production increase will create opportunities and challenges for Russia's giant oil companies and for regional and global oil traders, refiners, and marketers.

After declining throughout most of the 1990s, Russian oil output is on the rise (OGJ, Apr. 29, 2002, p. 24). This oil production increase will create opportunities and challenges for Russia's giant oil companies and for regional and global oil traders, refiners, and marketers.

The complex political, legal, technical, environmental, and economic issues associated with Russia's increased oil production will require substantial effort to address and resolve. Successful resolution of these hurdles, however, could yield potentially huge rewards for all parties involved.

Russia's oil is an attractive alternative to developing the reserves in other regions of the world. Russian oil companies will need to continue developing comprehensive strategies in order to exploit these reserves.

At the same time, the major global oil companies will need to implement plans to expand in Russia while simultaneously preparing to compete against Russia's giant companies in Europe.

Growing importance

Increasing oil production in Russia and the other republics of the former Soviet Union (FSU) is becoming a major factor in the overall European-Central Asian oil supply-demand balance (Table 1).1

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Russia's giant companies are benefiting tre men dously from this increased output. Their cash flows and capital reinvestment are rising sharply. In fact, as recent events suggest, Russia's giant companies are focused on continuing oil production increases even if lower international oil prices occur as a result.

OAO Lukoil, OAO Yukos, and OAO Sibneft all lobbied the Russian government earlier this year to make only small export cuts as part of Russia's voluntary effort to help OPEC stabilize plunging oil prices.

Although the giant Russian oil companies have similar interests, their strategies differ. Yukos has a relatively strong financial position, relatively low production costs, and a 70% oil export rate. Its management is interested in pushing production increases and expanding export markets globally, confident that the company will be a long-term survivor in even relatively low price environments.2

By contrast, Lukoil exports slightly more than 50% of its oil production and is investing heavily-to the tune of $850 million-in downstream assets in the Balkans, Ukraine, Romania, and Bulgaria. These investments are the fruits of deep relationships Lukoil established in Eastern Europe through many years of supplying the region.2 3

Lukoil's investments signify larger change, that more market outlets are available to Russian crude oil and petroleum products than in years past.

Similarly, the major global oils now have greater access to the Russian oil industry and both the global and Russian oils can evaluate oil export, trading, processing, and marketing arrangements on the more transparent standards of market economics and logistical criteria. This is welcome contrast to the years when Russian oil export decisions were governed more by political than economic realities.

The recent actions of the major global oil companies are verifying this new reality and validating the strategies and optimism of Russia's giant oil companies. For example, all five super majors-BP PLC, Royal Dutch/Shell Group, ExxonMobil Corp., ChevronTexaco Corp., and TotalFinaElf SA-are either currently invested in Russia or other FSU countries or considering large new or additional investments.

Unfortunately, headlong aggressive investments are still limited by the perception that such investments carry excessive legal or regulatory risk-see the accompanying sidebar.

Transportation issues

Russia essentially has four options for transporting its increasing oil production (see map of Russian and CIS oil pipeline routes in OGJ, Mar. 25, 2002, p. 62):

  • Southern, land-based routes via pipelines that supply end users directly.
  • Pipeline-only, marine-only, or combination pipeline-marine routes that allow access to the Mediterranean Sea (OGJ, Mar. 4, 2002, p. 64).
  • Expansion of existing export routes via the Baltic Sea.
  • Pipelines into Europe.
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Even now there are many proposed and pending projects that will seek to take advantage of each of these routes.4 While all will work to place Russia's increasing oil export volumes, the European pipeline option will likely, by far, be seen as the most attractive alternative (Fig. 1).

The giant Russian companies' need to identify markets for large volumes of oil exports within the next 3-5 years through Eastern Europe would seem to set the stage for new, mutually beneficial relationships in that region. This is true despite Central and Eastern European politicians, business executives, and citizens being able to remember when Russia and the Soviet Union were their bitter enemy.

Compared with options involving the southern Islamic republics, Turkey, or the Baltic countries, however, the European export routes provide logistical advantage and much lower odds of intricate political intrigues among the nations involved.

But when compared with the major global oil companies, Russia's giant companies will have certain incumbent competitive advantages to the extent that their oil pipeline exports into Europe can be maximized.

The odds now favor the likelihood that Eastern European leaders will successfully negotiate new oil-related deals while avoiding accusations by their political opponents of untoward arrangements.

European export issues

While exporting oil to Europe appears to be the most promising long-term outlet for increased Russian oil production, significant hurdles remain.

First, negotiations must create some semblance of a market-based financial return for all parties. The upstream companies that bought market share by acquiring refining and marketing assets have produced mixed financial results, as evinced by the uneven track records of Kuwaiti and Venezuelan downstream asset investments of this type.

Any uneconomic deals concluded for reasons of "security of supply" or "guaranteed market access" cannot adequately address the necessity to achieve a market-based return on invested capital.

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As Russia's giant oil companies look to sell equity shares globally to institutional and retail investors, stock market participants will demand that such deals create enduring economic value.

Second, the loose ethical frameworks that have historically prevailed in business dealings in Russia and Eastern Europe are legendary in the industry. Business practices and legal frameworks in the Eastern European and Central Asian downstream oil sector must be restructured to enable a viable business atmosphere.

Contracts must be structured to endure beyond the personal relationships of the individual dealmakers involved. Western companies (particularly US-based companies) will not enter into long-term agreements that run afoul of the ethical standards their public shareholders and government officials require.

Finally, the mutual trust required for large, long-term arrangements between Russia's giant oil companies and the major global oil companies will not be created instantly. Such trust is built over time, step-by-step, as small but successful contracts lead to bigger and better commercial agreements.

A best practice for sizing up a commercial partner for a compatible long-term relationship is to work with it on a short-term basis. Striking small deals and conducting "pilot" projects help each side see the other in action. Trust grows via creation of frameworks that help to solve problems mutually. Business integrity is best determined by a sustained willingness on both sides to act as effective partners.

For example, most people within BP would readily admit that the company's Sidanko experience provided enlightening insights into how to construct commercial arrangements under Russian law. The real-world knowledge gained from BP's Sidanko experience could not have come any other way.

At many points, parties on both sides undoubtedly vowed never to do business with each other again. After all the accusations and charges of bad faith, however, BP is now a bigger player in Russia than before. And BP's managers in Russia now have a much more informed sense of how business there actually gets done.

Given how the major global oil companies currently view the Russian oil industry, Russia's giant companies should not expect Big Bang deals in the short term. Instead, dealmakers should seek small, relatively low-risk deals that can be executed well and consistently. Otherwise, trading partners and major global oil companies may not develop enough confidence in Russian companies even to consider complex, long-term agreements.

Increasing European presence

Russia's giant companies are well funded, commercially savvy, and committed to a long-term presence in European and Central Asian oil markets. As these companies expand geographically, they will by definition be competing in more places against the major global oil companies.

The global companies know this and thus are watching the actions of the Russian companies closely. In addition, the internationals are taking tentative steps to expand their own market footprint in both Russia and Eastern Europe.

While some of the global companies primarily want access to Russia's oil reserves, others want access to potential customers for oil products and natural gas in Eastern Europe. Most global oil companies consider Russia as a potential strategic alternative to investments in the Middle East. While both regions have risks, they are not necessarily the same in each location.

As a result, both Russian and global oil companies will seek increased market shares in various parts of Europe. Thus, it is likely that the global majors and Russian companies could both cooperate and compete in Europe and Central Asia simultaneously.

As an example, Shell CEO Philip Watts met with Russian Prime Minister Mikhail Kasyanov recently to discuss existing and potential future Shell projects in Russia. At the same time, Shell is known to be expanding its presence in Germany, a key downstream target market for Russian oil companies, by buying retail outlets from Germany's RWE AG.

These types of discussions indicate why all parties will need to evaluate strategies carefully when assessing the interrelationships among potential partners and likely future competitors in Europe.

Interactions among Russian and global oil companies will take many forms. For example, decades of socialist economic policy provided many Russian managers with only limited perspectives on retail marketing and branding. Thus, the Russian oil companies will likely welcome help with developing brand awareness and image campaigns to attract European customers.

One potential source of this help is the major global oil companies. Alli ances or joint ventures could bridge the Russian companies' knowledge gap while simultaneously providing the global companies access to Russian retail markets on a small scale. For example, before its merger with Exxon, Mobil partnered with local entities to build retail stations in several FSU countries.

These types of commercial alliances and joint ventures with global oil companies will evolve as circumstances warrant. But such agreements will provide Russia's giant oil companies greater access to the world-class knowledge and expertise of the majors, while providing the majors with access they desire to Russian exploration and production projects and new downstream markets.

The real losers in such a scenario might turn out to be the smaller, Central and Eastern European oil companies. Austria's OMV AG and Hungary's MOL RT, for example, are dwarfed in size by both the largest Russian oil companies and the major global oil companies.

OMV and MOL are trying to stay relevant by looking at their own opportunities for expanding market presence: Both have evaluated several strategic acquisitions and divestitures, as well as expansions into Poland. It is difficult to envision these companies, however, caught between the giant Russian and major global oil companies, remaining independent except as potential niche players. An interesting point to follow will be whether Russian giant companies or major global oil companies invest in them.

Next steps

Two wildcard factors will affect the timing of future events in the development of the downstream sectors in Russia and Eastern Europe.

The first wildcard is the pace at which Eastern European countries attempt to join the European Union (see box on this page). To become an EU member nation, a country must meet many fiscal, economic, and environmental standards.

Such standards directly affect the downstream oil sector. For example, the quality standards for petroleum products are far less restrictive in parts of Eastern Europe than they are in EU member states. To comply, the Eastern European, Central Asian, and Russian refiners will require massive capital infusions for the plant improvements needed to produce EU-quality products. Funding these upgrades internally is neither a preferred nor in some cases even a realistic or feasible option for may refiners in Eastern Europe.

Given this constraint, there are a number of opportunities for Russian companies to enter the Eastern European refining sector by offering equity infusions or capital for plant modernizations. The major global oil companies will be less interested in such arrangements because there are far fewer strategic incentives for them to do such deals, in part because most global oil companies are trying to decrease their shares of worldwide refining capacity.

Accordingly, the willingness and speed with which Eastern European governments allow their companies to strike deals with Russia's giant oil companies are likely to be affected by the pace at which these same nations seek EU admission.

The more difficult wildcard to assess is the political stability of the entire Eastern European and Central Asian region. The current trend for Russia appears fairly positive. Cash flows for Russian oil companies are very strong. But favorable, short-term financials and rapid growth tend to gloss over potentially serious, longer-term problems.

The Eastern European and Central Asian countries have an entrenched history of political animosity and distrust. Ethnic and religious biases and long-disputed national boundaries cannot be eliminated overnight.

In this environment, what would happen if oil prices fall sharply? What happens if political disputes in Central Asia spill over into Russia? It is not inconceivable that the Balkan bloodshed of the mid-1990s could be repeated elsewhere in the region.

What happens if the financial improvements in Russia and its giant oil companies are fleeting? The degree to which Russian giant companies anticipate and prepare for the next economic downturn or political upheaval will determine their relative staying power over the long haul.

References

  1. BP Statistical Review of World Energy; www.bp.com/downloads.
  2. Jack, Andrew, "Russian Implements 150,000 b/d Cut in Oil Exports," Financial Times- FT.com, Jan. 1, 2002.
  3. Wagstyl, Stefan, "Russia - Process of Growth is the Main Target," Financial Times, Apr. 15, 2002.
  4. Vysokyy Zamok (Ukrainian newspaper report), Jan. 24, 2001.

The authors

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James R. Harrison is vice-president and Houston area director for the consulting firm Cap Gemini Ernst & Young. He has been with Cap Gemini Ernst & Young or its predecessor firms for 23 years and has more than 30 years' consulting experience. Before his current role, he served as deputy director for the energy and utilities global sector unit and has held various other senior management and global account executive roles. Harrison holds a BS in business administration from Oklahoma State University, Stillwater.

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Barry A. Curtis is an associate director in the Houston office of Cap Gemini Ernst & Young. He has 9 years of consulting experience and more than 10 years' integrated oil company experience with Standard Oil/BP. Before his current role, he was a senior manager for Cap Gemini Ernst & Young, focusing on the downstream oil segment. He also has deep expertise in strategy development, performance management, and major process and organizational change. Curtis holds a BS in chemical engineering from Purdue University, West Lafayette, Ind.