Uncertainties for FSU projects threaten LPG export potential

June 2, 2003
Resource development by the oil and gas industry of the former Soviet Union faces many obstacles. Keys are access to and control of export infrastructure...

Resource development by the oil and gas industry of the former Soviet Union faces many obstacles. Keys are access to and control of export infrastructure; these more than anything else will dictate the rate at which oil and gas projects can develop.

From an LPG perspective, supply will exceed demand, prompting exports from the region to increase. Without additional fractionation facilities, however, export of mixed product may become increasingly difficult in the longer term. And, high transportation costs have depressed netback value realized for LPG exports and make it difficult to justify additional investment in existing facilities. This revenue stream will likely make only a marginal contribution to the economics of new development projects.

Above all, realizing the LPG export potential of the FSU will require investment in additional infrastructure, as existing infrastructure is inadequate to meet producer export expectations.

These observations are part of the most recent analysis of world LPG supply and demand by Purvin & Gertz Inc., London. The company recognizes, however, the huge obstacles that face oil and gas companies seeking to develop projects in the FSU.

For this reason, the rate of development may be less rapid than some players expect, which will in turn retard the rate at which LPG production, hence exports, increase.

FSU resources; risks

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It has been well reported that the FSU has potentially huge oil and gas reserves remaining to be exploited. In its World Petroleum Assessment 2000,1 the US Geological Survey reported oil and gas reserves in Russia that far exceeded those in the US, while those in Central Asia FSU (Azerbaijan, Kazakhstan, Turkmenistan, and Uzbekistan) are similar to those in the North Sea (Table 1; Fig. 1).

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Of significance, cumulative production in Russia is far lower than for the US. Its known remaining and mean undiscovered oil reserves are comparable to those in Saudi Arabia, while its known remaining and mean undiscovered gas reserves dwarf those in any other part of the world.

As described, total reserves (mean undiscovered, remaining, and cumulative produced) for Central Asia FSU are comparable to those in the North Sea, suggesting predictions that the region would be the next Middle East are likely to be overly optimistic.

These reasons, explain why the international oil and gas industry has maintained a high degree of interest in the FSU since the disintegration of the Soviet bloc.

That interest has been somewhat cyclical in the last decade or so. Initially, the region was heralded as a new frontier, and, herd-like, most companies sought to gain a foothold in the region. Reality failed to match expectation, however, and many entrants chose or were forced to withdraw, many carrying significant financial losses.

As the industry underwent a period of retraction and consolidation in the late 1990s, a combination of low oil prices and some disappointing exploration results led to waning interest in the region. Through this period, the potential of the FSU was still recognized, but a financial commitment on the part of many industry players was not forthcoming.

In more recent years, the development of some major projects and implementation of new export routes, combined with higher oil prices, have renewed interest in the region.

But the question remains whether this new momentum can be maintained. Reports of bureaucracy, corruption, and protectionism have received widespread publicity in the past, and undoubtedly combined with the financial crisis and debt default of 1998-99, these have all deterred some potential investors.

There is clear evidence, however, that business is improving, although concern remains over standards of corporate governance and financial transparency. (Some of these concerns may be misplaced, given the accounting scandals that have come to light in the West over the last 18 months.)

Nevertheless, potential project developers must still mitigate many risks that will likely continue in the near-to-medium term. In this respect are several hurdles to doing business in Russia and Central Asia FSU, including:

  • Political risk.
  • Uncertain legal status of the Caspian Sea.
  • Increasing environmental regulation.
  • Lack of well-developed export infrastructure.
  • Export transit risk.

Investors in any country face some political risk, although risks appear to increase when involving an oil and gas project in a newly industrializing or developing country. The primary link between an oil and gas project and a host government is via the collection of tax revenue.2

Compared to other resource industries, employment of local people is relatively low, and in many developing countries equipment is imported. In countries where the ability to distribute revenues transparently and accountability and audits are of a low standard, there is potential for corruption at government level and the perception that benefits are not being distributed fairly.

Furthermore, strong growth in oil and gas-related income may affect investment in the rest of the economy leading to a decline in income in non-energy sectors. This leads to a dualistic economy with increasing inequality between beneficiaries and non-beneficiaries that, over time, can create political tension and hence opposition to further development of oil and gas sectors.

One potential reaction by host governments to placate the local population is to provide some form of subsidy for energy purchases via either low tariffs or a lack of enforcement over non-payment (with government agencies often being the worse culprits).

Not only can this make residential and industrial consumers very wasteful, but also it encourages abuse of the system when price dislocations occur between subsidized domestic and higher regional or international prices.

A longer-term consequence of this action is increased service unreliability as utility companies have insufficient funds to maintain and invest in infrastructure. Such a result serves not only to damage the reputation of the energy sector but also damage a country's attractiveness as a recipient of investment and increase the cost of doing business in that country.

A more serious consequence of political instability in any country relates to property rights. This has proven to be difficult in the Caspian countries given the structure of political authority, weak legal and judicial frameworks, and reports of widespread corruption.

Property rights have been accommodated in production sharing agreements with the force of law provided by presidential assent and ratification by parliament. Such protection is only good, however, so long as presidential and parliamentary authority and the rule of law are valid.

In times of political instability or change in government, the integrity of PSAs may be challenged, although it should be noted that this has yet to be reported in the FSU.

Caspian issues

The legal status of the Caspian Sea remains unsettled and experience shows that uncertain legal status discourages investment in disputed areas. The Soviet Union and Iran signed bilateral treaties to cover the Caspian Sea in 1921 and 1940, but neither established seabed boundaries or discussed oil and natural gas exploration.34

The break-up of the Soviet Union increased the number of parties interested in the legal status, and to date it has not been possible to agree on a legal framework governing the use and development of its oil and natural gas reserves.

The key issue is whether the Caspian is covered by the Law of the Sea Convention, which does not cover inland lakes. Under the convention, full maritime boundaries for the five littoral states bordering the Caspian would be established based upon an equidistant division of the sea and undersea resources into national sectors. If the Law of the Sea is not applied, the Caspian and its resources would be developed jointly, a division referred to as the "condominium" approach.

As is often the case, Mother Nature has created tension among the littoral states, as there appears to be an uneven distribution of petroleum resources in the Caspian. Naturally, this will contribute to the negotiating position of each littoral state, with Iran potentially the biggest loser, gaining a 20% interest under the "condominium" approach and 12-13% using the equidistant method favored by most of the states.

Although the littoral states have made progress in bringing their positions closer together, a final agreement remains out of reach. There is now general agreement among Russia, Azerbaijan, and Kazakhstan on both "the principle and method" of dividing rights to the seabed and mineral wealth beneath it, but Turkmenistan agrees only on the principle of division and Iran disagrees with both the principle and method.

Recently, however, Iran and Turkmenistan have reportedly agreed to demarcate their shared offshore sectors.

Failure to reach a consensus will retard development of the region's resources because it will be difficult to conduct exploration and production in contested areas and develop any trans-Caspian pipeline infrastructure. Furthermore, it will complicate the development and enforcement of environmental regulations.

In the Soviet era, environmental law was non-existent, and even though there has been some progress since, legislation and regulations are generally weak and some conflicts exist between local and national authorities and among different laws.5 In early post-Soviet years enforcement of environmental laws was sometimes subjugated to economic development goals and seen as a threat to the continued influx of foreign investment.

The region's governments, however, are taking an increasingly sharp stand on environmental issues as their economies improve. Environmental-impact assessments are mandatory for export pipelines and development projects, and both Azerbaijan and Kazakhstan have passed legislation requiring energy companies to use associated gas rather than flare it, as was typically the case previously.

There have also been reports of companies having to cease operations and being fined for accidents that have caused or had potential to cause environmental damage.

Export obstacles

Perhaps the biggest hurdle facing project developers in the FSU is the export of hydrocarbons to international markets. Historically, Russia has dominated all export routes from the FSU and its state companies, Transneft (oil) and OAO Gazprom (gas), still exert significant influence over this activity.

For oil producers, exports can be routed to the Baltic Sea, the Black Sea, or into Central Europe via the underutilized Druzhba pipeline.

The potential to increase exports via the Black Sea is limited, not only by weather at the port of Novorossiysk but also by congestion in the Bosporus Straits. Currently, exports via Druzhba are restricted by the lack of potential demand growth from refineries in Central Europe, although once the Adria pipeline is reversed, it will be possible to route oil exports via the Druzbha-Adria pipelines to the port of Omisalj on the Adriatic Sea (OGJ, Mar. 4, 2002, p. 64).

One favored export option appears to be the Baltic Sea, and Transneft is keen to expand the capacity of this route. These plans are being threatened, however, by proposals from private Russian oil companies to build their own pipeline to China or Murmansk on the Barents Sea.

Naturally, progression of these plans would provide a challenge to Transneft's business, whose position, currently, appears to have Russian government support. Similarly, there is a conflict of interest in Gazprom's activities as it dominates gas export routes to European markets.

As was clear in the 1990s, Gazprom has been reluctant to carry gas from competing suppliers into the European market at the expense of its own production. It has since shown a change of heart, however, by agreeing to transport increased volumes of gas from Turkmenistan and to enter into a marketing joint venture with the Kazakhs.

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The export issue is particularly relevant to companies active in the Caspian Sea region (Fig. 2). If they go north, they are totally reliant on the Russian system. While demand-growth potential to the east is high, consumers are remote from the source of production requiring long pipelines that have to cross some very difficult terrain.

Exports to the south are possible with oil sales via the Persian Gulf and gas sales to India or Pakistan. This option carries considerable political risk, however, as transit via Afghanistan or Iran will be required (plus Pakistan for sales to India).

Export to the west appears to be the favored option, although as described previously there is limited expansion potential via the Black Sea, but development of new routes will allow oil exports to be routed to the Mediterranean Sea via either the Druzhba-Adria pipeline or the yet-to-be completed Baku-Tiblisi-Ceyhan (BTC) pipeline.

The options for gas exports to the west are less well developed with the Turkish market currently oversupplied and with any new projects in direct competition with Russia's Blue Stream project.

Even so, until trans-Caspian pipelines are developed, sellers in Kazakhstan, Turkmenistan, and Uzbekistan will still have to cross Russian territory to access western markets.

The geography of the Caspian region dictates dependence by producers on transit countries for exports of oil and gas. Geopolitical forces and environmental concerns create pressures for the development of pipeline projects that do not always follow the shortest route to market and sometimes involve a number of transit countries.

Once pipelines have been installed, the potential exists for a host transit country to extract a greater share of the rent without making operations on a cash cost basis uneconomic.2 This could either be in the form of higher transit fees or increased hydrocarbon offtake (not always with the pipeline owner's agreement).

The degree of transit risk is a function of several economic factors, such as if transit fees represent a high proportion of host government's revenue, particularly if paid in foreign exchange. Furthermore, producers will be reluctant to cease pipeline operations to mitigate against this, as such action would only curtail supply to the ultimate consumer.

The strongest incentive to minimize transit risk is for producers and sellers to create some form of export-route competition. This could lead to inefficient utilization of capital, however, and possibly having to cross countries that are also competitors in the end market.

LPG

As can be seen, a great many hurdles face potential oil and gas producers in the FSU, which suggests that progress will be neither straightforward nor easy. While the intentions of many parties may be aligned, the complex geopolitics of the region will more than likely create some form of opposition.

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It is highly unlikely, therefore, that LPG production in the FSU will increase as rapidly as some observes believe. Historically, Russia has been the dominant producer of LPG in the FSU, with product from refineries, petrochemical combines, and gas processing plants (Fig. 3), although in recent times exports from the Tengiz field in Kazakhstan have been directed to the international market.

Net exports from the FSU will increase to 1.7 million tonnes in 2005, 2.5 million tonnes in 2010, and 3.7 million tonnes in 2020 from 1.2 million tonnes in 2001 (Fig. 4). Most of the increase will come from Kazakhstan with the ongoing development of the Tengiz, Karachaganak, Kashagan, and Uzen fields.6

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Production from Azerbaijan will also increase with exports forecast to reach about 350,000 tonnes in 2010. Russian production increases will be offset by rising local demand to such an extent that exports will hold at about 900,000 tonnes until 2010 and increasing thereafter.

Within Russia, refinery LPG production will decline in the near term with producers exporting more crude oil as new export routes become available at the expense of lower refinery runs, hence reduced refined-product output, and offset by higher gas-plant production. In the longer term, higher LPG production will come mainly from increased gas-plant output.

Currently most Russian LPG is produced as a mixed propane-butane product as very few facilities can produce pure product. So long as Russian exports can be directed to the Central and Eastern European and Turkish markets, which mainly consume a mixed LPG product, this will not be an issue. However, with the exception of autogas in some Western European markets, a pure product is demanded by most Western European consumers (a situation that is also starting to evolve in Turkey) as residential-commercial consumers switch from cylinders to bulk-delivery systems.

In recognition of this potential marketing restriction, production from Tengiz is segregated into pure propane and pure butane product in order to enable some marketing flexibility. Unfortunately, the high cost of transportation to European markets has depressed netback prices to producers and may provide insufficient incentive first to recover and then split LPG into pure products. The alternative is for supply into the domestic market where consumer prices are subsidized.

The cost of transporting LPG to European markets is also a major challenge to producers. Unfortunately, there are no LPG export pipelines, with exports to European markets or sea export terminals effected by rail (Fig. 5). Although rail track capacity is not known to be limiting, the availability of rail track cars has proven to be a limit.

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Most such rail cars, owned by SG Trans, are old and have suffered from a lack of investment.

Furthermore, poor operations planning and management and a slow turnaround at border crossings often result in low utilization of rail car capacity.

LPG export options from the FSU are rather limited with the main choices being by rail to Central and Eastern Europe or to terminals at Hamina and Riga in the north or Odessa and Illichevsk (Ukraine) and Batumi (Georgia) on the Black Sea coast in the south.

Despite several proposals to develop more seaborne export capacity in Russia and other locations, none of these has made significant progress. With the exception of the Hamina terminal, none of the other terminals has significant storage capacity, and they often rely on rail cars for additional or short-term storage.

The long distances involved between the main production locations (Surgut, Orenburg, Tengiz, Perm, etc.) and export locations push up the cost of rail transportation. This is further increased by the fact that it is necessary either to transload product or change axle-bogeys at border crossings before delivery to consumers can be completed because the rail gauge is different between European and FSU nations.

Thus, taking into account the hire of rail cars, utilization of rail track capacity, and the cost of transloading at the border, a producer can expect to pay $100-125/tonne for transportation to the Polish market and $120-150/tonne for FOB Black Sea/Finland sales, depending on the source of production. In addition, Russian exporters have to pay an export tax of 45 euros/tonne.

References

  1. World Petroleum Assessment, 2000. US Geological Survey.
  2. Walters, Jonathan, "Caspian Oil and Gas: Mitigating Political Risks for Private Participation," The Centre for Energy, Petroleum and Mineral Law and Policy, September 2000.
  3. Vinogrador, Sergei, "The Legal Status of the Caspian Sea: A Card in the New 'Great Game'?" sourced via Alexander's Gas and Oil Connections.
  4. "Caspian Sea Region: Legal Issues," US Energy Information Administration, July 2002.
  5. "Caspian Sea Region: Environmental Issues," US Energy Information Administration, February 2003.
  6. "World LPG Market Outlook," Purvin & Gertz Inc., June 2002.

The author
Chris Holmes ([email protected]) is a principal with international energy consultants Purvin & Gertz Inc. in its London office. He holds a BSc (honors) in chemical engineering from the University of Birmingham and has worked for with Amoco (UK) Ltd., as a process engineer at its Milford Haven refinery and as a refined products trader in London and for international energy advisers Gaffney, Cline & Associates as a senior consultant.