Kremlin moves to curb fallout from Yukos debacle, but questions linger

Nov. 17, 2003
As controversy continues to swirl around the OAO Yukos scandal, experts see the Kremlin looking to limit the potential damage on foreign energy investment in Russia.

As controversy continues to swirl around the OAO Yukos scandal, experts see the Kremlin looking to limit the potential damage on foreign energy investment in Russia.

While traveling in Europe early this month, Russian President Vladimir Putin moved to allay mounting concerns about foreign energy investment conditions in Russia, given the crisis surrounding the recent jailing and resignation of OAO Yukos Chairman and CEO Mikhail Khodorkovsky. On Nov. 6, Putin openly criticized a recent threat made by the Russian Natural Resources minister over the possible revocation of two oil licenses previously granted to Yukos, one for the Talakanskoye field in Eastern Siberia.

The Kremlin is likely to face a protracted period of damage control. Major credit rating agencies are reassessing their investment grade ratings for Russia in light of the Yukos debacle. And a rush by foreign companies into Russia's highly prospective oil and gas sector may have come to a screeching halt amid the uncertainty the scandal has spawned.

The Yukos incidents raise questions regarding the future of foreign investment in Russia's oil and gas sector, whether through equity stakes in the dynamic new companies of that sector or through direct participation via such mechanisms as production sharing agreements (PSAs).

Where there is consensus is that Russia's untapped hydrocarbon potential is too huge to be overlooked—for foreign investors; for the US, Europe, and other major oil and gas consuming regions; and for competing oil and gas exporters. The potential remains for an investment flurry and consequent exploration and production activity boom in Russia.

Observers are mindful of a similar boom in upstream interest, followed by disappointed retrenchment amid legal and political uncertainty, after Russia's oil and sector first opened to private investment a little over a decade ago. Then the uncertainty centered on Russian oil and gas legislation and ownership issues. Frustration with a lack of progress in Russian energy law was the major impetus behind supermajors such as BP PLC and ExxonMobil Corp. shifting their investment focus away from PSAs to the dynamic new Russian companies—with Yukos in the forefront.

So the overarching question remains: Will history repeat itself as interest in Russia's upstream attenuates with fresh uncertainty, or will the Yukos scandal be just a brief bump in the road for the future onrush of investment?

Damage control

Putin said that his government isn't in the business of revoking licenses and that Yukos is free to continue its operations, despite the detention of Khodorkovsky.

Putin's comments came on the heels of comments by Natural Resources Minister Vitaly Artyukhov, quoted in the Russian daily Rossiskaya Gazeta as saying it is "practically inevitable" that Yukos will have production licenses for several of its oil fields revoked.

"The legal incorrectness of the statement by the natural resources minister, who has shown his absolute ignorance of basic legal concepts, causes deep regret," Yukos spokesman Alexander Shadrin told Interfax news agency.

Analysts see Putin's response as an effort to stem the damage to investor confidence and anxiety about the rule of law in Russia.

"Putin himself has never spoken with such specificity on a particular matter before the Ministry of Natural Resources, [so] we're reading this as a very strong indication he is very sensitive to the impact the Yukos law enforcement actionUis having on investor sentiment," said Ian Hague, partner and cofounder of Firebird Management LLC, based in New York. "Russian politicians are falling all over themselves to say critical things, and they threaten damaging actions against foreign investors."

Hague has vested interests in how the Khodorkovksy controversy turns out, adding that Firebird owns close to $12 million worth of Yukos shares, a small share of the $31 billion company. Hague said Firebird also has sizeable investments elsewhere in the Russian oil and gas sector.

"There's been a movement by some members of the Russian Duma to call for revoking previously grandfathered PSAs," said Hague, specifically referring to the Sakhalin I and Sakhalin II oil and gas megaprojects off Sakhalin Island, led by ExxonMobil Corp. and Royal Dutch/Shell Group, respectively, and Total SA's Kharyaga oil field development in the Timan-Pechora region.

"Certain members of parliament are seeking to curry favor with the FSB [Federal Security Service, successor to the KGB] and Russian Prosecutor's office by moving to revoke the grandfather clauses attached to these projects, but they are misreading the political tea leaves. They think that billionaire oil company owners who try to run for president will get in trouble, especially if they haven't always complied with the Russian tax code, which no one does," said Hague.

"Putin underestimated the reaction in the West. I think the Kremlin is in retract mode," said Michael McFaul, senior associate at the Carnegie Endowment for International Peace on a conference call hosted by United Financial Group, adding that he thought Putin's recent reversal of his Natural Resources minister's comments were "politically orchestrated."

Putin awareness of fallout growing

While Putin has said that international oil companies interested in investing in Russia will be there for the long haul, nevertheless, he also may have made some misjudgments in the handling of the Yukos scandal.

"Putin is having to navigate between two extremes: One extreme is an uncompromising attitude on Khodorkovsky as a political opponent, and the other extreme is the concern that his actions raise in the investment community, in Russia and abroad," Hague said.

Russian President Vladimir Putin
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"Mr. Putin doesn't see his political strategy as incompatible with foreign investment and economic reform. He sees this being about one guy going too far outside of the rules of the game," said McFaul, adding that this scandal may hurt Putin's reputation internationally but is not hurting him politically, at home in Russia.

Late Nov. 7, another disturbing development occurred: The offices of George Soros's Soros Foundation were raided in Moscow, just days after the billionaire investor and philanthropist publicly said the "persecution of Khodorkovsky sends an unmistakable message: that nobody can be independent of the state."

The foundation, which oversees several charitable organizations in Russia, has been at the center of a 2 year commercial dispute over control of the building in which it is housed.

Credit risk concerns raised

While some are minimizing the significance of the Yukos scandal, two major credit ratings agencies are voicing concern about the risks of operating in the Russian market.

The credit rating agency Moody's has put Yukos and OAO Sibneft, with which Yukos soon is set to merge, on "negative watch." Moody's said it "believes that this action is unprecedented and that the potential impact on the financial creditors of Yukos and bondholders of Sibneft is unpredictable."

Standard & Poor's has said it may revise its rating for Russia, if there is considerable capital flight or a downturn in the economy stemming from the crisis. A downgrade in Russia's credit rating could cost both the government and private Russian oil companies dearly in future borrowing costs, but S&P isn't saying that is going to happen.

"The arrest and resignation of Mr. Khodorkovsky, the freezing of the company's shares, and the subsequent Russian stock market decline does not affect our rating on Russia, but these events corroborate what we mean by repeatedly indicating that weak political institutions, a weak legal system, and clear political infighting between various political actors constrain the existing ratings," S&P said.

"My expectation is that when Yukos reports its next financial results, I think S&P will have cause to revisit their most recent outlook," said Hague.

Yukos: 'Rule of law'

At a recent energy roundtable in Houston, Ray Leonard, the US-born vice-president of exploration and new ventures for Yukos, said he and other company officials still believe "the rule of law will go forward. Anyone who has watched Russia from 1989 to the present knows that it is two steps forward and one step back—sometimes two steps forward, two steps back—but if you total up the number, it's still going forward."

Leonard said, "This is may be another turning point, something to watch very carefully. Like you, I read the newspapers everyday and am constantly surprised." He said Khodorkovsky resigned as chairman and CEO of Yukos "to allow the company to go on by itself," separate from "whatever political questions and legal questions" that involved its former top executive.

Fate of CEO's stake

While some analysts contend that Khodorkovsky's arrest shouldn't have been that much of a surprise, considering recent crackdowns on other executives close to him, they say the clumsy handling of the scandal by the Kremlin makes it a difficult situation to predict. One key question is what will happen to Khodorkovsky's Yukos shares, which have been frozen.

"If a Russian court finds Khodorkovsky guilty, then some portion of his Yukos shares have the potential to be forfeited, and my guess is that block of equity will be sold to ExxonMobil or Chevron[Texaco Corp.] through the negotiations with the Kremlin," said Hague. Both supermajors have been reported as being interested in buying a large stake in the merged YukosSibneft.

McFaul he said he doesn't think Putin wants to prevent ExxonMobil or ChevronTexaco from being a partner with Yukos. He added that Putin's strategy is to marginalize Khodorkovsky and "eliminate him as a political actor, but not to eliminate Yukos."

McFaul said he thinks Putin believes the major western oil companies are going to do business in Russia, because its hydrocarbon resources are too potentially lucrative to ignore.

ExxonMobil has plans to develop fields off Sakhalin Island in the Far East with estimated reserves of 2.3 billion bbl of oil. Putin has confirmed that Yukos held talks about selling a stake in the company to ExxonMobil. On Nov. 7, Andrew Swiger, chairman of ExxonMobil's international division, told a conference in London that Russia is "a long-term proposition" for his company, and it may even expand its presence in Russia in the future, according to Bloomberg News.

'Still political risk'

The Khodorkovsky arrest and freeze of his Yukos stake was a wake-up call to prospective investors in Russia, according to Joseph Stanislaw, president and CEO of Cambridge Energy Research Associates, Cambridge, Mass. "It has reminded the industry that there is still political risk in Russia. No Russian is an angel," Stanislaw told OGJ. "The Kremlin has struggled over economic reform and how far it can go. It's an issue of wealth and the support of other political parties by Khodorkovsky and others," he said.

Cambridge Energy Research Associates CEO, Pres. Joseph Stanislaw
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"I don't think [Russian President Vladimir] Putin wants to stop or reverse the privatization of Russian industry, but there is a question of how those assets were acquired," said Stanislaw. "The Russian government wants to continue the efficiencies of entrepreneurs, but it also retains some of the old communist suspicions of capitalists. The question is whether it can attack one without harming the other."

Moreover, he said, "Russians are very nationalistic, even xenophobic at times. They don't want foreigners to own [Russian] assets or [Russia] to become dependent upon [foreigners]".

However, Stanislaw said, "Russia is still the biggest available [E&P] market. Western companies still want to get in, but that has been put on hold for a while as they study developments. It will take time for them to get comfortable with the new playing field."

It "is not unexpected" that Russian government action against Khodorkovsky initially would produce some concerns among Western oil companies and investors, said Ian Woollen, senior analyst at Edinburgh-based industry analyst Wood Mackenzie Ltd. However, he expects Westerners "will warm again soon" to investments in Russian oil and gas, "particularly after the [Russian] presidential elections in March 2004."

He predicted, "Putin will continue his policy of general support for the long-term health of the oil and gas industry and encouragement of foreign investment. The effect on the role of international oil companies in Russia is likely to be much as it was before the recent events."

Market fallout

Beyond whether Russia's oil industry will be damaged by the scandal, there is the current issue of Russian production vs. efforts by the Organization of Petroleum Exporting Countries to limit production in a bid to strengthen world oil prices.

Russian Energy Minister Igor Yusufov has called on OPEC to raise production, saying prices were too high. Subsequently, OPEC Sec. Gen. Alvaro Silva-Calderon was in Moscow to express the group's interest in developing "cooperation with Russia as closely as possible." Silva-Calderon said he thought prices are "not too high" and that oil prices at OPEC's target band of $22-28/bbl for a basket of OPEC crudes are "fair."

Russia is the world's second largest oil exporter after Saudi Arabia, and the largest non-OPEC producer. There are reports Saudi and Russian officials met near the first of this month, but details of those discussions are not available.

"The [Persian] Gulf Arab oil producers think this is a golden opportunity for increased cooperation with the Russian government, because of a perceived increase in the state's control over the oil sector," said James Richard, a cofounding partner of Firebird Management.

However, Richard says Russia is vastly different from OPEC members, and its energy assets are being used to transition the country's economy away from dependence on energy. He said Russia is getting pressure from Saudi Arabia to "jump on board to OPEC's pricing plans."

Russia has said it will increase production, and there is no indication that if OPEC were to ask Russia to cut its oil exports, that it would comply.

"We do not think the whole Yukos controversy will impact world oil prices. The Russians are in the middle of a multiyear ramp-up in production, and the upper limit hasn't been reached. Russia's export potential is limited by the state of the pipeline infrastructure, not anything internal to the Russian oil companies themselves," Hague said.

Russian oil output for the first 9 months of 2003 was up 11%, compared with the same period a year ago. While OPEC decided to cut production to 900,000 b/d beginning Nov. 1, it is possible that Russia and other independent producers will continue to keep pressure on OPEC's planned production curbs.

Russia's potential

Last year, Russia became the world's No.1 producer of crude oil (7.7 million b/d) and the world's second largest oil exporter (3.8 million b/d), outpacing all major oil suppliers except Saudi Arabia (OGJ, Oct. 6, 2003, p. 62).

"Russia has plenty of oil, plenty of natural gas," said Stanislaw. "The biggest problem is getting those supplies out" to world markets. However, he said, "The US needs more natural gas; Russia should be at the top of the list for alternative gas supplies to the US in the future."

Previous projected growth of Russian oil and gas production "can still happen," he said. "Nothing has been done to slow current operations. Russian officials and private enterprise are already committed to energy projects over the next 1-2 years. And Russia needs companies like Yukos.

"Personally, I'm optimistic about Russia," said Stanislaw. "All we can say with certainty at this point is that the rules of the game have been altered." As for what may evolve from this change, he said, "We'll just have to wait and see. Russia still has the best prospects—we can't deny those facts."

In an interview with OGJ prior to Khodorkovsky's arrest, Stanislaw said, "Everyone is trying to queue up to get into Russia. There are opportunities for foreign players to develop joint ventures, [make] swaps for Russian properties in exchange for holdings outside of Russia."

He said, "Russian rules now provide a more even playing field for foreign companies in Russia. They don't have [PSAs], but contracts are available with Russian companies. The judicial system is now more developed. It's not 100% risk free, but a lot of rules are now in place."

In order to "move closer to access Western capital," Stanislaw said in that earlier interview, "Russian companies are progressing, at various speeds, toward more transparency and the corporate governance issues that we say we want."

Moreover, Russia offers huge, long-life reserves that are "already found" and can be developed at a relatively low cost. "When you look at the large basins around the world, Russia is open and still operating. Its reserves may be a lot bigger than the official figures," Stanislaw said earlier.

"Some Western companies understand that, and some don't."

Thinking 'Russian'

"The biggest problem for Western companies in Russia is to understand how to work in Russia," said Stanislaw. They have to learn to "think Russian," he said, which means adopting a certain mind-set and local approach to problems and opportunities. "The Russians understand their wells and how technology can be used in their wells," said Stanislaw.

"The role of US oil field technology in Russia is complicated," he said. Russian oil companies may not adopt Western technology in its "pure' form. "Russian technology may not be 'gold-plated,' but they are using technology that is appropriate and can be adapted to Russian conditions," he said.

Russian production forecast

By 2010, Russian oil production is likely to reach 10.4 million b/d and, with the requisite level of investment, could reach 12 million b/d, according to a recent report by Wood Mackenzie.

"This is higher than Russian government estimates and has significant implications for prospective oil investors in Russia, as well as the medium-term balance in the global oil market, said Wood Mackenzie.

"Oil production in Russia continues to increase at a rate of 11% per annum, on target to average 8.5 million b/d in 2003, and industry projections that a few years ago seemed unlikely now seem plausible. Russian exports to the US may even begin to displace traditional Middle East supplies within the next 2-5 years," Woollen said.

He noted that, in the past year, BP and Tyumen Oil Co. (TNK) formed the TNK-BP megaventure with upstream and downstream assets spread across Russia (OGJ Online, Feb. 17, 2003), while Yukos and Sibneft agreed to merge to propel the new firm, YukosSibneft Oil Co., "into the global supermajor peer group" (OGJ Online, Apr. 22, 2003).

"There is a growing positive view of Russia, supporting the involvement of international oil companies, which is now extending to potentially the largest megamerger in the history of the oil industry. The development capital expended in Russia over the next few years will be critical in defining its longer-term potential," said Woollen.

In its report, Wood Mackenzie described an "unconstrained case" for Russian production reaching a peak of 12 million b/d, with peak exports of 7.5 million b/d, in 2010. That represents Russia's production and export potential "without constraints from either export capacity or investment levels," said Wood Mackenzie officials.

They also forecast a "most likely" base case, with Russian exports peaking at 5.9 million b/d in 2007.

"The [Russian] government's moderate case [of production around] 9 million b/d is a bit pessimistic, but their optimistic case of 10-10.5 million b/d is similar to our base case, although they take longer to get there," Woollen subsequently told OGJ.

Recent political events in Russia do not impact Wood Mackenzie's base case expectations of Russian production increasing to 10.4 million b/d. "And I am still optimistic that higher production could be achieved under the right circumstances," said Woolen.

"I am not gloomy about Russia's future," he said. "I am much more concerned that they (the government, state pipeline firm OAO Transneft) provide the required export capacity, because of their lower (and later) production expectations." Delays in expanding exporting capacity could make the lower Russian projections "a self-fulfilling prophecy," he said.

"I am also concerned that the companies spend sufficient development [capital] to realize their production aspirations and that any [capital expenditure] shortfalls over the next few years will have more serious, longer-term consequences," Woolen said.

No more PSAs

Khodorkovsky was a leading opponent of PSAs in Russia, and Yukos continues that opposition in his absence.

Russia will honor its three existing PSAs with Western oil companies. "But that's it—there won't be any more," said Leonard, at a roundtable conference on global production sharing contracts Nov. 6-7 in Houston.

The new PSA law enacted late last year by the Russian Duma does little more than "grandfather in" the existing agreements. "The conditions that it puts on new [PSAs] are so onerous that it is unlikely there will be any new ones," said Leonard at the Nov. 7 session of the conference sponsored by Daniel Johnston & Co. Inc., Hancock, NH, and King & Spalding LLP, New York.

As a former 19-year employee of BP predecessor Amoco Corp., including appointments in 1989 as Amoco's director of new ventures for the Soviet Union, Eastern Europe, and China and in 1995 vice-president of resource acquisitions for Amoco Eurasia, Leonard once worked "passionately" for PSAs. But as the executive responsible for diversifying Yukos's upstream portfolio out of its core areas and concluding partnership agreements with non-Russian companies, he now sees no need for PSAs in Russia.

"The Russian government realizes [PSAs] reduce near-term revenue" because they "allow companies to recover their costs as a first priority, and revenues to a country are delayed," he said. "Since under a production-sharing system, the first thing you do is recover your costs," Leonard told industry representatives, "a company is not as focused on cost controls as it would be under a normal tax system."

Russians also are convinced that PSAs increase corruption—"not so much in terms of dealing with Western companies but in dealing with Russian companies or with consortiums that had Russian companies that did the dirty work. A system where you have to individually negotiate every major parameter leads to that sort of problem," he said.

Third World stigma

"Also there is a perception of production-sharing contracts as a Third World system, and the Russians do not like to think of themselves as a Third World country," Leonard said. "Tax royalty agreements are used in the US, Canada, Europe, Australia. They adhere to the tax and legal systems of the country. Risks of changes in costs and oil price are assumed by the companies. The legislature has the right to change the terms."

Such agreements "are characteristic of democratic societies," he said.

On the other hand, Leonard said, "[PSAs] are used in Libya, Indonesia, Nigeria, Angola, Kazakhstan, Azerbaijan. The contracts are outside of the normal tax revenue system. Risks in changes of costs and oil price are assumed by the host country. No change in fiscal terms are allowed, which disenfranchises a democratic legislature. The state oil company plays a key role."

To Russian government officials, he said, the PSA issue boils down to belonging to one of "two clubs": the industrial, democratic Western countries that use tax and royalty agreements and Third World countries where PSAs prevail. "Which club do you want to be in? That's how it's portrayed," said Leonard.

"This is not just an economic issue. It's an issue of how a country sees itself," he said.

Lobbying for change

"The Underground Resource law to be debated in the Duma the last quarter of this year and next year will address contract stability, property rights, etc.," Leonard said.

An investment committee cochaired by Leonard as part of a current "US-Russia energy dialogue" has formed "a working group with US oil majors to allow them a role in formulating the draft law, which will address fiscal stability," he said. That collaboration has been successful "below the surface," said Leonard.

The next move will be "joint lobbying by Russian and international companies for improvement of central terms for high-cost projects," he said. That group is using as a model the "special set of terms" in the US that provide flexibility in the royalty and tax regime to encourage development of deepwater Gulf of Mexico acreage.

"That's the sort of thing that we want to do, so when a company goes offshore in Russia, there's a different set of terms," said Leonard. With an adjustable system in place to encourage development of high-cost areas, he said, there will be no need "to negotiate specific terms for each project."

Lobbying for "the sort of things that need to be done to make high-cost projects attractive in Russia" in the long term will work better coming out of the joint US-Russia investment group rather than individual companies," said Leonard. "The one place where demonstrably Russia is behind in technology is the offshore. It is to the advantage of Western companies to help get Russian terms to where they're attractive for such projects."

The "two main factors" to such improvement, he said, is reduction of depreciation time to 5 years rather than 15 years and elimination of the customs duty, which originally was put in place "to try to equalize international vs. domestic crude flow. What they didn't want to happen is to have such a [price] gap [between the two markets] that everyone would send their oil internationally."

PSA opportunities closed

Prior to 1996, Western international oil companies succeeded in obtaining three significant PSAs in Russia, "to a large extent because there was no alternative," said Leonard.

The original timeframe for some of the early Russian projects by Western companies were "too quick and too aggressive," said Stanislaw. "Sakhalin lacked infrastructure. It was in a rough environment, and there were fewer rules in place then." Nonetheless, he noted, Royal-Dutch/Shell and ExxonMobil. "are still going ahead in Sakhalin."

In 1996-99, there was "limited progress" in attempts to negotiate PSAs because of "low oil prices and also fiscal and legal instability," said Leonard. But since 2000, he said, there has been "a defeat of further PSAs, which coincided with domestic stability and a strong domestic lobby."

Before 1996, he said, "There was a sense of competition between Russia and Central Asia for investment dollars. Many in Russia were saying, 'With the limited amount of money out there, if we don't put together a structure that attracts investment, it will all go to Azerbaijan.'"

At that time, he said, "There were certain parts of Russia in which there was a desperate need for investment. Populations were leaving, areas were destitute, and they recognized that without investment, some of these areas might not have any future. Sakhalin was a prime example of that. The local administration realized that more than anybody else and was one of the strongest backers of production sharing contracts."

That helped push through "presidential decrees authorizing" PSAs for Sakhalin I and Sakhalin II, as well as for Kharyaga, "which was a separate and limited case."

In 1996, the Russian government ratified a PSA law that entailed "a two-stage procedure—the first procedure was to place fields on a production-sharing list, which didn't mean you were going to get a [PSA] but did mean you were now qualified to negotiate for one," Leonard said. "While this was a complicated procedure, it wasn't especially difficult, and if you just had fortitude and persistence, eventually you could get your field on the production sharing list."

Different objectives

However, he said, "One of the problems is that there were three major players out there—Russian companies, Western companies, and the Russian government. And when the PSA legislation was passed, all three of them had different ideas of what this legislation meant."

The Russian government's objective, as "clearly stated" in the law, "was the development of fields that were not profitable under the normal tax system of 15% on [initial rate of return]," said Leonard. "These were fields that had very difficult reservoirs, fields offshore, or far from infrastructure—in other words, fields that Russian companies could not or would not develop because they didn't have the funds or they didn't have the technology."

However, Western international oil companies "wanted contract stability, minimizing their exposure and obtaining 100% export rights. They were not looking for marginal fields; they were looking for the very best fields. And they were looking to get production sharing terms for the very best fields," said Leonard, who represented Amoco in negotiations at that time.

"In the mid-1990s, the Russian companies were in very different shape than they are right now. They were still in the chaos of reorganizing after the breakdown of ministries. Their idea was to attract investment through partnerships," he said. With Western companies refusing to invest without PSAs, Russian companies generally supported PSAs, he said.

Prices impact PSAs

"With the oil price collapse of 1998-99, virtually every Russian field became marginal, when you calculated in the rate of return and the transportation cost for getting oil out of Russia. As a result, there was an explosion in the number of fields placed on the [PSA] list, despite the fact that nearly all of them did not resemble what the Russian government had in mind as the sort of field that qualify," said Leonard.

He said 30 potential projects placed on the PSA list in that period contained 47 billion bbl of oil—or about half of Russia's total identified reserves, by Yukos's estimates—with only 15% of those reserves in 8 fields offshore or in Eastern Siberia that would have qualified under the Russian government's outline for PSAs. "Many of the largest projects were sitting in the middle of the most prolific areas that were the easiest to develop and at the lowest costs," Leonard said.

"Another problem was that in the Russian ministry there was a limited number of people who really understood what [PSAs] meant," he said. Faced with so many requests for PSAs, he said, "They were completely overwhelmed."

It's possible that more PSAs might have been approved in 1996-99, said Leonard, "if everybody had not rushed in there but had focused on a limited number of projects."

The situation changed in 2000-02 with "a dramatic increase in oil price that made it very, very difficult to justify keeping some of these projects on the production sharing list," said Leonard.

Also there was "a dramatic improvement in Russian terms [for Western participation], both in the reduction of government take and improved predictability, with the change in terms based on formulas," Leonard said. "Virtually every aspect of Russian terms now is based on formulas, in which [one can figure] that if the price of oil goes from $25[bbl] to $30/bbl, the export tax will go from $4[bbl] to $5.50/bbl." As a result of lobbying by Yukos and other Russian oil companies, he said, the Russian government has abolished or reduced several taxes that previously impacted oil industry operations and reduced customs duties on oil exports.

Moreover, he said, "Onshore projects are highly profitable without [PSAs]." That's obvious, he said, by the aftertax profits of the Russian oil companies. And with increased money available for investment among Russia's domestic oil companies, said Leonard, "foreign investment is not needed" to develop Russia's onshore fields. "That doesn't mean that it wouldn't be accepted or wouldn't be wanted in some cases, but it's not needed," he said.

Western leverage lost

This means that Western companies have lost some of their previous leverage in trying to force Russia to grant PSAs by threatening to withhold investment, Leonard said.

"Another point, which I don't think is appreciated [by Western oil companies], is that as Russian production began to rise, it squeezed the export system," he said. That in turn resulted in an oversupply of oil for Russia's domestic market and increased the price gap between the world market and the Russian market. Oil was selling in the Russian market at the equivalent of $5-6/bbl "as recently as this past spring," said Leonard.

The gap between international and domestic prices for Russian is "something that will be resolved" with more export pipelines. "In the interim, I think BP has shown a pretty clear understanding that the best way to get into the system is either to buy or partner with a [Russian] company that has a role in the downstream to protect against the fluctuations in prices," Leonard said.

Because of the added transportation cost in getting Russian oil to world market, "there always is going to be some differential between the domestic and the international price," Leonard said. However, he said, "I think that if Western companies look at a domestic price on the order of $15-16/bbl, something like 60-70-80% of the international price, they could live with that." What international companies don't like, he said, "is the situation where one day it's 55% of the international price, and a month later it's 30%. I think a domestic price of 60-70% of the international price will probably be acceptable to the Western companies. It certainly is acceptable to the Russian companies."

Nevertheless, he said, "Western oil companies for the most part have desperately hung onto the concept [of PSAs] despite the loss of their fiscal rationale. Some high-cost projects, such as Sakhalin III, still fit the parameters that the Russians originally had in mind for PSAs. But in other cases, Leonard said, "There had to be some fancy cost-juggling to say some of these projects deserve 15% rate of return when oil prices are around $25/bbl."

Russian oil companies such as Yukos that have already made massive investments in Russia's onshore fields have found them to be highly profitable and oppose PSAs that they see as giving foreign investors an unfair advantage. They see it as a "dual system of terms" that is "unstable" and reduces the value of their own projects. "Also—and this is a very important point—[Russian companies] are fighting desperately for every barrel of pipeline space. The idea of a Western company getting 100% export guarantee is like a triple whammy against them," said Leonard.

Russian companies that favor PSAs are primarily "state companies that wanted to acquire licenses without competition and farm out on production-sharing terms," said Leonard. "They didn't have the money to pay their share, and the only way they could get terms good enough to be able to be carried [for up to 50%] was if they could get a production-sharing agreement" guaranteeing a Western partner 15% return on its investment.