View of 12 million b/d Russian output by 2010 places focus on export limits

July 26, 2004
Russian production has been growing rapidly in recent years, and many observers consider that it could exceed 10 million b/d by 2010.

Russian production has been growing rapidly in recent years, and many observers consider that it could exceed 10 million b/d by 2010.

On an unconstrained basis, assuming that all required investment was put in place, Wood Mackenzie believes that production could reach 12 million b/d in 2010.

Significant growth in production, combined with limited growth in domestic demand, has led to a major drive to export crude. This in turn has exposed capacity constraints in the export pipeline system, which needs to be expanded significantly to cope.

Major projects to build new pipelines to China, the Pacific Coast, and Murmansk, and expansions of the existing Baltic Pipeline System (BPS) all have powerful advocates. These schemes would open up the possibility of increasing exports to China, Japan, and the US, and so the debate has strong geopolitical overtones.

The feasibility of these pipelines and the level of crude exports will depend critically on the extent of production growth through 2010.

The Russian oil market therefore presents major opportunities for international oil companies and also significant challenges. The series of strategic moves in Russia over the last year by major oil and gas companies, including the leading Russian organizations, demonstrates the dynamism and attractiveness of the Russian market.

The opportunities will be highly competitive, however, and any company wishing to pursue them will need to be fully aware of the risks presented by the business environment.

Russian reserves, production

Wood Mackenzie's take on Russia's oil and condensate production potential is based on a bottom-up, field-by-field analysis using its proprietary Pathfinder database.

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This database includes fields in production and expected future developments of discovered fields. For production in the near to medium term, the analysis focuses on ABC1 reserves, which approximate to proved-plus-probable (2P) reserves. These are estimated to amount to some 116 billion bbl (Fig. 1).

West Siberia dominates the picture, accounting for some 74% of ABC1 reserves. The Volga-Urals and Timan-Pechora are also significant, while East Siberia accounts for only around 4% of these reserves.

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If the ABC1 reserves were to be developed on an unconstrained basis, i.e., all necessary investment in production and transportation was put in place, then the production profile would be as set out in Fig. 2, and Russian oil production would peak at some 12 million b/d in 2010.

Two of the main drivers in realizing this production potential are the pace of field development and the impact of new and refurbished wells. Most new development activity to date has focused on the better reservoirs, areas with more immediate and higher incremental production, with the net effect of accelerating production and increasing access to known reserves. The scale of the asset base would suggest that these gains can be sustained for some years to come.

More than 50 fields (over 2 billion bbl of reserves) were put into production over the period 1996-2001, and many new fields are awaiting development. Field extensions are providing additional production, and new reservoirs are being developed at mature fields, e.g., at the Samotlorskoye and Fedorovskoye supergiants.

Licensing and exploration activity are also on the increase with significant scope for reserves additions, mainly in established areas such as West Siberia and in other less well-established and more remote areas.

More sophisticated technologies, such as horizontal drilling and multilateral wells, are also being widely applied, increasing access to reserves and oil recovery, as well as reducing water cuts. Fracturing and better well completions applied at Yuganskneftegaz (Yukos) in West Siberia, for example, more than doubled flow rates on average. The redevelopment of major fields is increasing recovery expectations, e.g., around 14% more reserves could be recovered from Mamontovskoye field using improved waterflood and other development techniques.

It should be emphasized again, however, that the 12 million b/d is very much an unconstrained view. There are two principal reasons why future production may turn out to be somewhat lower than this: constraints in the export infrastructure and the level of investment in E&P.

Export constraints

Export capacity has emerged as a key issue for Russia's oil industry, with transportation constraints an increasing problem as oil production increases.

This has led to a range of major projects, debottlenecking schemes, and a significant increase in the use of rail transportation, although the latter is significantly more costly than using pipelines.

It has also led to debates over the strategic options for development of the pipeline system, and there has been disagreement between the state-owned pipeline monopoly Transneft and the major private Russian oil companies (ROCs) as to how to accommodate exports (a) from East Siberia to the Far East, and (b) from West Siberia and Timan-Pechora to Europe and the US.

For production from East Siberia, Transneft has proposed to build and operate a major new line to Nakhodka on the Pacific Coast of Russia. The alternative destination was a Yukos proposal to build a pipeline to Daqing in northeastern China.

These competing schemes have been subject to intensive political lobbying by the respective customers, and their relative probability has fluctuated over time. More recently, the prospects for the China pipeline have been significantly reduced as a result of the Yukos dispute with the government, although the company intends to fulfill at least part of the planned volumes by rail.

As regards Russia's westbound exports, Transneft favors expansion of Baltic system to its terminal at Primorsk. The alternative proposal was originally advanced by a consortium of ROCs for a new pipeline from West Siberia to Murmansk, where the existing port and terminal would be expanded.

Major advantages of this option over Primorsk are that Murmansk could take VLCCs, opening the possibility of exports to the US market, and the port is ice-free year round. More recently, Transneft proposed a route to Indiga on the Arctic coast, potentially a faster build than the Murmansk route but requiring offshore loading.

Complicating the debate is the issue of whether any form of private involvement in oil pipelines should be allowed. Some of the major ROCs have proposed to build pipelines to ensure that increased production can reach more lucrative export markets. However, Transneft has mounted a strong campaign to maintain its monopoly on ownership and management.

A possible outcome is that outside investment in oil pipelines could be allowed but that Transneft will retain operating and management responsibilities.

Other schemes to expand export capacity from current levels are complicated by foreign interests. Examples include the reversal of the Odessa-Brody line in Ukraine to transport Russian oil to the Black Sea and the reactivation of pipeline movements to Ventspils in Latvia.

Whether and when these options will deliver additional export capacity for Russia remains uncertain. The construction of a Bosporus bypass is also ever more likely as Black Sea exports become increasingly congested.

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A view of export capacity, which could accommodate the unconstrained case production scenario, is shown in Fig. 3, separated into its major elements. Under this scenario, export capacity would reach 9 million b/d by 2008, although peak oil available for export (i.e., production less Russian domestic demand) would amount to only 7.5 million b/d (in 2010).

The analysis indicates that export constraints, although severe initially, will ease after 2006. Also, apart from the strategic importance of the Murmansk pipeline and a deepwater port to facilitate crude exports to the US, its additional export capacity is not required unless it replaces the more expensive rail (non-CIS) or other routes do not deliver up to their expected capacity.

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Fig. 4 illustrates a less aggressive expansion of the export pipeline system and a slower growth of rail transportation, both of which are considered in this analysis as part of the most likely export capacity scenario (Wood Mackenzie's base case).

Under this scenario, there is a near-term shortfall in export capacity peaking at 570,000 b/d in 2005, and export restrictions remain until 2007. This would limit the growth of production over this period, with no effective outlets for increased oil volumes in either the export or domestic markets.

The level of E&P investment

The other major factor that will affect future production is the level of upstream investment. This will determine the pace of development and, particularly as the percentage of more difficult to recover reserves in the asset base increases over time, the degree to which reserves can be recovered.

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Wood Mackenzie has conducted a high level analysis of the E&P investment that would be required to achieve the unconstrained case level of production. Transportation capex and tariffs are excluded from the estimated capital expenditure and corresponding operating expenditure to 2020 (Fig. 5).

On the basis of this analysis, the capex required to support production at the level of the unconstrained case is estimated to be on the order of $11-13 billion/year over the period 2005-13, falling thereafter.

The total capex required over the period 2003-20 is estimated at some $180 billion ($214 billion nominal), less than the US$230-240 billion indicated in Russia's 2003 Energy Strategy.

The 'E&P capex' line on Fig. 5 is the total capital spend over 2003-05 estimated from company financial statements and published plans. The analysis suggests that in the near term there could be a shortfall of $4-6 billion/ year against the E&P capital spending needed to achieve the unconstrained case level of production.

Whether the required investment levels will be achieved will depend on how much additional cash will be generated from operations, the world oil price being a clear although potentially volatile influence; the level of dividend payments to shareholders; and the extent to which the government will demand a bigger share of rent from the oil sector, either through general increases in production-based taxation, windfall taxes, or pursuit of past tax liabilities.

Clearly, the actual capex, oil price, and production levels achieved in 2004 and 2005 will be critical in setting the foundation for the longer-term potential.

'Base case' forecast

In addition to potential export constraints and limitations from upstream investment levels, other factors such as field development inefficiencies and political, legal, and fiscal issues, including the impact of the still pending subsurface code and sidelining of the PSA regime, may all be expected to contribute in some way to restrict production and exports to levels lower than the unconstrained case.

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The 'base case' production scenario (Table 1) represents Wood Mackenzie's view as to the most likely outcome. Base case production peaks at 10.4 million b/d in 2010.

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Using base case production, the oil and condensate available for export is derived by subtracting Russia demand, as before for the unconstrained case. The exports are shown against the base case export capacity in Table 2 and Fig. 6.

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Under the base case liquids export and production scenario, export capacity remains tight until 2006. Fig. 6 shows that neither the Murmansk nor Ventspils pipeline options is actually required unless it replaces significant capacity on other routes. Rail options beyond the CIS could supply the indicated additional capacity requirements to 2007.

If the larger capacity Pacific pipeline route (to Nakhodka) is chosen over the China options, it could require redirecting exports from West Siberia, if adequate reserves are not found in East Siberia, to make the Pacific pipeline economically viable.

Production scenarios

The Russian Energy Strategy, which the government presented in August 2003, forecasts production levels lower than Wood Mackenzie's unconstrained and base case scenarios until beyond 2010 (Table 3).

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The 'optimistic' energy strategy forecast is almost 10 million b/d by 2010 and 10.5 million b/d by 2020. The 'moderate' forecast reaches around 9 million b/d over the period 2010-20.

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The Wood Mackenzie unconstrained case and base case production scenarios are shown in Fig. 7. The net impact of the 'base case' assumptions is to delay around 11 billion bbl of production to beyond 2030 and produce a gentler decline in output. Also illustrated in Fig. 7 are the 'optimistic' and 'moderate' Russian Energy Strategy cases.

It can be seen in Fig. 7 that each of the Wood Mackenzie cases (base and unconstrained) exceeds both of the government's scenarios in the near term to at least 2012. Current production, at levels in excess of 9 million b/d, exceeds even the government's optimistic scenario for 2005 suggesting a degree of conservatism in the government's forecasts.

It should be noted that, in a broader sense, the 2003 Energy Strategy could be a self-fulfilling prophecy. If the government does not believe the higher production forecasts or does not want to see production at such levels until later, it may not make the necessary efforts to ensure that sufficient export capacity is put in place and, consequently, production and exports will be constrained.

Equally, if it is concerned about the period after 2010, it may orient the fiscal and licensing regimes to encourage development for the longer term rather than for the enhancement of current production. Nor has the full impact of the government's tax claims against Yukos yet been felt.

Other reserves and resources

The analysis above has been based on ABC1 reserves of discovered fields, broadly equivalent to 2P (proven-plus-probable) reserves, which will dominate Russian production to at least 2010.

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Production in the second decade of the century will also be influenced by the development of C2 (possible) reserves and undiscovered, or yet-to-find, resources (YTF).

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These additional reserves and resources are significant for Russia. Wood Mackenzie estimates C2 reserves to be around 30 billion bbl, and YTF resources on the order of 90 billion bbl. Their regional breakdowns are illustrated in Figs. 8 and 9.

Once again, West Siberia dominates the picture, although East Siberia is now significant and is the largest of the 'other' regions, accounting for around 15% in each case. Estimating the potential impact that the development of these reserves and resources might have on the production profile is highly uncertain and heavily dependent on assumptions about the efficiency of their conversion to ABC1 reserves and rate of development.

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Fig. 10 illustrates the impact on production, assuming that C2 reserves are developed at ~1 billion bbl/year for 15 years, with a 50% conversion to ABC1 reserves, and that the YTF development rate is ~800 million bbl/year.

The analysis illustrates if these assumptions were realized, a production level of ~10.5 million b/d could be maintained beyond 2025.

Implications for investment

The scale of the Russian oil sector has led to serious interest on the part of international oil companies struggling to replace reserves. Moreover, the capital investment that would be needed to sustain production suggests that Russia could present a major opportunity for outside investors, and there has been no shortage of interest.

In 2003, BP, Shell, and Marathon made investments, and 2004 has seen interest in the Russian government's remaining stake in Lukoil and all or part of Sibneft, depending on how the Yukos-Sibneft merger is unwound.

Whether outside investors can develop a position in Russian oil will depend critically on the attitude of the government towards the sector.

Recent developments have not been entirely encouraging: The general level of taxation on the sector has been raised, and PSAs look set to play a much less significant role than appeared likely at one stage.

It is also clear that the government wishes to exert greater control over the oil and gas sector. The role and importance of state-owned entities Transneft, Rosneft, and Gazprom are being increased.

The state is consolidating a majority shareholding in Gazprom, and it is possible that a stake in Yukos could be placed into state hands once the current legal processes have been concluded. How all this impacts the interest of international companies in Russia and whether this in turn will affect the level of Russian oil production remains to be seen. F

Bibliography

For more information, see the following web site (http://www.woodmac.com/russia).

The authors

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Tim Lambert is director-energy consulting with Wood Mackenzie in Edinburgh. He has more than 15 years' energy consulting experience focused on strategy and market analysis, restructuring, policy analysis, and mergers and acquisitions. His clients have included major international energy companies and national oil companies, and he worked on the restructuring and IPO of energy enterprises for a number of governments including the UK, Ukraine, and Greece.

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Ian Woollen is a senior analyst covering Russia, the Caspian, and Central Asia for Wood Mackenzie. He joined the firm in 1990 as manager for operations in Russia, the Caspian, and Central Asia. Initially based in Moscow for over 5 years, he helped develop Wood Mackenzie's research products on the commercial analysis of the oil and gas industry of these regions and has contributed extensively to consultancy projects. He was previously a geologist with Shell Oil Co. and BP.