Special Report: Russian oil firms combat ‘perfect storm’ of grim events

March 9, 2009
The Russian Federation’s oil industry currently is facing a “perfect storm” of difficulties—with simultaneous, sudden low oil prices, high taxes and tariffs, the devaluation of the ruble, and the global financial crisis—according to Russian oil executives evaluating the outlook for Russian oil at a February CERAWeek presentation in Houston.

The Russian Federation’s oil industry currently is facing a “perfect storm” of difficulties—with simultaneous, sudden low oil prices, high taxes and tariffs, the devaluation of the ruble, and the global financial crisis—according to Russian oil executives evaluating the outlook for Russian oil at a February CERAWeek presentation in Houston.

Russian tax reform is high on the list of priorities leading back to growth and profitability for oil companies, said Peter O’Brien, chief financial officer of OAO Rosneft. The price of oil fell so rapidly in the second half of 2008 that, under existing tax laws, profits were squeezed out in the fourth quarter, with “99% of the price of oil [going toward] the export duties, profits tax, and transportation duty, providing for a difficult operating budget,” he said. “There wasn’t much left with which to generate cash for operating expenses.”

Russia cuts production

“In addition to that, Russia experienced its first year of [oil] production decline in a decade,” O’Brien added.

Russian oil production may continue to decline due to capital restrictions and to a deal Russia made last year with the Organization of Petroleum Exporting Countries. Andrei Gaidamaka, deputy vice-president of strategic development for OAO Lukoil, said Russia had been providing 50% of non-OPEC global oil production but agreed in 2008 to reduce production as part of efficient cooperation with OPEC.

The compound annual growth rate (CAGR) for 2009 is expected to be 1-2%, O’Brien said, “making the economics more difficult for us and our peers.”

New government policy

However, recent political developments in Russia, including the second election with changes in government in 2007 and the presidential election in March 2008 “bring a new and very much invigorated policy toward the energy industry and offshore industry as included in the various discussions on taxes,” O’Brien said, along with the recognition of the “pain that the industry is going through.” Russia is attempting to counteract the same financial downturn that other nations are experiencing, he added.

Some positive changes that have occurred in response were a reduction in the profits tax from 24% to 20%, and on Nov. 1, the export duty was reduced, O’Brien said. “This is huge progress….” However tax and transportation burdens are still high, he stressed, and “the multifold growth in natural monopoly tariffs doesn’t leave much left to invest for the future.”

Improved performance in downstream operations offset some of Rosneft’s E&P and transportation costs, O’Brien said. “The company looks good, but it is getting difficult to maintain growth,” he said. The potential is there, with resource potential of 3 million b/d of liquids. The company’s implied CAGR is 16.4%, with costs averaging $2.49/bbl.

O’Brien said major elements to watch include the oil price in US dollars compared with the ruble, inflation following devaluation, and further tax improvements to reduce the industry’s risk, he said.

Gaidamaka, speaking of “continuous growth in an improving macro environment,” was more optimistic, saying market fundamentals support oil production at $50-80/bbl and that Lukoil “will be cash positive under any scenario.”

While the ruble is weakening, oil prices are still comfortable and support earnings growth, he maintained, adding: “Downstream operations in Russia have become infinitely more profitable,” with Lukoil’s refining throughputs also up since 2006 and a 15% increase in the number of its filling stations. “We will not have any reduction in our growth prospects in retail because the company does have sufficient capital to fund them.”

But, he said, “the company’s most exciting growth right now is in natural gas.”

During the next 8-9 years, Lukoil plans to produce 300,000 b/d of oil from the North Caspian Sea area, and he said the Y-K project in the Barents Sea has over half a billion bbl of reserves to be produced.

He also said the major portion of the company’s operating expenses (88%) are based in rubles, which contributes to its cash flow by reducing capital costs and operating expenses in Russia. Lukoil also operates in nearly 40 other countries.

Kudrin’s scissors

The advantages of Russia’s lower production costs, however, are offset by the taxes, duties, and tariffs, which the government sets, recalculating export duties every 2 months, said Boris Zilbermints, vice-president of exploration and production for Gazprom Neft, the oil subsidiary of OAO Gazprom.

However, “Minister Kudrin’s scissors” [delayed revisions of high oil export duties following sharp reductions in oil prices]“caught up with the oil industry in the second half of 2008 when export taxes exceeded oil prices and revenues,” he said.

The government’s legislative changes as of Jan. 1, which reduced corporate income taxes and other taxes, “are substantial but still insufficient,” Zilbermints agreed. “A lower tax burden would be totally offset by growing oil production,” he stressed.

Enormous reserves

The Russian state estimates that Russia has 30 billion tonnes of oil and 74 trillion cu m of gas reserves. BP PLC statistics put them at 11 billion tonnes of oil and 45 trillion cu m of gas. “Either way they are enormous,” Zilbermints said. However, he said, they have mainly been explored and many are depleted, another ‘storm’ element. Furthermore, there have been no major discoveries in the former Soviet Union in the last few decades, he said. The States Reserves fund of 400 million bbl is intended for future generations—a “dog in the manger.”

Russia, which has the reserves, is participating in joint ventures and partnerships with international oil companies, which have the technology, enabling Russian companies’ technology acquisition and participation in overseas projects. Areas of expertise and cooperation include exploration, oil-gas condensate fields, offshore fields—especially in Arctic waters such as the Barents Sea—and fields with highly viscous oil, such as in western Siberia fields in which Chevron Corp. is participating on a JV basis.

Developing talent

Another issue Russia must address is investment in talent and human capital. The shortage resulted from structural, economic, and demographic changes following the breakup of the Soviet Union. Although Russia’s university system has expanded greatly, Zilbermints said, technical and vocational education has been neglected for years. Competition for talent leads to speculative demand and overpayment.

There are employee rotation difficulties for two reasons, he said: lack of tradition and willingness. “It is easy to get someone from Siberia to Moscow, but not vice-versa.” He said the company is creating a talent pool and implementing new employee incentives.