PRODUCTION RISE, CONSUMPTION FALL MAY TURN SOVIET OIL EXPORTS HIGHER

Theodore R. Breton, John C. Blaney
ICF Resources Inc.
Fairfax, Va.

Oil production in the Soviet republics has been falling as the Soviet Union's economy and political structure have deteriorated. The decline in Soviet oil production has accelerated in 1991, and given the current state of chaos in the Soviet Union further declines in Soviet oil production seem likely in short run.

Many oil analysts in the U.S., perhaps conditioned by U.S. experience, have assumed Soviet oil production has peaked and are expecting the decline to continue indefinitely. However, in an analysis of the Soviet Union and Eastern Europe recently completed for its Energy Service subscribers, ICF Resources Inc. concluded that the long run potential for Soviet oil production is surprisingly bright.

ICF Resources believes that the conversion of the Soviet republics to a market economy could lead to an increase in oil production over the level achieved in recent years. Based on a comparison of Soviet and U.S. oil resource and development data, ICF Resources found that the Soviets are at about the stage of oil resource development achieved in the U.S. in the early 1960s.

Accordingly, the U.S. oil development path between 1965 and 1990 was used as a model of what the Soviets may be able to achieve with free market incentives and foreign investment and technology.

Of greater importance, ICF Resources' analysis indicates that free market energy prices would lead to tremendous reductions in oil consumption. Although Western analysts have only recently been permitted to assess the true state of the Soviet economy, it is already clear that the level of inefficiency in oil production and consumption is enormous.

Much of the technology currently utilized is so old and inefficient that it will be replaced with much more energy-efficient Western technology within the next 10-20 years. While the use of energy in the Soviet republic is currently very different from the industrialized and developing Western world, during the next 20 years it is clear that the Soviet Union will become much more like the rest of the world in its industrial practices and use of energy.

Increased oil production combined with reduced oil consumption could permit Soviet oil exports to increase from 2.3 million b/d in 1990 to 4.5 million b/d by the year 2000. By 2010, net oil exports are projected to stabilize at 7.0-7.5 million b/d.

This increase in Soviet oil exports will reduce the demand for OPEC oil and could postpone a potential rise in oil prices.

PRODUCTION PROBLEMS

Soviet crude oil production, excluding natural gas liquids, increased from 2.9 million b/d in 1960 to a peak of 11.7 million b/d in 1987 and 1988 but has since fallen precipitously.

Production declined to 10.7 million b/d in 1990 and has fallen to 10.0 million b/d in 1991 due to a number of technical, political, and economic factors:

Soviet reservoir management practices are suboptimal. Heavy reliance on early waterflooding to meet aggressive production targets has reduced the productivity of existing wells.
The collapse of the centralized Stalinist system has caused drilling to be cut back. Recently investments have barely reached 80% of the rate required to maintain production levels.
The lack of incentives for oil field workers has led to low worker productivity. Perestroika has reduced management's authority to discipline workers for poor performance. Combined with low wages and few goods to buy, oil field laborers have little incentive to work.
Strikes and a general breakdown in centralized control have led to a lack of drilling and pipeline equipment. As a result many oil wells in Tyumen province, the major oil producing area, are now shut-in.

The adoption of a free market system and the resolution of the political conflict between the central government and the republics are required to reverse the current decline in oil production and overall economic activity. Implementation of a free market system will permit prices to direct efficient oil field development.

A free market system would also provide proper incentives to improve worker productivity and alleviate the chronic shortages of materials and equipment. Although the timing remains in doubt, adoption of a market pricing system appears inevitable.

In addition to a free market system, the Soviets require foreign participation to provide badly needed investment for oil development. Numerous joint venture agreements with foreign companies are in place or near completion. The major obstacle to further foreign investment is the political uncertainty of the Soviet government's and the republics' authority to grant oil concessions.

Foreign companies interested in investing in the Soviet oil industry are unclear who has authority to negotiate with them. However, the recent failed coup attempt was a watershed event, and clearer lines of authority should ultimately result.

Resolution of this political question will accelerate the further introduction of western technology into Soviet oil fields. Work done to date in existing fields shows that western equipment and well management practices can increase oil production.

For example, the excessive use of waterflooding in many reservoirs has resulted in extremely low oil/water production ratios, which Western operators have already shown can be greatly improved.

SOVIET OIL PRODUCTION

In order to examine the potential impact of foreign investment and technology on future Soviet oil production, ICF Resources developed a simple oil supply model.

The model simulates the development of the resource base from undiscovered resources to proved reserves to production and the economics of discovering and producing these resources. There are essentially three components to the model structure:

A resource extraction cost curve that denotes the proportion of the Soviet oil resource base that is economic to develop at a given wellhead price.
Reserve addition parameters that represent the rate at which undiscovered resources are converted to proved reserves.
A production-to-reserves function that simulates the speed at which proved reserves are produced.

ICF Resources has used this same modeling structure for many years to project oil production for the U.S. and other regions. The exact formulation used to represent these three supply relationships depends on the data available and the purpose of the analysis.

For example, for the U.S. we have developed engineering-based estimates of regional resource extraction cost curves and formulations of the reserve addition and production-to-reserves ratio that explicitly represent the economics of exploration and development drilling.

For the Soviet Union, information on regional drilling, reserve additions, and production are less detailed and in some cases not available. Further, oil development cost data for the Soviet Union are not meaningful because government-specified prices throughout the economy are not cost-based, and resource development decisions have not been based on expected world oil prices and development costs.

Consequently, historic oil data are not a very useful indicator of future oil production after the Soviet Union undergoes a major economic and political restructuring. Because of the limited availability of Soviet data, a simple supply model was developed that utilizes data on U.S. oil resource development as a benchmark to gauge potential future Soviet oil production.

RESOURCES COMPARED

The Soviet oil resource base is similar to the U.S. in several key characteristics.

Both countries have enormous oil resource bases. The U.S. Geological Survey estimates that the Soviets had an ultimate recoverable oil resource of 420 billion bbl (Fig. 1). In comparison, the U.S. had a smaller, but still large, oil resource base of 282 billion bbl.

The Soviet Union, like the U.S., is a vast country with a large proportion of the oil production concentrated in one area. In the Soviet Union, West Siberia accounts for about two thirds of Soviet oil production. Similarly, the Gulf of Mexico, offshore and onshore, accounts for about 40% of U.S. oil production.

Like the U.S., the Soviets have oil resources in remote arctic regions. The Soviets also have a large network of oil pipelines and marine terminals to transport oil from producing areas to consuming areas. However, the oil infrastructure is in worse shape in the Soviet Union than in the U.S.

The Soviet Union's and the U.S.'s oil resource bases also differ in some significant ways. As shown in Fig. 1, the Soviets have a higher proportion (32%) of more costly unconventional heavy oil resources than the U.S. (11%). A higher proportion is in higher cost arctic regions.

Heavy reliance on early waterflooding also has left the Soviets with the need for different technology requirements for continued development of some of its existing reserves. These differences will tend to make the development of oil resources more expensive in the Soviet Union than it has been in the U.S.

RESOURCE DEVELOPMENT RATES

The Soviets lag the U.S. in the development of their resource base.

To date, the Soviets have found about 40% of the USGS estimate of their ultimately recoverable oil. In contrast, the U.S. has found about 80% of its ultimate recoverable oil resources.

While the U.S. had produced about 56% of its recoverable oil resources as of the end of 1990, the Soviets had produced only about 27% of their oil resources. That is about the stage of development the U.S. had reached in the early 1960s (Fig. 2).

The Soviets are developing their oil resources at a much slower rate than occurred historically in the U.S. According to the Soviet Minister of Geology, the Soviets had completed a total of 675 million ft (206 million m) of exploratory drilling as of the beginning of 1990, which corresponds to about one quarter of the exploratory drilling completed as of that date in the U.S. (OGJ, June 3, p. 71).

The U.S. had completed about the same amount of exploratory footage over the period from 1947 to 1959.

This slow rate of development is reflected in the rate of reserve additions. During the 1960s, the Soviets were able to match the U.S. reserve addition rate of about 1.7% of the remaining recoverable resources. However, during the 1970s and 1980s, the Soviets were not able to keep pace with the U.S. rate of reserve additions.

The Soviet rate of reserve additions declined to less than 1.0% of remaining recoverable resources in the 1970s before recovering somewhat during the 1980s to 1.3%. In contrast, the U.S. was able to boost its reserve addition rate to 2.5% in the 1970s and 1980s by investing in more intensive exploratory drilling and using better technology.

The Soviets are producing their oil reserves at a much slower rate than the U.S. is currently, and even at a slower rate than the U.S. did at the comparable early 1960s stage of development (Fig. 3). In the early 1960s, the U.S. produced about 8.5% of its reserves each year, which is higher than current Soviet production rates. Since 1985, the Soviets have been producing on average about 7% of their reserves each year.

FUTURE SOVIET OIL PRODUCTION

In order to quantify the future oil production potential of the Soviet Union, ICF Resources used the Soviet oil supply model to examine the potential implications of a thorough reformation of the Soviet political and economic systems.

As part of the reform process, the Soviets are assumed to aggressively pursue foreign participation in oil development. This external financial and technological boost enables the Soviets to accelerate the rate of oil resource development.

For this analysis, the Soviets are assumed to follow a resource development path similar to that achieved by the U.S. since the 1960s. Both the rate of reserve additions and the production-to-reserves ratio are assumed to increase, approximately reaching current U.S. levels by 2020.

Given the lack of meaningful Soviet cost estimates, the conventional and unconventional cost curves for the Soviet Union's oil resource base were also assumed to be similar to the U.S. curves. Specifically, the proportion of remaining conventional and unconventional oil resources economically recoverable at a given price was assumed to be the same for the Soviet Union as for the U.S.

ICF Resources has estimated that, with currently implemented technology, about 62% of the USGS estimate of U.S. remaining conventional oil resources are economic at a price of $24/bbl (in 1989 dollars) and an addition 8% would become economic with oil prices of $40/bbl.

For unconventional heavy oil resources, ICF Resources has estimated that about 29% of remaining oil resources can be economically recovered through thermal enhanced oil recovery at $24/bbl and an additional 23% would become economic at $40/bbl, again using existing technology.

Using the U.S. conventional resource cost curve as an approximation of the cost of Soviet conventional oil resources is probably conservative given the earlier stage of oil resource development in the Soviet Union.

The resulting projection of future Soviet oil production indicates that if the Soviets can overcome their serious political problems and obtain foreign investment and technology, they can reverse the recent sharp decline in oil production (Fig. 4). In the ICF Resources scenario, the decline in Soviet oil production is halted after 1995 with subsequent oil production increasing slowly, reaching 12.5 million b/d by 2020.

SOVIET OIL CONSUMPTION

Energy consumption normally increases as the economy grows, and in a free market economy the amount of energy used depends on the price of energy relative to other factors of input over time.

Although prices have tended to be a relatively unimportant factor in centralized energy use decisions in the Soviet Union, energy clearly has been very cheap. In fact, at black market exchange rates energy is almost free. As a result, energy is currently wasted at a rate that is almost incomprehensible to people in the West.

Until recently it was not clear how much energy is wasted because the Soviet Union was widely believed to have a relatively high level of economic activity and a standard of living between the industrialized nations and the developing world.

With the recent opening of the Soviet Union to Western observers, it has become clear that the standard of living in the Soviet Union is very low and that energy use per unit of true value added is many times the level common in the West. It is now evident that the communist system converted a vast amount of resources into relatively few useful goods and services.

Given the isolation of the Soviet Union from the world economy, the poor quality of the goods and services provided, and the complete lack of convertibility of the ruble, the true gross national product of the Soviet republics is hard to estimate.

ICF Resources estimates that true GNP per capita in the Soviet Union is approximately equal to Mexico (Fig. 5). Income may not be as skewed as in Mexico, but overall vast numbers of people live poorly with few of the amenities common to even the poorer industrialized countries.

This estimate would indicate that GNP per capita in the U.S.S.R. is less than one tenth the level in the U.S. Although not a sufficient indicator in itself, the availability of automobiles is consistent with this estimate. The U.S.S.R. has only 46 automobiles per thousand people, while the U.S. has 571.

Prior to a detailed examination of the economic structure of the Soviet Union, it would seem impossible that so much energy could be used to produce so little, but it truly seems to be the case.

For example, steel production uses double the amount of energy per ton of output as in the West. Subsequently, double the steel is used in structural applications due to over-designing and compensation for low quality.

In addition, significant quantities of steel parts may be stockpiled and never used to overcome the unreliability of the economic system to provide materials upon demand. In this way the inefficiencies build and add up to enormous waste.

Based on this estimate of the true GNP per capita, it follows that energy use per unit of output is enormous, over five times the level in the U.S. and Mexico.

The Soviet Union's energy consumption is extreme relative to that of other countries (Fig. 6). High energy use per unit of output is common in countries with an abundance of energy supplies, but nowhere in the world as high as in the Soviet Union.

In the West similar technology is used everywhere, and this technology has been developed in the industrialized countries where energy costs are at a level to have encouraged energy conservation for a long time.

Although some of Soviet industry may be modernized, most of its industrial plants are obsolete. Although it may take longer, these factories face the same fate as those in East Germany. They will have to be closed down because the quality of their products is too inferior and the level of pollution is too great to justify the large investment required to keep them operating.

As the most wasteful factories are closed down or replaced with modern facilities, the average energy consumption per unit of output will plummet.

SOVIET OIL CONSUMPTION MODEL

As the Soviet republics free their energy and other prices and open their border to world trade, their energy consumption patterns will become more like those in the West.

Over time, the West's more efficient technology will be adopted and much higher energy prices will encourage conservation. Unlike the West, as their GNP per capita rises, energy use per unit of output will decline.

The Soviet republics will over time become separate countries with GNP per capita that ranges from poor developing countries to poor industrialized countries. As a major energy producer in a vast, northern region, Russia may develop energy consumption patterns similar to Canada.

Other republics with fewer resources may come to resemble countries like Turkey. As an overall group, however, there is little doubt that as GNP per capita rises, energy use per unit of output will fall toward the levels common in the U.S. and Europe.

ICF Resources has prepared a forecast of future Soviet republics' oil consumption using the following approach:

First, GNP per capita is forecast, based on an estimate of the speed with which the modernization of existing plant will take place.
Second, total GNP is projected by multiplying the GNP per capita estimates times projected population levels.
Third, the energy use per unit of GNP is forecast, consistent with the same modernization of plant assumptions used in the GNP per capita estimates.
Fourth, total energy use is forecast by multiplying total GNP times the energy use per unit GNP estimates.
Finally, a forecast of future oil use was calculated using the estimates of total energy use assumed and energy market shares. The market shares were estimated based on an analysis of the technical potential and the economic attractiveness of the Soviet Republic's energy resources.

ICF Resources estimates that the aggregate Soviet republics' GNP per capita will initially remain flat at current levels until improving after 1995.

While others forecast a decline in GNP per capita during the next few years, ICF Resources has already accounted for the decline by discounting the current GNP to reflect the fact that a significant portion of current industrial activity actually has no value (i.e., output has less value than input). As a result, closing down existing plants does not lead to any decline in real value added. After 1995 real GNP per capita is projected to increase at the rate of 3.4%/year through 2020.

Although the GNP per capita will not change in the near term, energy use per unit of output will decline as the most efficient plants are closed.

Energy use per unit of output is forecast to decline radically over the 1995 to 2010 period as the majority of all existing energy-using equipment is replaced (Fig. 7). Nevertheless, the forecast is based on the presumption that even by 2020 energy efficiency in the Soviet republics is only just approaching the current (1989) rate in the U.S.

Fig. 8 shows the ICF Resources forecast of declining Soviet energy consumption for oil, coal, gas, and other energy types. Absent cost data on production costs, these forecasts are based on the following rationale:

The use of nuclear energy will be cut back as dangerous, obsolete nuclear reactors are closed down.
The use of coal will decline as the republics attempt to eliminate the worst polluting plants and the least efficient mines.
The use of oil will change dramatically as the Soviets attempt to export as much oil as possible to earn foreign exchange. Gas will replace oil as a stationary boiler fuel, particularly in the electric power and industrial sectors. Concurrently, the use of oil in transportation will rise substantially.
Gas will increase its energy market share due to its low cost and superior environmental properties.

The decline in oil and gas use in the Soviet republics will permit those republics with oil and gas resources to make more available for export, particularly between 1995 and 2010.

OIL EXPORTS

Soviet net oil exports in 1990 were 2.3 million b/d.

ICF Resources' analysis indicates that Soviet oil exports will continue to decline for the next several years. However, after 1995, the combined effects of reduced oil consumption and recovering oil production should lead to significant increases in Soviet oil exports.

Soviet oil exports are projected to increase to 4.5 million b/d by the year 2000 (Fig. 9).

Increasing Soviet exports will tend to delay any worldwide oil supply problems caused by steadily increasing oil consumption in the developing countries, particularly in the Pacific area.

By 2010 net Soviet oil exports are projected to stabilize at about 7.0 million to 7.5 million b/d.