Russia's Petroleum Progress Changing Tax System Challenges Producers And Refiners In Russia

The oil city Nefteyugansk, in the Khanty Mansiisk Autonomous Okrug in Western Siberia, developed in conjunction with Russia's oil producing industry. Amoco Corp. opened a camp there in spring 1994 (foreground). Photo courtesy of Amoco.

Over the past several years, economics of the Russian oil industry has undergone considerable change reflecting the radical transformation of the country's core industry from a wholly state-run and heftily subsidized distribution system toward a formally privatized, cash-strapped, and quasi-market entrepreneurship.

All-out price liberalization, launched by the Russian government at the start of 1992, did not apply to the national oil industry. Domestic oil prices remained tangibly restrained until mid-1993 and were officially deregulated in March 1995. Consequently, rising costs diminished profit margins of Russian oil producers, whose operating costs were never as low as popularly believed.

Most Russian producers that sprang out of state-run oil-producing associations have inherited a heavy financial burden of supporting the social infrastructure of "oil cities" built during the Soviet era in remote oil-producing areas of West Siberia and Timan-Pechora. Few Russian oil majors have been able to transfer the burdens to municipal authorities.

Furthermore, by summer 1993, the freed domestic prices of oil products hit their equilibrium levels and began to scrape the ceiling of consumers' purchasing power. This could not but translate into downward pressure on crude oil prices, which, measured in real terms, have leveled off below what they were before the recent price reform.1

Jammed between the soaring production costs and depressed oil prices, the once prospering industry has faced a severe financial crunch and should have received tax relief. However, as the perestroika-triggered recession quickly deepened and the Russian state budget became critically dependent on a few relatively stable sectors of the dilapidated economy, the oil tax squeeze got tougher.

Swelling upstream taxes

At the threshold of the 1990s, generously subsidized oil producers paid only symbolic charges for state-owned tangible assets and nothing for surface and mineral rights. Since 1992, however, oil-producing enterprises have been subject to an increasing number of taxes, duties, and levies, which have soaked up as much as two thirds of an average oil producer's revenues (Table 1 [43696 bytes]).

The most burdensome among those new fiscal measures were profit-insensitive (output-related) excise duties, contributions for mineral reserves replacement, royalties, and deductions to the industry's centralized investment fund and to the short-lived price control fund.

The excise duties on crude oil were introduced in November 1992 at an average rate of 18% on the wholesale enterprise price and applied at rates of 0-30% to individual producers.

In July 1993, duty rates were increased by approximately one-third-to as much as 42% but nil in some cases, with the standard rate being raised to 24%. Then, with effect from May 1, 1994, the duty was set for the first time in absolute terms-at 14,750 roubles/metric ton ($8.20/ton) on the average and between zero and 36,000 roubles/ton ($20/ton) for individual producers. To allow for rouble depreciation the rate was subject to monthly indexation in line with the rouble-dollar exchange rate. After some interim adjustments, by June 1995 the general (but now maximum) rate of the duty was raised to 53,040 roubles/ton ($11.30/ton), with the weighted average of its different rates reaching 41,400 roubles/ton ($8.80/ton).2

The contributions for mineral reserves replacement, which were introduced in February 1993 and are paid by all subsurface users to make up for centralized geophysical and geological (G&G) expenditures, were fixed in the case of crude oil and condensate at 10% of gross sales revenues. Initially, the rate was applied to wholesale enterprise prices (before imposition of excise taxes), regardless of whether the output was sold on the domestic market or exported. Since the start of 1995, for exports, the calculated (netback) field-gate price has been used for determining a taxable base for this G&G compensation charge.

The same taxable base is used for calculating royalties on extracted and exported hydrocarbons, which, if sold domestically, are also taxed in relation to their wholesale enterprise (i.e., producer) prices, excluding excise tax. The rate of royalty, which has been a feature of Russia's oil taxation since October 1992 and is deductible from taxable profit as a production expense, may be fixed at between 6% and 16% but is usually negotiated at 8%.

The investment fund deductions were designed for intrasectoral redistribution of differential rent and, until their official abolishment in May 1995, represented the largest immediate withdrawal from oil producers' revenues. The average rate was 28% of gross proceeds (excluding excise tax). Differentiated between 5% and 40% for individual producers and supposed to return with the "life-giving rain" of centralized investments, those deductions tended to vanish in bottomless government coffers as the state ceased to finance the industry by 1993.

As state-controlled oil prices were allowed to rise beginning May 18, 1992, a punitive price-capping mechanism was introduced. Revenues from sales of crude above fixed (and periodically revised) price levels were confiscated or heavily taxed to fill a specially established Price Control Fund (PCF). However, in several months, under conditions of overproduction, PCF deductions became redundant and, on July 1, 1993, this system of indirect control of crude oil prices was officially abandoned (Table 1 [43696 bytes]).

Finally, the general tax on profit (profit tax), introduced at 32%, was raised at the start of 1994 to a maximum 38% of "balance" (operating) profit. Technically speaking, the formerly indivisible 32% tax was replaced by a two-part levy: Its federal part was set at 13%, while regional authorities were allowed to tax additionally up to 25%.3

By the time of the change, however, the profit tax had lost its basis. Under the pressure of ever-increasing taxation, the core sector of Russia's economy had turned into the main tax-paying but hardly profitable business, surviving on marginal and even negative after-tax returns.

After-tax returns

According to official data, the after-tax profitability (profit-to-cost ratio) of the country's oil-producing industry dropped to a meager 7% in 1994, compared with 50% at the beginning of 1992, in the aftermath of the sharp increase of state-controlled prices. Even so, this poor but average (and annualized) economic indicator hid the fact that for the first three quarters of 1994 (during which domestic oil prices remained relatively stable), two thirds of national oil-producing enterprises had their account books covered with red ink.4

Although the total state take in oil producers' revenues has quickly risen from an average 15% at the beginning of the 1990s to the current 60-70%-reportedly exceeding 80% in some instances-the tax-collecting authorities could not stop imposing new levies. While at the end of 1993 Russian oil producers could distinguish 28 various fiscal charges levied at different administrative levels, by March 1995 their number had increased to 46, including 18 federal, 5 regional, and 23 local taxes and duties.

Local taxation authorities were especially innovative. Some of them introduced taxes for supporting municipal militia and for sponsoring local soccer teams.

Downstream charges

Downstream, several sizable indirect taxes and distribution surcharges take effect.

Since 1993, it has been repeatedly stated that oil product taxation has exceeded all conceivable limits as numerous taxes sponge up to 70-75% of Russia's retail product prices, particularly those of gasoline. Being tailored to strike the imagination of tax-shy Russian citizens, those statements cannot stand up to professional analysis.

The state tax take on products, in fact, is not as high as the average in Western Europe, where indirect taxation snips 65-80% of retail gasoline proceeds. In Russia, even after the latest two-fold increase in gasoline excise tax, all applied indirect taxes absorbed just 30% of an average ex-pump price for regular motor gasoline (Table 2 [47474 bytes]).

As a rule, gasoline sales ensure the highest refinery margins-currently up to 15% in relation to production costs. This is achieved at the expense of furnace fuel oil (mazut), which accounts for 35-40% of Russian refinery output and is often sold at break-even prices. Understandably, taxes on motor gasoline are heavier. The tax load shown in Table 2 [47474 bytes]on retail proceeds of a ton of the most widely used gasoline grade is most illustrative of Russia's taxes on oil products.

In particular, the gasoline excise tax, introduced in April 1994 at 10% of refinery sales, was raised a year later to 20%, applicable to both domestic and export sales.

The general value-added tax (VAT) was imposed at the start of 1992 at 28% of "excised" refinery proceeds and lowered, effective Jan. 1, 1993, to 20%. At the beginning of 1994, it was supplemented with a 3% special tax (ST), which had the same taxation base but was aimed at supporting vital branches of the national economy, such as agriculture and the coal industry. Effective Apr. 1, 1995, the Parliament reduced the rate of ST to 1.5%, targeting its complete abolishment by the beginning of 1996.

Although VAT is only applied to sales within the Commonwealth of Independent States (CIS), this is not the case with the sales tax on motor fuels and lubes (Stmfl), which took effect at the start of 1993 at 25% of sales proceeds, excluding VAT and ST, even if the taxable products (gasoline, diesel fuel, lube oils, and compressed and liquefied gases) are exported outside the CIS.

Distritution markups

Owing to general mismanagement and the breakup of former centralized, state-run supplies, oil product distribution costs in Russia are relatively high and, as a rule, exceed 20% of a product's retail price. Distribution surcharges, which were limited by local authorities until March 1995 but often set by distributors at higher rates, ordinarily account for one fourth to one half of retail product prices in the European part of Russia but can, in fact, treble the price to the consumer in some remote, poorly supplied areas of the North and Far East. Consequently, an "average" Russian car owner, who used to fill his gas tank at 30 kopeks/l (a negligible 0.7/gal at the end-1991 market exchange rate) and nowadays survives on a modest annual paycheck of about $1,000, has been exposed to price levels easily comparable to those paid for motor gas by his far better-off American counterpart.

Such prices encourage Russian consumers to curtail their use of gasoline and import it, at lower prices, from the "near" and "far" abroad. This puts palpable competitive limits to further growth of domestic product prices, which have tended to level off despite irrepressible inflation.

In turn, refinery margins, squashed between ever-rising crude acquisition costs and depressed ex-refinery prices, have tended to shrink and, on the average, rarely exceed 5% and often drop to 1% of gross product proceeds.5 Profitability of Russia's refining industry thus has been well below the official 10-20% profit-to-cost ceilings which had been applied since September 1992 to cap refinery prices and were demolished by the government in March 1995.

Not surprisingly, being concerned about the miserable state of the national refining industry, in mid-1995 the government publicized its intention to slash excise taxes, offer tax exemptions, and alter fiscal policies generally to reflect refiners' production costs and "make product exports profitable."6 The intended tax relief has apparently materialized in a presidential decree ordering the complete abolishment of export duties for Russian oil products, beginning Dec. 1, 1995.

By cutting export tariffs, the government seeks to prevent a surge of cheap imported products and to make Russia's obsolete refineries competitive on global markets. Indeed, as domestic prices, swelled by higher taxes, moved toward world levels, the existing export duties and relatively higher transportation costs have deprived Russian oil exports of their former economic appeal.

Export tolls

The export duties for crude oil and refined products were introduced at the beginning of 1992, following dismantlement of the state foreign-trade monopoly. Since then they have been fixed in European currency units (ECUs) but payable in roubles in line with current exchange rates set by the Central Bank of Russia.

Although these customs duties tend to decrease and, under pressure from the World Bank and International Monetary Fund, must be completely phased out in the "near future," for most of 1995 they still accounted for around 25% of the average fob price of crude oil and 10-12% of the price of gas oil exported to Western Europe (Table 3 [36219 bytes]). In February, the government agreed to lift export taxes on oil and gas by July in conjunction with an IMF agreement to lend Russia $10.2 billion over 3 years.

In addition to duties, Russian export of crude and products to the "far abroad" is ponderously "taxed" by extra delivery costs, which include supplementary hard-currency payments to Transneft (the national oil pipeline monopoly), transit tariffs through territories of Russia's western neighbors, and (in the case of seaborne shipments) various and hefty port (transshipment) dues. Alongside domestic pipeline tariffs, which typically account for 3-12% of the delivered price, during 1995 Russian crude exporters had to pay Transneft a hard-currency pipeline charge that amounted to an average $3.98/ton and was differentiated as follows (per ton): $4.33 to Novorossiysk and Odessa, $5.27 to Tuapse, $2.39 to Ventspils, $4.57 to Poland and Germany, and $3.49 to the Czech Republic, Slovakia, and Hungary.

Transit fees for use of the Druzhba pipeline in Ukrainian territory were fixed at $4.53/ton and those for the Polotsk-Ventspils pipeline at $2.33/ton. In addition, crude exporters using seaport outlets have to pay port dues amounting to $3.50/ton in Novorossiysk, $2.80/ton in Tuapse, and $5-6/ton in Ukrainian and Latvian ports.

In turn, due to predominance of railroad transportation (which now serves about 80% of oil product turnover), shipment of oil products is more expensive-on average around $20/ton of refinery output shipped within Russian territory. At the same time, shipping oil products via export outlets on the western sea and land borders of the former Soviet Union ordinarily requires $25-45/ton.

Taken together, all these extra transport-related charges, which are not payable for domestic and "near-abroad" sales, can easily double, treble, and even quadruple delivery costs. These costs consequently may make up as much as 20-25% of the export price of crude oil and account for 25-70% of sales revenues from export of oil products.7

Waiting for exemptions

Coupled with sizable export duties, the higher transportation costs eat into an exporter's revenues and compel many export-oriented projects to lobby and wait for export duty exemptions. High vulnerability to additional export charges is most typical of oil-producing joint ventures with foreign partners, which have the right to unrestricted export of their output and are usually (though far from automatically) exempted from export duties until payback of their project investments. By March 1995, 14 oil-exporting joint ventures, out of 20 foreign-backed joint ventures that had applied for export tariff exemptions, had been freed by the Russian government from paying customs duties on crude oil for up to 3 years.

Table 4 [63801 bytes], incorporating results of recent feasibility studies by Western and Russian economists, shows price components for various destinations. Although some of the assumptions made by the cited analysts are questionable and do not provide reliable ground for unbiased and definite conclusions, the resultant figures show that until recently, in the case of non-CIS ("far-abroad") exports, the additional export-related charges have tended to be counterbalanced by higher gross revenues, which left room for larger profits, not to mention quicker and guaranteed hard-currency payments.

In turn, the CIS ("near-abroad") exports were arguably presented as the least attractive destination of crude oil sales, owing to the unavoidable value-added tax (VAT) as well as to lower export prices, (which, in fact, do not apply to commercial sales). Moreover, at the beginning of 1995, exports to Belarus and Kazakhstan, members of a trilateral customs union with Russia, were freed of related tariffs. As a result, deliveries of Russian crude and products to these nearby markets became more lucrative than exports to the remote "far abroad"-if timely payments are received.

Furthermore, last July the ever-weakening rouble was backed by Russia's Central Bank, which began to control the market rouble-dollar exchange rate within bounds of the so-called "hard-currency corridor" fixed at 4,300-4,900 roubles/$. As a result, by the end of 1995, the persistent inflation-driven depreciation of petrodollar revenues made oil exports to the "far abroad" generally unprofitable and prompted Russian oil producers and refiners to consider redirection of their marketing efforts to the "near abroad" and domestic sales.

Needed changes

While during the summer and autumn of 1995 most Russian oil exporters, which already suffered substantial losses from non-CIS exports of gasoline and fuel oil, still could boast a meager profit of 45-65/bbl of exported crude, by the end of the year it became clear that Russian oil sales to hard-currency markets could regain lost profitability only if the domestically hobbled dollar was allowed to rise above the breakeven range of 5,300-5,500 roubles/$ (as against the new official corridor of 4,550-5,150 roubles/$, effective Jan. 1).8

Also, any other measures aimed at limiting the current massive confiscation of oil export revenues would definitely improve economics of Russian oil, now vitiated by numerous profit-insensitive taxes.

In this light, the recent abolishment of nearly all oil product tariffs and probable reduction in export duty on crude oil, envisaged in the 1996 federal budget at 10 ECUs/ton, are all much-needed moves in the right direction.

Still, lasting improvement of the currently poor economics of Russia's oil can be assured only through enlightened, market-oriented management of the industry and radical modernization of its obsolete refining sector.9

Acknowledgment

The article is partly based on a study of Soviet/Russian oil prices performed by the author when heading the Russia Energy Project at the Program on Resources: Energy and Minerals (PREM), East-West Center, Honolulu (1994-95).

References

1. Khartukov, E.M., "Russia's Oil Prices: Passage to the Market," East-West Center Working Papers: Energy and Minerals Series, September 1995, No. 20, pp. 1-8.

2. Russia Oil & Gas Monitor, 1995, Vol.1, Issue 3, p.19.

3. Effective Jan. 1, 1995, the ceiling for the "regional" part of the tax was lowered to 22%.

4. Delovoy Mir (Business World), July 10-16, 1995, p.8.

5. Shmidt, V., "Need for Debt and Equity Financing," Proc. Trade and Investment Opportunities in the Russian Oil Industry Conf., London, Mar. 23-24, 1995, p. 45.

6. Weekly Petroleum Argus, July 31, 1995, p.5.

7. Russian Petroleum Investor, October 1995, p.30.

8. Segodnya, Sept. 1, 1995, p.4; Kommersant-Daily, Sept. 7, 1995, p.11; Russian Petroleum Investor, October 1995, p.26, and November 1995, pp.71-72; Neftyanoy Kur'er, 1995, No. 28-30, p. 2; Rossiyskiy Neftyanoy Byulleten, December 1995, No. 70, pp. 29-30.

9. Khartukov, E.M., and Kulakova, T.P., "The Russian Petroleum Industry: A Pandora's Box?" OPEC Bulletin, 1994, Vol. XXV, No.8, pp.12-14; Khartukov, E.M., Op. cit., pp. 27-29.

The Author

Eugene (Yevgeny) Khartukov heads World Energy Analysis & Forecasting Group (Gapmer), Moscow, and International Petroleum Business Program (IPBP). During 1970-82 he worked in various research centers, departments, and enterprises of the U.S.S.R. ministries of geology, oil and gas industry, external trade, and foreign affairs.

Since 1984, he has advised and consulted on oil and gas economics and policies, energy pricing, and modeling to various Soviet/Russian ministries, international agencies, foreign governments, private oil and gas companies, consulting firms, and financial institutions.

Khartukov is a professor at the Moscow State Institute (University) of International Relations (Mgimo) from which he received a PhD in international petroleum economics in 1980, a post-doctorate degree (professorship) in international energy economics in 1990, and a lifetime title of professor in 1994. He has authored and coauthored more than 170 articles, brochures, and books on petroleum and energy economics, management, and politics.

Copyright 1996 Oil & Gas Journal. All Rights Reserved.