Low oil prices, economic woes threaten Russian oil exports

June 8, 1998
Eugene M. Khartukov International Center for Petroleum Business Studies Moscow Profitability of Russia's Oil Exports [165,097 bytes] Average Gasoline Price Components [114,639 bytes] World vs. Russian Oil, Product Press [115,711 bytes] Average Russian Oil Production Costs [96,067 bytes] Average Refinery Yields, By Region [71,402 bytes] Russian Oil Prices, Netback vs. Actual [110,201 bytes]

Eugene M. Khartukov
International Center for Petroleum Business Studies
Moscow

The recent plunge in world crude oil prices has forced Russian oil producers to reconsider the feasibility of their exports vs. economics of domestic sales, which have become seemingly preferable because of higher netbacks.

Unfortunately, Russia's nationwide nonpayment crisis and the domestically suppressed U.S. dollar value make such comparative economic analyses of little practical use for the cash-strapped producers that resort to hard-currency exports as the only reliable means of paying their taxes, wages, and loans.

Moreover, as the domestic price of Russian crude oil remains stuck halfway on its path toward global parity, even rare cash deals with domestic refiners leave producers with too little room for profitable switching to capture the illusory local "bonanza."

Falling world oil prices have narrowed the once-substantial price gaps between Russia's external and internal markets and swept away the teasing differentials that used to justify the country's foreign trade in crude and products. Coupled with high transportation charges and undying excise taxes, lower export prices have palpably eaten not only into oil producers' revenues but also into oil-related tax receipts, which ordinarily secure a hefty fifth of Russia's budget income.

Understandably, the country's oil industry has immediately jacked up its demands for lower oil taxes and has backed those demands with threats to stop the unprofitable exports. These demands have been primarily backed by referring to an apparent economic disadvantage of exporting crude and products compared with selling them at home.

Exports hold steady

The data in the table on this page-provided by Kortes, Russia's most authoritative oil price reporter-illustrate a regrettable fact: Even without export duties (which were completely phased out by mid-1996), the once highly lucrative exports of Russian crude tended to secure ever shrinking returns. By last spring, exports had virtually lost their former commercial appeal.

Meanwhile, suppliers of Russia's main exportable products-gas oil and mazut, or resid-could no longer make ends meet. Since the beginning of 1997, they have suffered considerable export losses.

The collapse of world oil prices was bound to result in the crucial deterioration of Russia's oil export economics. The crunch was felt most last February, when the country's largest oil company, Lukoil, claimed an average loss of $9/metric ton of crude shipped via the port of Novorossiisk. This oil sold for only $85/ton, and the company's export-related expenses exceeded $94/ton.1

Nevertheless, "far-abroad" hard-currency sales have been going full tilt and show no signs of contraction.

There are at least three important reasons for keeping the ostensibly unprofitable exports high:

Domestic sales are not as attractive as they look if compared on a purely monetary basis. During the nationwide nonpayment crisis, only 10-20% of domestic oil deliveries are paid for in cash, with the rest being bartered, sold for various sorts of "quasi-money" (promissory notes, treasury and municipal bills, state and corporate bonds, offsetting tax obligations, etc.), or simply not paid. Instant cash payments are typically rewarded by generous price discounts-in some cases as much as 50% off listed crude and product prices. Hence, published prices do not fully translate into actual sales revenues.

Second, the oil payments actually received should be further depreciated when converted to U.S. dollars, the exchange rate for which is suppressed in Russia by the Central Bank's regular interventions in the undeveloped Moscow currency market. Admittedly, if the related ruble receipts were presented in dollars, based on a really competitive purchasing-power parity of the currencies involved, they would be two-thirds or perhaps even half as high as those resulting from traditional currency-conversion arithmetic.

Third, as domestic sales do not ensure adequate cash receipts, Russian oil producers are dependent on hard-currency exports, which guarantee the much-desired financial liquidity.

In Russia, an oil company's ability to export a higher proportion of its output is regarded as important evidence of good general performance and high solvency. Although the far-abroad sales are capped by congested export outlets to just a third of indigenous crude supplies, those hard-currency exports constitute the only reliable source of the cash that is badly needed to pay oil companies' wages, taxes, and loans.

Symptomatically, Russian oil majors start to index their workers' pay to the dynamics of world oil prices on spot or futures markets. Since last November, oil producers have been allowed to export additional volumes of crude far abroad in exchange for clearing their tax debts.

Starting in January, the federal government, worried by growing salary and pension arrears, began declining any form of tax payment except the deficient cash. To make the situation worse, beginning in July, the state tax service will be authorized to confiscate hard-currency revenues from oil pipeline exports, which will be used primarily to settle exporters' overdue taxes. This may further undermine oil producers' ability to pay Western bank loans, which also are secured against oil export receivables.

Thus, unwavering Russian oil exports can't be explained by the comparative economics described, which are rather confusing, if not meaningless. Not surprisingly, when the world oil market declined this year, with prices plummeting below any conceivable break-even levels, no Russian crude exporters threw in the towel and shifted from unprofitable hard-currency sales to the apparently more lucrative domestic markets.

What could really surprise an outside observer is why Russia's domestic prices have remained virtually unaffected by the recent world price plunge. Despite being completely decontrolled and opened to competitive international trade, Russia's domestic oil prices seem safely shielded from world market competition.

But the question remains: Is there room for profit in Russia's domestic market, which has proved to be resistant to both upward and downward movements of world oil prices?

Upstream economics

Contrary to widespread belief, producing Russian oil was never cheap, because of centrally planned mismanagement and high social costs.

Most domestic producers inherited a burdensome legacy of expensive social infrastructure that emerged during the Soviet era around remote oil fields and added substantially to production costs. As a matter of fact, at the threshold of perestroika, about a third of the capital requirements of Soviet oil production was subsidized through the federal budget.

All-out price liberalization, launch- ed by Russia at the start of 1992, initially did not apply to oil production. Crude oil prices remained significantly restrained until mid-1993, when the state virtually ceased its dwindling financial support for oil producers. This unleashed inflation of oil prices.

In the meantime, decontrolled refined-product prices hit equilibrium levels and started to try consumers' purchasing power. This translated into increasing downward pressure on crude oil prices, which, measured in real terms, stabilized at a level below what they were before the price perestroika.2

Jammed between soaring production costs and depressed oil prices, the once prospering oil industry faced a severe financial crunch and had to beg for tax concessions. Unfortunately, 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, tax pressures increased further.

Prior to 1992, the generously subsidized oil producers had to pay only nominal charges for the state-owned tangible assets they used (not to mention their complimentary use of land and subsoil). On average, the state budget took up only about 15% of crude oil revenues.

Since then, however, Russian oil producers have become subject to an ever-increasing number of various, and mostly profit-insensitive, fiscal charges, which quickly jacked up the average state take to nearly half of wellhead revenues in mid-1993 (see table, this page).

Under the increasing pressure of upstream taxation, this core sector of Russia's economy became the main provider of taxes. But the hardly profitable business had to survive on marginal and even negative after-tax returns.

According to official data, in 1994, the after-tax profitability (profit-to-cost ratio) of the country's oil-producing industry dropped to a meager 7%, compared with 50% in early 1992.

Tax breaks

Existing Russian legislation provides for some tax concessions with regard to oil operations carried out by foreign entities and their joint ventures with Russian partners.

In the upstream sector, the most valuable tax privileges relate to crude oil excise and related export duties, which may be applied at lower rates or completely, but temporarily, exempted.

Still, the envisioned tax breaks are not granted automatically and do not free foreign oil producers from many other federal, regional, and local taxes. Until recently, in the heyday of local taxation, one could easily distinguish more than 40 different taxes and duties imposed on producers of Russian crude, with no regard to remaining profits.

Despite the subsequent withdrawal of some upstream taxes and the sector's apparently better performance in the later 1990s, the financial "stabilization" of the Russian economy has resulted in a nationwide nonpayment crisis that has made the ruble-based economics of Russian crude increasingly questionable and murky.

Understandably, oil-producing companies, both domestic and foreign, are vigorously lobbying Russian government officials and lawmakers to implement a new tax code and effective production-sharing legislation, both of which would reduce the number of upstream taxes and make them more profit-related.

Downstream margins

In Russia's downstream industry, several sizable indirect taxes and distribution surcharges are added to make up retail prices for Russian petroleum products.

Starting in 1993, it was said repeatedly that product taxation in Russia exceeded all conceivable limits, as numerous taxes composed as much as 70-75% of Russia's retail product prices-particularly for gasoline.

Such statements were tailored to strike the imagination of the tax-shy Russian citizen. They cannot, however, stand up to any professional criticism.

Unlike, say, in Western Europe (where indirect taxes compose 65-80% of retail gasoline proceeds), even after the recent increase in gasoline excise tax, taken together all the applied indirect taxes carve off no more than a third of an average ex-pump price for Russian regular motor gasoline (see table, top of p. 26).

Squashed between rising crude acquisition costs and the depressed ex-refinery prices, refiners' net profits have tended to shrink. On average, they have dropped from 4% of gross product proceeds in 1992 to only 1% in 1997. In other words, in the last 5 years, the profitability of Russia's refining industry was well below the official 10 and 20% profit-to-cost ceilings that were applied in September 1992 to cap refinery prices and demolished in March 1995 when the market weakened.

Owing to general mismanagement and the breakup of former centralized, state-run suppliers, product distribution costs in Russia are relatively high. As a rule, they exceed 20% of a product's end-user price.

As for distribution surcharges, which were limited by local authorities until March 1995, they ordinarily account for one fourth to one third of end-user prices, but can treble product prices to consumers in some remote, poorly supplied areas of the North and Far East. Undoubtedly, that is the "golden link" in the domestic oil chain (the place where the most money is made, and hidden).

Not surprisingly, gasoline distribution is regarded as the most lucrative inland business. This bonanza leans on the solid ground of a sizable gap between depressed domestic prices for Russian crude-isolated from world markets by export bottlenecks and a refining structure that doesn't match product demand-and the relatively higher domestic prices for refined products, which are exposed to international market competition.

Domestic, world prices

The unprecedented cost-driven inflation, triggered at the start of 1992 by all-out price liberalization, has jacked up Russia's domestic crude and product prices 5,000-10,000 times and has driven them to the limit of consumers' purchasing power. Consequently, the average Russian car owner, who used to fill his gas tank at 30 kopeks/l. (a negligible 0.7¢/gal, at the yearend-1991 market exchange rate) and nowadays survives on a modest annual salary of about $2,000, has been exposed to price levels easily comparable with what is habitually paid for gasoline by his far-better-off American counterpart (see table, top of p. 26).

Likewise, wholesale prices of Russian petroleum products have become somewhat comparable with those in the nearest international trading center, Northwest Europe. Meanwhile, the average producer price of Russian crude increased from around 1% of the dated Brent price in 1990-91, to about 7% in 1992, to 30-40% in 1994-95, and to almost 50% in 1997 (see table, bottom of p. 26). These price relationships may prompt an observer to reach the tempting conclusion that Russia's gradually liberated market has been setting domestic oil prices on the straight path to world parities. Nothing, however, is more misleading than this illusory trend.

It was often argued that the remaining price regulations, and particularly the reluctantly trimmed export tariffs on Russian crude oil, kept domestic prices from rushing toward comparative world market levels. In order to remove this hurdle from Russia's path to an unrestrained oil market, starting in 1991, representatives of the World Bank, the International Monetary Fund (IMF), and the International Energy Agency (IEA) repeatedly insisted or advised that Russia's domestic oil prices should be completely freed and raised to world parities.

A special study on Russian energy prices, taxes, and costs, completed by IEA in 1994, explicitly suggested that "domestic crude oil and product prices should reach world market levels as soon as possible through abolition of export restrictions.3

Oil export tariffs were first introduced at the beginning of 1992, following the dismantling of the state foreign-trade monopoly. To avoid a rapid depreciation of the ruble, tariffs were fixed in European currency units (ECUs) but payable in the national currency in line with the current exchange rate set by the Central Bank of Russia.

Those customs duties-nearly $50/ton for crude oil and $25-80/ton for most refined products in 1992-have been gradually phased out since then. During most of 1995, however, they still accounted for about 25% of the average fob price for Russian crude and more than 10% of the prices of gas oil and fuel oil exported to Western Europe.4

Yielding to IMF's pressure, in December 1995 Russia finally abolished virtually all the remaining export tariffs on oil products (except for a seasonal duty on fuel oil, which was in short supply). By July 1996, the government had completely removed the notorious export duty on crude oil.

Virtually nothing happened to the liberated prices, however. As was expected by those who really comprehend Russia's oil market, crude prices did not soar to the targeted world parities but instead stuck to about one half of the related world benchmark.

The persistent overproduction of Russian oil-a problem since 1993-suggests that the potential increase in domestic prices has been hindered not so much by the remaining export tariffs but rather by insufficient inland demand for indigenous refinery feedstock. Indeed, market prices for crude oil are objectively capped by ex-refinery prices and processing costs and, consequently, cannot exceed the net product worth of consuming refineries' output for any long period of time.

Hence, the "abnormal" behavior of the freed crude oil prices in the aftermath of the related tariff abolition was just another vivid illustration of the fact that domestic crude oil prices had bumped into the relatively low ceiling of Russia's weighted average ex-refinery price.

Unfortunately, this price impasse is greatly aggravated by the "backwardness" of most Russian refineries, which are typically short of upgrading capacities. Hence, the country's refinery yield is dominated by heavy fuel oil (35-40%), while more-valuable lighter products (gasoline, naphtha, LPG, kerosine, and gas oil) account, as a whole, for only half of refinery output.

Technically speaking, the degree of crude processing (the ratio of light and medium distillates to total refinery throughput, called conversion) in Russia is typically rather low-60-65%, compared with 75-85% in Western Europe and Japan and 85-95% in the U.S. (see chart, p. 28). Therefore, the gross product worth (weighted average market price of products) yielded by outmoded Russian refineries is also fairly low and, according to the author's estimates, does not allow for any substantial increase in the real (inflation-adjusted) costs of crude oil acquisition and processing (see table, p. 28).

The low market value of refinery output encapsulates the following surviving challenge in Russia: Raising product prices (which was done vigorously until the end of 1993, when end users became virtually unable to pay) or, alternatively, curtailing the intake of relatively expensive refinery feedstock and, by doing so, exerting downward pressure on crude oil prices.

The latter has taken place only since the end of 1993, when the actual producer price of Russian crude exceeded its netback value and national oil producers experienced an unprecedented crisis of overproduction.

Thus, Russian crude oil is considerably underpriced by the dire state of the national refining industry, which requires radical modernization, not to mention the long-delayed replacement of dilapidated facilities, over 80% of which are physically worn out.

However, the nationwide refinery modernization (or reconstruction) program-which was originally declared by Russia in 1992, aimed at increasing conversion to 73-75% by 2000 and 82-85% by 2010-will hardly ensure more than an average 65% by 2000 and 74% by 2010.

Oil price globalization?

The condition of Russia's refining industry means that the increase in domestic oil prices to international levels is neither desirable nor possible in both the short and medium terms. Notwithstanding, rapid oil price "globalization" is still on Russia's agenda, as urged by IMF and the World Bank, which are concerned about the profitability of western (almost exclusively upstream) projects unable to dispose of much of their output through Russia's export bottlenecks.

Alas, this interest in higher domestic prices for Russian crude cannot but facilitate the consequent protectionism of the national refining industry. Prohibitive import restrictions on foreign oil products may provide the only packaged solution to the emerging dilemma of increasing domestic oil prices while keeping Russia's backward refining sector alive.

In a bid to protect Russia's refiners from the ever-increasing inflow of cheaper gasoline from the Baltic region, Ukraine, and the country's Pacific borders, in June 1996 the government announced an indefinite ban on imports of oil products. It was stated that the ban would be removed as soon as the conversion at Russian refineries was properly increased through large-scale modernization "over the next year or two."5

A partial oil price solution is sought under the auspices of "introducing internal settlement pricing" in Russia's vertically integrated companies. However, when and if finally legalized, the introduced transfer pricing, which was officially proclaimed as one of the key measures to balance the federal budget and company investments needs, will hardly keep Russia's oil majors from selling underpriced crude to their low-taxed affiliates abroad and offshore subsidiaries.

Admittedly, such misguided policies and business practices are fairly typical of transitional or emerging market economies. Yet, in the case of an economy that was isolated from market competition for so long and governed by the antimarket mentality of three successive Soviet generations, the current (and imminent) woes of its most prominent industry are rooted much deeper and cannot be cured by a simple shift in government policy or business behavior.6

Acknowledgment

The author thanks Yakov L. Ruderman, director of Kortes Information Agency, for providing data and other support for this article.

References

1. Ekonomicheskie novosti Rossii i Sodruzhestva, March 1998, No. 6, p. 1. 2. 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. 3. Russian Energy Prices, Taxes and Costs, 1993, OECD/IEA, Paris, 1994, p.82. 4. Khartukov, E.M., "Changing Tax System Challenges Producers And Refiners In Russia," Oil & Gas Journal, Mar. 25, 1996, pp. 41-46. 5. Kommersant Daily, June 19, 1996, p. 10. 6. Khartukov, E.M., "Incomplete Privatization Mixes Ownership Of Russia's Oil Industry," Oil & Gas Journal, Aug. 18, 1997, pp. 36-40.

The Author

Eugene (Yevgeny) Khartukov is general director of the International Center for Petroleum Business Studies and head of the World Energy Analysis & Forecasting Group, both in Moscow. 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 for various Russian ministries, international agencies, foreign governments, private oil and gas companies, consulting firms, and financial institutions.

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

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