Roots of systemic woes in Russian oil sector traceable to industry evolution

Tina Obut
Ryder Scott Co. Petroleum Engineers
Houston

Avik Sarkar
Brown & Root Energy Services
Houston

Sankar Sunder
Sterling Consulting Group
Houston

• Major Oil and Gas Basins of Russia
• Russia's Transition Era Production And Consumption

An overview of the Russian oil industry, from the Soviet era to the policies and structures of present-day Russia, is necessary because of Russia's importance to world energy markets and the importance of the oil and gas sector to the country's economic development.

Russia's reserves are estimated at 50 billion bbl of oil (ninth largest in the world) and 1,700 tcf of gas (largest in the world). The oil industry is a leading sector in Russia's economy; oil export revenues account for almost 40% of the country's foreign currency inflows, and taxes levied on oil and gas companies account for more than 50% of the federal government's tax receipts.

In recent years, the promise of exploiting Russia's untapped reserves at relatively low costs has made Russia, along with the Central Asian nations of the former Soviet Union (FSU), a leading destination for Western capital investment. Newly privatized Russian oil majors, or vertically integrated companies (VICs), have replaced Soviet-era entities to become dominant players in the domestic industry. VICs have struck alliances and joint ventures with Western companies (see related story, p. 28); however, a few JVs have unraveled in recent times because of the economic meltdown, volatile political developments, and lack of progress towards establishing democratic institutions and developing meaningful, investor-friendly legislation.

Russia's oil history

Russia has played an important role in the oil industry since the industry's beginnings.

Early oil was produced in Baku (which was part of the Russian Empire) in the 19th century by Western investors, such as the Nobels and the Rothschilds, who dominated the domestic Russian market and also supplied oil to Western Europe right up to the Russian revolution.

Shell Transport & Trading gained its entry into the oil industry by ferrying oil produced by the Rothschilds to Western Europe, and presented the Standard Oil Trust with the first major challenge to its plans for dominance of the oil industry.1

After the Russian revolution, most major Western investors fled Russia, with the Nobels eventually selling a significant part of their Russian holdings to Standard Oil of New Jersey (the precursor to Exxon Corp.). Standard Oil bought these assets in the hope that the Bolsheviks would soon be out of power and planned for an eventual return to Baku. In 1920, however, the Bolsheviks marched into Baku and nationalized all the oil assets. In 1921, in recognition of the dismal economic situation of Soviet Russia, Lenin's New Economic Plan allowed Western companies a limited role in Russia's oil industry and access to Russian oil. While many Western oil companies (including Standard of New Jersey and Royal Dutch) protested forced nationalization and refused to cooperate with the Soviets. Other companies, such as Standard Oil of New York (the precursor to Mobil) and Vacuum invested in Russia.

Western technology and investment enabled Russian oil production to recover, and by 1923, Russian oil exports to Europe had risen to their pre-revolution levels, with oil exports becoming the Soviets' principal source of hard currency.

The entry of cheap Russian oil into the world markets forced Western oil companies to reduce their own prices, thus igniting a price war in the industry. To resolve this, major oil producers of the world united in 1928 at Scotland to formulate an agreement (the Achnacarry, or "As-is," agreement) to divide the world's oil markets (outside of the U.S.) among themselves in a manner reflecting current realities. Russian oil was included in the "As-is" agreement in recognition of its market presence. With the discovery of oil in the Middle East, and a growing recognition of the Soviets' staying power, Western oil companies eventually lost interest in Russia.

In the 1930s, 1940s, and 1950s, Russia's domestic consumption of oil grew rapidly, causing a reduction of Russian oil exports. The 1950s saw a resurgence in Russian oil exports due to massive investments in the newly discovered Volga-Urals oil province. By the early 1960s, the Soviets had replaced the Venezuelans as the second largest oil producers in the world and had once again become major competitors with the west. The renewed presence of Russian oil forced Western oil companies to cut their posted prices for Middle Eastern oil, thus reducing royalty revenues for governments of the Middle East. This reduction in revenues provided some of the impetus to the formation of the Organization of Petroleum Exporting Countries (OPEC).

In the 1960s and 1970s, the Russians discovered the Tyumen and Samotlor oil basins in Western Siberia. Production from these basins increased rapidly to make Western Siberia the major oil-producing region of the Soviet Union by 1980. While the Soviet oil industry was relatively isolated from the West all through the 1960s and the early 1970s, the sizable production and reserves of the Soviet Union prompted the Nixon administration to attempt to negotiate a bushels-for-barrels (wheat for oil) agreement with the U.S.S.R. The administration believed that such a deal would bring price stability to world oil markets and undermine the oligopolistic power wielded by OPEC. The Russians, however, decided against this deal for fear of antagonizing the oil-producing nations of the Middle East.1

By the collapse of the Soviet Union, more than 70% of Russia's oil was being produced from fields in Western Siberia, and over a fifth from the Volga-Urals. Other oil basins such as Timan-Pechora, Sakhalin, and the Baltics accounted for the remaining production (see map, p. 27). Other regions, namely the North Caucasus, experienced production declines because of the war in Chechnya.2

Industry structure

The Soviets viewed an uninterrupted supply of oil as crucial to economic progress. Therefore, under the administrative-command economy, the country's energy sector was bound by law to provide oil to domestic industries and consumers at prices significantly below that of the world market. Under Soviet rule, the oil industry was regulated by a group of Soviet ministries that wielded complete control. These were the ministries of oil industry, gas industry, construction for the oil and gas industry, oil refining, and geology.

The principal corporate units of the Soviet era were NPUs, NGDUs, and Production Associations (PAs). NPUs were companies that integrated a wide range of oil field services for a given territorial area. NGDUs were companies organized by functional specializations rather than by geographic jurisdictions. PAs were companies that integrated all managerial and operational functions for oil fields in given geographic areas. In a sense, NGDUs were analogous to Western oil service companies, while PAs were like Western oil-producing companies. While PAs, NPUs, and NGDUs handled daily production operations, production levels and pricing continued to be set at the Soviet ministry level.3

Systemic troubles

The centralized control of oil assets led to three adverse developments.

First, PAs tended to overproduce existing fields to meet production quotas without regard for proper reservoir-management practices. Second, since there was no market-driven incentive to improve operating efficiency, the Soviets chronically underinvested in technology. Third, the low price of oil to the Soviet consumers and manufacturing sector resulted in abysmally low levels of energy efficiency for the economy as a whole: 1990 GDP (in U.S. dollars) per barrel of oil was: $513 for the U.S.S.R. vs. $922 for the U.S., $1,186 for Japan, and $1,412 for the European Community.4

The systemic problems with Soviet-era policy resulted in sporadic bursts of turmoil in the Russian oil industry. Symptomatic of these crises were two bouts of rapid production decline in the fields of Western Siberia. The first decline, in 1977-78, which was caused by chronic underinvestment in exploration in the Tyumen fields, was reversed by the allocation of additional resources to drilling. The second decline, in the Tyumen and Samotlor complexes during 1982-86, was also abated by the infusion of additional financial resources and manpower. Solving these crises, the Soviet Union became the largest oil producer in the world with production exceeding 11 million b/d by 1988.3

This dramatic increase in oil production, however, only temporarily masked the systemic problems of Soviet-era mismanagement. Central planning favored the exploitation of big reservoirs rather than small ones. To meet production quotas with as little investment as possible, Soviet-era managers neglected to follow responsible reservoir-management principles, which resulted in the overuse of techniques such as waterflooding and the consequent permanent damage to several oil fields. These problems, combined with the continued deterioration of the Western Siberian reserve base, resulted in a steady decline in Russian oil production from 1988 onwards.

Post-Soviet Russia

The political breakup of the Soviet Union in 1992 caused a disruption of ties between oil field equipment manufacturers in Azerbaijan and Ukraine and oil producers in Russia.

The collapse of the ruble meant that the prices of many input goods and services rose steeply, while the domestic price of oil remained at the old subsidized level. To add to the troubles of oil producers, many state entities that purchased oil from the producers had become insolvent, precipitating a rash of nonpayments to producers. Concurrently, the collapse of the economy resulted in a drop in the domestic consumption of oil. The financial troubles of producers, combined with the collapse in domestic demand, forced a complete halt to all new exploration and drilling activity, and even work- overs of existing wells. This disruption, coupled with the systemic problems of the Soviet-era oil industry, meant that the decline in Russian oil production that started in 1988, when output was 11.4 million b/d, continues unabated to this day with Russian production falling to 5.9 million b/d in 1998 (see graph, p. 29).3

The concurrent collapse of domestic demand for oil and Russia's declining production meant that oil export volumes remained fairly uniform even through the transition era. The foreign exchange realized by the export of oil was the principal source of hard-currency revenues to the Russian government. Hence, the growth of these revenues was set as a priority by the Russian government. Since the government was incapable of making the managerial and financial decisions necessary to reverse the industry's decline, it privatized the oil sector and decided to allow limited foreign investment.

Privatization

The Russian government initiated privatization through the passage of the Law of Underground Resources (1992) and the adoption of a new constitution (1993).

As a result, the industry was restructured into 12 VICs and a small number of independent producers. The Russian government initially retained a controlling interest (51% of common equity) in the VICs, while limiting foreign ownership to 15% or less. Some shares in the VICs were distributed to employees and managers of the companies, while others were sold to the public in auctions. The presence of a large number of well-connected insiders in the management of VICs resulted in the sale of these companies for substantially sub-market values. Under the loans-for-shares scheme, the government relinquished its shares in VICs as collateral for loans to the government from Russia's newly privatized banks. The state's default on these loans, which some say was pre-arranged, resulted in banks attaining majority control of a number of VICs.

The Financial Industrial Groups (FIGs) that resulted from the loans-for-shares scheme now control a significant fraction of Russia's industrial assets. The management of the FIGs and the VICs reads like a veritable who's-who of Soviet and Russian politics. Lukoil CEO Vagit Alekperov was a minister of the oil industry in a former Soviet government. Viktor Chernomyrdin, a former chairman of Gazprom, was the Prime Minister of Russia during privatization. Mikhail Khodorkovsky, chief executive of Yukos, was an important ranking member of the Communist Party's youth wing. Boris Berezovsky, whose financial support is credited with assuring Yeltsin's last electoral victory, is the current chairman of a banking group that owns Sibneft. Rem Viakhirev, president of Gazprom, was a minister of the gas industry under Soviet rule. Five Russian chief executives who participated in privatization were new additions to the Forbes magazine list of the world's 200 wealthiest people.5

The ownership of oil companies by financial groups was seen by many as evidence that Russia's oil industry did not need Western investment to grow. However, the banks controlling VICs were never banks in the truest sense. Most ordinary Russians, even to this day, keep their money in the state-owned savings bank. The two primary routes to growth envisioned by FIGs were control of commodity assets and trading in highly speculative financial assets. The recent collapse in the price of oil and the subsequent collapse of the ruble have bankrupted many FIGs and laid waste to their plans for growth. Simultaneously, the decline in world oil prices has also reduced the level of Western interest in Russian oil assets.

Regulation, administration

Under the new Russian constitution adopted in 1993, the federal and regional governments share the regulatory responsibilities for the energy industry.

The federal government focuses on energy-sector legislative issues pertaining to defense, foreign policy, and taxation, while the regional governments determine energy policies on land ownership, natural resource allocation, and subsoil use. The genesis of this devolution of legislative authority on mineral resources between federal and local jurisdictions is the Law of Underground Resources (1992).

A more comprehensive Law of Oil and Gas, further defining the ownership, licensing, and transportation issues, has not been blessed by the Duma. Instead, the government and the legislature have focused on ad-hoc licensing and production-sharing agreements (PSAs) for the development of oil and gas fields.

Under economic reforms, a ministry of fuel and energy and committees for geology and mineral resources have replaced Soviet-era oil ministries. The power vested in these agencies is administrative rather than managerial, because they no longer have the power to "micromanage" daily production levels and investment strategies. However, the agencies continue to wield proxy power in the form of licensing requirements, regulation of prices, and influences on legislature and on Transneft, the state-owned pipeline company that manages the 31,000-mile oil pipeline network in Russia.

Production-sharing agreements

The Duma passed the first PSA legislation in 1995. PSAs define the relationship between the government and oil companies.

Under PSAs, oil companies (both foreign and domestic) recover their operating costs as a percentage of the revenues from oil and gas projects. The remaining revenue is split between the government and the private company. Details of the split are determined through bilateral negotiations prior to the commencement of the project.

An amendment to the 1995 PSA legislation gives the government authority to change a PSA after a project is under way, if the government feels that the economic situation warrants it. This amendment has taken away much of the rights of private ownership in the Russian energy industry.

A new draft law, passed by the Duma and recently signed into law by President Yeltsin, requires oil fields of national significance to be guided by separate PSA laws and limits existing PSA agreements to a maximum of 30% of all reserves.

In a recent positive development, an amendment to the law governing PSAs removed the requirement of the Duma's approval for small oil fields.

However, the law now imposes stringent requirements to use mostly Russian manpower (80%) and equipment (70%) in all projects governed by PSAs and may, therefore, adversely affect the acquisition of key Western skills and technologies.

Tax reforms

Faced with huge fiscal deficits and declining tax revenues caused by non-payment of taxes, the Russian government has singled out the energy industry for financing a major part of its budget.

The tax burden on Russia's oil industry is high. Taxes include a 20% value-added tax (VAT), a high oil excise tax, a 3% tax on profits and property (including non-performing assets), and special taxes on exports and ports. In the Russian tax system, many operating expenses (usually viewed as the cost of doing business) can only be deducted on an after-tax basis. Moreover, depreciation is calculated on a straight-line basis and is tied to the

original ruble-value of capital goods. Specific tax exemptions are sometimes awarded to some projects; they are, however, seldom honored.

More than the high tax burden, the arbitrary and frequent changes in tax policies make investments in Russia risky propositions. A comprehensive and "normalized" tax code, slated to go into effect in 1999, looks unlikely, given the current atmosphere of hostility between the Duma and Yeltsin. One side effect of the arbitrary tax policy is the serious record of tax underpayment by VICs.

Exports, transportation

Russian oil companies see exports as the principal means to grow earnings and pay tax arrears to the government.

After the collapse of the ruble in July 1998, the government ordered oil companies to direct all earnings from exports (projected at 2.3 million b/d in 1998) to tax payment.

The government's current need for increased hard currency earnings from exports is in conflict with Russia's promise to OPEC to lower its exports by 100,000 b/d.

Russia exports most of its oil through terminals at Novorossiisk (Russia), Ventspils (Latvia), Odessa (Ukraine), and Tuapse (Russia) on the Baltic and Black Seas.

Russia's major oil pipeline is the 1.2 million b/d Druzhba. Because this pipeline is running near full capacity, proposals and financing efforts are under way to expand capacity and to build new pipeline systems. The Baltic Pipeline System, proposed by a consortium of 10 private and foreign oil companies, will have an ultimate capacity of 450,000 b/d and link fields at Timan- Pechora to the Baltic Coast.

A 300,000 b/d crude oil terminal is also being planned next to the existing 800,000 b/d terminal at Novorossiisk.2

Conclusion

Russia's vast oil and gas reserves have made it an important player in the past and present of the world's energy industry. Since the 1920s, the oil industry has been the core industry of the Russian economy.

In spite of a collapse in Russian oil output in the early 1990s, oil exports remain the principal source of foreign exchange to the country, while tax revenues on the oil industry remain the principal source of revenues to the Russian government.

Privatization of oil companies that began in 1992 has culminated with the launch of the re-nationalization of Rosneft and other companies in 1998.

Post-Soviet regulation of the oil industry has been fraught with problems due to flawed privatization, arbitrary and excessive taxation, changeable PSAs, and export bottlenecks.

In spite of the many problems associated with the current state of privatization and regulation, the world's oil industry currently remains interested in opportunities in Russia's oil sector.

That, however, could change with the renewed openness to foreign participation in the oil sectors of Saudi Arabia and Kuwait.

It would be ironic, indeed, if the West again exited Russia en masse for the relative attractions of Middle Eastern oil.

Acknowledgment

The authors thank Prof. Paul Gregory, Dr. Michelle Foss, and Dr. Gurcan Gulen of the Energy Institute at the University of Houston for their guidance; Mike Wysatta of Ryder Scott Petroleum Engineers for editing; and our respective employers for their support.

References

1. Yergin, Daniel, "The Prize."
2. www.eia.doe.gov; United States Energy Information Administration, Russia Country Analysis Brief.
3. Salomon Bros., "European Emerging Market Research-Russian Oil"; March 1996.
4. Gregory, Paul, "The Russian Oil and Gas Industry in Transition," a University of Houston Energy Institute White Paper, December 1997.
5. www.msnbc.com/modules/RussiaWealthy/ default.htm, "Russia's Robber Barons-The Twelve Men Who Own Russia's Economy."

The Authors