Dean E. Gaddy
Senior Editor, Drilling & Special Projects
Oil & Gas Journal
HOUSTON, Mar. 12�Mikhail Khodorkovsky, CEO of the Russian firm OAO Yukos, says the ability to expand domestic and foreign markets�not limited access to working capital� will determine oil production over the next 5 years in Russia.
He recently spoke at the Cambridge Energy Research Associates executive conference in Houston.
Khodorkovsky also thinks that if Western companies understood the economic conditions that are reshaping Russia's petroleum industry, they may find profitable ways in which to operate in Russia. "Some of those who have attempted to operate in Russia have been unsuccessful. This is not a satisfactory thing for us to realize because it makes the international community think that Russia is not a very attractive object for investment."
He said, "If you take a take a look at a map of Russia, you will see that the opportunities to export oil, are limited. �
On the domestic front, for example, Russian consumption may rise to 2.8 million b/d from 2.3 million b/d by 2005. Internationally, however, Russian exports to Europe may increase by 1.3 million b/d from 3.7 million b/d today. Yet other areas such as Sakhalin Island exports to Japan, and Siberia and the Russian Far East exports to China, hold limited mid-term growth potential as harsh working conditions and limited infrastructure development pose technical and political barriers that may take years to overcome.
"Thus, the opportunity for growth in the Russian oil industry in the next 5 years is limited," Khodorkovsky said. "We have no deepwater ports so we cannot ship our oil, for example, to the US. Therefore, the maximum oil production in Russia ranges between 8.2 and 9 million b/d."
Misconceptions
Yet Khodorkovsky feels that western investors and analysts wrongly interpret the current situation and the ability of Russian oil companies to react to changing economic conditions. "Five years ago, money was the most important thing for us," he told OGJ. "The industry was extremely inefficient, cash flow held us by the throat, and there was nothing else that we thought about."
Yet after 5 years of progress, reorganization at the corporate level, improved technology management at the field level, and increased commodity prices have resolved the cash flow problem.
"Today we understand the most important thing is knowledge and are looking to acquire this knowledge at the best price." Working towards this goal, Yukos is trying three business models: "true cooperation" with oil companies, service company alliances, and work-for-hire arrangements.
"There is a myth that foreign companies operate at a lower cost than Russian companies under comparable geological and environmental conditions," Khodorkovsky said. "As a matter of fact, the cost of production incurred by Western companies under similar conditions, for instance in Western Canada, Kazakhstan, and Alaska, are higher than the costs of Russian oil companies."
There are several explanations: First, Russia has a 110-year-old oil industry whose experience is only exceeded by the US. "This means that Russia has the manpower with necessary qualifications. It has an elaborate system of education and training in place."
Second, the Russian petroleum industry manufactures most of its equipment at a much lower cost than in the West. "Only a small portion of the ever-growing investments by Russian oil companies is made in imported equipment," Khodorkovsky said. At Yukos, for example, only 4% of the company�s expenditures went for foreign equipment. All the rest is bought domestically at local prices.
And just as important, due to the global economy, Yukos and other Russian companies have access to Western field services in addition to their own. "This explains why our expenditures under similar conditions are lower than our Western counterparts."
Misconceptions of the current tax regime and "so-called advantages" of production sharing agreements (PSA) is another sticking point with Khodorkovsky. "Until 1999, there was an unsustainable, very tough tax regime in effect. If this is translated into PSA terms, the government took 100% of the profit with 'minus 10%' of the profit remaining with the investor"
Since 1999, however, legislative action by the Duma and executive branch has altered the situation. "Now the government takes about 70% of the profits, which represents a conversion into PSA terms, and about 30% remains in the pockets of the oil companies," Khodorkovsky said. In 2000, Russian production broke a 5-year flat streak with output rising to 6.5 million bo/d, a 5.7% increase over 1999 (OGJ, Feb. 19, 2001, p. 30).
"As anyone can plainly see, as the effective tax rate fell, the Russian industry grew. Now maybe even the government finally believes this."
Two concerns, however, have yet to be resolved. Concerning the profits tax, ongoing negotiations are showing promise. "The outlines look perfectly acceptable. It�s very similar to what you see in world practice."
Of greater concern is the export duty. "The government wants to leave this as is, but retain the rights to amend it as necessary," he said. "Yet the prevailing opinion is that the customs duty really ought to be regulated by a law rather than administrative fiat." This question will perhaps be resolved this year.
Equal conditions
Khodorkovsky is not so sure PSAs will provide the advantages that foreign investors so desperately seek. "We can see that the production sharing format being offered by the Russian government is less advantageous than the international PSA standards."
Khodorkovsky says that if western companies really desire PSAs, however, they can work towards this goal.
"But they should not for a moment expect that this will be a more favorable regime than the national tax regime." Furthermore, he feels that PSAs, or "custom-designed" joint venture agreements for that matter may continue to create a condition of animosity between the Russian government and the oil industry.
"There is one thing that we are not going to tolerate, ever, and that�s for Western companies to have more preferential terms in Russia than we do. Equal conditions fine, preferential no."
Instead, Khodorkovsky feels there should be an all-embracing system, founded on an unbiased national tax regime, which is perhaps the only practical way to produce a competitively fair working environment. "Looking back, if Conoco Inc. agreed to work within the national tax regime, instead of seeking preferential treatment, they may have been in far better shape today." Since production from Conoco�s Polar Lights project line, for example, the company has seen four major tax increases.
Additionally, external forces may have also played a role in this tax volatility with negative effects on production. "I want to bring to your attention that the ratcheting up of taxes in the oil industry was partly brought on by the insistence of the IMF (International Monetary Fund)," he told OGJ.
And perhaps because the IMF's recommended monetary policy focused on increasing hard-cash reserves, needed to secure loan commitments, the Moscow and local governments may have been compelled to tax those projects with an established revenue stream, such as Polar Lights.
"Every time the IMF made such recommendations, the result was invariably a decline in production, and naturally the Western companies were stuck in the same situation."
Investment scenarios
Khodorkovsky says foreign investors can successfully take certain routes. "But you need to make the right choice and move properly along the way you have chosen."
These opportunities include offshore production projects and asset swaps. "International oil companies can undoubtedly develop offshore production projects in Russia (Barents Sea, Caspian Sea, Sakhalin Islands). They are very competitive in this area because Russian companies do not have such experience."
Additionally, Yukos is willing to sell parts of the company's assets as before. Although such sales formed its core strategy 5 years ago, Yuko�s increased cash flow, a better idea of core-property values, and improved knowledge of how to generate more value from these assets, now provide the company with other options.
"Now we�re interested in international investments so we are ready to swap. We are ready, willing, and able to learn how to operate in the international market," he said. "Having said that, we are not prepared to admit that our western colleagues work better than we to in Russia. We are ready to take a look, without prejudice, at how they do it. But we demand proof that they work better than we do."
