Yukos Priobskoye project litmus test for foreign investment in Russian E&P

March 6, 2000
Turning around Russia's oil industry poses challenges as huge as that nation's alluring potential must seem to the foreign majors that would pursue investment there.

Turning around Russia's oil industry poses challenges as huge as that nation's alluring potential must seem to the foreign majors that would pursue investment there.

For some companies, the frustrations have been partly self-inflicted, say leaders of Russia's emerging group of major oil companies that have adopted some western-style management practices. For leaders such as Yukos CEO Mikhail Borisovich Khodorkovsky, there is a comparable level of frustration with prospective foreign investors that entered the Russian market with inadequate preparation and preconceived notions (OGJ, Feb. 21, 2000, p. 23).

Nevertheless, companies such as BP Amoco PLC and ExxonMobil Corp. have, with justification, complained of having to endure surprise tax changes, bureaucratic delays, and deal reversals. They clearly found that Russia is a tough place to invest, regardless of the degree of preparation invested in the effort.

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As a result, the number of petroleum-oriented joint ventures remains the same today, at about 70, as 3 1/2 years ago.1 This is further shown by a lack of direct foreign investment in Russia (excluding the Russian stock market), amounting to only $10 billion since 1993.2

Yet if Khodorkovsky and other leaders like him are to successfully introduce a practical working model for future Western and Russian business ventures, the next century must see a resolution to problems related with increased capital spending, operating philosophies, and clashing cultures that were experienced in the 1990s.

"The problem will be: making room for major (Western) integrated companies that have the necessary technology and capital to tackle large finds," said Thane Gustafson, research director for the Cambridge Energy Research Associates Eurasia team. "The Russian oil industry has simply been living on its Soviet inheritance too long, with most activities centered on rehabilitation. Instead, they must increase capital spending to $10-12 billion/year from $2-3 billion."

For access to that kind of capital, Russia's majors must turn to joint ventures or other partnerships with foreign majors. And they are now armed with a new law on production-sharing agreements (PSAs) that could jump-start stalled foreign investment in Russia's upstream oil sector (see related story, this page). At the same time, despite the problems incurred with the federal bureaucracy and Duma politics, there is an enlightened stance among local government authorities toward foreign investment in Russia's oil sector-and an urgent need for help with the socially dependent infrastructure of the oil-producing regions.

With that in mind, Yukos may have at hand a project that could serve as a litmus test for Russo-foreign JVs and the implementation of the new PSA law: development of giant Priobskoye oil field, near Nefteyugansk.

Priobskoye project

Although Yukos has access to capital from its own internal revenue stream, aided by elevated oil prices, it wishes to accelerate development of Priobskoye.

"Priobskoye is a priority for us," Khodorkovsky said, "and can provide a leap in future total production and open new opportunities to cooperate with foreign companies."

Speaking at a press briefing in Moscow Jan. 31, he said foreign investors in the development project "would enjoy the benefits of PSAs," via a legal instrument designed to provide tax benefits for investors and spur inputs of capital and technology into the Russian oil industry.

On Nov. 20, 1999, a PSA bill was signed by then-President Boris Yeltsin and subsequently passed by the Duma 312-25, providing authorization to develop Priobskoye field. Currently, there are 19 areas actively engaged or awaiting development under PSAs (see table).

Priobskoye field, which has been under development since 1994, has so far produced 35.4 million bbl of oil with 700 wells in place. Yukos estimates the structure holds 18 billion bbl of original oil in place. A long-range development plan that extends over the next 56 years foresees extraction of 4.7 billion bbl of oil, with production peaking during 2010-20 at 130 million bo/year. In 1999, total output reached 11.14 million bbl, which amounts to 3.4% of Yukos's total 1999 output.

Yukos invested at least $50 million of its own funds in development of Priobskoye last year, with a further $170 million planned for 2000-without outside help. "This year, we expect production to rise to about 22.4 million bbl, and investment may be further increased, depending on well yield," said Yuri Beilin, president of Yukos Exploration & Production.

Discovered in 1982, Priobskoye occupies an area of 5,446 sq km and is located along the Ob River, 65 km east of the city of Khanty-Mansiysk (see map). The field unit's Northern Territory, available to the PSA, accounts for 75% of Priobskoye's total reserves.

Investment opportunity

If a foreign investor chooses to join Yukos in development of Priobskoye field, Khodorkovsky is prepared to negotiate terms based on a variety of factors: "It's always been our position that the best thing for a foreign oil company is to take the first steps in Russia jointly with a Russian oil company. Of course, that would require certain intellectual investments. But that gives you better chances for success."

He feels that Western companies will obviously bring in technical expertise, "but we obviously have the experience in working locally," he said. "So, when I'm asked if I would be prepared to give away 70% of the oil share and operating authority to a foreign oil company, I would say that I'm prepared to give 100%, but I am forewarning you of the result: It's going to be negative."

On the other hand, "If you want positive results, at least in the initial stage, we must play a substantial part, and we must see to the kind of people you send in." In regards to local, regional, and federal relationships, "We should also be the determining voice. In this case, I would be prepared to take up the risk accordingly."

Yet Khodorkovsky says that, if the foreign company would send competent people, his firm would take a role similar to that of a working-interest partner. "I would be willing to give operations to them, because I also have a shortage of good people and always have a place to apply them."

The degree of development will also play a role in PSA negotiations between partners for Priobskoye. "If we take a field that has been fully explored by us, and the infrastructure is already in place, then I could give away 100%. But I would demand payment for that."

On the other hand, "If it is an oil field that hasn't been explored, and it's a joint bridge where we're taking and splitting everything as we progress, the best option would be 50-50."

Khodorkovsky feels that a consortium, although normal for other regions of the world, would be difficult to conduct under current Russian conditions. This is because there will be "no common understanding of the local markets among the participants. For that reason it is better to play a game of two and then expand into a consortium at a later time."

Industry sources speculate that Exxon-Mobil, Texaco Inc., and Enron are Corp. currently interested in the Priobskoye PSA.

A governor's incentive

Another key factor that has substantially changed the investment climate for some of Russia's oil deposits involves the determination by regional leaders to pave the way for foreign investment (see related story, above). In an interview early in February in Nefteyugansk, Gov. Alexander Vasil- ievich Filipenko of the Khanty-Mansiyski Autonomous Okrug told OGJ his region has special legislation in place to provide favorable conditions for foreign investment.

For example, "We have an act where we permit tax payers, who pay on a regular and consistent basis, to pay just half of the property tax normally due...while other tax breaks are also possible." Although these taxes are on the regional level, they encompass a significant share of the tax base. "I can now say that [the] regional tax is far more liberal for foreign investers than [the] federal [tax is]," Filipenko said.

There are other incentives that may promote investment in Khanty-Mansiyski as well. For example, "The oil deposits in this region are capable of high production rates, and we have a well-developed infrastructure," such as industrial facilities, roads, railroads, airports, and pipeline networks, "to support any kind of oil field work." Thus, resource development and delivery to markets will be much easier than, say, in the Russian Far East.

Altogether, Filipenko's aggressive approach towards resource development has enabled him to place five areas under the PSA umbrella. However, he feels that the current PSA in place "is not as favorable as it should be. Instead, it's better to reduce taxes 10-20%. But in the light of what's available, it's the best option."

Headed east

Expanding on Yukos's strategy of incorporating Western management and technology in current and future operations, the company also plans to diversify internationally and build relations with China, providing a secure market for the company's crude oil from the Tomsk area.

According to the Yukos newspaper Neftyanaya Parallel, China National Petroleum Corp., Yukos, and Transneft are considering two routes to transport Western Siberian oil via pipeline to China.

The first route proceeds from Angarsk, Russia, and heads southeast through Ulaanbaator, Mongolia, to its final destination in Beijing. The second route bypasses Mongolia altogether, proceeding east through Chita, Russia, then southward to Kharbin, China.

The Russian variant encompasses a shorter distance to refining facilities in China. Although this route provides a more-economic variant, the Chinese prefer to bypass Mongolia for political reasons.

Transneft estimates the first route will cost $1.7 billion, and it is expected that throughput capacity for the 2,400-km pipeline will reach 600,000 bo/d by 2010.

Currently, Yukos is consulting with Chinese officials about including the planned pipeline in its 5-year plan, and Yukos is optimistic that construction can begin during 2004-05.

China currently consumes 200 million tonnes/year of oil, producing 160 million tonnes/year internally. It is expected that, by 2010, in order to meet demand, China will have to import 90 million tonnes/year of oil.

Small amounts of crude are currently shipped by rail to China from Yukos fields.

Oil towns

Of all the problems that face the Russian oil majors, the greatest challenge that lies ahead concerns dealing with the near-unbreakable social-industrial relationships of the oil towns, scattered throughout Siberia.

These one-company townships, which bear a disproportionate share of the country's social responsibilities, including public transportation, construction, and utility service, lack the economic diversification needed to independently support fundamental social requirements.

Unfortunately, because privatized oil companies must shed these activities or go bankrupt, they have been forced to examine their business portfolios and divest unprofitable activities. For example, as Yukos restructured its business units to improve the bottom line and operating efficiency, it spun off 82 JVs, transferring 42,420 of its employees to new companies in Samara, Nefteyugansk, and Strezh- evoy.

While Yukos retained some ownership in the ventures, each company became independently managed and they must now compete among themselves and against other outside companies to provide oil field services to Yukos and its subsidiaries.

Fortunately, some of these firms, such as cement companies and heavy-equipment providers, can continue to provide services for civil works as well as the oil sector. Yet many city and regional administrations have small budgets from which to pay for these services.

Thus, these divestitures, which are necessary for economic survival of the newly privatized companies, will continue to create special problems for the northern communities born out of the petroleum rush 15-20 years ago. "There are two kinds of townships," Khodorkovsky said. The first kind is like Samara or Tomsk, where it is clear other industries (and even competitive oil companies) can provide alternative employment."

Yet towns like Nefteyugansk, which encompass the second category, "cannot live without oil," he said. "In this case, the oil companies that do not wish to have social problems (with the citizens), must form special programs for its pensioners and adapt its younger people to other (employment) possibilities."

Thus, in Nefteyugansk, the town council and Yukos are now grappling with these problems through joint efforts. "One way of coping with it is by pursuing information technology projects that will remain promising in the 21st century," Khodorkovsky said.

Another means is created by leapfrogging across generations of technology. On a field trip to Priobskoye field in February this month, Yukos Chief Engineer Vladimir Paltsev showed OGJ a village (Seliyarvo) that was recently hooked up to electricity, which had gone without since its founding over a century ago.

Taking this one step further, Yukos provided the village school with computers, an incomprehensible technology for many parents who still shelter their livestock at home during winter. Paltsev said that, within a year's time, Yukos will provide a satellite link to the village as well, in effect, precluding the need for telephone lines while allowing students to access the outside world through the internet.

Another social problem, however, concerns the resettlement of retirees in the "mainland," as many veteran oil workers, stripped of their savings by runaway inflation, have found themselves stranded in colder climates without the possibility of moving to warmer regions befitting their age.

Yukos has come to grip with this challenge by launching a corporate Veteran Program, whereby all of its local workers with employment records of 10 years or more will be provided sufficient subsidies to buy new homes elsewhere.

Unfortunately, this still leaves the enormous task of producing alternative industries from which to diversify the economy, and it will be some time before independent industries can develop. "Sometimes I feel I'm trying to spoon water when there is a hole in the spoon," Khodorkovsky said.

References

  1. Eastern Bloc Energy, July 1996, p. 20.
  2. Gyetvay, M.A.,