Etienne H. Deffarges
Booz*Allen & Hamilton Inc.
San Francisco
Phillip A. Ellis
Booz*Allen & Hamilton Inc.
Paris
John Elting Treat
Booz*Allen & Hamilton Inc.
San Francisco
Andrew L. Waite
Booz*Allen & Hamilton Inc.
San Francisco
The Commonwealth of Independent States, or the former Soviet Union, offers unparalleled opportunity across all oil and gas industry sectors despite the obvious obstacles and pitfalls in entering the market.
Many existing fields have huge production potential with managed workover and rehabilitation or by application of well-established enhanced recovery techniques. If recent production declines can be reversed in a costeffective manner, there should be a considerable source of hard currency available to fuel subsequent major capital expenditure programs.
The recent political events in the C.I.S. have had two major impacts on Western firms' efforts to provide products and services in the oil and gas sector.
The ruble collapse has caused the pricing out of most Western imports with the effect that only products or services that are of critical importance and offer significant technical advantage over locally made products remain very attractive opportunities.
The establishment of internal borders within the C.I.S. may become an impediment to trade, although this negative impact is to some extent mitigated by the reduction of price differences between Western and C.I.S.made products if inter-republic sales occur on a hard currency basis.
MARKET SIZE
The C.I.S. holds 6% of the world's proven oil reserves and 37% of the natural gas reserves. C.I.S. oil and gas production, which accounts for approximately 24% of worldwide energy production in the oil and gas sector, has a value of approximately $140 billion per year at current market prices.
To illustrate the magnitude of the potential capital investment in the C.I.S. in a free market situation, an estimate of 15% of the value of production is assumed for capital investment. This figure suggests annual capital investment on the order of $21 billion.
With a focus exclusively on hard currency availability, approximately $20.6 billion of hard currency would be generated annually based on the current reduced export levels at market prices. A breakdown of this figure reveals $6.8 billion from crude oil, $5.6 billion from refined products, and $8.2 billion from natural gas.
However, the continued use of barter trade with most of Eastern Europe would probably reduce the hard currency generated by the oil and gas sector by approximately 25%. Under a first order approximation, the oil and gas industry in the C.I.S. appears to have around $15 billion of hard currency available.
Assuming that a significant proportion of that hard currency could be spent on services and equipment from Western firms, after local operating costs have been deducted, it is clear that a huge potential market exists. Western service and supply firms therefore have attractive opportunities in all of the major sectors of the oil and gas industry at present.
DECLINING PRODUCTION
At the end of 1991, the C.I.S. fell behind the U.S. to become the second largest energy producer in the world (Fig. 1). Since then, oil and gas production in the C.I.S. has continued to decline substantially.
Oil production fell by 18% between 1988 and 1991 (Fig. 2), and current estimates for 1992 predict that oil production will decline to the lowest level since the early 1970s. The Western Siberia region has experienced the bulk of this decline (Fig. 3). In general, C.I.S. oil production has moved steadily east over the last decade, from its origins in the Caucasus to the Volga/Urals to Western Siberia.
After a decade of growth averaging 6.5%/year, natural gas production declined last year by approximately 0.5%-the first decline since the end of World War 11 (Fig. 4). Gas production in the first quarter of 1992 was down approximately 1.5% compared to the corresponding period in 1991. The historical shift in gas production to the east and north, from the Ukraine to Central Asia and northwestern Siberia, is shown in Fig. 5.
Figs. 2 and 4 show three alternative production forecasts for oil and natural gas, respectively. These forecasts illustrate the vital impact of policy reforms and the successful implementation of joint venture operations on future C.I.S. production. The policy reforms have the potential to increase production more significantly than the joint ventures.
PRODUCTION LOSSES
Although crude oil production declined by 18% between 1988 and 1991, apparent consumption of crude oil dropped by only 8% (Fig. 2). The remaining reduction in production resulted in lost export sales-a vital source of hard currency for the C.I.S.
Gas consumption continued to increase through 1991 (Fig. 4). There were no obvious signs of a decrease in consumption in 1992.
There are considerable hydrocarbon losses occurring in all sectors of the C.I.S. oil and gas industry. Oil losses, mainly a result of leakage from pipelines, are estimated by one source to be on the order of 1 million b/d. This loss approximately equals 10% of total production, but official sources claim a significantly lower figure of 1%.
Gas losses are also the subject of considerable speculation, with one analyst estimating losses as high as 20% of production. In the refinery sector, a European agency estimated that C. I. S. refineries are losing more than 25% of their energy output.
The common problem linking both of these trends is a lack of incentive to conserve energy by either reducing consumption or stemming losses. This problem was particularly severe when hydrocarbons were priced at artificial levels and with an incentive system in the former Soviet Union which emphasized meeting 5-year plan production targets. With the move towards market pricing and the transition to private enterprise, the correct incentives may be in place to help reverse these trends.
Outside pressure may also be brought to bear on these issues as western banks, particularly multilateral lenders, have shown an unwilling ness to lend money for new development projects until appropriate conservation measures have been implemented.
LACK OF FUNDS
One of the root causes of the fall in output is a lack of funds available for capital investment. This shortage of funds affects production in two respects:
- Critical maintenance or replacement of existing facilities and equipment cannot occur, resulting in output restrictions on current fields or no output in severe cases.
- Without capital investment, new capacity cannot be brought on line to replace production lost because of natural decline of existing fields. This new capacity would be gained either by additional drilling or enhanced recovery techniques in existing fields or by developing new fields.
The lack of domestic funds is exacerbated by a failure to obtain commitment for foreign funding. Most potential projects and joint venture negotiations which fail do so because the risks and uncertainty associated with the venture outweigh the potential returns. The uncertainty arises in several respects:
- Do those negotiating on the part of the C.I.S. republic, regional authority, or production association actually have the authority and ability to deliver the promised contract or payments in the future?
- How and when will the fiscal climate change, with regard to income tax rules or import duties for foreign supplies and equipment?
- What will be the future of the ruble exchange rate?
- If payment is to be made in crude (or gas, products, etc.), at what price point will it be delivered, and will the appropriate export licenses be available? If it is made in products, from which part of the barrel will they be drawn?
TRANSITION
The process of transition to a market economy has not progressed uniformly across the oil and gas sector. Whereas prices for refined products and petrochemicals have risen by more than 3,000% over the last 12 months, the government-controlled price for crude oil rose by only 400%. These imbalances create potential funds for capital investment in the refining sectors but create a serious cash shortage in the pipeline and oil and gas production sectors.
When the rate of oil price increases falls below the rate of inflation, the producing companies are unable to pay for vital materials and equipment and, in several extreme cases reported lately, unable to pay workers' wages.
Even though the provision of up to $24 billion in foreign aid is contingent upon having free oil prices by the end of the year, there is considerable speculation that this timetable will not be achieved, despite official statements that full liberalization of energy prices would take place within 3 months of the May 1992 price increases.
DOMESTIC EQUIPMENT
In line with former Soviet industrial policy, manufacturing facilities for petroleum industry equipment were concentrated in certain strategic locations.
Tubular goods were manufactured in Ukraine. Pumps and production equipment were primarily produced in Azerbaijan. In fact, more than 60% of all petroleum industry equipment has historically been manufactured in Azerbaijan, in factories which are widely considered to be obsolete. This large number of oil field equipment manufacturers in Azerbaijan has proved a severe drawback because of the state of ethnic unrest over recent years. The unrest has encouraged the flight of skilled production workers from the area.
Further difficulties have arisen since the demise of the former Soviet Union. Under the current structure of the C.I.S., Ukraine and Azerbaijan demand payment in hard currency for shipments of oil field equipment to Russia, where 90% of oil production is based. Thus, Western-manufactured equipment can now compete directly on hard currency terms with imports from these republics.
JOINT VENTURES
In a previous article (OGJ, Sept. 24, 1990, pp. 80-90), Booz*Allen & Hamilton Inc. predicted that opportunities in completion equipment and production services would be the most attractive. Favorable opportunities were also predicted in measurement while drilling (MWD), wire line, drilling services, and gas completion.
Booz*Allen & Hamilton anticipated that joint ventures with C.I.S. firms would best enable oil field service and supply companies to exploit the market potential. As may be expected, a review of company activities in the C.I.S. over the past 2 years indicates mixed fortunes. However, there have been a few success stories, indicating that well-managed and carefully followed C.I.S. opportunities can pay off.
The recent experiences of Sperry-Sun Drilling Services, Canadian Fracmaster, and Dresser Industries Inc. provide examples of successful ventures in certain oil field service and supply sectors.
Sperry-Sun Drilling Services concluded a successful joint venture agreement in June 1991 with Nizhnevartovsk Neftegaz, the largest production association in the former Soviet Union, and the Siberian Drilling Association. Within a 1-year period, Sperry Sun has been able to receive the specified financial contribution from its joint venture partners, set up the joint venture company (Siberian Sperry-Sun), mobilize its equipment, perform horizontal drilling and MWD services and, most importantly, receive and repatriate payment for those services. Sperry-Sun received payment in crude oil which was then exported and sold outside of Russia.
Fracmaster has also formed successful joint ventures and is working with two former Soviet production associations. Fracmaster provides hydraulic fracturing services which enable the profitable exploitation of certain oil wells which might previously have been abandoned. The company also reports being able to repatriate dividends. Royal Dutch/Shell has a 50% investment in Fracmaster joint venture operations in the C.I.S.
Dresser has had success in selling both products and services to Western major oil companies working in the C.I.S. and directly to C.I.S. clients on a hard currency or letter of credit basis. Dresser is also very interested in setting up joint ventures and has continuously reviewed potential opportunities. Dresser, however, has not yet been able to complete a workable deal which ensures an adequate return for its risk in the exploration and production services.
SMALLER FIRMS
Firms in other sectors have also had success in their ventures in the C.I.S.
Era Aviation Inc. of Anchorage has signed a contract with Marathon Petroleum Sakhalin Ltd. to provide helicopter support services for offshore drilling activities near Sakhalin Island. The helicopters will transport personnel and supplies between the city of Okha on Sakhalin Island and offshore drilling rigs. Era was chosen because the conditions on Sakhalin are similar to those in Alaska and the Russian joint venture partners wished to use a company with experience in supporting offshore drilling in an arctic environment.
GHK Co. of Oklahoma City has signed a joint venture agreement with the first priority of repairing 110 oil wells in the Samara province of Russia as a step toward a larger joint venture with other partners.
Lufkin Industries Inc., an oil field equipment supplier from Lufkin, Tex., has a business agreement to supply about $95 million in oil field equipment to the Russian oil company Rosneftegas.
MD Seis U.S.A. Inc. has been working with local oil production associations in the Russian and Kazakhstan republics to prepare seismic data packages for new upstream joint venture opportunities in the C.I.S. Other ventures involving Gebco and Wavetech have also been formed to market seismic data to the West.
A number of other firms had promising initial breakthroughs but subsequently ran into problems, which are hoped to be temporary.
Parker Drilling Co., whose 3-year drilling contract with the White Night's joint venture was terminated earlier this year, has not yet been able to secure further contracts for its rigs in the C.I.S. Parker Drilling remains optimistic about future prospects, particularly in the areas of horizontal and directional drilling and deep drilling which will be required for some future gas prospects.
Pride Petroleum Services Inc., which had previously announced receiving a letter of intent from Quintana Trading Inc. to provide well servicing rigs and personnel for its OVH field workover project in Western Siberia, still does not have any personnel or equipment on the ground in the C.I.S. Quintana is reported to have delays because of problems with securing guarantees required for financing. Nonetheless, both companies are still optimistic about the project. To underscore this point, Pride continues to explore further opportunities in the C.I.S.
In many cases, attempts to set up joint ventures have been frustrated by a lack of confidence on both sides of the negotiating table. C.I.S. partners are concerned as to whether they are negotiating the best deal possible. Many have engaged the services of Western investment banks and law firms to protect their interests in the negotiations. Similarly, Western partners are concerned with the huge risks and uncertainties associated with their investment.
OPPORTUNITIES
The opportunities in the upstream sector can basically be categorized in three areas:
- Exploration in new areas
- Development or continued development of already proven fields
- Rehabilitation or workover of older production.
EXPLORATION
Western firms continue to offer superior technology for seismic and geophysical survey services. In exploration drilling, Western firms can no longer clearly enjoy a significant advantage, except for directional drilling or deep drilling beyond 5,000 m (16,000 ft).
Although an analysis of total footage drilled vs. the number of rigs in service in the C.I.S. typically suggests productivity levels less than half that of U.S. rigs, the latest information available indicates that the comparison may be deceptive.
There has typically been a surplus of rigs in the C.I.S., with the result that rigs were set up on location in advance of crews becoming available. In some cases, rigs remained on location for up to a year awaiting a crew. A direct comparison of drilling rate (after spudding) could reveal productivity levels much closer to U.S. figures.
A corroborating piece of anecdotal evidence reported by Eastern Bloc Energy concerns the much-celebrated drilling crew of Gennadii Levin, who are reported to have established national drilling records of over 160,000 m/year (525,000 ft/year). By comparison, the average U.S. drilled footage is approximately 160,000 ft/rig year.
Because C.I.S. drilling crews move between rigs which are already rigged up, the drilled footage recorded by an individual crew is significantly higher than that calculated for an average U.S. rig. U.S. rigs' drilled footage is influenced by rig moves and setup time. Consequently, with better management of logistics and available resources, local drilling crews could offer comparable productivity levels, on a per rig basis, with considerable savings in labor rates.
On the supply side, Western firms do not have significant advantages in basic drilling equipment. Local firms produce completely adequate drilling rigs, drillstrings, casings, and cement for normal service applications.
Drilling rigs are manufactured by the Uralmash Co. at Ekaterinburg and the Barrikady plant at Volvograd, both in the Russian republic. Some rigs have been imported in the past, mainly from Romania. Despite reported financial problems at the Russian plants, it is unlikely that there is an opportunity for Western rig suppliers, except for deep drilling applications.
In the past, the C.I.S. has imported Christmas trees, blowout preventers, and beam pumps. Romania supplied nearly 70% of the C.I.S.'s drilling equipment imports in 1990.
Although Western firms can now compete directly in hard currency terms with Romanian imports, for normal applications it is not clear that sufficient technical superiority exists to surpass the advantages of familiarity with the products and available spare parts.
DEVELOPMENT
For the development of proven fields, directional and horizontal infill drilling and enhanced oil recovery techniques offer significant potential to increase production in a relatively short period of time. Many of the biggest opportunities in the C.I.S. ire found here; the Amoco Corp., Chevron Corp., and C.F.P. Total ventures could all be categorized in this area. The success of this type of operation is critical to the rapid recovery of C.I.S. crude production.
Provision of reservoir engineering services is also an area of significant potential. Forrest A. Garb & Associates of Dallas is currently starting three projects providing reservoir engineering services. Few local firms exist which provide these types of services, although some Russian technical personnel have begun to form consulting firms with advice from Western experts.
WORKOVERS
The older fields offer tremendous opportunities for Western service firms to achieve considerable production improvements by the use of relatively straightforward procedures such as well workovers, equipment repairs, and regular preventive maintenance programs. Good returns are available for relatively small investments and certainly without the risks associated with exploration in new areas. One estimate puts the number of wells in need of workover as high as 20,000.
The workover potential is particularly attractive because it plays on one of the former Soviet Union's greatest weaknesses-the inability to set up supply and logistics chains. This problem is a legacy from Marxism, which condemned such intermediaries (traders and wholesalers) as "parasites" in a system which considered only producers as making a worthy contribution to society.
In general, many of the services in the development and workover categories were not used in the former Soviet Union.
Extensive waterflooding was applied to most fields since the beginning of production. The typical response to declining production was to drill infill wells. The consequence of these actions was early damage to the reservoirs.
OPPORTUNITY FRAMEWORK
Opportunities arise for Western service and supply firms typically under two scenarios:
- Whenever there is an identified need in one of the sectors of the C.I.S. oil and gas market and the need is key to the further development of that sector
- When local or international competitive presence is small.
To evaluate the relative attractiveness of opportunities, the criticality/relative advantage framework has been developed (Fig. 6). The basis of this framework is that the attractiveness of the opportunity is directly related to two principal factors:
- The criticality of the identified need to the industry sector.
- The relative advantage which the Western firm enjoys over local firms in the market.
Criticality can be primarily determined in terms of impact on the profitability of the industry sector. Impact is a function of the magnitude of the change and, very importantly, the speed with which the change occurs. Thus, the importance of the service or equipment is related to its increase in revenue generation through an increase in production rates, a decrease in costs, an increase in productivity, or a reduction in downtime and unplanned maintenance.
The relative advantage of Western firms has traditionally involved a trade off between technical superiority and product quality offered by Western firms and the relatively low cost prevailing in the local market. This comparative analysis has become more complicated with recent events.
Western firms have discovered that personnel from Russia and other republics are often very capable technically. The heretofore automatic assumption of achieving technical superiority in service operations with the use of Western personnel is no longer valid.
Additionally, some manufacturing facilities in the C.I.S. are equipped with modern machine tools, eliminating some of the Western manufacturing advantages. Under certain circumstances, the use of Western equipment, drilling rigs for example, may prove to be a disadvantage if there are no spare parts or maintenance expertise available in the area where the equipment will be used.
Cost comparisons have also become more complex with the breakup of the Soviet Union and the Eastern Bloc. The key impact of the collapse of the ruble relative to Western currencies is the pricing out of Western products and services, except for those goods and services which are the most technically innovative or are indispensable to production.
Some mitigating factors work in Western companies' favor, however. Whereas previously, equipment obtained from within the Eastern Bloc was priced in nonconvertible rubles, Russian oil and gas ventures must now pay hard currency for all imports from other C.I.S. republics or other Eastern Bloc countries. These effects are more applicable to products; for labor costs, there is still a clear difference between Western and local firms.
The framework suggests that the most attractive opportunities in the upstream sector will occur in well workovers, field facility rehabilitation, and enhanced recovery techniques such as well stimulation.
The criticality of these areas is extremely high because of the decline in production from existing fields and the delays in bringing new fields on stream. No local expertise currently exists in these areas because these techniques did not have widespread use in the former Soviet Union. Reservoir engineering services can be categorized similarly.
For the companies mentioned previously in the article, most successes to date in the C.I.S. have been in the critical need/high relative advantage segment (Fig. 6).
DRILLING
With respect to drilling, the relative advantage factor can be clearly illustrated. Whereas Western expertise can provide a significant technical advantage in the area of horizontal or directional drilling, Western firms offering conventional drilling services cannot justify the huge cost difference over technically capable C.I.S. crews. The technical advantage of Western personnel and equipment will again become the dominant factor for deep drilling and for drilling in arctic or offshore locations, however.
An area which appears unattractive based on this conceptual framework is the provision of drilling rigs and tubular goods. Rigs and tubulars are not in critical demand because of current availability of supply and because no significant Western technical advantages exist to offset the price premium over locally manufactured goods.
Technically sound drilling rigs, although somewhat dated, are available at a considerable price discount compared to Western products. This situation may change if the reported problems in the Russian drilling rig plants escalate and a supply shortage occurs.
With respect to tubular goods, the technical advantage of Western products appears to be declining as Russian and Ukrainian plants produce more specialized products. For example, the Novotrubnyi plant at Pervouralsk produces sulfur-resistant pipe for gas lift systems and stainless steel pipe. The Severski pipe mill of Polevskoi produces high strength casing and casing with special joint threads.
There are still some drilling equipment sectors where opportunities may be found, but only if Western firms can offer technical advantages.
In the past, Dresser had set up a rock bit plant in Kuybyshev, and the plant was later turned over to a Soviet company. Dresser is aware of requirements to update the plant with newer technology and a heat treating facility. In addition, the company has examined proposals to set up a mud company and a facility to manufacture packers and tubing perforators.
With respect to production equipment, there are requirements for facilities to manufacture compressors, gas turbines and high pressure gas compressors, piping valves, and control systems for gas injection schemes.
Western firms still have advantages in providing expertise to manufacture equipment for sour or highly corrosive service where more exotic materials are required.
A relative advantage for Western equipment also results from a lack of available supply of local goods. The waterflooding techniques create a huge demand for high capacity submersible centrifugal pumps. This demand cannot be met by C.I.S. manufacturing capacity alone, hence the need for imported pumps.
SUCCESS FACTORS
Many of the oil field service and supply companies have sold services or equipment directly to major or independent oil companies that are part of joint ventures in the C.I.S. Others have been successful selling equipment directly to C.I.S. associations or enterprises on hard cash terms, usually by means of a guaranteed letter of credit.
Success has proved more elusive to date for Western service or supply companies who opted to proceed via the joint venture route. Many companies have failed to reach a satisfactory agreement at the negotiating table. In many cases, the root cause of failure was a lack of confidence that a suitable investment return would ever be achieved to justify the risk and uncertainty of the investment in the joint venture.
Nonetheless, to achieve a significant long term presence in the C.I.S. and fully exploit the market opportunities, Western firms should still consider the joint venture route. An examination of successful joint ventures, with particular reference to the experiences of Siberian Sperry-Sun, identifies the following key success factors:
- Use a controlled entry.
A low profile, 'testing the waters" type of venture is a good starting point for a joint venture relationship. Early success with a small endeavor can build the confidence of both partners and pave the way for future investment. Royal Dutch/Shell used such an approach to enter the C.I.S. market by buying into the Fracmaster joint venture.
Even Chevron's huge Tengiz joint venture agreement is structured in such a way that progressive investment depends on a demonstrated ability to repatriate dividends from earlier activities.
- Minimize exposure to risk.
The initial investment should be limited to an amount which can be written off under a worst case scenario without endangering the financial stability of the company. The equipment used should not be critical to operations in other areas, if possible.
- Ensure partner's commitment.
The deal must be as attractive as possible; a real financial incentive for both partners is necessary for a venture to succeed. A partner's commitment will have particular importance if payment is to be made in crude or products. The partner can ensure that the crude or product is delivered according to specifications and that the appropriate export licenses are in hand. (The Western joint venture partner must also have in place an arrangement to sell the crude or products outside the C.I.S.)
- Maximize Russian/C.I.S. content.
The objectives of the C.I.S. are to restore the oil and gas industry as quickly as possible by using Western capital and a transfer of the latest Western technology to local personnel. The local personnel are well educated and technically very competent. They have a desire to learn new methods and technology and assume responsibility for the new businesses.
The republics are under pressure to maintain employment of local personnel where possible and ensure their economic well being. A successful joint venture must plan to maximize local content at each stage of the venture's life and design the organization accordingly. The business advantage of this strategy is that a local staff is considerably less expensive than expatriates.
- Plan for new obstacles.
The business climate is still extremely uncertain. Western companies can expect changes in import duties for supplies and equipment, laws regarding repatriation of dividends, income tax rules, and export rules. A company should obtain a "grandfathering" type arrangement to maintain a stable basis for operation or design an agreement which is flexible to changes in laws (e.g., a service agreement in which prices can be raised if taxes orange).
- Plan for ambiguity.
Various republics, regional authorities, and local associations may have unique stipulations. Decrees are frequently issued but often amended or canceled shortly afterwards. A joint venture partner with a real incentive for success can be a powerful help in overcoming difficulties here.
- Investigate innovative opportunities with existing joint ventures.
Some companies will not work with direct competitors but will work with others that offer services which are either upstream or downstream of their market segment. In this manner a broader range of services can be funneled through a successful existing joint venture.
Copyright 1992 Oil & Gas Journal. All Rights Reserved.
