RUSSIA GRAPPLING WITH ECONOMIC AND POLITICAL CHALLENGES

Lucian Pugliaresi LPI Consulting Inc. Washington, D.C. Russia remains the key to any substantial improvement in production in the Commonwealth of Independent States during the next 5-7 years. Despite a decline in oil reserves and the increasing complexity of oil fields' Russia still has one of the richest hydrocarbon bases in the world. The C.I.S. as a whole is at the stage of oil resource development that the U.S. was in the early 1960s. At the end of 1990, the C.I.S. had produced only

Aug. 2, 1993

15 min read

Lucian Pugliaresi
LPI Consulting Inc.
Washington, D.C.

Russia remains the key to any substantial improvement in production in the Commonwealth of Independent States during the next 5-7 years.

Despite a decline in oil reserves and the increasing complexity of oil fields' Russia still has one of the richest hydrocarbon bases in the world. The C.I.S. as a whole is at the stage of oil resource development that the U.S. was in the early 1960s. At the end of 1990, the C.I.S. had produced only 27-40% of its recoverable oil resources.

Russia can clearly support substantially higher levels of oil production if economic conditions improve.

The Russian oil industry, however, is in serious trouble. Russian oil production has declined from 10.4 million b/d in 1988 to approximately 8 million in 1992 and is expected to decline to roughly 7 million b/d in 1993. Largely because of that decline, exports of crude and products from the C.I.S. have fallen to less than 2 million b/d from more than 4 million b/d in 1988.

To end the production slide, Russia must quickly improve infrastructure and well rehabilitation work in Western Siberia, by far its largest and most important province. Many of the problems causing the downturn in production--such as inadequate well stimulation, bad cement, paraffin buildup, casing leaks, failure of mechanical pumps, and limitation of drilling depth--can be addressed quickly with adequate investment and appropriate technology.

But investment and technology must come from outside the federation, and access to them depends greatly on the extent to which Russia reforms its economy and the speed with which it does so.

Russia faces a formidable task in moving to a market economy. While the end of central planning is a signal of hope for the future of Russia's oil production, it is also a curse because of the large dislocations that will inevitably occur in restructuring the industry.

These dislocations have begun and are adding to the political turmoil and the sense of uncertainty on Russia's role in the world oil market.

SOURCES OF FUNDS

Like all C.I.S. countries, Russia must rely heavily on investment from oil companies. But assistance from western financial institutions can accelerate investment by helping create a stable investment framework. The pace of economic reform will affect total funding levels.

While the Russian government and regional authorities are struggling to please their various constituencies, they also must adopt suggestions on economic reform made by lending agencies such as the International Monetary Fund (IMF).

The IMF linked a promised $24 billion aid package to approval of Russia's reform program. The package includes as much as $4 billion in borrowing from the IMF, a $6 billion stabilization fund for ruble conversion, and almost $14 billion in aid from individual countries.

This aid package is especially significant for Russia's energy sector because a main demand of the IMF is that Russia move quickly to free oil prices.

In addition, the aid package makes project financing from the World Bank, in areas such as energy, readily available.

The memorandum on the economic policy of the Russian federation, which the IMF conditionally approved, called for a gradual increase in oil prices from 3% of the world level in January 1992 to 33% by April 20 and to 66% by the end of 1992.

Despite the fund's support of a gradual approach to price liberalization, Pres. Boris Yeltsin accused the IMF of demanding immediate liberalization of wholesale energy prices and has said that such action would hurt families and the agricultural sector. Yeltsin later announced postponement of further price increases.

Despite difficulties in getting the Russians to agree to a full reform program, the IMF changed the conditions for beginning the aid package and advanced $1 billion to Russia in July 1992.

Under the new plan, the IMF will divide the aid package into segments, starting with the $1 billion, which will be linked to a set of initial targets. This plan removes some of the pressure to increase fuel prices--further delays are likely--but it also removes some of the opposition to the reform program and gives the reformers time to make a case in support of the IMF assistance package.

CURRENT FUNDING

Although the Russians have not yet met all the fiscal and monetary requirements for full IMF funding for ruble convertibility, specific projects in the oil and gas sector are now receiving funding and support from the European Bank for Reconstruction and Development (EBRD), World Bank, U.S. Export-Import Bank, and various government-supported assistance agencies in the West.

The EBRD, although suffering from criticisms from member contributors, is now actively supporting small oil and gas ventures. Over the next 18 months, EBRD investments in the Russian oil and gas sector should exceed $200 million, much of which will be leveraged with Ex-Im facilities and private banks.

For the near term, the EBRD is focusing on rehabilitation projects (one project seeks to start 300 abandoned wells in Western Siberia), assisting in corporatizing production amalgamations, and in coordination with these programs, encouraging the government to establish various policy reforms (tax, legislation, etc.).

For the medium to long term, the EBRD will be assisting with pipeline rehabilitation and construction, and restructuring the electric utility sector.

The World Bank has now authorized a direct government loan of $610 million to three local Russian oil companies: Kogalymneftegaz, Purneftegaz, and Varienganneftegaz. This will allow these Western Siberia production amalgamations to contract directly, under competitive World Bank procurement rules, for oil field services essential for rehabilitation of their oil fields.

The International Finance Corp. is also getting involved and will likely invest in two projects shared by U.S. and Canadian companies.

The U.S. Ex-Im Bank has successfully funded one field rehabilitation project in Western Siberia and now has in the pipeline over $2 billion in proposals for field rehabilitation. Such projects represent the backbone of any strategy to stabilize production in Western Siberia.

Last April, Ex-Im Bank agreed to provide up to $2 billion to assist the Russian oil and gas sector, and under this plan all projects must involve rehabilitation. However, projects not involved in rehabilitation of existing fields can obtain loans and guarantees as well. Anderman/Smith received a $44 million loan to buy equipment for their project in Chernogar, which is a new field.

Ex-Im Bank plans to spend $500 million in the next 6-9 months on rehabilitation projects in Russia. The only constraining factor will be the ability of the Russian side to move quickly and structure the deals to meet Western investment criteria.

UNCERTAINTIES ABOUND

While institutional investment issues are being settled, oil company investment remains sensitive to the political questions still plaguing Russia. These political uncertainties, if not settled, will also undermine multilateral commitments for financial support to the oil and gas sector.

Yeltsin's victory in the April 26 national referendum was a positive sign that at least some of the political uncertainties could be addressed. More importantly, his victory gives his government some flexibility and time to continue with reform of the oil and gas sectors and gain greater political support from the West.

On a macro level, resolving jurisdictional disputes between federal and regional authorities over the resource base remains a critical problem. Many of the uncertainties associated with export tariffs, access to pipelines, and custom duties all reflect a lack of consensus (and authority) among competing jurisdictions.

Yeltsin's initiative to create a new Russian constitution is a vehicle for resolving these conflicts but so far has created more opportunities for the regions to assert their independence.

Moscow has recognized this problem for some time and is attempting to assert greater control. The new Minister for Fuel and Energy, Yuri Shafranik, has restructured the ministry to expand its influence over day to day operation. Of special importance is the ministry's responsibility for the allocation of export/import quotas, a critical component in the risk and potential profitability of any joint venture or production sharing investment by a foreign oil company.

At the same time as the ministry is seeking greater control, the government is also creating independent vertically integrated oil companies, which are to be the prime instrument for privatization of the Russian oil industry. The three initial companies are Lukoil, Yukos, and Surgutneftegaz.

Although the government will retain a 50% share in these three integrated oil companies, they are presumably free to make their own deals and export arrangements without interference from the central authorities. Whether these companies can, in fact, operate with full independence of Moscow remains to be seen.

Even with these changes in the structure of the Russian oil industry, irregularities in transportation fees, extra taxation from a regional authority, and region-specific environmental regulations all tend to work against the efforts of oil producers, Russian and foreign alike.

POLITICAL DILEMMA

The Russian government faces a political dilemma as a result of its cheap oil: While its hard currency earning potential can help dig out the entire economy, it is also a "low cost" resource heavily used by the country's industry and consumers.

Virtually the entire capital structure of the Russian Federation was constructed under the assumption of unlimited cheap oil. Clearly, change is needed, as well as foreign assistance.

The government is trying, on the one hand, to attract foreign investment and has encouraged greater independence for oil producers to stimulate production. On the other hand, it is trying to exert further control on the industry as a whole in order to manage the oil producers and regional authorities, to maintain deliveries to industry, and to keep prices affordable for the Russian people.

In other words, it is trying to do the impossible: simultaneously meet conflicting policy objectives, a strategy that could block genuine economic reform.

Early in February 1992, the Russian government announced a three stage plan to reform the oil industry. The first stage envisioned stabilizing prices for refined products. The second stage would see organizational restructuring in the oil industry via formation of holding companies that eventually would be privatized. The third stage would be privatization, overseen by a council of the Ministry of Fuel and Energy (MFE).

Last Feb. 25, Yeltsin's decree on "measures to stabilize the fuel sector" was published. It included these elements:

Enterprises, associations, and organizations that extract or process gas and oil are permitted to sell 40% of their production at free prices on the condition that they have completed their state deliveries. The Russian Federation Ministry of Economics and Finance and the MFE retain the right to change as necessary this level of sales at free prices.
Yeltsin named four production associations that are permitted to sell the entire volume of their petroleum production at free prices in order to stimulate the application of new methods of increasing production yield. The four associations are Termneft, Nefteotdacha, Tyumenneftegas, and Sakhalinmorneftegas.
Geological prospecting organizations have the right to sell at free prices any petroleum they extract.
The MFE and other key economic ministries are to work up a list of proposals for using foreign credits to import technical equipment, materials, and food for the petroleum producing regions. These ministries are also assigned the task of negotiating for foreign credit agreements to finance these imports.
The MFE and Ministry of Ecology and Natural Resources are charged with designing a program for commissioning new oil and gas fields for 1992-2000, using measures to stimulate accelerated development. The program should include the participation of oil and gas extraction enterprises, geological prospecting associations, including those from other republics, foreign investors, and the regional administrations in the affected areas.

LEGAL ISSUES

Of course, normalization can occur only after the question of ownership of resources is decided.

When the MFE was formed in September 1992, ownership of resources was considered to be the legal jurisdiction of the ministry. The MFE ceded control of resources to local producing amalgamations.

Further insights into what this means can be gleaned from the Law on Underground Resources.

This law outlines the procedures for exploitation of Russia's natural resources and contains some promising elements, including the possibility of concessions and production sharing agreements. The document stipulates that licenses for exploitation will be issued through tenders and auctions held by government agencies.

The law also outlines the split of royalties: 60% for regional authorities, to be divided between the region and the local oil producing area, and 40% for the Moscow government.

There is an upper ceiling of 5 years for exploration permits and 20 years for exploitation rights. The law stipulates that a different allocation of royalties can be negotiated by federal and local authorities in the case of strategically important wells.

The specific petroleum legislation under development offers promise to clarify some more of the ambiguities inherent in the Russian government's attitude toward its oil resources, but the slow pace of getting the legislation adopted reflects the inherent political conflicts that remain. The purpose of the legislation is to make Russian laws compatible with those in other countries and to create a favorable climate for the operation of domestic and foreign oil companies in Russia.

The Russian government has also grappled with tax policy, striving to find the proper mix to ensure enough state income while attracting foreign investment.

Western companies have complained not only about the taxes themselves, which, as long as they remain, will virtually eliminate new investment, but also about the arbitrary methods used to formulate tax policy.

CONCLUSION

Russia continues to struggle with the central elements of reform; i.e., who will own the resources, delegation of authority for transferring public resources for private development, structural reform of a politically powerful industry, and what guarantees to provide to the foreign investment community to alleviate concerns over political uncertainties that are still viewed as too high.

Even with these uncertainties, the enormous oil and gas reserve base of Russia represents a major and potentially profitable opportunity for western oil companies, oil service companies, and vendors.

There are some positive trends developing. In those areas where government authority is irrelevant or where enforcement of complex regulations does not take place, such as small business, the economy is expanding. Employment in the private sector continues to grow. There are strong indications that investments with low capital requirements and quick paybacks are increasing rapidly.

Rationalization of prices to consumers for both natural gas and petroleum products is beginning to take place on a more or less regular basis. Rather than price controls, the Russian government appears to be moving to a system of controlling the volume of oil and gas exports as a strategy for keeping domestic prices from rising too rapidly. We can expect some continuation of erratic tax and export licensing policy as a result. What the Russians are now missing is a framework which provides security for the large and essential long term investments for rehabilitation of the oil industry.

Even investments with payback periods over 5-7 years (such as many field rehabilitation projects) will require a greater degree of certainty than now exists. Building such a framework can of course come from a sound legal and political structure as well as assistance from multilateral lending agencies.

But perhaps what is needed now is some demonstration to jump-start western interest as frustrations grow. Whether it is the Barents Sea, Western Siberia, or offshore Sakhalin, a large demonstration of Russian willingness and commitment to do what is necessary to close a large deal could go a long way to get the essential long term investment under way.

The Chevron deal in Kazakhstan has provided an enormous boost in reassurance and interest among investors there. The Russians have several large projects on the table. Perhaps they should pick one up and make it work. Perhaps they will.