Russian oil price-setting mechanism evolving toward world standard

March 13, 2000
As a result of the privatization process under the direction of former President Boris Yeltsin, Russia's petroleum assets have changed hands over the past 9 years from a centrally controlled state monopoly to an oligopoly of 11 major, regionally defined oil companies.

As a result of the privatization process under the direction of former President Boris Yeltsin, Russia's petroleum assets have changed hands over the past 9 years from a centrally controlled state monopoly to an oligopoly of 11 major, regionally defined oil companies.

This transfer of wealth into private hands, however, and the end of government-set oil prices have created an infant market for competition among producers, refiners, bankers, traders, and metropolitan areas that may eventually lead to global integration.1

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According to Andrei Sergeev, a petroleum trader in Moscow, oil prices depend on the distance between the producing site and the refinery. For example, "Producers located in Siberia set their price 5-6% lower than ones operating in the Urals." This is so Siberian producers can stay competitive, because transportation costs from Siberia to refineries, mostly located in central Russia, are higher than in the Urals.

However, like all petroleum markets, crude oil type also plays an important role in price levels. "In Bashkiria, we have low crude oil quality with a high sulfur content, which costs 40% lower than Siberian crude and is 35% lower than in the Urals," Sergeev said. Thus, "This oil is delivered specifically to specialized refineries in Bashkiria."

And gasoline prices, which are highly dependent on supply and demand, also vary from region to region. For example, in the Perm region (Urals), middle-octane gasoline costs $206/tonne FCA (free carrier) at the refinery, but in the Ryazan region (central European Russia), it costs $200/tonne FCA at the refinery. Sergeev noted: "This [$6/tonne] difference covers the transportation costs from these points to each other. So if we want to deliver the product from one place to another, or the place where a local refinery serves local demand, it would not make sense, because, after delivery, we would still get the same price that has been pegged by the local traders."

The government tries to regulate these prices indirectly by giving some operators partial tax exemptions if they peg their prices for a certain time. In addition, the government may step in, as it did last year, and close pipeline export access or raise export taxes in order to divert cheaper supplies to farmers in times of need.

But the main force that affects the prices is the market. "This is because everything depends on the ability of the end-user to pay for the product," Sergeev said.

Regionally, rival companies compete in certain markets from which the local authorities can become either "main allies or enemies."

Yet, similar to tactics used over 100 years ago by Standard Oil Trust founder John D. Rockefeller,2 barriers of entry for small refiners can become quite high, as larger refiners, such as Lukoil or Tyumen Oil Co., aggressively cut price below cost to maintain or increase market share.

Nevertheless, the overall market depends on local demand and the prices of the neighboring refineries, which can be oriented towards export products or towards local power plants, the agriculture sector, or filling stations.

Price setting

The impetus for price-setting used by major refinery owners is simple: those companies that can export only limited amounts of crude are forced to sell the rest on the domestic market, Sergeev notes.

Thus, "They try to raise the domestic prices as high as possible until the local buyers stop buying." Next, these companies establish price elasticity by setting prices "a bit lower," which is then fixed for a certain period of time.

Sergeev does not think domestic Russian prices will approach world levels in the near future. The demand is rather narrow, payment terms are often 10-20 days with deferred payment, and the buyers do not have enough cash to pay against delivery and are instead wholly dependent on point-of-sale end-user demand for their goods. "A lack of cash is the most common disease," he said.

Sergeev outlined the product flow from the field to market:

"Your clients-the gas stations and other buyers-make the order for quantities for the next month. Next, the marketing units enter into contracts with the product buyers, who then fix the price. Then you fix the crude oil price with your oil producer on a long-term basis."

At this point, the producing oil company initially has an agreement with the state-run pipeline monopoly, Transneft, which "sets the prices for transportation at its discretion and often without apparent necessity." Thus, the payment for transportation affects the crude oil producer and buyer. Transneft then delivers the oil to the port for export or to specified refinery. At the refinery, the company manufactures oil products based on a processing agreement wherein the cost of service output for each product is set beforehand.

In about a week, after the refinery processes the order, the buyer can instruct the refinery to order the tank cars and ship the products to the final destination via pipeline or railway.

Thus, a market mechanism for selling crude and products has now gained a foothold, as shown by the relationship between Russian domestic crude and world oil prices (see chart). Other than at the time of the August 1998 ruble devaluation, Russian crude has paralleled the Brent crude spot price over the past 2 years.

Currently, with prices for Brent at about $29/bbl, domestic prices for Siberian oil averages $17/bbl, whereas Ural crude costs about $15.50/bbl. Sergeev says that, although a futures market has not developed yet in Russia, operators now understand this instrument can be used for making plans.

References

  1. Gustafson, T., "Capitalism Russian-Style," Cambridge, 1999.
  2. Chernow, R., "Titan: The Life of John D. Rockefeller, Sr.," Vintage, New York, 1998.