RUSSIA STRUGGLING TO REVIVE PRODUCTION, REBUILD OIL INDUSTRY

Dr. A. Konoplyanik
Former Deputy Minister
Russian Federation Ministry of Fuel and Energy
Moscow

The Russian energy sector and, in particular, the oil industry have been passing through hard times.

The decline in energy production continues. Total primary energy production decreased in 1992 by 104.5 million metric tons of coal equivalent (TCE), or 6%, from its level in 1991. Primary energy consumption in the country dropped by 47.8 million TCE, or 3.8%, and energy supplies to the countries of the former Soviet Union (F.S.U.) were diminished by 23%.

The oil industry faces a very difficult situation. Oil and gas are among Russia's principal sources of wealth. The federation's reserves of hydrocarbons constitute over one third of the world total. They are sufficient to serve as a source of the country's prosperity and meet a considerable portion of the world's demand for oil and gas.

Over the past few decades, Russia's oil and gas industry developed rapidly, providing for the raw material requirements of the F.S.U. and yielding a large part of hard currency earnings through the export of oil and gas.

During the past few years the gas sector has developed relatively rapidly, but there has been a substantial decline in oil production--more than 20% during 1986-91.

Oil production in 1992 was 62.3 million tons lower than in 1991 and 170 million tons lower than the record high of 1988. That is equivalent to revenue losses of $20-22 billion/year, which in turn is equal to half of Russia's 1993 foreign debt repayment obligations if existing restructuring deferrals are not taken into account.

According to the Ministry of Foreign Economic Relations, debt repayment obligations amount to 541.8 billion. Last year, all of Russia's export earnings totaled $44 billion, but the country was able to pay lenders only $2.5 billion out of $75.8 billion of the total foreign debt of the F.S.U.

This is why problems in the oil industry are so important.

This year the situation in the industry remains difficult. Oil and condensate production are expected to total 350.6 million tons, which is 48.2 million tons, or 12.1%, lower than in 1992. The total export volume is expected to be 38.3 million tons in 1993-27% lower than in 1992.

CAUSES OF CRISIS

Russia's major high-yield deposits of oil are 60-90% depleted, which is largely why production has dropped so much.

Overproduction and inefficient secondary recovery methods have sharply increased the water cut of produced liquids in many areas. Many fields are now idle, and the proportion of marginal reserves to the total has increased. The deterioration in quality of residual reserves will require more financial, material, and technical resources than before for development.

The quality of new discoveries also has deteriorated. No highly productive deposit has been found recently. The average production from new wells in the Tyumen region, Russia's main oil province, fell from 138 tons/day/well in 1975 to 12-13 tons/day/well in 1992. Thus, the financial, material, and technical costs of producing 1 ton/day from new wells has risen 10-fold in 17 years.

Financing of exploration has dropped. This and the reduction in quality of new reserves resulted in a progressive reduction in the absolute growth of oil reserves.

From 1989 on, financing for geological work dropped by 30%, and volumes of exploratory drilling were reduced b), the same amount in West Siberia, where the level of development of forecast resources is about 35%. Reserves growth has stalled as a result.

The sector needs advanced technology and equipment. Most of Russia's technical resources are more than 50% depreciated. Only 14% of its machines and equipment meet worldwide standards. Some 70% of the assets at drilling installations are outdated and need replacement. And a third of the federation's well repair units were taken out of production 5-7 years ago.

The domestic industry satisfies only 40-80% of the sector's requirements for the principal types of material and technical goods. After the collapse of the U.S.S.R., the situation with respect to supplies of oil field equipment from the Commonwealth of Independent States republics deteriorated. Being monopoly producers of many types of goods-Azerbaijan alone currently owns about 37% of the material and technical goods produced for the oil industry-factories in the republics are inflating prices and cutting supplies of equipment to Russia.

Low domestic oil prices have made it impossible for oil production enterprises to finance themselves, despite a series of increases in oil prices. At the same time, a high rate of reserve depletion has created the need for an accelerated rate of compensation for diminished extraction capacities. In the absence of such compensation, the oil sector's access to material, technical, financial, and hard currency resources has suffered.

Total investment in the oil industry during 1992 fell by 25-30% from its level in 1991. At the same time, budget appropriations, previously the main source of financing, fell by more than 40%.

DRILLING DECLINE

The sharp reduction in government investment, the shortage of hard currency resources available to enterprises, and the severed economic relations with some republics of the F.S.U. have led to a sharp decrease in supplies of oil field and drilling materials and equipment. Drilling has declined.

In order to maintain Russia's current level of oil production, the industry must install facilities providing for the extraction of 118 million metric tons/year. This will require the drilling of 62 million m of development well borehole. Drilling totaled only 27.6 million m in 1991 and 20.3 million m in 1992.

During the last few years, oil and gas production enterprises have been subject to consistent shortages in supply of material and technical resources needed to keep wells producing. Moreover, equipment supplied by domestic factories is of low quality, leading to increasing requirements for repairs.

The number of idle wells has, therefore, increased sharply. As of Mar. 1, 1992, there were more than 25,000 idle wells--17.3% of total. Of the idle wells, 12,400 were technically productive.

At the beginning of this year, 31,900 wells--21.7% of total--were idle, including 12,800 considered technically productive. Idle productive wells are estimated to be able to produce an average of at least 8 tons/day each. Thus, at least 30 million tons/year of oil remains unproduced because of well problems.

Pollution has become a particularly serious problem in the oil sector, mainly due to the shortage of efficient and environmentally safe equipment. This means that much material and money now goes to resolving problems that do not lead directly to increased oil production.

The refining industry's upgrading capability hasn't changed much since the 1970s. Equipment depreciation and low technical standards require high refinery consumption of petroleum products and product yields out of proportion to demand.

Unleaded gasolines and low sulfur diesel fuels represent about half of total products output. The share of high-index lubricants is even smaller.

Refining capacity is in surplus in some regions and deficient or nonexistent in others. Transportation requirements are high, making many areas susceptible to disruptions in supply.

DEMAND-SIDE APPROACH

In the long term, it is impossible to solve problems of the fuel and energy complex without restructuring the whole system of energy utilization and implementing energy-saving technologies on a wider basis.

At the end of the 1980s, energy intensity--the amount of energy consumed per unit of gross national product (GNP)--of the U.S.S.R. and Russia was twice its level of the major West European countries and 1.5 times higher than that of the U.S.

During 1990-92 the level of economic activity in Russia declined by 18-20%, but energy consumption stayed almost constant. Energy intensity thus increased by 16-18% and significantly exceeded its all-time high of 1975. In 1992, the GNP energy intensity was 34% higher than in 1988, the year of maximum energy production.

It is estimated that Russia could reduce its energy consumption by 35-40% through efficiency improvements and conservation, which would reduce production costs or leave more energy available for export.

Investments in energy conservation are two to three times more effective on a macroeconomic basis than incremental investments in energy production due to reduced consumer costs. Russia, therefore, has adopted a strategy of maximum improvement in energy use efficiency.

Any major results of such energy-conscious policies--from the technological and structural energy savings--will not appear until perhaps 57 years later, and during the first 2 years the initial investment requirements of energy conservation programs may be as high as or even higher than the costs of normal energy expansion.

At present, the primary short term objective is to stabilize Russia's energy production and, first of all, to halt the runaway slide in oil production.

If all of these trends persist and current domestic demand for crude and refined products follows current patterns, the country may have to import crude or products within the next few years.

FINANCING DEMANDS

Today, foreign investments in the Russian oil industry may effectively contribute to the stabilization of the oil industry.

The government on June 1, 1992, adopted decrees NN 368, 369, and 372 specifying short and medium term (through 1997) requirements for $30 billion in external financing for oil production and refining. That is only 1.4-1.5 times the export value of the amount by which current annual oil production falls below the historic peak.

Only one source of external financing existed for the economy of the U.S.S.R. and Russia in the recent past. That was foreign, almost completely governmental, loans secured by governmental guarantees. These loans were distributed by government agencies among enterprises at no cost.

Currently, as Russia has been transforming to a market-oriented system of business management, enterprises have become more economically independent, and domestic oil supply can hardly meet demand.

The monopolistic form of providing external financing is no longer appropriate. The required $30 billion cannot be provided exclusively in the form of debt, which would require 50 million metric tons/year of additional oil exports during 1993-98. And with the oil industry in its current condition, debt financing on such a scale is impossible.

Hence the emphasis on direct foreign investment. And with that emphasis comes attention to private investment, since at least 80% of international financing flows come from nongovernmental sources. The necessary change is clear: from government loans to direct private investments.

Unofficial assessments indicate that foreign investors are ready to invest as much as $60-70 billion in the Russian oil industry. That is even higher than short-term external financing requirements. But, of course, these investments won't be made immediately for several reasons.

At present, competition for international investments is high. Many firms and financial institutions prefer to keep investing in traditional oil producing countries with stable legal and economic environments, such as the Middle East, Southeast Asia, or the U.S., rather than enter the new and risky Russian oil market, previously closed to most foreign investors.

However, this market possesses tremendous appeal. Russia has a large resource base, production costs that compare favorably with many other countries, highly skilled workers, relatively low wages, and the potential for conversion of former defense industries to production of oil and gas equipment.

However, no major rechanneling of cash flows in favor of Russia can be expected until the country creates an investment climate that would be at least as favorable as that in the traditional oil and gas producing areas.

Western analysts believe that for the time being many obstacles and uncertainties exist for investment in the Russian oil and gas industry. Tables 1 and 2 summarize some opinions from the U.S. and Canada.

These opinions can be accepted or questioned (particularly with respect to inconsistency of the decisions of the Russian government or its president with Russian law as observed by U.S. analysts). But at least they represent a system of concepts that are entertained by at least some of the North American oil business community.

If we are to promote a practical and mutually beneficial interaction with western industrial groups and financial institutions, we should learn to live with these opinions and, consequently, take into consideration what we perceive to be uncomplimentary or erroneous pronouncements.

RECENT INVESTMENT CLIMATE

Even a few years ago, none of the above problems in the relationship with foreign investors existed.

Until very recently, notably while the U.S.S.R. was still a union with its powerful institutions of central government, federal agencies were in charge of any contacts with foreign companies. Such agencies naturally preferred to go to a handful of major companies for investment.

The agencies were oriented towards foreign companies located at the top tier of the industrial and financial hierarchy and possessing formidable economic capability. This narrowed cooperation to a small number of multibillion dollar superprojects and an equally small number of credit lines obtained from the governments of their home countries.

The agencies were able to keep these projects under constant control. And the projects usually required governmental guarantees, which could be obtained only through government authorizations for particular investment projects, credit lines, and commercial deals.

Therefore, alongside the widely used intergovernmental financial agreements, virtually the only other type of interaction with foreign companies were the so-called diagonal deals, whereby a contract is executed between the government of the host country and the foreign company in question, rather than between two companies-that is, between economic entities of the same level.

Under such government-controlled circumstances, any legislation regulating investment, trade, and political issues became redundant. Cooperation with a small number of large companies could occur without such laws, relying on government resolutions adopted case by case. Besides, no one questioned the legitimacy of direct contacts between the supreme government agencies of the old U.S.S.R. as the host country and major foreign monopolies with annual sales equivalent to the GNP of small countries. Now governments are decentralizing, enterprises and associations in increasing numbers are entering into direct relationships with foreign companies, and the scope of cooperation with potential foreign investors is growing through the enlistment of small and medium sized businesses from both sides.

In these circumstances, the former scheme, the "system of individual legal restrictions," (or "agreement system") ceases to work. The number of entities involved is too great.

The only legal regulatory medium for the relations between the host country, which owns the subsurface, and the prospective investors is a branched system of economic laws. Such a system is only emerging in Russia.

According to V. Shumeiko, first vice-premier of the Russian government, the country will have to draft and enact at least 100 laws for such a system to fully emerge. Y. Shafranik, Russian minister for fuel and energy, believes that at least 50 laws are required for normal privatization alone.

The existing laws and regulations do not include many general and specific laws and regulations to govern the activities of the energy sector and, specifically, the oil industry in a market-oriented economy or in the transition to such an economy. It is for this reason that we attach so much importance to creating the necessary business and legal environment in the energy sector, particularly in the mining industry, which suffer from the largest number of legislative "white spots."

LEGISLATIVE ACTIVITIES

At present our internal legislation includes legal fundamentals that regulate relations between the owner of the subsurface and the investor, as well as other aspects of the use of the subsurface.

In June 1992 the Supreme Soviet of Russia adopted the law "On the Subsurface," and in September of that year it adopted the "Procedure for Licensing the Use of Natural Resources."

In October 1992 the Russian government approved the regulation "On the Procedure and Conditions for the Right to Use the Subsurface, Water Areas, and Sections of the Seabed."

In November, pursuant to Pres. Boris Yeltsin's October decree "On the Introduction of an Excise Tax on the Users of Underground Resources in the Territory of the Russian Federation," the government adopted the resolution "On an Excise Tax on Oil Produced in the Territory of the Russian Federation."

In February 1993 the Supreme Soviet approved the regulations "On the Off-Budget Fund for the Replenishment of Known Mineral Resources." And the Russian government adopted the resolution "On Price Control in the Oil Industry."

The Russian Ministry of Fuel and Energy, the Russian Ministry of Science, and other agencies developed a concept for Russia's new energy policy, which was reviewed and approved by the government in September 1992. The concept contemplates the drafting of a package of prior" laws to regulate energy operations.

The procedure for the development of this legislation and the schedule for its submission have been agreed upon by the leadership of the Supreme Soviet (Table 3). For the energy sector as a whole, the most important bill is the one entitled "On the Fundamental Energy Policy of the Russian Federation," the first version of which should be ready soon.

To coordinate the drafting of the legislation outlined in Table 3, the federation government, in concurrence with the Supreme Soviet, set up an interdepartmental coordinating group headed by A. Samusev, deputy minister for fuel and energy. Working groups to prepare each of the other draft bills have been set up.

Work is under way to draft the laws entitled "On Oil and Gas," "On Concessions and Production Sharing Agreements," and "On Amendments to the Fiscal System of the Russian Federation With Respect to the Use of Energy Resources and the Operation of Energy Facilities." All of the above are priority bills for the oil industry.

OIL AND GAS LAW

Soon the draft law "On Oil and Gas," the main dedicated law for oil and gas industries, will be completed.

When working on this draft law the special interdepartmental commission managed to avoid some errors made during the preparation of the law "On the Subsurface," such as submission to the Supreme Soviet of two conflicting versions prepared by the Russian Committee for Geology and the Ministry for Fuel and Energy.

The attempts to agree upon these versions were made at the early stage of discussions in the Supreme Soviet, which often resulted in confrontation of the two versions, mutually exclusive in some respects, rather than in the desire to find a mutually acceptable wording of certain articles.

There seems to be no such confrontation this time despite the fact that three versions of the draft law on oil and gas initially existed as compared to the law "On the Subsurface," which only had two.

The first version of the law on oil and gas was prepared by the Vniioeng Institute. It is called the Tishchenko version, by the name of the study group manager and institute director.

The second version, called the gas version, was prepared by Ministry of Gas Industry experts who proposed separate laws for oil and gas.

The third version, called the Gazeev-Hardy version, was the result of a joint effort of the group that included Russian experts, headed by M. Gazeev, a department manager of the Vniiktep Institute, and the World Bank experts headed by George Hardy 111, a professor of law at the University of Houston.

These versions were discussed and reviewed by the Ministry of Fuel and Energy and other interested governmental organizations, by Russian and foreign experts and organizations, and by independent experts at conferences and workshops including international forums, as well as by the Supreme Soviet Committee for Industry and Energy Engineering.

Based on the experience of passing the draft law "On the Subsurface" through the Supreme Soviet, it was understood that a uniform trade-off version of the draft law "On Oil and Gas" should be prepared. To this end, a commission headed by Samusev was created, together with a special subcommission, a working group of experts headed by A. Perchik, a professor of law at the State Academy of Oil and Gas.

The trade-off version of the law, known as the Perchik version, is now under independent expert examination and review in order to prepare this draft law for submittal to the Supreme Soviet.

EUROPEAN ENERGY CHAPTER

In December 1991, Russia, among 48 other nations and two intergovernmental organizations from three continents, signed the European Energy Charter, which became the first international agreement signed by the republics of the former U.S.S.R. as independent sovereign states.

Currently, active negotiations are under way on a package of binding legal documents supplementary to the European Energy Charter. They include the Basic Agreement, which, as opposed to the charter per se, a purely political declaration by the signatories, will be a multilateral horizontal commercial, political, investment, economic, and legal agreement, and vertical protocols on cooperation in selected energy sectors. Among these, the Protocol on Hydrocarbons is the most significant.

In our lawmaking activities we assume that relations with all states and companies should be built on principles stated in the European Energy Charter and the supplementary binding documents.

Pursuant to these documents, a common energy, economic, and legal space for the whole industrially developed world will be created. Fifty European, North American, Pacific Rim, and C.I.S. states are negotiating the document package. Here, uniform conditions will be created for all participants with respect to access to energy resources, markets, transportation facilities including transit privileges, technologies, capital markets, etc.

Such a system would provide a balance of interests for the host countries and potential investors in terms of both investment regimes as well as commercial and political issues.1

We believe that the development of our internal energy legislation is closely linked to the negotiations in Brussels since the problem of creating the necessary economic and legal environment in the Russian energy sector includes three distinct aspects, which should complement one another:

Creation in the domestic legislation of a series of special energy laws reflecting the distinctive features of the energy sector, including its mining industries, as an object of legal regulation. Currently, a package of 11 basic legislative acts related to activities in this sector is under development. Nine are designed for internal use in the energy industry (Table 3).
Development of diversified general legislation, with the energy industry as one of its objects; for example, tax and concession laws.
Development of a system of bilateral and multilateral international contractual and legal acts facilitating integration of our national economy into the world economy and into the system of international economic relations; for example, international agreements on mutual protection of investments, on avoidance of double taxation, and so forth.

In our view, development of an efficient and balanced package of legally binding documents as a supplement to the European Energy Charter and their ratification by the parliaments of the negotiating parties will undoubtedly help stabilize the business environment in the energy industry of Russia and make it less risky.

INVESTMENT RISKS

According to both western and domestic experts, the current environment is still characterized by a high risk for potential investors.

We have already analyzed western estimates of risk for foreign investment in Russia and the other C.I.S. countries.2 3 These estimates dictate that minimal rates of return which would satisfy the U.S. investor should be 25-40% higher in Russia than in Western Europe and from 66-75% higher than in the U.S., thus reflecting the perception by some U.S. companies of the relative risk of investment in the former U.S.S.R. (Fig. 1).

A similar picture with respect to risks typical of the business climate in Russia is presented by Univers, an independent Russian information agency. According to its data, quantitative estimates of risk he in the range between the mean and worst possible values for each of three assessed risk categories -- socio-political, internal economic, and foreign economic.

Developments that occurred in the second half of last year and in the beginning of the current year caused an insignificant increase (4%) in sociopolitical risks and a noticeable (33%) increase in foreign economic risks. As a result, the weighted average estimate of risk involved in the Russian business climate has gone up 8% in 6 months (Table 4).

Nevertheless, despite repeated statements to the effect that oil business in Russia is highly risky, many foreign companies spare no effort to secure a place in the Russian oil market. In a manner of speaking they are trying to establish a sort of stepping stone for the future large-scale expansion of their businesses in the country in case its legal and economic environment evolves in the investor-friendly direction.

Hence, about four dozen joint ventures that are operating or being established in the Russian oil industry seem to be for-ward-based emissaries of western investors. The objective of this task force is to formulate rules of the game and "show the flag" in the Russian oil business and also to track from the inside changes taking place in the Russian economic balance of forces.

Direct investments by foreign companies in the development of Russian oil fields are insignificant and only slightly exceed $150 million, according to the estimates of the Main Administration on Coordination of Foreign Economic Activities of the Fuel and Energy Complex, under the Ministry of Fuel and Energy.

Foreign companies, however, are very noticeable, particularly in Western Siberia. Data presented in Table 5 confirm that, showing that one fourth of the Russian oil fields and 40% of Tyumen oil fields will be matured to the production stage in 1992-2000 with participation of foreign companies.

Western companies participate in the activities associated with the development of proved recoverable oil reserves, which amount to one fourth of the Russian fields and about one fifth of the Tyumen fields to be developed by the end of the century.

More than a half of the Russian fields to be put into production in 1992-2000 with assistance of foreign companies, and 60% of oil reserves are located in the Tyumen region.

So it is not a matter of involving more foreign companies in the Russian oil business; their number is high enough, as shown in Table 5. Rather, it is a matter of providing a better environment for the existing interaction among Russian oil producers and foreign companies and of more benefits for Russia from the foreign capital in the petroleum sector.

REFERENCES

"European Energy Charter: First Anniversary of Signature," Finvest (Financial Newsletter), No. 51, 1992.
Konoplyanik, A., "Foreign Investments: Risk Ranges," Finvest (Financial Newsletter), No. 9, 1991, p. 12.
Konoplyanik, A., "The Less Risk, the Better," Energy: Economics, Technology, Ecology, No. 3, 1992, pp. 23-26.