Russia’s Oil Woes
From the January/February 2007 Issue
Moscow’s attachment to statist economic policy is undermining its bid for global energy dominance, writes LEON ARON. By re-nationalizing its energy sector, Putin’s regime is slaying its largest golden goose.
The idea that Russia is a new “energy superpower” is all the rage in Moscow, thanks in part to President Putin’s vigorous salesmanship. The country holds between 6 and 10 percent of the world’s known oil reserves and exports around seven million barrels a day—second only to Saudi Arabia. Last summer, the Kremlin pushed hard to make energy security the centerpiece of the G8 summit in St. Petersburg. Lost in the crash of cymbals, however, is Russia’s uncertain ability to keep up with growing world demand—or even to maintain its current level of production, after a dazzling run from 1999 to 2004. While there are several reasons for concern, the underlying problem is sadly familiar in Russian history: a state ideology is poised to undermine the country’s progress at precisely the time when Russia seems on the verge of a breakthrough.
The government’s campaign to take control of energy firms began in 2004 with the selective prosecution of Russia’s largest and finest private oil company, YUKOS. In a series of blatantly rigged trials, Russian courts found YUKOS guilty of corporate sins and tax violations, including the nonpayment of a tax bill far exceeding the company’s profits. The company was bankrupted, and its most productive unit, Yuganskneftegaz, was sold through an intermediary to the state-owned Rosneft. YUKOS’s founder and principal shareholder, Mikhail Khodorkovsky, is serving a sentence of nine years’ hard labor at a prison camp in eastern Siberia. Soon thereafter, another leading private oil company, Sibneft, was purchased by the state-owned natural monopoly, Gazprom. In 2004–2005, the state’s share of oil production increased from 10 percent to 30 percent.
By re-nationalizing its energy sector, Russia is slaying its largest golden goose. Between 1999 and 2004, the much maligned “oligarchs,” as the young tycoons who became fabulously rich in the privatization of the 1990s are often called, invested over $36 billion, or 88 percent of their net profits, in “greenfield” exploration, drilling, and modern technology. Helped along by the cheaper ruble and an overhaul in the companies’ corporate management (which became leaner, more transparent, and responsive to the markets), the private sector’s oil production grew by 47 percent. Trillions of rubles were paid in taxes to the Treasury and, for the first time in post-Soviet history, dividends went to the shareholders.
By contrast, during the same five years, extraction by state-owned companies was up by a mere 14 percent. But ever since “acquiring” most of YUKOS, Rosneft—which was an obscure firm about to be put up for sale when Putin’s confidant and deputy chief of staff, Igor Sechin, took over as chairman—has aggressively continued to buy oil assets. Gazprom has been on a shopping spree of its own: in just the last three years it has spent $18 billion on acquiring “non-core” businesses outside the gas field (such as Sibneft, for $13 billion)—more than it has invested in exploration and production since 1996.
Thus, some of the most productive assets of the Russian oil industry have been transferred from the most transparent and efficient companies (YUKOS and Sibneft) to the least transparent and efficient (Rosneft and Gazprom). The result? After an average growth of 8.5 percent between 2001 and 2004, in the last two years, the growth in oil production has dropped to 2 percent.
Russia has begun to pressure the existing foreign operators of oil and gas fields into renegotiating their agreements.
Russia’s largest deposits of hydrocarbons lie thousands of miles away from the terminals that can carry them to world markets. The state-owned pipeline monopoly, Transneft, operates over 29,000 miles of pipeline. But of the seven million barrels a day that Russia produces for export, only about four million are shipped via the pipelines. The rest have to be transported much more expensively and slowly, by rail. This year, Russia’s production may exceed its total shipping capacity by between 220 and 294 million barrels.
The Russian pipelines are not only short of what’s needed, they are also old. Two miles in three were laid over 20 years ago. Breakdowns and leaks are becoming increasingly common. Last year’s survey of the 1960s-era “Druzhba” (Friendship) pipeline, which carries 1.2 million barrels a day to Eastern and Central Europe, found almost 500 “damaged points.” Last July, 11,000 gallons of crude leaked from the Druzhba near Russia’s border with Belarus, briefly shutting down the route and sending world oil markets up to about $75 a barrel.
Four years ago, a consortium of the largest Russian private oil companies offered to build a pipeline that would have carried one million barrels a day over 960 miles from the main fields in western Siberia across the White Sea to the terminals in Murmansk, the only northern port in Russia that does not ice over in winter. The project, estimated at about $4 billion, was to be financed entirely by private capital. By that time, however, economic re-centralization was becoming the dominant state policy, and the Kremlin turned down the construction, in effect vetoing private pipelines in Russia.
With some of its key potential domestic investors expropriated, scared into selling, or forced to reduce their investments because of the increasingly uncertain business climate, Russia needs a massive infusion of foreign capital in order to continue developing its energy sector. Here too, however, statist ideology trumps the country’s long-term interests.
As-yet-unwritten laws (which are understood as effective constraints on firms in the country) limit foreign ownership in joint ventures to 25 percent and bar companies of which foreigners own more than 49 percent from participating in the largest oil fields.
Moreover, Russia has begun to pressure the existing foreign operators of oil and gas fields into renegotiating their agreements. Last September, the authorities were suddenly so concerned about environmental and ecological “violations” that they threatened to halt the construction, led by Royal Dutch Shell, of the world’s biggest liquefied natural gas plant on Sakhalin Island in the Far East. Known as “Sakhalin-2,” the project is the largest direct foreign investment in Russia, estimated to cost Shell and its Japanese partners $20 billion. Projected annual output is 70 million barrels.
At the same time, pressure was also brought to bear on ExxonMobil’s offshore Sakhalin production (“Sakhalin-1”) just as it was about to start shipping. That project was expected to cost $17 billion and produce 88 million barrels of oil annually. There is no Russian participation in Sakhalin-2, while Rosneft has only a 20 percent stake in Sakhalin-1. Now that oil and gas are so much more expensive than when the original deals were struck, the Kremlin wants a larger share of profits—or all of them.
Some of the most productive assets of the Russian oil industry have been transferred from the most transparent and efficient companies (YUKOS and Sibneft) to the least transparent and efficient (Rosneft and Gazprom).
It is now widely assumed that the government will pull the license of Russia’s second-largest oil company, half-owned by the British, unless the three principal Russian owners agree to sell their shares to Gazprom. That firm, TNK-BP, is developing the Kovykta, a giant gas field in eastern Siberia. The latest addition to the Kremlin’s hit list is Russia’s largest remaining private company, Lukoil, one-fifth of which is owned by ConocoPhillips. The company, which pumps 18 percent of Russia’s daily production, has been charged by the Ministry of Natural Resources with unspecified “violations” in the development of oil fields and is threatened with the recall of almost two dozen licenses.
These moves are bound to make foreign direct investors think twice before going into Russia—and if last July’s float of Rosneft’s shares on the London Stock Exchange is an indicator, harvesting stock markets might not work either. Intoxicated as they were with high oil prices, investors’ response to the largest initial public offering in Russian history (and the sixth-biggest in the world) was less enthusiastic than Moscow had hoped for. The interest from international institutional investors, such as insurance companies, was weaker than an offering this large would normally produce. The three biggest accounts belonged to the entities clearly seeking to refurbish their Kremlin loyalty credentials: BP (10 percent of the offering), the Malaysian state oil company Petronas (9 percent), and the China National Petroleum Corporation (4 percent). The offering produced half the revenues expected.
By choosing re-centralization and re-nationalization over liberal reforms in energy markets, and opting for state control over direct foreign investment, Russia may stop itself from raising enough capital to sustain the current level of energy production and transportation, much less to expand it. “Energy superpower” is likely to become an even more distant dream than it is today.
Leon Aron is a resident scholar and director of Russian studies at the American Enterprise Institute. He is the author of “Yeltsin: A Revolutionary Life” (St. Martin’s Press) and of the forthcoming “Russia’s Revolution” (AEI Press).
Image credit: photo by Flickr user alex756
 Vladimir Milov, “Russian Energy Policy in a Broader Context,” (presentation, U.S.-Russian Working Group luncheon at the American Enterprise Institute, Washington, D.C., March 16, 2006).
 Vladimir Milov, “Anatomiya odnogo zabluzhdeniya,” Kommersant, August 18, 2006 (the author is president of the Institute of Energy Policy, Moscow).
 Isabel Gorst, “The Energy Dimension in Russian Global Strategy” (speech, James A. Baker III Institute for Public Policy, Rice University, Houston, Texas, October 2004), 1.
 “O vozmozhnykh variantakh razvitiya infrastructury po exportu nefti v Rossii” (paper, in Russian, Center for Strategic Research, Moscow, October 2004).
 Andrew E. Kramer, “Russian Pipeline Leak Causes Prices to Rise,” The New York Times, August 1, 2006, D3.
 Joanna Chung and Arkady Ostrovsky, “Rosneft is afloat but few remain onboard,” The Financial Times, July 15, 2006.