Russia looks to take up the slack

Could Russia emerge as the world oil market’s true alternative to the OPEC cartel? Alex Williams investigates

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By  Alex Williams Published  July 4, 2005

|~||~||~|Rarely, if ever, has the dominance of the Organisation of Petroleum Exporting Countries (OPEC) in the global oil markets been of more pressing concern to the leaders of the world’s largest economies than it is now. It is not just that the pattern of demand in the sector has mutated beyond anything previously seen, with Chinese take-up alone growing by 800,000 barrels per day (bpd) in 2004, against the 300,000 bpd that had been widely predicted. Nor is it only that the majors are struggling to find new reserves and boost production, with opportunities limited to costly deepwater sites in West Africa, the Gulf of Mexico, Brazil, and Indonesia. And nor is it solely that the broad political situation in the Middle East grows daily more precarious. It is, rather, the confluence of all three factors that continues to hold the one month Dated Brent crude oil price hostage above the key US $50 per barrel (/bbl) level that weighs on the minds of the G8 finance ministers. This found resonance in their most recent communiqué that “volatile oil prices and global imbalances remain the main challenges to world economic growth, and that all countries should take vigorous action to address these imbalances.” In practical terms, of course, nothing can be done to curtail the ongoing demand cycle from China, or from India, Japan, or the USA, for that matter. Nor are the major international oil companies likely to find a huge new oil deposit anywhere south of Houston, or any such convenient and easily recoverable location. All this puts the onus on consuming countries to redress imbalances in global oil markets, which realistically means OPEC, which really means Saudi Arabia. Although Saudi oil minister, Ali Al-Naimi, recently supported the notion of a 500,000 bpd increase in OPEC’s output ceiling, he also stated that Saudi Arabia is not concerned with the absolute level of the oil price but rather with the stability of the market. This statement followed similar comments by Saudi government spokesman, Adel Al-Jubeir, in the wake of Crown Prince Abdullah bin Abdulaziz’s recent meeting with US President George W. Bush. In these, instead of the quick fixes to the high global gasoline prices urged by Bush, Al-Jubeir re-iterated a four-year plan to increase the Kingdom’s capacity to only 12.5 million bpd by 2009, from the current 11 million bpd. Saudis have also pointed out that while above official production levels of around 9.5 million bpd, the excess capacity lies in heavy crude, which is more difficult and costly to refine, and thus of less value in the battle to provide short-term oil price relief. Against this backdrop and with the traditional high supply areas — the US, the North Sea, Mexico, and Latin America — all in decline, the importance of safeguarding and expanding interests from more stable, and thus largely non-OPEC, sources grows ever greater. Non-OPEC oil production overall has been outstripping that from OPEC itself for some time now. Since 1970, non-OPEC production, as a share of total world oil production, has reached a high of 71% in 1985, a low of 48% in 1973 and has averaged 60% across the entire period. Although the bare figures do not adequately reflect the ‘power premium’ of the cartel, the fact is that non-OPEC producers have perhaps never been better placed to exploit distortions in the pattern of market trading, and nor, more specifically, has Russia. “Not even areas like the Arctic National Wildlife Reserve in Alaska can make much of a dent even in US supply, never mind anywhere else,” says Calvin Cobb, head of specialist oil consultancy, Cobb & Co, in Houston. “To all intents and purposes, this only leaves the offshore deepwater fields, and the former Soviet Union [FSU] as the non-OPEC areas of interest, and the major international oil companies are active in the FSU because it offers the greatest promise of containing the largest fields.” The turnaround in Russian oil output since 1999, when the industry began to undergo privatisation after, has been impressive, to say the least. From a total liquids production level of about 6.3 million bpd in 1999, 2004 saw production of around 9.2 million bpd, 8.8 million bpd of which was crude oil. This made Russia the second largest producer of crude, behind Saudi Arabia, and from March to May 2004, Russian crude oil output actually surpassed that of the Kingdom. As for whether this fierce momentum can be maintained sufficiently in the coming years to significantly keep a lid on global oil prices remains a question that divides industry opinion. There is no doubt that Russia’s reserve profile is an extremely healthy one. Overall estimates vary, of course, depending on the analyst, but the majority view tends to centre around a figure of about 60-65 billion barrels of proven reserves. Most of these are located in Western Siberia, between the Urals Mountains and the Central Siberian Plateau, although around 14 billion barrels exist on Sakhalin Island. Given total global oil reserves of roughly 1.05 trillion barrels, this means that Russia accounts for around 5-6% of the world total, while OPEC still accounts for a massive 78% or so, of which the Middle East alone constitutes around 65%. Within the non-OPEC sphere, however, Russia’s position is much more dominant, accounting for just over a quarter of all proven reserves. Only Mexico and China come close, but they possess far less than half of Russia’s reserve capacity, and in any event Mexico is entirely dominated by state-owned Pemex, while China is only slowly offering opportunities to foreign investors through state-owned firms or joint ventures. It is on the issues of production and exports that industry views begin to markedly diverge. Roger Nightingale, special consultant to Sarasin Asset Management in London, says that because Russia’s oil & gas sector accounts for around 25% of its GDP, while employing less than 1% of the population, there is a clear incentive to continue to maximise production levels. “This drive to keep the pumps going, even sometimes to the detriment of well integrity, has been a characteristic of Russian oil production for a few years now and until recent demand distortions it has been invaluable for the world economy,” he says. However, Paul Horsnell, senior oil analyst for Barclays Capital, points to the maturing West Siberian oil fields and the lack of significant new field development as indicators that the longer-term production trend will be much lower than it is now. As an adjunct to this, he stresses the negative effect on production that the recent sequestration of Yukos assets by the administration has had on output. “It seems to me that more time is being spent at the moment on deciding how to cut the cake between the private sector and the government than on actually increasing the size of the cake.” He adds that much of the investment monies at the margin, which could have been used to increase exploration rates and well efficiency, are instead being spent on endless administrative and legal tasks. There are also major challenges to overcome in terms of exporting supply, underlines Dr. Manouchehr Takin, senior petroleum analyst at the Centre for Global Energy Studies in London. While the continued expansion of Russia’s crude oil export capacity appears important to the Kremlin and the country’s oil companies, the fact remains that the two camps often seem at loggerheads over precisely how best to boost this capacity. Currently, crude oil exports via pipelines fall under the jurisdiction of Russia’s state-owned pipeline monopoly, Transneft, but bottlenecks in this system mean that although Russia actually produces almost 7 million bpd of liquids for export, only around 4 million bpd can go through the major trunk pipelines. The remainder has to be either shipped by rail, river or sea, all of which are less reliable and more costly than pipeline transportation. This situation is poised to worsen as China’s consumption continues to increase, as the main way for Russian crude to make its way East is via rail to the northeast cities of Harbin and Daqing, and to central China via Mongolia. A further complicating factor in predicting the net effect of Russian production on the world’s non-OPEC oil supplies, and thus on prices, is the shifting tax dynamic in the country. The last 10 months or so has seen the tax burden on Russian oil producers increase considerably. In August 2004, the government introduced a new mechanism for assessing crude export duty, which is linked to the external price of Urals blend, and recalculated bi-monthly, with the duty rising progressively as the price of Urals exceeds US $25/bbl. At the same time, export tariffs on oil products, which had previously been set at 90% of the crude duty, were decoupled, and earlier this year the duties on light and heavy products were differentiated further. Finally, the 2005 mineral extraction tax, which is also tied to the global price for Urals blend as well as to the rouble/dollar exchange rate, was increased by almost 15%. “In addition to their obvious bottom line impact, these adjustments have had several important implications, which, against the backdrop of the persistently wide spreads between internal and world crude prices, help to explain the shift towards increased domestic throughput that we have been witnessing recently,’ says Yulia Woodruff, senior Russia & CIS oil analyst for US Security Analysis in Washington. The first of these, she highlights, is that Russian oil exporters are less sensitive to crude price changes in world markets. Indeed, according to Lukoil, under the current taxation system, the net export margin of an average Russian exporter is 19% at US $40/bbl, declining to 16% at US $25/bbl. Secondly, she underlines, regional fragmentation and oligopolistic competition in the domestic oil products markets allow Russian oil majors considerable flexibility in internal price setting. Finally, she says, export tariffs on oil products remain significantly lower than on crude. In fact, currently at US $10/bbl on light products, and US $7/bbl on fuel oil, Russian oil companies will continue to favour the practice of maximising domestic runs at the expense of crude exports. Thus, concludes Woodruff, a return to high rates of export growth from Russia is ultimately dependent on policies to expand production. “The key areas to focus on here would be targeted tax breaks to promote the exploitation of both new and depleted fields, as well as the creation of a stable and transparent licensing environment,” she says. Overall, Russia has the reserve capacity and the potential for production growth to make it an increasingly important alternative to OPEC oil supply, particularly in the current price environment. Evidence of this are the recent ground-breaking mergers between Russian companies and the global oil majors. Of particular note are the outright merger of BP and Tyumen Oil Company in 2003 and the September 2004 alliance between ConocoPhillips and Lukoil, in which the US firm could eventually acquire a 20% stake in the Russian oil giant. “When you get western firms of this calibre participating in deals like this then you have to draw the conclusion that others will follow and that, as such, Russia will continue to be a major alternative to OPEC going forward,” says Nightingale at Sarasin Asset Management. “Additionally, I think it is reasonable to assume that they would not get involved in such deals if they did not believe that there is plenty of upside in the current reserves and production forecasts over the next 10 years, while much of the rest of non-OPEC reserves and production is moving into the decline phase.”||**||

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