#8 - JRL 9142 - JRL Home
Russian Oil & Gas: Energizing the Summit & Raising Risk
By Chris Weafer (Cweafer@aol.com)
Chief strategist at Alfa Bank
Moscow, May 6th 2005

While this weekend’s events in Moscow are mainly symbolic, it is not too much of a stretch to say that they may also mark a watershed in relations between Russia and the rest of the world. Paring the recent talking points down to the core issues, the rest of the world wants more Russian energy supplies while Russia wants what it perceives to be foreign meddling in its backyard to stop. For both sides, time is now rapidly running out.

For President Putin the stakes are very high. He will want to make the right commitment to the US, the EU and Asian countries on energy cooperation in exchange for reciprocal agreements, but he simply may not be able to deliver. This is because several important groups within government are clearly not interested in committing to the next phase of future industry development until the current phase of ownership reorganization and state control over the country’s most important industry is completed. That looks like dragging on for several more years, as the urgency that brought an end to the “oligarch ownership reorganization” phase in 2000 no longer exists. Putin’s inability to deliver on energy promises and the exposure of the perception (at least) of different group agendas splitting the Kremlin will sustain the current high risk premium that is keeping equities at a discount to their emerging market peers.

The main agenda

Most of the world leaders that will come to Moscow this weekend want one thing from Russia; that it pushes ahead with promised energy developments and raises export volumes of oil, gas and processed product. Most also want participation in that development, either in the production and processing phase or as a primary recipient of exported product. They want the government to stop meddling in the industry, to drop planned restrictions on foreign participation in new projects, to make clear the rules of the game for investors and partners, and to stop procrastinating over project scheduling and export routes. In return, those net consumer countries seem ready to side-step issues such as Chechnya and restricted democratic infrastructure and to smooth Russia’s entry to the WTO. In return, Russia has a shopping list of issues that it wants in exchange for greater energy cooperation.

But, there are very practical reasons why Russia will want to avoid specific commitments and keep the discussions both general and opaque. For both domestic and geopolitical reasons, the country is neither ready nor willing to make the specific commitments required. Time is, however, fast running out on this game of energy chess, and while Putin will undoubtedly make the right noises on future cooperation to keep the route to WTO membership (and to ensure it takes the role of G-8 Chairman starting next January), the need to complete the reorganization of state ownership and control over targeted industries that is now underway offers the prospect of increased risk for minority investors.

If the state is pushed to complete this phase quickly because of international pressure, then minority investor risk will increase. If, on the other hand, it continues to stall on industry development and try to buy time with these opaque promises, then the net consumer countries might lose patience and, for example, step up their “meddling” and criticism of Russia. That would also raise investment risk over the medium term.

Russia continues to be a country with a great future for investors. The problem is that this great future may already be behind us at least for several years if the state does not handle the next phase with the kind of pragmatism that was the hallmark of Putin’s first term. The “difference this time” might well be the fact that the people at the top of government had a unifying purpose in the term, i.e. establishing control. Now there are several different agendas, and most do not take into account the interests of minority investors over the next few years.

“Guest” at the top table

One of the reasons why Russia now enjoys a prominent place at the top table of global politics and expects continued speedy integration into the infrastructure of the global economy is because it bumped up oil production from 6.1 mln barrels per day (bbl/d) in 1998 to an average of 9.3 mln bbl/d currently, i.e. from 8.3% of total global production to 11.1%. More important, Russia’s exports of oil now account for just over 15% of the daily net transfer from net producing countries to net consumers. For Russia, that was a relatively easy task; it had the capacity and needed the money.

Note: I will issue a separate note on oil and gas production and exports, plus a more detailed look at the reasons for the current slowdown in Russian oil production growth specifically NOT primarily as a result of YUKOS but more as a consequence of the plan that the Economy Ministry pushed aggressively through Putin’s first term and also look at the broader relationship between Russia, OPEC and consumer countries, etc.

Consumer countries want more oil and gas from Russia to help ensure the adequacy of future supplies and to support price stability. They also want Russia to “cooperate” with efforts to build more export routes out of the Caspian. The UK government, which takes over the presidency of the EU next month, has already said it intends to focus on energy issues with Russia because Europe will need more gas imports from end-2007, when the production profile of North Sea wells starts to drop sharply. But while the country has the declared intention of adding more production, processing and export capacity for oil and gas, the government does not yet want to commit to any specific export projects. The reason for this is a combination of three main things:

1. The first is that it has done very nicely out of not formally siding with either the net producers or net consumer blocks over the past five years. It is no coincidence that in the run-up to this weekend’s meetings the seemingly “done deal” on a primary routing of East Siberian oil to the Pacific coast is now deliberately thrown in doubt.

2. The second reason is that the re-distribution of asset ownership is not complete, and until it is there is less interest in future developments. Ironically, this is exactly what led to the sharp slowdown in the country’s oil production in the 1990s. The new owners the oligarchs were more interested in acquiring ownership and control of the industry, so that there was little incentive to actually build out those businesses. The fact that the “corporate ownership reorganization” phase came to an end just as Putin pushed for increased export volumes and the price of oil started its recovery phase was a fortunate coincidence. Essentially, we have now moved into the next ownership reorganization phase, i.e. one in which the state or those close to the state either increases direct ownership or control over the operation and development of targeted industries. That means national industrial energy policy and national champion industries.

3. The third reason is simply that the easy bit is over. In 1998 Russia had spare capacity, and through incremental expansion (e.g. most notably the Primorsk terminal) has managed to increase that capacity to today’s daily level of about 5 mln barrels of crude and about 2.0 mln barrels of products. The oil to fill that capacity came from rehabilitating older wells with international standard management and new technologies plus the opening of new fields that were mainly already identified by Soviet geologists. In issues such as the recent botched monetization of social benefits (an issue much more critical for the government than expanding energy cooperation), we have seen either a lack of proper planning or the lack of effective implementation of decisions due to inadequate infrastructure, i.e. a properly trained and motivated civil service. Hence, even if the government actually wants to push the development of future energy projects, it may simply lack the infrastructure to do so.

Issues

This weekend the main discussion groups can be broken down by four main geographic areas.

United States There is an element of “good cop, bad cop” in the approach of the US to Russia. Secretary of State Rice continues to highlight issues related to the lack of full democracy and the threats posed by Russia’s interference in CIS countries, and in her recent interview on CNN made it clear that she sees no problem with provoking or supporting civil unrest or uprising as a mechanism for change.

Against that background, President Bush is likely to adopt a more conciliatory tone and to push the core agenda. So, what’s likely to be on his real shopping list?

1. Russian cooperation in dealing with countries that the US has a strained or no relationship with but which Bush would like to “neutralize” as part of his administration’s crusade to rid the world of terrorism and spread democracy before his term ends. These include North Korea, Iran, Sudan, Syria and Venezuela, i.e. all countries with which Russia has a much better relationship than the US.

2. The US wants the next major oil export pipe out of the Caspian (a probable 1.5 mln bbl/d pipe from the Kazakh Kashagan field) to flow west along a parallel route to that of the current Baku-Ceyhan pipe.

3. The US would like to head off any more serious consolidation of the growing political cooperation between Russia and China (and to a lesser extent, India) that has at least the potential for a third geopolitical bloc to that of the US and the emerging EU.

4. The US would like Russia to stop selling advanced weaponry to China. Analysts in Washington regularly cite this as a future problem for Russia, i.e. that China might invade the Far East or Siberia to grab land and hydrocarbon assets. In reality of course, Russia’s nuclear deterrent should discourage any and all from attempting to invade Russia with the use of exported weaponry. Hence, Russia’s future defense strategy is obviously not to fight any new land engagements, but rather to contain internal and regional strife and to use nuclear missile technology as the response to external threats.

5. Agreement to build the Murmansk oil pipeline, which would primarily serve as an export route to the US. State Department officials are also pushing for the involvement of some US company (e.g. Exxon) in development and management of the oil reservoir that would fill that pipe. For that to happen, there must be clarity on issues that are blocking investment and cooperation, e.g. sub-soil legislation, the tax regime for JVs, access to pipelines, environmental conditions, etc.

6. Faster development of natural gas exports, particularly LNG, which can be exported to the US. Conoco is still hoping for participation in development of the giant Shtockmann field inside the Artic Circle to the north of Murmansk. One of the plans for this project is to build an LNG facility in Murmansk, i.e. the ideal export point for the US.

In return, Russia’s wish list probably includes the following:

7. An end to US meddling, actual or apparent, in Russia’s backyard. That includes not just areas within the Russian Federation such as the Caucuses, but also chiefly the Caspian region and the “Stans”.

8. US involvement in Georgia, to which US President Bush will travel immediately after Moscow, is a great source of irritation to Russia. Putin will want some sort of deal that limits such involvement and recognizes Russia’s “interests” in the region. Georgia is, of course, a very critical part of any energy export routing from the Caspian to western markets.

9. White House support for Russia’s entry to the WTO at this year’s December meeting in Hong Kong. Unlike the long promised but still outstanding Jackson-Vanik removal (which requires Congressional approval), the approval process for WTO membership is exclusively an executive decision.

10. Easing of restrictions on existing trade barriers between the two countries.

11. US help/cooperation, albeit on Russia’s terms, to fast-track development of industries that will help Putin’s long-term ambition of creating a better diversified economy (technology, aviation, aerospace, etc).

EU Summit The EU summit takes place on Tuesday. In broad terms, the agenda is not too dissimilar to that listed above for the US-Russia dialogue. The question of Ukraine and Moldova will probably feature more prominently in terms of “meddling” (by both sides), and the still vexed question of visa transits to Kaliningrad needs to be resolved.

Otherwise, the two main issues are: a. The timetable for EU involvement in the proposed Baltic gas pipeline to Germany and the UK. The original timetable called for gas deliveries starting from end-2007, and both the UK and Germany would undoubtedly like to stick with that timetable before the lights start going out due to declining North Sea gas supplies. There are several proposals concerning the project (BASF and Siemens are currently engaged on some project work), while E.ON and the UK’s Centrica are also thought to want participation. b. Agriculture remains a contentious issue (as it is with the EU and all other countries). Both sides will want some agreement to prevent dumping, etc, to protect their respective industries. c. The “official agenda” highlights four very general areas of cooperation, i.e. 1) the common economic zone; 2) security and justice; 3) external security; and 4) education and health.

Asia The big debate here surrounds the final routing of the eastern pipeline. Both China and Japan would like an exclusive direction on the 1.6-mln bbl/d pipe, while Russia continues to hedge its bets (see below).

CIS Russia is trying to carve out a more stable role for itself as the de facto head of the group of CIS countries. A very difficult task given both historical animosities and the external pull on these countries from the US, the EU and China (in the East Caspian region).

Pipeline politics: Follow the Yellow Piped road

One of the most active discussions this weekend will take place between Russia and separately China and Japan. The subject of that discussion will be the final routing of the Eastern pipeline. Until recently it appeared as if Russia had agreed with Japan to construct the 4,200 km pipeline from Eastern Siberia to the Pacific port of Nakhodka, i.e. only 250 km from Japan. Only last week the Japanese daily Yomiuri quoted that country’s industry and economy minister as saying that Russia’s energy minister Khristenko promised that the pipe would be built as agreed and that Japan was still committed to funding a major element of the approximate $12 bln cost.

But the paper quoted the Japanese minister as saying that Japan would only commit funding if it was guaranteed to get the major oil flows from the pipe. The plan is that this route will eventually carry 1.6 mln barrels per day, and Japan wants at least 1 mln of those barrels to arrive at the Pacific terminal.

Then last week Energy Minister Khristenko signed an order to start construction of the pipeline in two phases, with the first phase terminating halfway (just over 2,000 km) and at a point only 70 km from the Chinese border. At the same time, Transneft said it would start to construct an export terminal on the Pacific coast, just north of Nakhodka, that will accept oil by rail from the end of the eastern pipe’s first phase. That is a distance of over 2,000 km, and clearly makes no economic sense. The assumption is that Russia is simply leaving its options open to either build the second phase of the pipe straight down into China’s industrial heartland, with a smaller spur line to the Pacific, or to proceed with the original plan.

By taking this interim decision, Russia can continue to play off both sides and delay a final commitment until 2007 or early 2008.

Right now it seems as if the most likely route will be the Chinese option. This is something that the US would rather not happen (better to keep energy-hungry China dependent on sea-based imports) and that will play some role in continued Russia-US talks.

Note: It always seemed unlikely that the Japanese proposal would work anyway. As soon as the original proposal was announced a few months ago, the legislature there moved quickly to start adding conditions to any financing package. The main one of these is that Russia hands back control over the disputed Kurile Islands that Russia “took back” during WWII. That, in my view, is never going to happen.