№ 5 (May 2012)
From Dream to Offshore Reality: Tax Breaks Breathe Life Into Arctic Exploration
For years, exploration and drilling off Russia’s energy-rich northern coast has been at a frustrating impasse. Located hundreds of meters beneath ice-bound waters in the frost-blasted conditions of the Arctic circle, Russia’s vast offshore oil and gas reserves in the North often seemed too high-risk for state owned majors and off limits for the more offshore-savvy foreign majors that also balked at burdensome taxation laws and dubious potential profit margins.
By Tom Balmforth
Last month that appeared to change.
On April 12, then Prime Minister and now President Vladimir Putin made a play to lure foreign companies into partnership with Russian state gas and oil monoliths Gazprom and Rosneft. Russia, he said, would lighten the offshore tax burden by cutting mineral extraction tax and scrapping duties levied on exports of hydrocarbons produced in Russia’s Arctic offshore zones for 15 years after the start of mass production. The move promised to breathe life back into the vast, but delay-marred Shtokman project and paved the way for a rush by foreign majors to tie up lucrative deals elsewhere in the Arctic Ocean that holds a fifth of the world’s undiscovered energy resources, according to estimates by the U.S. Geological Survey.
It indicated the Kremlin’s desire to open up “strategic” Arctic assets – the exclusive stomping ground of state owned Gazprom and Rosneft – to foreign oil majors (on a joint venture basis only) in exchange for offshore know-how and shares in assets beyond Russia’s borders. “The fact that the Russian government has presented such serious advantages by way of what is essentially an utterly different tax regime for the projects in question marks an undoubted breakthrough for foreign investment in the Russian oil industry,” said Alexander Kirevnin, an oil and gas analyst at VTB Capital. Landmark deals swiftly followed.
On April 18, Exxon Mobil, the United States’ largest oil company, led the rush after it unveiled an offshore exploration partnership potentially generating $500 billion of investment in the Arctic and Black Sea alongside Rosneft, the world’s largest oil producer. The U.S.-Russian alliance will explore three fields in the Arctic Ocean’s Kara Sea holding estimated recoverable hydrocarbon reserves of 85 billion barrels. Just a week later, Italy’s ENI signed a deal with Rosneft to explore several fields in the Arctic Ocean, mostly in the Barents Sea, the body of water above Norway and European Russia. Then, most recently, on May 5, Rosneft and Norway’s Statoil agreed to jointly explore the Perseevsky license block in the Barents Sea as well as three license blocks in the Far East’s Sea of Okhotsk.
Rosneft made its thanks to the government immediately known. “The key factor that prompted [Rosneft and Eni] to sign the agreement was the steps taken by the government of the Russian Federation to introduce tax incentives for offshore production, including canceling export duties and introducing a reduced Mineral Extraction Tax rate of 5-15 percent depending on project complexity,” Rosneft said in a press release released on April 25. “The government also offered guarantees that the favorable tax regime will remain in place for a prolonged period of time.”
The government’s rationale for smoothing the way for joint ventures between state and foreign majors in the Arctic is clear. Analysts say the Kremlin hopes the legislation will boost long-term oil production as it seeks to maintain production of no less than 10 million barrels per day until 2020. Speculation has mounted that domestic output will go into decline by 2015 without government intervention to stimulate Eastern Siberian and the Arctic reserves as Western Siberian fields continue to dwindle. But the effects will not be felt immediately, warned Maria Yegikyan, an oil and gas analyst at Alfa Bank. “It is going to take some time for production to increase. These deals are signed, but exploration drilling is only going to start in 2015 and production may come only as early as 2020. This is a long-term process that is being commenced right now.”
Former Deputy Prime Minister Igor Sechin lobbied extensively for the tax breaks and his return as president of Rosneft as Putin returns to the Kremlin signals Sechin may remain Russia’s informal “energy tsar” despite missing out on a place in Premier Dmitry Medvedev’s new cabinet, announced May 22. Spearheaded by Putin and Sechin, the legislative amendments are virtually guaranteed enduring political backing, according to analysts. “The Russian government without a doubt supports these projects so I do not expect any legislative or bureaucratic obstacles,” said Alexander Kirevnin, an oil and gas analyst at VTB Capital. “If we just think about how difficult it was to agree on changes to the law on taxation – it won’t come any harder than this.”
Kirevenin said that the largest hurdle he envisages is the practicality of drilling in the harsh conditions of the Arctic. “The level of study hasn’t been that big and the difficulty of drilling is extremely high. This of course is the main risk that companies have to battle,” said Kirevnin. But it is important the tax regime is fine-tuned. France’s Total, Norway’s Statoil and Gazprom have put off a final investment decision on Shtokman until the small print of the overhauled tax regime is clarified. Kommersant news daily reported earlier this month that Total is ready to postpone the final investment decision until mid-2013, increasing speculation that Shtokman will miss its 2016 production start date.
Nonetheless, the political weight behind the ENI, Exxon and Statoil deals is telling and the question is rather who will be next on the scene. Some commentators believe United States majors are well placed to tie up further deals in the Arctic, given Rosneft’s new penchant for foreign asset swaps and the prize fields owned by U.S. majors.
Meanwhile, however, domestic private companies – read LUKOIL, Surgutneftegaz, TNK-BP and Bashneft – have cringed as international majors have swooped in. On April 19, the four domestic private companies formally petitioned Putin for access to the fields which they are currently prohibited from accessing in line with laws that make state assets judged “strategic” closed to non-state venture.
Citing Rosneft spokespeople, Reuters on April 27 reported that Rosneft has since invited Russian domestic companies to take part. Moreover analysts believe it may only be a matter of time until they are given access, while some point to LUKOIL as the favorite to join in. As Russia’s second largest crude producer that also has experience of offshore drilling, LUKOIL may be best placed to partner Rosneft in a potential Arctic venture. LUKOIL is also seeking to tap into new reserves as its brownfields production is in decline.
“The terms of their [smaller domestic companies’] participation will be a little different from those of international companies and are less attractive for domestic companies,” said Yegikyan. “This is why we have not seen any deals yet, but that may soon change as I hear that negotiations are pending.” Gaining access to the Arctic is more complicated for Russia’s nonstate energy companies who can afford less exposure to risk. The Kremlin has effectively opened up the Arctic to foreign majors because they are willing to shoulder the high risks linked to exploration costs and the project potentially stalling. The terms of this concession are palatable for giants like Exxon, but for Russia’s comparative minnows they still appear too much.