June 9, 2009
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Home / Issue Archive / 2009 / January - December #1 / Don’t Miss the End of an Era

№ 1 (January - December 2009)

Don’t Miss the End of an Era

Overcoming the stagnation in Russian oil production will only be possible through a significant increase in investment in existing fields and the exploration and development of new ones. The option of conserving the oil resources in the ground is not best idea.

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Editor's Note: The Russian version of this article first appeared in the Russian business weekly Expert, (September 22, 2008); the English version first appeared in the bi-monthly AmCham News (October-November 2008). Both are reprinted here with the permission of Expert and AmCham News.

The nine-month-long decline in Russian oil production has attracted close attention in Russia and abroad. This trend had inspired interest partly because production declined despite rising oil prices on world markets. What is the reason? Reserve depletion? Does it mean that oil production has reached its peak, and, as the management of some of the leading Russian oil companies say, will only decline from now on? Or is it the result of fiscal policy failings in this industry? And can the adjustment of economic instruments help stabilize or even increase production?
The answer is important not only for Russia, where oil production remains the most important source of Russia’s positive current account on the balance of payments and a budget surplus, but also for the world oil market. It is enough to mention one fact: over the past ten years (1998-2007) the increase in Russian oil production (3.8 million barrels per day) fully covered the increased (3.6 million barrels per day) oil consumption in China – a country that increased oil consumption more than anyone else in the world. Of course, direct supply of Russian oil to China is not that significant. But if Russian production had not increased, the global oil balance would have been much tighter. So, what should oil consumers expect from Russia in the future?
Let’s analyze the facts and figure out what’s happening with oil production in Russia at the moment, and what is the outlook for the future.
At the Drill Bit
During the first years of this decade average daily oil production (including gas condensate) in Russia grew at an increasing rate. However, after reaching peak growth (almost 11 percent) in 2003, growth rates started to decline and only slightly exceeded 2 percent in 2005-2007. This year Russia for the first time in many years is facing the threat of a fall in production: based on the results of January-August, production decreased by almost 1 percent compared to the previous year. There was a warning last year. As can be seen in Chart 1, compared to 2005-2006, in 2007 there was no material production growth during the year. Practically all growth in the average daily indicator was due to the increase in production during the first half of 2006. All that was achieved in 2007 was to preserve average annual production at the level reached at the end of 2006.
The immediate cause of the fall in production is quite clear – the depth of the seasonal decline in development drilling volumes during the second half of the year in 2007 was much more significant than during previous years (23 percent versus 9-12 percent in 2005-2006). Taking into account that the correlation of average daily production with the average daily penetration of development drilling (with three months lag) for the past years was equal to 0.88, it would have been surprising if production had been maintained at the same level. And no such miracle happened, indeed; following the decline in development drilling, reaching its peak in June-July 2007, average daily volumes followed: from a maximum 9,942 million barrels in October 2007, to 9,742 million barrels in April 2008. As was noted by one of the captains of the Russian oil industry, “oil in Russia is at the drill bit.”
In 2008, development drilling volumes resumed their growth (taking into account traditional seasonal dynamics), but it still remained modest, compared to the previous years: just over 7 percent in the first year half versus 18-24 percent in the respective periods of 2006-2007. Oil production reacted with a modest increase in May-August, but, as was previously pointed out, still remains in the negative zone (minus 0.9 percent) in annual terms (i.e. compared to January-August of last year).
We also have to note that the majority of companies faced deteriorating production conditions at their brownfields (rising water cuts, high decline rates etc). Moreover, the impact from applying modern technological methods of production stimulation at brownfields is slowly wearing out. Any further increase in the recovery factor (RF) (RF at most Russian fields remains below 30 percent, which is 10 percentage points below the average global indicator) requires the implementation of new technology and significant improvement in reservoir management.
Due to these changes, the relationship between development drilling penetration volumes and production may weaken. But it will not change the fundamental dependency; without increased investment by the oil companies, in real terms, it is impossible to ensure production growth or even its maintenance at the current level in Russia. The country has no spare production capabilities, as with Middle East oil producers, that would make it possible to “turn the tap” and increase oil flow.
But it would seem that with still high oil prices there shouldn’t be problems with investment. However, there are two crucial factors which can explain why there may be no production increase despite the high oil prices.
First of all, we shouldn’t forget about a simple fact: high prices and high profits are not the same thing. Taxation and high production costs may neutralize the attractiveness of high prices. Second, the system for stimulating private and state companies is not necessarily the same. A private company, honestly paying taxes and operating in a competitive environment, has no other way to increase its profit than to increase the production volume. A state company and the government behind it may have other objectives (for instance, to consciously conserve oil reserves for the future – this article will review this scenario below), and other methods to increase profit – for example, by trying to impact the price by manipulating production volumes (OPEC is an example of such joint acts). The balance of oil producing companies is tipping to the side of state-owned companies, including in regard to issues related to access to new fields, and may lead to new corrections to the oil supply for the high prices.
Let us try to consider which explanation is correct for Russia.
Excessive Tax Load
Lately the press and the government have paid significant attention to the detail of Russian taxation policy. We illustrate how Russian taxes have altered world prices for Russian oil producers in Chart 2. The average price for Russian crude oil increased over the last five years by approximately $100 per barrel (from $30 per barrel in January 2004, to almost $130 per barrel in summer 2008). However, after the deduction of export duties and mineral extraction tax (MET), the net price has increased by much less – from $20 per barrel in January, 2004, to $50 per barrel in summer 2008. In other words, Russian oil companies gained less than a third of the price increase for their product on global markets.
But this is not the only issue with the fiscal system. The Russian petroleum fiscal system has one peculiar and rare feature: it is quite sensitive to world oil prices, but absolutely insensitive to the costs of oil production. And the costs were growing. Everywhere in the world (please see Chart 3), and in Russia, this situation was aggravated by the appreciation of the ruble in real terms vis-a-vis the U.S. dollar, which is the currency in which Russian oil exports are denominated.
There is no systematic data on cost inflation in the Russian oil sector. According to estimates of one of the leading Russian companies, its operating costs from oil production increased by 76 percent over the last five years (in 2003-07), and the capital costs for development of new oil resources increased over this period by 250 percent. Partially this increase was related to worsening geological conditions. But the main role was played by the growth of prices in the Russian supply chain – the suppliers of goods and services for the oil industry. During recent years it was very significant: for example, over just two years (2006- 07) Russian pipes increased in price by around 50 percent, electric cable by 80 percent, and other oil equipment by 24 percent.
If we evaluate the damage caused by increased costs and the strengthening ruble, using an indicator of the real appreciation of the ruble against the U.S. dollar, then the growth in net prices that Russian oil producers have experienced from 2004, becomes even less impressive (please see Chart 2): from $19 per barrel in January 2004, to $28 per barrel in summer 2008. In fact, the situation was even worse, since, as was noted, the rate of price growth for the majority of products purchased by the oil companies, exceeded the growth rate of consumer prices used in the calculation of the real ruble exchange rate. As a result, even record high world oil prices at some point ceased to have a stimulating effect on the development of Russian oil production. This applied to investment in additional production at brownfields and investment in the exploration and development of new fields. The latter is subject to the specifics of Russian petroleum taxation. The investment terms for the development of a “typical” new oil field in Russia are much worse than abroad.
One of the results of this difference is the fact that some fields that would be developed abroad, in Russia are being preserved in the expectation of better times.
Lately – especially following recent concerns about the potential decline in oil production in 2008 – the government has acknowledged these problems and proposed partial tax incentives in order to improve investment terms. The price threshold was increased for calculation of the tax exempt amount, when calculating MET (from $9 to $15 per barrel), and MET fiscal holidays were introduced for depleted fields and fields with difficult access (basically fields on the continental shelf and in the polar regions).
The incentives come into force from 2009, so we will be able to assess the efficiency of these measures, aimed at stimulating oil production in Russia. But even now it appears that the short-term effect will be more noticeable that the longterm. Possibly, the benefits will be sufficient to increase the attractiveness of investments into additional production at the depleted fields (even though managers of some oil companies have already stated that the threshold should have been increased to $24 per barrel). But, as shown in the Table 1, the attractiveness of investment in the development of new Russian oil resources will remain lower than in other countries.
Therefore, it is unlikely that the announced incentives will be enough for positive investment decisions into many cost-intensive new oil fields, especially those located on the continental shelf. From the information supplied in Table 1 it can be seen that even total exemption from MET would not be sufficient for ensuring better profitability of investments into a “typical” continental shelf oil field in Russia, compared to similar foreign projects. It can also be seen that MET incentives (announced and maximum) provide investment terms that are worse than those prescribed in the existing Production Sharing Agreements.
We may sympathize with the government’s fears concerning changing export duties, as well as an overall revision of petroleum taxation principles – moving from calculating the tax base based on revenues to accounting only the profit of the companies. First of all, oil export duties are still a very important source of revenue for the state treasury. In 2007, according to the Finance Ministry, they provided for more than half of the oil and gas revenue of the federal budget, and, therefore, about one-fifth of all budget revenues. It is not easy to adjust such an important revenue source. Second, notwithstanding apparent progress, the transfer pricing problem is still far from being resolved in Russia. And this means that, from the tax authorities’ point of view, it is too early to trust the profits which companies declare. All of this is true. But it is also true, that while investment terms in Russia are worse, Russian oil companies will still be motivated to allocate their capital into more attractive projects abroad.

To be continued in the February issue of Oil&Gas Eurasia

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