State of play

Julian Lee, an analyst at the Centre for Global Energy Studies answers questions from O&G about the biggest challenges facing the Russian oil and gas industry.

How significantly has the economic downturn affected Russian oil companies' capital expenditure programmes?
Julian Lee. At the beginning of this year there was a great fear that Russian oil production would fall because all of the major Russian oil companies announced very large cut backs for their capital expenditure programmes for 2009 in the wake of the collapse in the oil price and the consequent collapse in their revenues. But that hasn't really happened. There are a couple of reasons why. One is that the oil price recovered a lot more quickly than we'd anticipated. So we've seen a number of companies, including TNK BP, LUKOIL, Gazprom and possibly Rosneft, which have subsequently increased their budgets again. Also the cuts that they did make in their budgets tended to be focussed on longer-term projects that were not expected to come into production for two, three, perhaps four years, rather than current projects. That helped them to maintain production. The other thing was that budgets were all denominated in US dollars. And the rouble at the beginning of the year fell very heavily against the dollar. Which meant that a reduction in a dollar denominated investment was a much smaller reduction in rouble denominated investment. And most of their costs were in roubles. So that meant that in fact the budgets cuts they announced were a bit of an exaggeration.

Has Russian oil and gas production recovered to pre-2008 levels yet?
What we've actually seen is that Russian oil production has been going up again this year. And a large part of that is due to a number of new fields that have all come into production, not simultaneously but over the last six to 12 months. And those fields have been ramping up towards their peak production level at varying speeds. They had contributed by August, around 300,000 barrels a day of incremental production. So that's really where the increase in Russian output has come from. The biggest one of those in terms of its contribution at the moment is what's generally known as the YK field because it's virtually unpronounceable. It's a field being developed by Lukoil and Conoco in the far north of Russia and that's producing about 150,000 barrels of oil a day at the moment. TNK BP has two or three new fields that it is producing from; the Verkhnechonskoye in East Siberia. Uvat in West Siberia, and another small one. Surgutneftgas is developing Talakanskoye oil field in East Siberia and of course Rosneft has just brought on stream the Vankor field which made a fairly small contribution in July and a much bigger one in August.

The other source of increase has been the Sakhalin-II project, which up until the end of last year was only able to produce oil in summer. Because of the icing of the sea in winter it couldn't get tankers in to offload the oil. But when the pipelines to the south of Sakhalin were completed at the end of last year that meant that they could start producing all year round and increase the production volume. So that production there has gone from an annual average of 30,000 barrels a day if you took what it produced over the summer and averaged that over the whole year to something around 115,000 bpd at the moment. So that's effectively another 70,000 barrels a day on the average daily production.

Is there enough investment currently in oil and gas facilities in Russia and what concerns are there about levels of investment?
There are ongoing concerns in Russia about the continuing decline in investment and production in the core production area of West Siberia. If you look at a map where all these new fields are they are all outside of the historical core production area of the Russian oil industry. So the worry is that these new fields are expensive and will take a lot of time to develop. But while this is going on production in the core industrial heartland of the Russian oil industry is still in decline which is a concern. Obviously one of the reasons the investment is taking place elsewhere is that companies get better tax breaks. They are developing some very big fields outside Russia which is close to the new pipeline infrastructure that Russia has built and is building. And they get tax holidays from mineral extraction tax and from export duty from crude oil produced in places like East Siberia, whereas they don't for crude oil produced in West Siberia. So what this has meant is that there's been something of a migration away from the heartland of West Siberia. And this is still where the bulk of Russian oil comes from. And I think there are concerns that there is insufficient investment being made in maintaining production in West Siberia through step-out drilling and exploration around the current producing fields. That region has been producing oil for 40 years. It's not been terribly well looked-after for some of that time. And so I think some of the reservoirs there are very heavily depleted. What is produced out of them is a very large proportion of water and a relatively smaller proportion of oil. That makes them relatively expensive to produce. And a great deal of work is needed to rehabilitate a lot of these older fields.

How strong currently are relations between the EU and the Russian oil industry?
There's always a lot of heat generated over that subject. Much more so over gas than oil, which is a whole separate subject. Over oil it's much less of a political issue because the oil is exported by a number of private, semi-private and publicly owned companies. Some is exported by pipelining to Europe but a great deal is exported by tanker out of various ports under long-term contracts and spot sales as well. So the oil trade is not quite as politicised in the context of Russia and Europe as the gas trade is. And the gas trade is much more political, partly because it's conducted on the Russian side by a state owned monopoly which is seen by many as really being an arm of government rather than an independent commercial corporation. And partly because Europe is very dependent on Russian gas.

But Russia is even more dependent on the European market and that makes the whole thing extremely political. I don't think it has particularly dissuaded companies. What we have seen is changes in the way that foreign companies are able to invest in Russia. We had a very brief period in the early to mid 1990s where companies were chasing production sharing agreements through three of those agreements were signed. Sakhalin-I, Sakhalin-II another small one through Siberia called Hariago. And they have run into their own difficulties too. Sakhalin-II was the only one that had no Russian partners up until Gazprom was muscled in to that project. Sakhalin-1 is facing some difficulties over what happens to its gas, which is hampering future developments. The principle partner is ExxonMobil and it has an MOU to sell their gas to China. They haven't yet been able to agree a price. But Gazprom is flexing its muscles and claiming it has sole rights to export gas from Russia and it wants to buy all of Sakhalin-1's gas itself to supply the eastern part of Russia. And they are still haggling over prices and trying to find a way forward. Ultimately I think they will end up selling the gas to Gazprom one way or another. They would either sell it on to China or more likely they would sell it to the Eastern part of Russia.

How favourable are the business conditions in Russia currently for the companies that operate there?
Taxes have come down a lot recently. Certainly there was a huge problem at the end of last year because the level of export duty was calculated based on the average oil price for two months before, when the oil price was falling very fast, the tax break would have been set on a two month old price that was 40 or 50 dollars a barrel higher than the current price. That meant that in around October, November, December last year, the export territory was actually higher than the value of the oil. The government did take steps to reduce that to cut the tax rate. And at the beginning of this year they changed the way they calculate the export duty to make it much more inline with recent prices rather than much older prices. So a lot of that has disappeared. The problem I think comes in the combination of mineral extraction taxes, plus the export duty, plus the pipeline tariff to get the oil from West Siberia to an export port are fairly burdensome on some of the smaller less productive fields in West Siberia. And what companies have been saying to the Russian government is that in order to invest in new exploration and new development in West Siberia they need to be given better tax conditions because at the moment it's not profitable.

What are the biggest issues facing the Russian gas industry today
I think a lot of the biggest political issues are in gas rather than oil. The main issues are that demand for Russian gas has fallen very sharply both in Europe and in Russia itself. Russian gas production is down by about 25 percent year-on-year. As a result of that Russia really doesn't need gas from Central Asia at the moment. And relationships with Turkmenistan in particular have become quite strained because Russia has stopped buying gas from Turkmenistan. But Turkmenistan hasn't really got anywhere else to sell it. In the longer term the issue is over Gazprom's and the Russian government's investment decisions for the gas industry. There are a large number of pipelines that are planned, proposed and being talked about. And a number of new field development projects that are also being talked about.

It seems increasingly the case that Gazprom isn't going to have the money or the manpower to do everything. So there are really big issues over how it's going to prioritise this project and which ones take priority. And at the moment there are two big pipelines to Europe that are being proposed; North Stream and South Stream. There are also a number of pipelines in the Eastern part of Russia. One from Sakhalin down to Vladivostok and another one is planned from East Siberia to the Pacific coast. There's the expansion of the pipelines they've been talking about from Central Asia to Russia. And there the pipelines they started building from the Yamal Peninsula down towards Europe. They will need to build a pipe from the Shtokman field to the Bering Sea. So there's all of those plus there's the field development on the Yamal Peninsula plus the field development of Shtokman.

What challenges do you think could arise as a result of the building of these pipelines?
I think is of concern is how these projects are prioritised. Are they going to prioritise the Eastern pipelines? Which are about the industrial development of Eastern Russia. And creating new export markets for Russian gas in Asia. Are they going to prioritise the two big pipelines to Europe which at least initially are more about bypassing Ukraine and Belarus than they are about providing more gas to Europe because they don't have the production and perhaps don't have the market for more gas into Europe. And what's going to happen to the gas field development projects that are going to supply the next phase of Russia's gas exports. And the worry is that those production and field development projects are going to be pushed further and further back in favour of the pipeline projects. It could potentially (affect gas supply to Europe) if there is a rapid rebound in European gas consumption. That's certainly a possibility.

Julian Lee is Senior Energy Analyst, Centre for Global Energy Studies. Specialist in oil market analysis, Russia, the Caspian Sea and West Africa, producing major studies on the oil and gas industries of these regions. Julian is also Deputy Editor of the Global Oil Report. Julian holds an MSc degree in operational Research from the London School of Economics.