Jennifer Gorton of ForexIndicators.net discusses the future of the Russian Oil & Gas industry.

Oil and gas industry headlines have been extremely negative recently due to the BP oil spill disaster in the Gulf of Mexico. Long-term environmental and economic impacts are only in their early stages of estimation, but previous oil spill disasters tell us that the effects may last for many years. However, the global demand for petroleum products has not abated, perhaps slowed a bit during the current recession, but prospects of economic recovery will only add pressure to current demand forces.

Industry experts in Russia also noted in a recent report that the toxic agents deployed in the Gulf by BP will threaten the eastern half of the North American continent with total destruction. Despite the dire warnings, the report does raise the question as to whether a state-owned or a privately owned oil and gas industry is the better path to take by public policy makers. During the days of Gorbachev, Russia was forced to accept foreign investment in its petroleum industry to meet trade and market demands of its economy. During the transition years that followed, superpower status in the world was reclaimed on the back of oil and gas, but a similar tipping point is fast approaching the industry in Russia once again.

Diversification was the primary priority for policy makers in Russia for the past decade. The government had established an objective to catch up with the world's most efficient and innovative economies. Large taxes were assessed on oil production to fund the expansion and diversification plan. However, budget deficits were the result and oil and gas remain the backbone of the economy, actually increasing its share of GDP over the period. Russian known reserves are eighth in the world, but it is number two in production. Industry analysts estimate prospective reserves at over twice known reserves, but foreign investment capital will be a necessity to meet future production goals.

To even retain current production levels, Russia will need to modify its policy-making infrastructure in a number of key areas to attract the necessary capital. Forex indicators alone have noted a serious out-flow of capital from Russia, driven by domestic producers who see easier paths to wealth outside the borders. This flow must be reversed if material change is to occur.

First, the assets of existing refineries and production facilities were built and funded in Soviet times. The lack of reinvestment has been due to a 70 percent tax on production. External companies have managed to profit by USD$150 billion, but less than 40 percent of that figure has been reinvested in new drilling exploration or enhancement of ongoing operations. Incentives need to be created to encourage foreign investment.

The government also needs to make up its mind as to whether control should reside with the state or whether private ownership is the way to go. Two of the top eight oil producers are state-owned, but these two companies account for 36 percent of the production. As for the six private companies, it is difficult to discern what share the government controls in these entities. Fear of a government takeover persists, and legal mechanisms are required to ensure that ownership rights will be protected.

Another roadblock pertains to where production should proceed. Government policy cites Eastern Siberia, where costs are high and perceived prospects low, as the targeted area for development. Private enterprise, if allowed to invest capital where it sees fit, would choose areas with higher potential and lower capital requirements in Western Siberia and the Caspian Sea. Freedom of choice is another prerequisite for foreign capital to return.

Due to turmoil in international capital markets following the recent European debt crisis, many Russian companies have decided to delay their IPO's and secondary private offerings. Large capital issues to meet the estimated USD$1 trillion need for oil and gas development in Russia could never hope to be floated over the MICEX, the Moscow Interbank Currency Exchange, the largest stock exchange in the Russian Federation and Eastern Europe. The money will need to come from China, the U.S., or from Europe. Since 80 percent of the world's known reserves are state-owned, private companies are always searching for new investment opportunities. Why not in Russia?

In late 2009, the Russian government published its revised energy strategy to the year 2030. The primary objectives were threefold, to ensure sustainable economic growth, to help improve living standards in Russia, and to help strengthen the external, international position of Russia. External investment is a necessity if these goals are to be achieved. Russian policy-makers need only modify existing tax structures, provide legal protection from possible privatizations, and allow capital the freedom to seek its own reward on its own terms, if they are firm in their resolve to address the true market requirements for their strategy to be successful.

Previous blogs:

Security of supply in the CIS | Russia lines up gas purchases for 2010 | Europe's frosty relations with Russia