Russia’s Petroleum Industry At Critical Juncture

September 2013, Vol. 240 No. 9

Russia faces a looming oil crisis that places the country at a crossroads.

Production could well be in decline by 2020, even as the state’s dependence on oil as its primary source of income continues to grow. Yet oil also offers Russia’s best hope for continued progress if the state’s precarious relationship with the industry can be reformed, said IHS Senior Research Director Thane Gustafson, author of “Wheel of Fortune: The Battle for Oil and Power in Russia.”

As oil becomes more difficult to find and more expensive to produce, Russia’s growing dependence on oil revenues, along with its traditional management of the industry, is unsustainable, Gustafson said.

“Russia is not running out of oil, but it is running out of ‘cheap oil’ as the ‘legacy’ assets inherited from the Soviet Union begin to decline,” Gustafson said. “They have come to the end of one chapter and moved on to another. And, so far, that new chapter is full of blank pages.”

Russian oil production is on track to increase by 1.5% this year, but only at the price of a sharp rise in capital spending. Investment in the oil fields increased 34% in 2011 to a record $31 billion and could exceed $35 billion this year. To prevent declining production, the industry will have to expand beyond its Soviet-era fields to more remote, geologically complex and cost-heavy areas, such as the arctic offshore, where it has little experience and know-how.

“Over the past twenty years, the oil industry and the state have fought for control,” Gustafson said. “The result today is an industry that is overtaxed, over-regulated and under-motivated to prepare for the challenges ahead.”

The state’s heavy tax burden and restrictive regulations have reduced companies’ incentive to invest in new technology or to improve efficiency, Gustafson said. Oil provides nearly 40% of the government’s tax revenues. If the industry fails to evolve, costs will continue to rise, spelling lower profits and, ultimately, lower revenues for a state that is increasingly dependent on oil income.

A decline in oil revenues could usher in a major crisis, forcing cutbacks to major spending programs such as pensions and subsidies that underpin the stability of the Putin regime. In such a crisis, the state would be forced to confront the difficult choice it has avoided for so long — whether to lessen the tax burden on the oil industry and enable it to invest in the next generation of fields and technology.

Gustafson said many in Russia’s government realize that trouble lies ahead but that consensus is lacking on how to move forward. A reduction in oil revenues could unravel into a power struggle between interest groups over shrinking oil rents. Or Russia’s leaders could pursue a course of comprehensive reform to reduce the state’s dependence on oil revenues while stimulating changes in the oil industry itself, so as to encourage the innovation and entrepreneurship that will bring about its renaissance.

Rosneft-ExxonMobil Agreements
One major step forward came last January in St. Petersburg, Russia when its biggest oil producer, Rosneft, along with ExxonMobil announced the achievement of several milestones under their 2011 Strategic Cooperation Agreement. Those included the formation of a joint venture for the Kara Sea and Black Sea projects, and establishment of foundations for joint ventures to explore seven other licenses in the Russian Arctic and to manage the joint West Siberia tight oil project. The companies have also agreed to move to the next planning phase for an LNG development in the Russian Far East.

The Black Sea and Kara Sea joint venture operating companies, Tuapsemorneftegaz SARL and Karmorneftegaz SARL, respectively, will start project implementation activities as operator, pursuant to agreement with Rosneft, which is the license holder. Rosneft holds 66.67% interest and ExxonMobil holds 33.33% interest in the two projects. Initial cost of exploration in the two areas is estimated at more than US $3.2 billion, the majority of which will be financed by ExxonMobil. Collection of data for both regions will continue until the start-up of drilling operations in the Kara and Black seas in 2014.

In February, ExxonMobil and Rosneft announced plans to increase the scope of their strategic cooperation by adding seven new blocks in the Russian Arctic in the Chukchi Sea, Laptev Sea and Kara Sea, spanning 600,000 square kilometers (150 million acres). Rosneft and ExxonMobil have entered into agreements that lay the foundation for joint venture entities for these areas. Data acquisition is being planned for these blocks, which represent some of the most promising and least explored offshore areas globally. The license obligations stipulate that 14 exploration and appraisal wells will be drilled, and a significant amount of 2-D and 3-D seismic will be conducted over the next 10 years.

Agreements are also in place establishing the foundation for a new joint venture for a tight oil pilot project in West Siberia, where data collection operations are underway. Rosneft will hold 51% interest, and ExxonMobil will hold 49% interest in this project.

Also in place is an agreement identifying further steps for the development of an LNG plant in the Russian Far East. Following the agreement, by the end of 2013, the parties will undertake work to determine an LNG plant site, gas liquefaction technologies and commercial structure of the project. Once this work is finished, the parties plan to progress engineering definition.

“ExxonMobil is making a significant investment in Russia, and these agreements serve as the foundation for our projects and future work together,” said ExxonMobil CEO Rex Tillerson. “Experience tells us that a good foundation is critical for success in the Arctic and elsewhere. ExxonMobil’s Sakhalin-1 project with Rosneft is an example where we have put this experience to work.”

Additionally, on June 11, Rosneft and ExxonMobil signed agreements to create the Arctic Research Center and jointly use of technologies in different regions of the world. ExxonMobil will provide $200 million in funding for the initial research phase of the Center. Rosneft and ExxonMobil will equally fund the next $250 million to continue their joint research work. The partners’ interests are Rosneft 66.67% and ExxonMobil 33.33%. The center will build on current best practices of Rosneft and ExxonMobil to create more environmentally safe and efficient technologies.

Gas Projects Abound

In recent months, President Vladimir Putin and Gazprom CEO Alexei Miller announced a colossal series of gas projects. These involve an expansion of existing big projects or a reactivation of earlier, unimplemented proposals, which include:

• Reviving the Shtokman extraction project in the Russian Arctic.

• Adding a third parallel line to Nord Stream pipeline on the Baltic seabed to Western Europe, and prolonging that third line to supply the Netherlands and Britain with Russian gas. This would boost Nord Stream’s capacity from 55 Bcm to 80 Bcm per year.

• Designing the South Stream pipeline for its originally proposed capacity of 63 Bcm per year, with four parallel lines on the seabed of the Black Sea en route to Europe. This implies reinstating South Stream’s southwestern branch toward Italy, which Moscow had dropped from the initial project, instead prioritizing the northwestern branch to Central Europe.

• Building a pipeline from Belarus via Polish territory to Slovakia – the long-proposed Kobryn (Belarus)-Poland-Velke Kapusany (Slovakia) line – to connect Russia with Central Europe. This line would plug into Slovakia’s gas corridor.

The Slovakian corridor carries the lion’s share of Russian gas supplies to the European Union, representing direct continuation of Ukraine’s transit pipelines to Europe. The proposed Kobryn-Velke Kapusany line would circumvent Ukraine but not affect Slovakia inasmuch as the same gas volume would enter Slovakia from Poland instead of entering from Ukraine. The export destinations (Austria with the Baumgarten distribution center, Czech Republic, Germany, Hungary, Italy) would not be affected either.

Compared with the Nord Stream and South Stream mega-projects, a Kobryn-Velke Kapusany pipeline with its proposed 15 Bcm annual capacity looks almost restrained. But, if built, it could deal a coup de grace to Ukraine’s gas transit system, which is already facing the South Stream bypass threat. A Kobryn-Velke Kapusany line would not add any new volumes of Russian gas to Europe. The operative goal of this project is to increase Russian pressure on Ukraine to cede control over its transit pipelines to Gazprom.

To achieve that operative purpose, the Kobryn-Velke Kapusany project need not be actually implemented. It only needs to become a credible threat, which would however require Warsaw’s and Bratislava’s acquiescence, at least in the form of conducting serious discussions about this project with Moscow.

Apparently, the Kremlin and Gazprom hope that the European Union member countries Poland and Slovakia might assist Russia’s efforts to obtain control over Ukraine’s transit pipelines under compounded pressures. According to Putin and Miller in their joint appearance, Gazprom has recently held talks with Polish and Slovakian companies, which were said to express “very strong interest” in the implementation of the Kobryn-Poland-Velke Kapusany pipeline.

According to Putin and Miller, this line could be built and become operational by 2018–2019, after South Stream will have been built by 2017. Stipulating such deadlines (without a discussion of resources for the South Stream project) is designed to scare Ukraine into submission. Russia would not need to come up with new gas volumes, but merely to re-route existing export volumes into a Polish transit pipeline, before they reach Ukraine’s transit system.

Kobryn, in the southwestern corner of Belarus on the Polish border, is the exit point of the Beltranshaz trunk pipeline connecting with Poland’s pipeline grid. Gazprom’s proposal envisages a 600-km pipeline from Kobryn, via eastern Poland, to Velke Kapusany in easternmost Slovakia, the entry point of the main transit pipeline from Ukraine en route to Central Europe. Gazprom would divert 15 Bcm per year from Ukraine’s transit pipelines into the Kobryn-Velke Kapusany route. Whether the re-routing of this volume would still allow sufficient capacity for Russian gas supply to Belarus, itself, through the Beltranshaz pipeline, is unclear.

Gazprom completed, in 2011, a phased takeover of Beltranshaz, achieving an integrated gas transportation system on Belarus’s territory. This was partly intended as an overture to a phased takeover of Ukraine’s gas transit system. It is more profitable for Gazprom to use its own transit pipeline on Belarus’s territory than to pay transit fees for using Ukrainian transit pipelines.

Separately from Beltranshaz, Gazprom owns and operates the Yamal-Europe One transit pipeline, with annual capacity of 30 Bcm, running across northern Belarus into Poland and into Germany. The Yamal-Europe One pipeline is fully dedicated to supplying Poland and Germany with Russian gas. Russia – and, at times, Poland – intermittently discussed building a Yamal-Europe 2 pipeline, parallel to Yamal-Europe 1, toward Poland and possibly Germany.

Construction of Nord Stream on the Baltic seabed, bypassing the mainland, has rendered that version of Yamal-Europe Two moot. Moscow proposes the name Yamal-Europe 2 for the Beltranshaz trunk pipeline that would carry Russian gas from a junction point within Belarus to Kobryn and then exit to Poland. Poland has no need for this pipeline nor any reason to cooperate with this Russian project. However, Slovakia is a vulnerable target of Gazprom and like Ukraine is fearful of losing transit volumes in the event Russia builds South Stream. In that case, the same westbound gas volumes that would be shifted from Ukraine’s transit pipelines could ipso facto be shifted from Slovakia’s transit pipelines, these being a direct westward continuation of Ukraine’s pipelines.

Moscow seems to want to maintain the gas transit volumes through Slovakia, re-directing them via Poland, instead of Ukraine, into the Slovakian pipeline system. This would isolate Ukraine while incentivizing a separate Slovak deal with Gazprom. The South Stream project is designed to scare Slovakia almost as much as Ukraine.

Between 2000 and 2002, Russia insistently discussed the Kobryn-Poland-Velke Kapusany project with Belarus, Poland and the European Union, in an early effort to circumvent Ukraine’s transit system. In 2002, Ukraine ostensibly agreed (without seriously intending to deliver) to share its transit system with Gazprom in a “consortium,” possibly with minority German participation. After this, Moscow de-emphasized the Kobryn-Poland-Velke Kapusany project because it counted on using the Ukrainian system under Gazprom’s control. This story may recur, albeit to a full denouement this time, if Ukraine yields to Russian pressure. In that case, the unaffordable South Stream and the more bankable Kobryn-Poland-Velke Kapusany project would become redundant.

Meanwhile, Gazprom reported development of the Shtokman gas field, located 650 km north of Murmansk in the Barents Sea, will be postponed due the upheaval in the world gas market. The gas produced from the Shtokman field was originally planned for export, particularly to the U.S., which is experiencing a boom in production of shale gas and other unconventional gas. Production under the harsh conditions of the Shtok man field would not be profitable at present.

Gazprom said main markets for LNG are in Asia and the Pacific Rim, so the company is planning an expansion of its LNG terminal on Sakhalin Island as well as a new LNG facility in Vladivostok. Both facilities would be supplied with gas from producing Sakhalin fields and the Sakhalin 3 fields, which are under development. The exact timing of when Sakhalin 3 production will be inaugurated is uncertain.

Gazprom is planning a smaller LNG facility on the Gulf of Finland, where gas would be supplied via the Nord Stream pipeline, and the LNG would be sold to customers in Europe. Gazprom would use the LNG sales to offset lower domestic demand.

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