RussNeft and Its Oil Output

In recent months, RussNeft has lifted and delivered about 3% of total Russian oil output. The oil reserves of RussNeft (or what the Russians call the “net effective pay”) are estimated to exceed 630 million tons (about 4.6 billion barrels, using a conversion factor of 7.3 barrels per ton), and its annual oil production is near 17 million tons (about 124 million barrels per year). RussNeft’s oil output translates into about 324,000 barrels per day, or, by comparison, slightly more than 40% of the total daily oil output of Alaska’s North Slope. And by way of further comparison, the daily worldwide oil output of a well-regarded Western independent oil company such as Anadarko Petroleum is about 190,000 barrels per day (110,000 from the U.S. Gulf of Mexico and 80,000 from overseas operations). So RussNeft is quite a bit larger than Anadarko, and a significant player in the Russian oil business by any measure.

For all its size and scope, RussNeft is a new player in the Russian oil industry and began its existence in September 2002. The company is what one might characterize as a roll-up, meaning a series of acquisitions to a core entity. Under the control of company president Mikhail Gutseriev, in 2002 and 2003, RussNeft acquired numerous upstream, oil-producing assets across Russia’s vast landscape. During the second stage of its development, in 2004, RussNeft integrated its newly acquired assets into a unified production structure. In 2004 alone, RussNeft’s oil output quintupled, and the firm became one of the top 10 oil majors in Russia. In 2005, RussNeft became vertically integrated with its acquisition of several refining and marketing properties, and has been aggressively upgrading its refineries to world standards. In 2006 RussNeft stabilized its oil extraction operations. It began to ramp up for an intensive drilling program in 2007, intending to increase its reserves. Thus, the past five years have been a time of rapid and outwardly enviable growth for the company.

RussNeft currently employs over 17,000 workers and runs 30 producing plants, two refineries, a transport plant, and a state-of-the-art distribution network of 311 retail filling stations that sell about 9% of the motor fuel distributed in Russia. The company’s facilities are located in 23 regions of Russia and the Confederation of Independent States (CIS). Within Russia, RussNeft is engaged in what it characterizes in its press releases as “large-scale social and charitable programs based on agreements with the administrative bodies of the subjects of the federation.”

According to a statement by company president Gutseriev:

“Our RussNeft is the youngest company among Russian vertically integrated oil companies, which operate at Russian and world crude oil markets. We are just beginning to talk about ourselves, our plans, and development trends. But the most important thing is that we are sure that in the nearest future, we shall be able to take up a leading position and be among the leaders of the domestic fuel-energy complex.”

So up to now, RussNeft has demonstrated and exuded an aura of confidence as to its place in Russia’s energy future, or what Mr. Gutseriev calls its fuel-energy complex. And on its Web site, RussNeft announces prominently that its goal is “Russian oil for the welfare of Russia.” But that is, apparently, not good enough.

Not Good Enough?

On July 30, 2007, the board of directors of RussNeft issued a translated press release announcing that it has “approved Mikhail Gutseriev’s declaration about deliberate laying down of the power of the president of oil and gas company RussNeft.”

Gutseriev later issued a statement saying that he was quitting the oil company and selling his shares, citing “unprecedented persecution” by the authorities. Gutseriev also said that the persecution by Russian officials was in the form of multiple inquiries by tax authorities, the prosecutor general’s office, and the interior ministry. Gutseriev said that he would retire to the countryside “to conduct scientific and technical research.”

Arresting All the Shares

And on July 31, 2007, Moscow’s Lefortovo (the shorthand term for Russia’s Ministry of Justice, interestingly named after the former Soviet secret police prison) issued a statement that it had officially “approved the request to arrest 100% of the shares of [RussNeft].” The request for seizure of RussNeft shares was made by the ministry in relation to a criminal case against RussNeft’s former chief executive Mikhail Gutseriev for tax evasion and what were termed “illegal business activities,” according to the Russian statement.

On Aug. 8, the Justice Ministry followed up with an announcement that “The shares [of RussNeft] have now been seized.” (There is an eerie semantic parallel here to the words of the Soviet pilot of a Sukhoi-15 interceptor aircraft who shot down a Boeing 747 Korean Air Lines Flight 007 on Sept. 1, 1983. After shooting down the Boeing, the Soviet Su-15 pilot radioed to his ground controllers, “The target has been destroyed.”)

We Predicted This

In an earlier report, Whiskey & Gunpowder predicted this course of events for RussNeft. We wrote:

“Unlike many other Russian businessmen, Gutseriev does not owe his success to ties with the Kremlin. In fact, he is neither a friend of Putin’s inner circle nor the pawn of a larger Russian oligarch. Gutseriev’s secret is foreign support in the form of Glencore, the Swiss-based resources-trading firm founded by the infamous American power peddler (and Bill Clinton pardonee) Marc Rich. It was Glencore that supplied Gutseriev with the majority of the financing he needed to build RussNeft into the firm it is today.”

We also wrote:

“RussNeft appears about ready to be swallowed by Rosneft, in part because Gutseriev had the temerity to challenge Rosneft for the ownership of some assets Rosneft was seeking. Those clashes ended Gutseriev’s ability to fly under the Kremlin’s radar, and now he — and RussNeft — is squarely in the Kremlin’s sights.”

According to one press report from AFX News Ltd., a Russian concern called Basic Element, the holding company of Kremlin-friendly tycoon Oleg Deripaska, has stated that it has requested of the Russian federal anti-monopoly committee for RussNeft to be absorbed into its energy subsidiary. But this is not yet a fait accompli.

In the past two years, the Russian government has steadily extended its reach over the country’s energy industry. The Russian Federation has built its state companies into major global players. Originally, the logic for the expansion of state control was basically nationalist, coupled with elements of the Byzantine political culture that has been part of Russia for many centuries. As part of the motivation, Russian power players were incensed that oligarchs (and, even worse, foreign corporate entities such as Shell or BP) were able to profit from private ownership of the country’s oil wealth. Thus, by consolidating within the “fuel-energy complex,” the Kremlin gained access to a powerful tool for influencing the Russian people at home, the nations of Russia’s near-abroad, and, by implication, the behavior of the European states further downstream.

But now there is a new logic in the nationalization process: political competition. Within Russian President Vladimir Putin’s inner circle, there are two power centers. The first power center, comprising First Deputy Prime Minister Dmitry Medvedev and Deputy Chief of Staff Vladislav Surkov, is the power behind Gazprom, which is the Russian state-owned natural gas mammoth. The second power center, comprising Defense Minister Sergei Ivanov and his colleague Igor Sechin, controls Rosneft, Russia’s major state oil firm.

The Gazprom and Rosneft teams are more than simply two adversarial state companies, competing for business like, say, Exxon Mobil and Chevron in the West. Gazprom and Rosneft are representative of the two factions struggling to succeed Mr. Putin as Russia’s next president, with Medvedev and Ivanov as the candidates and Surkov and Sechin as the powers behind the throne. For these two teams, the competition for resources between Gazprom and Rosneft is more than simple one-upmanship. This not-so-friendly competition is the most clear-cut and public means of evaluating who is doing better at consolidating power in the critical energy sector of the Russian economy and who will be selected (not elected) as the next president of Russia in March 2008.

Thus the slogan “Russian oil for the welfare of Russia” takes on an entirely new meaning. And it is not good to be standing in the way of the ongoing consolidation within the Russian “fuel-energy complex.”

Until we meet again…
Byron W. King

August 10, 2007

Russian Oil for the Welfare of Russia was originally featured on Whiskey and Gunpowder

The geographic connection between high-ranking Russian government officials and Gazprom executives is not a coincidence. A very high proportion of those in the halls of power happen to be from St. Petersburg, a port city on the Baltic Sea — the city called Leningrad prior to 1991.

In “Gazprom May Thwart Putin Drive for Russian Energy Dominance,” Bloomberg writer Lucian Kim takes us back to the formative years of Putin’s St. Petersburg crew:

“The president [has] personal connections to the men who run Gazprom. Putin worked in the office of then St. Petersburg Mayor Anatoly Sobchak from the collapse of the Soviet Union in 1991-1996. When Putin served as head of Sobchak’s foreign investment committee, Gazprom CEO [Alexey] Miller, 45, was his aide. Valery Golubev, 54, a Gazprom deputy CEO appointed last year, was, like Putin, born in St. Petersburg, served in the KGB intelligence service and worked in Sobchak’s office starting in 1991.

“Dmitry Medvedev, Russia’s first deputy prime minister and Gazprom’s chairman, was Putin’s legal adviser in Sobchak’s office. In a poll released by the All-Russian Center for Public Opinion on April 17, those surveyed picked Medvedev, 42, along with Sergei Ivanov, also a first deputy prime minister, as most likely to succeed Putin. The president must leave office next year after completing his second four-year term.

“‘It’s not a state company; it’s the president’s personal company,’ says Vladimir Milov, a former deputy energy minister who runs the Institute of Energy Policy in Moscow. ‘It’s a bunch of people from the St. Petersburg administration enjoying the windfall.’”

In the wake of the Soviet Union’s collapse, a mad rush to acquire former state-owned assets convinced many that if you wanted a piece of Russia’s economic future, you’d better have the right connections. While most oligarchs pursued profit by snapping up inefficient companies for pennies on the dollar, Putin craved power and influence more than riches. His doctoral thesis centers on the importance of using natural resource wealth to enhance Russian power, so he believes that the government should have control over this vital sector, rather than privately owned companies.

Russian Gas Needs an Investment Boom

In his quest to reestablish Russia’s position as great power — and gain enormous public popularity in the process — Putin seems to ignore why private ownership and free markets do a better job of efficiently extracting the maximum value out of resources. Left without a real profit motive, government-controlled companies like Gazprom are more like burning matches than they are going concerns.

Gazprom uses its stranglehold on the Russian pipeline grid and connections with environmental regulators to bully its way into growth. Like a gangster, it threatens corporate death in exchange for majority ownership in any project it covets. Companies like Shell just say, “Thank you, sir, may I have another?”, happy to salvage some of their sunk costs from projects like Sakhalin 2. They have no leverage over government-backed Gazprom.

But while it was busy stealing others’ properties, Gazprom seems to have ignored the basic necessity to replenish its ever-depleting production base. It must now accelerate big projects to make up for lost time. Kim’s Bloomberg article continues:

“[Gazprom’s] options for expanding [natural gas] output are challenging. One is to open the 700-kilometer-long Yamal Peninsula that juts into the Arctic Ocean to gas production. While Gazprom said in October it would begin developing the project, the remoteness of Yamal, which holds an estimated 10.4 trillion cubic meters of gas, demands a huge investment…

“The other option is Shtokman, a field holding as much as 3.7 trillion cubic meters of gas and located 500 kilometers offshore in the icy Barents Sea. A year ago, Gazprom’s plan was to develop the site with the help of two or three foreign equity partners. The bidders were Norway’s Norsk Hydro ASA and Statoil ASA, Chevron Corp. and ConocoPhillips of the U.S. and France’s Total SA.

“After months of delaying a decision on choosing its partners, [Gazprom CEO Alexey] Miller last October went on Russia Today, the Kremlin’s English-language satellite news channel, to tell the world that Gazprom would develop the project without foreign investors. ‘On the technical side, Gazprom needs foreign expertise,’ says Roland Nash, chief strategist at Renaissance Capital in Moscow. ‘But Gazprom can afford to wait because there’s fierce competition for its reserves.’

“Gazprom has pushed back the earliest production date for Shtokman to 2013. Chevron puts the price tag of the project at as much as $20 billion.

“Gazprom executives insist they won’t have any trouble meeting future demand. ‘We’re investing as much as necessary,’ Deputy CEO Medvedev says. In January, Gazprom’s board approved total 2007 investments of more than $20 billion, including $1 billion for Yamal and $600 million for Shtokman. The company says it plans to spend $24 billion on capital projects in 2008 and $27 billion in 2009.

“Economy Minister German Gref, who sits on the Gazprom board, is skeptical. At a government meeting in March, he complained the company still hadn’t submitted production plans through 2020. Miller replied that Gazprom wouldn’t produce new gas until there were concrete buyers for it.”

By “concrete” buyers, Miller refers to reliably profitable buyers. A highly regulated Russian natural gas market leaves Gazprom in a difficult position. The state subsidizes consumers by capping the price at which gas can be sold. This has led to a situation in which Gazprom is losing money on the gas it sells domestically, so the company has made up for it by jacking up prices on its European customers.

Gazprom Is Running on a Fast Treadmill

Ending gas price subsidies to former Soviet Union states like Ukraine and Belarus enabled Gazprom to receive full market prices for the gas it sells to European customers. The Kremlin rightly received criticism for the way in which it abruptly cut off customers in the middle of winter, but the fact remains that Gazprom needs to charge fair market prices in order to fund its massive investment program. Putin’s government (and that of his handpicked successor) plans to gradually raise the cap on domestic gas prices as well. This clearly won’t bolster his popularity.

Why would Putin risk his legacy by lifting the cap on domestic natural gas prices? Because he realizes that the situation is dire for his old St. Petersburg friends. Intelligence service Stratfor recently wrote that if the current status quo is maintained, Gazprom will literally run out of natural gas within a decade.

“Gazprom’s problem is simple. Its investment into bringing new fields on line is absolutely abysmal. As of 2000, only three major fields in western Siberia — Urengoy, Yamburg and Medvezhye, with reserves of 16 trillion cubic meters of natural gas among them — accounted for about 70% of Gazprom’s total natural gas production. All are past maturity, and efforts to replace them are middling and lagging. The first major field brought on line since the end of the Cold War — the 3.3-trillion-cubic-meter Zapolyarnoye superfield — only began commercial production in 2001, and its output peaked in 2004.

“All the low-hanging fruit already has been picked, and Gazprom has not shown the managerial foresight, interest in foreign investment, or technical capacity to replace output at a pace that will forestall production declines. The chart below indicates the International Energy Agency estimation of Russia/Gazprom’s output decline without a substantial and immediate increase in investment dollars. Most of the increase — the blue region — is likely to come from Kazakhstan and Turkmenistan, and since those increases depend on an improvement of the infrastructure linking Russia to Central Asia, the real picture might even be bleaker.”

Gazprom desperately needs to invest massive amounts of capital into mitigating production declines at its existing properties. Companies that provide drilling services, drilling equipment, and enhanced recovery technology stand to benefit. At first glance, many would say that this projection going out to the year 2020 is too pessimistic since it doesn’t include much of a bump from potential future discoveries.

This may be true, but in order to bring potential discoveries into production, Russian operators will require more drilling and more rig equipment. It’s not a stretch to assume that the Russian rig fleet is old, overtaxed, and must be refurbished in order to accomplish a very busy future.

The North American natural gas industry appears to be in a similar situation. It will need to gradually increase drilling activity just to maintain current production rates. This chart, maintained by EOG Resources, shows the production from gas wells drilled in each year since 1990 and how much the wells contribute to total U.S. gas supply:

It appears that production from wells drilled prior to 1990 makes up less than 20% of total gas supply. Decline rates are accelerating because higher and higher proportions of U.S. gas production comes from “unconventional” sources. This helps explain why the number of land rigs actively drilling in the U.S. has gone up and up, yet gas production remains flat.

Russian Oil Needs an Investment Boom

Natural gas is not the only industry that needs massive investment. The Russian oil industry requires an investment boom as well.

For the May issue of Petroleum Review magazine, editor Chris Skrebowski wrote a piece entitled “Dancing with the Bear.” Skrebowski wrote it after attending the Energy Institute’s International Petroleum Week 2007 in February. Held in London, IP Week’s “Russia Day” attracted a standing-room-only crowd eager to hear key leaders of Russia’s oil and gas industry. I was intrigued by Skrebowski’s views on the evolving role of private oil companies in Russia, drawn from Vladimir Milov’s presentation:

“Vladimir Milov of the Institute of Energy Policy, Russia, then spoke to the title ‘The Rise of State Energy Companies and Its Effect on Oil and Gas Sectors in Russia.’ He started by showing that up to 2004, private oil companies had accounted for 83.5% of production, with state-owned companies providing just 16.5%. By the end of 2006, the state section had grown to 32%, the private sector had fallen to 42%, and there was a ‘gray zone’ accounting for 26% of production. The gray zone comprises Surgutneftgaz, the remainder of Yukos, and the Russian-owned 50% of TNK-BP. He anticipated that these were likely to move into the state sector over time, giving the state dominance in oil production.

“He then went on to show how production from companies that had been nationalized had fallen over the last two years. He also noted that if the Yukos companies had just maintained production at end-2004 levels, Russia would already be producing over 10 million b/d [emphasis added].”

For perspective, here’s an updated version of the Russian/Saudi oil production figures as reported by the Energy Information Administration:

Russia is producing about 9.5 million barrels per day and is widening its lead over Saudi Arabia as top oil-producing country in the world.

Skrebowski continued:

“Milov then went on to show the way that Western technology was leading to the greatest expansion in Russian production. Rosneft’s re-establishment of links with Schlumberger had allowed Yuganskneftegaz production to expand by 4.5 million tonnes in 2006. Foreign-owned projects — Salym, Sakhalin 1, Kharyaga — had contributed another 3 million tonnes in 2006. Schlumberger was performing 30 hydrofracs a month for Yuganskneftegaz and 100% of the wells in the Priobskoye field had been treated.

“His estimate was that Russian production in 2006 would only have expanded by 1.6% rather than the actual 2.2% without foreign investment. Yet, ironically, the campaign against foreign investors escalated in 2005-2006. This has already led to laws defining ‘strategic’ oil and gas fields where foreign investment is limited to a minority holding. President Putin at two recent meetings had floated the idea of not expanding Russian oil production any further [emphasis added].

“Milov went on to show that a similar pattern was seen in the gas sector, with production from the independent sector growing fast while Gazprom’s output was little changed. In his view, a gas supply gap was already emerging as Gazprom’s investment in gas production was too low to meet the requirement.”

President Putin is floating the idea of not expanding Russian oil production any further? Even the possibility of this occurring should grab large media headlines. Yet few in the Western world are thinking about the possibility that a) Russia may not be able to expand production much beyond current levels without massive assistance from private international companies like Schlumberger, or b) whether Russian leaders would want to expand production in exchange for foreign currency.

As I noted to Strategic Investment readers in recent weeks, the long-term value of the U.S. dollar (and other paper currencies) will become more and more of an issue for those in Asia and the Middle East who find themselves overwhelmed with too much cash and too little energy and resources for themselves.

It remains to be seen whether Putin and his cronies at Gazprom will come crawling back to big Western oil companies once they discover just how difficult big future projects will be. But this much should be expected: International oil service companies have an opportunity to satisfy huge demand for cutting-edge oilfield technologies in places like Russia and the Middle East.

Meanwhile, those who feel they’re entitled to buy all the cheap hydrocarbons they want with U.S. dollars need to realize that Russia has re-emerged as a great power. President Putin and whichever crony he’s lining up to be the next president have a firm grip on the future of Russian energy, and it doesn’t look like they’re going to loosen it anytime soon.

Good investing,
Dan Amoss, CFA

June 7, 2007

From Russia With Love was originally featured on Whiskey and Gunpowder