Raising Oil Output Still State's Goal


Editor's note: This is the 11th in a series of reports about the effect of the global financial crisis on Russia.

Anyone who thinks that oil and wealth automatically go hand in hand obviously hasn't been paying attention to export revenues in recent months.

Producers of crude lost an estimated $3.3 billion on exports in September and October, according to Alfa Bank, and the losses have continued to mount this month.

The financial difficulties come at a hard time, as production will fall this year for the first time in a decade, threatening the country's share in the global market. But the government continues to press for production to grow and guarantee Russia's place as the world's second-largest exporter — a factor that has underpinned the country's growing international clout.

"Suppose that global crude prices recover in a couple of years and we have dwindling production," said Alexandra Yevtifyeva, an economist at VTB. "We would lose our significance as a reliable supplier of energy."

Falling production would mean a reduced ability to influence international prices, a goal that the government has articulated of late, said Igor Lotakov, a partner at PricewaterhouseCoopers.

"If we begin a rollback now, our position will no doubt grow weaker," he said. "If we give up everything, revenues will drop, and we will still be unable to influence the situation [with prices], much as we are unable to now."

The reason for the financial difficulties is that while oil prices have fallen by about two-thirds since their summer highs to just below $50, the fall in export duties that the government charges per barrel of oil has lagged behind.

The strong earnings in the first half of the year mean that the major producers should end up comfortably in the black, but smaller producers have seen those profits wiped out.

The last time Russian oil traded below $50 per barrel was in the first half of June 2005, when the ruble was trading at about 28.5 rubles to the dollar — less than a ruble off its current value.

In that sense, the situation today is a virtual mirror of conditions then.

But costs have soared since 2005, as reserves in existing fields have been depleted and the locations of the greenfields meant to replace them have grown more remote and difficult to exploit. Double-digit annual inflation has also contributed to increased outlays.

The steep rise in the cost of borrowing generated by the current global crisis has only put further strain on producers.

Some producers have already scaled back their investment plans for next year, and it is almost inevitable that others will follow suit. Senior executives at LUKoil, the country's second-largest producer, and Gazprom Neft, in the fifth spot, have predicted further declines in national output next year.

LUKoil chief Vagit Alekperov, however, has vowed that the company will raise production by at least 1 percent in the year ahead.

The crisis has also had a chilling effect on the world's largest gas producer, Gazprom. A company executive said in mid-November that the state-owned giant would extract less gas this year, in part, because of falling domestic and European demand.

Prices for gas exports, Gazprom's main source of revenue, are tied directly to oil prices, but with a lag time of six to nine months, meaning that the company is currently reaping the highest export revenues in its history. But these prices will also start to slide in the second quarter of next year.

Even with lower gas prices, Gazprom is in better shape than companies in the oil sector, as export and extraction taxes are lower than on oil.

The company has said it will continue developing new Arctic fields in Yamal and the Shtokman deposit in the Barents Sea, and deputy CEO Alexander Medvedev said at a recent industry conference that the company's investment plans depend on a long-term oil price of $45 to $60 a barrel.

With possible difficulties at Gazprom still off in the relative distance, the government's focus has been on helping the oil sector.

Even before the financial crisis struck in full in August, the government had already devised tax incentives for the oil sector to take effect in January, in a move to try to halt the slide in production.

Following the plummet in world prices, more tax cuts to stimulate production are in consideration, and changes have been introduced to help export duties track prices more closely. The new system — approved by the State Duma on Nov. 21 — would see the duties revised every month, as opposed to every two months, as was the case before. The duties will now also be calculated on prices for the previous month rather than the previous two.

There is disagreement whether the change would make exports profitable in December. Whatever the case, the percentage of revenues earned going to the government would remain unchanged.

Moreover, the profit tax reduction proposed on Nov. 20 by Prime Minister Vladimir Putin, to come into force in the new year, will not be significant enough to prompt oil companies to jack up investment, said Artyom Konchin, an analyst at UniCredit Aton.

LUKoil vice president Leonid Fedun said last month, before Putin's profit tax proposal, that the government would have to offer the industry significantly higher tax savings if it wanted output to grow even marginally.

"Russia is in a phase of dwindling production," Fedun said at a recent investment conference. "So far, I don't see when we will move out of this phase."

Royal Dutch Shell chief executive Jeroen van der Veer said earlier this month that investment in oil projects could still be attractive at a world price of $50 per barrel — if taxes and royalties on production were not too high. LUKoil will decrease drilling next year, which will slow production growth in 2010 and 2011, Fedun said. Senior executives at Surgutneftegaz, the country's fourth-largest producer, and Gazprom Neft have said in recent weeks that their output will fall next year.

"With oil companies starting to wind back their 2009 [capital expenditures] programs … the reversal of the downward production trend in 2009 is no longer a guarantee," Uralsib's Viktor Mishnyakov wrote to investors in a recent note.

The government, however, is still calling for a rise in production.

"The global financial crisis, instability on the global commodity markets and a fall in oil prices demand that we take the measures that would allow a sustainable growth and development of the industry in contemporary conditions," Putin said at a meeting this month.

Finance Minister Alexei Kudrin was more specific, saying at a separate event that the ministry was betting on annual output increases of 0.5 percent per year until 2015. He said the price for Urals blend would remain about $50 a barrel next year.

Officials at the Energy Ministry and the Economic Development Ministry declined to be interviewed for this story.

The growth projections may, ironically, be based on the positive effects of changes brought on by the financial crisis, such as a weaker ruble, which has lost almost one-fifth of its value against the dollar since mid-July.

"That is a substantial benefit for companies like ourselves, which are primarily exporters of raw materials and generating revenues in dollars," said Peter O'Brien, chief financial officer at Rosneft, the country's largest oil company. "That should help us substantially in continuing to manage this cost growth."

Prices from providers of oil-field services could also come down, as costs for steel and cement fall and there is more competition for fewer investment projects in the industry, O'Brien said at the investment conference.

Despite the losses on fall exports, major oil producers will still boast robust profits for the year.

"It will without question be the best year on record for Rosneft in terms of volume and in terms of earnings," O'Brien said. "And that is despite what we all see today."

Alfa Bank estimated that Russian oil producers lost an average of $9.70 on every barrel they exported in September and $14.60 in October. It put the total losses across the industry for the two months, based on total export volumes, at $3.3 billion.

Integrated oil companies were able to redirect some exports to their refineries or to channel some production into storage tanks owned by Transneft, the national pipeline company. But shutting down wells is not a real option, as the substantial cost to restart them makes the practice too expensive.

Smaller oil companies, without their own refineries as an alternative to crude exports, were desperate, said Yelena Korzun, director of Assoneft, an association that brings together a number of smaller producers.

"Exports in September and October ate up absolutely all of the profits that had been accumulated over the year," Korzun said. "It led some companies to reduce production in November."