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. Last Updated: 07/27/2016

Bad Times Big Oil




World oil prices have collapsed, ending the party for Russian oil exporters. Jeanne Whalen reports on how they will weather the storm.


The last time world oil prices crashed, in the mid 1980s, the consequences for Russia were catastrophic.


Leonid Brezhnev's stagnating economy had been living on the proceeds of high oil prices since the 1970s. The oil billions financed one last spurt of the Cold War and gave communism another decade.


But when a booming global supply sent prices down in the mid 1980s, the Soviet economy collapsed. Soviet leader Mikhail Gorbachev had little choice but to seek radical solutions. The failed gamble of perestroika was the result.


That same cycle may now be repeated. The Gulf War sent prices through the roof, and since then Russia's oil sector had been sharing the profits from a world oil shortage that had kept prices close to $20 a barrel.


Since November, however, a glut of oil on world markets and the crisis in Asia have depressed prices by almost 40 percent. The dilemma threatens to cut profits of Russian oil companies by up to 50 percent this year and could cut into margins for years to come if oil prices remain low.


With the export market dead, Russian oil companies are struggling to cope with crippling tax burdens and a domestic market where customers are more likely to pay with bathtubs than with cash.


As the largest sector in the Russian economy, the oil industry will not be the only sector to suffer. Other industries serving the oil sector will also feel the pinch. And the effects will quickly spread through the whole Russian economy, where crude oil and oil products account for 25 percent of exports and oil companies make up 25 percent of the federal government's total tax revenue.


The government is already scaling down its modest predictions of 1 to 2 percent growth in gross domestic product for the year.


Origins of the Fall


The crisis began on world markets in November last year, when OPEC announced it would raise production quotas by 10 percent, to 27.5 million barrels per day from 25 million.


OPEC's timing couldn't have been worse. The market for this increased supply collapsed in November when financial turmoil hit Asia, leaving the oil industry's fastest growing customers unable to pay for large quantities of fuel.


Since OPEC's announcement in November, the price for benchmark Brent North Sea crude has fallen about 37 percent from an average of $19.30 last year. Russian oil, considered to be of poorer quality, trades at an average discount of $1.00 to Brent.


Sinking prices finally forced members of OPEC and some non-OPEC producers to promise production cuts. Over the weekend, key producers, including Saudi Arabia, Venezuela, Mexico, Iran and the United Arab Emirates, pledged to reduce production by up to 2 billion barrels a day.


If achieved, such a production cut would almost offset OPEC's November production increase of 2.5 billion barrels per day. Reacting to the news, Brent crude rose by $1.80 to close at $15.07 in London trading Monday. Russian oil also climbed, ending the day up $2.00 at $13.81.


Still, analysts treat OPEC's offer with caution, noting that the group is notorious for breaking production quotas.


And other factors will likely keep prices in check. Demand in Asia will remain weak until the region pulls out of its financial crisis, while an increasing number of non-OPEC producers, including Vietnam, Mexico and Central Asian developers of Caspian Sea reserves, will be eager to step up production, said Stephen O'Sullivan, an oil analyst with MC Securities in London.


The United Nation's decision to allow Iraq to double exports under the food-for-oil humanitarian program also could increase the problem of oversupply. This will hit Russia especially hard since Iraq produces oil of similar quality to Russia's.


O'Sullivan cautioned against rushed predictions that OPEC's action will push up prices. "Let's not get carried away with euphoria," he said. "Let's see where prices settle, let's see whether OPEC sticks to its promise, and let's see what happens with Iraq."


Effect on Russia


Before this weekend's promises of production cuts, investment bank Deutsche Morgan Grenfell predicted Brent oil would fetch $15 this year, $16 in 1999 and $17 in 2000.


The dilemma is of great concern to Russian producers, which are poised to lose big money this year.


Analysts offer different estimates, but most predictions are grave: MC Securities calculates profits will fall 20 percent to 25 percent for even the best-run Russian companies, while MFK-Renaissance predicts an average drop of 50 percent.


Russian companies carry some of the highest tax and production costs in the world, leaving their profitability dependent on high export revenue. Today's prices leave many Russian producers exporting at break-even levels, and others exporting at a loss.


Getting a barrel of Russian oil to market can cost up to $13.50 per barrel when all is said and done.


Operating costs range from $7 to $8 per barrel, while transportation fees paid to pipeline monopoly Transneft eat up another $4.90 per barrel. A fixed excise tax of $1.30 is also levied on each barrel.


If those basic numbers are correct, Russian exporters lose money when prices for Russian crude drop below $13 to $13.50. And with prices for Russian crude averaging $13.22 since Jan. 1, Russian producers have lost a lot of money.


LUKoil, widely considered to be Russia's best-run company, announced earlier this month it had lost $30 million on February exports from the Black Sea port of Novorossiisk.


Economics Minister Yakov Urinson offered an even more sobering account when he reported this month that Russian companies in total lost $500 million in January and February exports.


The situation varies widely from company to company, however, and the numbers are rubbery. In a recent issue of the Kommersant Daily newspaper, Mikhail Fridman, whose Alfa Group owns the Tyumen Oil Company, said most Russian oil producers would be pushed into the red when oil prices sink lower than $10 a barrel.


Cost Cutting


Russian companies acknowledge their high production costs are making this tough market even tougher. Producers in the Middle East, on the other hand, face production costs of "almost zero," according to Mark Henderson, an oil analyst with Deutsche Morgan Grenfell, London.


Difficult climatic conditions and outdated production equipment are part of the reason for Russian oil's high costs, but part of the problem is bad management. The head of Russia's fourth biggest oil producer, Sidanko, last week said low oil prices are waking companies up to the need to cut costs.


"Never have falling world prices for products improved the situation of companies producing those products," said Vladimir Potanin, president of Sidanko's controlling shareholder, Uneximbank. "But to find something good to say about the situation, Sidanko and other Russian companies after this crisis have started to pay more attention to their cost of production."


Yuksi, Russia's biggest oil company, which is now being formed from a merger of Yukos and Sibneft, last week also announced a sweeping program of cost cutting, including job cuts.


Improving efficiency is a noble goal, but analysts say it will take years for most Russian companies to do so. What Russian producers want is a quick fix in the way of huge tax cuts.


A tax burden equaling one-half of revenues has long frustrated the growth of Russian oil majors. Moreover, many of the taxes are not based on profits but on volume. As the oil price falls, taxes hurt more. "The Russian government is aware that as it continues to demand the bulk of its budget revenues from the oil industry, production is declining and even the strongest firms in Russia are forced to operate along an uncomfortably narrow profitability threshold," Deutsche Morgan Grenfell analyst Steve Allen wrote in a report last year.


Since prices began falling, oil companies have started to lobby for lower taxes. In January, the heads of seven major oil companies sent a letter to Prime Minister Viktor Chernomyrdin urging that excise taxes be halved and pipeline tariffs reduced.


The letter to Chernomyrdin, dated Jan. 19, argued that current tax obligations will exceed oil companies' ability to pay in 1998 by 20 percent, or 16.8 billion rubles ($2.6 billion). The letter argued that if oil prices continued to fall, the oil industry's 1998 losses could reach as much as 27 billion rubles ($4.5 billion) at current tax levels.


"In the case of a sharp growth in this deficit, the oil companies will be forced to sharply reduce agreed upon levels of production ... and to reduce the number of production workers," the letter warned.


The oil tax issue will be at the top of the agenda of the new Cabinet that takes shape after Chernomyrdin's dismissal Monday. Government leaders have offered conflicting views up till now.


New acting Prime Minister Sergei Kiriyenko on Monday gave the order for a decree cutting oil excise taxes to be prepared immediately. First Deputy Prime Minister Boris Nemtsov agreed that oil companies needed help.


"Oil prices have fallen by 50 percent and oil companies just cannot pay," he said.


The excise tax is perhaps the most dreaded of all oil taxes. It is a flat tax levied on each metric ton of oil sold, meaning the tax remains the same when the price per metric ton drops.


Another tax -- the pipeline tariff -- is particularly burdensome for producers shipping oil long distances to export. Producers exporting


crude on the Black Sea from faraway Siberia, including LUKoil, Sibneft, Sidanko and Surgutneftegaz, are particularly vulnerable to pipeline tariffs.


Those with production closer to export terminals, such as Tatarstan's Tatneft, Yukos' Samaraneftegaz, and Rosneft's Krasnodarneftegaz, feel the pinch less. In part because its oil fields are relatively close to Black Sea ports, Tatneft says it can break even on exports at prices as low as $10 per barrel.


"Tatneft perhaps is in a more advantageous situation, as our transport costs for export are much lower than for other oil production companies," said Maxim Dyomin, Tatneft's advisor to the general director on finance and investments. "Under current conditions we can still work. If the price gets any lower, it will be very tough for us."


Ultimately, Russia's producers will have to turn off the tap on some wells if prices don't recover, said Irina Pinkovsky, an oil analyst with Merrill Lynch in London.


"I truly fail to conceive of a rational reason for them not cutting production," Pinkovsky said. "Many Russian companies are already operating at a loss, they are not making any money on the current price, and exports are becoming increasingly unattractive."


Still, Yuksi is the only Russian oil major that has announced it will cut costs this year by cutting production. In a statement last week, the holding company said world prices will force a 5 percent cut in production and a decrease in refining, as well.


Many Russian companies don't have a choice in whether to cut exports. They rely on the steady source of cash provided by exports and will export even at a loss to get cash to pay salaries and other basic operating expenses.


And although export prices have moved nearer domestic prices, many Russian companies are obliged to continue exporting to meet the terms of loans they have taken out that guarantee exports as payment. Yukos, LUKoil and KomiTek are among the companies that have pledged their exports as payment against multi-million dollar loans from Western banks.


Domestic Market


At first glance the domestic market would appear to offer a promising alternative to unprofitable exports. Crude prices in Russia have remained stable at about $11 per barrel, and the cost of selling oil within Russia's borders is much less, as the buyer, and not the seller, is required to pay pipeline tariffs.


According to one oil analyst who asked not to be named, some companies have begun to give up export quotas to sell their crude on the domestic market. Onaco, based in the Urals region, is one company that is doing so, the analyst said.


"I've heard that a significant number of Siberian companies are now cutting back on their export programs," agreed Tatneft's Dyomin.


The down side of selling to the local market is that payments are rarely in cash. Russian oil majors conduct from 50 to 90 percent of their domestic sales in barter, as many Russian customers are unable to pay cash.


Some companies, such as LUKoil and Surgutneftegaz, have strict cash collection policies and could probably manage to squeeze some cash out of increased sales in Russia, the analyst said. But as more oil seeps into the domestic market, prices are sure to go down.


The domestic price for crude oil has reflected this increase in supply, dropping from about 560 rubles per metric ton to 510 rubles per metric ton in recent weeks.


According to the president of one Russian oil giant, there is not enough domestic industry to consume the vast supply Russian oil producers offer. Vladimir Bogdanov, president of Surgutneftegaz, Russia's third largest producer, said at a news conference last week that "until Russian industry really changes ... nothing will happen."


Investment Plans


Despite the threat of drastically reduced profitability, Russian oil majors seem to be forging ahead with planned investment programs for 1998.


Tatneft, Russia's fifth biggest oil producer, plans to cut back slightly on plans to invest $500 to $600 million in operations this year, but can rely on the proceeds of a $300 million Eurobond to bolster investment funds, Dyomin said.


"Of course, because of the fall in world prices, the amount of capital we use from company operations for investments will be less this year," Dyomin said. About 80 percent of Tatneft's investment spending in 1997 came from operations.


Tatneft's spending will largely focus on improving the efficiency of oil wells, Dyomin said, the area most vital to reducing high production costs.


Surgutneftegaz's Bogdanov said he will reduce planned investment expenditures of about $1 billion by 10 percent to 12 percent.


Surgutneftegaz will spend on projects that "pay back quickly," Bogdanov said, such as tapping new deposits that can start producing within a short period of time, and improving production efficiency at current wells.


LUKoil, meanwhile, doesn't appear to be cutting back on plans to invest $7 billion in capital expenditures through 2000. The company continues to acquire massive new deposits without blinking an eye at falling prices.


LUKoil and U.S. oil major Conoco announced this month they plan to invest $2 billion to develop four fields in Russia's Timan-Pechora region. The company in December also acquired full control of a vast Caspian Sea field called Severny.


LUKoil, of course, has a wealth of financing available to speed its aggressive growth plans despite troubled oil prices.


The company in January appointed five Western banks to underwrite a $1.5 billion loan that will provide much of this year's financing for capital expenditures.


Long-Term Investment


The jury is out on how long-term investment in Russian oil will be affected should world prices remain low. French major Elf Aquitaine's announcement Monday that it intends to purchase a 5 percent stake in Yuksi for $528 million suggests the foreign community's interest in Russia has not wavered.


Elf is the fifth foreign oil major to sign a deal with a Russian company in recent months. In addition to the LUKoil-Conoco deal, British Petroleum in November purchased 10 percent of Sidanko, while Italy's ENI and Royal Dutch/Shell both have signed strategic partnerships with Gazprom.


But with oil prices low, foreign companies will be more concerned than ever over high Russian taxation, said Deutsche Morgan Grenfell's Allen. Foreign investors will be even more stringent in their condition that they will invest in Russia only under production sharing agreements, which guarantee tax levels more stable and favorable than current regimes, Allen said.


"If oil prices are hitting all producers the same, there are places where investment plans will be cut back sooner, and because of high taxation, Russia is one of those places," Allen said.