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. Last Updated: 07/27/2016

A Pumping Economy

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As oil goes, so goes the nation. Or does it?

Two years ago, this country was heading into a white-hot summer of protests over wage and pension arrears — total unpaid salaries alone had reached the $10 billion mark. Miners were blocking the railways, cutting the country in half, and workers from teachers to defense and even oil and gas industry staff were either on strike or threatening to do so.

Industry was stagnating as the nonpayments reached its peak. And the federal government was so short of cash that only emergency foreign loans and the GKO pyramid scheme were allowing it to keep up with at least some of its obligations. Futile efforts to maintain a strong ruble were draining the nation's hard-currency reserves at an alarming rate. Several prescient souls started to take their cash out through the back door, while an occasional voice — such as that belonging to liberal economist Andrei Illarionov — cried in the wilderness that catastrophe was just around the corner.

This summer there is still some social unrest, but it is mostly focused on government plans to change the Tax Code — changes that unions fear will stop the government from properly funding pensions and other social welfare payments.

That's right, those payments — along with wages in general — are now being funded in full. Meanwhile, industrial growth is booming, the economy as a whole grew 3.2 percent in 1999 and there are high hopes it will grow 5 percent or more this year. And the ruble has been appreciating at what the government feels is too rapid a rate f so much so that it has asked the Central Bank — with reserves standing at $19.9 billion as of June 9, their highest level since late 1997.

A High Octane Mixture



Why the difference? After all, very little has been done to try and fix the moribund banking system, crony capitalism and many of the other woes that helped spark the 1998 crash. National political and business life is still dominated by the so-called oligarchs f from uber-tycoon Boris Berezovsky and his protege Roman Abramovich, through Anatoly Chubais, "newcomer" and aluminum magnate Oleg Deripaska, to oil and gas kings Mikhail Khodorkovsy of Yukos, LUKoil's Vagit Alekperov, Rem Vyakhirev of Gazprom and others. Some changes have been made to tax and other legislation, but the bureaucracy is still as massive, stifling and arbitrary as it ever was.

Devaluation has helped, but the single most important factor has been one that is almost exclusively external to the nation's economy — oil.

Two years ago, Benchmark front month Brent crude futures were hovering between $14 and $14.50 per barrel, as much as $5 below the 1997 average of $19.30 per barrel. And as summer 1998 waxed, then waned into an autumn of economic collapse, world oil prices collapsed almost as fast as Russia's economic bubble — and for much the same reason, the Asian crisis, which crippled demand for oil just as supply boomed thanks to the OPEC cartel's poorly timed decision in March of that year to raise output levels.

But since March 1999, when the Organization of Petroleum Exporting Countries slashed output by some 1.7 million barrels per day, world oil prices have rocketed to reach close to $30 a barrel f levels not seen since the Gulf War. Even a decision earlier this year to again raise output to 1998 levels has done little to take the heat out of world oil markets. For Russia f a price taker for oil f the effect has been enormous.

Money and Power



"The health of the oil and gas sector is very important for Russia," said Stephen O'Sullivan, director of research at United Financial Group. "It's important for external perceptions of Russia's stability since it is a commodity economy," he said. "Internally, it provides jobs and a lot of money for the budget.

"And [tax] collection rates are rising all the time."

Not everyone agrees with that assessment. Roland Nash, chief economist at Renaissance Capital investment bank, said the oil sector is overplayed. "It's less significant than the media says and people expect," he said. "They think that if oil prices move, it's the be-all-and-end-all for Russia, but that's not necessarily the case."

Nonetheless, the industry has been producing huge profits over the past two years f and with costs in rubles and a large part of their earnings in dollars, the sector's bottom line has benefited more than any other from the devaluation. The oil and gas sector combined provide half of the country's foreign trade and 20 percent to 30 percent of its gross domestic product, O'Sullivan said.

Presidential adviser Illarianov said last month that high oil prices had helped the government keep close to its budget for the last two years. Nash estimated the oil sector alone provided 15 percent to 20 percent of budget revenues.

Perhaps the most ringing endorsement of the sector's importance is provided by the behavior of the oligarchs. Their establishment as a class of power brokers owed much to their success in snapping up major oil assets in the early stages of privatization, culminating in the now-infamous loans-for-shares scheme. By the time the process was over, almost every oligarch worthy of the name had his own oil firm. Those "oligarchs" without one f such as Media-MOST's Vladimir Gusinsky, Unified Energy Systems chief Chubais and Deripaska f all seem vulnerable; they could readily be called "fringe" oligarchs. The strongest of them, Deripaska, has nevertheless been forced into an alliance of convenience with Abramovich and Berezovsky.

For the foreseeable future, oil and power will go hand in glove in this country. And it is far from clear whether or not Russia will be able to shake its dependence on commodities in general and oil in particular as long as that situation continues.

That is at least symbolically important at a time in which the oil industry, one of the country's largest, produces the chief export, bringing in a large chunk of national hard-currency revenues and a significant contribution in taxes. Oil companies are set to export record volumes of 3 million tons per month this summer to capitalize on soaring prices on the European market.

But as long as large portions of these revenues are used to fund political power plays, the country's oil majors are likely to struggle to raise sufficient funds to invest in improving efficiency and flexibility. The government's role f especially its control of the pipeline system f is also likely to be a drag on investment. That means that the oil sector and, with it, the economy will be easy prey for the next global oil bust.

The Boom



Few could foresee the current boom even a mere 12 months ago. Industry analysts were predicting doom and gloom after August 1998's financial crisis. Indeed, the oil industry seemed it would be hit hard. In the years leading up to the crisis f when the raging local stock market fueled the country's rating as the top emerging market f oil companies eagerly borrowed money from international lenders all too happy to give loans to what seemed a stable industry.

When the crisis hit, the price of oil was at a low-point, and the industry faced a massive cash crisis. However, while other sectors f most notable the banking industry f collapsed faster than the blink of an eye, the oil industry reaped two key benefits that actually led to a reversal of fortune.

Oil companies were able to cash in on a devaluation of the ruble, after which the currency shed some 75 percent of its value, bringing costs down and export revenues up.

With OPEC's manipulations causing prices to triple, Russia f which is not an OPEC member f increased output to post-Soviet record amounts. If local oil wells and the creaking pipeline system of state-run Transneft f the monopoly operator f could have stood the strain, the country's oil producers would have undoubtedly raised output further. As it was, the urge to cash in on record profits was so enormous that gray and black market exports of finished petroleum caused sudden shortages and price explosions on domestic markets. In ludicrous scenes for a country as oil rich as this one, St. Petersburg, Sochi, Perm and Vladivostok were merely the most well-publicized of a nationwide gasoline shortage. At one stage, international airline Aeroflot had difficulties maintaining sufficient stocks of aviation fuel.

By mid-1999 profits and production were up. Leading the industry was Surgutneftegaz, which increased output 6.7 percent last year, according to company figures.

Profits surged also, with total net profits industry wide rising to 11.8 billion rubles ($417 million), compared to a relatively paltry 1.5 billion rubles in 1998 ($150 million according to an average of the year's wildly fluctuating ruble/dollar rate).

Overall financial improvements have also combined to buoy the oil industry, which has grown since the second quarter of last year.

All that is welcome news to the country's economy, which in turn helps the oil industry by boosting demand for fuel at home. That will further help the sector with increased domestic prices when world prices inevitably start to fall.

But despite the removal of one crony, those now running the oil industry f who emerged either out of the Soviet-era oil sector or banking and business circles f still have huge political clout. Oligarchs control six of the country's top oil companies: LUKoil, Surgutneftegaz, Yukos, Sidanko, TNK and Sibneft, all privately owned. That accounts for around 60 percent of Russia's daily oil production of 6 million barrels.

However, Steven Dashevsky, oil and gas analyst at the Aton investment company, said that the oil industry is murky everywhere. "It's not an open and transparent business and there's nothing that can be done about that."

Trickledown Effects

Until recently, one of the local oil and gas industry's most persistent problems has been the lack of sufficient investment in the sector, which badly needs modernization in order to bring its mostly Soviet-era infrastructure up to speed. With a few exceptions, companies have been too busy maximizing current profits at the expense of their own futures. Those cash flows have all too often gone to fund all manner of nonenergy industry projects, including investments in banking, media and other sectors deemed vital for the health of the company in question's financial-industrial group.

The Fuel and Energy Ministry has regularly raised the alarm, saying that the lack of investment on capital expenditures is so low that the country's oil production capacity is doomed to slide unless there is a reversal in where the oligarchs spend their fortunes.

Nevertheless, the investment drought is starting to break. The massive profits being made every month as world oil prices stay high have started to seep toward reinvestment.

"There's a tremendous cash flow," Aton's Dashevsky said. "And companies are doing the right thing by investing."

As past experience shows, a rise in capital investment does not necessarily mean increases in drilling volume. Oil companies spent a lot of cash last decade building expensive new offices and funding other perks for their executives. Even larger amounts of money were siphoned to offshore bank accounts.

But it seems the country's oil tycoons have realized they need to pump money into their assets.

"Most companies are now investing," said Dmitry Avdeyev of United Financial Group.

But he added that investors' expectations have also risen, so that what oil companies often see as potentially good news f such as announcements of dividend payoffs f often do not live up to investors' hopes.

Capital investment rose 10 percent last year, Interfax reported. LUKoil, for one, is expected to increase its capital expenditure to $1.5 billion this year, the Financial Times reported.

The Economics Ministry predicts a 2 percent overall rise in oil production this year.

But the figures for the first four months of this year have shown a production increase of 4.5 percent, analysts said.

"That's a big turnaround," said Dashevsky.

Meanwhile, primary oil refining rose 2.9 percent in 1999, including up 2.2 percent for gasoline, up 4.2 percent for diesel fuel and up 5.2 percent for fuel oil.

The refining sector, however, continues to face difficulties. Customers' inability to pay for oil products and limited capital at refineries has hampered operations and slowed the pace of plant modernization and reconstruction.

Meanwhile, performance in the exploration sector improved due to higher oil prices in 1999 and the first quarter of 2000 and higher prices for domestic producers, which provide 85 percent of the funds invested in exploration.

Deep drilling rose to 330,000 meters in the first quarter, up from 303,000 meters last year. The number of wells put up rose 46.3 percent last year. Meanwhile, tax incentives this year are expected to add 2,500 oil wells to the total, which will together extract an additional 1.8 million tons of oil, Interfax reported.

Outside Investment Needed



But analysts say that large undertakings, such as LUKoil's Timan Pechora exploration project in the very north of European Russia, just to the west of the Urals, can only be funded by money raised on international capital markets. That will only happen if the oil companies become significantly more transparent than they are now f that is also something the companies know well themselves.

LUKoil said it would invest 134.2 billion rubles ($4.7 billion) within the next 10 years into projects in the region, which the company said could produce up to 20 percent to 30 percent of LUKoil's total output.

Dashevsky said with the growth in investment, poor regulation and a large tax burden have become the industry's largest problems.

President Vladimir Putin has promised the government will crack down on the oil and gas industry, including the large amount of money outflow to offshore zones and insufficient capital expenditure, which has led to a deterioration of assets in the past.

Putin also threatened inefficient producers by saying the government would withdraw operating licenses. That would be a key step in reforming the sector, which would in turn boost investor confidence. But doing that is no simple task in the highly politicized industry.

Even several weeks after the formation of Prime Minister Mikhail Kasyanov's Cabinet, it isunclear what the government's oil policies will be. The Fuel and Energy Ministry has become the Energy Ministry, and the much-criticized Viktor Kalyuzhny f who publicly aided Sibneft and Tyumen Oil Co. f has been replaced at its head by Alexander Gavrin. The new man f who has strong ties to LUKoil f has kept a very low profile, in stark contrast to his predecessor. Gavrin has said he favors the market over "strict" market regulation, but he has said little and done even less.

Meanwhile, Kalyuzhny has been appointed as the president's special representative to the oil-rich Caspian region. It is unclear exactly what the position entails, but Deputy Prime Minister Viktor Khristenko has said that it will involve liaison work with Gavrin.

Analysts said it is too early to tell whether Kalyuzhny's sacking will indeed bring any tangible effects to the industry on the whole.

And Gurami Avalishvili f an old Kalyuzhny ally who worked under him when the ex-minister was vice president of Tomskneft f has retained his post as first deputy energy minister. Avalishvili has been tasked with drawing up a reorganization plan for the ministry.

"The main question now," Dashevsky said, "is whether the government will continue to stand in the way or do the right thing by working with oil companies."