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. Last Updated: 07/27/2016

Falling Oil Production Threatens Pipeline Plans

Itar-TassTransneft facilities at the Primorsk port on the Baltic Sea. Doubts are being raised about the planned BTS-2 pipeline.
The country's falling oil output may make a planned export pipeline to the Baltic Sea a costly white elephant -- built for political rather than economic ends, its critics say.

Designed to cut Russia's dependence on transit states, the BTS-2 link is poised to boost shipping costs for oil majors and further dry up state funds at a time when Russia needs billions to support the ruble and help companies refinance foreign debts.

"It is unclear where Transneft intends to find oil for the new pipeline given declining oil production and exports and already ample spare capacity in the pipeline system," said Valery Nesterov, an energy analyst at Troika Dialog.

"Transneft faces the prospect of paying up to $5 billion for a project that would bring no additional revenues, except those accompanied by a similar increase in costs," he added.

Transneft designed BTS-2 nearly two years ago after a pricing dispute with Belarus briefly disrupted deliveries of crude via the Druzhba pipeline to Poland and Germany.

Since then Russia has moved to an export capacity surplus as expansion has outpaced the growth in output and domestic refineries have been modernized.

Thus last week's funding approval by Prime Minister Vladimir Putin for BTS-2 took many observers by surprise at a time when Russia is spending billions on supporting its currency and banking system.

"Russia could easily end up with massive spare capacity, even if all flows from Druzhba are diverted to the new Russian pipelines," JBC Energy analysts said in a research note.

The 1 million barrel-per-day link will branch off from the Druzhba pipeline in Russian territory and go to Ust-Luga near its largest oil port of Primorsk on the Baltic Sea.

Russia is the world's second-largest oil exporter. It reduced exports to less than 4 million bpd during some months this year, from an average of 4.2 million to 4.3 million bpd in 2006 to 2007, and is heading for its first output decline in a decade this year.

Initial estimates for the cost of BTS-2 were about $2 billion, but have since been as high as almost double that.

Its purpose has also evolved. Designed initially to avoid Belarus, it could also serve to divert crude from Ukraine and Poland amid strained political relations with both neighbors.

"The project has in the meantime become a political weapon, which Russia is wielding in its clashes with the transiting neighbors," JBC Energy said.

Transneft's head Nikolai Tokarev said in September that it would stop sending crude to the Ukrainian ports of Odessa and Yuzhny and Poland's Gdansk from 2012 when it launches BTS-2's first, 600,000 bpd stage.

By then, Russia's first oil link to China should be at full capacity of 600,000 bpd, diverting west and east Siberian crude from its traditional European destination.

Transneft still needs to find billions of dollars to finish building the Asian pipeline and has been negotiating a $10 billion loan with China as part of a broader crude supply deal.

"The main issue that continues to cause doubt about this project [BTS-2] is the economics of it," said Denis Borisov from brokerage Solid.

Transneft plans to sell ruble bonds to state banks to fund BTS-2, which means that it will be competing for state money with other companies at a time when capital markets are virtually shut for Russia.

Collapsing oil prices could bite into the project heavily.

"Both low and abnormally high oil prices -- of below $40 per barrel or above $100 per barrel -- threaten the economics of the project," Borisov added.

He said low prices lead to lower output, while high prices would push domestic refining margins up and discourage exports.

"The project is motivated by the interests of a small group of people. There is no strategic interest underneath it," a trader with a large Western major said.

The BTS-2 foresees building a spur to feed the Kirishi refinery of the country's No. 4 oil producer, Surgutneftegaz, one of the closest oil firms to the Kremlin, while the pipeline itself will terminate at the new Ust-Luga port.

The terminal will be developed in cooperation with Gunvor, a Swiss-based oil trader that enjoys close ties to Russia's political establishment and major state oil firms.