Cyclopedia Of Economics 1st edition

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Russia, Energy Sector of

The pension fund of the Russian oil giant, Lukoil, a minority shareholder in TV-6 (owned by a discredited and self-exiled Yeltsin-era oligarch, Boris Berezovsky), this week forced the closure of this television station on legal grounds. Gazprom (Russia's natural gas monopoly) has done the same to another television station, NTV, last year (and then proceeded to expropriate it from its owner, Vladimir Gusinsky).

Gazprom is forced to sell natural gas to Russian consumers at 10% the world price and to turn a blind eye to debts owed it by Kremlin favorites.

Both Lukoil and Gazprom are, therefore, used by the Kremlin as instruments of domestic policy.

But Russian energy companies are also used as instruments of foreign policy.

A few examples:

Russia has resumed oil drilling and exploration in war ravaged Chechnya. About 230 million rubles have been transferred to the federal Ministry of Energy. A new refinery is in the works.

Russia lately signed a production agreement to develop oilfields in central Sudan in return for Sudanese arms purchases.

Armenia owes Itera, a Florida based, Gazprom related, oil concern, $35 million. Itera has agreed to postpone its planned reduction in gas supplies to the struggling republic to February 11.

Last month, President Putin called for the establishment of a "Eurasian alliance of gas producers" - probably to counter growing American presence, both economic and military, in Central Asia and the much disputed oil rich Caspian basin. The countries of Central Asia have done their best to construct alternative oil pipelines (through China, Turkey, or Iran) in order to reduce their dependence on Russian oil transportation infrastructure. These efforts largely failed (a new $4 billion pipeline from Kazakhstan to the Black Sea through Russian territory has just been inaugurated) and Russia is now on a charm offensive.

Its PR efforts are characteristically coupled with extortion. Gazprom owns the pipelines. Russia exports 7 trillion cubic feet of gas a year - six times the combined output of all other regional producers put together. Gazprom actually competes with its own clients, the pipelines' users, in export markets. It is owed money by all these countries and is not above leveraging it to political or economic gain.

Lukoil is heavily invested in exploration for new oil fields in Iraq, Algeria, Sudan, and Libya.

Russian debts to the Czech Republic, worth $2.5 billion in face value, have just been bought by UES, the Russian electricity monopoly, for a fraction of their value and through an offshore intermediary. UES then transferred the notes to the Russian government against the writing off of $1.35 billion in UES debts to the federal budget. The Russians claim that Paris Club rules have ruled out a direct transaction between Russia (a member of the Club) and the Czech Republic (not a member).

In the last decade, Russia has been transformed from an industrial and military power into a developing country with an overwhelming dependence on a single category of commodities: energy products. Russia's energy monopolies - whether state owned or private - serve as potent long arms of the Kremlin and the security services and implement their policies faithfully.

The Kremlin (and, indirectly, the security services) maintain a tight grip over the energy sector by selectively applying Russia's tangle of hopelessly arcane laws. In the last week alone, the Prosecutor General's office charged the president and vice president of Sibur (a Gazprom subsidiary) with embezzlement. They are currently being detained for "abuse of office".

Another oil giant, Yukos, was forced to disclose documents regarding its (real) ownership structure and activities to the State Property Fund in connection with an investigation regarding asset stripping through a series of offshore entities and a Siberian subsidiary.

Intermittently, questions are raised about the curious relationship between Gazprom's directors and Itera, upon which they shower contracts with Gazprom and what amounts to multi-million dollar gifts (in the from of ridiculously priced Gazprom assets) incessantly.

Gazprom is now run by a Putin political appointee, its former chairman, the oligarch Vyakhirev, ousted in a Kremlin-instigated boardroom coup.

Foreign (including portfolio) investors seem to be happy. Putin's pervasive micromanagement of the energy titans assures them of (relative) stability and predictability and of a reformist, businesslike, mindset. Following a phase of shameless robbery by their new owners, Russian oil firms now seem to be leading Russia - albeit haltingly - into a new age of good governance, respect for property rights, efficacious management, and access to Western capital markets.

The patently dubious UES foray into sovereign debt speculation, for instance, drew surprisingly little criticism from foreign shareholders and board members. "Capital Group", an international portfolio manager, is rumored to have invested close to $700 million in accumulating 10% of Lukoil, probably for some of its clients. Sibneft has successfully floated a $250 million Eurobond (redeemable in 2007 with a lenient coupon of 11.5%). The issue was oversubscribed.

The (probably temporary) warming of Russia's relationship with the USA and Russia's acceptance (however belated and reluctant) of its technological and financial dependence on the West - have transformed the Russian market into an attractive target. Commercial activity is more focused and often channeled through American diplomatic missions.

The U.S. Consul General in Vladivostok and the Senior Commercial Officer in Moscow have announced that they will "lead an oil and gas equipment and services and related construction sectors trade mission to Sakhalin, Russia from March 11-13, 2002." The oil and gas fields in Sakhalin attract 25% of all FDI in Russia and more than $35 billion in additional investments is expected. Other regions of interest are the Arctic and Eastern Siberia. Americans compete here with Japanese, Korean, Royal Dutch/Shell, French, and Canadian firms, among others. Even oil multinationals scorched in Russia's pre-Putin incarnation - like British Petroleum which lost $200 million in Sidanco in 11 months in 1997-8 - are back.

Takeovers of major Russian players (with their proven reserves) by foreign oil firms are in the pipeline. Russian firms are seriously undervalued - their shares being priced at one third to one tenth their Western counterparts'. Some Russian oil firms (like Yukos and Sibneft) have growth rates among the highest and production costs among the lowest in the industry. The boards of the likes of Lukoil are packed with American fund managers and British investment bankers. The forthcoming liberalization of the natural gas market (the outcome of an oft-heralded and much needed Gazprom divestiture) is a major opportunity for new - possibly foreign - players.

This gold rush is the result of Russia's prominence as an oil producer, second only to Saudi Arabia. Russia dumps on the world markets c. 4.5 million barrels daily (about 10% of the global trade in oil). It is the world's largest exporter of natural gas (and has the largest known natural gas reserves). It is also the world's second largest energy consumer. In 1992, it produced 8 million bpd and consumed half as much. In 2001, it produced 7 million bpd and consumed 2 million bpd.

Russia has c. 50 billion oil barrels in proven reserves but decrepit exploration and extraction equipment, and a crumbling oil transport infrastructure is in need of total replacement. More than 5% of oil produced in Russia is stolen by tapping the leaking pipelines. An unknown quantity is lost in oil spills and leakage. Transneft, the state's oil pipelines monopoly, is committed to an ambitious plan to construct new export pipelines to the Baltic and to China. The market potential for Western equipment manufacturers, building contractors, and oil firms is evidently there.

But this serendipity may be a curse in disguise. Russia is chronically suffering from an oil glut induced by over-production, excess refining capacity, and subsidized domestic prices (oil sold inside Russia costs one third to one half the world price). Russian oil companies are planning to increase production even further. Rosneft, the eighth largest, plans to double its crude output. Yukos (Russia's second largest oil firm) intends to increase output by 20% this year. Surgut will raise its production by 14%.

Last week, Russia halved export duties on fuel oil. Export duties on lighter energy products, including gas, were cut in January. As opposed to previous years, no new export quotas were set. Clearly, Russia is worried about its surplus and wishes to amortize it through enhanced exports.

Russia also squandered its oil windfall and used it to postpone the much needed restructuring of other sectors in the economy - notably the wasteful industrial sector and the corrupt and archaic financial system. Even the much vaunted plans to break apart the venal and inefficient natural gas and electricity monopolies and to come up with a new production sharing regime have gone nowhere (though some pipeline capacity has been made available to Gazprom's competitors).

Both Russia's tax revenues and its export proceeds (and hence its foreign exchange reserves and its ability to service its monstrous and oft-rescheduled $158 billion in foreign debt) are heavily dependent on income from the sale of energy products in global markets. More than 40% of all its tax intake is energy-related (compared to double this figure in Saudi Arabia). Gazprom alone accounts for 25% of all federal tax revenues. Almost 40% of Russia's exports are energy products as are 13% of its GDP. Domestically refined oil is also smuggled and otherwise sold unofficially, "off the books".

But, as opposed to Saudi Arabia's or Venezuela's, Russia's budget is based on a far more realistic price range of $14-18 per barrel. Hence Russia's frequent clashes with OPEC (of which it is not a member) and its decision to cut oil production by only 150,000 bpd in the first quarter of 2002 (having increased it by more than 400,000 bpd in 2001). It cannot afford a larger cut and it can increase its production to compensate for almost any price drop.

Russia's energy minister told the Federation Council, Russia's upper house of parliament, that Russia "should switch from cutting oil output to boosting it considerably to dominate world markets and push out Arab competitors". The Prime Minister told the US-Russia Business Council that Russia should "increase oil production and its presence in the international marketplace".

It may even be that Russia is spoiling for a bloodbath which it hopes to survive as a near monopoly in the energy markets. Russia already supplies more than 25% of all natural gas consumed by Europe and is building or considering to construct pipelines to Turkey, China, and Ukraine. Russia also has sizable coal and electricity exports, mainly to CIS and NIS countries. Should it succeed in its quest to dramatically increase its market share, it will be in the position to tackle the USA and the EU as an equal, a major foreign policy priority of both Putin and all his predecessors alike.

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