RUSSIA: Lack of investment threatens oil sector

Analysis

In recent years, the Russian oil industry has operated almost exclusively on the basis of its inheritance from the Soviet era. Its capital stock is ageing and a rapidly growing proportion of the fields developed in the Soviet era are in decline. Until 2000, the oil industry also underwent a steady deterioration in its resource base: the volume of exploratory drilling fell by 75% during 1990-98 and drilling of new production wells dropped by around 85%. The rate at which new production capacity was introduced declined by 80% over the period, with more than 70% of Russian oil reserves now located in fields where the wells produce low yields and operate close to zero-profitability.

These conditions largely reflect the instability of the last decade. Oil sector investment is characterised by extremely long time horizons. During the 1990s, it was impossible to undertake long-term projects. Moreover, the most easily recoverable reserves -- located in relatively well developed parts of the country -- are being exhausted. It will soon be necessary to develop fields in Eastern Siberia and offshore in the far north and east. The cost of production at these sites is high, with drilling costs in northern Siberia at around 60-80 dollars per cubic metre at a yield of five to ten cubic metres per day. At current world prices, this is close to the break-even point.

Investment trends . There has been a significant recovery in investment since 1999:

According to Goskomstat, investment in oil production amounted to 217.1 billion roubles (6.9 billion dollars) in 2001, of which 176.6 billion was short-term. Investment in oil refining reached 24.8 billion roubles (13.7 billion short-term). This suggests that the majority of investment is aimed at maintaining current production. However, according to the Ministry of Energy, investment in the oil complex as a whole amounted to 7.8 billion dollars -- an increase of 33% on 2000 and more than triple the 2.2 billion recorded for 1999. While investment in crude oil extraction predominates, the ministry reports the fastest growth in investment in refining and transport (up by around 40% year-on-year in 2001).

Foreign investment is increasing (see RUSSIA: Foreign majors make inroads in oil sector - OADB, May 20, 2002, II. ). Foreign inflows last year amounted to 964 million dollars, making the oil sector Russia's third best in terms of attracting foreign investment (inflows into the food industry and ferrous metallurgy were greater). In the first quarter of 2002, foreign investment in the fuel and energy complex as a whole, including gas and electricity, amounted to 648 million dollars, up 320% on January-March 2001.

However, this apparently rapid growth in investment is from a very low base and overall investment levels are still low. In 2001, total fixed investment in all sectors of the Russian economy amounted to just 5.5 billion dollars, of which only 200 million was foreign. The main source of investment capital for the medium term seems likely to remain the companies' own retained profits. Yet the Ministry of Energy and the Ministry of Economic Development and Trade (MERT) estimate that the sector needs to invest ten to 15 billion dollars per year during the 2001-05 period in order to maintain production and develop new fields for the longer term. The estimate for the Khanty-Mansi Autonomous District, which accounts for 55-60% of oil production at present, is six to seven billion dollars a year. Required investment levels for 2005-20 are even higher, at 40 billion dollars per year for oil and gas together. Private-sector estimates are yet higher, with Lukoil President Vagit Alekperov suggesting that 100 billion dollars is needed in the next ten years.

Strategic planning . The Ministry of Energy recently presented to cabinet its new draft of the Energy Strategy for the period to 2020. The strategy places great emphasis on state action -- through structural reforms and tax incentives -- to attract investment. It also proposes measures to stimulate accelerated depreciation of oil-sector assets, and further suggestions to boost investment are expected in the revised version due by October.

However, many oil executives have criticised the proposals:

The strategy envisages a substantial increase in the fiscal burden on oil producers and extensive intervention by the ministry to direct oil-sector investment.

The ministry's proposals for stimulating investment in the development of more difficult, less profitable oil fields could mean de facto state support for the growth of those companies like TNK, Bashneft and Tatneft, which hold the licences to many such fields. The losers would be companies such as Yukos and Sibneft, which operate lower-cost fields.

The proposal to shift more of the cost of exploration from the state budget onto private companies has also aroused criticism. It is not clear that a company undertaking successful exploration would be guaranteed the licence to develop the newly discovered field.

One of the major problems is that the main bulk of capital expenditure in the sector comes from the budgets of the oil companies themselves: 85-90% of fixed investment is currently financed by retained profits and depreciation deductions. These budgets depend directly on fluctuations in oil prices. The fall in oil prices late last year led quickly to cuts in capital expenditure for 2002.

Russian banks are not in a position to finance oil investment, while the state remains interested in increasing its own share of the sector's income. Share issues by Russian oil companies or increases in their market capitalisation promise to make only a small contribution to the sector's requirements, given the current state of Russian financial markets. Thus, for the coming decade, companies will continue to rely on their own resources to finance 70-75% of their investment.

Investment opportunities . Many Russian oil companies control far greater reserves than they can hope to develop in the foreseeable future -- in some cases, an amount sufficient to maintain current production levels for up to 80 years. These companies needlessly tie up resources and also have very little incentive to invest in further exploration. The Ministry for Natural Resources (MPR) therefore wishes to introduce legal limits on the reserves controlled by individual companies. This could, in conjunction with further improvements to the legislative framework governing foreign investment -- especially that concerned with Production-Sharing Agreements (PSAs) -- lead to a redistribution of oil reserves, creating opportunities for foreign investors.

In early June, Duma deputies finally reached agreement with the Ministry of Finance on the tax regime for PSAs. The ministry will allow investors to recover capital expenditure fully and immediately, rather than over a period of years via depreciation. The long-delayed tax code chapter on PSAs is likely to pass its first reading in the Duma before the summer recess. Moreover, the MPR itself plans to spend 1 billion roubles this year on exploration and evaluation of mineral resources. Its target is to bring the discovery of new reserves up to current production levels, eventually pushing beyond this until reserves growth outpaces production by 20-40%, to make up for the under-investment of the last decade and more.