Mergers, fears of oil renationalization spark Russian market instabilities

Richard Swann

Russia remained in the worldwide energy spotlight this year despite a notable slowdown in the growth of its oil production from the heady rates of 2004. A year dominated by corporate deals and failures has resulted in a big shakeup, with the government taking a central role in the drive to find new markets for the country's abundant energy reserves.

AS LIBERALIZATION OF RUSSIA'S POWER sector continues and progress is made toward the long-awaited opening of its huge gas market, investors might think they are witnessing a typical deregulation. Normally, energy liberalization leads to a flow of foreign capital into the sector.

Turmoil rules markets

Look at Russia's all-important oil patch, however, and a different picture emerges. After an unprecedented corporate dismemberment, a failed merger, and an agreed takeover, the net effect of a year of profound changes has been the catapulting of state-controlled companies up the list of the biggest crude oil producers in the country.

Although 2004 saw a daunting—and ultimately insurmountable—number of charges against Yukos, then the fastest-growing oil major, 2005 has seen the company brought to its knees. With no letup in sight, few would bet on the company surviving far into the future in any meaningful form.

Rosneft, which is currently 100% state-owned, has already got its hands on Yuganskneftegaz, the undisputed jewel in Yukos' crown. Yuganskneftegaz accounts for around 1 million bbl/day of upstream oil production and was the engine behind most of the growth Yukos enjoyed in the early part of this decade.

The future of what is left of Yukos—including its production subsidiaries Tomskneft and Samaraneftegaz and its refining assets in Russia and Lithuania—is clouded by outstanding back tax claims and legal challenges to the company. Federal tax authorities, Yuganskneftegaz' new owner Rosneft, and a number of leading western banks are still looking to recoup more money and/or assets from the remnants of the company.

With a large chunk of formerly privately owned oil production back in state hands in the form of Rosneft, the government's grip on the energy sector also was strengthened when Moscow anted up $7.5 billion to take a further 10.47% interest in gas giant Gazprom, giving it majority control over the company.

Mother Russia tightens her grip

Gazprom, which already controls the world's largest gas reserves, has had ambitious plans for some time to expand its oil operations. The company was widely expected to win the December 2004 bankruptcy auction of Yuganskneftegaz.

The buyer ended up being Rosneft. But at that time, Rosneft and Gazprom were still working on merging to create a single state-owned energy giant. Though the plan appeared to be attractive on paper, issues such as the future status of Yuganskneftegaz quickly became problems, and the planned marriage of the two companies fell apart in early 2005.

Few people expected Gazprom's desire to expand into the oil sector to subside, so almost immediately speculation arose that a hookup with Sibneft, Russia's fifth-largest oil company, could be in the cards. Even Russian Federation President Vladimir Putin said he was aware of ongoing talks.

In September, Gazprom announced an agreement to pay a little over $13 billion to buy the 72.7% stake in Sibneft held by Roman Abramovich's Millhouse Capital. As with Rosneft and Yukos, it's another case of more oil in the hands of the state, and one fewer high-profile oligarch on the scene.

If approved, the deal would propel Gazprom into the league of Russian oil majors by giving it the lion's share of Sibneft's production, which averaged around 678,100 bbl/day in 2004. That may sound like a big number, but it's worth remembering that it is still dwarfed by Gazprom's gas business. Controlling reserves of over 28 trillion cubic meters, the company produced 545 billion cubic meters in 2004, or almost one-fifth of the world's gas. In oil-equivalent terms, Gazprom produced over 9 million bbl/day last year, or almost as much as the entire Russian oil industry combined.

The planned takeover of Sibneft still has a few issues that need to be resolved, including what to do with the 20% stake in the company owned by embattled Yukos, a legacy from an aborted merger between the two companies.

The clear result of a year of deals and disputes is a much greater state presence in the oil sector. A year ago, the top five oil producers were all privately owned, but Yukos and Sibneft have disappeared from the list, and Rosneft and the ambitious Gazprom now sit alongside Lukoil, TNK-BP, and Surgutneftegaz.

Bigger isn't always better

Another cause of uncertainty in Russia's energy markets is fear that Moscow has a plan to slowly but surely renationalize the nation's oil industry. The worries have been fueled by a stream of announcements about the details of a proposed amendment to Russia's subsoil law that could potentially limit the ability of foreign companies to own oil and gas reserves.

With precise details expected to be drawn up before the end of the year, the latest word from the natural resources ministry is that the list of "strategic fields" deemed off-limits to foreign oil companies may only include those with proven reserves of over 150 million metric tons. If this turns out to be the case, it would likely mitigate the impact of the legislation, as it would not apply to most investment opportunities. Nonetheless, companies will be watching carefully to see what final legislation is approved by parliament next year.

This debate also has been taking place as Russian oil output growth has slowed dramatically. 2004's almost double-digit increase in oil production pushed Russia well beyond Norway, making it the world's second-largest exporter, and even allowed it to challenge Saudi Arabia for the production throne. This year, however, the pace slowed considerably. Output was virtually flat in the first half of the year, and many expect to see overall year-on-year growth of only about 2.5% to 3%. One senior energy ministry official even suggested that Russian output could hit a plateau sooner rather than later.

Although 2004's growth rates were widely seen as unsustainably high, the downturn has been exaggerated by the demise of Yukos, whose output had previously been growing rapidly. Since late last year, the company's tenuous status prompted an understandable dearth of new investment at its upstream facilities.

Crude export growth has slowed even more rapidly than overall production, due mainly to higher export taxes and transportation fees. As global oil prices soared to record highs, Russia made sure that state coffers did not miss out on the windfall, raising crude export taxes to as much as $140 per metric ton, a level that would have been unthinkable until recently. Further changes to the tax regime also appear likely. The government reportedly is considering adjusting taxes on crude exports and wellhead production in an effort to simultaneously spur production growth and encourage companies to refine crude in Russia, thereby helping to ease domestic fuel prices.

A slowdown in the recent growth in crude exports seems to have been offset by more refined products being shipped overseas. This process is being helped by increasing efforts by Russian refineries to raise the quality of fuels they produce, bringing them in line with EU standards.

Great aspirations

Russia's desire to build on its position as a key exporter is reflected in its continued expansion of export projects. They range from Transneft's expansion of the Baltic Pipeline System to clear support for the much-discussed idea of building a pipeline bypass around the shipping bottlenecks at Turkey's Bosporus and Dardanelles Straits.

Russia's oil industry has not had a monopoly on high-profile export projects. Final approval has now been given to the North European Gas Pipeline, a project to be carried out between Gazprom and Germany's BASF and E.ON that would involve building a $5 billion gas pipeline under the Baltic Sea. Expect Russia to continue to seek new markets for its oil and gas, making it more competitive with other suppliers, through strong state-owned company involvement or at least state backing of all the major ventures.

Large parts of Europe have a long history of depending on Russia for gas supplies, and projects moving closer to fruition should add new customers to the list. Russia has never been a liquefied natural gas (LNG) producer, but projects on opposite sides of the country are expected to change that, bringing the energy-hungry U.S. market within reach for the first time.

Gazprom has edged closer to selecting partners to help it develop the giant Shtokman field in the Barents Sea, having watched some of the largest oil and gas companies in the world jostle to grab part of the project. Shtokman's attraction is, as much as anything else, its sheer size, with reserves estimated at a massive 3.2 trillion cubic meters. But the field is not likely to start producing any gas for some years to come.

Thousands of miles to the east, the Shell-led Sakhalin Energy venture should start producing LNG by 2008. However, the project made headlines for the wrong reasons in July after announcing a slip in its timetable and a doubling of its expected costs to $20 billion. ExxonMobil also operates a major project offshore of Sakhalin Island and has been in talks with potential gas customers in South Korea, Japan, and China. But firm contracts from Sakhalin 1 have yet to be signed.

These are among the best examples of foreign expertise and money leading the way in some key Russian projects. Attempts by non-Russian companies to gain a position in the existing upstream oil and gas sector are less common. Compared with the benchmark of BP's $8 billion tie-up with TNK in 2003, only ConocoPhillips' acquisition of a stake in Lukoil—currently at around 12%—warrants direct comparison.

Outside help arrives

France's Total hoped it had gained a similar, if somewhat less-expensive entry in the market when it announced plans in September 2004 to buy 25% of Novatek, the largest of a number of independent gas producers trailing in Gazprom's wake. Although presented as an agreed deal, the acquisition failed to materialize as Novatek pushed ahead with a separate initial public offering of its stock in July.

Russia is proving a tough nut to crack for Total, with the French company also coming up against opposition from Russian authorities over its budget for developing the Kharyaga oil field in the Timan-Pechora region. It also seems out of favor with Rosneft at the giant Vankor oil field in the Krasnoyarsk region of Western Siberia, where it had been the early favorite to join the project.

With Sibneft and Yukos both disappearing from view, the number of possible opportunities for cash-rich western majors to buy their way into Russia is diminishing. Firm plans are being drawn up, however, for an offering of Rosneft stock, although the state plans to keep a majority holding. Shares could be sold toward the end of 2006.

Russia's importance as a major supplier of both oil and gas to the world is unparalleled, and the volumes it is producing are expected to rise further. But over the past 12 months not much of this has been due to private capital, and even less to foreign money. BP's investment in TNK is starting to look less like a trailblazing deal, clearing a path for others to follow, and more like an exception to the norm.

Much uncertainty still surrounds the timing and extent of the liberalization of the country's gas and power sectors. Progress often has been slow and sometimes seemingly halted altogether somewhere in the machinery of government. The paradox of a situation that has seen the return of Gazprom to state control and its rapid expansion into the oil sector, even as the gas market is being readied for competition, gives a hint of what the future could well hold in store. That would be the long-awaited and called-for opening of the Russia energy sector—but on very Russian terms.

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