As veterans of the Russian oil industry, we believe these issues need further discussion, particularly given rising global demand for energy of all types. This article will review Russia’s recent energy history and discuss the highly destructive tax regime that is thwarting foreign investment. We will conclude with a look ahead. And unfortunately, that outlook is not bright: we believe that Russia will suffer from falling oil production for the next several years.

The Growth Period 2000 – 2003

The Russian oil industry opened the new millennium with an extraordinary awakening from a fifteen year slumber, during which the production had dropped by almost half, to 6.2 million barrels per day. In less than four years, crude output rose to 9.3 million, due to a new class of Russian entrepreneurs who took advantage of the residual potential left over from a rather inefficient exploration and production industry. Previously, oil wells had been significantly under-produced and headcount and operations cost well out of proportion; and much of the technology and know-how and many operating practices were outdated, to say the least.

The recovery couldn’t have come at a better time, with the developing world, headed by China, demanding more and more crude and the rest of the world finding it difficult to maintain production levels. In four short years, Russian oil industry personnel added the equivalent of Norway’s output, each year adding more than an “Oman equivalent.” This represents almost half of the world’s growth rate in crude production for the period.

The growth was led by Yukos, with Sibneft later following. Russia quickly became a very competitive arena, with each Russian company trying to out-perform the other. The companies were greatly assisted by stock analysts and reporters, who enjoyed stoking the competitive fires. An examination of Yukos’ performance will shed light on the unprecedented performance improvement managed by these entrepreneurs. While Yukos’ production doubled from 800,000 barrels of oil per day to 1.6 million, its employees dropped from 22,000 to 14,000; active wells plunged from nearly 14,000 to just over 7,000; the average production per well increased four-fold to 260 barrels per day; new well drilling was slashed in half to just 300 wells per year; the reserve-to-production ratio was halved to 20; SPE-proved reserves grew by almost a third to 14.9 billion barrels; the activation index was one of the lowest in the world at $530 per barrel; operation expenditures dropped to $1.54 per barrel; and finding and development costs dropped to $1.07 per barrel.

During this time, the Russian tax rate was reasonable and that allowed net income and cash flow to rise to world-class levels. Although Yukos produced about 20 percent of Russian crude, its production growth was 32 percent of the Russian total. The two dominant leaders, Yukos and Sibneft, were responsible for almost half of Russia’s entire production growth.

From 1986 to 1999 production went from more than 100 to 44 million tons per day. In the subsequent four years the company led the Russian Federation by almost doubling production from 44 to 84 million tons per year (1.68 million barrels per day). This period coincides with the time that the authors were responsible for Yukos production.

From 2000 to 2003, this new class of Russian entrepreneurs not only moved the Russian oil industry to global competitiveness but also led Russia to become the world leader in production and reserves growth.

Sustainability

Is it possible that all of the potential that once existed has been exploited? That pipeline infrastructure is finally full to capacity? On the contrary; although the potential gap that existed in 1999 has been narrowed, there is plenty of gap remaining. For example, even though Yukos raised the average well’s potential production efficiency from 7 to 14 percent, actual production could still be doubled before reaching 25 percent, the world average. There remains plenty of opportunity for growth in Russian oilfields, where the very high reserve-to-production ratio of 40 (compared to a world standard of 15) means that Russian oil producers could triple their production rate from current assets. Calculations also show that the recent high growth rates are technically sustainable for several more years and within accepted reservoir management standards. Furthermore, the country’s pipeline infrastructure currently has about 500,000 barrels of oil per day of idle capacity.

That said, there are several reasons why we are bearish on the future of Russia’s oil industry and none of them have anything to do with geologic potential or efficiency gains.

The Tax Regime

To fully understand the effects of the current tax regime, it is necessary to first consider several other coincidental factors affecting Russian oil. Normally, when taxes are increased, businesses cut expenses or increase efficiencies to compensate. However, Russian oil producers are getting hit with several other significant costs on top of the onerous tax regime.

First is the cost of oil transport. Due to the limitations and inefficiencies of the Transneft export system, almost all of the incremental exports since 2001 have been by “combined routes” rather than the Transneft system. The “combined routes” are mostly rail but also include tank cars, barges, pipeline spurs, etc. The cost of the “combine routes” scheme has risen rapidly and is expected to continue to rise at an even faster pace. There is no efficient transport infrastructure for further incremental production. Building a new efficient infrastructure would require a massive investment by the Russian oil companies when cash flows are already under heavy pressure from increasing cost and the current tax regime.

The potential for sustainable production and the potential for increased production depend on the reserves-to-production (R/P) ratio. The larger this number, the larger the potential. Russia’s R/P is at least 3 times that found in the West, suggesting significant future potential from the physics of production. Of course this greatly depends on reservoir management infrastructure and government policy.

Second, the cost of producing and selling oil is growing significantly faster than the retail prices of the products. The costs of steel, pipe, energy, drilling equipment, personnel, and outside services have surged, perhaps more so in Russia than elsewhere.

Also, domestic consumption is declining about two percent per year due to energy-saving programs introduced by all major consumers to fight the price increases. We expect additional savings programs to contribute to this decline for several more years.

Russian crude oil is bottlenecked. State-owned Transneft operates and controls the pipelines. But there aren’t enough of them. In 2003, combined transport, involving rail cars, road tankers, and spur pipelines, accounted for almost 50 percent of exports. This mode is eminently inefficient and by 2004, there was a decrease of almost 50 percent in the netback (profit) for oil exported by combined means, compared to that moved solely by pipeline.

Exporting more refined products would seem to be an alternative. However, this would provide no relief, since the export price for products made from one ton of crude is almost the same as the crude itself, and the production and transport cost of the refined products greatly exceeds the crude’s cost.

Another way forward would be to increase domestic prices for crude products which we are witnessing at the moment. This process is encouraged by the Natural Resource Extraction Tax, based on the world oil price. To compensate for the increase in taxes from rising Brent prices, Russian oil producers must increase domestic prices. Any gap between domestic and the Urals crude prices must be covered by product price increases. However, this scenario is not a panacea either, since the domestic market is tight— flat demand has resulted from rising costs for refined products due to dramatic tax increases. Further price increases will result in more imports of crude products from Eastern Europe, with domestic production decreasing accordingly.

To summarize, Russian oil companies’ profits are under siege on several fronts: increasing transport costs, surging OPEX costs, huge investment requirements, and accelerating taxes. Add to these factors the declining domestic market for crude oil.

A further word about these accelerating taxes. Our calculations show that when oil is selling for $55 per barrel, and Russian producers export their oil, the state gets $40 of that amount. Capital requirements eat up another $9, leaving the owners with just $6. However, for domestic sales, the state gets $28, with capital costs of just $2. That leaves the owners $26. You don’t have to be Alan Greenspan to figure out which route is more profitable. And the export tax regime is having a serious impact on the country’s exports. Russian oil companies are currently exporting just 67 percent of their production. In 2004, that was 71 percent. In 2003, they exported 75 percent.

One of the reasons for Russia’s and Yukos’ success in production enhancement is the incredibly low “activation index.” The activation index is equal to the cost of generating a new barrel of crude oil, per day. The activation cost for U.S. offshore drilling is $14,000 per barrel. In Saudi Arabia and Venezuela, it’s about $5,000. In Russia, it’s about $1,500. Careful selection of wells and reservoirs at Yukos dropped the activation index to nearly $500 per barrel per day, a feat unlikely to be replicated.

Even so, we expect less Russian oil to be exported in the future, despite the fact that the production cannot be sold domestically. The Russian production will drop but the required investment and expenses will drop even more, meaning that current profits for Russian oil companies will still improve significantly. Our models show that free cash flows [free-cash flows or free cash-flows?] will increase with the drop in production.

Production Forecast

Currently Russian oil is half privatized and half nationalized, with major disincentives for the private half and confusion and uncertainty for the state half. During the Soviet Era, Russian oil was reasonably competent, with decades of experience and effective business controls. The current “half and half’ is probably the worst of all alternatives. Of course, history has shown that the best would be full privatization with growth and investment incentives, or at least no disincentives. However, full nationalization with the restoration of the old Soviet management and control systems would be better than the current situation.

The higher forecast is from the Russian Ministry of Economics; the lower by the authors. While the Ministry forecasts an oil production of 558 million tons per year (11.16 million barrels per day) by 2008, the authors’ forecast is for only 389 million tons (7.78 million barrels).

The higher cash flows for Russian producers won’t mean good news for the global market, which will see higher prices because of declining production. We believe that by 2008, assuming no change in the “half and half” mode, Russia’s total yearly production will be just 389 million tons of oil, equal to about 7.8 million barrels per day. That’s a decrease of about 18.7 percent from the 9.6 million barrels per day that Russian fields produced in November 2005.

This drop in production will have serious side effects. We believe that, to maintain profitability, the Russian E&P sector will significantly reduce investment across the board, both in operation expenditures and new hires. That means bad news for both the oil infrastructure and Russia’s job market. And once those spending and job cuts occur, it will take years, perhaps even decades, for the Russian oil industry to recover.

Yuri Beilin was the president of Yukos E&P company. Joe Mach was first vice president responsible for Yukos’ exploration and production business.