Why Russia can't afford to alienate oil majors

Whether it's reasserting control over strategic energy supplies, allegedly ordering the assassination of enemies like Alexander Litvinenko, or silencing all dissent in the press, Russian President Vladimir Putin is behaving like a classic James Bond villain. He claims to be taking these actions for the benefit of the Russian people, but I suspect he's looking out for himself and his buddies.

The geographic connection between high-ranking Russian government officials and Gazprom executives is not a coincidence. A very high proportion of those in the halls of power happen to be from St. Petersburg, a port city on the Baltic Sea - the city called Leningrad prior to 1991.

In "Gazprom May Thwart Putin Drive for Russian Energy Dominance," Bloomberg writer Lucian Kim takes us back to the formative years of Putin's St. Petersburg crew:

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"The president [has] personal connections to the men who run Gazprom. Putin worked in the office of then St. Petersburg Mayor Anatoly Sobchak from the collapse of the Soviet Union in 1991-1996. When Putin served as head of Sobchak's foreign investment committee, Gazprom CEO [Alexey] Miller, 45, was his aide. Valery Golubev, 54, a Gazprom deputy CEO appointed last year, was, like Putin, born in St. Petersburg, served in the KGB intelligence service and worked in Sobchak's office starting in 1991.

"Dmitry Medvedev, Russia's first deputy prime minister and Gazprom's chairman, was Putin's legal adviser in Sobchak's office. In a poll released by the All-Russian Center for Public Opinion on April 17, those surveyed picked Medvedev, 42, along with Sergei Ivanov, also a first deputy prime minister, as most likely to succeed Putin. The president must leave office next year after completing his second four-year term.

"It's not a state company; it's the president's personal company,' says Vladimir Milov, a former deputy energy minister who runs the Institute of Energy Policy in Moscow. It's a bunch of people from the St. Petersburg administration enjoying the windfall.'"

In the wake of the Soviet Union's collapse, a mad rush to acquire former state-owned assets convinced many that if you wanted a piece of Russia's economic future, you'd better have the right connections. While most oligarchs pursued profit by snapping up inefficient companies for pennies on the dollar, Putin craved power and influence more than riches. His doctoral thesis centers on the importance of using natural resource wealth to enhance Russian power, so he believes that the government should have control over this vital sector, rather than privately owned companies.

Russian Gas Needs an Investment Boom

In his quest to reestablish Russia's position as great power -- and gain enormous public popularity in the process -- Putin seems to ignore why private ownership and free markets do a better job of efficiently extracting the maximum value out of resources. Left without a real profit motive, government-controlled companies like Gazprom are more like burning matches than they are going concerns.

Gazprom uses its stranglehold on the Russian pipeline grid and connections with environmental regulators to bully its way into growth. Like a gangster, it threatens corporate death in exchange for majority ownership in any project it covets. Companies like Shell just say, "Thank you, sir, may I have another?", happy to salvage some of their sunk costs from projects like Sakhalin 2. They have no leverage over government-backed Gazprom.

But while it was busy stealing others' properties, Gazprom seems to have ignored the basic necessity to replenish its ever-depleting production base. It must now accelerate big projects to make up for lost time. Kim's Bloomberg article continues:

"[Gazprom's] options for expanding [natural gas] output are challenging. One is to open the 700-kilometer-long Yamal Peninsula that juts into the Arctic Ocean to gas production. While Gazprom said in October it would begin developing the project, the remoteness of Yamal, which holds an estimated 10.4 trillion cubic meters of gas, demands a huge investment

"The other option is Shtokman, a field holding as much as 3.7 trillion cubic meters of gas and located 500 kilometers offshore in the icy Barents Sea. A year ago, Gazprom's plan was to develop the site with the help of two or three foreign equity partners. The bidders were Norway's Norsk Hydro ASA and Statoil ASA, Chevron Corp. and ConocoPhillips of the U.S. and France's Total SA.

"After months of delaying a decision on choosing its partners, [Gazprom CEO Alexey] Miller last October went on Russia Today, the Kremlin's English-language satellite news channel, to tell the world that Gazprom would develop the project without foreign investors. On the technical side, Gazprom needs foreign expertise,' says Roland Nash, chief strategist at Renaissance Capital in Moscow. But Gazprom can afford to wait because there's fierce competition for its reserves.'

"Gazprom has pushed back the earliest production date for Shtokman to 2013. Chevron puts the price tag of the project at as much as $20 billion.

"Gazprom executives insist they won't have any trouble meeting future demand. We're investing as much as necessary,' Deputy CEO Medvedev says. In January, Gazprom's board approved total 2007 investments of more than $20 billion, including $1 billion for Yamal and $600 million for Shtokman. The company says it plans to spend $24 billion on capital projects in 2008 and $27 billion in 2009.

"Economy Minister German Gref, who sits on the Gazprom board, is skeptical. At a government meeting in March, he complained the company still hadn't submitted production plans through 2020. Miller replied that Gazprom wouldn't produce new gas until there were concrete buyers for it."

By "concrete" buyers, Miller refers to reliably profitable buyers. A highly regulated Russian natural gas market leaves Gazprom in a difficult position. The state subsidizes consumers by capping the price at which gas can be sold. This has led to a situation in which Gazprom is losing money on the gas it sells domestically, so the company has made up for it by jacking up prices on its European customers.

Gazprom Is Running on a Fast Treadmill

Ending gas price subsidies to former Soviet Union states like Ukraine and Belarus enabled Gazprom to receive full market prices for the gas it sells to European customers. The Kremlin rightly received criticism for the way in which it abruptly cut off customers in the middle of winter, but the fact remains that Gazprom needs to charge fair market prices in order to fund its massive investment program. Putin's government (and that of his handpicked successor) plans to gradually raise the cap on domestic gas prices as well. This clearly won't bolster his popularity.

Why would Putin risk his legacy by lifting the cap on domestic natural gas prices? Because he realizes that the situation is dire for his old St. Petersburg friends. Intelligence service Stratfor recently wrote that if the current status quo is maintained, Gazprom will literally run out of natural gas within a decade.

"Gazprom's problem is simple. Its investment into bringing new fields on line is absolutely abysmal. As of 2000, only three major fields in western Siberia -- Urengoy, Yamburg and Medvezhye, with reserves of 16 trillion cubic meters of natural gas among them -- accounted for about 70% of Gazprom's total natural gas production. All are past maturity, and efforts to replace them are middling and lagging. The first major field brought on line since the end of the Cold War -- the 3.3-trillion-cubic-meter Zapolyarnoye superfield -- only began commercial production in 2001, and its output peaked in 2004.

"All the low-hanging fruit already has been picked, and Gazprom has not shown the managerial foresight, interest in foreign investment, or technical capacity to replace output at a pace that will forestall production declines. The chart below indicates the International Energy Agency estimation of Russia/Gazprom's output decline without a substantial and immediate increase in investment dollars. Most of the increase -- the blue region -- is likely to come from Kazakhstan and Turkmenistan, and since those increases depend on an improvement of the infrastructure linking Russia to Central Asia, the real picture might even be bleaker."

Gazprom desperately needs to invest massive amounts of capital into mitigating production declines at its existing properties. Companies that provide drilling services, drilling equipment, and enhanced recovery technology stand to benefit. At first glance, many would say that this projection going out to the year 2020 is too pessimistic since it doesn't include much of a bump from potential future discoveries.

This may be true, but in order to bring potential discoveries into production, Russian operators will require more drilling and more rig equipment. It's not a stretch to assume that the Russian rig fleet is old, overtaxed, and must be refurbished in order to accomplish a very busy future.

The North American natural gas industry appears to be in a similar situation. It will need to gradually increase drilling activity just to maintain current production rates. This chart, maintained by EOG Resources, shows the production from gas wells drilled in each year since 1990 and how much the wells contribute to total U.S. gas supply:

It appears that production from wells drilled prior to 1990 makes up less than 20% of total gas supply. Decline rates are accelerating because higher and higher proportions of U.S. gas production comes from "unconventional" sources. This helps explain why the number of land rigs actively drilling in the U.S. has gone up and up, yet gas production remains flat.

Russian Oil Needs an Investment Boom

Natural gas is not the only industry that needs massive investment. The Russian oil industry requires an investment boom as well.

For the May issue of Petroleum Review magazine, editor Chris Skrebowski wrote a piece entitled "Dancing with the Bear." Skrebowski wrote it after attending the Energy Institute's International Petroleum Week 2007 in February. Held in London, IP Week's "Russia Day" attracted a standing-room-only crowd eager to hear key leaders of Russia's oil and gas industry. I was intrigued by Skrebowski's views on the evolving role of private oil companies in Russia, drawn from Vladimir Milov's presentation:

"Vladimir Milov of the Institute of Energy Policy, Russia, then spoke to the title The Rise of State Energy Companies and Its Effect on Oil and Gas Sectors in Russia.' He started by showing that up to 2004, private oil companies had accounted for 83.5% of production, with state-owned companies providing just 16.5%. By the end of 2006, the state section had grown to 32%, the private sector had fallen to 42%, and there was a gray zone' accounting for 26% of production. The gray zone comprises Surgutneftgaz, the remainder of Yukos, and the Russian-owned 50% of TNK-BP. He anticipated that these were likely to move into the state sector over time, giving the state dominance in oil production.

"He then went on to show how production from companies that had been nationalized had fallen over the last two years. He also noted that if the Yukos companies had just maintained production at end-2004 levels, Russia would already be producing over 10 million b/d [emphasis added]."

For perspective, here's an updated version of the Russian/Saudi oil production figures as reported by the Energy Information Administration:

Russia is producing about 9.5 million barrels per day and is widening its lead over Saudi Arabia as top oil-producing country in the world.

Skrebowski continued:

"Milov then went on to show the way that Western technology was leading to the greatest expansion in Russian production. Rosneft's re-establishment of links with Schlumberger had allowed Yuganskneftegaz production to expand by 4.5 million tonnes in 2006. Foreign-owned projects -- Salym, Sakhalin 1, Kharyaga -- had contributed another 3 million tonnes in 2006. Schlumberger was performing 30 hydrofracs a month for Yuganskneftegaz and 100% of the wells in the Priobskoye field had been treated.

"His estimate was that Russian production in 2006 would only have expanded by 1.6% rather than the actual 2.2% without foreign investment. Yet, ironically, the campaign against foreign investors escalated in 2005-2006. This has already led to laws defining strategic' oil and gas fields where foreign investment is limited to a minority holding. President Putin at two recent meetings had floated the idea of not expanding Russian oil production any further [emphasis added].

"Milov went on to show that a similar pattern was seen in the gas sector, with production from the independent sector growing fast while Gazprom's output was little changed. In his view, a gas supply gap was already emerging as Gazprom's investment in gas production was too low to meet the requirement."

President Putin is floating the idea of not expanding Russian oil production any further? Even the possibility of this occurring should grab large media headlines. Yet few in the Western world are thinking about the possibility that a) Russia may not be able to expand production much beyond current levels without massive assistance from private international companies like Schlumberger, or b) whether Russian leaders would want to expand production in exchange for foreign currency.

As I noted to Strategic Investment readers in recent weeks, the long-term value of the U.S. dollar (and other paper currencies) will become more and more of an issue for those in Asia and the Middle East who find themselves overwhelmed with too much cash and too little energy and resources for themselves.

It remains to be seen whether Putin and his cronies at Gazprom will come crawling back to big Western oil companies once they discover just how difficult big future projects will be. But this much should be expected: International oil service companies have an opportunity to satisfy huge demand for cutting-edge oilfield technologies in places like Russia and the Middle East.

Meanwhile, those who feel they're entitled to buy all the cheap hydrocarbons they want with U.S. dollars need to realize that Russia has re-emerged as a great power. President Putin and whichever crony he's lining up to be the next president have a firm grip on the future of Russian energy, and it doesn't look like they're going to loosen it anytime soon.

By DaN Amoss for Whiskey and Gunpowder

Whiskey & Gunpowder is a free, twice-per-week, e-mail service for more from the team, go to https://www.whiskeyandgunpowder.com