The Russian Energy Ministry on Oct. 2 released its oil production figures for September, indicating that oil production fell for the ninth straight month. Oil production fell 0.4 percent in September compared to the same period last year, to 9.83 million barrels per day (bpd). If this decline continues — and it most certainly will, since output normally contracts during the winter due to the lack of river shipping options — for the rest of the year, it would be the first time since 1998 that Russia has experienced an annual oil production decline.
Russia has the world’s eighth-largest proven oil reserves (60 billion barrels) and is the world’s second-largest producer (9.83 million bpd) and exporter (7 million bpd), after Saudi Arabia. Russia’s energy exports (and particularly its position as the main natural gas supplier to Europe) account for roughly 20.5 percent of its gross domestic product and generate 64 percent of its total exports, allowing the Kremlin to amass an emergency surplus fund of approximately $750 billion. It is the revenue from its energy sector — mainly natural gas, but also oil — that has allowed Moscow to resurge on the world scene by challenging the West in Georgia and Ukraine and pot entially even globally. In short, Russia’s energy sector is the main source of the Kremlin’s contemporary geopolitical power.
The news of the potential annual decline in production is therefore troubling for Russian long-term force projection — if not necessarily an issue for the immediate short term — particularly because it comes two years before most experts predicted Russian oil production would begin to stagnate, let alone decline. If the decline is not just an isolated blip on the radar and is a continuing trend, then Russia eventually could begin facing problems in sustaining its current level of geopolitical activity into the late 21st century.
At the heart of the decline is the obvious problem of Russian geography. The vastness of Siberia may contain enormous reserves of crude, but accessing them is nearly impossible. Aside from the obvious problem of distance, actually setting up operations anywhere in Siberia is a Herculean task. Roads can be traveled only in the winter; they are impassible in the summer due to the melting of the permafrost and are snowed in during the fall and spring.
The fields that have been exploited thus far are the ones that are relatively easy (for Siberian conditions) to access. These Soviet-era fields are, almost across the board, now maturing and in decline. This is a result of years of overproduction and the gutting of Soviet infrastructure and oil wells by the oligarchs in the early 1990s. Most of the main fields are now over 50 percent depleted.
In terms of new fields, there is very little that will come online in the next few years to boost production output. LUKoil’s South Khylchuyu field should begin to yield its full capacity of 150,000 bpd by 2009. The Piltun-Astokhskoye field within the Sakhalin-2 project is another sizable find, active since 1999 but developed at enormous cost (more than $20 billion). The 300,000 bpd Vankorskoye field, owned by Russian state-owned oil behemoth Rosneft, is also being counted on to stem the decline.
The problem, however, is that these three fields — as well as any future ones that may be developed — all suffer from high infrastructure development costs. LUKoil was faced with extreme Arctic weather, a tumultuous Barents Sea and the total lack of infrastructure in Timan-Pechora when developing its South Khylchuyu field. The Sakhalin-2 project is in the equally daunting Sea of Okhotsk on the similarly infrastructurely-challenged Sakhalin island, while Rosneft’s Vankorskoye is faced with the further problem of being far from any viable export infrastructure.
The point here is that because of lack of infrastructure and the distances involved, Russia’s export options are limited, particularly as new fields become developed in more and more inaccessible regions of Siberia. Tapping the Vankorskoye field, for example, will require plugging it into the Eastern Siberia-Pacific Ocean (ESPO) pipeline, the project that has cost $20 billion and has been delayed since mid-2007 due to cost overruns, though it is finally getting back on track in 2008.
This sort of infrastructure development will require active and enthusiastic participation by the Russian government — which is difficult to imagine during the global credit crunch.
The Kremlin is currently more concerned with consolidating its banking system and assuring economic stability at home. On a more positive side, the Kremlin is aware of the problem and has begun thinking about investing more thoroughly in some projects (especially with the ESPO pipeline). The question is whether Moscow will be willing to seriously invest in development in the next few years as the global credit crunch dries up foreign investment and forces the government to be the only lender to the Russian energy companies.
The irony, however, is that the very reason the Kremlin is so flush with cash at the moment is because it has taxed its oil companies (literally) dry. One of the main reasons the Russian oil fields are maturing and very little greenfield development is occurring is that the tax structure encourages mature-field development to the neglect of greenfield projects. This means that a private (foreign or domestic) company trying to break into the Russian market not only is faced with daunting infrastructure challenges — and obviously many political hurdles — but is in fact discouraged by the tax system from developing greenfield projects.
Taxes also make it impossible for Russian oil companies to invest profits from high commodity prices into capital expenditure. Any revenue received for an exported barrel of oil that cost more than $25 is taxed at 65 percent. That proportion can grow to more than 90 percent when other ancillary government taxes are imposed. A further export tariff is imposed on any exports going outside the Commonwealth of Independent States.
Ultimately, the problem with Russian oil production is political. A high tax structure that discourages capital expenditure and new greenfield investments actually benefits the market leader (in this case, the state-owned Rosneft) by making it difficult for new market entrants — such as LUKoil — to break into the field. That means that the company most in need of capital expenditure to replace its maturing fields — Rosneft — is also the one least likely to lobby the Kremlin for low taxes to get that extra revenue, as it is precisely the tax structure that allows it to dominate the field.
It is therefore clear that Russia will not be able to maintain current oil production without a concerted effort to develop new production and transportation infrastructure and encouraging greenfield projects. A declining oil production, combined with the ongoing natural gas production decline, is a challenge to the Kremlin’s overall long-term prospects for successful geopolitical brinkmanship with the West.