For years, the economy has been addicted to high oil prices. But, as Ben Aris reports, by keeping the taps open, President Vladimir Putin has managed to break Russia's crude habit.
"Putin came to the job of president convinced that the 1998 financial crisis
was caused by Russia's overdependence on oil. His first priority since then has been to break this addiction by boosting production so that Russia Inc. is profitable at any price," says Chris Weafer, head of research at Troika Dialog. "And he has already succeeded."
Weafer believes Russia has kicked its habit of coasting along and relying on
oil exports to bail out the economy while reforms are ignored. Rising oil production means Russia has already passed the crucial breakeven point. From
now on, oil money is only going to make reform easier.
The key to understanding Russia's attitude to oil, Weafer says, is to realize that the budget needs to generate about $20 billion per year from oil-related taxes to balance. President Vladimir Putin's strategy has been to encourage oil companies to increase production as fast as possible: the more they export, the lower the price of oil can be to earn the money the government needs.
For the most part, Russian oil majors, with the notable exception of LUKoil,
have gleefully stepped into the breach. Sibneft announced output was up by nearly a third in March while exports rose a whopping 44 percent year-on-year in the middle of April. No. 2 oil company Yukos has boosted production by about 20 percent per year. And as a whole, the oil sector's production has been putting in 8 percent growth per year for the past three years.
All this frenetic activity has come as a nasty shock to the rest of the world, and the Organization of Petroleum Exporting Countries in particular. Russia regained its Soviet-era title as the world's biggest oil producer in March, outstripping Saudi Arabia for the first time since the fall of the Soviet Union with 7.28 million barrels per day.
This was quickly followed by another record when, a week later, the International Energy Agency announced Russia had broken new ground with an all time oil export high over the first quarter of this year, exporting more
than 3.3 million bpd.
The oil production high is temporary as Russian companies are working at full capacity, while Saudi Arabia is at two-thirds capacity, but the export record is permanent, and Russia is unlikely to give up territory gained to OPEC, which has been badgering Russia to cut production to boost sagging prices.
"At the end of last year, OPEC believed that Russia was still a basket case economy that needs prices over $20 a barrel to get by," says Weafer, who was
recently in Geneva to advise OPEC secretary general Ali Rodriguez on what is
happening in Russia. "But they have had a rude awakening. Now it realizes that it will have to deal with Russia -- and as the second most important oil country in the world after the Saudis."
Russia is pretty much the only place in the world -- apart from Kazakhstan and the Caspian region -- with significant unexploited or unexplored reserves of oil and as the international companies are running out of new reserves, they will be increasingly forced to deal with Russia.
At the same time, the conditions for working with Russian oil companies have
changed radically in the past two to three years as the focus of Russian companies changed -- almost overnight -- from asset stripping to investment and boosting production and profitability. With their new emphasis on corporate governance, they are now viable partners for multinationals. This has been fuelled in part by the fact that Russia has broken its addiction to
oil. It means that the macroeconomic climate is stable and the country will not lurch from boom to crisis anymore as the international price swings up and down.
Already this year, a spate of hook-ups has been announced. BP decided in April to pay $375 million for 10 percent of oil major Sidanco, bringing its total share in the company up to 25 percent plus one share. Two days later, Royal Dutch/Shell followed with the biggest-ever investment pledge into Russia, with chairman Phillip Watts announcing he is considering projects worth $16 billion, half of which will be financed by the company. A final decision will be made by the end of the year. Royal Dutch/Shell has already invested $2 billion into the Sakhalin-2 oil field off the coast in the Far East.
Then a week later, TotalFinaElf announced it was getting into bed with state-owned oil company Rosneft in exploration projects in the Black Sea, as
well as investing $350 million in the Kharyaga project in the Siberian Nenetsk Region, one of only three projects run under a production-sharing agreement that guarantees foreigners' investment.
Economic Comfort Zone
Russia's oil production has reached the point where the country's addiction to high oil prices was broken for the first time since the fall of the Iron Curtain. Going forward, Putin is now concentrating on building an "economic comfort zone" in the form of a strategic oil reserve fund.
Given that the government needs to earn $20 billion from oil, this year's budget balances at $18.50. When the budget was written, oil was significantly higher and the extra money was going to be siphoned off into a special reserve fund, but prices fell in November to around $18. On the back of recent unrest in the Middle East, they rose again and talk about the reserve
fund was revived.
As prices spiked briefly over $24 a barrel in the last month, the reserve fund grew to 100 billion rubles ($3.2 billion) by the start of May, according to Duma budget committee chairman Alexander Zhukov. Regardless of what prices do from now on, as production continues to grow, money will continue to pile
up in the fund.
The reason why can be seen by plotting the price of oil needed to balance the budget -- a price that generates the government's $20 billion of taxes -- against projected oil production volumes.
Between 1997 and 1998, the budget's breakeven price for oil was between $26 and $28, while actual prices fell to around $10, sparking the financial blowout. Between 1999 and 2001, however, the breakeven price fell from $26 to $23 as production volumes began to rise, while the price of oil in international markets also rose. The two met last summer at a price of about
$26.
>From now, the Russian budget can freewheel downhill: as production levels
continue to plough ahead at a robust 8 percent per year, the breakeven price
will continue to fall. Oil production is already up to about 7.5 million bpd
from 6 million bpd, where it languished for most of the last decade, and is expected to regain its Soviet-era production peak of 9 million bpd by 2006, by which time Troika estimates the breakeven price will be an easily obtainable $14.
Making Life Easier
Russia is already in Putin's comfort zone and the Kremlin has been using it to make life easier in the future. Given that this policy forms the cornerstone of his grand economic strategy, Putin will snub any efforts by OPEC to cut production in the future.
"[The Russian comfort zone] is an important part of the [Minister for Economic Development and Trade German] Gref's plan and one major reason why Russia will not, and cannot, comply with OPEC requests for production and export restraints," says Weafer. "But the price can't fall too much below $20 as the Saudi economy's very dependence on this price creates a brake."
In the midst of covering the Russian oil story, it is often forgotten that the Middle East is even more addicted to oil than Russia ever was. With petrodollars flowing in for decades, the Arab countries have never bothered to diversify their economies. Saudi Arabia, for example, draws 80 percent of
its budget revenues from oil, while oil only makes up about a third of Russia's. And the Saudi budget won't balance with oil fetching less than $20
per barrel.
Weafer argues that if prices do fall well below $20, the Saudi regime will be in danger of collapsing and this instability will drive prices up again.
Assuming that prices do remain around $20, then cash in the strategic oil reserve fund will begin piling up.
The windfall incomes of recent years have already been used to pay off international debt, which has fallen from more than 80 percent of gross domestic product in 1998 to about 40 percent, or $130 billion. At the same time, the oil revenues have allowed Putin to push through radical tax cuts, bringing personal income tax down to 13 percent and corporate profit taxes down to 25 percent -- the lowest levels in Europe.
Until now, the tax cuts looked like a one-off stab at doing something about the appalling state of tax collection and were largely written off as an aberration when they were announced in the spring of 2000. However, now that
oil prices are above the breakeven level and more tax cuts are being announced, those cuts are starting to look like part of a long-term strategy.
"[Oil] production volumes are important when it comes to balancing the budget, but more important are the tax reforms," says Peter Westin, chief economist at Aton. "In the past, oil companies only paid taxes when they were forced to, but recently -- for the first time -- there is a correlation between oil prices and tax revenues. The tax reforms have created tax revenues where none existed before."
Finance Minister Alexei Kudrin announced a fresh round of cuts in the middle
of April, this time to value-added tax, the biggest single contributor to the budget, and to the hated employee social taxes. Kudrin said social taxes would be reduced in increments of 2 percent to 3 percent over coming years until they reach about 30 percent. VAT will also be dropped this year from the current 20 percent to 17 percent, or even lower. And more recently, there has also been talk of dropping the corporate profit tax rate further after disappointing growth results in the first quarter of this year.
The logic behind all this fiscal tinkering is to meet the Kremlin's overriding objective of reducing the burden on nascent and existing business
as much as possible to boost growth. Russia has put in a sterling performance over the last three years, but Putin is far from happy.
"Are we satisfied with what has been achieved [since 1999]? Our answer, of course, is no and again no. There are no reasons whatsoever for us to be dizzy with success," Putin said during his state-of-the-nation speech in April. "Russia's economic problems, which have been piling up in the course of previous decades, decades of stagnation and crises, have not disappeared.
Poverty, even though it has receded, just receded, still continues to torture nearly 40 million of our citizens. In terms of economic growth in recent years, we have only managed not to fall further behind other countries."
Putin has set Russia the task of catching up with Portugal, and if it continues at this year's estimated rate of 3.5 percent annual gross domestic
product growth, it will be the 22nd century before Russia overhauls the European Union's poorest economy. Russia needs to put in 8 percent a year for at least a decade to pass Portugal.
Eurasian Economic Union
It is hard to overestimate the importance of Putin's success at breaking Russia's addiction to oil at home, but Putin has bigger ambitions than just turning Russia Inc. into a viable enterprise.
Almost as soon as he took office, Putin began touring the Central Asian countries offering them a new deal: forget our imperial ambitions of the past, we want to work as business partners.
It has been a tough sell -- following the break up of the Soviet Union, all the "Stans," as they are nicknamed, shunned Russia and looked to the West for help. The landlocked presidents of Central Asia were hoping foreign investors would come and unbottle their huge oil and gas resources. All the oil and gas pipelines out of the region run over Russian territory, and Russia under Yeltsin was playing hardball. Turkmenistan, for example, was cut off from lucrative Western gas markets in the early '90s and forced by Gazprom to sell all its gas to impoverished Ukraine.
The foreigners came, but the huge new pipes remained a dream. Putin wants to
change all that and after a decade of economic misery, the "Stans" are showing signs of being responsive to Putin's overtures.
Last year, Russia restructured Ukraine's massive energy debt on very favorable terms, converting it into Eurobonds. Russia's main gas pipeline to
the West runs across the Ukraine.
Then in January, Russia signed a new bilateral gas agreement with Turkmenistan. Similar agreements are in the works with Kazakhstan and Uzbekistan -- both of which have significant, if not huge, reserves of gas. A few days after the Turkmen deal was signed, Putin announced the creation of a "Eurasian Energy Union," that brings together Russia with Turkmenistan, Kazakhstan and Uzbekistan.
"Its creation would allow us to have effective control over volumes and the direction of exports of Central Asian gas," Putin said after the agreement was signed.
The Union brings a double benefit to Russia. Last year, Russia signed agreements to significantly increase energy deliveries to Europe, where Russian gas already accounts for a third of Germany's needs. The trouble is that because reforms at Gazprom are only moving slowly, Russia is not producing enough gas to meet its obligations. By buying Central Asian gas at
$40 per 1,000 cubic meters, or tcm, Russia frees more of its own gas to be sold to the West at about $100 per tcm.
The second fillip is that Europe is currently liberalizing its gas market and doing away with the long-term contracts that it used to sign with Gazprom.
"Putin wants to make sure that none of the Central Asian states -- Turkmenistan in particular -- emerge as a competitor on the European market," says Martin Raiser, the European Bank of Reconstruction and Development's senior economist for Central Asia. "But to make it work, Putin has to give away something."
In the wake of the Sept. 11 terrorist attacks on New York, the West is keener to diversify its energy supplies, and financing for long-discussed pipelines
out of Central Asia that don't run across Russia would be easier to raise. With a working Energy Union that doesn't need major investment in new pipelines, the economics of building new pipelines looks less attractive. In
return Russia will have to be prepared to pay a bit more for Central Asian gas.
The next key step on building out Russia's energy resources will be to bring
in more investment to keep up the pace of expansion.
Bush's Wish List
Energy was high on the agenda during U.S. President George W. Bush's visit here last month. U.S. Undersecretary of Energy Robert Card had said in an interview with Kommersant at the end of April, "The U.S. is seeking increased supplies from Russia. If Russia offers a reasonable price, we will buy oil in Russia."
And just days before the summit, Russia's biggest oil producer, LUKoil, said
it was willing to fill any shortfall in supply the United States may suffer.
Bush and Putin signed a largely ceremonial missile treaty in Moscow during the summit, but the real meat of the meeting went on behind closed doors: Bush came to Russia to talk oil and push his energy agenda on the Kremlin.
Since the terrorist attacks on New York last year Washington has intensified
a program to find energy sources outside the Middle East: despite its own oil wells, the United States remains a net importer of crude oil.
And Russia and the Caspian Sea countries are an obvious alternative source -- the former Soviet Union is one of the few places in the world with significant unexploited reserves.
America wants to, "reduce volatility and enhance predictability of global energy markets and reliability of global energy supply," an agreement signed
by the presidents says.
A flurry of activity was visible in Moscow during the days prior to Bush's visit to Moscow as officials prepared the ground. The U.S. State Department has already said it would like to increase cooperation with Russia and hours
before Bush was due to arrive U.S. Commerce Secretary Don Evans met with Gazprom chief Alexei Miller to talk about cooperation.
As Russian oil production rises relentlessly, Moscow is looking for new markets. LUKoil, Russia's largest oil company, said last month it was willing to fill any shortfall in supply American may suffer. Russia currently exports an insignificant amount of crude oil and a small amount of oil products to the United States.
"The U.S. administration is very oil-orientated as three senior people -- including the president -- are former oil executives," says Timur Karimov, an oil analyst with Aton brokerage in Moscow. "Bush is looking for new sources of oil, and Russia is the obvious choice."
According to sources close to the talks, the White House's wish list contained three items, all designed to boost the world's supplies of non-Arab oil.
Bush's first concern is to secure supplies leaving the former Soviet Union. Bush asked Russia to stop hampering the operation of the Caspian Pipeline Consortium oil pipeline -- a new pipe that went on line last year and carries Kazakh oil from the huge Tengiz field on the Caspian to the Russia Black Sea
port of Novorossiisk.
The Kazakh economy has boomed since and exports from the land-locked Central
Asian country should double every year for several years. Russia has been prickly about the pipeline and, among other problems, is keen to mix its sour and less valuable Siberian oil with the sweeter Caspian-region crude.
Washington also wants the Kremlin to publicly commit to a long-discussed oil
pipeline from the Azeri capital of Baku on the western shore of the Caspian Sea to the Turkish Mediterranean port of Ceyhan.
Huge new oilfields have been found under the Caspian Sea, but as all the pipelines out of the region run over Russian territory to the north, the newly minted republics around the sea are keen to build a new pipeline out of the region to the south or west. The Kremlin, unable to completely shake imperialistic habits, has been lobbying against the $3 billion Baku-Ceyhan pipeline, which would effectively break its hegemony over the Central Asian states. The United States has been lobbying for the pipeline for exactly the
same reason.
Following the Sept. 11 attacks, Putin has made a revolutionary turnabout in his relations with the west. A dispute over missiles and the United States' national missile defense shield -- the so-called Star Wars program -- had chilled relations between the two countries.
But Putin's new real politik has persuaded analysts that the Baku-Ceyhan pipeline is looking more likely. Rumors in the Kazakh capital of Almaty late
May say that construction could begin this July.
Bush didn't go to Moscow without carrots. On the table for Russia is official recognition as a market economy -- the U.S. steel industry has effectively lobbied for trade barriers against Russian steel on the basis that it is artificially cheap due to non-market price of energy in Russia.
And Washington is offering to help boost investment into Russia's own oil industry. However, this help comes with strings attached. The third item on the list is that Bush wants Putin to push through production sharing agreement legislation that locks in tax rates for foreign investors into the
oil sector.
Russian companies are unhappy with the idea of production-sharing agreements
as they ask why should foreigners get a special deal while they get none. According to Yukos, Russia's No. 2 oil company, the White House is behind the curve on this issue. In recent months several multinational oil companies have taken the plunge and invested in Russia without PSAs. Yukos says it is in cooperation talks with four international oil companies, all of which are
willing to commit without a PSA.
"The summit is an opportunity to form an energy alliance between Russia and America," said Hugo Eriksson, the head of Yukos' investor relations. "We hope this summit will be the start of a new relationship between the two countries, phrased in purely economic terms."
Putin, for his part, has already said American companies should step up their investment into Russian energy.
Tackling the Ring Fence
Russian companies are also keen to go down this road. Yukos has already announced it is considering selling a stake to a strategic investors and the
international oil majors continue to sniff around Russia for deals.
But the jewel in the crown will be reforming Gazprom. A new gas pipeline route through Poland is already on the table for discussion, but the gas behemoth needs to boost production before all else. For this, the company needs money, but as it is already carrying a $13 billion debt load, backed by future deliveries, the new management has little room to maneuver.
The obvious answer would be to sell some of the company's equity to a strategic investor such as Germany's Ruhrgas, which already owns 5.5 percent. However, restrictions on foreign ownership of local shares -- the so-called ring fence -- have held the company's stock price down. If the government is
serious about reforming its energy producers, then the fence needs to be pulled down.
According to Bill Browder, the chairman of Hermitage Capital Management, Gazprom's board intends to take a first step in this direction at Gazprom's annual general meeting, which is slated for later this month.
"Dmitry Medvedev, the deputy chairman of Gazprom, says the company plans to announce plans to increase the amount of shares open to foreign investors to
20 percent at the annual general meeting," Browder says.
The Cabinet is currently preparing a review of energy strategy, which will be released in June and it will lay out a development plan for the gas market in December. In the meantime, the Kremlin will not be willing to sell its stake
until the value of Gazprom shares move a little closer to their "fair value."
Making the gate in the ring fence a little bigger would be a good first step.