Valery Nesterov, Troika Dialog
Release Date: 2011-06-16
What is the significance of Russia overtaking Saudi Arabia in 2009 in oil production?The Russian industry is not overly concerned with its position as an oil producer and whether it is number one or two. Indeed this is only a temporary situation given that Saudi Arabia disposes of much larger oil reserves and has higher production capacity. Saudi Arabia has a production potential of 600-700 million tonnes of oil per annum mt/a whereas Russia’s potential is between 530 and 550 mt/a. The reason for the current situation is that Russia was simply not restricted through association with OPEC countries and could afford to build up output while OPEC countries cut production in order to stabilise global oil prices. The situation is therefore purely dependent on the market prices.
In the past, there have been negative statements about Russia’s ability to maintain production but these have probably been exaggerated. Russia has been able to maintain a sustainable output even on brown fields where 1%-2% y-o-y production decline was stopped as highlighted by 5m11 data.
What would you advise as the best tactics for oil companies to follow regarding the share between green and brown fields?
All Russian producers have a number of green fields projects however the portfolio of these projects is in decline. Among these companies there are some such as Rosneft and TNK-BP with larger portfolios and other companies such as Lukoil and Surgutneftegaz who have fewer opportunities to increase production through new sites. These companies will need to spend more money on increasing recovery from brown fields employing techniques such as hydrofracking, horizontal wells and other methods of enhanced recovery.
Overall, in 2011 the production profile is relatively good with scope for another slight increase in oil production by 0.5 or 1%. By 2014/5 production should be a flat rate around 500-510 mt/a.
What does this mean for the profitability of oil companies?
The government monitors closely the profitability of oil companies and takes away excessive profits. This is because the federal budget is heavily dependent on the export duties for oil and gas exports and mineral extraction tax. However, the government intends to decrease export duties on crude oil and at the same time to equalize duties on oil products.
According to our estimates, oil majors along with Gazprom and Novatek will do well in 2011 earning about $90bn in net profit. Taking the whole oil and gas sector this figure could be around $100bn. Despite heavy export duties, Russian producers can take advantage of reserves which are easy to access with the average cost of production for a barrel of oil 2.0-2.5 times less than international peers.
But considering the increased technical difficulties for brown field extraction costs will inevitably go up.
There is an increase in expenditure especially when we consider as an example Lukoil’s horizontal drilling projects and the fact that drilling companies have increased their fees. Production costs are especially increasing for oil produced in the remote regions of Eastern Siberia where oil recovery is harder. This represents a significant challenge for the industry. Russia is also on the eve of expanding E&P projects offshore which is very technically challenging and will demand heavy investment. Furthermore it will be nearly impossible without foreign companies.
Considering that the industry is due to make about $100bn in net profits this year. Which companies would you highlight as the key performers?
Looking at performance year on year the main driver will be high oil and gas prices. In this respect the main winner could be Gazprom because natural gas prices have increased sharply recently. Gazprom is hoping that this year will be a financial success for the company because of higher domestic gas rates and export volumes increasing to the pre-crisis level.
What do you make of the IEA report of the gas glut and the fall of gas prices?
I learned a recent report by the IEA called “Are we entering a golden age of gas?”. This report is very optimistic about the future of gas because the inherent qualities of this source of energy. It is liked as a fuel because it is environmentally friendly. Furthermore because of the disruption in the Middle East and North Africa and the shutdown of Libyan gas exports as well as the additional demand for gas in Japan because of the Fukyashima disaster and the decision taken by Germany to shut down nuclear plants by 2022. Russia’s gas future is secure. The country stands to benefit from its very high reserve score and reserve-to-production ratio of 75 years. The only issue for gas customers in the world is the difficult geographical distribution of these ample reserves and the recent regionalization of gas markets.
The future of oil is less certain because of attempts to transit to other forms of motor fuels. Indeed, in 20-30 years there may be a completely different fuel for car transportation. Gas on the other hand is a good fuel for electricity and domestic use. Its use as transportation fuel can be also expanded.
Given the less certain future for oil is there the potential for Russian oil producers to pursue the refining route?
The future of refining in Russia is uncertain as well. There is a consensus that Russia must completely overhaul the refining sector. After the Soviet period Russia only built one grass-route refinery which is located in Tatarstan. Most of the refineries have been in operation for 40-50 year and efforts to modernise undertaken over the last 10-20 years have produced patchy results. Some companies like Lukoil in Perm, Nizhniy Novgorod and Volgograd or TNK-BP in Ryazan and have upgraded their oil refining units with hydro cracking facilities, catalytic cracking, cocking facilities and so on. Still refining depth (measured as a proportion between total oil product yield minus fuel oil to total product yield) remains at a low of 71% which is much worse than the world average of around 85%.
Previously such refining slate met the demands of the domestic market which was not concerned with quality. Last year Russia refined around 250 mt of which 70 mt was diesel oil and 70 mt was fuel oil. The bulk of fuel oil was sold to Europe for prices below that of crude oil - because of low export duties. Russian oil companies do not care much about the quality of distillates. European refiners buy Russian semi-finished products in order to crack it for other uses.
Now Russia has endorsed a plan to move towards high quality motor fuels because of a sharp increase in the car park and high levels of pollution from vehicles in the country. Transition to motor fuels containing less sulphur is occurring. Russia also needs to build more upgrades to ensure high quality product exports as Europe has imposed restrictions on products with high sulphur content.
There are plans to cut fuel oil exports substantially from 70 million tonnes to about 25 million tonnes by 2030. Russia seeks to increase light product yield by its refineries. The government is still hesitant about which direction to take in this sector and there are several proposals. The most well known is 60/66 which indicates that crude oil exports will be taxed less with the rate reduced from 65 to 60% and instead the oil products will be unified and their rate unified at 66%. Thus there will be a lower export duty on lighter products but fuel oil exports will become unprofitable.
However, the core problem regarding taxation is the government inconsistency in policy regarding the oil sector. Some companies and regions ask for and receive privileges and some do not. There is a need to move towards more stable profit based taxation. The company must know the rules of the game from the beginning and unfortunately this does not happen at the moment. The most evident example was the tax breaks for the Vankorskoye field which we believed would last for a few years and have since been cut.
Oil and Gas Service companies are meant to be doing well because of higher levels of investment based on high oil prices. How optimistic are you about the growth of this industry?
The industry is certainly making progress and oil companies have a wider range of services from both Russian and international providers. All the main international players are present in the Russian market. 3-4 years ago there were very bright expectations for this market and then the crisis hit which had a dramatic effect on the industry. Companies such as Integra suffered a lot whilst other companies who maintained secure contracts with parent companies survived well. It would be wishful thinking to say that there are boom years ahead. The growth will probably be about 5%.
There is no host of green field projects which could be a source of major new contracts for oil service companies. An exception is northern part of Yamal peninsular and Krasnoyarsk region. There will however be a lot of work on brown fields to drill more sophisticated wells and conduct more detailed exploration to apply EOR methods to improve recovery rates.
In addition, government tax breaks for small fields of under 5 million tonnes of oil will improve the environment for small companies whilst larger companies bypass these fields. These smaller companies could provide a market for oil services with the size of their contribution at around 10 million tonnes of oil/year.
As Russia heads towards offshore reserves, will Russian service providers be able to compete with more experienced international counterparts?
Offshore is Russia’s last frontier. There are 6.2 million square kilometres of the offshore arctic shelf and 4 million of these have prospective oil and gas deposits. Total resources are estimated at around 100 million tonnes the majority of which is gas. However, many zones have not seen exploration and in other areas exploration is only around 5-10%.
There are also doubts about the desirability of stepping up E&P projects offshore because Russia has the option of simply increasing oil recovery from existing brown fields onshore through new technologies which would take these fields from 27% to 35% recovery and which would add billions of tonnes of additional reserves.
There are also opponents regarding offshore because of environmental hazards and because the expense of drilling one exploration well offshore is around $150 million.
All the same, for Russia it is a strategic priority to produce LNG. As the largest gas producer, Russia cannot fall far behind competitors in offshore production. Globally offshore production contributes 35% to total production whereas this is only 3% in Russia.
Exploring offshore is impossible without foreign participation. Three years ago the government passed amendments which restricted participation in offshore projects to Russian state controlled companies. However, there is now a growing understanding that these deposits will not be developed probably for 100 years if only a few Russian companies are involved. At the moment arguably even foreign companies do not have 100% safe and well-tested technology to handle with Yamal LNG or Shtokman located in extremely harsh and sensitive environmet.
A recent proposal by the Ministry of Natural Resources suggested giving access to arctic exploration to any Russian private and international company. Then if this company discovers a field it has the right to recover cost plus premium or to participate (as a minority partner) in the field development in a consortium with a Russian state company. This proposal is slightly revolutionary at the moment and would take years to develop. However the trend towards more a more open regime is evident. Rosneft and Gazprom are both seeking new partners either for new technology such as Total or to secure outlets for produced LNG such as Indian companies.
| Company: | Troika Dialog |
| Position: | Oil and Gas Analyst |
| Country: | Russian Federation |