Russia: Talking Modernizing, Prioritizing Energy

Chris Weafer           Chief Strategist Uralsib Group

By Chris Weafer Chief Strategist Uralsib Group The most prominent buzzword in Russian politics today is “modernization”. Everybody understands that this is something that must happen or the country will face a declining growth rate and increasing social instability. In practice, the more significant actions continue to be in the energy sector.

Establishing Russia as the world’s biggest energy provider was critical in returning the country to a position of importance in geo-politics and in restoring the strong sense of national pride and confidence that, as much as improving living standards, underpins majority public support for Vladimir Putin. For that reason, maintaining average daily oil production at 10 million barrels per day and connecting additional gas pipes to Europe and Asia are by far the greater priorities in Russia. Keeping oil production at the current rate over the next ten years, i.e. the declared objective of government, while keeping tax revenue high enough to fund planned budget expenditures, is going to be a difficult juggling act. Nobody doubts that there will have to be changes to the current tax oil & gas sector structures and that capital investment in the industry will have to be increased. Otherwise average daily production will inevitably decline. The evidence points to the fact that remaining the world’s most important oil producer is a greater priority than, e.g. domestic projects like Skolkovo, for both domestic and geo-political reasons. The debate over how this may be achieved will likely dictate investor’s approach to the sector, and the debate over government fiscal priorities, later this year and post election. From a strategic viewpoint, the most likely outcome is that tax breaks will be applied to greenfield projects in East Siberia, Sakhalin, the Caspian and in other off-shore areas.

Energy Minister Shmatko recently said that Russia is considering creating new Production Sharing Agreements (PSAs) to involve international oil majors in new projects. That way the Finance Ministry can keep a high tax take from existing, albeit maturing, oil fields while the 10.0 million average daily oil target might be achieved with new investments in greenfield projects and using a lot of foreign investor capital. Russian PSAs have become are a bad word in the oil industry because of Sakhalin II. It is, however, important to bear in mind that Putin’s government did not like the PSAs that it inherited because of what it considered to be unfair terms agreed under the previous administration. However, over the past eight years new “rules of the game” have been established and PSAs concluded under these rules will be safer. That is entirely consistent with the oil major’s experiences in other oil regions over the past 100 years. The National Oil Companies of countries such as China, India, Malaysia and Gulf Arab states are already eager participants and several International Oil Companies, which are already active in Russia, e.g. Shell, BP, Total, ENI, are also expected to have active roles.

Portfolio investors

For investors that doesn’t mean that Russia should only be considered an energy, or materials, theme within global markets. Far from it. The trickle down effect of oil and gas tax revenues via budget distribution and the confidence factor generated by the country’s energy strength provide a very strong foundation for the investment case. The fast pace of growth in consumer spending and services is very evident for all to see. But what it does mean is those investment opportunities in the most attractive industries for stock market investors are far fewer than in the highly regulated industries. Russian listed stocks can be split into distinct categories; state controlled energy producers/distributors; state regulated utilities; metals & miners; commercial sector; infrastructure. Breaking down the current $1 trillion market capitalisation of all Russian listed equities into those broad categories shows; Oil & Gas 45% of total stock market* Metals & Miners 20% Utilities: Electricity & Telecoms** 16% Consumer: Banks, Retail, Pharma, Housing, Media*** 17.5% Infrastructure: Transport, IT, Manufacturing 1.5% * as at December 31st ** assumes a greater role for Rostelecom ** includes Mail.ru The most attractive long-term growth categories only account for less than 20% of the total market capitalization.

New Direction – But Only Geographic

As 2010 gave way to 2011 on Russia’s Far East border with China, the first direct oil pipeline connecting both countries was officially inaugurated. This is Russia’s first eastern oil export pipeline and China’s second direct oil import pipeline (the first was from Kazakhstan). Over the next six months it is expected that Russia and China will finally bring to an end the long drawn out negotiations to build a gas pipeline between both countries. In 2011, Russia also wants to wrap up plans to build the South Stream gas pipe, to push ahead with plans to co-ordinate gas exports from North Africa to Europe, to conclude talks to build two Bosphorus by-pass oil pipelines and to push its claim for greater sovereignty in the potentially energy rich arctic. Contrast the near frenetic activity, and real progress, in the energy sector with the much more modest advances in the modernisation agenda. Most of the hype about Russia’s future, and the core of investor expectations, is based on the assumption that the country is accelerating efforts to make the country more attractive for strategic investors outside of extractive industries and that the country will continue to diversify both in terms of economic growth drivers and budget revenues. That is also the base case assumption that I recently set out in a note, Economic Glasnost, i.e. that there is today simply no choice but to make the changes/reforms required to advance that goal. Aggressively pushing ahead with energy projects of course does not exclude progress with the modernisation agenda. But what it does mean is that progress in the latter will remain slow, and project specific, so long as the government priority is focused on the former. We have seen time and time again that even as the President and Prime Minister talk about wide-ranging reforms and investment priorities, etc, the only real progress is in those areas where the most senior members of government are personally active. Last year those efforts were mainly directed towards rebuilding the auto-sector and this year the signs are that the pharmaceutical, housing and agriculture sectors will be prioritized (see separate note to follow). Bottom line is that so long as energy projects remain the key priority, as they clearly are today, progress elsewhere will be slow and selective.

Russia’s Energy Growth

Since the start of the Putin administration on January 1st 2000, Russia’s average daily oil production has grown from 6.2 million barrels (1999) to 10.15 million barrels (2010). More importantly, Russia’s average daily exports of both crude and refined oil products grew from an average 2.6 million barrels to 7.3 million barrels in the same period. Today, Russia is the world’s largest oil producer and the largest exporter. In that same period, Russia earned approximately $1.5 trillion from exporting oil and gas. When Putin became president in 2000 his most important economic/industrial policy was to push the oil companies to stop playing corporate politics and to invest in the industry, i.e. to restore production. The tax reforms put in place during Putin’s first term were as much about stopping capital flight in the oil sector, e.g. via such mechanisms as transfer pricing, as they were to stimulate investment in the broader economy. Raising oil production had two important objectives; to increase oil revenues for the budget and to make Russia too important to be left out of geo-politics. Those are still the key objectives today.

Geo-Politics

The argument over whether an abundance of oil and gas is a curse or a blessing is one that has been waging, and will continue to wage, for decades. If you are in Norway or Nigeria then the respective answers are clear. In most other countries the answer is less clear. $1.5 trillion of oil and gas export revenues has certainly transformed Russia while arguably slowing the pace of economic, social and political reforms that might have taken place if the relatively easy money was less abundant. Becoming the world’s biggest energy power has undoubtedly helped Russia reclaim its seat at the top table of geo-politics. There are plenty of arguments to be made as to whether the pace of the country’s economic growth and its economic structure justify Russia’s place in the so-called B.R.I.C. category or in the G8 group of countries. But there can be no arguments as to Russia’s importance to the global economy as a source of energy and minerals. That places Russia is a different category to other, faster growing, developing economies, e.g. Indonesia, and ensures its prominent position in geo-politics. Russia is the biggest energy supplier to the E.U., in terms of piped gas, crude and refined oil. It is also the most important route for Central Asian oil and, to a lesser extent, gas to western markets. Russia is also now much more important as an energy supplier to China and that role will expand with the expected gas export pipeline. The planned development of projects in Sakhalin and the expansion of the East Siberia Pacific oil pipeline will mean that the country’s importance across all of north eastern Asia and to the west coast of the United States will increase further.

Domestic Political Agenda

The economic and social impact of $1.5 trillion from oil and gas exports is clear. Russia cut its foreign debt from $160 bln (80% of GDP) at the end of 1999 to not much more than $40 bln (2.5% of GDP) today. The country’s foreign exchange reserves grew from $12 bln to almost $500 bln in the same period, having been at $600 bln in mid 2008. The average monthly salary has increased from around $50 to over $700 and GDP per capita has risen from $1,375 to almost $11,000. More importantly, it is the basis for Vladimir Putin’s popularity. The rapid recovery in the economy and the associated improvement in living standards during Putin’s presidency was certainly one factor that increased his popularity. The other was equally important; the fact that Russia has recovered its importance in the world. The opinion polls consistently show that people support Putin because he has made, and keeps, Russia strong. A survey carried out by polling company Levada Center in July showed that the three main reasons why people support Putin are, in almost equal measure; he strengthened the country’s international standing; he improved international relations; he improved living standards. Whether Putin decides to contest the 2012 presidency or trusts the current “tandem” arrangement (see separate Private Briefing to follow) it is clear that he wants to retain the position of national leader that he now enjoys. But, according to the Finance Ministry’s figures, the budget now requires over $90 p/bbl to balance. The budget is now much more exposed to, and dependent on, global economic trends. That places a bigger question mark over the future economic trend than was the case in 2000-2008. Keeping Russia’s position of strength and importance in the international community is a more achievable target. Ensuring that Russia remains as the world’s biggest energy supplier is key to that and is a major factor in Putin’s enduring popularity.

Priority Projects

The government has a number of specific energy related priorities that it wants to advance in 2011. We have written, and will write more this year, about these projects. Amongst the major priorities are;

China gas

Negotiations between Russia and China over a gas link started in 2004 and now appear to be close to an agreement. There is room for one more twist to this saga as Rosneft is thought to be lobbying to be allowed buy the Kovykta gas deposit from BP controlled Russia Petroleum. The auction of that licence is scheduled for mid February. If Rosneft does get control of that deposit then it would likely try and grab the China gas export contract China. Rosneft already has an energy relationship with China via the ESPO oil pipe and having a dedicated source of gas with a direct pipeline would clearly suit the Chinese more than connecting into the Gazprom grid. The key political issue in government, and which appears to have been a major sticking point since the AAR-BP dispute left it clear that Kovykta would be sold, is that such a move would break Gazprom’s exclusive export licence.

South Stream Gas Pipe

The economic case for South Stream, especially now that the 27.5 bcm Nord Stream pipe (phase 1 - phase 2 will add an additional 27.5 bcm of capacity) is under construction, is unclear. LNG is emerging as a strong alternative to piped gas and Shale gas, although expectations have diminished since the exuberant predictions of 2009, will also take market share from piped gas. South Stream’s planned capacity is 30 bcm in phase 1 and with an additional 30 bcm in phase 2. But, while the commercial rationale is unclear, the political objectives are very clear. Building the pipelines would tie-in an expanded customer base and leave Russia in a stronger political-trade position with the connected countries. Of course pricing would be an issue and, as alternatives become more available, Gazprom’s longer-term pricing position will be weaker.

North Africa

President Medvedev visited Algeria in early October. The backdrop to that visit was a deal that, several years earlier, Gazprom and Algeria’s state gas producer signed to jointly develop gas assets. But, the deal quickly turned sour and very little progress has actually been made. Russia is now keen to revive that deal. With Gazprom’s position in the European gas market under threat from LNG and increased supply from Norway, etc, the government is keen to push ahead with pipelines that can secure long-term supply contracts. Now that Nord Stream is underway and South Stream is a being pushed aggressively, the missing part of the land encirclement of Europe is from the south, from North Africa. Russia has long held an ambition to create a trans-Sahara gas pipeline that would take gas from Nigeria, where it has a JV called NiGaz, and to include gas from Algeria and Libya. The export route to Europe could be either from Algeria or Libya or both. Either way, sorting out the issued with Algeria in order to ensure the option of the trans-Sahara pipe, is now a priority as Gazprom faces a long-term threat to its share of the European gas market.

Bosphorus By-Pass & Central Asia

Russia is very keen to get agreement for the long delayed construction of the Burgas-Alexandroupolis oil pipeline. The pipeline is one of two planned to take most oil tankers out of the congested Bosphorus. Freeing the Bosphorus from oil tankers, while providing sufficient alternative routes, is a critical element of Russia’s plans to expand external trade beyond extractive industries and to allow it remain a key player in the Central Asian energy sector. It is also a necessary pre-condition for the planned expansion of the CPC pipeline that carries Caspian oil via Novorossiisk.

• Almost 2 million barrels of oil transit the Bosphorus each day. Most of that is Russian oil but there is also a significant volume of Caspian oil transiting via Russian ports.
• Russia cannot grow the volume of other exports via Novorosiisk – required as part of the plan to create a more diversified economic base - and other Black Sea ports, without removing the bulk of the oil traffic
• Russia also wants to accommodate significantly more Caspian oil via Novorosiisk but cannot do so until the bypass pipes are built. If it does not accommodate the extra oil volume from the Caspian then Moscow’s position of influence in the region will be further undermined
• The Burgas-Alexandroupolis pipe has a planned capacity of 1.0 million barrels per day and the second pipe, via a Turkish route, has a planned capacity of 1.5 million barrels. In aggregate, both pipes would take all the existing oil and most of the planned Caspian (CPC) expansion
• Greece is just as keen to build the pipeline, as it needs the transit fees and the economic boost from building the oil-loading terminal.
• Bulgaria’s stated objection is because of environmental concerns. In reality, its objection has more to do with the government’s wish not to increase economic ties with Russia as it looks to build stronger ties with the EU. The economic crisis across the EU, and the solvency problems in Eastern Europe in particular, has reduced the possibility of the latter while making the former economic pragmatism.
• Moscow has a better chance of pushing forward with the by-pass pipeline now than at anytime in the past. In mid 2009, the Bulgarian delegation wouldn’t have even considered coming to Moscow.

The Bosphorus is the only way for ships from Russia’s Black Sea ports (plus those from Ukraine, Georgia, Romania and Bulgaria) to exit into the Mediterranean Sea. Currently the channel accommodates over three times the number of vessels transiting the Suez Canal. But, unlike Suez and the Panama Canal, Turkey cannot charge transit fees. The use of the Bosphorus is governed by the 1936 Montraux Convention, which set free passage for all commercial vessels. Turkey can, however, control the flow of vessels for safety reasons.

 

The big problem is the almost 2.0 million barrels of oil carried through the channel each day, most of which is from Russia’s Novorossiisk Seaport. In the past, Turkey has regularly held up the oil tankers for weeks citing safety factors. The political relationship between Moscow and Ankara is clearly much improved under Erdogan’s government but the environment issue about oil tankers using the Bosphorus is very sensitive and needs to be resolved. The oil tankers need to be removed from the channel. That is partly because of the risk of an accident that could block Russia’s Black Sea exit route for a very long time and partly because Russia wants to send more non oil traffic through the route. It cannot do that until the oil tankers are removed or, at least significantly reduced in number.    The proposed project is to construct an oil pipeline from Burgas, on Bulgaria’s Black Sea coast, to Alexandroupolis, on Greece’s Mediterranean coast. The total length of the proposed pipe is 280 kms. The planned initial capacity is for 700,000 barrels per day, rising eventually to 1.0 million barrels per day. The project was agreed between Russia, Bulgaria and Greece in 2007 and a deal to construct the pipe was signed in 2008. Construction was due to start in October 2009 and with a scheduled completion date in 2011.

The project never started. The proposed terminal and pipeline quickly became a contentious issue in Bulgaria and local governments on Bulgaria’s Black Sea voted against it. The current Center-Right government in Bulgaria won the July 2009 election and one of its promises was to review the proposed, and very unpopular, pipeline. In June of this year, Bulgaria’s prime minister unexpectedly said that his government was “giving up” on the project. Some phone calls later (from Brussels and Moscow for sure) and the government quietly backed off from this comment. In addition to the proposed Burgas-Alexandroupolis route, Russia has also agreed to supply oil to a second by-pass pipeline. This route will take oil across Turkey from the Black Sea town of Unye (previously it was to have come via Samsung but the terminal has been moved) to the country’s main oil terminal at Ceyhan on the Mediterranean. This pipeline will be 550 kms long and has a planned capacity of 1.5 million barrels per day. The main partners in the project are ENI and local company Calik Enerji. Last October, the leaders of Italy, Turkey and Russia signed a memorandum to allow Transneft and Rosneft join the project. According to media reports, the work has already started and the expected completion date is in 2012. Full capacity can then be reached by 2015. While the Unye-Ceyhan pipeline – at full capacity - would take the bulk of the current oil volume out of the Bosphorus, it would not allow for any additional oil volume. Russia wants to remain a key transit country for Caspian oil and that means it has to allow for the planned doubling of the CPC pipeline capacity. Otherwise that oil might go either along a new pipe built in parallel to the existing Baku-Ceyhan pipeline or across a new pipeline to China. CPC plans to double the current capacity of its Russian routed pipeline to 1.4 million barrels by 2014. For that to happen, both the Burgas-Alexandroupolis and the Unye-Ceyhan pipes will have to be operational. Otherwise the Bosphorus will be even more congested; delays longer and greatly limit Russia’s ambition to grow other exports from Novorosiisk.

Race for the Arctic

Russia and Norway in September signed an agreement to end a 40-year dispute over sovereignty of a 175,000 sq km block that straddles the Barents Sea and the Arctic Ocean. It is widely held that the Arctic region is the next, if not final, energy frontier and, below the seabed, lies untold energy and mineral riches. How much is there? The short answer is that nobody knows. But that of course does not stop lots of speculation about recoverable resources and that, in turn, has led to both this agreement and Moscow’s further attempt to persuade the UN to recognize its sovereignty over a much greater section of the Arctic based on the Lomonosov Ridge. Norway is now more likely to support Moscow’s claim at the UN.

Russia estimates that the recoverable resources in the block that is to be carved up today may equal the equivalent of 39 bln barrels of oil or 6.6 trillion cubic meters of gas or a combination of both. Others say it is less while some speculate it is greater. The point being that proper exploration work was not possible until last September’s agreement was reached. It is expected that Norway and Russia will cooperate, probably a JV between StatoilHydro and Gazprom, on an exploration programme to answer that question. The results of that exploration will also be very important for what happens elsewhere in the Arctic region. Disappointing results will cool enthusiasm for exploration in the Arctic and give the environmentalist lobby a breathing space. Results that confirm the existence of a large volume of energy riches will trigger an energy race.