08.02.2006
Russian Hydrocarbons and World Markets
№1 2006 January/March

Russia’s standing in the world is in great part contingent on
its rich mineral resources. It possesses approximately 13 percent
of the world’s known oil reserves and 34 percent of natural gas
reserves; in total, it produces 12 percent of the world’s primary
energy resources. Successful participation in the international
division of labor presupposes effective use of this advantage,
although it should not be confined to this.

Russia’s fuel/energy sector comprises about one-quarter of its
GDP, one-third of industrial output, and about one-half of federal
budget revenues and hard currency earnings. Unlike the majority of
hydrocarbon exporting countries, Russia has a vast domestic
hydrocarbon processing and consumption market. In light of these
figures, it is important that external demand does not come into
conflict with internal market priorities.

THE WORLD’S PRINCIPAL HYDROCARBON MARKETS

In the past 15 years, the world’s year-on-year oil consumption
rate has been steadily growing (in 1991-2000, it increased by 9.8
mln barrels per day [bpd]; in 2001-2004, 6.3 mln bpd). While the
market was generally well balanced, supply and demand varied by
region.

At the start of the said period, demand was driven mainly by oil
consumption in North America, Europe, and the Asian member
countries of the Organization for Economic Cooperation and
Development. In the past several years, however, China has posted
the highest consumption growth rates, where year-on-year growth was
up from 0.32 mln bpd to 0.4 mln bpd. Meanwhile, in North America
rates fell from 0.5 mln bpd to 0.3 mln bpd, while in Asia’s OECD
countries the rates approached zero.

The demand of the early 1990s was met mainly by OPEC production
with a year-on-year growth of 0.6 mln bpd. At the same time, output
in the countries of the former Soviet Union declined considerably.
Nevertheless, by the beginning of the 21st century, the situation
turned around: While the average year-on-year oil production growth
rate stabilized in OPEC, declined in Europe and slowed in North
America, Russia emerged as the main stabilizing factor in the world
oil market.

In the period 2002 to 2004, amid an unprecedented growth in oil
prices, average year-on-year consumption growth rates doubled,
reaching 2 percent. Last year, with the average year-on-year price
for Brent oil at $38.3 per barrel, global oil consumption increased
by 3.3 percent. The combination of high prices and low economic
growth, however, can cause a decline in oil consumption growth
rates to 2.5-2.7 percent, and less (in 2005-2006).

Nonetheless, during the past two to three years demand exceeded
expectations since the “new economies” (above all, China and to a
lesser degree, India) were not factored in; there is a rapid growth
of industrial output in these countries, including energy-intensive
production (e.g., ferrous metallurgy) and consumption (e.g., the
rapid expansion of the auto industry in China). If the economic
upturn in these countries continues with a growing middle class,
the aggregate growth in demand could exceed GDP rates for the first
time since the 1970s.

It is unlikely, of course, that rapid increase in prices and
demand will become a sustainable trend. The parallel coexistence of
these trends is conflict-prone. High prices, on the one hand, allow
for the development of oil resources that were earlier considered
unprofitable, but on the other, they expand the use of oil
substitutes. The latter could reduce demand.

As for supply, the situation is not as cloudless as it might
appear. The exploration and development of new oil fields requires
time and money, while new production facilities cannot always
offset depleting oil reserves.

In this regard, there has surfaced in Russia new grounds for
concern. The draft of the proposed New Subsoil Law, submitted by
the Government last spring, states (Article 9) the tentative
foreigner participation restriction rules. This seems to be a new
strategy of the Russian authorities, who aim for ‘controlled
foreign involvement’ in the upstart development of new major oil
and gas fields. This strategy is based on providing state-supported
national companies with exclusive rights to control a majority
stake in the field operator companies, and offering foreign
investors an opportunity to buy a minority stake in such companies
(the so-called ‘51/49’ concept). Under such a regime, foreign
participation is tolerated, because international investors would
bring the necessary capital, technologies, knowledge and personnel
to ensure proper development of the fields. In return, they would
receive somewhat exclusive access to resources and global marketing
opportunities, but the Russians would still retain control over the
operational framework and investment decisions.

According to this logic, it is most likely that foreign
companies will be barred from significant future auctions on large
oil and gas fields, e.g. the Sakhalin-3, -4, -5 and -6 projects,
the Chayanda gas field in Yakutia, Arctic offshore fields, and some
fields in the Timano-Pechora province.

Despite the Duma’s delay to approve the new version of this law,
Minister Yuri Trutnev expressed the hope that the law would be
adopted in the first half of 2006.
The uncertain situation over the resource base, shrinking oil
deposits, and the scarcity of new oil-bearing provinces, which in
the past were the main factor in the development of global oil
production, made market players more jittery and less rational,
thereby increasing the anxiety within political circles. The level
of political stability in a number of key exporting countries is
not a source of optimism, either. While demand will most likely
continue to grow, growth rates will be subject to sharp
fluctuations due to both internal and external conflicts, as well
as the possible emergence of new dynamic economies.

In the 1980s-1990s, the effects of the oil crises caused by the
Arab embargo and OPEC oil production quotas were in great part
offset by the development of the liquid global oil market and
appropriate market instruments, mainly short-term instruments.
Recently, however, the focus has shifted to forging preferential
bilateral relations between oil consumers and suppliers, which is
especially characteristic of both U.S. policy and the “oil
diplomacy” of China and India.

Record-high oil and natural gas prices (in liberalized markets,
gas prices are also driven by demand) could somewhat alleviate the
problem; however, they are unlikely to bring about drastic changes
in the short term. On the other hand, as is known, the developed
countries have been able to find ways to deal with such threats,
which is a principal argument cited by the optimists.

RUSSIA’S OIL POSITIONS

In 2000 through 2004, Russia, as the main stabilizing factor on
the world oil market, enjoyed the highest production growth rates –
three times higher than OPEC. Yet with falling production growth
rates in recent months and the impact of other, more fundamental
factors, Russia will hardly be in a position to maintain the role
as market stabilizer; however, it will remain a substantial factor
in the development of the world market.

Today, more than 3,000 hydrocarbon deposits have been discovered
and explored in Russia, with approximately half of them being
developed. More than one-half of Russia’s oil, and more than 90
percent of its natural gas output is concentrated in the Volga-Ural
region and West Siberia. The majority of these deposits are highly
depleted, thus, there is an urgent need to develop alternative
deposits. In the long term, priority in oil and gas production will
be given to Timano-Pechora; the Yamal Peninsula; the western part
of the Arctic shelf, and the Caspian shelf. Other areas include the
Caspian region, East Siberia, and Russia’s Far East. But in the
foreseeable future, Russia is unlikely to discover an oil and gas
bearing region, comparable in resources to Volga-Ural and
especially West Siberia, that could drastically affect output
level. Other oil production centers will largely serve to alleviate
the effects from the depletion of older fields.

Thus, production growth rates will likely decline over the next
decade; stabilization and fluctuations will play various roles,
contingent on the situation in the world market.

Russia’s oil exports are dependent on both oil production and
consumption levels on the domestic market; internal consumption is
growing slowly due to a sharp decline in energy-intensive
production. Thus, the export of oil and oil products will prevail
over the share of domestic consumption in total oil production for
a long time to come. Nonetheless, economic growth amid nascent
energy-saving technologies will push up domestic consumption.

The main oil production areas are linked by an integrated oil
pipeline system that is controlled by the oil giant Transneft,
which oversees the transfer of 95 percent of oil to Russia’s oil
refineries, as well as to export terminals via the Druzhba oil
pipeline network and deep-sea oil-loading terminals on the Black
and the Baltic Sea. Eventually, it is possible that Russia will
enter all of the world’s largest oil markets in Europe, North
America, and Southeast and South Asia. Presently, however, its work
remains focused on the European market (including the former Soviet
republics).

Until the 1970s, the bulk of Russian oil was produced in the
European part of the country. When the West Siberian oil- and
gas-bearing province was brought online, its transport
infrastructure was linked to the existing facilities, thus
orienting it toward the European market. The only exception was the
eastern and southern branches, which are relatively insignificant
in aggregate capacity (carrying oil to the Omsk, Achinsk, Angara
and Central Asian refineries of the former Soviet Union).

Oil deliveries to the Asia-Pacific market are slowly growing;
these exports are heading mainly to China, which accounts for the
bulk of the growth. Given the level of exploration and development
of Russia’s East Siberian resources (even factoring in shipments
from the West Siberian oil and gas provinces), Russian oil export
to the Asia-Pacific rim could reach 60 mln to 70 mln tons;
nevertheless, this rate would not exceed 15 percent of total
Chinese consumption. Russia, therefore, will not only be incapable
of meeting the oil demand in the Asia-Pacific rim; it risks losing
this market completely if it drags its feet on developing its
transport infrastructure and Sakhalin projects.

At the same time, the demand of the Asia-Pacific oil market
represents high growth potential for Russia’s oil export.
If after 2010, as predicted, production in the main oil-producing
countries in the Asia-Pacific rim – China, Indonesia, Malaysia, and
Australia – declines, rising demand for oil will require a
substantial increase in supplies from other parts of the world. The
principal source of this supply will come from the Middle East, as
well as North and Central Africa, Central Asia (including the
Caspian region), and Russia.

Pending the construction of an eastern oil pipeline, Russia is
planning to step up oil shipments to China by rail. This year, oil
exports to China via rail will total more than 11 million tons. By
2010, oil shipments to China by rail should increase to 20 mln tons
a year; this number could subsequently increase to 30 mln tons per
year. Rail tariffs are a serious constraint, but according to the
railroad giant, Russian Railways, tariffs could be reduced from $72
per ton to $30 as volumes of oil shipments via Zabaikalsk increase.
Incidentally, such a plan could make the rail option more
attractive than the “eastern pipeline.”

On the American market, the main consumer of Russian oil is the
United States, but these supplies are rather insignificant (in
2004, they totaled a mere 7.3 mln tons, or 4 percent of Russia’s
aggregate oil export). According to Transneft CEO Semyon Vainshtok,
the United States is not ready to guarantee substantial purchases
of Russian oil. Furthermore, the company “is not sure that the
United States really needs the declared 30 mln tons, and possibly
not even 20 mln tons of Russian oil.”

The European oil market is the smallest in terms of consumption
volumes, prices, and growth rates. Nonetheless, the established
transport infrastructure continues to support the Russian-European
oil trade. There are some problems with the passage of oil tankers
in the Black Sea straits, as well as in the Gulf of Finland, the
Baltic Sea and the Danish Straits. The resolution of these hurdles
would help Russia consolidate its position as a stable, major
supplier of oil to the European market.

Russia wants to transport its oil directly to consumers from its
own territory, thus reducing transit problems. Thus, it makes sense
to maintain the existing pipelines and terminals and build up their
capacity (expansion of the Baltic pipeline system, for example, as
well as construction of terminals in Varandei, Indiga and on the
Kola Peninsula). For example, the throughput capacity at the port
of Primorsk in the Baltic Sea is set to increase to 62 mln tons of
oil a year.

The problem of oversupply of high-sulfur oil, specifically the
Russian Urals blend, on the European market can only be resolved
effectively through the separate transportation of different grades
of oil; this could be accomplished by building new oil pipelines
from regions where low-sulfur grades are produced. Oversupply of
oil on the European market is the result not so much of growing
supply as growing oil prices. When prices were relatively low, a
considerable number of refineries were built in Europe that were
oriented toward high-sulfur oil – relatively cheap at that time. A
price difference of $2 to $4 per barrel made the complex and costly
refining process cost-effective. However, when prices doubled and
even tripled, that price difference became irrelevant and refining
facilities started to be taken out of operation as uncompetitive
and economically unviable. The refineries that did stay afloat were
on average $6 to $8 more expensive as compared to standard
blends.
Now, Russia need only wait for prices to fall to former levels
(which is unlikely) or build new pipelines to transport more costly
oil brands.

Another option, of course, is to process all of the high-sulfur
oil in Russia. But such a move would require not only extensive
technical modernization of the oil refining facilities in the Ural
and Volga areas, but also serious political and legislative
decisions –entire companies would be shut off from exports; these
would require compensation at the expense of those companies that
would benefit from the arrangement.

Presently, the Russian government is planning to increase
exports to the dynamic Asia-Pacific market to the maximum degree
possible, redirecting a considerable portion of supplies there from
the stagnating European market. There are several ways of
fulfilling this important task. For example, Russia may intensify
shipments by rail, reanimate dormant Sakhalin energy projects,
resume operations on other promising sectors of the Sea of Okhotsk
shelf, use the Kazakhstan-China oil pipeline that is now under
construction, and tap the oil potential of East Siberia. As
mentioned earlier, the plan at this initial stage is to transport
oil from West Siberia, which, given the rail tariffs, puts oil
companies in a rather difficult situation. Yet for all of the
government’s optimism, the success of this undertaking cannot be
taken for granted. This is mainly due to the uncertain status of
the resource base in East Siberia.

“MADE IN RUSSIA” OIL PRODUCTS

Amid the relatively low domestic prices for raw materials and
the impossibility of substantially increasing oil exports, many
Russian companies increased the output of oil products for export.
The main export products are fuel oil (45 percent of export) and
diesel fuel. The export of gasoline (5 percent of exports in
physical terms, and about 6.5 percent of export earnings) has
remained relatively unprofitable since there is stable and
efficient internal demand for it at prices that are quite
attractive to suppliers. Furthermore, the imposition by the EU of
even more stringent standards on the quality of oil products
compels Russian companies to spend more on the modernization of
refining capacities.

The country’s Energy Strategy until the year 2020 gives a high
priority to the export of oil products and refining a larger share
of oil slated for export.
The principal operator of export oil-product pipelines is the
state-owned Transnefteproduct Company (TNP). Compared with
Transneft, which controls an overwhelming part of oil transports
and exports, TNP’s positions are more modest: 23 percent of the
Russian transport of light oil products, about 60 percent of diesel
fuel export, and approximately one-quarter of gasoline export.

Other oil products are exported by rail, in competition with
TNP. One reason for this is the problem of preservation of quality
of oil products carried via TNP pipelines.
The majority of Russian refineries are currently implementing
modernization programs to bring the quality of their motor fuels in
line with European standards. So there is good cause to expect
substantial growth in the export of light oil products within the
next several years. The throughput capacity of TNP pipelines should
expand as this company has invigorated efforts to boost its export
capacity. It is planning to carry out a number of projects
envisioned to extend the main pipelines to the Baltic and Black Sea
coast, reduce the dependence of Russian oil export on transit via
neighboring countries, and increase the commercial effectiveness of
supplies. The Northern Project is designed to play an especially
important role here: under the project, a new export pipeline will
be built to the Russian Baltic Sea coast. This proposed pipeline,
both in terms of its route and concept, is similar to the Baltic
pipeline system that successfully fulfills the task of minimizing
oil transit via third countries. Furthermore, Russian companies
intend to expand their share of property and management in a number
of European oil refineries and marketing organizations.

As for the eastern vector, last year Russia shipped about 7 mln
tons of oil products – mainly diesel fuel and fuel oil – to
Asia-Pacific countries. This export volume could realistically be
increased to 10 mln to 12 mln tons, subject to a substantial
improvement in the quality of oil products.

NATURAL GAS

Output. Russia has the world’s largest proven
natural gas reserves (about 34 percent of the world’s known
reserves). West Siberia accounts for 76 percent; the Ural and Volga
region, 8 percent; the European north, 1 percent; East Siberia, 3
percent; Russia’s Far East, 3 percent; and the continental shelf, 8
percent. Today, more than 90 percent of natural gas output comes
from large, unique deposits. The Urengoi, Yamburg and Medvezhye
fields produce more than one-half of Gazprom’s gas output and about
65 percent of Russia’s total natural gas production. These three
gas fields, however, are being gradually depleted.

Gazprom is now developing several new gas production projects in
the Far East, the Yamal Peninsula, the Arctic shelf, and several
other areas. Their implementation will require the construction of
new gas transport facilities and the modernization of existing
facilities, while production costs will continue to grow.

Infrastructure. Russia’s unified gas transport
system is the world’s largest, at 153,300 km. The system’s
throughout capacity exceeds 600 billion cubic meters, but from 2006
it is slated to be increased.

Gas export and import. Gazprom exports gas to Central and
Western Europe mainly on a long-term contractual basis. The EU is
the principal buyer of Russian gas; Germany, Italy, France,
Hungary, Slovakia, the Czech Republic and Poland are its major
importers. Exports to the UK are expected to grow considerably in
the foreseeable future, while a substantial share of gas exports
now goes to Turkey. In addition to its own production, Gazprom buys
gas from independent producers on a medium- and long-term
contractual basis and sells it to consumers in Russia and
abroad.

Markets. The European market has been steadily
growing (last year, EU countries consumed about 470 bln cu m of
natural gas, while by 2010, according to the International Energy
Agency, consumption is to reach 610-640 bln cu m). The EU’s policy
of tough restrictions on greenhouse gas emissions under the Kyoto
Protocol, as well as the inability of renewable energy sources to
compete with traditional sources, will also cause an increase in
natural gas consumption in Europe.
This trend could change, however, if priority is given to nuclear
power. Thus far, however, forecasts for 2020 show that the EU’s
dependence on the import of natural gas will grow from its present
40 percent to 70 to 80 percent, while Russian gas exports to the EU
in the same period will increase from 26 percent today to 40 to 50
percent. This level of dependence compels European countries to
enhance their level of interaction, as well as search for new forms
of cooperation in the energy (above all, natural gas) sphere.

PRIORITY PROJECTS IN THE FORESEEABLE FUTURE

The North-European Gas Pipeline (NEGP). The
implementation of this project will open up a basically new export
route to Europe (across the Baltic Sea from Vyborg to the German
coast), diversify export flows, and directly link gas-transport
networks in Russia and the Baltic countries with the European gas
network. One distinguishing feature of the NEGP is that it does not
pass through transit states, which reduces both country risks and
the cost of gas transportation, at the same time making export
supplies more reliable. The project provides for the construction
of sea gas pipelines to ship gas to consumers in other EU member
countries. First gas shipments via the NEGP are scheduled for 2010,
with a maximum capacity of 55 bln cu m a year.

Due to the recently strained relations between Moscow and Kiev
regarding the price and volume of Russian gas supplies to Ukraine,
the commissioning of this project has been accelerated in
conjunction with the terms and conditions of gas transit to Europe
from Russia via Ukraine.

The problems associated with the transit of Russian energy via
neighboring counties require specific consideration, and we may
briefly consider some of them here.
On the international level, only the basic principles for such
energy transfers have been formulated so far. One of these
principles is that transit arrangements and supply contracts to the
transit countries must be separate deals.

For gas deliveries where the transit/transportation component is
of major importance, transit tariffs for various cases are widely
differentiated due to the lack of transparent and internationally
accepted methods. In case of former Soviet republics, the
historical experience of state funding, corresponding
infrastructure development plus and the monetary and financial
instability in the 1990s made it even more difficult to
substantiate tariffs levels. In the 1990s, therefore, the practice
of artificially linking transit tariffs (in most cases paid with
gas rather than cash) and prices for additional gas deliveries to
the transit countries became widespread. Both levels were
comparatively low by international standards.

Today, when gas prices have increased following a rise in oil
prices – and in some of the more liberalized markets they are
reflective of growing demand and even an aspiration toward the
scarcity of gas supplies – this practice has become far from
satisfactory. Of course, international politics has played its own
special role in the tensions around these disputes as well.

Projects designed to achieve the main objectives
established in Russia’s Energy Strategy until the year
2020.
They provide for the development of the oil and gas
complex of East Siberia and Russia’s Far East, while acquiring
access to the Asia-Pacific energy market. In the Russian
government, a program is pending for the creation of a unified gas
production, transportation, and supply system in East Siberia and
Russia’s Far East, with the possibility of exporting gas to China
and other Asia-Pacific countries. The program’s authors (it was
drawn up not by the Industry and Energy Ministry, but by Gazprom)
give priority to Sakhalin energy projects, while putting on hold
the development of the unique Kovykta and Chayandin deposits. The
implementation of Sakhalin energy projects will help create a new
major oil and gas production base to supply hydrocarbons to
Russia’s Far East and the Asia-Pacific rim, including the western
coast of the United States.

The Yamal-Europe gas pipeline. This project is
designed to provide natural gas supplies to Europe. The Yamal
Peninsula is one of the most promising oil- and gas-bearing
provinces of West Siberia and the most important of Gazprom’s new
strategic regions. There are 26 gas fields there with total proven
gas reserves of 10.4 trillion cu m; 228.3 million tons of
recoverable condensate reserves and 291.8 million tons of
recoverable oil reserves.

During the initial phase of the project, the resource base will
comprise pre-existing and new deposits in the Nadym-Pur-Taz area
(the Tyumen region). Subsequently, gas will be supplied from the
Bovanenkovo deposit on the Yamal Peninsula. At the initial stage,
this gas pipeline will have a length of 2,675 km with a design
capacity on the first stretch of about 33 bln cu m a year.

Liquefied natural gas (LNG). Given the growing
demand for natural gas on all the main markets (the United States,
Europe and Asia) and the constant reduction in LNG production and
transportation costs (by 35 percent to 50 percent in the past 10
years), Russia is deploying much effort to develop and implement
major projects to ensure LNG supplies to the world’s principal
markets. The Shtokman project, for example, will make it possible
to supply LNG products from the Shtokman gas and condensate field
to Europe, the Gulf of Mexico Coast and the East Coast of the
United States. This deposit, with reserves exceeding 3 trillion cu
m, is expected to become operational in 2010 with an estimated
capacity of 67.5 bln cu m per year. Furthermore, projects are being
developed to create a LNG complex on the Baltic Sea coast, in the
Leningrad region, while feasibility studies are underway for LNG
shipments by sea to certain parts of the Russian Federation (e.g.,
the Kaliningrad Region), as well as abroad.

COOPERATION OUTLOOK

Important factors in the evolution of Russia’s natural gas
sector include the liberalization of the European gas market, the
emergence of new producers in North and West Africa, the Middle
East and Central Asia, and the growth of the Atlantic and Far East
markets, including the formation of a gas market in China.

During the past several years, consumers of Russian hydrocarbons
have been pressing for the construction of “energy bridges,” while
offering full-scale cooperation in the energy sphere. Thus far,
however, everything has been confined to the export of energy
resources from Russia and the participation of foreign companies in
Russian production projects. It is critical to change this type of
relations – moving from raw material supplies to cooperation in
processing energy resources and subsequently to broader interaction
in the investment sphere.

A modern, diversified economy can only be built on a high
added-value products industry, and Russia will be increasingly
moving in this direction. Considering the traditions of
interaction, together with the economic potential of those
countries now consuming Russian hydrocarbons, and their interest to
intensify a partnership with Russia, foreign businesses should be
expected to become major participants in these processes. Their
involvement in Russian projects will provide our foreign partners
with highly processed products for their energy-intensive
production facilities, which will create a powerful synergetic
effect for all involved parties.

Energy-saving projects based on the use of state-of-the-art
technologies, processes and equipment have a very good potential,
as they will help to develop export energy resources. Oftentimes,
however, this will require adaptation to the Russian environment,
including price conditions and buyer/consumer specifics.
Interaction and effective forms of tapping the “Russian component”
are of essence here.

Meanwhile, one key condition for more intensive cooperation in
the energy sphere is the harmonization of national laws. This, in
particular, refers to transborder pipelines – e.g., information
exchange and emergency procedures. It is also important to take
into account Russia’s obligations arising from existing and future
international agreements. More specifically, the Energy Charter
Treaty may require a clarification of rules for the use of transit
facilities.

Another aspect involves the advancement and intensification of
integration in the post-Soviet area, based on the interoperability
of infrastructure complexes, reciprocal supplies, and energy
transit. It has to be said, however, that the political component
plays an increasing role in this process, although not always a
constructive one.