Streetwise Professor

Two stop-me-if-you’ve-heard-this-before stories relating to Russian energy.

First, ExxonMobil is complaining that the Russian government was staging a holdup on the heretofore unscathed Sakhalin I project:

ExxonMobil complained Friday that the government was preventing its subsidiary from continuing to develop a multibillion-dollar project in the Pacific Ocean, just days before the ceremonial opening of production facilities at a Gazprom-led neighbor.

The operator of the Sakhalin-1 project has clashed with the government over the terms of its production-sharing agreement, which exempts the venture from restrictions on gas exports. Exxon Neftegas Limited has faced pressure from Gazprom to scrap plans to export the prospective gas to China in favor of selling it to the state-controlled company.

The Energy Ministry said late Friday that Sakhalin-1 must cut its budget by 15 percent to 20 percent, in line with reductions at other projects, including Sakhalin-2. The cuts must focus on optimizing costs — including for materials and services — rather than halting work, which would delay the project’s launch, the ministry statement said.

The conflict comes days after an Energy Ministry-led body approved the budget for Sakhalin-2, a rival multinational offshore project. The Gazprom-led Sakhalin-2, which operates under a PSA with Royal Dutch Shell, is preparing to launch Russia’s first liquefied natural gas plant on Wednesday.

After sustained pressure over purported environmental violations, Shell handed over control of the project to Gazprom in 2006.

Exxon Neftegas has “no choice but to implement a controlled and orderly suspension of work” on two fields off Sakhalin because the government has not approved its investment plan for this year or supplements to last year’s budget, ExxonMobil spokeswoman Dilyara Sydykova said Friday, before the ministry’s statement.

Sydykova could not be reached for comment Sunday.

The ExxonMobil subsidiary operates the Sakhalin-1 oil and gas project for an international consortium, which also includes a group of Japanese companies such as Itochu and Marubeni, a subsidiary of Indian state energy firm ONGC and two Rosneft units.

ExxonMobil says the delay is because of bureaucracy at the Authorized State Body, which approves budgets for projects operating under PSAs.  

The body includes officials from the energy, finance and natural resources ministries as well as local officials from Sakhalin.  

Exxon Neftegas was planning to start drilling production wells on its Odoptu field and continue building a gas pipeline from the field to the shore, the Sakhalin government’s industrial safety watchdog reported recently, Interfax said. The company was also preparing to halt unspecified work at another field, Arkutun-Dagi.

Chayvo, the third field, began producing oil in late 2005. Gas production followed, but the company needs to invest more to produce enough gas for exports.

Exxon Neftegas has “fully responded to all” information requests that is within the requirements of the project’s PSA, Sydykova said. The Sakhalin-1 development has provided the region with resources, jobs and revenue, she said.  

“The Sakhalin-1 future phases will significantly expand these benefits to the state and local communities, but we are concerned that the Authorized State Body’s failure to approve budgets may defer or limit these positive results,” she said.

Operators of PSAs have traditionally inflated costs to claim a greater share of the output, said Konstantin Simonov, director of the Fund for National Energy Security, a think tank. Exxon Neftegas may be trying to coerce the authorities into accepting its investment plan by threatening a scandal before the grand opening of the LNG plant, he said.  

President Dmitry Medvedev is expected to attend the opening, and Japanese Prime Minister Taro Aso has been invited.

The Industry and Trade Ministry, which used to oversee the project, approved last year’s budget for Sakhalin-1 in December 2007, striking down a proposal to start designing a pipeline to China.  

Gazprom deputy chief Alexander Ananenkov said at a government meeting earlier that year that the company wanted all Sakhalin-1 gas for domestic supplies.

ExxonMobil has a tentative agreement with China’s CNPC to sell the country 8 billion cubic meters of gas annually by pipeline. It is also supplying gas to the local market from its only operating field, Chayvo.

A Gazprom spokesman declined comment Friday. Simonov and Alexei Kokin, an oil and gas analyst at Metropol investment company, said they doubted Exxon’s problems were linked to the talks with Gazprom.

Now, perhaps XOM is engaging in ex post opportunism, in an attempt to extract rents from the PSA.  But I place very high weight on Russian shenanigans given: (a) the track records of the Russian government and Gazprom, and (b) Gazprom’s desperate need for gas to meet domestic demand and export needs in the face of declining output (down 10.5 pct year-on-year in January, although that reflects in part the gas war) and having to pay what are now above market prices for Turkmen gas (I’m sure it sounded like a good idea at the time).  I am metaphysically certain that it is stark raving nuts to dismiss out of hand, as Simonov and Kokin do (last paragraph), the possibility of any linkage between Exxon’s difficulties in Sakhalin with talks with Gazprom about which way the gas will flow.  

XOM is in far better shape to withstand Russian pressure than BP, or Shell for that matter.  Moreover, the company has told Venezuela to pound sand in response to expropriations, and may well send the same message to the Putinistas as it did to the Chavezistas.  Here’s hoping.  

Sure puts a different spin on Putin’s sweet words (delivered in Davos) about Russia’s desire to attract foreign investment, don’t it?  I also remember Putin saying late last year in the presence of Shell’s CEO that foreign oil investors had no reason to fear the safety of their investments in Russia.  Ha!  [And yes, that’s a laugh, not a stray Russian preposition.]

The second story is one of intramural rent wrestling:

Prime Minister Vladimir Putin agreed on Thursday to consider more incentives to reverse declining oil output, as the energy minister delivered the grimmest outlook yet for the industry.  

Crude output will drop by nearly 8 percent from last year’s level through 2013 if the government doesn’t provide further aid to producers, Energy Minister Sergei Shmatko said at a meeting that Putin convened at a refinery outside St. Petersburg to talk to oil executives.  

Any potential incentives would further dent federal revenues, which are already expected to contract drastically this year on the back of low oil prices and the global economic crisis.  

Putin announced that the government was willing to discuss lower export duties for oil that is flowing or will flow later from eastern Siberian green fields. These new fields must also enjoy lower taxes, he said.  

Existing fields in western Siberia have been depleting, forcing companies to venture out into wilder expanses to the east.  

“We know that transportation costs are high there and infrastructure is not developed,” Putin said to the chief executives of companies including Rosneft and LUKoil, the country’s biggest and second-biggest crude producers, respectively. “I believe it’s possible to support you.”  

In return, the companies will have to invest the money that they save on taxes in exploration and development, “not bonuses or other needs that are not of primary importance,” Putin said.  

Current taxes do not encourage companies to invest in new fields, Putin conceded. If introduced, the new incentives will come in addition to a package of tax breaks that was approved last year and went into effect in January.  

Putin said at the meeting — held at the Kirishi refinery owned by No. 4 crude producer Surgutneftegaz — that the previous measures would help the industry to save 500 billion rubles ($14.3 billion).  

The easing of the tax burden coincided with the devaluation of the ruble, benefiting the oil industry by raising the amount of rubles being earned from exports.  

Despite that, Shmatko said oil companies might fall short of 200 billion rubles earmarked this year to invest in increasing output. Next year, the shortage may expand to at least 500 billion rubles, he said, citing data from oil producers.  

“The industry is stagnating,” he said.  

Should the government not -intervene, oil output will drop to 450 million tons per annum by 2013, he said. He said the forecast was based on an oil price of $60.  

Alternatively, production will grow to 511 million tons by that year if the state extends more tax breaks and state guarantees for loans, Shmatko said.  

Russia produced 488 million tons of oil last year, registering the first annual production drop in a decade.  

Shmatko’s estimate for output contraction is realistic only if the oil price falls further, said VTB analyst Svetlana Grizan. A barrel of the Russian export blend, Urals, has stabilized at about $40 in the past several weeks.  

As a way out, Shmatko offered a transition to a tax on excess profits for new fields, but it was unclear if the proposal received the green light from Putin at the meeting. Putin said any new taxes in the oil industry must be easy to collect.  

Analysts have warned that oil producers might want to inflate their costs to reduce tax payments in the event that an excess-profits tax becomes reality.  

The oil industry generated 43 percent of all federal budget revenues, or 4.4 trillion rubles, last year, Shmatko said.

Shmatko also warned that the transportation rate of $16 per barrel on the East Siberia-Pacific Ocean pipeline that Transneft plans to charge would make oil production unprofitable in eastern Siberia. The pipeline is scheduled to begin operating in December.

This could reflect an industry poor-mouthing in order to extract more from the government.  But, it must be recognized that the Russian oil tax regime is draconian, not to say punitive, and that it drastically reduces the incentive to invest, especially in low-to-moderate price environments like those of the present.  It should also be noted that some of the output declines reflect the inefficiency of Rosneft, a poster child for the economic consequences of Putinism.  

This is also just another illustration of the myriad Russian policy dilemmas.  The budget is heavily dependent on tax revenues from the oil sector.  The budget is deep in the red.  So, cutting taxes will exacerbate an already desperate budgetary situation–and put further pressure on the ruble.  The RF needs revenue today.  Lots of it.  But, the ability of the industry to generate revenues for anybody, including the government, in the future is threatened by the maturation, and outright decline, of existing fields and the tax-driven (and lack-of-property-rights-driven) lack of incentive to invest in new fields.  Russia must choose: money today, or money tomorrow.  Even though reducing taxes would be a positive net present value move (i.e., the present value of future taxes would almost certainly be greater than the value of the taxes foregone), the pressures of the short term crisis may well lead the government to choose to let the future take care of itself, and to attempt to maximize current revenues.

I especially liked Putin’s remark that any tax had to be easy to collect.  This speaks volumes about (a) his trust in the probity of Russian corporations, and (b) his stationary bandit mentality.

One last historical note.  Part of the discussion raging on SWP over the weekend focused on the role of the collapse of oil prices in the late-80s in causing the demise of the entire USSR.  I should note that not only did oil prices decline, but Soviet output plunged too.  The finances of the USSR were thus hit by the effect of selling smaller quantities at lower prices.   That’s exactly what Russia faces today.  It’s deja vu all over again.  

Apropos that earlier discussion, I agree that the structural defects of the Soviet economy, and the burdens imposed on it by a gargantuan defense establishment, were far greater than today’s counterparts.  That doesn’t mean, however, that the Soviet precedent is irrelevant.  Russia is unlikely to fall as far as fast as the USSR, but that is cold comfort.   If A died from falling from a 100 story window, should B take solace because he is plunging only from the 40th floor? I think not.  The RF’s economic problems aren’t as bad as the USSR’s, but they are of the same kind, and sufficiently severe to jeopardize the country’s short, medium, and long term economic health.