Russian Oil , Gas and Gold

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http://www.russiablog.org/2006/07/investors_betting_on_surging_r.html

Private Energy Producers Rising in Russia?



An anonymous Moscow-based blogger writing for Ruminations on Russia is making some interesting claims about a report issued last week by UBS, an international investment bank. According to RoR's Thursday July 13 blog post, foreign investors are seriously underestimating how quickly the Russian economy is growing, and therefore how much gas Russia will soon burn at home instead of having available for export. For those of us hoping that Russia can provide the U.S. and Europe with a major alternative to importing more oil and gas form the Middle East, at first glance this sounds like very bad news.

Contrary to the dire predictions of Peak Oil doomsayers, the main obstacle to Russia meeting the world's need for more energy is not geology, but waste and corruption.

RoR quotes the UBS report arguing that the real issue is not the amount of gas in the ground (Russia holds a quarter of the world's proven reserves) but the massive subsidies and price fixing that distort the Russian domestic market:

Their conclusion is that the supply/demand equation is just in balance (“tightness means 'crisis risk' is real”). They believe that domestic demand and hence domestic pricing, is and has been under-estimated (which is definitely my view). In order to stimulate supply from independents (i.e. not GAZP) the regulated domestic price needs to rise faster than currently forecast. As they point out UES already purchases 1/3 of its gas on the (quasi)-open non-regulated market. In the Volga Region, for example, FOB well-head gas prices are about 40% higher than the regulated price. I can confirm that this is stimulating investment. UBS forecasts that non-GAZP [Gazprom] producers will account for a 27% share in total production in 2015, up from 15% today, and will account for 43% of domestic sales. 2015 is an unimaginably long time frame in a Russian context, but the trend is clear even if forecasting that far out is fairly meaningless. Their forecast for domestic price rises are the most aggressive of any Russia-based investment bank; forecasting netback parity (i.e. it's equally attractive to sell domestically vs export) by 2011.
The UBS report suggests that private competition for Gazprom and Rosneft may force the state-owned behemoths to become more efficient in response. The first step for Rosneft would be to stop flaring gas from its Siberian oil wells.

Before asking why competition is limited in Russia by a monopolistic Kremlin, our readers should understand why these policies are popular with many Russians. First, the "privatization" of the early 1990s, led by Yeltsin's advisors Gaidar and Chubais, was a disaster for Russia. These Western-backed reformers were blamed for lining their own pockets while massively enriching the oligarchs. Most Russians have a very bad taste in their mouths left over from this period. The Putin years have been a logical backlash to the 1990s attempt to create free markets overnight without the rule of law. The Kremlin also has some justification for its claim that since the state began to collect its "fair share" of energy profits, either via taxation or kickbacks, Russia is at last receiving market prices for raw materials. As one our Russian readers commented, the oligarchs were happy to sell these resources to foreigners at below world market prices, to avoid paying taxes.

None of this means that the Kremlin's state-driven model of energy development will work well for Russia indefinitely, only that it is far more popular than Yeltsin's "reforms". As the American libertarian P.J. O'Rourke remarked in his book Eat the Rich, there was no way Russia's gross domestic product in 1999 was actually smaller than that of tiny Belgium. In a country as vast as Russia, there is still far more business activity "off the books" than is recorded in official statistics. For the last 15 years, these off-the-books deals have spurred many business-related murders in Russia, since people could not sue for breach of contract. Now even The Economist admits that mafia violence has been reduced under Putin. In a recent article, they declared that Yekaterinburg's gangsters were "mostly dead, in jail or 'legitimate businessmen' now."


The problem for foreign investors is that even the capital-intensive energy sector is not immune from the endemic Russian drive to pocket millions under the table. This is why it is difficult to tell if the statistics above reflect Gazprom and Rosneft being wasteful and inefficient, or local Governors and operators making sure that some gas has slipped through the cracks. Russia faces the same problem it deals with at home in its relations with equally corrupt officials throughout the former Soviet Union. For example, the dispute last year when Gazprom temporarily stopped the flow of gas to Ukraine had less to do with the Orange Revolution, and a lot more to do with prominent Ukrainian politicians cutting into Gazprom's sales to Europe. This history of Ukrainian siphoning was not widely reported in the Western media, so the Kremlin looked like a ruthless regional bully.

Nonetheless, Gazprom understands that it cannot become a global exporting powerhouse until it sets market rates for gas, thereby forcing its customers to stop wasting so much energy. It is far easier to start this process externally, by making former Soviet republics pay up first, than internally against powerful industries in Mother Russia that don't want to give up their subsidized gas. Gazprom also understands that with world gas prices continuing to climb, eventually burning natural gas for domestic heating will be seen as a form of waste. This is the official reason Russia has supported Iran's "right to peaceful nuclear energy" even while discouraging Iran from enriching uranium.

To illustrate the demand side of the energy equation, Chevron-Texaco published a pie chart ad in several popular magazines, revealing that 49% of U.S. energy consumption is for heating and cooling. In Russia, where freezing temperatures usually last much longer than in the U.S., the percentage of gas burned to heat homes and offices is even higher. Russia (and America) could substitute relatively cheap nuclear power for natural gas to keep people warm and air-conditioned. Eventually, natural gas will be used mainly as a transportation fuel for heavy trucks, or be refined into diesel and jet fuel. For now, consumption from NG power plants built in the U.S. in the last twenty years has depleted supplies in the lower 48 states. Since natural gas prices quadrupled in the last decade, utilities around the world are again looking at nuclear power plants and coal to meet their needs. As Peter Huber explains in his book The Bottomless Well, this strategy of "burning uranium and coal" instead of oil and gas is pivotal for the future of the world economy.

Westerners tend to forget how important codifying mineral rights were in establishing the rule of law in 19th century America. Add to this worldwide issue a Russian cultural legacy of centuries of thievery, hoarding and violence, and you begin to understand why Russians wanted stability after a turbulent decade. Russia's transition from a massive centralized, state-directed model for energy development to some Western-style competition will probably take at least another generation. But for now, having the Kremlin act as the mokre kryshe (good roof) limits the competition within Russia for control over energy resources from turning violent.

Someday Russia will recognize that state-directed firms are too large and inflexible to tap the most remote parts of Siberia, far from multi-billion dollar pipeline corridors. To do that, Russia will need a new generation of independent entrepreneurs and wildcatters equipped with truck and railmobile gas to liquids (GTL) machines that only the West can provide. More importantly, it will need the rule of law, and that is something that the West cannot provide.