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ODAC Guest Commentary - Russian Production Decline: Why and what next?

In the first quarter of 2008, Russian production declined by 1% reversing a trend begun in 1998 that had resulted in a 58% increase in production from 6.2 MMBO/D to the current 9.76 MMBO/D. Actually, this was not the first decline in the ten year period, however, the slight decline in the first quarter of 2005 could clearly be attributed to an exceptionally cold period in Siberia and the reorganization and temporary drop in production as Rosneft took over Yuganskneft, the main producing asset of YUKOS. However production growth then resumed, albeit at a much slower pace than the preceding years. In 2008, though, the winter has not been exceptionally cold (rather the reverse) and there are no shifts in ownership that would interfere with production activities. Therefore, the 2008 decline could possibly not be a temporary phenomenon.

To understand what is happening, it is necessary to review the reason for the 58% production growth in the preceding 10 years. Surprisingly, exploration success played almost no role, just as the amount of oil (shortage or excess) in the ground plays no role in the plateau and possible decline. After the ruble collapse in 1998, development costs in Russia were extraordinarily low. This, combined with attractive fiscal terms and introduction of new technologies opened an opportunity that was mainly filled by the Russian companies led by YUKOS and Sibneft, those two alone accounting for about 35% of the 1999-2003 growth. There was another subtle factor however. While at YUKOS, I worked with Leonid Filimonov, the last Oil Minister in the Soviet Union. One day in 2003 Filimonov sat me down and explained a critical development philosophy in the Ministry planning process. As new discoveries were made, the Ministry would categorize them as “easy fields” with good reservoirs, high quality oil and favorable physical location characteristics as opposed to “difficult fields” with tight reservoirs, heavy or high sulfur or paraffinic oils, and in difficult places to develop, such as swamps or flood plans. Development plans were approved on approximately a 50/50 basis to save a number of “easy fields” for the future. Filimonov was upset that in the new uncontrolled environment, the companies were focusing on the “easy fields” racking up tremendous production gains, leaving only the “difficult fields” for the future.

Coming back to the reasons for the production gains of 1998-2008, the low cost advantage in development has disappeared, slowly at first, but rapidly in the past three years due in large part to the strong ruble. The attractive fiscal terms are long gone, and the export tax has now reached a rate of close to $50/bbl, and almost 90% of the value of oil above $27/bbl is taken in taxes and fees. The “new” technologies are of course still there, but in light of current fiscal terms, it is not economic to utilize them. The final point is that the “easy fields” which provided a significant portion of the increase in the past 10 years are in full production. Any further increase must come from the more difficult and expensive projects.

I am basing most of this discussion on West Siberia, currently holding two thirds of Russia reserves and two thirds of the current production. There are new provinces with coming increases, such as Sakhalin, East Siberia and Timan Pechora, balanced by the declining provinces of Volga Urals and the Caucasus. But the trend of the next few years will be dominated by West Siberia. The chart of West Siberia production, which I presented at the Hedberg Conference in November 2006, clearly illustrates the problem. The current reserve base can peak at about 7 MMBOD but then begins to decline sharply. Unless better fiscal terms are in place and significant investment made, production will steadily drop, taking overall Russian production with it. The current terms do not make optimized secondary methods and tertiary production attractive. Also, Russian companies are focusing efforts and best teams on new frontiers; LUKoil on Timan Pechora and the Caspian, Surgutneft on East Siberia, Rosneft on absorbing the many new assets it has acquired. The tough fiscal terms and political atmosphere (including new legal barriers to acquiring strategic projects, larger than 350 MMBO) is not at all encouraging to foreign firms to tackle the difficult development projects in the mature areas.

What will the future bring? There is serious discussion in Russia on some tax relief. I personally believe that it will happen this year and it will be enough to stem the decline, but not enough to bring back an increase. But then, I do not believe Russia wants nor needs a production increase. More money is coming in from oil and gas revenues than can be comfortably handled in the economy; a stabilization fund has been set up for the overflow, still inflation remains high. Russian production has not peaked, it has reached a plateau at close to 10 MMBO/D and there it could stay for many years. For those who cling to the (remote) possibility that world oil production can somehow exceed 100 MMBO/D in the next decade, they will have to look for places other than Russia for an increased supply.

WEST SIBERIA FUTURE PRODUCTION (Leonard, 2006)WEST SIBERIA FUTURE PRODUCTION (Leonard, 2006)

See also - http://www.davidstrahan.com/blog/?p=57

Ray Leonard, Vice President Kuwait Energy, and former head of exploration for Yukos

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