Has Russia’s oil production peaked?

Good night, and good luck.
    —Edward R. Murrow

Has Russia’s oil production peaked? The answer might as well be yes in so far as their smallish medium-term growth possibilities are well-delineated and longer term growth will require levels of investment that are not likely to to be forthcoming in time to remedy the situation. This report is a follow-up to For Russia, An End to Growth is In Sight, which establishes the basis for this view (ASPO-USA, August 15, 2007).

What you need to know about Russia’s future oil production is as easy as 1-2-3.

1. The slowdown in Russia’s output growth since 2003 is crystal clear (graph below left, Wall Street Journal).
2. The small set of large (≥ 50,000 b/d) new fields coming on-stream by 2012 is precisely known. Mature depleted Russian oil basins (Western Siberia, Tartarstan) and tough new fields (Eastern Siberia, Far East) require huge investments in infrastructure, new wells, enhanced oil recovery, etc. to maintain or add to production.
3. Government policy does not cap oil output but rather impedes exploration & production activity with burdensome tax rates on Russian oil companies. The Federation—Vladimir Putin and his sidekick Dmitry Medvedev—also hassles and seeks to eject foreign operators (and their capital) after they have exhausted their usefulness, e.g. Shell at Sakhalin-2.

There is no compelling reason to believe that Russia will break out of the current plateau—permanent decline?—of oil production as it did after 1999. Even if Russia changes policies that currently stifle investment to promote future production, that money will work, increasingly in vain, to maintain, not grow, oil output. And even if a modest medium-term gain of 2-3% over current production levels should somehow be achieved by 2012, that will very likely be the end of the line for Russia production growth.

The fact that the skittish oil markets have finally noticed that Russia’s output growth is flagging doesn’t add much to what anyone who has looked at the situation and can interpret a graph already knows. As for optimistic expectations, those are usually the product of standard bureaucratic dogma that “all will be well,” ignorance following from an inability to subtract, or our typically human emotional investment in a happy future—not the data and its reasonable interpretation.

Fuzzy Data and Expectations

This update is prompted by the news that Russia’s production fell 1-2% in the first quarter of 2008, depending on the type of data examined. The Wall Street Journal’s Russian Oil Slump Stirs Supply Jitters cited the IEA’s calculation that production of 10 million barrels per day (b/d, crude oil + condensate + gas liquids) was down 1% in the 1st quarter compared with 2007, noting that “industry watchers and Russian officials generally blame the country’s production slowdown on a combination of weather and tight electricity supplies in some parts of the country.” Electricity? That’s another subject.

Reuters cited Russian Energy Ministry data indicating that “oil production [crude + condensate] edged down to 9.76 million barrels per day from 9.79 million b/d in February, and well below the post Soviet high of 9.93 million b/d reached in October last year.” The preliminary EIA data is slightly higher than the Russian official data, but shows the same winter trend.

Despite the discouraging results in the 1st quarter, the IEA’s March, 2008 Oil Market Report (graph left) was still forecasting that Russia crude output would grow this year by as much as 250,000 barrels per day. They have now revised that forecast down to an all liquids addition of only 0.8% while taking a “cautious approach” according to IEA analyst David Fife.

The IEA’s sudden wariness, which has never been apparent before, has caused them to withhold their future Russian forecast “pending [the] spring results, which could eliminate weather-related distortions typical of winter months” (AP, April 15, 2008). Their hesitancy is absurdly shortsighted—Russia’s fate does not depend on any winter’s weather conditions or what happens in the Spring quarter of this year. The agency is now, like Napoleon during the harsh Russian winter of 1812/13, in retreat.

Optimism still abounds in some quarters. The Wall Street Journal cites some hopeful sources—

Many Russian oil officials say the industry could still resume growth. Some Western analysts point to more optimistic data and forecasts. Citigroup said in a report late last month that it expects Russian oil volumes to increase by 1.5 million barrels a day between now and 2012, largely thanks to new projects in eastern Siberia. Still, it cautioned: “Russian oil production growth is no longer to be taken for granted.” Russia’s energy ministry expects a rise of 1.8%…

Note: Citigroup’s happy projection provides for an increase of ≅ 15% within 4 years!

Citigroup’s economists are surely an authoritative source on future Russian output, but perhaps it would behoove us to look at the investment issues and what the facts are on—and under—the ground in order to maintain some perspective about what’s going on here. First, the finances.

Pressure on Investment in the Russian Oil Sector

The IEA’s February Oil Market Report gives us the basic facts about Russian taxes on operators. “Russian oil companies pay three separate taxes on their activities,” including—

1. A royalty on crude production; taxed at 22% after certain allowances
2. An export tax; based on the market price of Urals crude in the preceding two months. Light products attract a 30% discount on the tax charged and fuel exports benefit from a 60% discount.
3. A corporate profit tax of 24%, charged on net income, in common with other industries.

This added up to $65/barrel as of last February and the net profit for Russian oil companies was only about $10/barrel at that time. This staggering tax burden cuts significantly into the amount Russian operators have left over for exploration & production. It thus comes as no surprise that Rosneft is borrowing money, secured by crude oil export contracts, to finance its short-term debt (from Moscow journalist Sergei Blagov in Jamestown Foundation’s Eurasia Daily Monitor, February 28, 2008). Can Rosneft can carry out its investment plans in Eastern Siberia?

In December 2005, Rosneft paid some $260 million for a license to develop the East Sugdin oil and gas field, with reserves of some 200 million tons of oil and more than 40 billion cubic meters of gas…

In order to achieve significant production growth, Rosneft plans to invest 50 billion rubles ($2.04 billion) in Eastern Siberia this year, and up to 600 billion rubles ($24.5 billion) through 2020, [Rosneft CEO Sergei] Bogdanchikov said. Rosneft expansion plans for Eastern Siberia largely rely on the Vankor oil deposit, which has estimated reserves of 500 million tons, he said. However, Bogdanchikov complained that the company’s investment resources were limited, as it faced a tax burden of some 60%, while oil companies outside Russia pay about half that amount…

… Rosneft may still acquire new licenses, but developing new oil and gas fields in Eastern Siberia would require billions of dollars in investments. Therefore, it remains to be seen whether Rosneft’s expansion could prove economically viable in the longer term.

Deutche Bank oil and gas analyst Leonid Mirzoyan states that “Rosneft is still unlikely … capable of footing the expensive bill for developing the Vankor field on its own” (Moscow Times, April 3, 2007). Rosneft has been snapping up development licenses and shares, but they are overextended. How will Rosneft finance future development at Sakhalin-III, Vankor, North Vankor, Yurubcheno-Takhomskoye, East Sugdinsky, Verkhnechonsk and all the rest while continuing to drill more and more wells to get expanded production from older (former Yukos) properties like top Western Siberian subsidiary Yuganskneftegaz? And still pay their taxes? Rosneft’s CEO Bogdanchikov doesn’t know, and neither does anybody else.

Although plans have been announced to cut taxes by an estimated $4.2 billion in 2009, Leonid Fedun, vice president of OAO Lukoil, remains unimpressed. The Wall Street Journal quotes Fedun as saying that “Russia’s oil industry needs $1 trillion of investment during the next 20 years just to maintain production of 10 million barrels a day.” Lukoil will see a savings of about $1 billion after 2010, which will speed up development of the Filanovsky field in the Russian sector of the North Caspian. In line with Fedun’s pessimistic view, Lukoil recently cut its 2008 growth forecast from 5% to 1.8-2.0%.

Various optimistic estimates—including Citigroup’s overly cheerful private report, one presumes—have used Russian oil company growth targets to justify their forecasts. Forward-looking statements from TNK-BP, Rosneft or Lukoil are becoming increasingly worthless as a guide to future activity in light of the lack of capital available for exploration & production. Russia also has a paucity of large new fields coming on-stream and must fight off declines stemming from depletion in their mature oil basins.

Continuing Depletion and New Oil Fields

Lukoil’s Fedun believes Russia has peaked now (Yahoo! News, April 14, 2008). Here is what he told the Wall Street Journal about the short and longer term prospects—

In an interview, Leonid Fedun, vice president of OAO Lukoil, one of Russia’s biggest oil companies, said a mild winter and higher temperatures mean Siberia’s icy ground is less stable, making it harder to move drilling rigs between oil wells.

He acknowledged that the fall also reflects a longer-term trend — the depletion of Siberia’s older fields. “Western Siberia is repeating the fate of Prudhoe Bay, with a time lag of five to six years,” he said. “When the well’s productivity falls, you have to keep drilling more and more. You’ve seen it in Alaska and the Gulf of Mexico, and now you’re seeing it in Siberia.”

It will come as no surprise¹ to veteran peak oil observers that Western Siberia is going the way of Alaska or the North Sea. Putting this in context, much of Russia’s production growth in the last few years came from the offshore Sakhalin-I Chayvo field in the Far East, which peaked at 250,000 barrels per day in February, 2007. Rosneft now expects Sakhalin-I output to fall to about 160,000 barrels per day in 2008. Exxon Neftegas was drilling record-setting new wells at Chayvo back in April, 2007 but production will never return to peak levels at Sakhalin-1.

Declines at Sakhalin-1 must be offset by the implementation of year-round production of 70,000 b/d at Sakhalin-II, the Yuzhno-Khylchuyuskoye (“YK”) field in Timan-Pechora, which will likely produce 150,000 b/d sometime in 2009, and an unknown contribution from Rosneft’s Vankor in East Siberia starting this year. Rosneft has set its sights on 500,000 barrels per day from Vankor by 2015. (See These Are the Good Years for an update on factors affecting Vankor, ASPO-USA, February 20, 2008.) A few other large (≥ 50,000 b/d) projects are listed at 2008 Megaprojects page at Wikipedia, including the Salym field expansion which will likely add another 62,000 b/d in 2010.

Scheduled new projects delimit Russia’s ability to expand oil production in the medium term. If one makes the conservative assumption that Russian output outside of the projects mentioned here will decline in the 2-3% range each year from now on, it is easy to see that Russia’s post-Soviet growth is coming to an end. New project delays would only make the situation worse. Managing decline rates in the existing production base (in the medium term) depends directly on how much investment is available for new wells, new drilling technology (e.g. laterals) and enhanced oil recovery. There are tax discounts on some of these activities.

An End to Growth is Still In Sight

Everyone will have to wait & see how Russia fares in the next few years, but the only surprises will be on the downside—the limited upside possibilities are already mapped out. The Federation’s growth is constrained by lack of investment, too few new large projects coming on-stream, and the geological facts of life. And sometimes, the weather.

It appears that Putin’s policy is to intentionally restrain development through onerous tax burdens on Russia’s oil companies. The Urals Blend is selling at $109.66 today. Perhaps Putin truly understands, like the Saudis apparently do, that keeping some of Russia’s oil in the ground is a better longer term strategy than producing it in an unfettered way now and accruing future rate of interest returns on the unburdened revenues. All things considered, Russia is the largest crude + condensate producer in the world, and Vladimir Putin is no dummy.

Contact the author at [the original article].

Notes

1. Read part 1 (For Russia, An End to Growth is In Sight) for a thorough discussion of developments in Russia.