Untapped potential: the future of russia's oil industry. (Perspectives).

For a number of years, US energy policy has encouraged the search for oil outside the country, but away from the Persian Gulf. This approach recognizes first that access to those areas of the United States considered geologically attractive, but out-of-bounds for environmental reasons, will

continue to be denied. Second it accepts that the politically unstable Persian Gulf where the bulk of the worlds' oil reserves are located, cannot assure a secure oil supply. Because security of supply is valued above all other considerations in today's market, national and international policies must be adjusted to provide that security through diverse sources. As a result of this policy, the United States presently imports oil from some 60 counties, a policy that would appear to offer the desired protection. But because the United States is not isolated from the volatilities of the world oil market, even this diversity of importers is insufficient to guarantee the desired security.

It has been argued, for example, that the United States should reduce its dependence on Saudi Arabian oil as a way of reducing its import vulnerability. After all, Russia is now the second leading oil producer and exporter, has proven itself to be a reliable supplier to the world market for a number of years, and has indicated that it is prepared to respond to US needs. That approach simply ignores the reality of how the oil market functions. However, the argument is appealing because Saudi oil imports could be halted by government edict, if it were concluded that such actions would serve US interests. What then? Saudi oil would find other markets and the United States would have to turn to other, possibly less reliable, suppliers.

Given the status of oil as an international commodity, and given that no state is immune to the workings of the world oil market, what can be done to maximize the reliability of the market? There seems to be only one answer, and that is to continue the search for and development of oil supplies outside the Persian Gulf. Today, emphasis is placed on Africa, particularly West Africa, and deepwater resources in the Gulf of Mexico and offshore Brazil.

In recent years, media coverage has focused on the oil and gas production and export potential of the Caspian Sea and Central Asia, which some initially believed would become a substitute for the Persian Gulf. After further research, however, most analysts now place it on par with that of the North Sea. This reassessment nonetheless does not detract from the importance of the Caspian Sea and Central Asia as important marginal suppliers. Developing these regions will give importers another choice among suppliers, which then translates into greater security of supply.

This latter consideration motivated the very vocal US support for the development of Caspian oil and gas production and the construction of export pipelines, intentionally bypassing both Russia and Iran.

Looking to Russia

As late as 1938, Russia was the world's leading oil producer, at 11.4 million barrels per day (bpd). Then, in mid-1980, production began to collapse, a result brought about not by developments in the marketplace or war but by oil field mismanagement and a lack of fresh investment capital. The decline continued through the mid-1990s, when output hit a low of barely six million bpd.

The question then arose, how much further might production drop? The answer came in a somewhat unexpected way. First, the sharp ruble devaluation in the late 1990s reduced costs and stimulated production. Domestic demand was holding relatively constant, meaning most of the production increments became available for export. Then the Organization of Petroleum Exporting Countries (OPEC) began to raise oil prices by reducing supply. Prices did respond, providing an additional incentive to the now privatized Russian oil companies.

Russian oil producers quickly responded to these incentives and output is expected to average 7.5 million bpd during 2002. Of that volume, some five million bpd of crude oil and petroleum products will have been exported to buyers outside the country. Russia now stands second only to Saudi Arabia in terms of oil production and exports, though the Saudis hold that advantage by continuing to violate their OPEC-defined quota by nearly one million bpd as of October 2002. This presents a challenge to OPEC, at least in its effort to sustain prices, and diverts attention from the Caspian Sea and Central Asia.

Is this Russian oil growth sustainable and, if so, for how long? Russian oil potential has never been in doubt, but concerns have been raised as to how that potential might be utilized. Assessing the former Soviet oil industry has proven to be particularly difficult and not especially successful. During the past four decades, analysts have bought into four beliefs. The first three have been proven wrong and abandoned-and the current belief should be as well.

In the very early 1960s, the United States bought into the belief that the Soviet oil potential would be employed as a political weapon, flooding the world oil market and bringing ruin to Western economies. That never happened, for then, as now, contract commitments were met in full. The hard currency income from these exports has been far too important to the national budget to risk damage as an unreliable supplier.

By the mid-1970s, the US position on Soviet oil had been completely reversed, as the United States bought into the belief that the Soviet Union would soon be running Out of oil. That belief grew out of the famous, or perhaps infamous, US Central Intelligence Agency (CIA) finding that "during the next decade, the USSR may well find itself not only unable to supply oil to Eastern Europe and the West on the present scale, but also having to compete for OPEC oil for its own use."

The Soviet response was to provide increasing amounts of capital to the oil sector, stimulated, according to some oil watchers at the time, by the CIA report. As a result, Soviet oil production continued to grow, rising from 10.9 million bpd in 1977 to 12.5 million bpd in 1988, the peak year. It was then, however, that additional funding stopped. Moscow simply was in no position to further support the oil sector financially, and the oil collapse was imminent.

In the early 1980s, the United States operated under the belief that Europe should not become dependent on the Soviet Union for energy supplies. Imports of Soviet natural gas were scheduled to rise and the United States feared that Europe would become too dependent on the Soviet Union, once again viewed as an unreliable supplier. Another rationale was also at play; sales of Soviet natural gas to Europe would greatly enhance hard currency earnings that in turn would be directed to further strengthening Soviet military capabilities. Despite these fears, Europe generally ignored US entreaties and purchases of Soviet gas expanded. Again, deliveries continued to track contract commitments, not broader foreign policy.

More Bad News

The collapse of oil production, which began in mid-1988, was soon followed by more bad news. In December 1991, the Soviet Union fell apart, taking with it the future of Soviet oil, or so it seemed. Soviet planners always had an easy route to the future of oil. The oil fields of Baku had provided the bulk of production through the years up to and following World War II. But the geographic vulnerability of these fields became very apparent during the war. The search for oil moved eastward and was rewarded by the discovery of the Urals-Volga oil fields. These fields satisfied Soviet needs for the next 25 years. But, as these needs grew, rather than continuing Urals-Volga development, planners and geologists found it easier simply to continue the eastward search. Once again, these efforts were very successful, and the prolific new oil fields of Western Siberia quickly displaced Urals-Volga and Baku oil in importance. They now comprise approximately two-thirds of Russian oil production.

The richness of these fields enabled the Soviet Union to lead the world in oil production for the latter years of the 20th century.

Nonetheless, a decline in output eventually set in at the West Siberian fields. In response, Soviet planners shifted their gaze south to the Caspian Sea. But with the dissolution of the Soviet Union, that future belonged instead to Kazahkstan, Azerbaijan, and Turkemenistan.

Russian Oil Today

Meanwhile, the oil collapse continued, with output falling to barely six million bpd by 1996. How far could it fall? The answer came in a somewhat unexpected way. The 1998 devaluation of the ruble sharply reduced production costs. Equally important, the supply cutbacks imposed by OPEC member-countries helped sustain oil market prices at levels much higher than if this intervention had not been taken. As a result, growth replaced decline.

More importantly perhaps, the demand for oil by the Russian economy was showing only minimal expansion. Thus, most of the growth turned into surplus barrels available for export. The major Russian oil companies, by now privatized, were quick both to expand output and to take advantage of the higher market price of oil.

The Russian oil companies approach the future with considerable optimism. Company leaders speak of Russian oil production reaching as much as 10 million bpd by the year 2010. But they also know very well that any major future expansion will largely be determined by the development of markets outside their borders, given minimal prospect of any substantial growth in domestic requirements. In comparison to US consumption (an average of 19.6 million bpd in 2001), Russia's demand is quite small, on the order of 2.5 million bpd for the same time period. The European market, in the Russians' judgment, offers limited opportunities beyond current export levels. The growing markets of Southeast and East Asia, particularly China, are clearly attractive, but unfortunately the available Russian export infrastructure points west, not east.

At the same time, the export infrastructure has its limitations, both in capacity and in orientation. Considerable investment in expanding capacity is essential, to avoid limitations on volumes exported. To take advantage of China's growing appetite for oil, which can be satisfied only through imports, two pipeline proposals are being reviewed. Yukos, the second largest of the Russian oil companies, is anxious to build a pipeline from Angarsk, just east of Lake Baikal and the terminus of a crude oil pipeline from West Siberia, to Daching in China. Transneft, the oil pipeline monopoly, has proposed building a crude oil pipeline to the Pacific Ocean port of Nakhodka, arguing that all Southeast and East Asian markets could thus be served. For the moment, however, the Yukos plan--which calls for a carrying capacity of 560,000 bpd as opposed to Transnefts' one million bpd--is favored.

The proposed pipeline to China is of the highest priority, to meet China's needs with a diverse supply, and second, to provide an outlet for Yukos oil, which has jumped from 900,000 bpd in 1999 to 1.4 million bpd in 2002. Oil to fill the proposed line to Daching would come from established fields in West Siberia plus new finds in East Siberia.

Russia is very much aware of the US preoccupation with oil supply security, particularly in the aftermath of the terrorist attacks on September 11, 2001. Government and oil company officials have been diligent in their efforts to present Russia as an oil supplier of the utmost reliability, one to which the United States should turn. Varying levels of prospective deliveries of Russian oil have been put forward, and highly publicized tanker deliveries are already being made, undoubtedly at a short-term loss for Russian oil companies. But Russia lacks a deepwater port capable of handling at least 100,000 deadweight-ton tankers, and that shortcoming must be overcome if Russia is serious about making any substantial contribution to US oil imports.

Russia has proposed that Murmansk, an ice-free port on the Barents Sea, be developed to facilitate oil exports to the United States. Murmansk, they say, is well positioned to move oil more cheaply from northern Russia to the US West Coast than could be done for oil originating from the Persian Gulf. Yukos, for one, is hopeful that the port will be operational by 2007. But port development will require both US expertise and investment, with the scale and timing of US involvement still in doubt.

A Questionable Future

Recently, as the lasting stability in the Persian Gulf has become increasingly questionable, some analysts have bought into the belief that the United States should replace its imports of Saudi Arabian oil with imports of Russian oil. In their judgment Russia is and has been a far more reliable supplier to the oil market, and it would be in the country's interest to make this switch.

Russia, in turn, is playing to this belief, anxious in part to be recognized not just as a player in the regional oil market, but also as a force in the crowded international market. Moreover, what Russia needs is security and legitimacy, and it seeks to gain these from an oil relationship with the United States. Could Russia begin exporting as much as one million bpd to the United States before the decade's end? Simon Kukes, the president of Tyumen Oil Company, thinks so. Others, caught up perhaps in the emotions of the day, believe that Russia could be delivering that much to the United States in 2003. Hope seems to overtake reality in presently defining US-Russian energy relations.

But it really does not matter whether any Russian oil enters the US market. What counts is the continuing and expanding Russian oil supply to the world market. Crude oil is truly an international commodity, and that means all exporters and importers are vulnerable to any world event that impacts oil's supply and demand. Vulnerability, however, has less to do with volumes involved than with market prices. Exporters are vulnerable to low prices, which can lead to financial instability and potential public rest, depending upon the price duration. Conversely, importers are vulnerable to extended high market prices that can depress economic activity. The market works in the end, however, whether prices are low or high. A balance in supply and demand is eventually restored, and then the cycle of volatility begins anew.

Despite its general optimism, the Russian oil sector does have qualms about the future, including fears about declining oil prices, as some market watchers believe will happen in the not-too-distant future. What if the United States prevails in Iraq with a quick and decisive victory, giving a pre-eminent position in that country to US companies and allowing it to ignore Russian interests? And what if the United States presses for rapid development of Iraqi oil reserves to bring prices down in order to help an ailing US economy? How might the Russian economy react to prices considerably below US$20 per barrel? In the estimation of the World Bank, if oil prices fall drastically, the Russian economy will not be able to cope, although Russia would argue strongly to the contrary.

There are other concerns as well. Questions have been raised regarding the status of the oil sector itself, particularly the sustainability of output growth. To quote a leading Russian oil company official, "[W]e are investing to improve production from fields that were found in Soviet times and developed in a barbaric way. To find and drill new fields, investment of a very different size is needed. It can only come from big companies," meaning international oil companies.

It is not only the expansion of export pipelines and port facilities that require substantial capital expenditures. The whole of the infrastructure is in particularly dreadful shape, and billions of dollars will be needed for reconstruction and replacement. Pipelines in general are badly in need of attention. Breaks have become commonplace, and it is thought that annual spills may equal some two percent of production. Refineries are obsolete by any Western standard. Current light product yields (gasoline, jet fuel, diesel, and lubricants) on average are probably in the low 60 percent range, not sufficient to support a modern-day economy. Product quality is equally below average, and expensive refinery upgrading is in order. At the same time, there is considerable idle refining capacity (approximately 1.6 million bpd) that should be closed down.

It is not difficult to characterize the current Russian oil industry with some of the same deficiencies that led the CIA to render its 1977 prediction of future troubles: declining reserves-to-production ratio; a poor quality reserve base; emphasis on development drilling over exploration; overproduction and water encroachment at existing major fields; and no major new discoveries to build on, at least in the near-term future.

Yet the potential is still there, waiting for foreign investment. Foreign investors will not respond until Russia improves its investment climate. First and foremost, that means rule of law must be firmly in place. Moreover, the world oil market must be sufficiently attractive to offset the risks of doing business in Russia. Finally, the state of relations between Russia and the United States will greatly influence foreign oil companies' willingness to invest in Russia, as well as Russia's willingness to accept these investors.

[GRAPH OMITTED]

ROBERT EBEL is Director of the Energy Program at the Center for Strategic and International Studies.