The Russian energy sector is characterized by a lack of upstream exploration and development in oil and gas. Outside investment and market penetration problems for foreign companies decrease gains from newer technology and reduce production.

Weak and ageing infrastructure prevents Russia from fully realizing potentialrevenue from productionand transportation of its oil and gas reserves to European countries. Russia would benefit from sharp increases in infrastructure investment and has many avenues toward turning an old, inefficient and unreliable distribution network and refining sector into a world leader in capabilities and responsiveness to demand.

Current Exploration and Development

The Russian energy sector is characterized by a lack of upstream exploration and development in oil and gas. Throughout the past four to five years, Russian energy companies have used their capital to acquire additional corporate holdings rather than develop new or existing fields. Technology and infrastructure, in addition to exploration, have also suffered from investment. Since most Russian energy firms are majority state owned, the reduction in capital for exploration and development is attributable to Russian government policies. Evidence suggests that more liberal policies governing investment in Russia’s energy sector would increase output. As oil prices rose earlier this decade, the domestic coal industry increased investment by 67.5 percent and recorded higher profits.1 The oil sector lost capital as Putin’s effort to diversify Russia’s economy moved funds away from development to other industry sectors. The resulting decrease in output, some 2.7 percent, raised fears of stagnation in the energy sector.

When combined with a tight worldwide energy market there is cause for greater concern in Europe since decreased upstream investment in Russia may result in a decline in exports and a subsequent shortage in oil and gas3. President Putin’s strategy appears to be focused on maintaining modest funding for energy and has stated publicly that investing elsewhere is the best step toward a healthier economy. Energy exports, however, are Russia’s largest source of revenue and failing to advance the industry and maximize exports will reduce overall revenue. Putin’s emphasis on diversifying the Russian economy does not sufficiently target the oil and gas industries. The risk of stagnation increases as the energy sector atrophies.

Exploration projects in commercially viable areas such as the Barents Sea, as well as in geographically challenging areas such as Siberia, could help Russia prosper on high European energy demands in the long and short term. In order to do so, Russia will have to amend its current aversion to foreign investment in energy projects. Minister of Industry and Energy, Victor Khristenko and President Putin agree that tax incentives will increase investment in high-risk offshore oil fields in the Arctic and Barents Sea region; a tactic similar to that used in Eastern Siberia to stimulate exploration from foreign firms.4 Yuri Trutnev, Minister of Natural Resources, feels differently – that licenses for offshore blocks should be sold to companies directly.

Earlier this year, the Russian navy made a very public effort to introduce its discretion over areas near the North Pole but complete commitment to hydrocarbon exploration has not begun due to internal conflict over subsoil legislation, tax structures and license incentives. Whatever arguments are made over the details, the Kremlin appears to be moving towards granting investment to new exploration. Anything would be an improvement over the current situation. From 1991 to 2006 a total of 7,600 licenses were issued for exploration and roughly 2 percent were for offshore fields.5 Issuing licenses directly to companies would provide the security from expropriation needed to spur projects as laborious and expensive as offshore exploration. Arctic development involves many challenges but this region is thought to contain the majority of Russia’s offshore reserves.6 The northern coastline does not currently have the infrastructure required for these projects and an estimated $100 billion would be needed for work to begin, according to Chris Finlayson, chairman of Shell Russia.7 Recoverable reserves from the Barents, Pechora and Kara Seas total roughly 100 billion metric tons (mt) of oil.8 Russia may be able to pump 10 million mt of oil and 30 billion cubic meters (bcm) of gas per year by 2010 increasing to 95 million mt and 300 bcm by 2020.9

While the rules governing access to these new fields are unclear, it is highly likely that Rosneft and Transneft will play a major part in their development. These state-run companies add a political element guaranteed to undermine foreign participation in projects. Complex collaboration involving many parties interested in long-term investment may not solidify under such conditions and newer technologies such as liquefying natural gas and deep-water drilling may not be embraced by Russian companies. Development of small and medium sized oil and gas fields is also unlikely to occur without foreign investors – with enough capital, technology and dexterity – to approach risky projects.10 Expropriation is still a worry in Russia’s state capitalism. Opening Russia’s resources to world capital markets will achieve higher revenues from taxes on oil and gas and will allow increased government spending elsewhere.

Central Asia has also received considerable attention from Russia’s energy sector. It is estimated that $80 billion will be spent in the next two to three years on oil exploration, increasing total drilling funds to between $200 billion and $300 billion if considerable reserves are discovered.11 An international consortium agreed in 2005 to start exploration in Uzbekistan’s Aral Sea claims. PetroAlliance Services Co., based in Moscow, was awarded the exploration contract, which will extend into Azerbaijan.12 Russia’s energy relationship with Central Asia reverberates in other agreements with Eastern European countries such as Ukraine. The Ukrainian Economics Minister has referred to this relationship explicitly saying that, “Back in 2000-2002 [Russia and the Ukraine] signed corresponding agreements…guarantee[ing] uninterrupted flow to Europe [from Russia] and Russia guarantees access to Central Asian gas resources.” Agreements like these along with Russian exploration ensure a lasting presence in Central Asia’s energy sector for decades to come.

The coal industry remains a vital part of domestic energy production and is slowly being consolidated into private companies; however, like oil and gas, these entities are likely to be majority state-owned.13 It is thought that coal power generation will take a greater role in the future as more natural gas is exported rather than used in power plants. Russian resources of coal are the second largest in the world, although, coal is not useful as an energy security lever due to its availability elsewhere in the world. Government influence in this increasingly important domestic sector means that output will not be as great as economically achievable. Allowing domestic wholesale and distribution would allow for lower prices and more efficient use of resources.

Transneft and other state-owned energy firms are concentrating on distribution networks to upgrade capabilities, extend their reach and increase revenues from distributing Central Asian gas, oil and refined products to Europe. Khristenko was quoted in the summer of 2006 stating that a $1.1 billion pipeline from Bulgaria’s Black Sea port of Burgas to the Greek port in Alexandropoulos will be funded in part by Russian companies interested in moving more gas to Europe. Another pipeline project was launched in April 2006 to move gas from Eastern Siberia to the Primorsk terminal on the Baltic.14 Other independent development firms such as Tethys Petroleum are relying on the Russia’s distribution system to pipe gas from the Kyzyloi gas field on the Aral Sea through the Bukhora-Ural gas line to markets in Europe.15 Arrangements like this correctly take full advantage of Russia’s comparative advantage in petroleum distribution. As long as Russia responds to market prices for distribution fees it could remain the most important partner for the region.

Status of Foreign Investment on Energy

Increasing central control over petroleum reserves intimidates outside investors and causes market penetration problems for foreign companies while decreasing gains from newer technology and reducing production. Chevron is contracted to finance exploration at sections belonging to Gazprom under the framework of a joint venture called North Taiga Neftgaz.16 The actual licenses for the fields belong to Gazprom and its subsidiaries, Noyabrskneftegaz and Neretoyakhaneftegaz. If suitable progress is made it is possible that Chevron would be offered additional contracts. Such arrangements are typical in Russia where foreign firms are relegated to only a fraction of the actual business being sold. Elsewhere in Ukraine, Gaz de France is negotiating a contract to develop upstream gas projects. Part of the contract includes upgrading pipelines, which move Russian and Central Asian gas to Europe. Implicit in the Gaz de France deal is the understanding that properly working pipelines generate regular profits, a mechanism undervalued in Russia. Norwegian and Swedish firms, Statoil and Norsk Hydro, are each seeking roughly 20 percent stakes in the Shtokanozske gas field.

Strict contracts for oil and gas leases and a history of expropriation mean high risk for firms hoping to invest in Russian production. Increasing government control over oil and gas prevents companies from realizing the profits from new green field projects. Problems with licensing, taxes, property rights and arbitrary governmental behavior toward firms creates an environment inimical to anything but Russian operations.

Negotiations around the Energy Charter Treaty between the EU and Russia will determine a great deal of the financial relationship and will frame restrictions placed on each party when attempting to invest. Russia opposes a great deal of the Energy Charter and resists the European Union’s position that Russia allow more foreign investment in and licensing of oil and gas deposits and pipelines.17 A consequence of Russian opposition was reciprocal restrictions on Russian investment in European power utilities and distribution networks as well as proposed legislation in the European Community that requires reciprocity; A country involved in a foreign transaction must have open foreign investment policies. While the European reaction is understandable, it is not sufficient to move Russia towards liberalization. Russia must acknowledge that foreign investment in infrastructure would alleviate the burden of managing complex economically vulnerable energy production and distribution sectors.

Russia maintains state control over its reserves and transit infrastructure and continues to sacrifice growth for control. The impasse over reciprocal deregulation is in part due to Russia’s announcement in 2006 that it will tighten opportunities for foreign investment in the oil and gas sectors.18 Doing so compromised European energy security. This move illustrates that central control over domestic energy infrastructure is more important to the Kremlin than economic efficiency or growth. Russia sustained a drop in production from 8.5 percent to 2 percent in 2005.19 Raising oil taxes, banning contracts with foreign firms, consolidating government control over Sibneft and other domestic firms reversed the progress made in the previous decade to privatize and increase production, exploration and development with newer architecture.

Russia cannot claim to be a modernized global energy leader with such policies in place. Furthermore, the financial capital does not exist for development of Arctic or Eastern Siberian green fields. Debt from acquisitions over the past few years means that development will be slow or require help from abroad. Energy wealth is a double-edged sword that rewards producers economically and politically but requires transparency in order to realize fully. Opening investment, cultivating an image of transparency and refinancing bloated domestic firms is the best way for Russia to maximize its wealth.

If policies allowing foreign ownership of infrastructure were implemented, Russia would have to develop regulation amenable to internationally recognized norms of profit and risk. For instance, cost prohibitive taxes on foreign operations and restrictive policies on foreign ownership would have to be exchanged for tax policies that allow foreign firms running pipeline systems, power plants and production facilities to feel comfortable. In essence, the government would have to regulate the energy sector instead of managing it. Currently, with Gazprom’s established control over key resources, the Kremlin has the authority to require special pricing for transportation of Central Asian resources to Europe. Gazprom is therefore considered by many foreign firms as adverse to cooperation. State ownership is also named as a cause for internal problems and inefficiencies.20 Gazprom also holds licenses for huge fields, which are not being developed. Issuing licenses directly to firms interested in developing oil and gas fields provides the profit incentive needed to move projects through to completion. The financial successes of Sakhalin 1 and 2 should provide a good example of how privatization yields returns.

Infrastructure Projects in Central Asia

In Russia’s energy relations with Central Asian oil and gas producers, the situation is reversed. Russia attempts to provide investment in technology and capital in order to increase petroleum transiting through the Russian pipeline system to Europe. Uzbekistan and Turkmenistan are both open to foreign investment due to the lack of homegrown technology needed for demanding extraction requirements. Perhaps due to their geostrategic placement, Russia’s position is advantageous and proffers a leading role as Central Asia’s main investor in infrastructure.21 Kyrgyzstan is also planning joint ventures with Russian companies to begin exploration and repair production and distribution facilities.22 Alexei Miller, the CEO of Gazprom, believes such joint ventures to be, “optimal mechanism[s] for cooperation.” When observed in the light of European interests – which prefer bypassing Russian networks entirely – the Kremlin is easily able to alter the transit costs for client nations and set prices low enough to prohibit alternate plans for pipelines. The next few decades are likely to see current negotiations come to fruition and establish Russia as the dominate player in financing and facilitating oil and gas projects.

Ongoing Infrastructure Projects and the Future

Weak and ageing infrastructure prevents Russia from fully realizing potential revenue from production and transportation of its reserves to European countries. Russian energy companies do not have the financial or technical resources to be competitive in a global energy market. More importantly, they cannot sustain funding for long-term projects required for growth.

A poor record of maintenance reduces quantities transported as well as the distances covered from Central Asia to Western European transit countries. Ironically, poor maintenance provides the government with useful excuses for delayed shipments of oil and gas to Western Europe, as occurred in 2006 when Lukoil and Transneft used maintenance as an excuse for political motives.23 Nevertheless, leaks, spills and mechanical failure occur often on twenty- to thirty-year-old equipment and do, in fact, delay shipments from across Russia to markets in Europe.24 High prices today will not last forever and utilizing revenues to upgrade is an elegant solution to easily fixable problems.

An auxiliary problem to that of infrastructure is the poor quality of refined products. As long as refineries continue with old equipment and limited capacities, Russia will not be able to take advantage of the growing demand for higher-octane fuels in Western Europe. Demand in Russia for Western cars is also increasing. Only 75 percent of gasoline consumed in Russia is comparable to Euro 1 and Euro 2 grades of fuel designated for vehicular pollution control.25 Last year Russia refined approximately 220 million mt of crude into 480 million mt of fuel oil or poor quality gasoline. Many of Russia’s refineries are twenty-to-fifty- years-old and cannot compete with world standards. Developing a competitive refining capability will give Russia a nimble export that can be shipped throughout Europe and beyond with demand expected to increase in the future. There is some development occurring now that will benefit the refined products sector and reduce the likelihood of an oil products crisis. Planned investments will raise product quality and bring roughly 80 million mt of high quality products to market by 2015.26 The government has announced plans to develop a distribution network throughout Tartarstan and a new refining facility capable of seven million mt per year. The complex is scheduled to finish in 2010.

Russia is planning multilateral joint infrastructure projects with Central Asian and Caspian countries that will extend well into this century. One of the largest joint ventures proposes a common infrastructure between Russia, Kazakhstan, Turkey and other Central Asian nations. Gas and oil pipelines will link to export terminals on the Persian Gulf and the Baltic. Other agreements for automobile, electrical and high-tech communication links are also proposed.

Long-term transit agreements provide a common framework effective in securing a stable energy strategy. Minister Khristenko refers to “bringing closer our risk” to ensure business for Russian firms. Such a strategy ignores economic mechanisms in exchange for political arrangements. Unfortunately, political guarantees are inappropriate for commodity markets influenced by international (and domestic) market forces. Infrastructure projects will benefit from this arrangement as newer, more advanced facilities and pipelines – especially in the gas sector – are completed. Russia has committed to decades of work to construct a new energy partnership. The amount of supplies and reserves in Central Asia may provide the impetus toward a common market but creating it in isolation from international economic forces (by using state-owned companies rather than foreign investment) presupposes long-term importance of Russia to energy security in the region. Helping Central Asian producer nations open to international oil companies rather than relying on political structures is a more efficient method of utilizing reserves and increasing capacities for transit through Russian pipelines to Europe.

Future infrastructure projects designed to respond to increased demand in Europe and even the Western Hemisphere will include new pipelines from Siberia to new or upgraded seaport terminals on the Northern coast for direct export to markets. President Putin pledged earlier this year to expand the Primorsk terminal by 1 million barrels per day, increasing its capacity by 50 million mt per year.27 Khristenko emphasizes the development of coastline export terminals for cheap transport by sea.28 Developments in diversifying export routes will exchange the complex relationships with transit countries for direct access to markets.

Russia would benefit from sharp increases in infrastructure investment and has many avenues toward turning an old, inefficient, unreliable distribution and refining sector into a world leader in capabilities and demand responsiveness. Protectionist policies will have to be jettisoned in exchange for new regulations on foreign firms operating domestically allowing profits to be made and taxed moderately. Exploration for new reserves and development of existing fields can be increased with current equipment if necessary. Inefficiencies can be reduced with newer technologies from international firms with experience operating in difficult areas. The sooner action is taken the easier it will be to take advantage of higher prices.