Much of the country’s fate over the last decade has been tied to the ascendancy of Vladimir Putin, of course. His Presidency started on Jan. 1, 2000, and lasted eight years before he “stepped down” to serve as Prime Minister in 2008.  Russia’s fortunes changed dramatically during Putin’s tenure as the economy stabilized and grew significantly in the last 10 years, reflecting the rapid rise of the oil and gas markets on which so much of Russia’s economy is based. Not surprisingly given its over-dependence on energy markets, the global economic crisis and the collapse of energy prices had a disproportionate impact on Russia, causing its economy to falter and natural resources production to slow.

While the roller coaster ride is likely to continue in Russia and its energy markets, it does beg the question: What can Russian leaders do to encourage stability in its volatile oil and gas markets today and into the future?

Russia: The Past

Russian oil production showed tremendous growth early in the decade and then reached a plateau as it neared 10 million barrels per day.  Russian oil production averaged 6.9 million barrels per day for 2001 (the first year of the new century and decade). By the beginning of 2010, Russian oil production crossed the 10 million barrels per day threshold.  Growth was quite uneven, with annual average production surging in the early years between 500,000 and 700,000 barrels per day (2001-2004), and then tapering off to annual average increases of 200,000 barrels per day (2004-2007).  This high growth was due to a number of key factors, including:

• The significant increase in oil prices. World oil prices increased from an annual average of about $26.00 per barrel in 2001 to a high of an annual average of $100 in 2008, declining to an annual average of $62 in 2009. Today, the current oil price is just over $80 per barrel;
• The application of modern technology to Russia’s aging West Siberia oil fields; and
• The devaluation of the ruble, which lowered production costs.

Russia’s economy surged during this period as high taxes on oil production and exports contributed significant revenues for Russia’s expanding state budgets.  In 2004, a new oil export tax was imposed. Marginal tax rates on oil exports exceeded 90 percent, adding to the already-burgeoning monies in the oil trust fund and allowing Russia to use these tax funds for its growing annual budgets. With oil reaching a peak of $147 per barrel in July 2008, future prospects seemed rosy.

Yet the precipitous decline in oil prices in December 2008 to about $35 per barrel in conjunction with the world economic crisis led to a shift in Russian oil production.  As discussed in a previous article in the Abraham Energy Report [Russian Oil Production Slides, April 2009], the impact of lower oil prices and the high Russian oil export duty led to a decline in oil production starting in September 2008, lasting six months through February 2009.  By March 2009, Russian oil production increased year-on-year and has continued to increase to the present.

As increases in Russian oil production slowed and reversed in 2008, Russia enacted tax incentives to encourage new production in high-cost producing areas, especially in the northern provinces and in East Siberia.  New production from Sakhalin Island came on line in 2007-2008, which masked the decline in Russia’s old West Siberian oil fields.  The combination of new incentives, Sakhalin production and a small number of new fields in East Siberia led to the marginal increases in Russian oil production during the remainder of 2009 to the present.  As of January 2010, Russian oil production has increased nearly 45 percent since 2001.

Russian gas production did not fare as well, although it did grow over the same period by about 14 percent (latest annual figures are for 2008).  Since Gazprom accounts for about 85 percent of Russian gas production, the industry’s fortunes are tied strongly to Gazprom.  Growth in gas production and exports to Europe, Russia’s primary market, grew consistently from January 2001 until 2007.  A warm winter in 2007 in both Russia and Europe led to a decline in consumption and production.  Russian production rebounded in 2008, although Gazprom’s production hardly increased that year.  While figures for 2009 are not available, Russian gas production in 2009 is likely to decline precipitously because of the two-week disruption in gas supplies to Europe due to the Russian-Ukrainian gas dispute in January 2009 (80 percent of European gas supplies transit through Ukraine) and the sharp decline in European gas demand stemming from the economic crisis.  Gazprom has been stretching production at its existing gas fields and has postponed investments in new gas fields in Yamal (Bovanenko) and offshore (Shtokman).  As an interim strategy Gazprom buys large volumes of gas from Central Asia (66 billion cubic meters in 2008).

A December 2009 article in the Abraham Energy Report [Central Asia: Pipelines are the New Silk Road] examined the fight over natural gas hegemony in Central Asia. The article concluded that Russia’s dominance was dwindling as Azerbaijan, Kazakhstan and especially Turkmenistan sought alternatives to Russia for selling their natural gas.  In December 2009, Turkmenistan opened its gas pipeline to China.  The opening of the pipeline was a wake-up call for Russia.  Within weeks, Russian President Dmitry Medvedev was in the capital of Turkmenistan, Ashkabad, seeking to improve relations with Turkmen President Gurbanguly Berdymukhammedov.  At the same time, Gazprom indicated that it had smoothed over its gas pipeline dispute with Turkmenistan stemming from an April explosion that halted all Turkmen gas exports to Russia.  Gazprom’s Alexander Medvedev said that it will resume purchases of Turkmen gas in 2010.  Gazprom also agreed to expand the Prikaspiiski pipeline running along the Caspian to Russia and to build the east-west pipeline linking eastern Turkmen gas fields to the Prikaspiiski pipeline route.  Obviously, the fear of losing Turkmenistan’s natural gas market to China and possible western routes spurred Gazprom and Russia to renew its energy relationship with Turkmenistan.  The open question is whether Russia’s effort is too little, too late.

A previous Abraham Energy Report article [The EU and the Great Pipeline Game, June 2009] discussed the many new pipelines (oil and gas) that Russia is proposing to construct to enhance its export opportunities or to bypass recalcitrant partners.  The proposed Nord Stream natural gas pipeline to carry gas from Russia to Germany under the Baltic Sea now has garnered all the construction permits required by the affected states—Finland, Sweden and Denmark—with German and Russian permits either in hand or to be issued soon.  The U.S. also appears to have scaled back its criticism of this pipeline as it increasingly becomes a reality.  On the other hand, the South Stream pipeline that would carry gas across the Black Sea to Bulgaria and then into Central Europe still appears mired in problems, including its astronomical cost, and does not appear to be any closer to reality.

Russia is proceeding with its oil pipeline across East Siberia to the terminal at Kozmino, near the port city of Nakhodka and near Vladisvostok in Russia’s Far East.  The first phase of the East Siberian Pacific Ocean (ESPO) is some 1,700 miles long. It is complete from the existing West Siberian pipeline system connecting at Taishet in the Irkutsk region and extending to Skovorodino, 45 miles from the Chinese border.  Transneft, Russia’s oil pipeline monopoly, is building a pipeline connection to its border with China in order to connect with China’s oil pipeline system. The pipeline will be able to carry up to 300,000 barrels per day, supplementing rail shipments of oil to China. This oil pipeline connection is part of the deal worked out earlier in 2009 between Russia and China in which China loaned Russia $25 billion for future oil deliveries. The remaining 1,300-mile section of the ESPO pipeline is under construction and expected to be completed by 2012.  Total cost of the pipeline is about $22 billion. Until the pipeline is completed to Kozmino, Russian oil will move by rail from Skovorodino to Kozmino, with Rosneft, TNK-BP and others planning to use this new port for oil exports to Far East customers.

Russia: The Present

The start of a new year almost invariably brings another crisis between Russia, Europe and its transit countries.  In January 2006 and January 2009 Russia created turmoil in natural gas markets when it halted gas deliveries to Ukraine.  Ukraine’s natural gas pipelines, built during the Soviet era when it was part of the USSR, carry 80 percent of Russia’s natural gas exports to Europe.  Russian gas accounts for between 25 percent and 30 percent of European Union gas consumption and about 35 percent of its natural gas imports. Some European countries depend on Russia for most of their gas supply, so any disruption has serious repercussions.  A similar gas disruption was averted this year as Russia and Ukraine agreed on terms of a new gas agreement, including market pricing. However, Ukraine’s ability and inability at times to pay its gas bills has left many Europeans on edge since Russia threatens to cut off Ukraine if it fails to pay its bills. Serious economic problems exist in Ukraine due to the world economic crisis, and it remains on IMF life support to prop up its economy. Another factor is the Presidential election in Ukraine. Incumbent President Viktor Yuschenko of Orange Revolution fame lost in the first round of voting. Opposition leader Viktor Yanukovych and Prime Minister Yulia Tymoshenko face each other in the run-off on Feb. 7. All these factors leave Europe in suspense as to whether Ukraine can meet its monthly gas bills.

Even as a crisis was averted in Ukraine, Belarus reared up to present additional problems.  On Jan. 1, 2010, Russia cut off oil shipments through the Druzhba pipeline (Druzhba means “Friendship”) that transits Belarus and provides about 10 percent of Europe’s oil supplies.  This stoppage is reminiscent of a similar dispute in January 2007, when Russia halted similar oil shipments.  Oil flows to Europe (primarily Germany and Poland) continued despite the Jan. 1 stoppage, while supplies to refineries in Belarus were directly affected. Why cut off the flow? Belarus refiners pay about one-third of Russia’s export tax rate due to previous tariff agreements between Russia and Belarus, so surplus products refined in Belarus are sold in Europe at a lower price than products from Russian refiners.  Russia wanted to raise tariffs for the Belarus refiners after the tariff agreements expired on Dec. 31, 2009, so that Belarus refiners would pay the same export tax rate as all others.  The new tax could cost Belarus as much as $5 billon annually, more than 10 percent of its gross domestic product.  The dispute escalated on Jan. 4, 2010, when Belarus threatened to cut off electricity to Russia’s Kaliningrad region, a small Russian enclave sandwiched between Poland and Lithuania and adjacent to Belarus. Russia immediately resumed all oil shipments. Negotiations between Russia and Belarus are ongoing. For the EU, the stoppage came as an unexpected and unwelcome New Year surprise, despite the EU and Russia putting an early warning mechanism into place last year to avoid these kind of bombshells.

Russia: The Future

For the future, Russian energy will continue to be an important part of the country’s domestic economy until it finds a way to diversify away from oil and gas.  Russia is pulling out of its economic crisis, assisted by higher oil prices in the last six months.  Oil production has stabilized and is increasing slowly, surpassing the 10 million barrel-per-day level in late 2009 and headed for 10.2 to 10.5 million barrels-per-day by the end of 2010, due to increasing production from East Siberian oil fields. Natural gas prices are likely to increase in 2010 since natural gas contracts with European buyers are linked to oil prices, although with a six to nine month lag.  If oil prices stay in the $70 to $80 range (or higher), expect European prices for Russian natural gas to rebound later this year.  Russia is keeping a careful eye on developments in Central Asia, its economic backyard, and is working to offset gains made by China and the EU.  Russia is slowly moving forward with its natural gas pipelines, with Nord Stream the most advanced.  In oil, it is moving rapidly ahead on its pipeline to the Far East, which can give Russia another outlet for its oil and will lessen its reliance on western oil markets.  It also is working to complete oil pipeline bypasses to Belarus, eliminating another thorn in its energy picture.

As the nation with the largest natural gas reserves and the eighth largest oil reserves, Russia’s energy future appears more than stable. The question is whether Russian leaders are able to leverage their natural resources to keep their economy afloat, maintain a reliable level of oil and gas production, and preserve viable trading relationships. In oil, after almost a decade of rapid growth, its oil production is reaching a plateau, and its success going forward will depend on its ability to provide sufficient incentives for development to occur in East Siberia and its Arctic offshore tracts. At present, its strategy appears to be working.

In natural gas, Gazprom continues to delay investments in new production, seeking to buy gas from other countries or from other domestic producers.  How long it can continue to play this game is an open question.  Its delays are worrisome to its long-term stability and to its ability to meet its long-term export commitments.