Pipe Dreams?

Russian Pipelines Back to the Future? Edward C. Chow

In Soviet mythology, the health of the country's economy, Edward C. Chow is Visiting Scholar at the national power, and influence in the world are directly linked Carnegie Endowment to the performance of its oil and gas industry. It is ironic, for International then, that peak oil and gas production in the U.S.S.R. was Peace. reached in the late 1980s just as economic collapse brought political disintegration. At the time, the was the biggest oil producer in the world, generating 12 million bar- rels per day, 11 million in alone. Peak consumption at this time was over 8 million barrels per day in the Soviet Union and 5 million barrels per day in Russia. Considerable volumes of crude oil and products were exported by the Soviet Union, first to other countries in the , and then approximately 3 million barrels per day to those outside of the Comecon.1 Oil and gas were part of the important barter trade in the Communist block and provided economic leverage for Russia in maintaining cohesion of the sphere. Moreover, they served as principal sources of hard currency and geopolitical assets in the Soviet Union's relationship with the outside world. Given the remote location of many Russian production fields, pipelines have always played a critical role in transporting oil and gas. The construction of a vast system of pipelines was often cited as a crowning achievement of the Soviet oil and gas

Winter/Spring 2004 [27] RUSSIAN PIPELINES industry. They were designed to move new export facilities—large-diameter production primarily within the Soviet pipelines and deep-water marine termi Union and Eastern and secon nals—to transport increasing volumes of darily for export to the West. oil to higher-value world markets in the Today's Russia inherited from the large ocean-going tankers favored in U.S.S.R. 46,000 km of these crude oil international trade. Otherwise, both the pipelines, 15,000 km of petroleum performance of its petroleum industry, product pipelines, and 152,000 km of which has been the growth engine for the natural gas pipelines, almost all of which Russian economy in recent years, and its are still owned and controlled by the ambitions of playing a larger role in state. By contrast, the , with world oil trade will suffer. only 55 percent of Russia’s land mass, has In order to harness the potential of its over four times more oil pipelines and energy sector and capture new markets, two times more natural gas pipelines, three key projects on the drawing board almost none of which are owned or con- are being discussed widely. These include trolled by the government.2 new pipelines to , to Daqing The Russian oil industry privatized in northeast China, and to Nakhodka on and modernized throughout the mid- Russia's Pacific Coast. The way in which 1990s. A more competitive cost structure Russia handles these pipelines and its after the ruble collapse of 1998, petroleum resources will signal the likely improved property rights protection direction in which its uncertain economic leading to greater reinvestment, and the future will unfold. introduction of Western and business practice allowed Russian oil Multiple Pipelines: The Answer? production to recover from a low of 6 November 2002 saw an unprecedented million barrels per day to nearly 8 mil- display of unity by usually-competitive lion barrels per day. This is still far below oligarchs. The four heads of Russia's the level achieved in the peak production major private oil companies announced year of 1988. Nevertheless, domestic oil an agreement to build a pipeline from consumption has dropped to only about their booming oilfields in West Siberia 2½ million barrels per day with lower (and high-potential fields elsewhere) to economic activity and better energy effi the port of Murmansk on the ciency. As a result, much more oil is . From Murmansk, crude oil being exported today, and Russia has (and perhaps one day oil products and become the second largest oil exporter in liquefied natural gas) would go to markets the world after Saudi Arabia.3 primarily in the United States and Russian oil production is forecast to Europe. Only a year old and still maintain this rapid growth while domes- unproven by rigorous commercial evalu- tic consumption is expected to be rela- ation, the Murmansk pipeline proposal tively flat in spite of better economic per has already come to represent a number formance. The existing pipeline system of trends in Russia, including its eco- was, however, designed to move oil to nomic and political transition, and inte- now diminished domestic markets and gration with the world. less desirable markets in Eastern Europe. Fundamentally, Murmansk is a mile- Thus, Russia is desperately in need of stone that challenges Russia to make crit-

[28] Georgetown Journal of International Affairs CHOW Pipe Dreams?

ical decisions that will permanently shape pany, marked the threshold of something the relationship between the state and the new: the possible end of the post-Soviet economy. For example, it raises questions scrap for assets, and a new era marked by of whether it is better to maintain strong business cooperation in which the whole elements of central planning and control is greater than sum of the parts, with a by expending public effort and scarce true and concrete partnership with the financial resources to manage the alloca- United States and Europe at the heart of

Russia has become the second largest oil exporter in the world after Saudi Arabia.

tion of economic resources (such as Russia's key industry. From Murmansk to pipeline capacity or upstream petroleum Nakhodka on the Pacific Coast, and investment), when the private sector is Samara to Novorossiysk on the Black Sea, perfectly capable of doing so efficiently. to the refineries of America, Europe, Or should Russia leapfrog these vestiges and , and the hallways of decision- of the Soviet era and adopt the proven making in the Persian Gulf and OPEC international market economic model? headquarters in Vienna, people are wait- Indeed, the public can entrust the private ing for President Putin's decisions on sector to conduct business while "con how to cross this threshold. trolling" the private sector through taxes, fair regulation, and publicly enacted legis- Central Planning: Last Throes or lation rather than through state owner- Retrenchment? In October, Minister ship and intrusive state planning. of Energy Yusufov made some economi Another issue is whether expanding pro cally-bizarre statements about the Far duction to seize greater oil market share is Eastern pipelines and Murmansk in call sustainable in the face of weak world ing for a Nakhodka pipeline before any demand growth and a disciplined consideration of either a Daqing pipeline OPEC—a possible recipe for confronta- or even a Murmansk pipeline, which, he tion. And finally, it is not clear that claimed, could at best be considered Russia's own public institutions are capa- simultaneously with one in Nakhodka. In ble of transforming fast enough to live by the same interview, he claimed that the international model. Can they cap "Murmansk will definitely develop...[but] ture only the economic rent necessary to we should do it in stages." He noted that provide for the public welfare and defense the uncertainty over which pipeline would while celebrating "useful greed" rather obtain political approval was the result of than ostracizing businessmen that make a a "need to assess the balance of our sup lot of money? plies to the international and the domes Yet, that unique moment of coopera- tic markets." Moreover, he claimed that a tion in November 2002, followed by the Japanese offer to commit to one million merger of TNK and BP in Russia and the barrels per day of oil imports from news of a potential merger between Nakhodka to help finance the line is actu YukosSibneft and a major U.S. oil com- ally unnecessary, given the wide array of

Winter/Spring 2004 [29] RUSSIAN PIPELINES potential customers in the Pacific Basin.4 Japan Inc., the Manchurian Yet, the state-run oil pipeline monopoly Candidate, Eastern Supporters. Transneft excuses the delay of the Japan has offered to finance the Murmansk line by citing the need for the Nakhodka line up to $5 billion, with United States to commit to volume pur another $2 billion for of chases from the pipeline even though any East Siberian resources to fill the line. As port serving the Atlantic basin would have justification for a willingness to commit an equally broad market at its disposal. such huge sums from a beleaguered The Nakhodka proposal and the Japanese economy in such an undevel Murmansk initiative are two entirely dif- oped idea, Japanese officials claim that ferent creatures—any state effort evaluat- diversification of supplies is paramount ing the merits of Nakhodka versus for the future of the Japanese economy. Daqing cannot provide a guide in com But this argument is highly suspect, paring Nakhodka and Murmansk. For for a number of reasons. First, since example, the private Russian companies Japan has a huge economy concentrated have pledged publicly up to 3 million on relatively small islands it has already barrels per day of crude oil to the ideal diversity of supply—they can buy Murmansk line from their future grow- from anyone in the world by tanker. If ing production in West Siberia and the Japan thinks Russian supplies from Timan Pechora region. No one has Nakhodka will somehow be lower priced pledged any oil from anywhere to the than competing supplies arriving by Nakhodka line. Additionally, the private ship, it should rethink the numbers: A companies are now prepared to finance simple net present value calculation Murmansk, but everyone, even the gov coupled with reasonable assumptions ernment, agrees there are not enough about demand growth in Japan indicates resources in the eastern half of Russia to that $5 billion of Japanese money spent commercially guarantee throughput for today on a pipeline would add about the line to Nakhodka. And while five pri $2/barrel to every imported barrel the vate sector companies are clamoring for country consumes for the next 40 years. Murmansk (with several more Russian Put another way, if it does not invest $5 and international ones in the wings), billion in Nakhodka, Japan could afford absolutely no private companies are yet to pay a $2/barrel premium for every backing Nakhodka. barrel to give it a competitive edge This is all a rather sad reminder that against every other oil consumer on the Russia remains committed significantly market, and still come out even. to some degree of central planning. In fact, their prices would arguably be Indeed, these pronouncements come lower because Middle Eastern crude oil, just as the Murmansk and Daqing otherwise destined for China, would be pipelines were about to emerge as the seeking other Asian markets if some first major post-Soviet examples of the Chinese demand were absorbed by state allowing the private energy compa Russian supplies. Moreover, Japanese nies to allocate their economic resources taxpayers and oil consumers may also as the market dictates, while paying their question the legitimacy of basing the dues through taxes and obedience to reg- energy security of the future Japanese ulatory and legislative authority. economy on untested results of prelimi-

[30] Georgetown Journal of International Affairs CHOW Pipe Dreams? nary estimates of unknown and unproven pipeline from Angarsk to Daqing, cost resources in an unfamiliar and remote twice as much to build as a consequence, part of the world. and require double the throughput guar- Finally, this Japanese initiative is com- antee and proven oil reserves to be sup- pletely out of synch with the history of the ported. If Japan chooses to subsidize a oil industry. It is oil supplies, not more expensive project and Russia accepts demand, that push pipelines into exis this offer, the Chinese strategic objective tence. The opposite is usually true for gas, of diversifying its oil import sources can but there is nothing fundamental about still be achieved if a pipeline is completed the Nakhodka pipeline, even geographic within a reasonable period of time since distance, that makes it any different from China can always buy Russian oil from the hundreds of other pipelines that have Nakhodka. However, if Japan's objective preceded it in the history of oil. were strategic denial, then prolonged With the economic rationale for delay from exploration in East Siberia Japanese support absent, suspicion natu and the arrangement of financing would rally turns to geopolitical motivations, suit its purposes just as well. which suggests that Japan is pursuing a Ultimately, Russia's action should be strategy of denial. First, undermining the driven by its own economic needs—not pipeline to Daqing denies supply diversifi the motivations or machinations of for cation to China, which has the fastest eign countries. growing energy markets in the world. This makes the Chinese arguably more con- Reform in the Russian Oil and cerned with diversity of supply than Japan, Gas Industry: Is it Over? As of this which has both longstanding supply rela- writing at the end of November 2003, it tionships and stagnant energy demand. is difficult to assess the arrest on 25 Secondly, it would deny China a stronger October of the former head of Yukos, economic and political relationship with Mikhail Khodorkovsky. It is unclear Russia; a relationship the Japanese have whether his arrest, along with the cam- watched warily as it has strengthened in paign against his business associates and recent years. Indeed, the Putin adminis- company since early summer, is a tempo tration has marked considerably more rary phenomenon connected to the state visits between Moscow and Beijing December Duma elections and the than between Moscow and Tokyo. Thirdly, March 2004 presidential election or if it would deny Russian companies a near- they represent a fundamental shift in term outlet for proven crude oil reserves Russia's decade-long economic transi- and force them to work instead with tion. It should be noted, however, that Japanese companies to develop resources Yukos was the Russian company sponsor- in the Russian east until enough volume ing an early pipeline to China and a exists for the Nakhodka line. This major proponent of a privately-financed arrangement would compel Japanese entry pipeline to Murmansk. into the Russian upstream where so many What is definitely transitory is the other international investors have failed. high global price of oil, which is Nevertheless, the fact remains that a presently above $30 a barrel. High oil pipeline from Angarsk to Nakhodka prices tend to cover up a multitude of would be roughly twice the distance of a economic sins in oil exporting coun

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tries, and Russia is no exception. The And, “The gas pipeline system is a child positive lessons of productivity gains of the Soviet Union, and only we are in a through the privatization of the oil position to maintain it in working condi industry itself are easily forgotten, but tion, even if you're talking about the sec- the memory of the admittedly flawed tions that lie outside Russia.”5 process of privatization that enriched a It is easy to understand the appeal to politically-favored few is well-recalled those who favor a centrally-planned com- and examined selectively. mand economy of government-con Reform of the chief remaining barriers trolled oil and gas pipelines. For one, it to growth and economic efficiency in the permits the government to control supply Russian oil and gas industry—the state and direct investment flows not only in owned monopolies in major oil the pipeline sector, but also in the econ pipelines, Transneft, and in the produc- omy as a whole. It also maintains a system tion, transportation, and export of nat- of differential pricing and preferential ural gas, Gazprom—has either stalled for access to resources, allowing the govern- the foreseeable future or been abandoned ment to hand out rewards and punish-

Russia is not a substitute for the Persian Gulf in oil production.

permanently. Both oil and gas pipeline ments for both economic and political sectors suffer from enormous investment reasons. Additionally, it is a more conve- deficits and operating inefficiencies. nient tool of foreign policy than a Meanwhile, the state is missing an oppor- pipeline system owned and operated by tunity to pursue restructuring and liberal- private owners governed by market com- ization at a time of high world energy petition and transparent regulations. prices. When oil prices inevitably return Even the fact that non-transparent busi- to a more sustainable level of around $20 ness operations often lead to rent seeking per barrel, reform will be more difficult can be seen by some as beneficial to to execute and with lower asset value, be political institutions or well-positioned less beneficial to the state. As it stands, individuals. chronic under-investment in both sectors It is, however, one thing to want to will persist to the detriment of oil and gas extract economic value for Russia from production and exports. natural gas production in Central Asia To compound matters, President and to better manage transit through Putin's statement to Chancellor countries like Ukraine; it is quite another Schroeder of Germany on the gas sector to abandon the much larger economic in their meeting on 9 October seems par benefits of capturing associated gas pro ticularly ominous. Putin told Schroeder duction from Russian oilfields and oil “We are not going to breakup Gazprom. industry investment in the gas sector by The European Commission should have not reforming the vertically integrated no illusion: they are going to be dealing monopoly of Gazprom. At a minimum, with the state in the natural gas industry.” natural gas transportation by pipeline

[32] Georgetown Journal of International Affairs CHOW Pipe Dreams? could be separated from production and Conclusion. Russia's long term eco regulated as a monopoly with fair tariffs nomic significance lies in the integration and access rules. of its population of 145 million into the There are equally gradual reforms that world market and its potential as a pro- could also be enacted in the oil pipeline gressive force in the economic integration sector in order to mobilize private capital of its neighbors from the former Soviet in much needed infrastructure invest- Union into the global system. With 5 to 6 ment. Partnership between government percent of the world’s proven oil reserves and domestic and international oil com and a production/reserve ratio of about panies to build new trunk oil pipelines, 20 years, Russia is not a substitute for the along the lines of the Caspian Pipeline Persian Gulf when it comes to oil produc- Consortium, can be encouraged. Instead tion, but enjoys better economic options this new model for Russian pipeline than those countries thanks to its agricul investment is perceived currently as an tural and industrial potential. obstacle to government control and its Development of Russia's larger natural success and future expansion are being gas resources will require greater open- threatened by the Russian government. ness to foreign direct investment due to Thus, a Russia that is profiting from the high investment costs and assured rapidly growing oil exports as a result of market access necessary for the remote oil industry privatization in the 1990s and gas projects around the world with which enjoying temporarily-high world oil it will be competing. prices may not see the benefits of contin Other countries, especially the United ual economic reform and reduced state States, Germany, Britain, China, and control-policies that could enable the Japan, will have to decide for themselves transition to a full market economy inte- the meaning and value of building an grated with the international system. energy relationship with Russia. In doing However, as proud successor to the Soviet so, there is no better touchstone than Union, all Mr. Putin has to do is draw Russia's pipeline policy at home and lessons from the Soviet economy of 1988, abroad. The path it takes, be it a statist or when Russian oil production was a third market-oriented, will tell us much about higher than it is now, when price distor the economic future Russia has chosen. tions and false market signals led to waste- ful consumption and nonproductive Author’s Note: The author would like to acknowledge investment, and when the Soviet system Geoffrey Lyon, of the United States Department of soon fell under the weight of economic Energy in Moscow, who was a font of information in inefficiency and corruption. the preparation of this article.

NOTES 1 All production and consumption statistics for Review, 2003, online. this piece can be accessed online through the 4 Transcript of Minister Yusufov, ITAR-TASS online B.P. Energy Reserves and Energy Con- online; see also Bayan Rahman and Andrew Jack, sumption Review at http://www.bp.com/centres/ "Japan Offers Russia $7 Billion to Build Oil Pipe," on energy/index.asp. Rusnet News (13 October 2003), available online at 2 Central Intelligence Agency, The World Factbook http://www.rusnet.nl/news/2003/10/14/businesseco 2003 (New York: Brassey, 2003), accessed online at nomics_02_3532.shtml. http://www.cia.gov/cia/publications/factbook. 5 ITAR-TASS online (9 October 2003), available 3 B.P. Energy Reserves and Energy Consumption at http://www.itar-tass.com.

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