The future of Russian energy policy

Vladimir Milov President, Institute of Energy Policy () http://www.energypolicy.ru

The Brookings Institution Washington, D.C., November 30th, 2006 The present: the ‘Two ’ from the economic point of view

100

30

35.5

Public sector 50 Private sector*** 70 55.3

0 Share in GDP* Share in employment**

Data: 2004. Sources: *EBRD Transition Report 2006; ** Rosstat *** Including Russian private and foreign owned enterprises; excluding mixed ownership enterprises The ‘Two Russias’ in the energy sector: private versus public

Average annual physical output growth rates in 2000-2005, %

12.6

8.4

Independent gas producers 3.5

Oil industry net of public oil companies Coal industry 0.1 * 3.6 Public oil companies**

2 RAO UES and Rosenergoatom

02468101214

Source: Rosstat, CDU TEK, RAO UES, Rosenergoatom, Gazprom, BP * Natural gas production only ** net of , Tatneft, Bashneft, Gazprom (oil production only) Power and gas supply shortages in public energy sector: energy weakness of the ‘energy superpower’

Power capacity cuts to consumers by Gas supply cuts to Russian power stations during RAO UES during cold temperatures of cold temperatures of January-February 2006, % of January-February 2006, MW contractual supply volumes

Moscow area -Finland - exports through Vyborg Overall gas supply 12.5 Minimum cuts to power stations Russia-Finland - other than Vyborg St.Petersburg area in European Russia Maximum

Chelyabinsk area

Middle Volga power 48 interconnection 72

35 497 400 95 244 30.6 Central Russia power interconnection 80

NorthWest power 51 interconnection 83

0 200 400 600 800 1000 1200 1400 050100

Source: RAO UES Shift in Government’s policy agenda in 2000-2006

Before 2003 After 2003

• Assertive privatization of the • End of privatization remains of public sector • Shift to ‘national champions’ • Improvement of business climate strategy for private sector, removal of • Increasing role of Government in regulatory barriers economic affairs • Reduction in Government spending • Increasing Government spending • Encouraging FDI • Restrictions on FDI • Market restructuring of public • Failure to separate regulatory monopolies functions and economic interests of • Largely, liquidation of the non- the Government market sector and separation of • Active arbitrary use of state’s economic interests and regulatory regulatory powers in order to functions of the Government advance market positions of state affiliated companies Recent developments: least efficient public sector expands at the expense of more efficient private sector

Structure of Russian crude oil output by ownership type

Today Tomorrow?

16.2 Private 56.9 companies 35.5

State 64.5 companies

'Grey zone' 26.9 (Sibneft, Slavneft, )

Source: Oil & Capital; * estimate

Who’s next and when? Yukos? TNK-BP? Surgutneftegaz? Why change?

Average Urals price in various periods of modern history, USD/bbl (money of the day)

62.18 Final closure of the reform agenda. Institutionalization 7 months 2006 of hardline foreign policy agenda

50 Massive dismantling of political freedoms, transfer to 2005 active paternalist state policies

34.39 End of economic reforms. Establishment of control 2004 over Yuganskneftegaz, abolition of governors’ elections

Beginning of dismantling of economic reforms. 2003 27.29 Beginning of Yukos case, arrest of M.Khodorkovsky

Period of not very active flirt with reforms. Clear lack of 2000-2002 24.82 consensus among decision makers on the country’s strategic direction

1991-1999 16.73

0 10203040506070

Source: The consequences of policy shift: increased risks, market bubble instead of modernization

Where Russian market players prefer to invest: fixed capital formation vs. acquisition of shares

80 Gross fixed capital formation, % of GDP 70 Stock market capitalisation, % of GDP

60

50

40

30 22 21 20.8 20.9 18.7 20 20

10

0

Source: The2000 World Bank, EBRD 2001 2002 2003 2004 2005 How the success of the Russian privatization is misunderstood in the West

“Russian oligarchs did nothing but send all the money they could outside the country’.

Dr. Marshall Goldman, Davis Center for Russian and Eurasian Studies, From a letter to the Editor of the ‘Foreign Photo: Rose Lincoln Policy’ magazine, March/April 2006

DID THEY REALLY ? Capital investments by the Russian private oil companies in 1999-2004

10 Ref inery business

1 1.3 Oil production 0.9 0.9

0.7 5 0.3 6.9 6.6 6.5 6 4.8 3.6 Source: Rosstat billion US dollars, money of the day the of money dollars, US billion

0

1999 2000 2001 2002 2003 2004 CUMULATIVE USD 39.5bn IN 6 YEARS IS NOT A BAD RESULT AT ALL... Was the impressive oil production growth in 2000-2005 ‘picking of a low-hanging fruit’ or a result of large scale investment?

Some performance indicators of the Russian oil industry, 1995-2004

Idle wells as % of the total oil wells (left axis)

25 Average productivity per active well, mtoe (right axis) 15 20.6 19.9 20.0 19.3 18.5 20 17.7

15

10.1

9.4 10 10 8.3 7.7 7.5 7.5 5

0 5 1995 2000 2001 2002 2003 2004 Source: Rosstat Russian privatization of large industries was unfair and corrupt.

But, it had helped to establish competitive private sector, and promote efficiency and development.

The achieved oil output growth was the result of large scale investment and improved productivity, not of the ‘low hanging fruit’ picking Oil & gas: picture of stagnation and tough struggle of the efficient private sector for survival

• Asset redistribution in favor of the state-affiliated companies in oil and independent gas producer sectors contains growth • In oil, production stagnates; in gas, it is about to start to severely decline • The potential of growth is there, but this is contained by state’s policies and market expansion of the state- affiliated companies Oil: no room for optimism on future crude output

10 Average daily crude oil output in Russia, 2003-2006 9.8 9.6 9.7 9.5 9.4

9.4 9.3 9

million barrels a day million barrels 26 m onths in a 9.4-9.8 m bd corridor 8.5 8.0

8 4 03 -0 04 06 Jul-0 3 Jul-0 4 Jul-0 5 Jul- Jan -03Fe b-0Ma 3 r-03Apr-03Ma y-03Jun -03 A ug- 03S ep- 03Oct- 03Nov-03Dec- Jan -04Fe b-0 4Ma r-04Apr-04Ma y-04Jun -04 A ug- 04S ep- 04Oct Nov- Dec-04Jan -05Fe b-0Ma 5 r-05Apr-05Ma y-05Jun -05 A ug- 05S ep- 05Oct- 05Nov-05Dec-05Jan -06Fe b-0Ma 6 r-06Apr-06Ma y-06Jun -06 A ug- 06S ep- 06Oct- 06 Source: Oil & Capital, CDU TEK Companies affected by ownership changes were the leaders of output decline in 2004-2006

Slavneft +1.9% Change of daily crude oil output, August 2006 as % to September 2004

Sibneft - 6.1%

Yukos ex-YuganskNG -37.8%

-10-8-6-4-2 0 2 4

Source: Oil & Capital, CDU TEK Gas: stagnation in upstream continues

442.2 448.0 448.4 451.4 500.0

400.0

300.0

200.0

100.0 Gas production by Gazprom, bcm Gazprom, by production Gas 0.0

Jan.-Oct.2003 Jan.-Oct.2004 Jan.-Oct.2005 Jan.-Oct.2006 Source: Institute of Energy Policy Source: Institute of Energy Policy, Gazprom data. Gazprom Policy, Energy of Institute Source: * - Gazprom estimate of 2002 m in 2000-2006, USD bn (money of the day) Sibneft company) ( Pow er Other 70 17.9 12.5 30.6 0 20406080 Gazprom invest more if domestic prices in 2003-2005 g as production otherthan g as production Capital investments in areas in investments Capital Actual investments in upstream g as fields ofYamal Peninsula* Investments req uired todevelop Acq uisitions outside g as sector Cumulative capital investment by Gazpro Who’s next? Mosenergo? Yukos? TNK-BP? Centrica? RWE? Scottish Power?

Will rise? In the monopoly environment and under strong state protection, Gazprom will not invest in production development, even if domestic gas prices in Russia will rise substantially. Policy towards FDI: ‘protected territory’ tactics

• Support of market expansion of the state-affiliated companies at the expense of • Little tolerance for historic agreements (Sakhalin, Caspian Pipeline Consortium) • Active and arbitrary use of regulatory powers (taxation, environmental protection) in order to create market advantages to state-affiliated companies Sakhalin-2: does environment matter?

• WHY Government was silent on environmental problems of Sakhalin-2 for years and raised attention only when Gazprom became interested in entering the project at lowest possible cost? • WHY revoke environmental permit completely, when most of the environmental damage is curable? • WHY environmental approvals were easily issued for far more environmentally damaging projects such as Eastern Siberian oil pipeline route passing by Baikal lake shore? • WHY everyone talks about low efficiency of the PSA, but no one is reconsidering it before Gazprom’s project entry? WHY environmental claims and not the actual reconsideration of the PSA? • ISN’T Russian Government simply using it’s regulatory powers to help advance market positions of the affiliated companies? Can Russia build a successful paternalist economy?

40000 Norway

35000

30000 UAE Qatar 25000 Russia 20000 Kuwait

15000 Saudi Arabia Oman 10000

5000 PPP GDP per capita, 2004 USD capita, per GDP PPP

0 0 10203040506070 Hydrocarbon net exports per capita, mtoe per annum

Source: Vladimir Milov, ‘Can Russia become an Oil Paradise?’, http://www.carnegieendowment.org/publications/index.cfm?fa=view&id=18500 Shift in budget policies: sharp rise in size of the Government

Non-interest spending of the Russian federal budget as % to GDP, 2002-2007

18

16

14

12

10 17.5 8 15.3 15.4 13.5 13.5 12.3 6

4

2

0

Source: Russian2002 federal budget, 2003 Russian Ministry of 2004 Finance; 2007 - draft 2005 budget adopted by 2006State Duma in the third 2007 reading Budget policies become far less cautious, driven by spending appetites

70 Urals price forecast used for the Russian federal budget income planning, USD/bbl 60

50

40

30 61

20 40

24 26 10 22 23

0 2002 2003 2004 2005 2006 2007 Source: Russian federal budget, Russian Ministry of Finance Investment fund spending: extremely inefficient, hardly a federal level infrastructure project

Allocation of the Russian Investment Fund expenses as of November 2006, billion USD

Regional projects related to S.Petersburg area

Access roads to large industrial objects of BasicElement & NorNickel in East

Petrochemical complex in

Other projects 0.38 0.63 2.16

2.96

Source: Russian media Conclusions. The future?...

• State policies in the energy sector drive this sector into stagnation and crises • Despite warnings, state’s policies become more paternalist and less cautious • Increased state’s role in the economy contains growth • The safety margin of the Russian economy is much larger than in the 1980s due to market reforms of the 1990s and large role still played by the private sector • Paternalist policies have no chance to succeed in terms of significantly increasing per capita GDP • But, Russia surely follows the policy path of mid-1980s Is there a real perspective for Sino-Russian energy relations?

• Most Chinese energy demand is located in South Eastern areas - land pipelines from Russia no solution • Chinese net gas imports will not grow significantly (IEA forecasts 60 bcm by 2030), most of it will be satisfied through LNG • Sakhalin-2 LNG is already contracted with other countries • There’s a tough situation on price negotiations for supplies through ‘Altai’ pipeline, high costs of the pipeline recently announced • Russian authorities are reluctant to Chinese access to significant upstream assets • Oil supplies under 2001 agreement (0.6 mbd from 2010) remain the only solid option Why no possibility of ‘gas OPEC’?

• Gas is not a globally traded commodity • Spare capacity factor does not exist • Markets are very fragmented; suppliers are divided between consumer territories • Iran, Venezuela are hardly net exporters yet • Turkmenistan interests tend to seriously contradict interests of Gazprom • Some experts believe a cartel in LNG supplies can appear and exert significant market power over importers (Stern 2006), but not as Russia-Iran-Algeria axis as much as a union of LNG exporters to the Atlantic basin (Qatar-Algeria-Nigeria-Egypt)