The Kremlin, National Champions and the International Oil Companies: The Political Economy of the Russian Oil and Gas Industry by Michael Bradshaw*

On 18 February 2009, the Russian President Dmitry Medvedev officially opened ’s first liquefied natural gas (LNG) plant built by the Investment Company (hereafter Sakhalin Energy) at Prigorodnoye on the southern shores of Sakhalin Island, near the town of Korsakov. This is the first LNG plant in Russia and is at the heart of the Sakhalin II project, one of the largest integrated oil and gas projects in the world. The final cost of the project is unknown, but it will be well over $20 billion. When fully operational, the plant will have a capacity of 9.6 million tonnes a year (13.3 bcm) and the majority of its output will be exported to nearby Japan, with South Korea and North America also being major consumers. At the Opening Ceremony, Sakhalin Energy’s CEO Ian Craig said: ‘Sakhalin has now firmly established its position on the global energy map. When the Sakhalin II project is fully on stream, it will supply around 5 percent of the world’s LNG and make a significant contribution to strengthening global energy security’.1 At the same ceremony, Christopher Finlayson, Chairman of the Board of Directors of Sakhalin Energy, said: ‘This achievement is a take-off point, which opens up a new era in the history of Sakhalin. This has only been made possible thanks to the cooperation between Sakhalin Energy and its shareholders, the Russian Federal Government and the Sakhalin Oblast authorities.’2

The Sakhalin II project is a major achievement, but the congratulatory remarks at the Opening Ceremony belie a difficult history, as the recent fate of the project has been synonymous, in the eyes of many western observers, with the rise of resource nationalism in Russia. This article explores the changing political economy of Russia’s oil and gas industry since Vladimir Putin became President in 2000, and it presents the Sakhalin projects as a case study of the Kremlin’s changing attitude to the role of the international oil companies (IOCs). It then considers the impact of the current global economic crisis on Russia and assesses how Russia’s changed economic fortune might alter attitudes to foreign investment in its oil and gas industry. However, before embarking on this more detailed analysis, the first section addresses two key context- setting questions: how important is Russian oil and gas production to global energy security and how important is the oil and gas industry to Russia’s economic performance and foreign policy aspirations.

The Global According to BP’s Statistical Yearbook, at the end of 2007 Russia held 6.4 percent of the Importance of world’s oil reserves and in 2007 produced 491.3 million tonnes of oil, accounting for 12.6 percent Russian of world output, just ahead of Saudi Arabia. Russia is not a member of OPEC but has increased its Oil and Gas contact with the organisation of late and has suggested appointing a permanent envoy. At the same time, in 2007, Russia accounted for 25.2 percent of the world’s natural gas reserves and produced 607.4 bcm of natural gas, accounting for 18.8 percent of total world output. Prime Minister Putin has at times supported the idea of creating a gas cartel similar to OPEC, but the very different contractual basis and infrastructure demands of the gas trade make this unlikely. Russia has supported the creation of a Gas Exporting Countries Forum (GECF) to counter what it sees as the IEA/EU consumers club. (Editor’s note. Please see Edward Kott’s article “Not so GEC fast” in the February 2009 Geopolitics of Energy for a detailed analysis of the gas cartel issue).

*Michael Bradshaw is Professor of Human Geography and former Head in the Department of Geography at the University of Leicester, UK. He holds a PhD from the University of British Columbia, Canada. His research centres on resource geography with a focus on the economic geography of Russia and global energy security. He is an Honorary Senior Research Fellow in the Centre for Russian and East European Studies at the University of Birmingham, an Associate Fellow of the Russia and Eurasia Programme at Chatham House in London, and a Visiting Senior Research Fellow at the Oxford Institute for Energy Studies. Mr. Bradshaw can be reached at [email protected].

2 MAY 2009/GEOPOLITICS OF ENERGY Russia’s recent prominence as a major oil producer is in marked contrast to the situation in the early 1990s. In the late 1990s, and for most of the current decade, Russian oil and gas production has increased on a steady basis; between 1998 and 2007 oil production increased by 61.5 percent, and this added production has been critical in meeting the growing demands of countries such as China and India (see Figure 1). In other words, without the rebound in Russian oil production, global supply would have been even tighter. However, much of the production surge was production delayed from the period of ‘transitional recession’ in the early 1990s when domestic demand was severely depressed; but a significant amount was also due to the application of enhanced oil recovery techniques by western oil field services companies and more recently TNK-BP, as well as some recent investments in new fields, predominantly by . During the second half of the 1990s, Russia’s oil companies were in the hands of , who, faced with political uncertainty and insecure property rights, sought to produce and export as much oil as they could to earn money. For example, between 2000 and 2004 doubled its oil production.3 The net result was the sweating of existing production assets with relatively limited investment in exploration and development of new fields.

The situation in the gas sector is structurally very different because has remained the monopoly producer and the de facto state control means that it is required to meet domestic demand at very low prices and often without payment. However, it has had the safety net of long term export contracts with longstanding customers in Western Europe. In fact, exports to Europe have traditionally accounted for about 25 percent of Gazprom’s production but have delivered 75 percent of its revenues. In 2006, Russia accounted for 43.3 percent of the EU-27’s gas imports, or about 25 percent of total EU gas consumption. But Gazprom also failed to invest sufficiently in renewing its existing infrastructure and in developing new fields, so much so that prior to the current global recession it was feared that it would not be able to meet its domestic obligations and maintain an exportable surplus. With demand depressed, this now seems less of a problem, though Gazprom may struggle to finance its ambitious plans to develop new fields on the Yamal Peninsula in West Siberia and at the Shtokhman field offshore in the Barents Sea. Yamal is essential to replacing Gazprom’s aging fields in Siberia and is a much larger undertaking that remains a priority, while Shtokhman is an exported-oriented project that could be delayed without compromising domestic plans.4

Figure 1: Russian Oil and Gas Production, 1985-20075

GEOPOLITICS OF ENERGY/MAY 2009 3 The key point is that while Russia’s oil and gas production has been crucial in meeting rapidly growing demand in recent years, there are currently doubts about the sustainability of its oil production, which, according to Energy Ministry data, declined in 2008 by about one percent compared to 2007 – with exports declining by five percent.6 Both the oil and gas sectors require substantial investments in the near term to develop new fields and their associated infrastructure.

The rebound of Russian oil production happened at a time when world oil prices also increased rapidly. This helped fuel a period of economic growth and recovery. Despite government rhetoric, while Russia’s economy recorded healthy growth rates, it failed to reduce its reliance on oil and gas revenues through diversification. In 2006, revenues from the hydrocarbon sector contributed about half of the federal budget. Oil, oil products and gas contributed 59 percent of Russian exports in 2007, with oil and gas providing 25-30 percent of GDP.7 Russia’s economic recovery brought with it political confidence and President Putin proclaimed Russia to be an energy superpower. However, many observed that natural resource wealth is not a reliable basis upon which to re-build an economy the size of Russia’s, and there was growing consensus that the country was exposed to the resource curse, with a fall in energy prices foreboding severe consequences.8 This was something that the Russian Government clearly recognized, so it set up a stabilization fund to siphon off the excessive rents being generated by oil and gas exports. In a highly provocative, but persuasive, analysis, Clifford Gaddy and Barry Ickes suggest that the policies of high levels of taxation and increased state control over the oil and gas industry were explicitly designed to capture rents and reduce the potential for investment in new, high risk projects, which might subsequently turn out to be unprofitable if prices were to fall.9

The Domestic In their analysis of the significance of resource rents to the Russian economy, Gaddy and Significance of Ickes observe: Russian Oil and Gas: Resource Russia is the second-largest producer of oil and the largest producer of Rents, and natural gas in the world. The abundance of these and other resources Boom and Bust has been a key determinant of Russia’s economic evolution for decades. Throughout its modern history, the country’s political economy has centred on the transfer of value created in the resource sector to other parts of the country. During the Soviet era, resource abundance made it possible to impose a costly economic structure on society. Today, the bounty from Russia’s resources continues to fuel its economy and its polity.10

In their analysis, Gaddy and Ickes reconstruct the value of Russian oil and gas rents (see Figure 2 for an update of their original analysis) about which they make four observations: first, the size of the oil and gas rents that accrued to the was huge; second, those rents were exceptionally volatile, from a high of $329 billion to a low of $40 billion; third, natural gas increased in importance as a source of income; and fourth, the fluctuation in oil price was the dominant factor.

Figure 2: Russian Oil and Gas Rents, 1970-2005

4 MAY 2009/GEOPOLITICS OF ENERGY Fortunately, an update of the original Gaddy and Ickes analysis is available to the end of 2008, and one can speculate what might happen in 2009.11 As we can see from Figure 2, as oil and gas prices increased in recent years so the scale of the rents followed, surpassing the peak of the mid-1980s. Since oil prices peaked last summer at $147.7 a barrel, they have fallen back to between $40-60 a barrel. If one assumes Russian oil and gas production remains flat during 2009, an average price of $50 a barrel for oil, and that the gas price follows oil, then the total value of rents falls back to around $300 billion, having peaked at $563.38 billion in 2008. However, oil output may fall further and demand, both internally and externally, is certainly falling, therefore the actual level may be lower. Whatever the eventual outcome, it is clear that Russia is experiencing a sudden and dramatic decline in resource rents. In the 1980s this sudden loss of resource rent played a major part in the collapse of the Soviet system;12 thus, as we shall see later, it is understandable that Russia now finds itself in considerable difficulty. Of course, in the Soviet period the state controlled these rents and determined what happened to them. This was not the case in the late 1990s, but the rapid increase in the scale of rents in the early years of this decade explains, in large part, why the Kremlin was so concerned to reassert state control over the oil and gas industry and to control the scale and distribution of resource rents, whether as part of their macro economic strategy, or for political and even personal gain.13

The "Re- Since Vladimir Putin became Russian President in 2000 he has overseen a change in the Nationalization" ownership structure of Russia’s oil and gas industry. Marshall Goldman observes: ‘Putin’s reassertion of Russian of the state’s role has had dramatic effects. After privatization, the share of petroleum produced Oil and Gas by state dominated energy companies in 2000 fell to 10 percent of the total. Today, state-controlled companies again account for about 50 percent of Russia’s total output’.14 Philip Hanson calculates the share of state-controlled companies in total oil and gas condensate production at 37.3 percent in 2007,15 which obviously means that the majority of production is still generated by the private sector (unlike many other oil exporting states), but why did this happen? As suggested above, a primary motivation was a desire to regain control over the rents being generated by the oil and gas industry, but that was actually achieved by a very high marginal tax rate on oil – 90 percent.

For Putin there was also a perceived need to readdress the actions of Boris Yeltsin in the mid-1990s when he sold off the assets of the state to the oligarchs in the ‘loans for shares’ scheme that enabled him to stay in power. As a result, much of the oligarchs’ power was based on their control of key resource industries, from which they could, potentially, launch their own political careers. Early in his presidency, Putin apparently made it clear to the oligarchs that if they wished to keep their economic empires they should stay out of domestic politics. Furthermore, the reassertion of state control was given intellectual weight through reference to a thesis, allegedly written by Vladimir Putin in 1997 at the St Petersburg Mining Institute, that maintained Russia’s economic recovery should be orchestrated via state control of the resource sector and the formation of large vertically-integrated companies that could compete with the Western multinationals.16 There is also a clear geopolitical imperative: Putin’s assertion that Russia is an energy superpower is based on both the global significance of Russia’s oil and gas production and the fact that the state controls the flow of oil and gas exports, capable of using them to promote the Kremlin’s geopolitical goals – witness the gas dispute with Ukraine in early 2009. Energy security was a major theme of Russia’s G8 Presidency in 2006 and this was clearly aimed at making everyone aware of the significance of Russia’s energy wealth. All of these factors, and doubtless others – such as personal profit – combined to provide a powerful incentive for the Kremlin to reassert its control over the oil and gas sector. However, one should guard against seeing this as a coherent and carefully orchestrated process. Russia’s political elite is highly fractured, with numerous interest groups characterized by continuous infighting for power and influence. For example, the two state champions, Gazprom and Rosneft, are aligned with different groups within the elite and the two companies compete against each other far more than they cooperate. What we see from 2004 onwards is a series of events that together culminate in the “re-nationalization” or “etatization” of the oil and gas industry in Russia. So how was it done?

GEOPOLITICS OF ENERGY/MAY 2009 5 The Reassertion In all cases, the state-controlled companies actually paid for the assets they acquired of State Control and, with the notable exception of Yukos, compensated companies for their loss of interest. However, it is also the case that in the instances involving foreign companies, the legal and regulatory systems have been used to exert pressure on the targeted parties, to force them into a position of having to accept the sale of their interests to a state company or face losing a license or having their project stalled. Thus, political persuasion and ‘administrative levers’ have been used to enable the state, via its control of Gazprom and Rosneft, to regain control over a large share of Russian oil production. It should be said that the actions of the Russian state are part of a well-established history of ‘resource nationalism’, which Bremmer and Johnston define as: ‘…efforts by resource-rich nations to shift political and economic control of their energy and mining sectors from foreign and private interests to domestic and state-controlled companies.’17 In fact, they describe recent events in Russia as ‘revolutionary resource nationalism’, as it is linked to a broader reconsolidation of state power during the Putin presidency. One might ask why shouldn’t resource rich countries seek greater control? After all, international law grants the sovereign state ownership of its natural resource wealth in the first place. Today the vast majority of the world’s oil reserves are in the hands of so-called national oil companies (NOCs). According to the EIA, in 2007, NOCs held 88 percent of world proven oil reserves and produced 52 percent of total oil production.18 In the case of its dealings with the foreign oil companies, Russia didn’t confiscate the assets and payment was made, even if it was often below the ‘market rate’.

Table 1: Major State Acquisitions of Oil and Gas, 2004-200719

The destruction of Yukos was the starting point in the process of renationalization. There were multiple reasons why Putin decided to arrest Platon Lebedev in the summer of 2003 and in October of that year. The courts then imprisoned them in 2004 and used the tax system to destroy Yukos.20 Doubtless, Putin saw Khodorkovsky as a political rival, but another issue was Yukos wanting to develop its oil and gas without reference to the desires of the Kremlin. Yukos had struck a deal to export oil and build a pipeline to China and was allegedly in negotiations about its possible acquisition by ExxonMobil. The actions against Yukos resulted in the sale of its main production asset Yuganskneftgaz to Rosneft. A series of further state acquisitions then followed (see Table 1) that put pay to the idea that Russia would develop a substantial private oil and gas industry.21

6 MAY 2009/GEOPOLITICS OF ENERGY The case of does not quite fit the picture, as Mikhail Gutseriyev was able to sell his controlling interest to ’s Basic Element Group; however, Deripaska’s own financial problems left him with little option but to sell the oil company to Gazprom for Rosneft. Thus, this is a process that is still ongoing. In early April 2009 Gazprom signed a $4.2 billion deal with Italy’s ENI to buy back the latter’s 20 percent stake in (previously Sibneft) and some gas assets that ENI bought at an auction of Yukos assets. In late April 2009 Gazprom outbid TNK-BP to purchase a 16 percent stake in the oil producer Sibir Energy, which is a partner to Shell in the Salym Petroleum joint venture. Undoubtedly, Gazprom will wish to obtain a controlling interest in Sibir. Not only have Gazprom and Rosneft consolidated their control over domestic oil and gas production, the remaining ‘private’ companies, such as Lukoil, Slavneft and TNK-BP, clearly understand that they must operate within parameters set by the Kremlin. However, it was not only the domestic companies that attracted the Kremlin’s attention, as Table 1 shows; both Shell and BP were forced to give up control over projects in East Siberia and the Far East.

The Changing Table 2 provides details on the major foreign investment projects in the Russian oil and Climate for gas industry. In the early 1990s the fledgling Russian Government was keen to attract foreign Foreign investment and signed three production agreements (PSAs), two on Sakhalin and one in the Investment in Nenets region of the European North (see Table 2). However, the level of investment remained Russian Oil and modest and it was not until 2003 – when BP formed its 50/50 joint venture with TNK and Shell Gas announced commencement of Phase 2 of its Sakhalin II project – that billions of dollars of investment were committed. In fact, even before the Kremlin’s change in attitude towards foreign investment, it is fair to say that given its reserve base and the desire of the IOCs to invest, the amount of foreign investment activity in Russia was disappointing. However, one should not assume that the Russian Government and private Russian companies actually wanted to see substantial foreign involvement in the domestic oil and gas industry.

Table 2: Major Foreign Investments in Russian Oil and Gas, 1995-200522

GEOPOLITICS OF ENERGY/MAY 2009 7 The change in attitude towards foreign investment in Russia started in early 2004 when ExxonMobil had its licenses for its Sakhalin III blocks (Kirinsky, Ayashsky and East Odoptu) revoked. At the time it had become clear that, despite President Putin’s initial enthusiasm, no more PSAs would be awarded in Russia and the project would not be developed without a PSA. Consequently, the Russian authorities may have felt that there was little to gain from having ExxonMobil and its partners sitting on the license doing nothing. ExxonMobil still do not accept the legality of this decision, but in late 2008 the Kirinsky license was awarded to Gazprom without a tender process. ExxonMobil’s Sakhalin I project has not been subject to the attentions of the Kremlin, for the simple reason that from the onset it had a Russian partner in the form of Rosneft and its Sakhalin affiliate Sakhalinmorneftegaz (SMNG). In the early stages of the project Rosneft and SMNG actually had a 40 percent share in the project, but they sold 20 percent to the Indian State Oil Company (ONGC) in 2003 for $1.7 billion to finance their continued involvement in the consortium. Although ExxonMobil is the operator through Exxon Neftgaz Limited, it has only ever had a 30 percent share of the project.

In marked contrast, until recently, the Sakhalin II project had no Russian involvement and, as a consequence of the departures of McDermott (US) and Marathon (US), Shell had ended up with a 55 percent share of Sakhalin Energy (see Table 2). Shell was only too aware that their position was becoming increasingly uncomfortable. Even the TNK-BP joint venture became problematic as the Kremlin pushed through legislation that required that Russian companies (by which they meant Gazprom or Rosneft) should have a controlling share of projects that were deemed of strategic interest to the Russian state. New laws on the ‘Sub-Soil’ and ‘Foreign Investment’ have now enshrined this view in the legislation. Furthermore, Russia’s 2003 energy strategy assigned Gazprom the role of coordinating gas exports to Northeast Asia, describing it as the ‘single channel’ through which Russia would export gas to the region. This posed problems for TNK-BP’s Kovyta project in East Siberia, as well as both Sakhalin projects, as they all planned to export gas without Gazprom’s involvement. That was in 2003. Since then the situation has changed dramatically, though, as we shall see, some disputes remain.23 One could suggest that change in attitude towards the IOCs was a separate issue from the re-nationalization of oil and gas production. The former was a matter of controlling rents and addressing domestic political and geopolitical concerns, what Bremmer and Johnston call ’economic nationalism’, while the latter was more about ‘resource nationalism,’ a desire to stop foreign companies controlling strategic projects on Russian territory. In fact, with the benefit of hindsight, one might see the PSAs granted foreign companies and the sell-off of domestic oil production to the oligarchs as anomalous, and the recent measures a return to the status quo of state control and suspicion of foreign oil companies.24

The Battle for In the summer of 2006 the growing tension between the Kremlin and the foreign oil Sakhalin II companies came to a head over the Sakhalin II project. Given the scale of the project, the involvement of Shell and its location offshore of Sakhalin Island, it is no surprise that it had caught the attention of the global environmental movement. Shell and its Japanese partners Mitsui and Mitsubishi were looking for over $5 billion in project finance from a number of international financial institutions, including the European Bank for Reconstruction and Development (EBRD). The environmental NGOs orchestrated a global campaign aimed at persuading the banks not to finance the project.25 The NGOs not only focused on the environmental impacts of the project, particularly the plight of the endangered Western Grey Whale and the potential damage to the Island’s Salmon fishery, they also argued that the Sakhalin II PSA was not a good deal for the Russian Government.26 This was a claim that resonated in , particularly as the cost of the project started to escalate and the point at which the investors recovered their costs was pushed further back. In 2005 Shell had tried to negotiate an asset swap with Gazprom to give it a 25 percent share of Sakhalin II in return for a share in a West Siberian gas field, however, the deal collapsed when it was made public that the Sakhalin II project was facing massive cost overruns – a $10 billion project had become a $20 billion project. This was part of an industry-wide problem of cost increases, but Gazprom walked away from the deal.

8 MAY 2009/GEOPOLITICS OF ENERGY Figure 3: The Sakhalin Projects

As the project progressed, the NGOs stepped up their campaign, aimed mainly at the EBRD. Shell responded by developing a special programme to monitor the impact of the project on the whales and also implemented a programme to assist the indigenous peoples on the Island. The NGOs then focused on the environmental impact of the oil and gas pipelines that travelled down the Island from the fields off the northeastern shore to the LNG terminal and oil export terminal in the south (see Figure 3). They provided the EBRD with evidence of damage during the pipeline construction phase and questioned why the pipeline was being buried. The pipeline crossed some 1,100 watercourses, a number of which were important salmon spawning grounds. Again, Shell and Sakhalin Energy responded to the NGO and EBRD concerns, adding cost and delay to the project, as well as generating adverse publicity.

The cost increases and environmental campaign caught the attention of officials in Moscow at a time when the Kremlin was increasingly determined to reduce the control of the IOCs over projects like Sakhalin II and Kovytka. That the Sakhalin II project was nearing completion and that it had managed to sell all of its LNG into an increasingly profitable market must also have caught the Kremlin’s attention. As energy prices continued to increase, the Kremlin attacked the terms of the Sakhalin II PSA. At the G8 summit in 2006 President Putin described Sakhalin II as a ‘colonial treaty having nothing in common with the interests of the Russian Federation.’ The writing was on the wall for Shell and its partners. In August and into September 2006, the Russian Ministry of Natural Resources took Sakhalin Energy to task over alleged breaches of legislation along the pipeline corridor. In mid-September, the Minister of Natural Resources, Yuri Trutnev threatened to revoke the State Environmental Expertise Review approved in 2003. This would have brought the project to a standstill. In the end no such action was taken, but the NGO campaign had provided the Kremlin with the leverage necessary to renegotiate the structure of the Sakhalin II project. Throughout the autumn, the pressure mounted on Shell and Sakhalin Energy; Gazprom denied any involvement. Then on 21 December 2006 a ceremony was held in the Kremlin with President Putin and the CEOs of Sakhalin Energy’s shareholders to announce that Gazprom would purchase a 50 percent plus 1 share interest in Sakhalin II for $7.45 billion; each of the existing shareholders would decrease their share by 50 percent. The deal was finally executed in April 2007 and Gazprom took control of the project. The environmental concerns relating to onshore pipeline construction went away and subsequently the project has been winning prizes and accolades for its environmental performance!

GEOPOLITICS OF ENERGY/MAY 2009 9 In January 2007 the EBRD announced that it was no longer considering financing the project, but negotiations continued with other potential lenders. In June 2008 Sakhalin Energy announced an agreement on financing with the Japan Bank for International Cooperation and a consortium of international banks, JBIC providing $3.7 billion and the banks $1.6 billion. When Gazprom took control and the EBRD left, the NGOs lost leverage over the project, but they have continued to protest about the impact of oil and gas exploration on the Western Grey Whale. However, most recently, Sakhalin Energy has agreed to abandon planned seismic work this summer to avoid disturbing the feeding Grey Whales. No sooner was the Sakhalin II dispute resolved than Gazprom turned its attentions to TNK-BP’s Kovytka project in Irkustk Oblast in East Siberia. There is not space enough here to delve into details,27 but the bottom line is that BP and TNK-BP have been forced to sell their stake in the project to Gazprom; the final details have still yet to be resolved and neither party seems in a particular hurry to finalize an agreement.

Most recently, ExxonMobil has had problems in getting budget approval for the second phase of their Sakhalin I project. This is now resolved, but it has hampered the progress of the project. This phase aims to develop further offshore gas production and deliver it to market in China via the construction of a pipeline. Not surprisingly, Gazprom has a somewhat different plan for Sakhalin I as part of its grandiose ‘Eastern Programme’, wanting the additional gas production to be sold to the domestic market in the Russian Far East. Gazprom has offered to buy gas from the Sakhalin I project. ExxonMobil maintains that the terms of the PSA give them the right to build an export pipeline and that selling the gas to China will attract a higher price than domestic sales, which is in the best interest of the Russian Government. As yet, no agreement has been reached, though there have been press reports that ExxonMobil has agreed to sell 20 percent of its gas output to Gazprom. This has been denied by ExxonMobil and the negotiations are probably complicated by the fact that the Japanese and Indian partners in the project would rather see their shares as LNG.

Lessons From The conflict over Sakhalin II confirmed a new set of rules governing foreign investment in Sakhalin the Russian oil and gas industry, and there are lessons to be learnt by all the parties involved.

First, despite the Kremlin’s opposition to PSAs, neither of the Sakhalin projects would have been developed without the PSAs agreed in the early 1990s. Notwithstanding their rocky ride, the PSAs have provided the investors with the security they need to go ahead with multi- billion dollar projects. The conflict over Sakhalin II has not resulted in a change in the terms of the PSA, from which Gazprom now benefits; the issue was an alleged failure to comply with host country legislation. This begs the question, if PSAs are not for Russia, how will the IOCs be persuaded to invest in the future? It is unlikely that BP, ExxonMobil, or Shell would accept the kind of investment agreed to by Total and StatoilHydro on the Shtokhman project, where Gazprom has retained 100 percent control over eventual production from the project.

Second, even in Russia, projects the scale of Sakhalin II will inevitably attract the attention of the global environmental movement who will impose a degree of accountability above and beyond that required by host country legislation—especially if project financing is sought—but host country compliance is essential. Sakhalin I has not attracted the same degree of NGO attention for the simple reason that have they paid particular attention to project execution and the shareholders are financing it themselves. At present, the NGOs are campaigning against Sakhalin I’s phase 2 project, but they have little or no leverage over the shareholders.

Third, it is the case that the involvement of the IOCs—Shell and ExxonMobil—in the Sakhalin projects has provided essential project management experience and expertise, capital and technology, without which the projects would not have been possible. It remains the case that neither Gazprom nor Rosneft has the capacity to develop future projects offshore of Sakhalin without IOC involvement. Equally, Gazprom may control Sakhalin Energy, but it has not yet acquired the ability to develop an LNG project.

Finally, at one point in the not too distant past, in addition to Sakhalin I and II, there were as many as five potential development projects offshore of Sakhalin. Today, only one exploration

10 MAY 2009/GEOPOLITICS OF ENERGY project is active, Rosneft’s Veninsky project and that is not close to development. The reality is that there was the potential to create a ‘conveyor belt’ of projects all benefitting from an established onshore service industry and a shared infrastructure. It is largely due to actions of the Russian Government that this oil and gas province is now subject to the classic ‘boom and bust’ cycle common to resource-based economic development. The Kremlin’s desire to limit foreign investment is not allowing Sakhalin to realize its full potential, which, I would argue, is not in the interest of the region or the Russian Federation. The Russian Far East is one of the least economically- developed regions of Russia, so development of its oil and gas potential is important for its future development. This is recognised in Gazprom’s gasification programme for the region.

The Impact of the Initially, Prime Minister Putin was of the opinion that Russia was well positioned to weather Global Economic the credit crunch and the associated global economic recession. For most seasoned Russia- Crisis on Russia watchers, this seemed very optimistic. While it is true that Russia’s banking sector is relatively small and not to a high degree exposed, Russia’s economy is far more open than it used to be and is driven by the export of raw materials that have experienced a dramatic reduction in demand and price. Equally, because the domestic economy is not diversified, or, as Gaddy and Ickes would put it, is addicted to rents from the oil and gas sector, production declines in the resource sector are quickly translated into the wider economy and impact significantly on the government’s finances. Just as Russia boomed in the years of high resource prices, averaging 7 percent per annum growth since 2000 and rebounding beyond 1990 levels of economic activity, it now faces a period of rapid decline. The initial 2009 budget was based on an oil price of $95 a barrel. In January Prime Minister Putin asked for the 2009 budget to be re-worked on the basis of oil at $41 a barrel and the Rouble at 35.1 to the US dollar. This resulted in a drop in revenues from 21.2 percent of GDP to 16.6 percent, which, with increased expenditures, will result in a forecasted budget deficit of 7 percent of GDP, compared to a surplus of 4.1 percent in 2008.28 In mid-January the Russian Ministry of Economy revised its outlook for growth in 2009 down from 2.4 percent to 0.3 percent. In their latest reports, the World Bank projects a 4.5 percent decline in GDP and the IMF foresees a 6 percent decline; the latter is considered realistic by the Russian Ministry for Economic Development, which reports that the economy shrank by 9.5 percent in the first quarter of 2009.29

Prior to the crisis, the Russian Government was relatively well-placed having salted away substantial foreign exchange reserves, which stood at a record $590 billion in September 2008. However, it has been calling on these funds at an alarming rate. In one week alone in January the Russian Central Bank spent $30.4 billion supporting the Rouble and by mid-March its reserves had fallen to about $380 billion and much of this will be required to balance the budget in 2009/10. Fortunately, the Russian Government has also been prudent in paying off its foreign debts; unfortunately, the corporate sector, including the likes of Gazprom with debts of around $50 billion and Rosneft at $22 billion, has been busy taking on substantial foreign debt as bankers rushed to Moscow to offer finance on attractive terms. In April 2009 the Russian Central Bank reported that Russia’s total corporate debt had fallen by $30 billion in the first quarter of 2009 to stand at $423 billion, this was down $76 billion from the almost $500 billion in October 2008.30 As much as $100-$130 billion of Russia’s corporate debt is due to be repaid in 2009 and both state and private companies are seeking, and some receiving, state assistance in meeting these obligations. Some of Russia’s richest oligarchs must sell off assets to meet their debt payments, and the state sees this as an opportunity to claw back ownership of key sectors of industry such as ferrous metals production. Even before the financial crisis struck, Russia’s invasion of Georgia in August 2008 scared foreign investors; the World Bank cites preliminary estimates from the Russian Central Bank showing that in 2008 capital flight reached -$129.9 billion, five times higher than the previous record in 1998, with net capital outflows of -$130.5 in the last quarter of 2008. This compares to a positive inflow of $81.2 billion in 2007. Taken together, all of this macroeconomic doom and gloom suggests Russia is struggling to cope with the collapse in resource rents discussed earlier. But things could have been a lot worse had the Russian Government not been so prudent when times were good. Russia still has substantial reserves, but the economy is now in rapid decline and it seems unlikely that it will recover before those reserves run out. What does this mean for the oil and gas industry and the future role of foreign investment?

GEOPOLITICS OF ENERGY/MAY 2009 11 The Impact of the Even before the global financial crisis, there were signs that the Russian oil and gas Global Financial sector was in trouble as production growth rates declined in 2007. As explained above, the Crisis on Russia's production increases of the last decade have not come from investment in greenfield production; Oil and Gas Sector rather they are from delayed production and enhanced recovery from existing fields. Why has there been insufficient investment? There are a number of reasons, but insecure property rights and high levels of taxation are usually identified as the most likely key factors. Why invest in costly new production if you might not own the fields in the future? The new sub-soil law does not guarantee the holder of an exploration license the right to subsequently develop a field if it is found to be commercially viable. Even if a company were of the mind to develop a field, the current levels of tax and royalty payments are such that it is hard to recoup investment in the difficult and costly operating environments found in Siberia and the Arctic offshore. Both Russian and foreign companies share the opinion that Sakhalin’s offshore potential cannot be developed under the current fiscal regime.

All the evidence suggests that Russia’s future oil and gas production will come from increasingly remote locations in Siberia and offshore in the Arctic and the Far East. Put simply, Russia is running out of cheap and easy oil to develop. This means the Russian oil and gas industry needs a high oil price if it is to develop its new production frontier; a sustained period of low prices will put a further damper on exploration and development activity. As noted above, Gaddy and Ickes argue that because Russia is a high cost oil producer, increasing state control and production declines are actually the intended consequences of a policy that seeks to avoid commitments to costly new projects in a high price environment, when future returns are difficult to judge.31 Furthermore, they argue that because of Russia’s addiction to resource rents, it is actually not in the economy’s best interests to expend effort into producing and exporting more oil and gas.

If developments were to proceed, the domestic industry would require access to capital and technology. It is estimated that the Shtokhman field needs an oil price of $45-60 a barrel to be profitable and that Gazprom needs to invest $150 billion in total over the next 10 years. While Gazprom should have no problem developing onshore Siberian production, though it is proving more costly and taking more time than anticipated, it has limited offshore experience. As does Rosneft for that matter, yet the Russian Government has decreed that the two state champions will be responsible for the development of the Arctic offshore. That Gazprom had to invite Total (France) and StatoilHydro (Norway) into the Shtokhman project, having previously stated that it would go it alone, is proof positive of the limitations of the domestic industry in Russia. There is no reason why they can’t learn, but mistakes would be very costly; perhaps they could use the service companies; but they lack the project management experience. All this suggests that Arctic offshore exploration and development in Russia will need the likes of Gazprom and Rosneft to partner with the IOCs, who, as Sakhalin has demonstrated, do have the capital, experience and technology to access difficult oil and gas.32 China’s NOCs may be a source of capital and a market for Russian oil and gas, but they too lack the technology and experience to ’s resource frontier. Interestingly, Gazprom is now looking for partners to develop its Sakhalin III Krinsky block, and press reports claim that it sees Shell as a favoured partner. Here our story turns full circle: over the past 4-5 years the Kremlin has alienated the IOCs and has now forced terms of engagement upon them that they may not find sufficiently attractive to take on the heightened country risk now associated with Russia, but the Kremlin is not going to return to the largess of the early 1990s any time soon.

Conclusions: The recent economic boom in Russia will no doubt be seen as another missed opportunity Reap What in the country’s already chequered economic history. Russia failed to use a period of sustained You Sow? growth to diversify its economy and to create a ‘constructive’ investment climate. Instead of promoting a vibrant private oil and gas industry open to foreign investment, the Kremlin used the two state champions and access to cheap foreign credit to regain state control over a large part of the industry. While this may have been a deliberate policy decision to correct the wrongs of the Yeltsin years, to limit investment in costly new production, and to manage Russia’s rent addiction, it does not explain why the state sanctioned the use of ‘administrative’ levers to force IOCs to relinquish control of key assets that they had developed or planned to develop with their own capital. Subsequently, the state has also introduced legislation that curtails the role that IOCs can play in the future development of the oil and gas industry. While such actions have their parallels

12 MAY 2009/GEOPOLITICS OF ENERGY elsewhere, the situation in Russia may be different. Under President Putin, a view prevailed that the deals struck in the 1990s were too generous and that a new set of rules relating to the IOCs was required. Nevertheless, the development of new productive capacity in Russia will be costly and technologically challenging and this may well require partnership with the IOCs. Clearly, the Kremlin believes that IOCs are so desperate to gain access to new reserves that the likes of Shell and BP will ‘forgive and forget’, but instead it may be a case of ‘once bitten twice shy’. Gazprom may consider Shell an obvious partner for Sakhalin III, but will Shell invest billions in another Sakhalin project, particularly one that will not be protected by a PSA? It is the case that both BP and Shell have positioned themselves to be able to respond to new opportunities in Russia in the Arctic offshore and may be prepared to accept the new terms of engagement, but the current global economic situation might demand caution. Continued economic hardship in Russia might result in a softening of the Kremlin’s attitudes towards the IOCs; one would think so if one believed all the platitudes at the ceremony on Sakhalin in February, but the reality is that nothing has really changed. Even if it does, a key lesson from the Sakhalin PSAs agreed in the early 1990s is that the IOCs cannot afford to be seen to be exploiting Russia’s current economic difficulties for their own reward.

Finally, to return to the consequences of all of this for global energy security, over the last decade increased oil and gas exports from Russia helped markets accommodate the ever-increasing demand from emerging economies. Whatever the motivation, the Kremlin now controls a substantial share of Russian oil and gas production and the majority of the rents generated by oil and gas production, but in doing so it has aggravated – deliberately so according to some – underlying structural problems that will make it difficult for Russia to maintain oil exports in the near to medium-term. There is even the view, held by some Russian oil company executives and government officials, that Russian oil production has peaked.33 This means that when economic growth returns, production declines in Russia will be part of wider concerns about the future of non-OPEC production, with the obvious implications for energy security. But this may well result in the higher prices that Russia needs to develop its resource frontier, supporting the Gaddy and Ickes hypothesis, and suggesting that longer-term Russian production may recover. However, the high cost and long lead-times associated with such development make this a risky strategy. The situation for gas is different, and the current recession may actually provide Gazprom the breathing space it needs to develop new capacity; but a lack of LNG experience and limits to expansion in Europe may place even greater emphasis on realizing Gazprom’s Eastern Programme and developing pipeline exports to China and Korea. All of this supposes that the Kremlin wants to see the level of oil and gas exports maintained, if not expanded, which is clearly what energy-importing states want, but Moscow may feel that this is not in the best interests of the Russian economy.

Endnotes

1 ‘Russia’s first LNG plant opened by President Medvedev, Sakhalin Energy Website. Available at: http://www.sakhalinenergy.com/en/default.asp?p=channel&c=1&n=328. Accessed: 23 April 2009. 2 ‘New Energy Source Comes Onstream at Sakhalin II’, Sakhalin Energy Website. Available at: http://www.sakhalinenergy.com/en/media.asp?p=media_page&itmID=259. Accessed: 23 April 2009. 3 Leon Aron, Russia’s Oil: Natural Abundance and Political Shortages, AEI Russian Outlook, Spring, 2006. 4 Jonathan Stern, ‘The Russian Gas Balance to 2015: Difficult Year Ahead’, in Simon Pirani ed. Russian and CIS Gas Markets and Their Impact on Europe, Oxford: OUP/OEIS, 2009 5 Data from BP Statistical Yearbook, online workbook, available at: www.bp.com. 6 ‘Russia oil output falls for first time in a decade’, Yahoo Finance.Com, 3 January 2009/ Available at: http://uk.biz.yahoo.com/03012009/325/russia-oil-output-falls-first-time-decade.html. Accessed 24 April 2009. If one removes the additional production brought on-line by Sakhalin I, then domestic production actually stagnated in 2007. 7 Phillip Hanson, ‘How Sustainable Is Russia’s Energy Power? Russian Analytical Digest, 38 (8): 8-10, 2008 8 Michael Ellman, ed., Russia’s Oil and Natural Gas: Bonanza or Curse? London: Anthem Press, 2006.

GEOPOLITICS OF ENERGY/MAY 2009 13 9 Clifford G. Gaddy and Barry W. Ickes, ‘Russia’s Declining Oil Production: Managing Price Risk and Rent Addiction’, Eurasian Geography and Economics, 50 (1): 1-13, 2009 10 Clifford Gaddy and Barry Ickes, 2005, ‘Resource Rents and the Russian Economy, Eurasian Geography and Economics, 46 (8): 559-83. 11 This analysis and Figure 2 comes from Clifford Gaddy at the Brookings Institution in Washington DC and should not be reproduced without his permission ([email protected]). 12 Yegor Gaidar, Collapse of an Empire: Lessons for Modern Russia, Washington DC: The Brookings Institution, 2007. 13 See Philip Hanson, ‘The Resistible Rise of State Control in the Russian Oil and Gas Industry,’ Eurasian Geography and Economics, 50, No. 1, pp. 14-27, 2009 14 Marshall I. Goldman, ‘The Russian power play on oil, natural gas reserves’ The Boston Globe, 23 August 2008. Available at: http://www.boston.com/bostonglobe/editorial_opinion/oped/ articles/2008/08/23/the_russian_power_play_on_oil_natural_gas_reserves/. Accessed: 23 April 2009. 15 Hanson, 2009, p. 15. 16 See Harley Balzter, ’The Putin Thesis and Russian Energy Policy’, Post-Soviet Affairs, 21 (3): 210-225. 17 Ian Bremmer and Robert Johnston, The Rise and Fall of Resource Nationalism, Survival, 51 (2): 149-158, 2009. 18 ‘Who are the major players in the world oil market? EIA: Energy in Brief, updated 29 January 2009. Available at: http://tonto.eia.doe.gov/energy_in_brief/world_oil_market.cfm. Accessed: 24 April 2009. 19 William Tompson, ‘Back to the Future? Thoughts on the Political Economy of Expanding State Ownership in Russia, Paris: CERI, Sciences Po, Les Cahiers Russie, no. 6, 2008. 20 See Philip Hanson, ‘Observations on the Cost of the Yukos Affair to Russia, Eurasian Geography and Economics, 47 (7): 481-494. 21 See also, Hanson, 2009. 22 Julia Kusznir and Heiko Pleines, ‘The Russian Oil Industry between Foreign Investment and Domestic Interests,’ in Russia’s Energy Sector between Politics and Business, edited by Robert Orttung, Jeronim Perovic, Heiko Pleines and Hans-Henning Schroder, Bremen. Working Papers of the Research Centre for East European Studies, University of Bremen, No. 92, February 2008. 23 Nina Poussenkova, ‘All Quiet on the Eastern Front…’ Russian Analytical Digest, 33 (8), 13-18. 24 I am grateful to Jonathan Stern for suggesting the need to see these issues from a Russian perspective. Western analysts are always likely to see FDI as necessary and private ownership more desirable than state control; neither view is predominant in Russia. 25 See Michael Bradshaw, The Greening of Global Project Finance: the Case of the Sakhalin II Oil and Gas Project’, The Canadian Geographer, 51, 3, 255-279, 2007 for a full description of this campaign and the actions of the Russian Government. See also: Michael Bradshaw (2009) Editorial: The Sakhalin Saga, Energy Current, 28 January 2009. Available at: http:// www.energycurrent.com/index.php?id=2&storyid=15571. Accessed 24 April 2009. 26 See Ian Rutledge, The Sakhalin II PSA- A Production ‘Non-Sharing’ Agreement, Sheffield Energy & Resources Information Service, 2004. 27 See Jonathan Stern and Michael Bradshaw, ‘Russian and Central Asian Gas Supply for Asia’, in Jonathan Stern, ed. Natural Gas in Asia, Oxford: OUP/OEIS, 2008 28 World Bank, Russian Economic Report No. 18, World Bank Russia Country Office, Moscow, March, 2009. 29 Nadia Popova, ‘Kelpach Says GDP Plunged by 9.5 percent’, Moscow Times, 24 April, 2009. 30 Russian corporate debt down $30 billion in Q1, CNBC.Com, 7 April 2009. Available at: http://www.cnbc.com/id/30089563. Accessed 24 April 2009. 31 Gaddy and Ickes, 2009. 32 See Nina Poussenkova, ‘Gazprom and Russia’s Great Eastern Pipe-Dreams,’ Russian Analytical Digest, 58 (9), 2009. 33 ‘Russian Oil has ‘Peaked’, Billionaire Vekselberg Says, Bloomberg.com. 23 April, 2008. Available at: http://www.bloomberg.com/apps/ news?pid=20601013&sid=abvPbR0TjuME&refer=emergingmarkets. Accessed 8 May 2009.

14 MAY 2009/GEOPOLITICS OF ENERGY Volume 31, Number 5 May 2009

Geopolitics of Energy ®

Geopolitics of Energy was founded by the late Melvin A. Conant of Washington, DC in 1979. Since 1993, it has been published under the auspices of the Canadian Energy Research Institute. Inside Geopolitics of Energy Editor-in-Chief Sulayman Al-Qudsi • The Kremlin, National Champions and the International Oil Companies: Associate Editor The Political Economy of the Russian Oil and Gas Industry Jon Rozhon By Michael Bradshaw

In this cogent, well-researched article, Michael Bradshaw explores the changes that Editorial Committee have occurred in the Russian Oil and Gas industry since Vladimir Putin became Alberto Cisneros Lavaller President of the Federation in 2000, paying particular attention to the Kremlin’s evolving Napier Collyns relationships with prominent international oil companies. Dr. Bradshaw first outlines Julian Lee Michael Lynch the growing importance to the world of Russian oil and gas production. Then he examines political and economic rationales behind the shift from the privatization Editorial Board model established under Yeltsin to the present model of state control. Dr. Bradshaw Peter Adam brings into focus the specific case of Sakhalin, where Moscow has dealt heavy- Preety Bhandari handedly with IOC’s – most notably Shell – and now finds itself in a difficult situation: Fatih Birol on the one hand, Russia hopes to limit further foreign investment, yet on the other Ged Davis hand, it does not possess the domestic capability to develop Sakhalin independently Robert Ebel of the IOC’s. Indeed, Dr. Bradshaw sees future Russian oil and gas development as George Eynon hinging on IOC involvement but wonders whether the companies will ‘forgive and Fereidun Fesharaki forget’ or be ‘once bitten and twice shy’. In terms of global energy security, the Herman Franssen author predicts Russian oil production declining over the near to medium-term but Antoine Halff holds out some optimism for increased Russian gas capacity. Paul Horsnell Tatsu Kambara • Oil Dependence and Economic Development: The Tale of Kuwait Alex Kemp Walid Khadduri By Mohamed Nagy Eltony David Knapp Edward Morse Mohamed Nagy Eltony provides a useful and engaging overview of the Kuwaiti Francisco Parra economy, how it has evolved over time, and the challenges the emirate faces in Robert Priddle trying to develop and diversify. Foremost among those challenges is the relationship John Roberts between the emir and parliament, which has been at an impasse for years, and Adnan Shihab-Eldin which Dr. Eltony believes needs to be resolved for a democratic, economically vibrant Robert Skinner Kuwait to arise. Other challenges facing Kuwait include a tight real estate market Subroto that drives domestic inflation and limits development of non-oil-related industry; a Paul Tempest central bank with limited independence; and an unskilled, poorly-educated Kuwaiti R. James Woolsey workforce that has clogged the public sector. Despite these and other problems, Dr. Wu Lei Eltony sees a promising future for the oil and gas industry, with four new oil fields to be opened up by 2012 and a new gas field coming online a year earlier. Non-oil sectors (petrochemicals, transportation, wholesale and retail trade, etc.) show promise, though limited, as is evinced by UNCTAD data that perennially ranks the emirate as a low FDI-performance country with high FDI potential.

GEOPOLITICSIt is the policy OF of Geopolitics ENERGY/MAY of Energy to publish2009 views by different authorities. The articles reflect the opinions of the authors 1 which are not necessarily those of the Editors-in-Chief, the Editorial Board, nor the Publisher (Canadian Energy Research Institute).