GLOBAL INITIATIVES IN MANAGEMENT:

The Russian oil industry presents tremendous opportunities for firms, particularly in areas of engineering services, technical consulting and finance (raising capital, auditing). Russia has about 49-55 billion barrels or about 4.7% of the world’s proven oil reserves, and about 1,700 trillion cubic feet or 33% of the world’s natural gas reserves. Of total oil production, 40% is exported to take advantage of unregulated world oil prices. Further, 16% of total European oil consumption, and 20% of natural gas consumption is of Russian origin. In sum, oil and gas account for 10% of Russian GDP, and about 50% of exports making the sector critical for Russia’s economic fortunes.

This stature has led to significant challenges. Oil and gas are more than commodities and are also, tools of international power, components of foreign policy, elements of national security and a source of national pride. The fallout has been for Russia to be slow on sector reform with measures such as Production Sharing Agreement Legislation (PSA) that would help define tax, production, cost, and revenue sharing between the government and oil firms. Similarly, 90% of gas production and pipeline distribution remains in the hands of Gazprom, a quasi-state body. Higher world oil prices may also have bred a sense of complacency in these sectors badly in need of approximately $25-40 billion in investments over the next 5 years.

The experience of foreign oil firms (e.g., BP, Arco) in Russia has been disappointing due to a misalignment of interests. Russian oil companies tended to view Western companies as cheap sources of capital and advanced technology, but reneged on promises to provide choice exploration and drilling opportunities. Western companies did not provide the technical know-how and training, but rather sought to gain cheap access to rich fields. Assessing activities of both Russian and Western oil companies, to be successful, a company should vertically integrate (to provide reliability throughout the value chain), combine Russian assets with Western management, focus on a few activities for large investments (outsourcing or partnering for others), choose partners carefully to calibrate business goals, build political networks at every level of government (rather than solely rely on higher executive power) and demonstrate a long-term commitment to Russia.

For the future, the industry is likely to be dominated by large vertically integrated Russian corporations relying on Western engineering and consulting firms for know-how and skills. Western companies are expected to be active in hard-to-reach areas such as offshore sites and fields in the Far East. PSA legislation should move ahead as the Duma is increasingly recognizing its benefits and it could attract up to $85 billion in much needed investment over the next 5-7 years.

2. INTRODUCTION

Understanding the Russian oil industry is fundamental to understanding the country’s economy, its involvement in an increasingly global industry and the dynamic changes shaping government policy, strategy and the competitive landscape. As the second largest oil producer after Saudi Arabia, Russia accounts for 8.8% of world oil production and 4.7% of world reserves. Closely related, Russia accounts for 33% of the world’s natural gas reserves and is the world's largest gas exporter, with 7.1 trillion cubic feet (tcf) in net exports. Despite the interactivity between the two sectors, this report will focus primarily on Russian oil, and upstream activities in particular.

The oil industry has experienced dramatic change over the past decade. After the demise of communism, the oil sector became fragmented. Privatization prompted the emergence of disparate Russian oil companies and the new environment encouraged the entrance of foreign investors. Despite much investment, oil analysts estimate the industry still needs $25-40 billion in additional capital investment over the next five years to exploit the country’s naturally endowed resource.

After the August 1998 financial crisis, the weakened ruble combined with a tight oil market made Russian exports very attractive. Countries in the former Soviet Union accrued significant debt and were no longer able to meet payment obligations. Therefore, Russian oil exporters have targeted Western Europe, where demand for oil is strong, supply is limited, and payment is in cash. This strategy remains in place although Russia is broadening its reach eastward towards Asia and other states under various international sanctions.

The research objectives have been to:

1. Understand the role and importance of the oil industry to Russia’s development;

2. Identify opportunities and barriers to growth;

3. Assess the implications and role of foreign companies in Russian oil industry development; and,

4. Determine how Russia could better leverage its vast oil reserves and sustain future growth.

To accomplish these objectives, the research methodology was comprised of two phases:

1. Pre-Russia Research: The main sources of information were industry experts, analyst reports and research obtained from the Internet, Russian media, and industry journals. Contact was established with industry-related companies and organizations to meet while in Russia.

2. Field Research in Russia: There was an opportunity to meet with executives from British Petroleum (BP), Tyumen Oil Company (TNK) and Yukos to hear firsthand about their Russian experiences. Additionally, meetings with several industry analysts from firms such as PricewaterhouseCoopers and The Boston Consulting Group (BCG) were beneficial. Furthermore, oil experts from the US Department of Commerce and the US Embassy’s Economic Section provided valuable information.

This document is the outcome of several weeks of research and will be structured accordingly:

· General industry overview

· Key opportunities and challenges

· Case studies

· Learning points, recommendations and future implications.

3. INDUSTRY OVERVIEW

3.1 History Background – Pre-privatization Era

For decades, the Soviet oil industry was a complex structure of oil drillers, producers, refiners and a sole transporter, all of which were controlled by the State. Control was enforced in various ways such as imposing production quotas on oil drillers and obligating them to sell to the state-owned transportation company. The production methods used did not foster quality assurance, continuous improvement, optimal lifetime of the oilfields, or high system efficiency. Instead of being shaped by common business principles, production was defined by the nature and composition of national fuel demand. Downstream operations were primarily designed to supply heavy fuel oil to energy-inefficient heavy industry and power stations. At the time, there were relatively few cars, and light refined products (e.g. gasoline) were not a priority. Consequently, much of the refining capacity lacked secondary processes to produce high-margin light products.

The State structure is comprised of three ministries to oversee the oil industry. The Ministry of Geology was responsible for finding oil, the Ministry of Oil and Gas was responsible for drilling, and the Ministry of Refining managed crude processing and downstream activities. The Ministry of Refining created a strong refining capability that still remains a major portion of current capacity. Russia’s refining capacity is 6.6 million barrels (bbl) per day, although demand is only 50% of that level.

Russian oil production peaked in 1988, with daily deliveries of 11.4 million bbl to domestic and export markets. From this peak, oil production steadily declined until it reached a low of 6.04 million bbl per day in 1996. This shrinkage was due to several reasons. The Russian economy experienced a slowdown between 1990 and 1992, thereby lowering energy demand. More importantly, most oil produced was extracted from fields that were already 60-90% depleted. The situation was worsened since the drilling equipment came from Azerbaijan, which after independence, increased the equipment prices, substantially increasing costs for Russian oil firms.

Another factor that made privatization the most suitable solution to alleviate this industry in decay was low world oil prices. Whereas the State historically would secure foreign loans, this was no longer the case. Now, there was a desperate need to finance immediate maintenance expenditures throughout the value chain, but declining production levels exacerbated by low oil prices made it difficult to secure loans. Therefore, privatization sought to encourage direct investment in the industry and was critical to its modernization and future development.

3.2 Privatization

During the first stage (1993-mid 1994), President Yeltsin’s administration started the commercialization of state enterprises into joint stock companies. Although the State maintained 38-55% of company shares for a minimum three years, remaining company shares were sold through a voucher system, with ownership restricted to Russian citizens and workers. In doing so, the plan was to create vertically integrated oil companies (VICs). Initially, four VICs resulted from this process: Lukoil, Surgutneftegas, Yukos and Rosneft. The remaining VICs were formed soon thereafter.

During the second stage (1995-today), the State’s shares were auctioned off in blocks to foreign investors in exchange for (i) commitment to maintain employment levels and make future contributions and (ii) cash payment. Examples of second-stage privatization include the sales of 9% of Lukoil for $200 million in cash plus $240 million in investment commitments, and of 48.7% of TNK for $90 million plus $184 million in investment commitments. In general, privatization has lacked transparency and has had problems with Russian bureaucrats and businessmen ‘discouraging’ or effectively prohibiting foreign investment through coercive tactics.

As part of this second stage of privatization, the State sought loans from domestic banks through the loans-for-shares program to address the desperate cash need since the mid 1990s. Selected Russian banks granted the State loans with flexible repayment conditions with the State’s shares serving as collateral in a disguised auction procedure. At maturity (three years hence), the State had two options: (i) repay the loan and get back its shares, or (ii) sell off the shares. If the State opted for the second alternative, it would pay the banks 30% of the difference between the privatization sale price and the original loan amount. The State assured the non-participation of foreign bidders in the process by describing the companies up for auction as ‘strategic’ and enacting vague legislation that essentially barred any foreign attempt to bid.

The State has since abandoned such covert practices. One recent promising example was the September 2000 sale of Onako, which realized $1.08 billion, twice the asking price. The privatization process is not yet complete, as the State still holds a 19.6% and 25.5% stake in Rosneft and Slavneft respectively.

3.3 Role of Oil in Russia Today

The oil industry plays a significant role in Russia’s macroeconomy, investment environment, infrastructure development, politics and foreign policy. When combined with natural gas, it comprises approximately 10% of GDP and more than 50% of exports. During the past couple years, oil companies have become the most profitable sector of the economy primarily due to high oil prices, a five-fold increase in export revenues, streamlined operations and lower costs.[1] Consequently, analysts estimate the oil industry has driven much of Russia’s economic recovery since 1998, with estimates ranging from 35-85% of economic growth fueled by oil.[2] Anders Morland, President of British Petroleum (BP) Russia, candidly explained, “Energy is the only sector that makes a real difference to the Russian economy;” several industry experts and executives share Morland’s sentiment, thereby underscoring the fundamental role of oil to Russian economic progress.

Given its central role in the economy,