In 2005, several major events transformed the oil and gas industry in Russia. In September 2004, Gazprom announced plans to acquire, via a share swap, the 100 percent state-owned oil company, Rosneft. A completed Rosneft-Gazprom merger would have put the new company into competition with Lukoil, the country’s largest oil producer. By 2005, however it was apparent that the merger would not be completed successfully due to Gazprom’s fears that a merger would leave it open to litigation targeted towards Rosneft as a result of the “Yukos Affair” (see below).

On October 25, 2003, the Russian government arrested Mikhail Khodorkovsky, the CEO of Yukos, Russia’s top oil producer, on charges of fraud and tax evasion. Since that time, the Russian government has arrested numerous other shareholders and top-level executives in the company for similar reasons. The government sought to recoup the cost of some of the allegedly questionable tax schemes used by Yukos by auctioning off 76.8 percent of the company’s prime asset, Yuganskneftegaz, in late 2004. The subsidiary, which produces approximately 1 percent of the world’s oil supply and 11 percent of Russia’s oil supply, was auctioned off to an unknown company called Baikal Finans Group (BFG). A week later Rosneft, the state oil company, announced it would buy BFG for $9.35 billion (with a loan partly financed by Chinese National Petroleum Corporation). Financial analysts concluded this price was far less than the unit's fair market value.

Another merger in the Russian energy industry introduced the participation of a new major Western oil company. In September 2004, ConocoPhillips announced a $2.0 billion strategic alliance with OAO Lukoil, under which ConocoPhillips will buy a 7.6 percent stake in the Russian oil company and get a share in joint projects. Through stock purchases, ConocoPhillips increased its share of the company to 10 percent by November 2004, enough for it to receive one seat on the 11-member board of directors of Lukoil. The deal will provide ConocoPhillips access to Russia's oil and natural gas reserves and opens a possible avenue for it to become the first Western petroleum producer to return to Iraq. Under the strategic alliance, ConocoPhillips can opt to raise its stake to 20 percent within two to three years, which would cost about $3 billion at current prices.

The combination of Gazprom’s acquisition of Sibneft and Rosneft’s acquisition of Yuganskneftegaz puts approximately 25 percent of Russia’s oil production into state hands.

In 2003, British Petroleum (BP) completed its merger with the Russian oil company, Tyumen Oil Company, creating a new company called TNK-BP. The company holds oil reserves of 8 billion barrels (SEC estimate, others vary) and produced 1.5 million bbl/d from January-October 2005, making it Russia's second-largest oil producer (behind Lukoil). The deal also includes retail outlets in Russia and Ukraine. The company is also an equal partner with Gazprom in Slavneft, which currently produces roughly 500,000 bbl/d.

Russia has 41 oil refineries with a total crude oil processing capacity of 5.44 million bbl/d. However, many of the refineries are inefficient, aging, and in need of modernization. With Russian domestic demand of 2.6 million bbl/d in 2004 (preliminary estimate), refining capacity far outstrips local demand for refined products. Because Russian refined product exports have a lower average price than crude oil, the Russian government reduced export taxes during the mid 1990s to allow for greater volumes of product exports. Russian oil exports to the U.S. (click for data table) have almost doubled since 2004, rising to almost 500,000 bbl/d of crude oil and products. Political pressures to maintain refinery operations, the need to pay for refinery modernization, and higher international oil product prices provide an incentive for Russian oil companies to continue favoring product exports. According to the draft plan for economic development during 2005-2008, the reconstruction and upgrading of refineries so that the refineries can convert a higher level of crude will be a priority for future oil refinery development. The draft forsees continued increases in the production of high quality light oil products, catalysts and raw material for the petrochemical industry. As production of fuel oil is reduced, local refineries are only meeting about half of the country’s demand for high octane gasoline. Consequently, Russia must import the remainder.

Gazprom , Russia's state-run natural gas monopoly, holds nearly one-third of the world’s natural gas reserves, produces nearly 90 percent of Russia’s natural gas, and operates the country’s natural gas pipeline network. Gazprom is also Russia’s largest earner of hard currency, and the company’s tax payments accounting for around 25 percent of federal tax revenues.

Despite its enormous size and significance, Gazprom is seriously encumbered by domestic regulation. By law, Gazprom must supply the natural gas used to heat and power Russia's vast domestic market at government-regulated prices (approximately $28 per thousand cubic meters), regardless of profitability. Accordingly, roughly two-thirds of the company's revenue comes from its export sales to Europe, where natural gas is sold for around $135-$140 per thousand cubic meters. Because exported Russian natural gas accounts for approximately 25 percent of Europe's demand for natural gas, Gazprom is also one of Moscow's main foreign policy tools (see Table 1).

As Gazprom's trade relationship with European consumers grows, contentious issues have arisen. European trade representatives denounced Gazprom's monopolistic market position and two-tiered pricing system and linked the pricing issue to Russia's accession to the World Trade Organization (WTO) in response. In response to calls for fair pricing, the Russian government increased prices to industrial consumers (from $0.79/million cubic feet to $1.61/million cubic feet), yet this price level is still far less than half the prices charged at the German and Ukrainian borders.

Russia agreed to grant independent natural gas producers access to Gazprom's pipelines, but independents still hold a very small share of the market and have no access to international natural gas export infrastructure.

The government hopes that the removal of the “ring-fence”, which limits foreign share ownership in the company, will finally allow Gazprom to raise much-needed investment capital. The consequences of a flawed reform package are serious. First, Gazprom provides subsidized gas to UES (Russia’s electricity monopoly), meaning that price increases as part of a deregulation program could make gas unaffordable for the Russian populace—one-fifth of whom are below the poverty line. Also, the government receives 25 percent of its tax revenue from Gazprom, and breaking the company up could lead to similar problems in revenue collection seen in the oil sector. Finally, the creation of a deregulated gas sector, run by much wealthier individuals would inevitably further reduce the Kremlin’s political control in the industry.

In September 2005, Gazprom announced it would buy a 75 percent share of Sibneft for $13.1 billion. Gazprom’s purchase of the oil company, the fifth largest in Russia (representing roughly 665,000 bbl/d of production), marks its first major foray into the oil business. Yukos also owns 20 percent of the company, but this share may yet be seized by the courts. Gazprom’s ability to pay for Sibneft was partially enabled by the state’s purchase of a 10.7 percent share in Gazprom in June 2005 for $7 billion. For the Russian gas company, the acquisition will enable it to diversify into other commodities and will allow it to obtain low-cost oil production, in relative terms, at around $3 per barrel.