Russia

The fall of the Soviet Empire ushered in an era of mass political, legal, and economic reforms. In Russia, the move to a market economy has involved the privatization of much of Russia's industry. Russia's large petroleum sector is currently going through the privatization process, though initially on a more limited scope and at a slower pace than other industries. A November 1992 presidential decree established vertically integrated oil companies from former oil-producing associations of the Former Soviet Union (FSU). The gas sector, however, was to remain intact under the gas monopoly Gazprom.

Like the breakup of Standard Oil in the United States during the beginning of this century, the FSU's oil production monopoly was separated along geographic lines, combining regional oil production associations with refineries and product distributors, and transforming them into integrated joint (public and private) stock companies (see Box entitled "Russia's New Petroleum Industry"). The final restructuring and consolidation of the industry's assets occurred in 1995 under a subsequent presidential decree that gave rise to the current structure of eleven vertically integrated oil companies {see Endnote 94}. Their estimated size in reserves and production allows them to compete with the world's major petroleum companies; eight of the eleven integrated Russian oil companies are ranked in Petroleum Intelligence Weekly as among the "World's Top 50 Oil and Gas Companies for 1994" {see Endnote 95}.

The partial privatization of the Russian oil industry has consisted of two stages {see Endnote 96}. The first stage, which ended in June 1994, was the commercialization of state enterprises into joint stock companies and the selling of shares through vouchers, with ownership limited to workers and Russian citizens. Thirty-eight to forty-five percent of the shares in the companies are required to remain in government hands for at least three years, after which the government share may be reduced. The privatization process is currently in the second phase, which opens ownership to foreign investors. During this stage, remaining shares will be distributed in one of two ways: 1) the disbursement of blocks of shares to investors in exchange for their commitment to maintain employment levels and to make future contributions to the enterprise and 2) the sale of shares for cash.

In 1995, under the shares-for-cash proposal, the Russian government implemented a shares-for-loans scheme, whereby large blocks of government shares in certain joint stock companies (which included five of Russia's oil giants) were auctioned to a group of Russian commercial banks for cash. The successful bidders are required to hold the shares in trust for a maximum of three years in return for providing loans to the government to reduce its budget deficit. At any time, the government can buy back its shares. However, because the affected shares are to be temporarily managed by the bidder awarded the shares, a controversy has arisen over the possibility of corruption entering the bidding process. Consequently, all future auctions have been terminated and the results of last year's auction are being challenged. These challenges have arisen from many parties, including government factions, the public, commercial banks, and both managers and owners of the former joint stock companies. Some of these challenges are currently in court.

Most of Russia's new oil companies are operating as regional monopolies. Others, like Lukoil and Rosneft, are using their size and influence to expand beyond their borders to other countries, and compete with the world majors. For example, in 1994, Rosneft and two of its subsidiaries at the time purchased a 24-percent interest in the planned Leuna refinery in eastern Germany
{see Endnote 97}. Lukoil also has stakes in several production-sharing agreements and joint ventures in former Soviet Republics and is pursuing interests in Europe.

Overhauling the Industry

Foreign capital and technology are needed in the oil sector to help stop the decline in production, which peaked at 12.5 million barrels per day in 1987 and fell to 6.2 million barrels per day by 1995 {see Endnote 98}. The decline in production, which only recently has begun to level off, is attributed mainly to management and production inefficiencies, outdated and inadequate infrastructure, lack of investment, declines in domestic demand, low domestic prices, an inability to export, and uncertainty surrounding pro- perty right issues.

Downstream, the rebuilding of Russia's petroleum infrastructure is also being delayed by the slow pace of foreign investment. Most of Russia's 29 refineries are old, inefficient, and in need of modernization. The total operational capacity of Russia's refineries is 6.6 million barrels per day with a utilization rate of under 60 percent {see Endnote 99}. Russia's Ministry of Fuel and Energy has begun to restructure the refinery sector, with plans to build several refineries in Russia and to upgrade existing refineries. The ministry hopes to increase throughput by 17 percent to 4.2 million barrels per day, in the year 2000 {see Endnote 100}. Costs of modernizing and expanding the industry during the 1995-2000 period are estimated at $7 billion {see Endnote 101}.

Gazprom, the World's Gas Company Giant

One company, Gazprom, dominates the Russian natural gas industry and is the world's largest gas company, with reserves of 848 trillion cubic feet. In 1994, Gazprom produced 20,160 billion cubic feet {see Endnote 102}. Consisting of 10 production associations, Gazprom produces over 90 percent of Russian gas and owns over 70 percent of the country's gas reserves {see Endnote 103}. In 1993, Gazprom was converted into a state-owned joint stock company, and then began to be privatized in April 1994. As in the oil industry, shares were divided among Gazprom employees and other domestic investors, while 40 percent of its shares is to remain in government hands for at least three years. Nine percent of Gazprom's stock has been set aside for foreign ownership. The sale of shares (even between private individuals) requires Gazprom's approval.

In contrast to the oil sector, Gazprom has been relatively successful at maintaining output, which is mainly in western Siberia, where over 90 percent of Russia's natural gas is produced {see Endnote 104}. However, much investment capital is needed for field development and for rehabilitation of Gazprom's extensive network of pipelines, almost 90,000 miles. Currently, nonpayment from Gazprom's major customers, Russia's electric utilities, and the republics of the FSU has developed into a crisis. Revenues that would have been used for projects have been diverted to subsidize the electric utilities, since cutting off supplies to the utility companies is forbidden by law. Of the FSU republics, the Ukraine owes the largest sum of money. However, the Ukraine has some unique leverage since Russian gas accounts for about 60 percent of Europe's gas imports, of which over 90 percent runs through the Ukraine. Exports to Europe are one of Gazprom's most secure sources of cash. Attempts to reduce gas deliveries to the Ukraine for nonpayment have failed because the Ukraine began to siphon gas destined for Europe to offset the shortfall {see Endnote 105}.

Currently, since transport costs are not taken into account in establishing price, gas prices remain uniform across Russia, creating further inefficiencies in the gas industry. Some critics have recently called for regulating the industry. Some would even like to see Gazprom dismantled, but no serious efforts have been made so far to break up their monopoly.

Even prior to privatization, Gazprom has had relationships with foreign companies, both in and outside the FSU. Currently, Gazprom is working on various projects with European and Asian countries that could eventually lead to the establishment of an intricately connected gas network system throughout these regions. Further, Gazprom holds an interest in a German natural gas transmission operation with its German joint venture partner, Wintershall.

Foreign Investment

The breakup of the Soviet Union and the move toward a market-driven economy are seen by many foreign investors as offering new exploration and production opportunities to one of the world's largest petroleum producing areas outside Saudi Arabia {see Endnote 106}. Russia first began to open the door to foreign investment in its petroleum industry through joint ventures. Foreign participation was not allowed in the initial stage of the privatization of assets. The second phase, however, did open up opportunities for foreign investors to take equity stakes in Russia's petroleum industry. ARCO became the first foreign company to buy an equity stake of up to 6 percent in the Russian oil firm Lukoil, paying $250 million for convertible bonds.

Joint ventures in upstream activities remain the main vehicle for foreign investment. Joint ventures are a way for Russia to gain access to capital and efficient, cost-saving technology and for foreign companies to gain a foothold in Russia. Oil and gas production from joint ventures has been increasing rapidly over the last few years, contrary to the trend for total Russian output. However, the joint ventures currently operating in Russia's oil and gas sector contribute only a fraction to overall production. Joint venture production increased by 39 percent in 1995 to 420,000 barrels per day, comprising 7 percent of total Russian output {see Endnote 107}.

Foreign joint exploration and development projects in Russia are mostly within known fields located in three of Russia's five largest producing regions. The regions include western Siberia, the Arctic Region, and the Russian Far East. In western Siberia, Occidental is operating the Vanyoganneft joint venture, one of its two enhanced oil recovery projects (the other is located in the Komi Republic). Amoco has a 50- percent interest in the Priobskoye field. In the Arctic Region, the largest production-sharing agreement being negotiated is the Timan Pechora Company (TPC), led by Texaco (with a 30-percent ownership share) and including Exxon (30 percent), Amoco (20 percent), and Norsk Hydro (20 percent) {see Endnote 108}. The joint venture includes the exploration and development of 1.8 million acres located in the Timan Pechora Basin (with 11 huge oil fields) north of the Arctic circle. Also located in the Timan Pechora Basin is Conoco's joint venture, Polar Lights, the first oilfield developed and brought on stream by a western company. In the Russian Far East, Sakhalin Island is the site where three agreements have been negotiated so far. Sakhalin I is being developed with the Exxon-Sodeco consortium, Sakhalin II is being developed with the MMMMS consortium (Marathon-USX, McDermott, Mitsui, Mitsubishi, and Royal Dutch/Shell), and Sakhalin III has been divided and will be developed by two different groups two blocks are being developed by Exxon and one block is being developed by Mobil and Texaco.

Twelve production sharing agreements have reached an advanced state of negotiation, and await finalization. However, uncertainty surrounding jurisdiction over resources, licensing, and taxation, have made many oil companies withhold an estimated $60 billion of investment until legislation that provides adequate investment guarantees can be passed. For example, Amoco, the Timan Pechora Company, and the companies operating in all three of the Sakhalin agreements have chosen not to begin their projects until the passage of appropriate legislation. The long-awaited Oil and Gas Law--which was signed into law in January 1996--was supposed to provide that framework. However, modifications that were made to get the law passed did not fully provide the guarantees desired by foreign investors. Some provisions that foreign companies find objectionable are: 1) the requirement to have parliamentary approval for fields in areas defined as "strategic" and for production sharing agreements not awarded by tender, 2) the Russian government's right to modify conditions of a production sharing agreement if "major economic changes" occur during the term of the agreement, 3) a provision that subsequent individual laws will determine which fields can be developed under production sharing agreements, and 4) the lack of recourse available to foreign investors to resolve disputes in an international tribunal {see Endnote 109}. Thus, the Oil and Gas Law (as passed) is considered a major setback by many of the companies and has forestalled their major investment plans {see Endnote 110}. Other barriers to foreign investment include a high tax burden in Russia. The absence of reliable transportation and access to foreign markets are other hurdles faced by both Russian and foreign companies. Access had been curtailed severely due to uncertainty surrounding changing export restrictions, which include quotas, requirements to export through holders of official special exporter licenses, and high export taxes. Investors faced a further barrier when the Russian government instructed joint ventures to supply the bulk of their oil to former Soviet Republics, where payment problems have arisen.

Once market conditions improve in Russia, substantial infrastructure investments will be needed before the decline in production can be reversed {see Endnote 111}. Physical constraints on the infrastructure, particularly the inefficient and outdated pipelines run by the state pipeline monopoly Transneft, plague both foreign and domestic companies. Furthermore, Russia's vast pipeline system has seen a change in flow patterns, resulting in supply disruptions. New pipelines are needed and existing pipelines must be repaired and upgraded. Plans to expand the system are being given top priority, but not much can be done until investments increase.

At present, ambitious plans to develop Russia's petroleum resources have faltered largely due to uncertainties surrounding oil and gas laws, changing tax regimes, and the ability (both physically and legally) to export crude oil to international markets. If economic reforms continue and political stability improves, Russia could rival the Mideast as a source of crude oil exports. To entice foreign investment capital, Russia must offer investors the opportunity to earn acceptable returns on their investments. To do so, Russia must implement laws that protect property rights, provide access to foreign markets, liberalize prices, and offer fair taxation. Further, Russia must reduce the twin destructive influences that widespread corruption and organized crime have come to have over legitimate commerce.