Russia's oil output decline is likely to continue as its tax policy prevents oil firms from investing enough in new greenfield production, a magazine quoted the head of Russian oil major LUKOIL as saying on Monday. Vagit Alekperov, president of LUKOIL, Russia's second-largest oil producer and biggest private oil company, said investment is also not sufficient for maintaining output at mature fields with their hard-to-extract resources. "Unfortunately, because of the tax policy, we have entered the phase of declining oil production because investment is not enough for launching new deposits and maintaining the existing fields," Alekperov told Smart Money business magazine in an interview.
Russian oil companies have long urged the government to change the tax system, which has not been amended for several years despite rising costs and inflation that have squeezed profit margins. Firms want a cut in mineral extraction tax as well as expanding tax breaks to new oil-producing regions. East Siberia is the only region where companies can apply for tax breaks. Former president Vladimir Putin, who took over as Russia's prime minister last week, has said the state has been withdrawing around 75-80 percent of oil companies' profits in taxes and pledged to cut the burden to support economic growth. Russia's overall output grew by just 2 percent in 2007 and has moved into negative territory in the first quarter of this year. Impressive spikes in previous years made it the world's second largest exporter after Saudi Arabia. Production is expected to plateau at the current level of 10 million barrels per day as new production in East Siberia offsets declining output in West Siberia. But Alekperov said LUKOIL's own prospects are brighter than those for the rest of Russia's oil industry. "We are convinced that progressive development will continue during the next 10 years. Our reserves allow us to look into the future with confidence," he said.
LUKOIL, in which U.S. ConocoPhillips (nyse: COP - news - people ) has 20 percent, last month cut its oil production growth forecast for this year to 1.8-2.0 percent from the previous estimate of five percent. It produced 91.4 million tonnes (1.8 million bpd) last year.
The Economist reports:
WHEN the price of oil reached another record on May 6th, of over $122 a barrel, analysts pointed to attacks on pipelines in Nigeria and turmoil in Iraq as the immediate causes. Even small disruptions to supplies from such places can cause the price to jump, since only Saudi Arabia has the capacity to replace the lost production, and it does not seem inclined to do so. But to understand how supplies became so scarce in the first place, one must look at the state of the oil industry in Russia, the world's second-biggest producer.
Over the past seven years, according to Citibank, Russia accounted for 80% of the growth in oil production outside the Organisation of the Petroleum Exporting Countries. The increase in its output in the early part of the decade matched the growth in demand from China and India almost barrel for barrel. Yet in April, production fell for the fourth month in a row. It is now over 2% below the peak of 9.9m barrels a day (b/d) reached in October last year. Before that, the growth in Russia's output had been slowing steadily, suggesting that the drop is not a blip. Leonid Fedun, a vice-president of Lukoil, a local oil firm, says Russia's production will never top 10m b/d. The discovery that Russia can no longer be relied upon to cater to the world's ever-increasing appetite for oil is naturally helping to propel prices to record levels.
Oil and gas have been the foundation of the regime of Vladimir Putin, Russia's outgoing president, and are also a preoccupation of his successor, Dmitry Medvedev, who was chairman of Gazprom, the state-controlled gas giant. The flow of petrodollars has created a sense of stability, masked economic woes and given Russia more clout on the world stage. Yet the malaise afflicting its most important industry is almost entirely man-made. “Geologically, there is no problem,” says Anisa Redman, an analyst at HSBC, a bank.
In principle, Russia's bonanza could continue for years: it has the world's seventh-biggest oil reserves, at 80 billion barrels, according to BP, a British oil firm. And oilmen reckon there are 100 billion more barrels to find—“the biggest exploration prize in the world”, in the words of Robert Dudley, the boss of TNK-BP, BP's Russian joint venture. But Russia has regulated the industry so poorly that production is falling despite the soaring oil price.
“Tax is the major impediment,” says Ms Redman. The government levies an export duty of 65% at prices over $25 a barrel. Add to that various corporate, payroll and production taxes, oilmen complain, and the state creams off as much as 92% of profits. Executives at TNK-BP have argued that rising costs across the oil industry will make many investments in Russia unprofitable unless the tax regime is changed. As it is, TNK-BP accounts for a fifth of BP's production, but only a tenth of its profits.
The government does offer tax breaks on production from older fields. So oil firms, naturally, have been concentrating on squeezing as much oil as they can out of those. Until recently, that was an obvious priority anyway, since fields that had fallen into ruin after the collapse of the Soviet Union in the early 1990s could be revived relatively easily and cheaply. By mapping existing fields more precisely, installing new pumps and injecting water and chemicals into wells to maintain pressure, private oil firms were able to raise Russia's production from 6m b/d to almost 10m b/d, mainly from western Siberia. In 2003 alone, output jumped by 12%.
But this strategy is now yielding diminishing returns. Mr Fedun says the western Siberian fields have reached their natural limit. To keep production at today's levels requires ever more investment. To get Russia's output growing again, firms must make huge investments to develop new fields in remote provinces such as eastern Siberia and the Sakhalin region.
There has been some growth in these areas, mainly thanks to the less heavily taxed projects, called “production-sharing agreements”, that the government offered briefly in the late 1990s but has since curtailed. Strip out the production from these projects, and Russia's output has been in fitful decline since August 2006, according to analysts at Citibank. Worse, the output from these projects declined last month too. The government's ill concealed expropriation of various prize assets over the past few years has only added to the reluctance to embark upon big new projects.
Lukoil, for example, is investing $10 billion a year, but roughly 30% of that goes into gas production, which is now more lucrative than oil, given rising domestic prices for gas and lower taxation, says Mr Fedun. It has also been investing in refining, since the export tax on petrol and diesel is lower than that on crude oil. It is still projecting 4% annual growth in its output over the next 15 years, but the figure would be much higher if the government eased the tax burden, says Mr Fedun. Rosneft, the state-controlled oil champion, took on so much debt buying the plum divisions of Yukos, a private firm bankrupted by the Kremlin's zealous tax collectors, that it has little leeway for expensive new projects. Other firms are hoarding their profits and waiting for the tax regime to change.
The government did provide some $4.5 billion in tax breaks last year. But this, the oil companies argue, is barely enough to keep production stable. In his inaugural speech to the Duma as prime minister on May 8th, Mr Putin said that taxes on the industry must be reduced. However, new fields can take a decade to develop. The Kremlin has also failed to hand out exploration rights in the Arctic—the region oilmen consider most promising. And it says that in future the foreign firms with the expertise to tap offshore fields beneath frozen seas will be limited to minority shareholdings in big projects. “Oil production will be whatever the government decides it to be,” says Mr Fedun.
Meanwhile, Russia today is more dependent on oil and gas than it has ever been, argues Chris Weafer, a long-time Russia watcher and chief strategist at Uralsib, a bank. The share of oil and gas in Russia's gross domestic product has more than doubled since 1999 and now stands at above 30%, according to the Institute of Economic Analysis, a think-tank. Oil and gas account for 50% of Russian budget revenues and 65% of its exports. Yet the government has put at risk the goose that lays these golden eggs.