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Tuesday, November 04, 2008

Russia targets downstream projects and export pipelines

3 November 2008 - by Chris Weafer - Amongst the key objectives set out by President Medvedev at the start of his presidency last May was to promote greater investment into downstream energy projects and into export pipelines. Russia plans to move up the value chain in the energy sector in order to increase the energy for trade leverage with the EU and Asian countries as well as to reduce the dependency and vulnerability to volatile raw material prices. That means, greater investment in refineries, LNG plants and petrochemical facilities. It also means building more export capacity for gas and oil products. Sitting alongside such environmentally sensitive, but energy hungry, regions and the EU and Japan, it makes perfect sense for Russia to build processing facilities and to export the valuable end product. It is, for example, the reason why the priority for the eastern oil pipeline might now be altered to place greater emphasis on bringing oil to the Pacific coast. Processing the crude at facilities on the coast makes more economic sense than simply exporting crude. If we are now entering a lengthy period of lower energy prices then there will almost certainly have to be changes to the Moscow’s planned approach to economic development, in general, and to its energy policy in particular. With lower oil and gas tax revenues, the government will have to rely to a much greater extent on foreign investor participation in the economy and also to help fund some of the major energy projects that are planned. It has already become clear that the state energy companies will need to involve the international majors in some projects, such as in the Arctic region and off Sakhalin, to leverage off their technical capabilities and experiences. But that was moving slowly because cash was previously not such a big problem, especially with the previous assumption that the industry tax burden might be cut by up to USD 20 billion tax from next year. That tax cut is not likely in the current price environment. Currently the government, like many of its international peers, is involved in something of a fire-fight to ensure that the country’s currency does not go into free fall nor the banking system fails. When this period is passed, there will have to be a reassessment of the assumptions, both revenue and spending, that make up President Medvedev’s strategic plan for the economy over the next three to four years. The energy lobby will undoubtedly push for a greater share of the available resources, i.e., tax cuts and funding, in order to shore up existing production and to push ahead with planned projects. Some in government will oppose that as they push for a greater focus on diversification within the economy. Decisions made as a result of that debate will also have a major impact on how Russia’s energy sector develops from here and the opportunities for coinvestment afforded to international energy companies. For the gas industry the position is even more acute. With tougher economic conditions ahead, the economy may not be able to support the higher gas tariffs that are required a) to bring the price of domestic gas up to the net-back export price or b) to help fund the major new projects in Shtokman, Kovykta, Yuzhno-Russkoye and, especially, the Yamal Peninsula. Apart from being required to compensate for the faster ageing of Russia’s giant gas fields, the output from these projects is required to fulfil international trade and political deals agreed with the EU and China. On a more optimistic note, what this should mean is that the government will have to encourage the use of foreign capital to a greater extent than was thought only six months ago. There was a sense of complacency, not just in the energy sector but also in other parts of the economy. A complacency that resulted from the expectation that oil and gas revenues would continue to grow and that, therefore, Russia had enough internal financial resources to fund its plans for the energy sector and the broader economy. It could bring in foreign partners and decide in the pace of project development when it suited. That has already changed. USD 70 p/bbl oil means that there is no spare cash and the threat of a faster decline in oil production from 2009 means that there is also no spare time. It is not quite a buyers/investors market yet. But it is no longer a sellers market either. The net result of this new energy price environment and global economic slowing is that Russia will have to push ahead with mechanisms to improve the country’s investment image. That means better legal protection for assets owned by foreign energy companies, it means a higher profile campaign against corruption and red tape. It also has to mean that the new rules-of the-game don’t change again. Russia has the geological capability to significantly add to current production in oil and gas and to become dominant in the emerging LNG business. But it is not going to realise that, and the diversification objectives for the broader economy, without the involvement, in a real partnership sense, of the international energy majors.

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