Russia Needs Exploration Technology; America Needs Oil Reserves

Published on Casey /Best of the Week, by Team, September 24, 2011.

Put yourself in Putin’s shoes. During his presidency (from 2000 to 2008), Russia accounted for 80% of the growth in oil production outside of the Organization of Petroleum Exporting Countries (OPEC). Russia’s increased output matched the growth in demand by China and India almost barrel for barrel. But about four years ago, Mother Russia’s oil production plateaued at just over 10 million barrels a day and has failed to increase appreciably since. Now production is starting to decline.  

The problem is entirely manmade. Russia has the world’s eighth-biggest oil reserves, at 60 billion barrels, and geologists reckon there are another 100 billion barrels waiting to be discovered. But poor fiscal management is choking out new production. The government levies an export duty of 65% when prices are above US$25 a barrel; when one adds in the various corporate, payroll, and production taxes, the state’s take comes in at as much as 92% of profits. Combined with rising production costs, taxes of that level make it pretty hard to make a profit on new investments … //

… Kudos to Exxon:

Exxon’s share price barely moved on the news, but that belies its importance. Sure, US$3.2 billion represents less than 1% of Exxon’s market cap, and any cash flows from potential discoveries are years away. But exploring for oil is a long-term game, especially when a company is looking for the next Big One. Just as importantly, the deal validates Exxon as an industry-leading operator when it comes to massive, technically challenging projects.

And it shows that Exxon has proven it has what it takes to operate in Russia and partner with a state-owned company. Exxon has already been working with Rosneft for 15 years on the major Sakhalin-1 offshore project in Russia’s far east. The partners have put two fields at Sakhalin-1 into production since 2005; the operation now produces more than 250,000 barrels of oil and 140 million cubic feet of natural gas per day.

As an interesting side story, the need to negotiate a new deal may have pushed Exxon and Rosneft to agree on a long-standing issue at Sakhalin-1. For years, the partners have been at odds over how to develop one of their other huge resources: the Chayvo field, which contains 17 trillion cubic feet of natural gas. Exxon has always wanted to sell the gas directly to China, which conflicts with Gazprom’s desire to control all of the gas from the Sakhalin projects (there are others, including Sakhalin-2, which was majority owned by Royal Dutch Shell until the Kremlin forced Royal Dutch to sell half its stake to Gazprom – a less successful Russian gamble). In June, Gazprom said it expects to reach an agreement with Exxon on Sakhalin-1 by the end of the year… a deal that we can be sure Exxon ironed out ahead of signing its new deal with Rosneft.

Exxon’s agreements with Rosneft share one key trait: Neither involves Exxon taking a stake in its Russian partner, a situation that invites trouble when the shared projects are in Russia. And Exxon added another layer of protection in its new Rosneft deal – by inviting Rosneft to take stakes in US projects, Exxon bought itself some extra insurance against political meddling down the road, as Rosneft will too have something big at stake.

So Exxon and Rosneft have found themselves able to work together, which in itself is significant. And they share a common goal – the desire to use new technologies to unlock massive new offshore reserves. It is hard – given Russia’s history of changing the rules to suit its needs – not to wonder whether Exxon has signed a deal with the devil. But for now let’s focus on the fundamentals: The buy-in is cheap (relative to Exxon’s bank account), and the potential pay-out is enormous. On top of that, the Russian oil industry (in cahoots with the Kremlin) essentially plays by whatever rules ensure they win the game. From that perspective, Exxon’s best bet is to put itself on their team … (full text).

Link for a Book-Review: Jeremy Rifkin, The Third Industrial Revolution, Toward A New Economic Paradigm (EXCERPT), Sept. 25, 2011.

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