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Financial Times: Oil and gas: Long on resources but short on clear rules

By Arkady Ostrovsky

Published: October 10 2006 11:17 | Last updated: October 10 2006 11:17

For a country which considers itself an energy superpower and which put energy security at the top of the agenda for its presidency of the G8 club of rich industrialised nations, Russia finds itself in a peculiar position.

It has the world’s largest reserves of natural gas, but its own industry is suffering from gas shortages. As the world’s second largest oil producer, it has benefited tremendously from high oil prices, yet its oil industry is barely growing.

The oil and gas sector has been the backbone of Russia’s economic revival over the past eight years. The first years of Vladimir Putin’s presidency were marked by rapid acceleration of oil production and investment, mainly by private companies. But over the past two years, the growth of oil production has slowed down and the industry has failed to keep pace with the country’s economic growth.

Analysts say this is the direct result of state interference in the energy sector. While few observers argue with the right of the state to play a more important role in oil and gas – just as most other countries do – a lack of clarity and transparency undermines the investment climate.

Establishing state control over Russia’s energy sector has been one of the main priorities for Mr Putin. The oil industry, largely privatised in the 1990s, is once again dominated by state companies which, together with Kremlin-friendly groups, control more than half of all oil production. This share is likely to grow.

Rosneft, which received the main production capability of the Yukos oil company in a controversial and opaque auction, is now eyeing the rest of the group. Gazprom, which had already swallowed Sibneft, another private oil company, is interested in buying the Russian share in TNK-BP, the Anglo-Russian joint venture.

But as the Kremlin tightened its grip on the oil and gas sectors, oil production growth slowed to two per cent a year, down from an average of nine per cent in the early 2000s, and gas production by Gazprom failed to grow.

“Russia has a lot of oil and gas in the ground, but it stays in the ground because of politics and the lack of clear and transparent rules on investment,” says Christopher Weafer, chief strategist at Alfa Bank.

Over the past few years Russia has not awarded any significant new licences. “Before handing out the licences, the Kremlin wanted to establish its national champions which would automatically qualify for these licences,” says Mr Weafer.

Gazprom has repeatedly delayed the development of the giant Shtokman project in the Barents Sea, which is supposed to deliver liquefied natural gas to the US. It has also put off other projects, including in the Arctic north, despite growing demand for gas both domestically and internationally.

German Gref, Russia’s minister for economic development and trade, says several industrial projects have been put on hold because of the shortage of gas. Gazprom argues that the best way to address gas shortages at home is to raise prices for industrial consumers which would make them use other sources of fuel such as coal and fuel oil. But at the same time it wants to preserve its monopoly control of the pipeline network – which prevents independent producers, including oil companies, investing in gas production.

Mr Weafer points to several other constraints. Russia has promised – and not delivered – new rules on taxation of oil companies which should differentiate between new and old fields and create tax incentives for developing new provinces in Eastern Siberia.

Instead of clarifying the rules, Russia’s ministry of natural resources, responsible for awarding licences, has made threatening statements which alarm or confuse investors. Russia’s laws remain open to inter­pretation by state bureaucrats who often act in the interest of state companies.

A recent crackdown on the Shell-led Sakhalin 2 project and a threat to revoke a TNK-BP licence to develop the giant Kovykta gas field in eastern Siberia are the latest examples of Russia’s cavalier attitude to the rights of foreign investors. The Ministry of Natural Resources has accused Royal Dutch/Shell, which owns a 55 per cent stake in Sakhalin 2, of causing enormous environmental damage and threatened to suspend an environmental permit issued three years ago.

But the real reason for the attack on Shell, Russian politicians admit, has more to do with the rising cost of the project which is being developed under a production-sharing agreement. Shell announced a doubling of the cost of the project to $20bn, which would delay the moment Russia starts receiving money from the project. The increase has already soured a deal between Shell and Gazprom to swap assets so that Russia’s gas monopoly would get a 25 per cent share of Sakhalin 2 in exchange for giving Shell a 50 per cent stake in a Siberian field.

Russia refuses to agree the cost rise and, says Shell, has instead changed the terms of the production-sharing agreement. Most observers say Russia has a legitimate cause for complaint, but using environmental issues as a pretext undermines its credibility.

“Russia’s approach to its strategic resources can appear sometimes to western eyes either as clumsy or as possibly overturning past undertakings,” Roger Munnings, chairman of KPMG’s global energy and natural resources unit, told a conference.

The ministry of natural resources’ threat over TNK-BP’s Kovykta development licence is seen as a hardball negotiating tactic, and was quickly followed by Gazprom expressing its interest in buying a stake in TNK-BP.

But Russia desperately needs foreign money and expertise to develop its vast reserves if it is to remain an important energy player. Foreign companies also need access to Russian reserves, but not at any cost.

“[In strategic sectors] we really need some clarity about how much foreign investment is welcome, what type of foreign investment is welcome,” says Mr Munnings. “At this moment in time it seems to be unclear.”

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