Friday, April 28, 2006

Russia must change course to maximize her returns

Russia is fortunate to have 5% of the world'’s oil and a third of the world'’s gas. Nevertheless, her future is murky. The market is changing and requires investment and innovation - two areas in which the Russian oil and gas sector has a poor track record. Russia must invest in technology and improve its business environment if she is to maximize her returns.

The demand for oil and gas has never been higher. In spite of oil prices more than doubling in the last three years, demand has risen, not least from the high-growth economies. China continues to grow at around 10% a year and recently overtook the UK to become the fourth largest economy in the world. China is motoring, figuratively and literally, and as Chinese cyclists take to cars the demand for oil will rise yet higher.

As this demand strengthens, supply is tightening. Downstream spare capacity is low and plant has been offline, putting into question the availability of finished products. In addition, at the peak of the "Peak Oil"’ debate, Jeroen Van Der Veer, Chief Executive of Royal Dutch/Shell conceded in the last few weeks that easy oil production may well have reached its maximum.

As well as problems with raw energy supply, there is now a further premium on energy security. Alternatives are being sought not only to overcome the depletion of traditional sources, but to build in protection against political disturbances.

Amid rising demand, tightening supply and the need for increased energy security, there is a dearth of industry talent. The industry has clearly been caught short. Its response is to innovate -– as must Russia if she is to avoid damaging her interests.

Leaders recently concluded at Davos that there is no shortage of energy, albeit that the new sources are unconventional and more costly. The industry is busy gearing up to exploit new sources such as heavy oil, shale oil, tar sands, remote gas and renewables.

The market has shown little hesitation in bearing the cost of innovation and there is major investment already in place. Large capital projects are underway in Canada'’s Alberta tar sands (a large high-security source for North America) and LNG projects are myriad, with new and existing facilities from the Adriatic to Zeebrugge.

These changes increase the likelihood that in the coming years there will be a large, diversified energy market. This market will be built up from multiple alternative sources, fossil and renewable, with greenhouse gas pollution addressed through technology such as carbon capture and storage. A global LNG market will be served by multiple suppliers. Participation in this market will require significant technical capability and a secure business environment.

The levels of investment needed to create and operate within this market will be high and in stark contrast to the levels seen in recent years, especially in Russia. There have been notable exceptions, such as Sakhalin, but in general more investment is needed. There is only so long that the over-engineered, but now old and failing, Russian infrastructure can last -– both oil and gas production fell in Russia during the 1990s, in part through poor reservoir management and poor equipment. Investment is also needed in supporting industries, especially power and transport.

This necessary investment will be helped by the right business environment. It is here where most of the innovation needs to happen. Russia is eroding trust in her ability, or willingness, to supply and thereby helping to stimulate a competitive market better able to supply world demand.

As Russia adjusts her contracts with her CIS customers, her heavy-handed use of the gas supply taps will not be forgotten in Europe. As well as the problems in the Ukraine at the beginning of the year, Georgia's supply problems have also not helped.

Whether the cause is terrorism, political manipulation, contractual dispute or mechanical failure, the West mistrusts the flow of energy from Russia. Europe and America are redoubling their efforts to improve their energy security accordingly. The UK is re-assessing its energy options with renewed concern, revisiting a 2003 white paper on energy security. Europe has already re-focused attention on its LNG plans for the Adriatic in direct response to Russia'’s dispute with the Ukraine. Iran has recently been limiting supplies through the Ukraine to Turkey, adding to the impetus of customers to find alternatives.

LNG and GTL will both play a significant part in this drive for diversification. LNG offers the promise to turn gas into a fungible commodity like oil and to create a significant spot market. Aside from releasing customers from the tyranny of a fixed pipeline, GTL could also make large quantities of stranded gas economic, some estimates of which have been as high as 2,500 TCF, a volume even greater than that of Russia'’s recorded reserves.

The market, however, will not change quickly. LNG requires long-term contracts to support its significant capital cost and new capacity takes time to construct. The development of a spot market must also take place in the gaps between these contracts, which will dominate at least the next decade of development. Then there are technical requirements for LNG at compatible calorific value for gasification, which will limit the effective market capacity in the short term before the appropriate plant is in place.

Alternatives are not straightforward and there is some muddled thinking going on. For all the talk of nuclear power, it can only displace gas used for electricity generation. Nuclear power cannot be used as a petrochemical feedstock, nor can it be fed into domestic boilers or car petrol tanks. The time spent creating a viable alternative hydrogen economy is measured not in years but in decades, assuming the technological hurdles can be overcome.

In short, there is obviously a significant opportunity for Russia to take advantage of higher hydrocarbon costs. She has a wealth of assets and access to technology, both home-grown and from abroad, through existing relationships with the super-majors and service companies.

Russia risks, however, failing to realise her full potential by creating an adverse business environment and being blind to competition from an expanded, diversified energy market. She must act to secure trust, put in place a clear tax regime and act against corruption, or risk diminished future returns by reduced participation in the new energy market.

This opinion piece first appeared in CIS Oil and Gas, April 2006

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