With the privatization of the oil industry, the decision on whether to spend drilling resources on producing oil or looking for it was taken by the management of the oil companies.

During the past year, a considerable amount of work has been carried out on expanding the capacity of export pipelines.

The increase in Russian oil production is exceeding the predictions of even government and industry officials here, as oil companies look to take advantage of the rising price of petroleum on world markets.

The price of oil, instead of declining -- as Western "experts" had predicted would happen when Iraqi oil flooded the markets – has reached record highs as instability rages in the Middle East and in other key oil countries, such as Nigeria.

Russia produced 38.5 million tons of crude oil and gas condensate in September. That’s a rate of 9.38 million barrels a day and a post-Soviet record for a monthly output. The previously record was set in August, with 9.33 million barrels a day.

Now a key question looms, however: Will Russia be able to put this money to use in building its economy to world standards or will it be gobbled up by oligarchs and taken abroad?

Russian oil-sector planning

During the Soviet era, long-term strategies were drawn up and periodically amended downward. Russian academics are still obsessed with the arcane science of trying to predict 20 years ahead, the only difference being that their forecasts are now periodically amended upward.

The latest long-term strategy was recently reviewed by A.M. Mastepanov of the Russian Academy of Natural Sciences one year after it was approved by the government in May 2003, and he notes that the most optimistic variant of oil production in 2005 was 445 million tons.

If production is maintained at the third-quarter 2004 rate, then 466 million tons will be pumped in 2005. If current rates of growth can be sustained, 475 million tons is feasible, and the long-term strategy target for 2020 of 520 million tons could prove to be on the low side.

This, however, is dependent on the world oil price continuing to exceed $45 a barrel. Nearly all the increase in output is exported, with Russian refinery throughput showing a rise of no more than 1% in January-September over the same nine months of 2003. This is because the domestic demand for oil products is sluggish, partly because the economy, excluding its oil component, is growing slowly, and partly because the growing demand for gasoline and diesel is being met by the increased cracking of fuel oil of which there has been a glut in Russia for the past 50 years.

This process has been foreseen by the long-term energy strategy, which expects refinery throughput to rise from about 200 million tons this year to 235 million tons by 2020. At the same time, the average refining depth is planned to increase from 72% in 2003 to 85% by 2020, which means that the production of light and medium products should rise from about 144 million tons a year to 200 million tons while the production of heavy products should drop from 56 million tons to 35 million tons a year, with fuel oil replaced at power stations by gas and coal. Most of the $12.5 billion of capital investment which the strategy hopes will be directed to oil refineries in 2005-20 will be spent on the installation of modern secondary refining plant such as hydrocrackers.

There should be only a limited demand for new primary refining capacity above the 271 million tons a year of operational capacity at the present time, although some of the larger oil companies anticipate the construction of new refineries in western Russia to add value by exporting products rather than crude oil. The plan for a refinery at the major export terminal of Primorsk is a case in point.

Exports

Russia exported 208.7 million tons of crude oil in 2003, including 186.4 million tons to foreign countries (excluding other CIS states). The long-term strategy expected net exports (taking into account the small but growing imports from Kazakhstan) to rise to 285 million tons a year by 2020, of which sales to foreign customers could exceed 250 million tons a year.

The faster-than-expected growth in output and the lower-than-expected rise in refinery throughput suggest that exports could be substantially higher than expected, especially if some of the more ambitious foreign-financed plans such as the Taishet-Nakhodka pipeline for exports to Japan and the pipeline to Murmansk for exports to the United States materialize. Exports in excess of 300 million tons a year by 2020 do not look unreasonable.

The Russians have been laughing all the way to the bank as the oil price has surged onwards and upwards. Their exports of crude oil earned revenue of $39.7 billion in 2003 and, if exports are sustained at current rates and the oil price averages $45 a barrel in the final quarter of this year, they are looking at revenue of $63 billion for 2004.

It is little wonder that, despite surging imports (up by 25% in January-September over the same period of 2003), Russia’s trade surplus is continuing to soar. It amounted to nearly $75 billion in the first nine months of this year, which compares with just over $43 billion in January-September 2003.

Although the outflow of capital remains a problem, reserves of gold and foreign currency are approaching the $100 billion mark. The week ended Oct. 8 saw an increase of $3 billion, bringing the total to $98.2 billon. All this is thanks to oil exports, although the rising price of gas is also starting to make its contribution to Russia’s increasingly healthy finances.

Blots on the horizon

The big question now is whether all this money is being invested in the Russian economy, and specifically the oil industry, or whether the oligarchs are paying it out in dividends and buying foreign football clubs. Is a huge boom in oil investment making the targets of the long-term energy strategy look unduly modest?

Sadly, it would appear not. There are three potential bottlenecks, in the absence of which oil production could conceivably soar way beyond the all-time record of 552 million tons in 1989 and exceed 600 million tons a year in 2020. These are: the shortage of pipeline capacity, especially on the export routes to the major marine terminals; the failure to boost development drilling; and, above all, the lamentable state of the exploration sector.

Russia, at first sight, is not short of oil. Although reserves are still supposed to be a state secret, and there is much debate about how big they really are, there is no doubt that they are large enough to sustain a considerably higher level of output than the current 460 million tons a year.

The "CIS and East European Energy Databook" estimates proved and probable reserves of oil and condensate at 10.575 billion tons at the beginning of 2004, including 7.616 billion tons in Western Siberia. This compares with 12.14 billion tons at the beginning of 1991, and the post-Soviet experience has been one of almost continuous decline. This is because, under the Soviets, exploration was the responsibility of the state and was funded from the state budget.

With the privatization of the oil industry, the decision whether to spend drilling resources on producing oil or looking for it was taken by the management of the oil companies, for whom exploration was a long-term consideration while production brought short-term gains.

Accordingly, the total exploration drilling footage for oil and gas slumped from a record 6.10 million meters in 1988 to a miserable 1.53 million in 2003. While the oil companies make impressive-sounding announcements of new finds every year, they generally turn out to be outliers of existing fields, or even fields discovered in Soviet times but never confirmed. Every year since 1990, with one exception, has seen new accretions to reserves substantially below production.

The oil oligarchs have gotten rich on oil discovered during the Soviet period, and have not yet grasped the need for exploration work to be massively boosted in the very near future. The Ministry of Natural Resources says that it will be necessary to prove 7.5 billion to 10 billion tons of oil up to A+B+C1 status by 2020 if the long term energy plan is to be fulfilled. That means an average 625 million tons a year. In 2003, however, only 390 million tons were added to A+B+C1 reserves and, with 421 million tons produced, there was a further net decline of 31 million tons in the total.

To be fair, 10.5 billion tons is a lot of oil and a reserves-to-production ratio of 25 is not bad, so there should be no need for panic just yet. However, current oil production is being taken almost exclusively from the easy reservoirs. The share of oil classified by the Russians "as difficult to produce" used to be about 45% of total reserves. Now it exceeds 55% and is gradually increasing, leading to higher costs of producing oil. In other words, the quality of remaining reserves is declining, with a growing share lying at great depths, in remote locations, in difficult geologies, below gas caps or with poor oil quality characteristics.

Drilling

With so much surplus cash at their disposal, and the prospects of making even more if they could only produce more oil, the oil companies should be expected to step up their development drilling rate. The peak footage was reached in 1988 when 37.05 million meters were drilled. By 2001 it had slumped to 10.01 million and in 2003 it fell further to 8.57 million meters. Not only has there been a big fall in the number of rigs operational from 960 in 1989 to 343 in 2003, but productivity has also declined from 36,500 meters per crew in 1988 to 22,686 last year.

With the exception of Surgutneftegaz, which works aging fields with low well yields and which has to increase its footage simply to maintain production, all oil companies have suffered truly dramatic declines in annual footage. Yukos, for example, drilled 4.516 million meters in 1990 and only 1.181 million in 2003. One reason for the decline in drilling is that oil companies are allocating more money on maintaining the quality of existing assets rather than acquiring new ones. During the chaos of the post-Soviet economic collapse, the number of idle wells, mostly awaiting the installation of pumps after the free-flowing period ended, rose from 10,769 in 1990 to 39,899 in 1995, or 27.7% of all development wells.

By 2003, the number had been slashed to 24,403, 16.9% of the total. There has been a vast increase in the amount of money spent on repairing oilfield pipeline networks, thereby cutting oil losses, and in improving water injection systems. A consequence of this policy is that average well yields have risen from 7.8 tons/day in 1995 to 9.22 in 2003. The reduction in idle wells and higher yields from operational wells have played the major role in enabling oil output to rise from 301.2 million tons in 1996 to 421.6 million tons last year. However it can be argued that both these strategies have economic and technical limits, and these limits may not be far away. It is time for the oil companies to start beefing up their drilling capabilities.

Pipeline capacity

The third blot on the horizon is the shortage of pipeline capacity. Although large parts of Russia’s crude oil pipeline network of 48,700 km is underused, the pipelines leading to the marine export terminals are operating at capacity and the railways have assumed an ever-increasing burden of getting oil to the ports.

During the past year, a considerable amount of work has been carried out on expanding the capacity of export pipelines. Obsolete equipment at pumping stations has been replaced, loopings have been built on pipelines and anti-friction additives have been added to the oil. In particular, new capacity has been added to the Baltic Pipeline System, which carries Western Siberian oil to the new oil port of Primorsk on the Gulf of Finland.

This port became operational at the end of 2001, but it now has a capacity of 50 million tons a year and will shortly be expanded to 67 million. There is now some spare capacity in the pipeline system and the President of the state-owned monopoly pipeline company Transneft, Sergei Vainshtok, says that the oil companies will be able to deliver 476 million tons in 2005 including 260 million tons for export pipelines and 216 million tons for pipelines leading to Russian refineries. Transneft say that the capacity of the pipeline network will rise by 16% next year, which compares with the plan increase in oil production of 4.4%.

Russia is also an important exporter of oil products, with 77.4 million tons sold in 2003. It is a stark reminder of the change that has taken place in the Russian economy during the past quarter of a century that the domestic consumption of oil products has more than halved from 250.6 million tons in 1980 to 123 million tons in 2003. Current plans foresee a significant rise in oil product exports with the completion of an important new product pipeline and export terminal.