Russian Oil Giants Battle High Taxes, Lower Output

Home to abundant oil reserves, Russia rarely worried about where the next barrel would come from—until now.

With analysts expecting production to fall this year for the first time in a decade, Russian companies are pushing to find new oil in remote regions such as the Arctic Shelf and East Siberia — but their efforts are hampered by crippling taxes that give the government much of the recent gains from high oil prices.

Oil Barrels
Oil Barrels

The Kremlin is now apparently considering tax cuts aimed at letting companies keep enough of the country's windfall from higher oil prices to invest in exploration—on top of cuts earlier this year that analysts and industry executives said they didn't go far enough.

Russia's oil industry is calling for $16.3 billion in further breaks from next year.

The prospering energy industry in Russia has been crucial to the career of Prime Minister Vladimir Putin, who as president oversaw an eight-year, oil-fueled economic boom which improved the lives of many ordinary Russians and helped restore national self-confidence.

Declining oil production is bad news for a resource-based economy where revenues from the oil industry account for about 25 percent of GDP—and undermines Russia's efforts to position itself as an influential guarantor of global energy supplies, providing as it does some 30 percent of Europe's oil imports.

"The Kremlin was very uncomfortable seeing the declining production curve," said Artyem Konchin, an oil and gas analyst at UnicreditAton. "If the Kremlin wants to position itself as an energy superpower—and a place where reserves are abundant, or at least available—a decline in production is detrimental to this message."

Oil production reached 9.87 million barrels per day last year, a 2.3 percent rise. It is down 0.5 percent in the first eight months of the year. While the Energy Ministry is sticking with its forecast of 1 percent production growth this year, analysts expect production to decline by up to 0.5 percent—its first decline in 10 years—followed by a rebound next year, as the already approved tax cuts take effect.

Older fields— located mainly in western Siberia — are nearing maturity, and there are few huge new developments coming onstream to drive production in the next few years, say analysts. Costly exploration is badly needed in areas such as East Siberia and the Arctic Shelf.

Rosneft—the country's largest oil producer—said last week it would delay the launch of its giant Vankor project and trimmed its production forecasts for the year, further blows to the Ministry's estimates. And according to data from Uralsib bank, Surgutneftegaz and Sibneft—a unit of Gazpromneft—both have seen falling output in recent months, while another big oil concern, Lukoil, is roughly flat.

"I am worried about the projects... You need to invest in them, and for that you have to find cash. To find cash, you have to get it from your own earnings, or debt. And the debt market is very bad right now ... So where exactly are you going to find this cash?" said Victor Mishnyakov, an oil and gas analyst at UralSib bank.

High Taxes, Low Investment Capital

Earlier in the year, the government approved tax breaks for new fields in remote areas, and raised the tax-free threshold to $15 per barrel from $9. The changes—which are estimated to save the industry $5 billion annually—come into effect next year. There is an ongoing debate within the government about going further, with the Finance Ministry urging fiscal restraint and the Economy Ministry pushing for cuts and growth.

In a recent interview in New York, OAO Lukoil deputy vice president Andrei Gaidamaka told The Associated Press that the taxes have a direct impact on their ability to plow money back into new projects. The government at present takes about $70 of the revenue in taxes from every $100 barrel sold, he said. The approved cuts will on their own give Lukoil a further $2 billion-$3 billion in pretax profits annually.

"We are very different from most of our international competitors," he said. "We are way more competitive on the cost side, but we still have lower profitability due to the high tax burden."

The oil windfall tax has served the government well, helping it amass $174 billion in a "rainy-day" fund, split off in February into a reserve fund and a national welfare fund. But with oil prices powering through to unprecedented heights earlier this summer, touching $147 per barrel in July, the energy companies have seen little of the benefits.

The proposed tax cuts are as yet unspecified, but potentially include raising the tax-free threshold from $15 per barrel to $25, said Deputy Energy Minister Stanislav Svetlitsky recently.

A debilitating dispute at Anglo-Russian joint venture TNK-BP, in large part resolved, has also stoked concerns. The company reassigned 148 technical specialists from the country earlier this year amid visa difficulties and litigation.

In July, chief operating officer Tim Summers said the Russian shareholders' desire to cut capital expenditure by $900 million in 2008 could wipe up to 1 million tons to 5 million tons from the company's output over the next 12 months.

Where once it was common practice for Russian investors to whisk cash out of the company via dividends, analysts say that practice is changing in the domestic oil industry, given the massive investment needs.

"If you take money out of the investment cashflow, you will probably face declining production," said Konchin.