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Russian Oil Companies Push East for New Growth

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VANKOR, Russia May 16, 2007 (Dow Jones Newswires)

Russia is scrambling to unlock the vast oil wealth of East Siberia to keep crude output in the world's largest oil producer from falling. But to succeed, Russian companies will need deep pockets.

High oil prices have helped Russian oil companies post record profits in recent quarters. Yet as output growth from Russia's main oilfields in western Siberia begins to slow, the country's oil giants are pushing eastward to tap new resources that sit under some of the world's most forbidding terrain. Without new production in regions like East Siberia, crude output in Russia, the world's second-biggest oil exporter after Saudi Arabia, will flatten or decline, industry observers say. Although Russia is the world's largest crude producer, at 9.79 million barrels a day, much of its output goes to meet domestic demand.

"It's difficult to overestimate the importance of East Siberia for our company, for the future of Russian oil," says Mikhail Stavsky, vice president for production of Russia's biggest oil producer, state-controlled OAO Rosneft (ROSN.RS). "But when you fly over this region, you see that the geography is much more difficult than where we work today. Clearly, this is going to require a lot of money."

Oil output growth in Russia has slowed in recent years from double-digit expansion in 2003 to just 2% last year. During the boom, growth came from reinvigorating oil regions, primarily in West Siberia, first developed in the Soviet era. Future growth, from new projects in places like Russia's untamed east, will have much higher startup costs.

East Siberia lies north of Mongolia. The region is bordered by Russia's Pacific coastal area, beyond which sits the oil-rich Sakhalin Island to the north of Japan, where Royal Dutch Shell PLC (RDSA) and Exxon Mobil Corp. (XOM) have large operations.

Almost as large as the continental U.S., East Siberia has few roads or powerlines. Temperatures can plummet to -60C (-76F). A proposed oil pipeline linking the region to East Asian markets will be longer than the distance from New York to Los Angeles, and the cost of the project is spiraling.

"We're working under the assumption that it's going to be two or three times more expensive to develop fields in East Siberia than in West Siberia," says Matt Thomas, an analyst at Morgan Stanley.

Total capital spending in East Siberia will be about $20 billion to $25 billion just through 2010, according to an estimate by Moscow's Alfa Bank, up from about $2 billion in 2006.

Exactly how much oil can be pumped from the frozen East Siberian ground remains uncertain, but volumes could be enormous.

East Siberia's proven crude amounts to about 7 billion barrels, according to a recent estimate by Anglo-Russian oil company TNK-BP Holdings (TNBP.RS), 50%-owned by BP PLC (BP). Less than 5% of the oil-producing zones have been explored, however, meaning proven crude could reach 75 billion barrels, according to TNK-BP.

Should it prove accurate, that would mean the region holds reserves on par with estimates for the proven reserves of the entire country, or more than a quarter those of Saudi Arabia.

Russia's Ministry of Natural Resources estimates the region may hold 110 billion barrels of oil, although that figure is classified as speculative according to Russian reserves standards, which differ from Western measures as they were devised during the Soviet era and don't account for the cost of production or oil's market value.

"It's possible that there are fields here like the fields of West Siberia," says Alexander Nazarenko, chief engineer at Rosneft's flagship East Siberian project, Vankor, "but we have to find them."

Russian officials are pushing companies to look harder. Russia's Minister of Natural Resources Yuri Trutnev is calling for a dramatic increase in exploratory work in East Siberia, saying if more reserves aren't booked the region's output may peak at a mere 25 million metric tons a year, or 500,000 barrels of oil a day. Marginal volumes are produced in the region right now and current rates of exploration "will hardly ensure quick oil reserves replacement," Trutnev says.

Stavsky, Rosneft's vice president, disagrees. "Twenty-five million tons is a very pessimistic outlook," he says.

Some observers argue that the development of East Siberia will require foreign capital, although Russia has made it more difficult for foreign players to gain access to significant reserves in recent years.

"There is at least a question mark over whether state companies have the funds and the expertise" to develop the area, says Roland Nash, head of equity research at Renaissance Capital.

Minister Trutnev recently brushed aside calls to bring foreign oil companies into East Siberia. "We respect foreign investors, but we respect Russian ones more," Trutnev said. "This is a question of strategic resources."

French oil major Total SA (TOT), for example, once held an option for 52% of Vankor but lost it after Rosneft bought the company that had sold Total the option and said it was no longer interested in cooperating with Total on the field. Total went to an international arbitration court in Brussels, but lost the case.

A trip to Vankor, the biggest new oil development in East Siberia targeting 400,000 barrels a day by 2012, demonstrates the challenges. Over 100 kilometers north of the Arctic circle, Vankor is accessible by car only when the roads are frozen. In the summer, the oil men use helicopters. Work stops only when temperatures plunge below -43C (-45F). Significant commercial output is to start in 2008.

The Verkhnechonsk field, majority owned by TNK-BP, aims for 200,000 barrels a day. Surgutneftegaz's (SNGS.RS) smaller Talakan field is expected to peak at 140,000 barrels a day.

Still, Russian state officials question the companies' ability to pump enough crude there to justify a planned 1.6 million-barrel-a-day pipeline to East Asian markets.

A first stage, from Taishet in East Siberia to Skovorodino near the Russian-Chinese border, is scheduled for completion by late 2008, with a capacity of 600,000 barrels a day. The cost of the first stage has ballooned from $6.6 billion to more than $11 billion.

Officials now say this stage will initially need significant amounts of West Siberian crude, and that construction of the second stage, from Skovorodino to Russia's Pacific Coast, won't begin until at least 2014.

The government is hoping to spur companies to develop East Siberia through targeted regional tax holidays, an initiative welcomed by the companies. Yet some argue that Russia's oil industry, caught between new high-cost projects in the East and rising capital expenditures at its older projects, needs far more broad-based tax relief.

Russian crude oil export tariffs are indexed to world oil prices, meaning that the government siphons off 90% of additional revenues when prices rise above $25 a barrel.

In a toughly-worded analysis drawn from examinations of dozens of individual projects, Moscow's Alfa Bank argues that rising costs and high taxes make Russia's entire oil sector long-term unprofitable, and says the government will inevitably have to re-jig the tax regime to favor producers.

Tax holidays in East Siberia make it the only region in Russia where greenfield projects make sense for the oil companies, the bank says.

Nearly all of Russia's big oil and gas companies, including Lukoil Holdings (LKOH.RS), Surgutneftegaz, Gazprom Neft (SIBN.RS), Rosneft and TNK-BP, have already flagged 30% to 50% capital expenditure increases for 2007 due to rising costs on projects throughout Russia.

In early May, Surgutneftegaz's CEO Vladimir Bogdanov announced that the company's future production in West Siberia will be flat, with all its output growth likely to come from East Siberia. The company slashed its output growth forecast to 0.9% for 2007 from an earlier forecast of 7%, and increased its capital spending budget 38%.

"Investors should have the courage to face the truth: the emerging explosion in capital expenditure is not a one-off event but the beginning of a new trend," writes Alfa Bank.

Copyright (c) 2007 Dow Jones & Company, Inc.

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