1999: Looking back and looking ahead

by Jennifer DeLay

The oil and gas sector in the former Soviet Union (FSU) experienced a significant amount of change and turmoil last year.
This column will take a brief look at several of the most consequential events and attempt to assess the impact of each development.

Up-and-Down Markets
Movement on world crude markets was a major factor on the oil scene in the FSU last year. Early in the year, when oil was being listed for $ 11 per barrel or less, energy executives began to worry about the twin issues of feasibility and profitability. Development of deposits in the Caspian Sea basin, for example, could hardly proceed with oil listed at $ 11 per barrel since production costs alone (to say nothing of transport costs in a region notoriously short on pipelines) amounted to $ 12 per barrel. Efforts to develop huge oil fields in the more remote regions of Russia also looked set to run into trouble.
The Russian government, meanwhile, had to confront another problem. Revenue from oil exports usually accounts for about 25% of Moscow's budget receipts each. This means, of course, that when world oil prices fall, Russian oil companies have less money to give the Kremlin and more incentive to withhold the money they do have.
The situation began to improve in the second quarter of the year, after Russia joined with the Organisation of Petroleum Exporting Companies (OPEC) in an effort to raise world oil prices by restricting exports. Since then, the oil market has not only rebounded but skyrocketed. Crude prices are now easily twice as high and more as they were a year ago. The increases have made development projects in the Caspian and other isolated areas -- and associated pipeline-building projects -- look feasible again, and Russian government officials are surely heaving a sigh of relief at the prospect of increased revenues.
Yet it is likely that the memory of last year's pain will linger for a while -- even if OPEC and other oil producers are somehow able to sustain the current high prices. The Russian government will probably continue pressing oil companies to do better about making budget payments, even though the market upswing gives it, to some extent, a cushion.
Meanwhile, both FSU producers and their foreign partners are likely to continue placing as great an emphasis on cost-cutting as they have over the last year. (Who likes to spend more money when he can get away with spending less?) Moreover, a series of high-profile mergers have helped remind oil executives everywhere about the importance of economy and streamlining. Companies have to be able to compete with huge multinationals such as BP-Amoco, Total-Fina and Mobil-Exxon, which are capable of working around the globe at relatively less expense. (Incidentally, all three of the super-companies listed above are working in several regions of the FSU.)

Consolidation in Russia?
The Russian oil sector, meanwhile, seems to be following its own bumpy course with regard to mergers and consolidation. The trouble is that it's not exactly clear where this path might be leading.
On one front, Kremlin officials have sparred all year over the issue of whether to set up a state-controlled oil holding by merging the government's shares in Rosneft, Slavneft and Onako. The idea was first put forward by Vladimir Bulgak, who served as first deputy premier in the government of Yevgeny Primakov. The next government, headed by Sergei Stepashin and installed in the spring of 1999, reacted with less enthusiasm -- and more ambiguity. Some officials said they backed the plan, and others derided it. A few high-ranking officials took a more, shall we say, balanced approach, alternating expressions of support with thoughtful comments about the difficulty of such an undertaking.
The government of Stepashin's successor Vladimir Putin has followed the same tack. Certainly, it is still hard to tell whether First Deputy Prime Minister Nikolai Aksyonenko or Fuel and Energy Minister Viktor Kalyuzhny back plans for the merger or not; both have contradicted themselves and each other on this issue. This confusion looks set to continue now that Putin has taken over (for the time being, at least) as Russian president. On December 29, just before Boris Yeltsin's surprise resignation, Aksyonenko said that he didn't back plans for creation of a national oil company at present. Putin had said just a month previously that the Kremlin was not ready to give up on the idea.
On another front, two of Russia's largest privately-controlled oil holdings -- Sidanko and Tyumenneft (TNK) -- have found themselves at odds over the issue of consolidation. A number of industry observers believe that TNK, or its allies, used less than honourable methods to force Sidanko and several of its subsidiaries into bankruptcy court. These charges look more credible when one considers the fact that TNK's head Semyon Kukes repeatedly and openly expressed his company's eagerness to acquire bits and pieces of Sidanko -- especially the juicy parts, such as the Chernogorneft production unit.
TNK did acquire Kondpetroleum, another Sidanko unit, without too much fuss last October. But the auction of Chernogorneft provoked the wrath of BP-Amoco, which owns 10% of Sidanko. The multinational's managers, already appalled by the swift decline in value of their Russian investment, reacted with fury to the decision to detach Chernogorneft from Sidanko. They also waxed indignant at the Kremlin's apparent indifference to that decision, despite earlier statements urging that the Sidanko holding be maintained intact. After a considerable amount of wrangling, TNK -- perhaps influenced by the U.S. Export-Import Bank's decision, amid a certain amount of lobbying by BP-Amoco, to block release of a $ 500 million credit -- agreed last month to let Sidanko have Chernogorneft back.
Nevertheless, it appears that some consolidation is still in order. Under the new agreement, TNK is to keep Kondpetroleum. Its major shareholders will also acquire a blocking stake of 25% plus one share in Sidanko. Meanwhile, Sidanko and TNK have agreed to consider proposals for joint management of the Samotlor field, where both Chernogorneft and TNK's subsidiary Samotlorneftegaz are working. If, after all of this squabbling, these two companies (and their shareholders) find a way to act as a team without going to the trouble of actually merging, they may set an example in 2000 for other companies whose spheres of interest overlap.
LUKoil, meanwhile, offers another (and less noisy) model of consolidation among producers with overlapping interests. In the summer of 1999, it mounted a successful take-over of Komitek. The merger secures LUKoil's place as Russia's top oil producer and will also give the company a leg up in efforts to develop the rich deposits of the Timan-Pechora province.

Running on Empty
Another significant trend in 1999 was one of fuel shortages. In the beginning of the year, many far-flung regions of Russia were suffering because they lacked the fuel oil, natural gas or coal needed to keep powerplants running through the last months of winter. Several months later, St Petersburg consumers began complaining of gasoline shortages. Soon afterwards, reserves of motor fuel in other Russian regions began dwindling. Ukraine, Belarus, Kyrgyzstan and other areas within the CIS that depend on Russian fuel also experienced shortfalls. Gasoline and diesel prices shot up in affected areas and remained on an upward trend for months, finally levelling off in the last quarter of the year. Then, as winter approached once more, power plant managers began complaining once again of fuel shortages.
Some (perhaps most) of these shortfalls stem from movements on the world oil market. Once prices for crude and refined fuels began rising in the second quarter of 1999, oil producers had more incentive to export. Moreover, they had far less incentive to keep delivering their products to the Russian market, where buyers seldom paid in full, on time or in cash. (Non-payments also remained a problem for Gazprom, which as a natural gas exporter was less affected by the upswing in world oil prices.)
It is all too possible the shortages will recur in some fashion this year. First, oil prices are expected to remain high (for a while, at least) -- meaning that oil and fuel producers would still rather export than sell on the local market. Second, the governments of Russia and other states have displayed a penchant for dealing with shortages through administrative measures rather than allowing artificially low domestic prices to rise to world levels. Third, the non-payment problem, which led Gazprom and suppliers of other fuels to curtail deliveries to some customers, has not been corrected.
Fourth, the governments of the FSU have yet to address seriously certain problems of distribution. World oil prices are not the only reason why delivery of fuel to certain parts of the FSU is an unprofitable business. It is, quite simply, a difficult and expensive affair to deliver oil or gas or diesel -- or any other type of good -- to far-flung northern outposts such as Chukotka or inconveniently located cities such as Almaty, which is uncomfortably far from fuel supply pipelines for a national capital. Problems of distribution will not in and of themselves create shortages -- after all, CIS governments do strive to ensure that even the most isolated communities survive the winter -- but they will continue to exacerbate them.

A Different Kind of Distribution Problem
Meanwhile, all of the players in the Caspian Sea basin have had to adjust their calculations in recent months to take into account a most significant development: the signing of a set of accords on construction of the Baku-Ceyhan main export pipeline (MEP). The agreements were concluded in mid-November as the Organisation for Security and Cooperation in Europe (OSCE) met in Turkey's largest city, Istanbul.
On the one hand, the signing seems to indicate that some of the major diplomatic players in the region -- mainly, the United States and Turkey -- have been able to convince oil companies of the need to rally behind this costly and controversial pipeline route, as opposed to shorter, possibly less expensive routes from Baku to Supsa or through Iran. On the other hand, transit states such as Georgia have indicated dissatisfaction with certain provisions of the agreement, while neither Azerbaijan nor Kazakhstan can commit to providing the pipeline with sufficient throughput.
But if Baku-Ceyhan falls apart, so do other things. For example, it would probably be harder and more costly for Turkmenistan to build the trans-Caspian pipeline (TCP), which is designed in large part to follow the Baku-Ceyhan route, if there were no Baku-Ceyhan pipeline. And if there is no Baku-Ceyhan pipeline, the parties will have to start talking all over again about other MEP routes -- which will only lead to more wrangling. Washington won't want a pipeline through Iran. Turkey won't want a pipeline to Supsa or other Black Sea ports. Azerbaijan won't want a pipeline through Russia. The Chechenswon't want a pipeline through Dagestan. And so on.
And even if all these parties are somehow able to resolve their differences on the MEP issue, there are still questions of gas with which to contend. Turkmenistan hopes to export gas, which it possesses in huge quantities, to Turkey via the TCP and perhaps beyond Turkey to Europe. Azerbaijan also hopes to use the TCP to export gas from its own fields, which are apparently quite rich, to Turkey and maybe Europe as well. Iran hopes Turkey will opt for the Eastern Anatolia pipeline. Russia, meanwhile, is rooting for the home team -- Gazprom, which is already a major player on the Turkish and European markets. With regard to Turkey, Gazprom, with its near-monopoly on the world's largest gas reserves, hopes to complete Blue Stream, a new underwater pipeline from Dzhugba to Samsun, by the end of next year. Company managers are already talking about building another such pipeline, parallel to the first. With regard to Europe, Gazprom is building the Yamal pipeline, a high-capacity conduit that will run to the Polish-German border, and signing plenty of contracts.
All this means that wrangling over pipelines looks set to continue in 2000. There are still wrinkles to be ironed out in Baku-Ceyhan and related projects, and competition for the Turkish gas market is shaping up to be fierce -- even though none of these ambitious pipeline projects has been completed yet.
There is also the conflict in the northern Caucasus to consider. It remains to be seen how the Russian government's new war in Chechnya and the effort to construct a bypass pipeline through Dagestan will affect the Kremlin's stance on Caspian oil and gas transport issues.

Conclusion
The FSU oil and gas sector experienced some significant shifts last year. Movements on the world oil market have had an impact on companies' ideas about budgeting and sales. Major pipeline accords have been signed. Movements toward consolidation of the Russian oil sector have sparked some controversy. Yet many of the old problems remain. Producer states and investors still don't have quite enough infrastructure to export their output efficiently. Oil-producing regions are still wracked by political conflicts. Government policy at times seems reminiscent of the Soviet era or designed to obstruct investment. For the next few months, the main question may be what will change and what will stay the same now that Russia, with its huge oil and gas reserves and not inconsiderable diplomatic leverage, has seen its long-time leader, Boris Yeltsin, leave the scene.