# Russia's Energy Politics: Focusing on New Markets in Asia

Date October 13, 2005 Vladimir IVANOV(Director of Research Institute for Northeast Asia (ERINA)) TANABE Yasuo(Vice-President, RIETI)

## Summary

Energy is one of the potential pillars that the economies of Northeast Asia should cultivate because it is in everybody's interest to enhance energy security, but also to develop very rich resources for energy in Eastern Russia. While Russia's relationships with some of its neighbors and major powers are not ideal today, as far as the country's energy is concerned, the European Union (EU), the United States, China and Japan tend to think of Russia in terms of a long-term partnership. The three main pillars of Russia’s contribution to international stability are (1) anti-terrorism activities, (2) efforts to prevent the proliferation of weapons of mass destruction, and (3) its role as the world’s leading energy supplier.

Russian oil production from the beginning of this decade has been growing quite fast, as have been exports, while Russian domestic demand remains almost flat. Oil exports are primarily to European markets. On the one hand, these exports are a strong revenue generator: US$32 billion from January to June 2005 or 53% of Russia's total export revenue. Yet on the other hand there is a concern among Russian energy planners and government officials that the over-concentration on Europe is not in Russia's long-term development interests. It is the opinion of many economists inside Russia that these significant oil revenues should not be wasted as they present a golden opportunity to solve the problems facing the country, including widespread poverty, low labor productivity and a declining population. Oil revenues recently provided the Russian government with an opportunity to establish the so-called Stabilization Fund. There are some projections that the Russian Stabilization Fund could grow up to US$100 billion in the next three to four years, reaching approximately one-third the size of Russian gold and hard currency reserves. Hence, the Stabilization Fund in addition to gold and hard currency reserves will give the Russian government more confidence in maintaining economic stability.

Strategic diversification in oil and natural gas exports is part of Russia's long-term energy strategy adopted in 2003. The new export plans are not just an attempt to project energy interests to the new areas of resources development and new markets. It can be seen as a genuine reaction to the existing economic conditions on the oil markets in Europe. Russia is trying very hard to reduce its dependence on the transit routes. The relationship with Ukraine as far as natural gas is concerned is thorny, and as far as oil is concerned, Russian oil companies do not want to pay additional fees for transiting oil via the neighboring states to the main European markets. The diversification of markets is important because people believe that Europe is saturated with Russian oil and Russia loses approximately US$1 per barrel through a sort of "European discount." Such losses are significant and estimated to be in the billions of dollars annually. Moreover, Russian oil from Western Siberia is mixed with oil from the Volga area to produce the so-called "Urals" blend, which is priced lower compared with most other oil blends supplied to European markets. So another challenge is to refocus the oil industry in the Urals-Volga area, shifting resources more to processing to make Russian oil exports of higher quality and better priced. New development centers in Eastern Siberia and the Far Eastern region are among the important elements of the Russian long-term energy strategy. Yet, it is going to be very expensive to develop new sources of oil in these new development areas, with current estimates for the next 20 years being above US$40 billion. The cost of the Pacific pipeline system (Eastern Siberia Pacific Ocean (VSTO) pipeline), which is a mega project, would cost about one-third of this investment.

The adopted strategy is to develop the new production centers with the key being a combination of commercial interests, long-term regional development interests, and long-term interests in terms of maintaining the potential of Russia as a major oil producer and supplier. The government believes that to promote the oil and gas industries in Eastern Siberia, the VSTO pipeline project is going to be extremely significant. The pipeline would create certainty for private investors, as well as for government-led companies in terms of investing in exploration and development of the new fields. Without the delivery infrastructure it is very difficult to expect any bold moves on the part of investors.

Russia's energy strategy assumed that oil exports and product exports to European markets will decrease in the next 15 years, with the reduction being accounted for low quality or insufficiently processed oil products. Recently, however, a notion prevailed that about half of the current oil exports should be diverted for deep processing, allowing Russia to enhance its role as the exporter of products. On the other hand, Eastern markets will receive approximately one-third of Russia's entire oil exports, or about 100 million tons a year. Russia has the technical capacity to produce more than 500 Mt of oil a year and there is some debate as to whether this target should be exceeded due to the very strong demand for oil. Much of this demand brings to question the need for new exploration by the oil producing companies. However, the new exploration project is dependent upon the possibility for new delivery systems.

Serving as the backbone of such infrastructures will be the VSTO pipeline. This project aims to (1) lessen export dependence on Europe to avoid unwanted commercial losses, (2) drastically improve the environment for exploration and development in new areas, and (3) contribute to the industrial and social advancement of Russia's eastern regions. The VSTO project is divided into two phases. The first phase (30 million tons a year capacity) is planned to be financed by a US$7 billion fund partially formed and partially raised by Trasneft Company, with the construction of the pipeline’s first stretch and the sea terminal to be completed in 2008. The construction of the second phase (50 million tons a year capacity), supported by the project financing scheme, is estimated to be completed by or after 2011. A branch pipeline to China is likely to follow the beginning of the first phase of the project. Other infrastructural issues related to the VSTO pipeline project involving the oil companies include, (1) Rosneft's decision to construct a feeding pipeline to connect its Vankor fields with Transneft's system, (2) Surgutneftegaz Company that controls the Talakan field in Yakutia announcing plans to build a feeding pipeline connecting it to the VSTO pipeline via the Verkhnechonskoe field, (3) investment by the TNK-BP in developing the Verkhnechonskoe field with 201.6 Mt in reserves, and (4) the Ministry of Natural Resources' publishing a list of 104 blocks to be offered for exploration by private companies. Uncertainties in the development approach include the modifications in the tax legislation for greenfield projects in the new areas, as well as the nature of yet to be amended law on subsoil use, including a provision for comprehensive licensing of the developers. There is an ongoing debate as to whether there is enough oil in Eastern Siberia and the Far Eastern region to operate a pipeline of 80 million tons a year capacity. In a way, the VSTO pipeline being part a strategic decision to lessen Russian export dependency on European market in favor of Asia will receive a significant part of oil for the first phase of the project from Western Siberia. As for Eastern Siberia, the 1.5 billion tons reserves ready for production would provide a production base for the mid-term operation of the pipeline. The plan is to add approximately 1.5 billion tons of new oil reserves in the next 10-15 years, as well as to move the existing reserves from the C2 category to higher categories. The expectation is that the modified law on subsoil use, which is under review currently, as well as the improved tax regime will promote exploration and development of the new fields in Eastern Russia through comprehensive licensing and tax benefits. This means that companies investing in exploration will be permitted to continue to work on the newly discovered reserves without asking the government for a new production license. On the other hand, the chances are high that the amended legislation would refer to "strategic projects," those large fields, which will be licensed only to Russian companies. In addition, although the oil production mostly is in the hands of private companies, the pipelines will remain under the control of the government and companies with a strong government influence, such as Transneft for oil and Gazprom for gas. The government is also set to act on expanding the size and influence of the companies in which government influence is strong, namely Gazprom and Rosneft. As for natural gas, the extracting potential in Eastern Russia is huge. There are four new production centers to be established in eastern areas with significant reserves of natural gas. Those areas include the areas near Krasnoyarsk and Irkutsk, as well as Yakutiya and Sakhalin. It is very important to note that Sakhalin’s position in this list is very prominent, owing to considerable exploration efforts of the last 20-30 years. Moreover, the geographic proximity of Sakhalin to the Asian market is a major advantage for projects there. As far as Krasnoyarsk, Irkutsk and Yakutiya are concerned, the development of natural gas there would depend on the ability of Gazprom to gain access to China's market and to build pipelines to transport gas to domestic users. There are also some over-arching uncertainties concerning the natural gas reserves and markets in Eastern Russia. The future of Kovykta giant gas-and-condensate field outlines a few of these uncertainties. Kovykta gas has a significant component of helium, for example. Helium is a valuable strategic material which at the same time cannot be utilized immediately and must be stored. Yet another concern is how to use the other valuable components for export-oriented gas chemical industry. In the longer term, gas-to–liquid technology could allow production of motor fuels, leading to a very large scale new industry, provided that oil prices stay high and technologies commercialized. Many experts are also concerned that natural gas could somehow come into competition with the coal industry. A lot will depend on the pricing of natural gas, which the internationally will certainly be above US$200 per 1,000 cu. m. of gas.

Not so long ago, looking at pricing forecasts made by ExxonMobil about 5 years ago, many experts were skeptical. ExxonMobil was predicting that around the year 2020 the low limit of the price band for oil would be approximately US$25 per barrel. No one expected that in 2005 some conservative analysts were suggesting that oil prices may go up to US$80 per barrel by 2008, declining to approximately US$60 afterwards. So the new projections for the low limit of the price band are likely to be above US$40 per barrel. This is not just positive news for Russia; it is also very promising environment for investors. In such an environment it is not only profitable to invest in the production of oil and natural gas, but also to develop new sources of energy.

Lastly, there is a very strong interest on the part of China to import significant amounts of electricity from Russia. China is going to add approximately 150 GW of generating capacity in the next 20 years, yet only in hydropower. Even if Russia managed to build 20 GW of generating capacity in the Far East region, that would be just a fraction of the potential Chinese demand.

In conclusion, the supply of energy from Eastern Russia on a large scale, followed by the increasingly efficient utilization of energy inside Russia is important not only for Russia itself but for all of Northeast Asia including Japan, China and the Koreas.

### Questions and Answers

Q: You said that the second phase of the VSTO pipeline would have a capacity of 50 Mt per year, and the first phase only 30 Mt. Is that excess of 20 Mt therefore a direct supply into Skovorodino, or is the first phase to be expanded to 50 Mt as well at that time?

A: Basically the first phase, Taishet-Skovorodino, will be more than doubled before the second phase is complete, so it will be 30 Mt plus 50 Mt to feed the resulting pipeline system of 80 Mt annual capacity. The main pipeline will go to the Pacific coast, being complemented by a branch pipeline to China. It is quite likely that China will build this branch pipeline and Russia will make its operation possible by supplying oil. However, Russian oil companies and Transneft would like to keep the entire system flexible so there are no long-term obligations. If the price is right, if the conditions are appropriate, more oil will flow into China. If not, more oil can be shipped to the Pacific coast. To some extent, this approach can be seen as a marketing device, which responds to commercial interests of oil exporters.

Q: So you are saying that in the first phase 30 Mt would be available to either/or both the Chinese and Pacific markets depending on the commercial conditions?

A: Yes, and also it is important that the sea terminal which will be soon be under construction to be ready by 2008. Some shipments of oil to this terminal will be made by rail from Skovorodino.

Q: So there will be a calculation of transportation cost? There will be an offering price of oil including transportation cost -- at the Pacific coast or at the Chinese border.

A: Yes, currently the estimates for the transport of oil by rail are quite high, approximately US$50 per ton or US$7 per barrel. If the price for oil was as low as it used to be, that would be a money-losing venture. But if oil prices stayed high, even rail would be an efficient way of oil delivery to the markets. Again, the decision is to ship 30 Mt of oil for the first phase of the project from Western Siberia; so for the first phase, oil is already available. This is a kind of strategic reorientation of the Russian oil companies towards Asia at the expense of Europe with the hope of getting better prices both in Asia and probably in Europe.

Q: So you are saying an additional 50 Mt will be prepared and come from Eastern Siberia, which is to be developed?

A: The three companies Rosneft, Surgutneftegaz and TNK-BP will be able to supply this additional oil. Of course, this would not be for at least a decade or two but they probably will be able to supply about 50 Mt of oil from the new sources in Eastern Siberia and Yakutia. In addition, there are good chances for more discoveries and more successful projects in this area.

Q: So when you say two decades, you are referring to the theoretical potential?

A: As far as these three companies are concerned, they have licenses for the fields which already have a known production capacity of 48 Mt of oil.

Q: The investment is made from where, and by whom? Have they not committed themselves yet to the year 2020?

A: Certainly this is not their responsibility to guarantee any oil over such a long span, but it is a very interesting equation. Many experts would be precisely right saying that without confirmed reserves it is too risky to build very expensive delivery infrastructure such as the Pacific pipeline. Other people would say that without building such massive but efficient delivery infrastructures, we cannot simply expect the companies to invest in new projects. So the approach is that the state provides infrastructure, and the oil companies go ahead and take chances as far as the development of new fields is concerned. But again, an available 1.5 billion tons of oil for the next 20 years is not a very reliable resource. This resource alone is not sufficient to justify the construction of the Pacific pipeline. On the other hand, the rate of geological exploration in Eastern Siberia and Yakutia is close to only 10%. For Sakhalin, the rate of exploration is very significant nearing approximately 30% to 40%.

Q: We were talking about the Sakhalin-2 project which was headed by Shell. They have long-term contracts now for LNG with Japanese electricity companies. What would you say for ExxonMobil and the Sakhalin-1 project, because up until now they seem to have had more problems with selling their resources?

A: That is exactly the problem with the Sakhalin-1 project. Not only for ExxonMobil but also for the Russian government because the production sharing agreement is based on the assumption that the project will be comprehensively developed -- not only in terms of oil production but also in terms of natural gas production and exports. Currently, some natural gas will flow to Khabarovskiy Krai. There is a pipeline project that is underway. It is medium-sized pipeline, at approximately 4 billion cu m/year of capacity. Initially, ExxonMobil will sell 1 billion cu m/year, increasing the volumes as the market advances. But the Russian government is working with South Korea and China, and Mr. Yanovsky (chief energy expert from Ministry of Industry and Energy of Russia) recently mentioned at a conference in Irkutsk that there is a draft agreement with the Republic of Korea involving the supply of natural gas via pipeline. The Republic of Korea is the best prepared economy in Northeast Asia for receiving natural gas by pipeline because it already has a very versatile, well-developed, efficient pipeline system in its territory.

In January this year, the Gazprom delegation chaired by Mr. Miller began working with both Koreas to discuss the possibility of building an inland pipeline via North Korea, or the alternative could be building a sub-sea pipeline via China to South Korea. The government is working with China on the same issue: how to ensure a market for gas from Sakhalin. It seems that the Chinese may reciprocate because if they are interested in getting oil or receiving electricity, they would probably respond to some kind of Russian proposal to support natural gas production in Eastern Russia. For Japan, ExxonMobil was planning a gas pipeline to be built either to the Tokyo area or to Niigata. The capacity of this pipeline would be approximately 8 billion cu m a year.

China and Korea are the two likely export destinations. Still, the production of natural gas under the production sharing agreement is important for both ExxonMobil and Russia. Ultimately, the revenues will be dependent on both ExxonMobil's export contracts and Russia's domestic volumes of natural gas consumption.

Q: You talked earlier about the G8 Summit and Russia's expectations for next year. I am wondering whether you could elaborate on that as to what Russia hopes to achieve out of next year's summit.

A: Well, for Russia, access to capital markets, direct investment, and particularly advanced technologies are all very important. Some of the mega offshore projects for oil and natural gas strongly depend on new technologies which Russia does not possess. I believe that those could be some of the potential interests that Russia would demonstrate during the G8 meeting. As far as the United States and Western Europe are concerned, there is evidence that both of these large energy importing entities would like to see Russia as a kind of long-term strategic partner. There were several non-governmental initiatives to network experts in the G8 countries throughout Europe and Japan to get in touch with the issues of the upcoming G8 Summit. Russia would like to use this Summit as an opportunity to present itself not only as a current energy superpower, but as a promising energy supplier in the global markets of the future. As far as Japan and Russia are concerned, they are G8 regional economies located in Northeast Asia. They have specific interests in other geographical areas. It could be very useful if Japan and Russia work together and present some of the issues related to Northeast Asia. Certainly, the European Union is less interested in Eastern Russia, including Sakhalin.

Q: We have been watching Russia-U.S. strategic dialogue since 2002. What route is being taken in terms of real money and real investment?

A: The website for the Russian Center of Strategic Research contains information on the recent expert-level meetings between Russia and the United States. These conferences have been focusing on LNG. Some other meetings were focusing on the taxation frameworks, and other issues. These discussions serve as the channel through which the U.S. government extends its influence and expertise. Furthermore, these discussions provide valuable information and know-how to Russia's energy policy makers.

Q: Concerning the reserves not under production in Eastern Siberia and the "Urals" blend, there was some discussion about production levels and whether they are sustainable. What is your take on this because from your presentation we learned that there is a lot of potential if there is enough investment? Yet, this is what is happening now, so it seems as though there are a lot of "ifs."

A: As far as the reserves additions and production volumes are concerned the situation is very sad. Companies do not invest enough in exploration and attempt to invest only a fraction of what is needed to enlarge the reserves, which are still large by the international standards in terms of reserves/production ratio. Among the problems of the Russian energy sector, energy efficiency and research and development looms large. The government is working on these issues, and legislation has been adopted which will progress and correct the situation. This requires time. However, oil companies will start to think about their own future investing more in exploration. Things may get worse somewhere around 2015. So the hope is that by that time, the private sector will take on more of its own responsibility on this issue.

Q: On the Pacific oil terminal issue again, I understand that even if there are sufficient reserves the costs of delivering that oil to the Pacific terminal or pipeline would be very substantial. In fact, there had been some calculations done by the Petroleum Association of Japan suggesting the costs would be more than double that of oil from alternative sources. If that is right, then there would have to be significant subsidies of that pipeline by the Russian government, either by using its own money or by allowing foreign investment to take on that role. How willing do you think the Russian government is to provide those kinds of subsidies to meet those strategic goals that you were talking about?

A: Well, the Russian government regulates the transportation tariffs for such natural monopolies as Russian railways, as well as Gazprom, United Energy Systems (electricity company) and Transneft. After several years, Transneft was able to increase its transportation tariffs at the rate of inflation. As far as the Pacific pipeline is concerned, Transneft itself is saying that the transportation on this route, until the investments are fully covered, would be double the cost of the Western routes. The good news is that Transneft claims that its oil moving charges are the most competitive in the world. So again, the charge of US$50 per ton by rail, or US$7 per barrel, would still be twice as expensive compared to the western direction. Oil companies will pay this money, reducing their profits. The whole story about the VSTO pipeline project is that it is a commercially viable venture, and does not require any government assistance. But at some points, some measures will have to be taken.

Q: What is the tariff regulation policy for Transneft? Is it a pool system so that cross-subsidies are possible in Transneft in order the Pacific pipeline project to be subsidized by revenues generated from the oil shipments in other parts of Russia?

A: Transneft maintains that other companies, who use existing routes in Western Russia, should pay a little more and help to maintain the VSTO tariffs at a reasonable level.

*This summary was compiled by RIETI Editorial staff.