Oil Politics Russia

OPR UPDATE: TAX CUTS FOR THE WEARY: GOOD NEWS FOR RUSSIAN OIL OR TOO LITTLE TOO LATE?

2006-04-17T15:15:00.000-05:00

The Russian economics ministry today submitted for government consideration a bill to cut development taxes in key resources. While the measure covers mining, logging, and other earthen riches, it is particularly aimed at the all important and ever aging oil industry.

The bill will introduce tax holidays for companies developing new deposits, and major privileges for those working on depleted deposits, in a bid to avert a medium-term production decline in industries that provide much of Russia's budget revenues, particularly the oil and natural-gas sectors. "The bill has been agreed with all the agencies involved and sent to the government for consideration," a ministry spokesman said.

The reduction in oil and gas production growth from 7 percent per year from 2000 to 2004 to this year's rather anemic 2 percent growth is reflective of a sea-change in the character of Russian production: from the relatively easy oil of the Volga-Ural and West Siberian basin to the much more difficult deposits in Russia's offshore Arctic regions and in East and Far East Siberia. Russian oil and gas revenues account for 25 percent of the Russian federal budget (see page 9 of the Gazprom 2004 Annual Report for a peculiar graphical presentation of the importance of oil and gas to Russian finances).

However, Russia may have waited too long to begin developing the latter this difficult these remote riches. Major oil and gas projects -and the pipelines to serve them- are developing slowly and in need of huge capital outlays. By cutting development taxes, Russia hopes to speed the time to market of these hard to access oil and gas deposits. The oil industry and the federal budget are in a race against time.

OPR UPDATE: QUID PRO QUO ON WTO

2006-04-13T13:18:00.000-05:00

Back finally from a long break, and much indeed has happend. One of the most interesting issues in Russian political economy to track is the ever-evolving relationship between statism and free-markets. The history of Post-Soviet Russia revolves largely around that single theme. From mass-privatization through vouchers, 'Loans for Shares', and the Rubble collapse to the destruction of Yukos and the recentralization of the oil industry, Russia has struggled mightly to figure out what level of state involvement in the economy will provide a stable balance of order and freedom.

An interesting wrinkle on this theme has emerged recently regarding Russian entry into the World Trade Organization that reflects Russia's ambivalent position regarding the importance of free markets. According to this piece in the Moscow Times, a tacit quid pro quo has developed linking U.S. company involvement in the development of the giant Shtokman gas field to progress on a U.S.-Russia WTO deal:

Two sources who spoke to senior Russian officials said the implicit quid pro quo has emerged in the last month. "My discussion with Russian officials has clearly suggested that while there is no formal connection" between WTO accession and participation of U.S. companies in Shtokman, "there is an informal understanding that if Russian membership in WTO is blocked, it would be considerably more difficult for American companies to win participation in Shtokman and other major Russian energy projects," said Dmitry Simes, head of the Nixon Center, a Washington-based think tank.

My sense is that while Russia would prefer to be a member of the WTO, it is not willing to trade too much for the honor. It will also be happy to punish companies from countries unhelpful to its cause. My sense is also that the U.S. is playing politics on this one as well. The Bush administration has been very aggresive in many instances to isolate Moscow (with the notable exception of its soft-pedal on Chechnya), and it may feel that it can leverage concessions in Central Asia by playing hardball on trade.

OPR WEEKLY: 'OPERATION SUCCESSOR'

2006-03-20T07:02:00.000-05:00

With presidential elections in Russia now just two years away, Russian press is rife with speculation about who will take over the presidency from Putin. The press has dubbed the Kremlin’s efforts to promote a likely candidate as ‘Operation Successor’. As I tried to get a take on this political operation of sorts, several key points have become clear.

First, opposition parties seem to have become irrelevant in Russia’s current political landscape. Second, it is almost unanimously believed that Putin will be able to choose his successor. Third, the traditional conflict between Russia’s liberals and hardliners seems to have faded somewhat, and will not be determinative in Putin’s preference for the next president of Russia. Fourth, despite the fascination in both the Russian and international press with the idea that Putin could somehow stay in power after his two terms are up, Putin himself has shown little interest in engineering such an outcome. Fifth, there is nearly as much speculation about what role Putin will play in Russian politics after 2008 as there is speculation about his likely successor. Sixth, Dmitry Medvedev seems most likely at this point to become the next president of Russia.

Opposition parties have become largely irrelevant in the face of Putin’s popularity, and there seems to be little concern that the absence of a vibrant opposition could be detrimental. In local and regional elections last weekend, Putin’s United Russia won 197 out of 359 seats in regional legislatures. The remaining seats were distributed among dozens of small national and regional parties.

Opinion polls similarly indicate that Putin’s United Russia party has few viable rivals. In October 2005 a poll showed that of the 37 parties registered in Moscow, only 17 will run in the next Duma elections, set to take place in December 2007. However, only five of them have a real chance to overcome the 10 percent threshold to serve in the body, and it is possible that only three will end up with seats. According to a poll taken last month, if Duma elections were held in February, 47 percent of the country would have supported the United Russia party, 17 percent would have supported the Communist party and just 9 percent would have voted for the conservative Liberal Democratic Party. The nationalist Motherland Party and the liberal Yabloko Party polled just 4 percent each.

The outlook for the opposition in the 2008 presidential election is even bleaker. When queried about their choice for Russia’s next President, 6 percent of respondents said they would vote for Communist Party leader Gennadi Zyuganov, 3 percent for Liberal Democratic Party leader Vladimir Zhirinovsky, 3 percent for former Prime Minister Mikhial Kasyanov, and just 1 percent for Sergei Glaziev from the Motherland Party.

Clearly, Putin’s United Russian party is in a position to retain power in the 2007-2008 federal elections.

Putin is widely, if not unanimously, perceived as Russia’s kingmaker. Putin received over 70 percent of the vote in 2004, and he still enjoys immense popularity. Putin is perceived as a decisive and pragmatic leader –especially in contrast to his predecessor, Boris Yeltsin—and he is credited with improving the nation’s economy while still protecting Russia’s traditional spheres of influence in Central Asia and Eastern Europe. This perception will certainly increase if, as seems likely, the Orange Revolution in Ukraine is overturned this month in federal elections there and the pro-Russian candidate Viktor Yuschenko wins the presidency.

Speculation in Russia is thus not about who will win the presidency, but rather about who Putin will choose as his successor.

The conflict between the liberals and siloviki, while still important, does not, at least yet, seem to be a driving force behind Putin’s choice of a successor. Since his election in 2000, Putin has had to balance two primary forces within the Kremlin, the pro-Western, liberal reformers, who are largely comprised of the nation’s oligarchs and business tycoons, and the siloviki, the nationalist faction made up of military leaders and former KGB. Putin has maintained the peace by drawing both advisors and policies from both camps. Moves toward greater economic participation with the West have satisfied the oligarchs, while policies to counter U.S. influence in Central Asia and an aggressive stance vis-à-vis Chechen militants have mollified the latter.

Putin’s recent appointment of Dmitry Medvedev and Sergei Ivanov as deputy Prime Minters was largely seen as reflective of this balancing act. Ivanov, who retained his post as Defense Minister, gives the siloviki a powerful promoter the government. Medvedev, who retained his chairmanship of state energy giant Gazprom, is a pragmatic reformer along the lines of Putin.

The appointment of the two officials was also believed to reflect Putin’s preference for who might succeed him as president. Neither Medvedev nor Ivanov has a natural political constituency and their appointments are considered ‘trial runs’ at leadership and an opportunity to gain a wider following. The youthful Medvedev (he is only 40 years old) especially has lacked the capacity to gain a public following from his prior position as head of the Presidential administration in the Kremlin. Although prime ministers in Russia are more managers than executives, the two presidential hopefuls will have an opportunity to involve themselves much more extensively in domestic issues than was previously possible.

However, both candidates are pragmatists in their support for the liberals and siloviki. Neither is an ideologue and either would likely be acceptable to liberals and siloviki alike. As long as Ivanov and Medvedev are the presidential front-runners, the schism between the two groups will not be determinative of which receives Putin’s eventual support.

There is very little talk of a constitutional amendment to allow Putin a third term. Putin has said nothing to suggest he supports such a measure. Absent a constitutional amendment, there has been some speculation that a reunification of Russia and Belarus could provide the structural conditions for Putin to assume the presidency of such a new federal structure, although the unification itself seems unlikely, and the terms under which that unification could take place extremely speculative.

While unrelated to the issue of Putin retaining the presidency, there is also interesting speculation that Putin may resign just prior to the December 2007 Duma elections in order to combine the parliamentary elections with the Presidential elections scheduled for March 2008. This would help ensure that United Russia wins both the majority in the Duma and the presidency. The other oft repeated argument for this move is that it would be seen in the West as a boost for democracy in Russia.

The question of what position Putin will have after 2008 is the subject of nearly as intense speculation as the question of who will succeed him. Because the Russian political system –partly as the result of Putin’s own reforms—gives such a preponderance of power to the president, no other political position seems powerful or substantive enough for Putin to assume and retain influence. Putin himself noted at a press conference recently that the post of Prime Minister in Russia is a technical position and should remain that way. He further noted that successful development of Russia’s economy necessitates a dominant executive branch.

While many have speculated that Putin could head Gazprom after he leaves the presidency, this speculation seems more driven by the media’s fascination with both Putin and Russia’s business elites than anything else. Putin himself, trained as a lawyer, says that in neither character nor training does he feel himself to be a businessman.

There has also been some speculation that Putin could head the Russian Supreme Court in order to help bolster legal institutions in the country. While such a position might be a better fit to Putin’s formal education, it is difficult to imagine that heading up the 19 member body would befit someone whose tenure as President has been marked by selective application of the law to achieve political ends (as in the Yukos case, for example).

It seems most likely that whatever position he takes up after 2008 will be one from which he can still exert influence on Russian political and economic development –assuming, that is, that his choice for President is elected and is willing to govern in cooperation with Putin’s powerful influence.

Given all these factors, Dmitry Medvedev seems like the obvious front-runner to succeed Putin. Like Putin, he is an economic liberal with a pragmatic conception of the role of state power in the evolving capitalist landscape in the country. As Chairman of the Board of Gazprom, he has both a clear conception of the importance of the oil and gas sector to the state, and also of the role that the state plays in economic development of the nation. His appointment as first deputy Prime Minister late last year affords him to gain the one thing he is missing –a public and popular persona. The first deputy Prime Minister is in charge of agriculture, education, and social programs, issue which will allow him –given sufficient state support—to become widely recognized as not only an oligarch, but also someone who has a clear sense for the condition and needs of ordinary Russians.

Medvedev also is said to be modest in his aspirations, making it more likely that he would be willing to govern in cooperation with Putin’s continued presence in the Russian political scene. Putin seems to have made the selection of Medvedev more likely by his recent criticism of the military’s failure in several high-profile army hazing cases. These comments make less likely that the other Presidential front-runner, Sergei Ivanov, could gain the popular support necessary to take the presidency.

The first 15 years of Russian democracy have been tumultuous ones, made more placid in the past several years by booming oil revenues. Should those fortunes reverse, either through a collapse in oil prices or a precipitous decline in Russian production, the popularity of Putin and his ability to prosecute ‘Operation Successor’ could diminish as well.

Regardless, the development of Russian capitalism and democracy still faces immense challenges. The next Russian president will face a daunting civil and political landscape. As one Russian commentator recently noted:

People see clearly that they are robbed at privately-owned as well at state enterprises (being underpaid as much as three or four or even five times). They still demand not fair collective agreements and worthy salaries, not improvement of working conditions, but a free ticket, free medicine, cheap gasoline, costless accommodation, a hotel voucher to a sanatorium. Judging by the questions and wishes, put forward by the citizens in spite of almost 15 years of adopting capitalism, we mostly remain ‘Soviet people’ that construe the government as the large ‘Social Provision Department’, and the president as a ‘do-gooder’.

OPR UPDATE: RUSSIA'S 'INALIENABLE RIGHT' TO REGULATE

2006-03-14T18:29:00.000-05:00

Russian Energy and Industry Minister Viktor Khristenko lent an interesting insight yesterday into Moscow's thinking on the role of the state in Russia's energy sector. Responding to U.S. Deputy Energy Secretary David Sampson's contention that the state's hand in the sector was hampering Russian supply growth, Khristenko said:

Market reforms are not an end in themselves, but an instrument to raise the efficient and reliable function of world energy. . . . An inalienable part of that process is the regulatory role of government in . . . eliminating the risks of energy insecurity.

Russia in particular needs both foreign capital and technical assistance to explore and develop frozen reserves in East Siberia and the Arctic. Russia's recentralization of the oil industry, however, isn't helping that cause. There is significant uncertainty in the investment community about just what the 'rules of the game' are for foreigners looking for a piece of Russia's large energy pie.

Russian online news service Kommersant summed up Khristenko's comments at the conference thus:

According to Khristenko, an alternative to competition of energy strategies could be “establishing a global system of power engineering, which will ensure the stream deliveries of energy to the population worldwide at the economically reasonable prices.”

Therefore, Russia’s proposals to the G8 summit could be as follows. Russia doesn’t think it is possible to improve the out-of-balance condition of the energy demand/supply through some private companies. Instead, it calls for introducing regulative actions of the state. The biggest consumers and producers of energy resources are expected to provide the state guarantees to each other concerning coordination of mutual interests. The interests of national companies should be naturally taken into account.

It is hard to fathom what Khristenko might mean by "establishing a global system of power engineering" but I bet it goes over like a lead balloon at the G8.

OPR WEEKLY: STATE RESURGENT: THE RENATIONALIZATION OF RUSSIAN OIL

2006-03-13T07:40:00.000-05:00

While the forced renationalization in December 2004 of Yukos’ Yuganskneftegaz was the loudest (and messiest) of the Kremlin’s push to gain control of Russia’s oil industry, it seems to be part of a still ongoing trend. It will be instructive to review the bidding on just where the renationalization plan stands, and where it may go next.

Following the collapse of the Soviet Union, enterprising and opportunistic oligarchs moved quickly to secure control of Russia’s major oil producers, combining them with the refining assets that had served the companies during the communist era. A cadre of powerful conglomerates took control of the country’s oil exploration and production, including Yukos, Lukoil, Sibneft, Slavneft, Tynumen Oil Company (TNK), Slavneft, Surgutneftegaz, Tatneft, and Bashneft. Only Rosneft remained in the state’s portfolio.

The country’s dominant gas producer, Gazprom, and its pipeline monopoly, Transneft, also remained in state hands. However, it is not surprising that these latter two entities remained in Kremlin control. Two-third’s of Russia’s enormous gas production is used for domestic consumption. In order to manage important subsidies of natural gas to Russian customers during the tumultuous decade after the collapse of the Soviet state, it made good sense for Gazprom to remain an arm of the state. Similarly, given the importance of Russia’s pipeline system for oil and gas exports -and the importance of oil and gas exports to the Russian economy- it made sense to keep Transneft in state control as well.

When the Kremlin moved in late 2003 to dismember Yukos, the consensus view was that it was for political, not economic, reasons. Yukos founder and CEO Mikhail Khodorkovsky had made little secret of his political pretensions and Russian President Vladmir Putin acted swiftly and brutally to quash his would-be rival by levying over $30 billion in back taxes. Khodorkovsky now languishes in a Siberian prison camp, while Yukos’ major production asset, Yuganskneftegaz, auctioned off at price well below its market value, is now owned by state oil firm Rosneft.

Yukos’ remaining production assets have been struggling to cover the rest of the tax burden, and until last week it seemed that the trimmed down company might survive. With its politically dangerous founder in prison, the company appeared to be of little threat to Putin. Last week’s events, however, make clear that the Kremlin won’t rest until the company is fully dismantled. If bankruptcy proceedings against the company commence, it is likely that even more of its assets will end up in state control.

The Kremlin, however, has also moved –albeit more civilly- to control other important oil assets. While the government’s plan at the outset seemed to be to incorporate Yuganskneftegaz into Gazprom, thereby giving the gas behemoth significant pull in the oil industry, the move failed for a variety of political and legal reasons. However, in October 2005 Gazprom purchased Sibneft, Russia’s fifth largest oil producer. Combined with Gazprom’s original oil assets, the purchase turned the gas company into a significant petroleum producer. Between Rosneft (including Yuganskneftegaz) and Gazprom (including Sibneft), the Russian state controls the country’s second and fifth largest oil companies, as well as the 50 percent of Slavneft owned by Sibneft.

Russian Oil Production in January and February 2006 (million tons)
Lukoil	14.318
Rosneft*	12.336
TNK	11.845
Surgutneftegas	10.455
Sibneft*	5.063
Tatneft	4.131
Slavneft	3.869
Yukos	3.458
Gazprom*	2.184
*State owned company

The state, however, may not be stopping there. Rumors have surfaced recently that Rosneft may be eyeing a purchase of Surgutneftegaz, Russia’s fourth largest oil conglomerate. The company has long had close ties with the Kremlin and would integrate relatively easily into state run Rosneft. While Rosneft is cash-strapped following its purchase of Yuganskneftegaz, it is planning later this year to go public in Russia’s largest ever IPO. The offering is expected to garner as much as $17 billion for the company. What better to do with cash on hand than purchase another oil major. The a Rosneft-Surgutneftegaz combination would put the company far ahead of Russia’s current leading producer, Lukoil.

In addition, the Kremlin is also rumored to be interested in taking control of Slavneft and the half of TNK-BP held by Alfa and Access/Renova. While no concrete plans for takeover have surfaced, the prospect is clearly worrying to those who fear increased state dominance over the oil industry. If both of these moves come to pass, the state share of Russian production would be truly immense.

What effect these moves would have on Russian production is unclear, primarily because the future character and stability of the Russian state is unclear. The prospect of Russia wielding its oil power similarly to its wielding of its natural gas power is undoubtedly unsettling to Russia’s primarily European customers. On the other hand, future Russian production may depend on development of risky and expensive projects in East Siberia and the Arctic shelf. To the extent that the state is capable of longer time horizon’s and greater capital commitment to such projects, Russian dominance may turn out to be beneficial in the long run.

Regardless, the coming year will tell us a lot about the future of Russia’s oil industry and thus about the Russian state.

OPR WEEKLY: MUTINY IN MOSCOW

2006-03-11T17:22:00.000-05:00

A strange scene unfolded Friday in the Moscow boardroom of OAO Yukos, once Russia’s mightiest oil conglomerate. Anatoly Nazarov, head of Yukos Refining and Marketing and the most senior manager remaining in Moscow (most of the team is safely ensconced in London), told a stunned management assembly that he was siezing control of the company and would no longer take orders from Yukos CEO Steven Theede.

According to a letter obtained by the Moscow Times, Nazarov told employees that the company was on the verge of bankruptcy, which, of course, came as news to no one. Yukos has been staving off bankruptcy since it was dismembered by the Kremlin in 2004. However, the letter went on to say that the company had been hit by a number of new court cases recently, which showed that “Yukos was constantly under attack by raiders of all flags.” Nazarov urged employees not to forget that “we live and will live in Russia, and should carry out our work only in a legal framework, not forgetting the interests of society, the state and the company.”

While Nazarov failed to elaborate, the cryptic claim concerning foreign flags may have been a reference to a suit filed Friday with the Moscow Arbitration Court by a group of foreign banks to declare Yukos bankrupt. Yukos owes the group of lenders approximately $480 million.

Nazarov’s move came amidst a widening company investigation in which Stanislav Vinokurov, head of Yukos’ domestic sales and financial arm, Yukos Trading House, was fired on suspicion of arranging unauthorized discounted sales to an unnamed third-party trader. The sales reportedly cost the company $50 to $100 million. When Theede directed Nazarov to appoint a Theede loyalist, Roman Khomenko, as the new head of Yukos Trading House, Nazarov refused. Instead, Nazarov rehired Vinokurov, promoted him to first Vice-President, and staged his mutiny.

But it gets worse. Khomenko on Thrusday was being questioned by Russian prosecutors as part of a “widening criminal investigation” about which no details are available. Yukos Chief Financial Officer Frank Rieger, currently in London, was issued a similar summons last week but is afraid that a trip to Moscow may lead to his arrest. A company source said Vinokurov's father was a senior Federal Security Service officer in Samara, and suggested Nazarov was trying to gain protection from the FSB in return for reinstating Vinokurov. Several other Moscow based managers have been issues summonses as well.

Yukos said that company management is reviewing the situation and will make a final decision soon on how to handle it. Yukos’ website makes no mention of the affair, but a webpage on company management updated last week bears an ominous message. “Under Construction.”

OPR UPDATE: DEATH AND TAXES IN RUSSIA, OR, 'ARE YOU CERAIOUS?'

2006-03-08T07:52:00.000-05:00

Cambridge Energy Research Associates (CERA) is well known for its optimistic production and reserve assessments. So what do they make of the decline in Russian production growth from the 8.5 percent mark achieved from 2000 to 2004 to last year’s 2.5 percent growth? They attribute the slowdown to the demise of Yukos, the “forced sale” of Sibneft to Gazprom, and high taxes on Russian production.

Konstantin Kovalenko, a research associate in CERA’s Moscow office told Petroleum Economist this week that between 1998 and 2004 Yukos and Sibneft output increased by 92 percent and 96.5 percent respectively. Following the forced transfer of Yukos main production asset Yuganskneftegaz to state owned-Rosneft and the purchase of Sibneft by state owned Gazprom, production the two companies’ output declines contributed 55 percent to the overall drop in Russian production growth. In Sibneft’s case, once the state’s purchase plan became clear, Sibneft cut back on investment in new fields and withdrew large amounts of money in dividends.

The other primary cause for Russian production growth declines is the steep tax scheme levied on Russian production. The Russian state takes a cut of about 50 percent in production and export taxes on revenues above $25 per barrel. However, the rate rises to two-thirds when the price hits $50 per barrel. According to Kovalenko, “90 percent of everything above $25 per barrel goes to the government.”

While the investment climate and taxes can no doubt did have a significant effect on production, the CERA analysis (at least as described in the Petroleum Economist article) doesn’t quite tell a complete story. Left unclear is whether or not Yuganskneftegaz’s production actually fell, or was simply transferred to Rosneft’s ledger. To the extent that the latter is the case, the dissolution of Yukos would not explain Russian decline.

As far as taxes go, the explanation makes sense only if the tax rate was revised upward to the current high levels in 2004; otherwise the taxes themselves wouldn’t explain the decline. Some other variable must be at work to explain the change.

All this is not to say, however, that Russia wouldn’t do itself a huge favor by ceasing its predatory accumulation Russian oil assets and revising taxes to make production more lucrative. Death and taxes may be certain, but they are no friend to production growth.

OPR UPDATE: RUSSIAN PRODUCTION IN DIRE STRAITS?

2006-03-07T19:37:00.000-05:00

An interesting article appeared on Kommersant yesterday. Apparently Russia’s Natural Resources Ministry has submitted a draft strategy on development of oil and gas reserves under the Russian continental shelf. The area under consideration is primarly north of the Russian mainland in the Barents and Kara Seas.

The plan claims that, given a sufficient boost to investment, the region will yield 250,000 barrels per day of oil by 2010 and 2 million barrels per day by 2020. The shelf, it says, holds over 100 billion barrels of oil and 73 trillion cubic meters of gas.

However, the article goes on to make an interesting claim about the future of Russian production.

[The Natural Resources Ministry] calculated that Russia will practically exhaust reserves of profitable fields on land as early as by 2015. 75 percent of discovered oil and gas deposits are under development and 50 percent of their reserves are already worked out, the ministry claims. Geologists stress that major discoveries are to be expected on the shelf rather than on land.

This paints a stark picture of Russian conventional oil production. While the report might wish to paint a dire picture in order to scare the Russian government into action –the Ministry is seeking €1 billion to kick-start development- the prognosis would have to be near enough to reality to convince the government to allocate funds. Although the largest Russian companies publish reserve estimates, the aggregate number is, alas, a guarded secret known only to the state.

OPR WEEKLY: BITING THE BULLET: A RESEARCH PROGRAM FOR RUSSIAN OIL

2006-03-05T18:46:00.000-05:00

Predictions about the future of Russian oil production abound in uncertainty. The large number of basins and complicated political and economic environment subject 'top-down' depletion models such as Hubbert's to a variety of confounding variables. The best hope for understanding the Russian production landscape thus seems to be a 'bottom-up' model, which considers Russian production field by field and basin by basin.

While this is a daunting task, OPR Weekly posts on Sunday will attempt just that in the comming weeks. OPR Updates during the week will continue to address a variety of topics concerning Russian political economy and oil. Today's post sets out the logic and guiding questions of the 'bottom-up' research program.

METHOD OR MADNESS?

Predictions about oil reserves and production are notoriously difficult to make. A bewildering set of technical, economic, and political variables confront those who attempt such prognostications. Because of these difficulties, some analysts have applied a fairly simple model called “Hubbert Linearization” to gauge a given field or region’s likely production path.

Named for its progenitor, American geophysicist Marion King Hubbert, the model posits that the total amount of oil extracted from a field or region over time will follow a logistic or ‘S’ curve because field discovery is followed by a rapid increase to the maximum rate of production (the top of the ‘S’) before falling rapidly to the point at which oil can no longer be economically extracted. The resultant bell shaped curve is referred to as a Hubbert curve.

The implication of Hubbert’s model is that given past oil production data for a field or region and an accurate estimate of the total quantity of oil in the field or region, one can predict the date of maximum oil production and estimate its likely rate of decline. In 1956 Hubbert famously predicted that U.S. oil production would Peak in 1970, which turned out indeed to be the case.

Current Hubbert modelers, using more refined variants of the original model, have predicted that world oil production will soon peak. In fact, Ken Deffeyes, a retired Princeton geologist and author of an acclaimed book on Peak Oil, claimed last year that Thanksgiving Day of 2005 would be the day that oil tops out. While that prediction turned out not to be true, many believe that world production is now hovering around its plateau.

HUBBERT AND THE RUSSIAN CASE

One of the primary weaknesses of Hubbert models is that they make two key assumptions that are often violated in the real world. First, they assume that the amount of total oil in the world is known, when in fact it is exceedingly difficult to know how much recoverable oil is in a given field, let alone the world writ large. Second, they assume that production levels are not subject to significant social or political interference. While small disruptions in production will not have a significant effect on the overall analysis, larger deviations from the full production assumption can weaken the predictive value of the model.

Recognizing these weaknesses, Jean H. Laherrère, another well known Peak Oil author, described the conditions under which the model will have the most predictive power. A simple Hubbert curve may be ideally applied, he says, only in the following cases:

Where there is a large population of fields, such that the sum of a large number of asymmetrical distributions becomes symmetrical;

Where exploration follows a natural pattern unimpeded by political events or significant economic factors;

Where a single geological domain having a natural distribution of fields is considered.

Where these conditions do not pertain, Laherrère says, the model is limited in its predictive ability.

Even a cursory glance at Laherrère’s conditions should make one skeptical of the model for Russia. While Russia certainly does have a large population of fields, exploration has certainly been subject to the vagaries of Russian political and economic upheaval and it its oil is distributed among a large number of disparate basins with varying geological and climatic challenges. Of all the world’s producers –and let us keep in mind that Russia is the world’s second most prolific—Russia is least amenable to Hubbert’s curve.

So what, then, should the erstwhile Russian modeler do? The only recourse left seems to be an inductive model, taking a look at Russia basin by basin and field by field in order to piece together some semblance of a prognosis. In addition, a better understanding of the political-economic effects on the Russian history of oil will help to understand the future. While this is a daunting task, there seems no other way.

'BOTTOMS UP!'

In the following weeks (months? years?), I will attempt to do this to the extent that data and information are available. At the outset, several key questions appear to be the most relevant guide to such an analysis:

How did the Russia’s primary producing regions achieve their growth and production until the collapse of the Soviet Union? Why did Russian production collapse after during the early to mid 1990s? How did Russian production rebound in the years following collapse?

To what extent is Russia’s primary oil region, the West Siberian basin, depleted? How fast is it declining? Are there any new projects there to make up the decline? Are there significant prospects for enhanced recovery there?

To what extent is the Volga-Ural basin depleted? How fast is it declining? Is there any enhanced recovery production potential there?

What is the potential for Caspian production? Are there any real prospects there for future discoveries? How much production can be expected from projects there already under development?

How much oil has been discovered in East Siberia? How much of East Siberia has been prospected? How difficult and expensive will East Siberian projects be to develop? How long will it take?

What is the potential production from Timan-Pechora and known Barents Sea discoveries? How quickly will it come on line? How likely is it that more oil will be discovered in these and other Arctic regions? Even if it is discovered, can such oil realistically be produced?

What is the potential for future production on Sakhalin Island and in the Far East? Has the Eastern shelf been fully prospected? If oil is discovered there, is it likely to be commercially viable?

These questions will guide my research in the coming weeks. While definitive answers would surely be too much to hope for, I suspect that significant insight into the vexing question of Russian production will be gained in due course.

OPR UPDATE: ENVIRONMENTALISM RUSSIAN STYLE

2006-03-01T18:39:00.000-05:00

When at first you don't succeed, rig the vote. That's at least what the Russians decided to do when an ecological commission initially voted down the environmental feasability of the propsed East Siberia-Pacific Ocean pipeline. The proposed path of the pipeline would run within 800 meters of Lake Baikal, a protected area holding a full 2o% of the world's unfrozen fresh water. The story from Russia CIS & Energy Newswire reported it thus:

Most of the experts in a state ecological commission signed a positive conclusion on a feasibility study for the first phase of the Eastern Siberia-Pacific Ocean pipeline at a meeting on February 28, Gennady Chegasov, chairman of a commission working group, told Interfax.

At the same time, Chegasov said that he considers "this decision to be illegal."

"After reaching a negative conclusion, the expert commission was increased by 24 people to 89 people. I do not remember any precedent for this. Yesterday there was a meeting of the expert commission at which permission to speak was given only to eight newly added members, and they were, of course, biased. There was no discussion, they said to sign immediately," Chegasov said.

He said that 24 experts were categorically against the feasibility study for the construction of the Eastern Siberia-Pacific Ocean pipeline.

Among the experts that signed the positive conclusion there are no ecologists, they are all engineers. There was not one seismic expert," he said.

Environmentalists fear that an earthquake could rupture the pipeline sending oil spilling into the lake.

The first stage of the project would build a 2,400-km oil pipeline from Taishet, about 400 miles west of the lake and not far from the central Siberan oil region, to Skovorodino about half way to the Pacific. Oil would then be transferred to rail for the rest of the trip east.

The second phase of the project would kick in as soon as Eastern Siberian oil fields are developed, and involves building the pipeline section from Skovorodino to Perevoznaya Bay. The Russians plan to supply the oil to Japan and possibly to China via a pipeline extension south.

OPR UPDATE: MISSING THE BOAT IN NIGERIA

2006-02-28T12:51:00.000-05:00

This story isn't about Russia, but it's too good to let go by. Apparently Nigeria is looking to China instead of the sluggish U.S. for help in protecting its oil production facilities:

Nigeria is turning to China for military supplies to protect its embattled oil fields, as its vice president says the United States isn't moving fast enough.

In an interview with the Financial Times, Vice President Atiku Abubakar said the U.S. government has offered the Nigerian military technical assistance and training, but has provided only four old coastal patrol boats for use in the oil-rich Niger Delta, where at least 200 are required.

Militant attacks on oil facilities and kidnappings of foreign oil workers this month have shut down one-fifth of oil production in Nigeria, the world's eighth-largest oil exporter.

A senior Nigerian naval official said Nigeria felt let down by the reluctance of the U.S. military to offer more support and that the Chinese boats were a very welcome development.

Why the U.S. didn't move more swiftly and substantively to help protect Nigerian production is beyond me. Why not protect the fields while urging Nigeria to deal more generously with its poverty-stricken populace? China is sure to do the former, without so much as a nod towad the latter . . .

OPR UPDATE: PEAKING (SIC) AT THE NUMBERS . . .

2006-02-27T21:52:00.000-05:00

Russia's Economic and Development and Trade Ministry reported today that Russian oil and gas condensate output was up 2 percent to about 9.4 million barrels per day from January 2005. The fine folks at International Oil Daily give us the breakdown:

Company	Jan '06	% Change
Lukoil	7.533	3
Rosneft	6.482	6
TNK-BP	6.264	3
Surgutneftegaz	5.496	4.9
Sibneft	2.603	-8.4
Tatneft	2.162	-0.1
Slavneft	2.052	3.2
Yukos	1.834	-30.5
Russneft	1.259	59.4
Gazprom	1.1	-0.4
Bashneft	1.006	-1.3

However, compared to December 2005, production was down 2.3 percent, largely explained by the not so balmy weather in Russia last month.

On a warmer note, premliminary figures suggest that Russia's crude and condensate production rose by 2.8% in 2005 to reach 9.44 million barrels per day. Not the heady days of 10 percent per year growth seen in the 1990's, but not indicative of immanent demise either, as some of my Peak Oil friends are prognosticating.

OPR WEEKLY: OIL POLITICS RUSSIA: TAKING ON THE BEAR

2006-02-26T14:00:00.000-05:00

I have decided to change the focus of this blog from international oil politics generally, to a focus on the oil politics of Russia.

While the world is replete with fascinating plots and characters daily unfolding the story of international oil, I have found Russia particularly intriguing. The following, in a nutshell, is why.

THE IMPORTANCE AND COMPLEXITY OF RUSSIAN SUPPLY

Russia is the world’s second largest producer at 9.4 million barrels per day, and by far the largest producer outside of OPEC. However, unlike the Middle Eastern producers, Russian production comes from a geographically dispersed collection of basins. While historically Russian production has come primarily from the Volga-Urals basin and the West Siberian basin, these two regions are mature, with the former in steady decline.

Click to Enlarge

Whether or not Russia can sustain, let alone increase, production will depend on the development of smaller fields in the West Siberian basin and development of a number of new and technically more difficult production environments, including those in northern Siberia (Timan-Pechora), East Siberia, the far east (Sakhalin Island and the Arctic shelf), and the Caspian Sea region. These projects will take not only massive Russian investment, but also foreign technical help.

Russia has already engaged several foreign partners to develop these challenging regions. ConocoPhillips is assisting Lukoil in developing Timan-Pechora, while Shell, ExxonMobil, BP and several Japanese companies are involved with Sakhalin Island development. In addition, the high-water mark for foreign involvment in Russia's oil sector was reached in 2003 when BP was able to arrange the only joint venture in Russia’s oil industry, forming TNK-BP.

However, the extent and success of foreign involvement in Russia’s oil sector is clearly as dependent upon political factors as much as economic rationale. It seems unlikely given recent trends that another joint venture of the TNK-BP sort is in the offing. In general, the investment climate in Russia is still uncertain following the government's destruction of Yukos last year. How Russian companies and their foreign partners will meet the difficult production challenes ahead remains to be seen.

Click to Enlarge

(The full IHS Energy briefing from which these graphs are taken can be found here. See also this excellent analysis on Russian oil Reserves at The Oil Drum.)

THE GEOPOLITICAL IMPORTANCE OF RUSSIA AND THE KREMLIN DIVIDE

Russia’s geopolitical impact on the world is vast and complex. It plays a critical role in the politics of Europe, Central Asia, Asia, and occasionally, still, the Middle East. While Russia has suffered geopolitically since the collapse of the Soviet Union, it continues to struggle to reassert itself as a world power.

However, Kremlin policy makers are divided on the best means for such resurgence. Russia’s economic liberals, including the powerful Russian oligarchs, seek to strengthen Russia through economic development in cooperation with Europe and the U.S., even at the cost of decreased military/territorial prestige.

Opposed to them are the ‘siloviki’, the old-guard KGB/military nationalists, who believe that Russia’s future depends on a reassertion of military power and dominance with regard to the countries on Russia’s periphery, especially Ukraine and the former Soviet states of Central Asia. Russia still maintains a large and sophisticated armed forces and a stockpile of strategic nuclear weapons with which it can effectively project power abroad.

STATE TRANSFORMATION AND THE UNCERTAIN FUTURE OF RUSSIA

Internally, Russia is still in the midst of the largest and most profound state transformation in history. In the 15 years since the collapse of the Soviet Union, Russia has struggled through massive privatization, political devolution, a currency crisis, an economic recovery, and most recently the recentralization of political and economic power.

Despite its recent economic success, Russia still faces daunting internal challenges. Its population is declining rapidly, putting increasing pressure on the social welfare and pension systems in the country. A bungled attempt at social security and pension reform last year sparked Putin’s most serious domestic crisis since taking power. In addition, Russia has also struggled to develop its non-oil economy. While Russian revenues have soared with the price of oil, domestic production has not developed sufficiently to absorb the inflow. The result has been a constant and not always successful battle with inflationary pressures.

THE EVOLVING CHARACTER OF RUSSIA'S OIL INDUSTRY

Russia’s oil and gas industry has undergone a wave of consolidation in the past several years, including the accumulation of production assets under control of the state. In the past year the primary production assets of two of Russia’s largest oil companies –Yukos and Sibneft—have landed in state hands. This has left the country with only 5 private oil conglomerates: Lukoil, Surgutneftegaz, TNK-BP, and two regional (and declining) independents, Bashneft and Tatneft.

The increased concentration of oil assets in state firms Gazprom and Rosneft will likely increase the politicized nature of the industry. This trend was clearly evident in the recent conflict with Ukraine over gas prices. Because large companies often eschew small projects, the overall concentration of oil and gas production may also make it more difficult for Russia to develop the smaller fields in the West Siberian basin, upon which much of Russia’s future production depends.

RUSSIAN ELECTIONS AND POLITICAL CHANGE

Russia is only two years away from a Presidential election in which the Federation will choose its third President. While the Putin administration is credited for making progress with regard to many needed economic reforms, he has also centralized power at the federal level.

Whoever takes the reigns from Putin in 2008 –and there is no heir apparent at this point—will thus inherit a powerful and complex state machine. Putin has worked diligently and skillfully to split the difference between the reformers and the siloviki. Unless an heir of similar talent and mind-set replaces Putin, Russian policy will tilt one way or the other with profound political and economic implications.

CONCLUSION

Because of Russia's complexity and importance -both to the oil and gas markets and to the world generally- it is a state and industry worthy of increased focus and attention. While my knowledge of both Russia and oil are limited, I will count on those of you who stop by to read awhile to carry on the converstation . . .

OPI WEEKLY: REBELS, RHETORIC, AND SECRET REPORTS: THE UNCERTAIN FUTURE OF U.S. ENERGY SECURITY

2006-02-19T20:47:00.000-05:00

Oil markets are set for a rough opening on Monday. Attacks this weekend in Nigeria have seriously curtailed that country’s production and more violence appears in the offing. Two problems closer to home, however, are also threatening U.S. energy security. Recent developments in both Venezuela and Mexico cast doubt on those two countries’ ability to remain steady crude oil suppliers to the U.S. The good news, however, is that Washington may be on the verge of understanding the real problem posed by a world addicted to oil.

‘TOTAL WAR’ IN NIGERIA

Just as the oil market seemed to be shrugging off its fears about Iran, Nigerian unrest has cut the legs out from under world supply. On Friday Nigeria’s Movement for the Emancipation of the Niger Delta (MEND) said that it would begin a ‘total war’ against oil production in the region. The price of oil closed up over $1 on the news. Violence in Nigeria over the previous two weeks had already cut 10% of Nigeria’s production. But then the rebels did something surprising: they made good on their threats. On Saturday rebels attacked Nigeria’s Forcados tanker terminal, one of the country’s largest crude loading platforms, as well as a nearby pipeline. Nine oil workers, including three Americans, were also taken hostage in a separate attack on an oil transport barge.

The damage to its facilities and fear of further violence has led Royal Dutch Shell to suspend exports of 380,000 barrel per day and shut down the 115,000 barrel per day EA oilfield, cutting 21 percent of Nigeria's 2.4 million barrels of daily supply to world markets. A spokesman for MEND said on Saturday that the attacks were a response to military air raids earlier this week and would be followed by another wave of violence “on a grander scale.” Earlier today a man identifying himself as a commander of the movement told reporters by telephone that his group was poised to escalate the violence by firing rockets at crude oil tankers offshore.

While Saudi Arabia announced earlier this month that it would cover any Nigerian losses from its 1.5 million barrels per day in spare capacity, the overture will have little dampening effect on oil prices come trading on Monday. Nigeria’s crude is of the highly valuable light, sweet variety best suited for production of refined products such as gasoline. Saudi spare capacity is in heavy, sour crude, which requires specially tooled refineries to effectively produce high-demand petroleum products. Nigeria supplies over 1 million barrels of crude per day to the U.S. and is its fifth largest foreign supplier.

A LINE IN THE (OIL) SAND

As if that weren’t bad enough, the situation with regard to the United States’ fourth largest foreign supplier, Venezuela, continues to deteriorate as well. Shortly before the Nigerian attacks, Venezuelan President Hugo Chavez claimed (yet again) that he would cut off oil supplies to the U.S. if it “crosses the line.” This time, however, he claimed already to have scouted buyers to take Venezuelan crude in America’s stead, although he demurred when asked for the details. Venezuela exports 1.5 million barrels per day of oil to the U.S., and with 77 billion barrels of conventional reserves and over 200 billion barrels of oil sands reserves, Venezuela has the potential to be a steady, long-term to supplier to the U.S. as world reserves diminish.

Fortunately for the U.S., nearly three-quarters of Venezuela’s crude ends up in the U.S. for good reason. Exports to locations other than the U.S. are problematic for Venezuela because it has no Pacific pipeline route to facilitate exports to Asia. Some crude travels through the Panama Canal, although those shipments are limited because the canal is not large enough to handle conventional crude transport ships. Sending crude eastward to Europe or around the Horn of Africa to Asia is a possibility, but shipping oil such long distances adds significantly to transport costs. Regardless, Chavez’s saber rattling still contributes to the risk premium embedded in world oil prices. Markets like consistency, which is a character trait somewhat less abundant in Venezuela than oil.

COMING OF AGE IN MEXICO

Despite the noisy and potentially serious disruptions in Nigeria and Venezuela, a third recent revelation, this time coming from Mexico, poses a much more serious and endemic problem for U.S. energy security. A secret report by Mexico’s state-owned oil company, Petroleos Mexicanos (Pemex),leaked to the Wall Street Journal, said the country may be facing a steep decline in output that would further tighten its export capacity and further fuel rising prices. Mexico is the U.S. second largest crude oil supplier behind Canada.

The problem in Mexico is easy to identify because 63 percent of Mexico’s oil production comes from a single field, Cantarell, which is the world’s second largest. Within a few years of its discovery in 1976, it was producing over a million barrels a day from only 40 wells. When Cantarell’s production began to decline in the 1990’s, Mexico successfully reversed the trend by injecting 1.2 billion cubic feet per day of high-pressure nitrogen into the field, bringing production up to its ultimate peak of 2.1 million barrels per day.

However, one of the few truisms in oil production is the adage that ‘the faster they rise, the harder they fall.’ According to the Mexican report, declines at Cantarell may indeed be soon and severe. In its worst-case-scenario description, output from the field could fall from its current level near 2 million barrels per day to 875,000 barrels per day by the end of next year and 520,000 barrels per day by the end of 2008. Pemex itself publicly acknowledges a clearly optimistic decline rate of 14 percent per year, which would knock over 500,000 barrels per day off its production total by 2008. Another major contributor to Mexican output, the nearby Abkatun-Pol-Chuch field, is also in decline. It produced 321,000 barrels per day of crude oil in 2004, but has been in steady decline since its peak in 1996.

In Mexico, as in all major oil producing regions, the largest oil fields are drilled first and fast. Once the inevitable production declines in set in, the losses must be made up through the development of a larger number of smaller fields. Lacking the economies of scale characteristic of larger fields, these small projects inevitably entail higher exploration, production, and development costs. Pemex, however, is heavily in debt, making exploration and production investments slow and expensive. Even if Mexico has sufficient resources in the ground to produce --which itself is not a foregone conclusion-- it seems exceedingly unlikely that new fields can come online fast enough to make up for the aging fields’ declines.

FRIENDS DON’T LET FRIENDS CONSUME OIL

While the U.S. has had to deal with declining domestic production of oil for decades, the reality that the world’s oil is quickly depleting while demand is soaring has begun to affect the policy thinking of those once inured to worries about the depletion of fossil fuels. The President himself declared that the U.S. is addicted to oil. That’s a pretty forthright appraisal for a Texas oilman to make; after all, the first step on the road to recovery is admitting you have a problem.

But that’s only half the story. In fact, the world writ large is addicted to oil. Even though the U.S., with just 5 percent of the world’s population, consumes 25 percent of daily crude production, the largest increases in the demand for oil in the coming decades will come from developing nations, such as India and China. A reduction in U.S. demand for oil would simply open the door for increased and lower cost consumption by these economies. The rate of world oil depletion would be slowed little, if at all.

This seems to be the thinking, at least, behind the President’s announcement of the Global Nuclear Energy Program. The program would develop partnerships with other established nuclear countries such as Britain, France, Russia, and Japan to export the waste from conventional nuclear reactors to developing countries and encourage them to use specially designed reactors that burn plutonium and other by-products from conventional nuclear fuel production. The US and other supplier countries would then dispose of the final waste, maximizing the amount of energy drawn from plutonium and preventing nations from acquiring weapons-grade nuclear material.

While the plan is in its infancy –a mere $250 million was allocated to it in the 2007 budget- it seems likely to garner the support of the international community. In fact, it is essentially an internationalized variation of the Russian offer to supply Iran with nuclear fuel for civilian nuclear power generation. While critics of the plan fear that the transport of nuclear fuel and waste will increase the likelihood of nuclear materials falling into the hands of terrorists, it is a risk that the energy hungry world may have to take.

There are other reasons too to think the U.S. is starting to understand the reality of oil depletion. The 2007 budget requests only $648.9 million for the Office of Fossil Energy. That’s a 23 percent reduction from the 2006 appropriation. $61 million of the savings is accounted for in the termination of support for energy companies to explore for oil and gas, ostensibly because, according to the Department of Energy, “such R&D activities are more appropriate for the private sector to perform.” From an Administration that is generally pro-oil and willing to assist large oil companies with various tax incentives, this explanation is hard to believe.

A more likely explanation for the program cut is that there simply isn’t enough cost-effective oil out there to find, even at current high prices. In fact, large U.S. oil companies themselves have been steadily decreasing their expenditures on new oil exploration because it is a bad investment. Instead, these companies have tried to replace produced reserves on their asset sheets by simply purchasing other oil companies with booked reserves. Any excess cash –of which there is a lot in the oil industry of late—is often used simply to buy back their own stock.

To what extent the President’s newly announced Advanced Energy Initiative, including the Global Nuclear Energy Plan, is reflective of a new thinking on scarcity of oil is unclear. A pessimistic reading would suggest that the new attention reflects only that the Administration recognizes energy efficiency as a political winner, but not a real problem. On the other hand, U.S. oil companies clearly understand in which direction the long term trends in oil supply and demand are headed. And if they know, it may indeed be the case that the Administration gets it as well. Alas, only time will tell.

CONCLUSION

In a world full of dangerous uncertainties, securing energy supplies at consistent price is always a challenge. Nigeria and Venezuela made that clear this week. The longer term supply issue, however, is much quieter and much more serious. After more than sixty years of oil production, the world’s major oil producing regions are mature and beginning to decline. Cantarell is only one of many giant and super giant fields whose days are now numbered. While nuclear energy can replace a portion of oil and natural gas used for heating and electricity, it cannot, at least any time soon, replace the gasoline that powers our cars and airplanes and that is a vital ingredient to agriculture, plastics, and petrochemicals. For those needs to be met, new technologies and ways to conserve oil will be needed.

OPI WEEKLY: PEAK OIL AND A HISTORICAL LOOK AT RUSSIA

2006-02-12T19:01:00.000-05:00

Anyone who frequents the oil blogosphere is familiar with the Peak Oil movement. In fact, the Peak Oilers, for all intents and purposes, are the oil blogosphere. Despite inattention to Peak Oil claims on OPI –I haven’t figured out yet what I think of them- I saw OPI listed recently on a list of Peak Oil blogs. So be it. A lonely and wayward blogger is always happy to be noticed. However, one topic of discussion among Peak Oilers has particularly caught my attention. It seems that one of the ‘curious’ cases for Peak Oilers is production in Russia, which topped out at 12 million barrels or so per day in 1988 before falling to 6 million barrels per day in the mid 1990’s. Russia, however, has slowly climbed back up the production ladder to nearly 10 million barrels per day last year. Obviously the changing political economic circumstances in the country had much to do with this roller coaster ride, but exactly how much it had to do with it is unclear. Hence, here is my sense of what happened in Russia and what we may expect going forward.

The history of Russia’s oil production proceeds primarily along geographic lines. Russian oil was first produced in Azerbaijan and the North Caucasus. From its beginnings in 1870 to the turn of the century, Russian output increased from 660 barrels per day to 500,000 barrels per day. At the time, Russia and the United States were evenly matched as the world’s largest producers. By the eve of the Second World War, the Soviet Union was producing over 620,000 barrels per day, almost exclusively from fields in the Caucasus.

The German invasion and drive toward Baku pinched flows from the Caucasus region and frightened the Soviet Union into exploring alternative regions for development. The most promising locale was the Volga-Ural basin on the Western flank of the Urals Mountains. A set of dispersed discoveries in the basin that earlier had been shunned because of the high cost of building out production and transportation infrastructures in the region received renewed attention. By the end of the war production from the Caucuses had fallen to just 305,000 barrels per day, but new fields in the Volga-Ural basin contributed another 55,000 barrels per day to the Russian total.

Three years after the end of the war, geologists discovered the Romashkino field one hundred fifty miles west of the Ural mountains in the center of the basin. At 17 billion barrels of proved reserves, it was at the time the largest field ever discovered anywhere in the world. It would ultimately produce around 1.5 million barrels per day before its decline in the mid-1970’s. Seven more fields containing over a billion barrels of oil each were discovered in the basin by 1960. The region single-handedly powered the Soviet Union’s postwar economic growth.

Since 1960 only two further fields containing more than a billion barrels of producible reserves have been discovered and developed in the Volga-Ural region. In 1976 production peaked at about 4.5 million barrels per day and began declining at a rate of 5 percent per year, resulting in a loss of 80,000 to 100,000 barrels per day in the late seventies and 100,000 to 200,000 barrels per day in the eighties. By 1995 the region’s two primary oil producers, Bashneft and Tatneft, had stabilized the situation by reducing declines at the largest fields and developing a handful of smaller fields in the basin. However, the quick and inefficient development of the region throughout the seventies and eighties depleted its most economically recoverable reserves. The basin now contributes only about 1.6 million barrels per day to Russian production.

Beginning in 1964 the Volga-Ural basin began to show the signs of decline. The percentage of water produced in the basin’s primary producing fields began to rise dramatically, making production in the region more expensive. Around the same time, major new field discoveries were made in the West Siberian Basin which lies on the eastern side of the Ural Mountains. Although Soviet managers were at first wary of the difficult operating conditions in the basin –the region is a vast frozen swamp, making the construction of oil infrastructure difficult—the region’s prolific reserves and the decline of the Volga-Ural basin quickly made clear that the Soviet Union’s oil future lay in West Siberia.

By the late sixties production in the West Siberian Basin was in full swing. Labor and capital resources that had been devoted to Volga-Ural production were transferred across the mountains to West Siberia. The region’s largest field, Samotlor, was discovered in 1965 on the right bank of the Ob River. It became the centerpiece of Soviet production, reaching a peak of 3.4 million barrels per day in 1980. The region’s two other super-giant fields, Ferdorovskoye and Mamontovskoye each reached peak production levels over a million barrels per day. By 1987, 32 producing fields and hundreds of smaller fields had been discovered in the lands surrounding the Ob River.

West Siberian production powered Soviet production to its peak of 12.4 million barrels per day in 1987 and 1988. By the early to mid 1980s, however, the region was showing the telltale signs of decline. In 1984 and 1985 Samotlor lost a combined 25% of its production, almost 700,000 barrels per day. Water cuts began rising quickly –from 25 percent in 1980 to 68 percent in 1985—and the size of new field discoveries was diminishing at an even faster rate. Whereas in 1975 it took only 40,000 wells to produce 10 million barrels per day, in 1990 it took almost 140,000 wells to produce the same amount. Water cuts at Ferdorovskoye and Mamontovskoye had also doubled by 1985, reducing output and increasing production costs.

Russia’s record production of 12.4 million barrels per day in 1987 and 1988 was the crest of a production wave that would crash fast and hard. The aging fields of the West Siberian basin responded only briefly to a massive infusion of labor and capital. Water cuts rose and production leveled off, and then fell. To make matters worse, between 1983 and 1987 the world price of oil dropped from $27 per barrel to $15 per barrel. Under these conditions the Soviet Union was losing money on every barrel of oil produced for export, and much more on oil sold at deep discount on the domestic market. Domestic sales accounted for almost two-thirds of total sales. In 1983 Soviet oil netted the country over $22 billion. In 1987 the industry’s net income was -$4.8 billion on 11.4 million barrels per day of production. In 1993 it was -$4.1 billion on just 7 million barrels per day of production.

By the fall of the Soviet regime in 1992 oil production was in free-fall. With the collapse of the Soviet Union, the state budgets that had propped up the Soviet oil industry shriveled. With real wages and earnings plummeting, non-payment of accounts-receivable to the nation’s oil industry ballooned. By the end of 1994, approximately $10 billion was owed to the industry; by the end of the third quarter of 1995 that figure had doubled. As much as 30 percent of receivables for domestic oil sales were either not paid, or paid in barter with goods of dubious quality. Moreover, oil export revenues were drained by tax and transportation tariff policies, while exploration and development slowed to a crawl as regional oil managers received no clear direction from the Kremlin or the newly forming oil conglomerates. In February of 1995, the Federal Board of Bankruptcy Affairs in Moscow reported that all of Russia’s oil production organizations except one (Surgutneftegaz) were insolvent. Russian production bottomed out around 6 million barrels per day from 1996 to 1999.

However, just as price and cost conspired against Russia from 1987 to 1993, they pulled Russian production out of collapse in 1999. World oil prices rose to over $20 per barrel, while the 80 percent devaluation of the rubble in 1998 cut Russian costs significantly. Domestic subsidies on oil were also cut.

Between 1998 and 2003 Russian production increased by 2.4 million barrels per day –a 40 percent increase—and the industry’s revenues flowed back into development projects. West Siberian fields that had languished for lack of funding during the early part of the decade were brought back to life, once again powering Russian production upward. By 2000, most of Russia’s oil sector had transferred into the private sector courtesy of the ‘Loans for Shares’ program. As the new century began, the Russian oil industry showed signs of promise, and a small cadre of Russian oligarchs stood to reap the enormous gains.

However, declining fields in West Siberia continue to drive Russian output. While the injection of western technology has improved recovery at its major fields, their decline rates are significant at 3 to 5 percent per year.

In order to replace this oil lost, let alone increase production, smaller fields that were bypassed during the Soviet era will have to be developed. But here Russia faces a political-economic problem. Unlike the U.S., Russia lacks a cadre of small independent oil producers willing to take on these smaller projects. With the consolidation of the Russian oil industry over the past decade, Russian exploration and development has concentrated on expensive, large-scale development in new regions that have the greatest chance of adding significant amounts of reserve oil to the Russian books. This trend has decreased the amount of oil likely to be available in the near term to make up for the large field declines.

In the worst-case scenario for Russia, some of these-large scale projects may prove disappointing in terms of ultimate reserves and production. The Russian Caspian region is turning out to just such a case. Whether or not the Russian political-economic landscape will allow over time for a ‘middle class’ of small, regional developers to take advantage of the smaller fields in West Siberia and other regions remains to be seen.

OPI WEEKLY: POLITICS AND PRICES: THE PRESIDENT'S UNLIKELY OIL PLEDGE

2006-02-05T20:18:00.000-05:00

In his State of the Union address last week, President Bush pledged to reduce oil imports from the Middle East by 75 percent by 2025. Never mind the fact that the pledge is politically peculiar because the two countries from whence the U.S. gets 90 percent of its Middle Eastern oil –Iraq and Saudi Arabia—are also fundamental to the war on terrorism; even if we didn’t buy their oil, we would still be crucially concerned about Saudi and Iraqi politics. The current U.S. concern about Iran, from whom we purchase no oil, makes that point abundantly clear. Nevertheless, supposing that not buying Middle Eastern oil were a worthy aim, how would we replace the 2.5 million barrels per day the region supplies us?

CRUNCHING THE NUMBERS

The answer at first glance depends upon the price of oil in the years between now and 2025. If oil prices were to fall back significantly from current levels to the historically more normal $20 to $28 per barrel range, oil from the Middle East will capture more of the market because production costs in the Middle East are so low. Alternatively, if prices remain in the $45 to$ 60 barrel range over the long term, supply from regions where production is more costly will compete with Middle Eastern production and capture more of the market.

The Energy Information Administration (EIA) forecasts production out to 2025 according to three price scenarios: a low price case of $21 per barrel, a high price case of $48 per barrel, and a reference case in between at $35 at per barrel. In the low price case, total world demand is projected to be higher, reflecting the higher growth rates that would result from the lower cost of oil. In the high price case, total world demand is expected to be lower given the softer growth that would result from higher energy prices. The reference case, of course, projects world economic growth and oil demand somewhere in between.

In the EIA’s low price case, demand for oil in 2025 is robust at 135.2 million barrels per day, up from the current demand of 84 million barrels per day. In that scenario, production from the Persian Gulf countries is expected to increase 142 percent to 50 million barrels per day, while non-Persian Gulf production is expected to increase only 44 percent to 85.2 million barrels per day. Persian Gulf oil would thus make up 37 percent of world supply, with other sources contributing 63 percent. In that case, it would be difficult for the U.S. to replace its Middle Eastern oil.

In the reference case, demand is still strong at 122.2 barrels per day. In this scenario, production from Persian Gulf countries is expected to increase 90 percent to 39.3 million barrels per day, while other sources will increase production by 40 percent to 82.9 million barrels per day. The percentage of the world’s oil coming from the Persian Gulf would increase to only 32 percent, with the remaining 68 percent coming from non-Persian Gulf sources. It would still tough to avoid Middle Eastern oil, but possible.

In the high price case, demand comes in at only 115.5 barrels per day. In this scenario, Persian Gulf production increases by only 34 percent to 27.8 million barrels per day, while non-Persian Gulf sources increase production 48% to 87.7 million barrels per day. If that happens, non-Persian Gulf sources would capture 76 percent of the market, while the Persian Gulf would supply only 24 percent of the market, about 2 percent less than it supplies today. Clearly then, high prices would help the U.S. if it wished above all to avoid Middle East oil.

So, which price case seems most likely? Once one digs in to the numbers, the picture becomes a little less clear. In the low price scenario, the EIA projects Saudi Arabia at a whopping 20.4 million barrels per day in 2025, a 94 percent increase over their already world-leading 10.5 million barrels per day. However, even the oft boastful Saudi’s themselves have never suggested that they could produce more than 15 million barrels per day. Most of their oil comes from aging super-giant fields that will increasingly demand expensive secondary recovery techniques to maintain production. While Saudi Arabia has smaller undeveloped fields it can bring on line, new projects come with smaller economies of scale and increased marginal production costs. The EIA does not give detailed estimates on production costs from the various producers under the alternative scenarios, but it could hardly be in the Saudi’s interest to produce 20 million barrels per day at $21 per barrel. And since Saudi Arabia, as the anchor producer in OPEC, has some control over prices, it seems highly unlikely that it would ever produce enough oil to hit the low price scenario described by the EIA.

THE REFERENCE CASE

Given the Saudi numbers and the two dozen or so other reasons why oil will not settle again in the $21 per barrel range, it seems safe to dispense with the low price case presented by the EIA. However, the EIA’s reference price scenario also yields some peculiar country and region level details. The major production boosts in this case are expected from Saudi Arabia, the former Soviet Union (FSU), Iraq, Kuwait, and Africa. The Saudis here are projected to increase production to 16.3 million barrels per day. This figure is probably too high for the same reasons as the 20.4 million barrels per day was too high, but it is at least plausible at $35 per barrel.

However, the reference case also has the FSU coming in at 17.6 million barrels per day. This figure is much harder to fathom. Russia’s primary producing region, its giant West Siberian basin, is well along in years and losing production capacity at around 3 percent to five percent per year. To make up for that amount, Russia is producing increasingly smaller West Siberian fields at ever increasing production costs. One recent study suggested that Western Siberia is expected to remain Russia's main production base, with crude output climbing there, but only until 2010-15 when it will level out at about 6 million barrels per day.

New oil production in Russia will have to come from several large projects, such as the Timan-Pechora basin, Russia’s Caspian Sea reserves, and its Sakhalin Island projects. The Timan Pechora basin holds an estimated 4 billion barrels of reserves, but it is still early in its development. The largest and most developed project there, the ‘Polar Lights’ project, is expected to yield only 440,000-460,000 barrels per day by 2015. Furthermore, Russia’s Caspian Sea reserves, once a source of great hope, have yielded a disappointingly high gas to oil ratio thus far. An optimistic projection puts Russian Caspian production at 500,000 barrels between 2010 and 2020. The Sakhalin Island projects too have been fraught with challenges and disappointments. Development of the frigid Island has been slower and much more expensive than had been expected and only two of the six production sites there are anywhere near market viable production. Output at the most advanced Sakhalin project is expected to be only 250,000 barrels per day in 2010.

The other major challenge Russia will face if it is able to significantly increase production is getting its new oil from remote production sites to market. The Russian pipeline system is currently operating at full capacity and new capacity to remote locations will be slow and expensive to build. Given the entanglement of the Russian oil industry with Russian politics, it seems unlikely that the most efficient path possible will be traveled to boost the production and transportation projects that will be necessary if Russia is to get anywhere near EIA’s expectations for the country.

The same transport problems dog the FSUs other primary oil producer, Kazakhstan, especially because much of its oil exports go through Russia. New pipelines from the Caspian Sea to Turkey in the West and from Kazakhstan to China in the east will help, but not nearly enough to account for the massive production increases surmised by the EIA report. While nineteen years seems like a long time to reach the EIA goal, it is not such a long time in oil years. Production and transport infrastructure of this magnitude would require tens of billions of dollars and geopolitically dicey international involvement to build, and neither Russia nor Kazakhstan has been a place in which international oil companies have felt particularly safe in recent years.

The EIA reference price case has Iraq producing 6.6 million barrels per day in 2025, up from its current level of around 2 million barrels per day. While that very well could be the case, it seems by no means certain or even likely. Wars and revolutions have a funny way of interfering with oil production. Iran is a good case in point. Before the Iranian revolution, the country produced 6 million barrels of oil per day. It has struggled in the 25 years since then to climb back above 4 million barrels per day. Even once the situation in Iraq is stabilized, it will take massive amounts of foreign investment to bring Iraq’s dilapidated oil infrastructure back to life, let alone accomplish the 230 percent increase envisioned in the EIA’s reference price case.

Kuwait is projected by the EIA in this scenario to increase production 148 percent to 5.2 million barrels per day. Kuwait indeed has big plans, dubbed “Project Kuwait” to permit foreign oil companies to invest in upstream production, though only with "incentivised buy-back” arrangements, wherein the Kuwaiti government will retain full ownership of oil reserves, control over oil production levels, and strategic management of the ventures. Foreign firms are to be paid a "per barrel" fee, along with allowances for capital recovery. While not as attractive as production-sharing arrangements, the Kuwaiti plan should generate significant international interest. The problem with regard to the EIA projection, however, is that Kuwait itself plans for the project to top off at 4 million barrels per day, a good bit short of the 5.2 million assumed by the EIA.

Africa, finally, is projected by the EIA reference case to increase production by 119%, from 3.1 million barrels per day to 6.8 million barrels per day. However, the EIA does not include in this figure Africa’s three most prolific oil producers, Algeria, Nigeria, and Libya, which it tallies separately with OPEC. This leaves Angola, Gabon, Equatorial Guinea, and Sudan to carry the load. With the exception of Angola, none of these producers have ever produced anywhere close to a million barrels per day, and in most of these countries production has been falling. While China has been a major foreign investor in several of these countries, political instability and corruption will make EIA investment and production targets extremely difficult to meet.

THE HIGH PRICE CASE

In the EIA’s high price case, even higher figures are given for the FSU and Africa. If the reference case estimates for those two regions seemed unrealistic, the high price scenario estimates of 20.4 million barrels per day from Russia and 8.1 million barrels per day from Africa seem out of the question. However, in the high price case, Saudi Arabia is projected to supply only 11 million barrels per day, hardly more than they now produce. Should Russia or Africa fall short of their lofty targets, it does not seem unrealistic to imagine 15 million barrels per day coming from Saudi Arabia. The high price case also estimates 121 percent increase from Canada to 6.4 million barrels per day. That seems reasonable given the abundant but high cost reserves in Alberta’s Athabasca oil sands region. At $48 per barrel, those reserves become economically viable.

The most peculiar figures in the EIA report, however, concern Venezuela, which also has abundant oil sands reserves. In the low price case, the EIA has Venezuela producing 7.3 million barrels per day, a 135% increase over recent levels. However, at increasingly higher prices, the EIA estimates a lower output from Venezuela. In the reference case, it projects 5.6 million barrels from th country, and in the high price scenario just 3.9 million barrels per day. Despite having reserves similar to Canada’s and a comparable infrastructure connecting it to the world’s largest oil consumer, the EIA’s production projections for Venezuela and Canada are almost precisely inversed.

CONCLUSION

Political pledges and oil production projections are similar in one regard: they are often made and almost never borne out by subsequent events. The combination of the two hardly leaves one with anything to stand on. The good news for Bush is that if the EIA is right in its high price scenario –and it seems reasonable to think that prices will stay high—the world will be awash in Russian, Iraqi, African, and Canadian oil come 2025. The bad news for Bush is that it is hard to imagine given the political and economic characteristics of Russia, Iraq and Africa that the EIA is right. If such high production targets are to be reached, massive investment and international involvement will have to begin soon and be sustained for the next 15 years. While Venezuela might make up for some of a shortfall in any of those countries, it will be Saudi crude that makes up most of the difference. So much for reducing dependence on Middle East oil.

OPI WEEKLY: DELAY TACTIC DIPLOMACY AND IDLE OIL THREATS: IRAN'S NUCLEAR ASPIRATIONS AND THE WEST

2006-01-29T20:44:00.000-05:00

Iran’s confrontation with the West over uranium enrichment is once again coming to a head. The International Atomic Energy Agency (IAEA) is set to meet next week to consider referral of Iran to the United Nations Security Council for possible sanctions, and a majority of the 35 member board has already signaled its intention to refer Iran’s case to the U.N. While sanctions are by no means a certainty –thanks largely to the uncertain stance of China on the matter—they are for the first time in the Iran crisis a real possibility. In preparation for possible U.N. action, Iran has reportedly transferred its European denominated assets to less ethically finicky countries and has threatened to cut oil supplies in response. What happens next will depend on Iran’s ability to once again wield its most effective weapon so far in the standoff over its nuclear intentions: time.

DELAY TACTIC DIMPLOMACY

In an attempt to forestall IAEA action or, failing that, Security Council sanctions, Iran has signaled its qualified support for a proposal to have its uranium enriched on Russian soil and then shipped to Iran for use in the generation of electricity. Russia and China immediately voiced their support for the plan, and the United States has also accepted the proposal in principal.

It is highly unlikely, however, that anything but delay will ever come of the plan. Once the U.S. agreed to the scheme, Iran took a step back, saying that in order for it to agree to Russian enrichment, “other countries” would have to be involved. Nothing stalls international agreements more effectively than adding more countries to the mix.

Iran’s tried and true best friend in its years-long effort to gain a nuclear weapon has been time, and delay tactics may well continue to work in forestalling U.N. action. The permanent members of the Security Council –Britain, France, Russia, China, and the U.S.— whose agreement would be necessary to pass a sanctions resolution, have a diverse array of interests at stake when it comes to Iran.

Tehran was exceedingly successful at dragging out its negotiations with the EU-3 (Britain, France, and Germany). The talks commenced in the late summer of 2003 and followed the familiar pattern with Iran of near compromise followed by Iranian defiance, followed by Iran calling for talks to continue. The EU-3 played along hopefully for over two years before finally throwing in the towel on the exercise late last year. France in particular was hoping to broker a successful compromise with Iran in order to show itself as a capable geopolitical arbiter. However, when those talks came to nil, Britain and France were left with no other option than to express their support for referral of Iran to the U.N.

While Russia has more sympathy –and business—with Iran than the West –indeed, they are helping Iran to build out its “peaceful” nuclear technology—a nuclear weapons capable Iran poses problems for Russia. A nuclear Iran could wield greater influence among the restive Islamic populations in Russia’s Caucasus region, already a thorn in Russia’s side. Combined with its hesitation to oppose the U.S. and Europe on an issue of such importance to the West, Russia may well cooperate with Britain and France if the issue makes it to the Security Council.

That leaves China. China sits between a rock and a hard place on the Iran question. It is currently walking a political and economic tightrope at home as it tries to reform its badly dysfunctional economy. Protests and public disturbances have become increasingly common as the result of the hardships that come along with economic reforms. A further blow to its economy caused by U.N. imposed sanctions on Iran would exacerbate an already critical situation. While China imports only 12 percent of its crude oil from Iran, it has significant current and pending energy development projects in the country. In addition, the impact of increased oil prices that would result if Iran made good on its threat to pull its oil off the market, would hit China’s economy hard.

On the other hand, China would not welcome the diplomatic consequences of opposing the West, particularly the U.S., on the Security Council. In a clear shift from the early days of the Bush presidency, the U.S. and China have recently initiated a “Strategic Dialogue” to deal with issues such as trade, Taiwan, and North Korea. A Chinese veto of Iran sanctions on the Security Council would bring this warming trend to a screeching halt. The U.S. Congress, not to mention the Bush administration, would no doubt react strongly and swiftly to an Iranian veto. Issues near and dear to Chinese economic reform, such as the overvaluation of the Yuan and open export markets abroad, would once again become front and center in U.S. legislative politics. A Senate proposal to impose a 27.5 percent across-the-board tariff on Chinese imports would certainly gain renewed support.

So what will China do? They will likely try to do what any rational country does when stuck between a rock and a hard place: nothing. Fortunately for Iran, this is exactly what it wants. China will push hard for more time on the Russian plan, while promising the U.S. that if it waits to see if the Russian plan works before bringing a resolution to the Security Council, China will support sanctions at that time. If China is able to convince Russia to take the same line, the likelihood of the U.S. pushing for a vote decrease even further.

IRAN’S IDLE OIL THREAT

If somehow the U.S. were able to convince China and Russia to vote its way in the Security Council, Iran’s options would be few. While creating hardship for a world economy already laboring under high oil prices, an Iranian curtailment of oil exports would hurt Iran much more than the world it supplies. Iran is the world’s fourth largest crude producer and exporter with 4.2 million barrels per day in production and 2.7 million barrels per day in exports. Almost 90 percent of Iran's total export earnings and about 50 percent of the government budget come from oil exports alone.

At the current OPEC price basket rate of $60 per barrel, Iran would lose $162,000,000 per day or $59.1 billion per year –a full 30% of its GDP—if it withheld all its supplies. Iranian budget deficits, already bloated in part due to large-scale state subsidies on gasoline and foodstuffs, would balloon. Even if Iran continued to sell a portion of its oil on the market, the effects on its economy would be profound. Furthermore, the more oil it continued to sell, the less effect the curtailment would have on oil prices, dampening the political effectiveness of the move and making more difficult for Iran to make up the revenue shortfall. As if that weren’t bad enough, Iran imports a third of its gasoline because of a lack of refining capacity at home. Increased oil prices would hit Iran along with the rest of the world as the price of refined petroleum products increased along with the price of oil.

Iran’s domestic situation would be hard-pressed to handle the economic blow that would ensue from an oil curtailment. With unemployment in Iran already averaging around 14 percent and significantly higher among young people, the social and political effects of an economic crunch could be extreme. Two bombings in the southwestern Iranian city of Ahvaz last week on the day that Iranian President Mahmoud Ahmadinejad was due to visit underscore the fact that Iran’s leadership has no shortage of enemies at home. Ahmadinejad’s motorcade also came under attack recently as it made its way on the Zabol-Saravan highway in the country’s southeastern provinces of Sistan and Balochistan. The economic collapse and social dislocation that would undoubtedly result from an oil embargo would give Iran’s internal enemies ample opportunity to challenge the ruling regime.

As for the rest of the world, a decrease in Iranian supplies, while not easy to swallow, would be far from catastrophic. With no love lost for Iran, Saudi Arabia would bring its 1.5 million barrels per day of spare capacity on line. This would fully cover an Iran supply cutback of over 50 percent, effectively muting the intended price increase. If Iran withheld all its oil, prices would likely jump to over $90 per barrel at the outset. However, in addition to Saudi oil, the U.S. and Europe could tap their combined 1.3 billion barrels of strategic petroleum reserves. Those reserves alone could replace the shortfall after Saudi capacity is maxed out for nearly three years. Even if Iran’s economy and political stability could hold out that long –which seems exceedingly unlikely—32 months is long enough for new production to come online in the Middle East, Russia, and elsewhere.

No matter how one slices it, a curtailment of oil supplies is a losing proposition for Iran. Conversely, U.N. sanctions which included an embargo on Iranian oil could be quite effective, although it is unlikely that even if the U.S. were successful in a Security Council vote that sanctions would go that far. For precisely this reason, Iran will work hard at the delay tactics with which it has been so successful in the past.

CONCLUSION

Given the array of interests involved in the Iran question, the chances of a vote soon at the Security Council seems unlikely, and the chances of a unanimous vote for sanctions even dimmer. The more realistic question is how long the U.S. and Israel will suffer Iran’s delay tactics before deciding on a military strike on Iranian nuclear sites. As is so often the case in international affairs, the unilateral use of force may turn out to be the easier softer way in comparison to the complications inherent to multilateral diplomacy.

OIL POLITICS WEEKLY: TAKING CARE OF KARIMOV: A NOT SO TACIT AGREEMENT WITH GAZPROM

2006-01-22T18:26:00.000-05:00

Russian daily Kommersant reported last week that Uzbek President Islam Karimov has promised gas production and transit deals to Russia in exchange for protection from his many political adversaries. While it seems at first curious for Uzbekistan to seek military protection from a gas company, it reflects a new reality in Russia –that Russia and its largest company have become one.

THE DEAL

Gazprom’s chairman Alexi Miller arrived in Tashkent on January 19^th to consummate the gas deal. The production sharing agreement will give Gazprom development rights over the three largest gas deposits in Uzbekistan, Urga, Kuanysh and the Akchalakskoe group. The three fields have an estimated 61 billion cubic feet of gas and 90 million barrels of condensate. Under the agreement, Gazprom will increase exports from Uzbekistan to Russia from 5 to 6 billion cubic meters per year to 17 to 18 billion cubic meters per year once the fields are fully developed. Uzbekistan, Central Asia’s largest gas producer, has reserves of 66 trillion cubic feet and produced 2 trillion cubic feet in 2003. The country produces natural gas from 52 fields in 12 major deposits primarily in the southwest region of the country.

In exchange for the gas deal, which further ties Uzbekistan’s already intertwined energy and economic infrastructure to Russia, Uzbekistan wants protection. In May of last year armed civilians stormed the city prison in the Fergana Valley city of Andijan and took over the regional administration building in the city’s main square, throwing the country and its leadership into crisis. Uzbek President Islam Karimov responded with force, ordering troops to open fire on the protesters, killing 8 and injuring 34. While the uprising was primarily the result of a rivalry between Andijan and other Fergana Valley clans and the Samarkand-Tashkent clans led by Karimov, officials in the Uzbek Interior Ministry reportedly believed that the uprising was in part orchestrated by the United States as a warning to Karimov that he should step down or face more armed uprisings elsewhere in the country.

LESSONS LEARNED

Karimov’s decision to open fire on the protesters was the direct result of lessons learned in the uprisings that vanquished the rulers of Georgia, Ukraine, and Kyrgyzstan. In those conflicts the order to use force against protesters never came, which further emboldened opposition leaders and ultimately led to regime change. While the Uzbek uprising was not as clearly inspired by pro-Western forces –Karimov’s detractors are a patchwork of legitimate businessmen, mafia controlled drug traffickers, regional political officials, reform-minded political activists, and Islamists—the real threat was significant, and the perceived threat even greater.

Karimov’s response in the months following the uprising was swift and total. Two weeks following the end of violence, Karimov moved to solidify the support of China, the only major power not to criticize Karimov’s crackdown. Chinese President Hu Jintao spent three days in Tashkent, signing a series of security, energy, and economic agreements. Both leaders fear the influence of Islamist groups, particularly the Islamic Movement of Turkistan, which is active throughout the region.

In early June, Karimov restructured Uzbek security forces, concentrating its power under trusted political allies. Troops previously under command of the Interior Ministry were transferred to the control of the Defense Ministry and the National Security Service, the country’s successor to the Soviet KGB. One month later, Tashkent banned U.S. troops and warplanes from the Karshi-Khanabad air base, effectively ending military cooperation between the two countries.

In October, Uzbek Security forces ransacked the headquarters of the Sunshine Coalition, a moderate Uzbek opposition group, and detained its leader, Sanjar Umarov, on charges of embezzlement and other unspecified financial misdeeds. Umarov, a prominent businessman, had visited the United States in September, meeting with senior Bush administration officials. In December, Nodira Khidayatova, another leader of the Sunshine Coalition, was arrested at the airport in Tashkent on allegations of tax evasion. Her brother-in-law, Orifjan Oydin, also a member of the group, had been shot and killed by unidentified gunmen the week before.

ENTER RUSSIA AND MEDVEDEV

While Russia was silent at the outbreak of the Andijan violence –it was an ‘internal problem,’ Moscow said—it later joined the West in calling for an investigation into the crackdown. This cooled Uzbek relations with Russia for a time. Once the international heat on Karimov subsided, however, relations quickly improved. In late October Uzbekistan announced its intention to join the Russia-led Collective Security Treaty Organization (CSTO), comprised of Russia, Belarus, Armenia, Kazakhstan, Kyrgyzstan and Tajikistan. Sources in the Uzbek government said on Oct. 26 that Uzbekistan was set to rejoin the security minded organization –it had been a charter member in 1992, but withdrew in 1999—in early 2006.

For Tashkent, membership in the organization will add an explicit security guarantee to the increased economic integration afforded by the Central Asian Cooperation Organization (CACO). Also Russia-led, the organization is comprised of Russia, Kazakhstan, Uzbekistan, Kyrgyzstan and Tajikistan. The CACO held a summit in St. Petersburg, Russia on October 6-7, inaugurating the Central Asian Common Market.

It now appears, however, that these strategic moves are not quite enough to satisfy the ever-fearful Karimov. Hence the gas deal and the odd request of Gazprom for protection. What makes Karimov so sure, all of a sudden, that Gazprom can make such guarantees? It has much to do with the ascension of Dmitry Medvedev, chairman of Gazprom, to the post of first deputy prime minister of Russia. He will also retain his position at Gazprom, making the already strategically placed company even more so. The joint appointments make Medvedev arguably the second most powerful man in Russia.

This added layer of protection for Karimov will not come cheaply. Russia will pay only $60 per one thousand cubic meters of Uzbek gas and pay a transit price of just $1.10 per 1000 cubic meters per 100 kilometers. Russia will then sell those very same supplies and prices at twice or more of that rate. Even ill-fated Ukraine will be getting its share of Uzbek gas from Russia at $95 per 1000 cubic meters and will receive a transit tariff of 1.60 per 1000 cubic meters per 100 kilometers. Not a bad deal for the Russia.

CONCLUSION

Russian President Vladimir Putin visited Uzbekistan last November to sign an “alliance” agreement which, according to some rumors, includes a military base for Russia in Uzbekistan. The text of the treaty states that “in order to ensure security and maintain peace and stability, the countries will grant each other the right to use military facilities located on their territories should it prove necessary.” While the scope of cooperation and the circumstances under which Russian troops might take up permanent post in Uzbekistan were left unclear, the implication is obvious. Russia will be Karimov’s guarantor, at least as long as it feels that Karimov’s survival is in Russia’s best interest.

Also unclear is what the quid pro quo with Gazprom adds to the alliance guarantee. The gas deal may simply be the quo to the quid provided in the November alliance agreement. Or it may be an attempt on Karimov’s part to win over the support of newly appointed Medvedev. Regardless, the deal with Gazprom further entrenches Russia’s interests in the Karimov regime, which, as far as Karimov is concerned, is worth the heavy price.

A new era of oil and gas politics has dawned in Russia. The significant re-nationalization of the oil industry over the past year and the ascension of Medvedev to one of Russia’s most powerful positions will tie Russia’s energy policy ever tighter to its foreign policy. The increased politicization of Gazprom became clear during the Russian conflict with Ukraine over gas prices, coming just weeks after Medvedev’s appointment. Medvedev used Gazprom to play geopolitical hardball and won. The gas for protection deal with Karimov and Uzbekistan follows in its footsteps. With Gazprom’s chairman at the right hand of the Russian president, a deal with one is tantamount to a deal with the other.

OPI WEEKLY: SPLITTING THE MIDDLE: RUSSIA'S UKRAINIAN GAMBIT AND TRANSATLANTIC POLITICS

2006-01-15T18:46:00.000-05:00

When Russia shut off gas supplies to Ukraine on January 1^st of this year because of a price disagreement, the whole world –Europe especially—took note. Since its independence, Russia has supplied natural gas to its eastern CIS neighbors and to Europe at prices far below the going market rate. Ukraine, for example, paid $50 per 1000 cubic meters of gas in 2005, well below the market price of $220 to $230 per 1000 cubic meters. Since Russia’s exports to Europe transit largely through Ukraine, a reduction in gas to Ukraine would mean a reduction in gas to Europe as Ukraine inevitably would siphon of gas intended for Europe for its own use. That’s precisely what happened between the January 1^st shut-off and the resolution of the issue three days later.

The Russian motivation for the move is complex. Undoubtedly they would like to receive the increased export revenues that increased prices would bring. However, their larger and more important goals here are political. The loss of Ukraine to a pro-Western regime was a monumental blow to Russia. Without Ukraine firmly in its camp, Russia’s geosrategic position is weakened significantly. Ukraine is not only key for transiting Russian oil and gas to European markets, it is also Russia’s primary connection to Europe when it comes to road, rail, and even water supply. Ukraine also hosts Russia’s only deep warm-water ports along the Black Sea and is a central point from which Russia can project power into the troubled Caucasus region of Russia.

By simultaneously cutting gas exports to Ukraine and Europe Russia hopes to weaken the pro-Western Yuschenko regime, making the regime appear in the eyes of Ukrainians to be dangerously uncooperative with Russia and also softening European support for Ukraine’s leadership. Predictably, Ukraine’s pro-Russian opposition, led by Presidential runner-up Victor Yanukovich, reacted strongly to the gas shut-off, saying that if it was in power, Ukraine would have all the cheap gas it needs. A significant portion of the Ukrainian populace no doubt agrees. Ukrainian parliamentary elections are scheduled for March and the Russian gas situation will likely be a dominant issue.

The compromise agreement worked out between Yuschenko and Russia on January 4^th only exacerbated the issue in Ukraine. Under the agreement Ukraine will receive Russian gas at the $230 per 1000 cubic meters, but the bulk of its supplies will come from Turkmenistan, Kazakhstan, and Uzbekistan through Russia at $95 per 1000 cubic meters. This way Ukraine forestalls an unbearable price increase, yet Russia still sets a precedent for charging market rates. Under the deal Ukraine will increase its price for transiting Russian gas to Europe from $1.09 per 1000 cubic meters per 100 kilometers to $1.60 per 1000 cubic meters per 100 kilometers.

The opposition dominated Ukrainian parliament, however, insisted that the deal was a bad one and voted to dismiss Yuschenko’s cabinet. While Yuschenko insists that the deal will stand and his cabinet will serve at least until the March 26 elections, his position has been severely weakened.

For Europe, the Russian move portends an even greater enfeebling of the already crisis ridden European Union. In a nutshell, the Russian move will further weaken the Franco-German axis that had been at the heart of European Union development. Germany’s reaction will likely be to both seek a diversification of its energy imports –for which the options are few—whereas France will seek to insulate its energy supplies from energy imports altogether. France already derives over 70 percent of its electricity from nuclear power, and that portion will likely increase. In a speech on January 4^th French President Jacques Chirac announced a strategy to create in a new breed of nuclear power reactors to be active by 2020, as well as improvements in building codes aimed at enhancing energy efficiency. France, he said, will also increase biofuel research and tightly curtail the use of petroleum anywhere but in the transport and chemicals sector.

Germany’s options are fewer and will likely play out in the complex relationship between Germany, Russia, and the U.S. On January 13^th German Chancellor Angela Merkel visited the U.S. for the first time. The outcome of the meeting was a clear shift in German policy toward a more pro-U.S. stance. Merkel went to great lengths to describe the common interests of the two countries on issues such as Nato, China, and Iran and downplayed the sensitive issues of Iraq and the U.S. handling of terrorist detainees. These are all issues on which France and the U.S. have deep disagreements.

These statements also beg the question of what Merkel is getting in exchange for this pro-U.S. shift. The answer may well have to do with Russia. While the Russian gas issue never came up in the press conference following the summit –a conspicuous absence—it no doubt was much discussed behind closed doors. U.S. policy toward Russia has been tough and relentless. The U.S. supported “colorful revolutions” in Georgia, Ukraine, and Kyrgyzstan struck deep at the heart of Russian security. However, they ultimately also had the effect of pushing the surviving leaders in Uzbekistan and Kazakhstan back into the Russian fold. U.S. policy vis-à-vis Central Asia has been stalled since then, and the Bush administration lacks the resources and bandwidth to mount a more concerted foreign policy effort in the region.

Given these circumstances the U.S. may be willing to cooperate with Germany on its policy with Russia in exchange for a tighter alliance with Europe’s most powerful country. Merkel will travel to Moscow on January 16^th to meet with Putin. The triangle of relations between Germany, Russia and the U.S. are bound to be a subject of lively –though not public—discussion.

One other recent initiative deserves mention here. In September 2005, Germany and Russia signed an agreement to begin construction of a 750 mile natural gas pipeline system running beneath the Baltic Sea. The pipeline, which will cost in excess of $5 billion will have an initial capacity of 5.3 bcf per day and will allow Germany to be significantly less dependent on gas transiting Ukraine. The new system could be operational by 2010. Gazprom will take a majority stake in the project, with Germany’s Wintershall and E.ON each taking minority shares. The newly named President of the consortium is none other than former German Chancellor Gerhard Schroeder.

While the pipeline may have the upside for Germany of separating energy security from Russo-Ukrainian politics, it carries the very same downside for Ukraine. Without this very important geostrategic reason to care about Ukrainian politics, Germany –and hence Europe—is likely to care much less –or at least care less concretely—about the plight of the struggling CIS state.

OPI WEEKLY: CHAVY ON THE SPOT

2005-08-21T22:42:00.000-05:00

Political unrest in Ecuador has shut in most of that country’s 400,000 plus bpd of production. Although not a huge total by world standards –Ecuador ranked 30^th overall in oil production in 2004, 5^th among Latin American producers—more than half of Ecuador’s exports is shipped directly to the

U.S.

Specially tooled refineries in California and Texas refine approximately 144,000 bpd of

Ecuador

’s heavy, sour crude into gasoline and other high-quality petroleum products.

Given the recent up-tick in tensions between the U.S. and Venezuela, one might imagine that Venezuelan President Hugo Chavez would be pleased to see the U.S. squeezed a bit more at the pump. Such, however, is not the case. Chavez announced on Saturday that Venezuela will lend Ecuador crude oil cost-free to cover exports shut in by the unrest. Although no details of the plan were announced, Venezuelan foreign minister Ali Rodriguez said there would be a meeting in Caracas on Monday to study the request and the availability of Venezuelan crude. With Venezuelan production still lagging its pre-strike highs, it is not clear where Venezuela will find the extra barrels of oil to send Ecuador’s way.

The political turmoil in Ecuador has taken the form of disruptive protests in the country’s eastern oil provinces of Orellana and Sucumbíos and a strike by workers at foreign and state owned oil production facilities. Protesters invaded oil fields in the two provinces on Monday, dynamiting pipelines, vandalizing pumping machinery and blocking highways. Orellana and Sucumbíos produce three-quarters of state oil production and about half of private oil production in the country. The protesters are demanding that the oil companies invest more of Ecuador’s oil revenues in local social and infrastructure needs and provide more jobs to local residents.

Although the armed forces said on Thursday evening they had secured the embattled provinces and the protest leaders have officially halted their attacks, production on Sunday had increased to only 54,000 bpd and oil exports had stopped altogether. Some PetroEcuador officials already estimate losses to the state-owned oil company alone of close to $450 million through September, saying it will take that long to reverse the 200,000 barrel per day reduction in oil production caused by the strike and unrest.

Chavez’s decision on Saturday to lend oil to Ecuador is not only typical of Chavez’s pattern of using oil diplomacy to gain allies in the region, it is also the second time in a month that he has been prominent in Ecuador’s political instability. Conflict between President Alfredo Palacio and former Economy Minister Rafael Correa ended in the latter’s resignation on August 5^th after Palacio opposed Correa’s plans to sell up to $300 million in Ecuadorian government debt to Venezuela’s government. Palacio has resisted Correra and others in his cabinet who have urged him to distance himself the United States and pursue a closer alignment with Chavez.

Chavez’s offer to replace Ecuador’s lost exports will not make life any easier for Palacio, whose political days may well be numbered. This is true even if the Venezuelan crude isn’t actually delivered or is only delivered in part. Either way it is a relatively easy way for Chavez to look ever the man of the Latin American people and to help ensure that Palacio ultimately is replaced by a more left leaning, and anti-U.S., administration.

OPI WEEKLY: TIT FOR TAT DIPLOMACY WITH CARACAS

2005-08-14T22:30:00.000-05:00

Relations between the U.S. and Venezuela continued their downward spiral last week. In a series of diplomatic tit for tats, the U.S. revoked the visas of six senior Venezuelan National Guard officers assigned to counter-narcotic operations. The move was based on DEA assessments that these officers were actively obstructing operations to interdict cocaine and arrest drug traffickers. The U.S. State Department also said it was considering sanctions against Venezuela, including blocking cheap credit for businesses and counternarcotics aid.

Venezuelan Vice President Jose Vicente Rangel responded by accusing the U.S. Drug Enforcement Administration of conducting espionage operations against his government, trafficking in drugs, and ignoring established legal protocols for running drug stings in Venezuelan territory. Venezuelan officials also announced that American citizens could be denied visas to visit Venezuela as ‘reciprocation’ for the U.S. move against the Venezuelan National Guard officers.

The deterioration in relations between the two countries, of course, raises concern about the future of Venezuelan oil exports to the U.S. Venezuela remains the fourth largest crude oil supplier to the U.S., supplying it with 13% of its crude oil. And Venezuelan President Hugo Chavez has made the most of the power that oil exports grant him, both vis-à-vis the U.S. and U.S. companies, as well his Latin American neighbors.

OIL DIPLOMACY

In the past year, Chavez has been active in making energy cooperation agreements with South American and Caribbean nations in need of oil. Support for Castro’s dictatorship has become one of Chavez’s favorite thumbs to stick in the eye of the U.S. In late 2004 Venezuela upped its delivery of oil to Cuba from 53,000 bpd to 90,000 bpd. Although details of the most recent agreement were not disclosed, Cuba is likely obligated to repay as little as 25% of the oil. The agreement is believed to be for a term of 15 years. Not long after the enlarged oil deal was closed, Venezuelan state owned oil company Petroleos de Venezuela (PdVSA) opened an office in Havana, Cuba, which will serve as the company’s headquarters for its Caribbean operations.

Venezuela earlier this year agreed to provide roughly 43,000 b/d of oil to Uruguay on favorable financing terms. While 75% of the tab will be paid within 90 days, the remaining 25% will be paid in-kind with shipments of Uruguayan cement.

Venezuela is also sponsoring the creation of PetroCaribe, an oil company that would allow Caribbean nations access to Venezuelan oil under preferential terms. In addition, Chavez is pushing for the creation of PetroSur, a similar venture to PetroCaribe for South America, as part of an energy cooperation agreement between Venezuela, Brazil and Argentina. Venezuela has been supplying Argentina with emergency fuel oil since last year.

With oil trading over $65 per barrel, these energy cooperation agreements provide substantial relief for struggling South American and Caribbean economies. Most importantly for Chavez, the agreements help ensure that those countries will cooperate with Venezuela in its struggle against U.S. influence in the region.

THE TAXMAN COMETH

In April Venezuela’s Oil Minister and President of PdVSA, Rafael Ramirez, announced that the government would restructure 32 oil production agreements signed prior to his ascension to power. The agreements involve over a dozen foreign oil companies and, according to Ramierez, resulted in a loss to the government of $260 million dollars in 2004.

Although few details on the planned restructurings were released, the Energy Ministry said all foreign-run development projects would be reorganized into joint ventures in which PdVSA would have a 51 percent stake. Foreign firms would also have a maximum income cap instead of the per barrel fee arrangement currently in place.

Last week the first of those agreements were announced. Eight oil companies on Thursday signed transition accords with PdVSA. The companies include Spain’s Repsol YPF, China National Petroleum Corp., and Houston-based Harvest Natural Resources. Negotiations are reportedly underway with 14 further companies.

Ramierez also claimed ion April that a majority of the foreign operators in Venezuela had evaded paying taxes on the projects and would be expected to repay some $2 billion once the investigations were complete. In addition, he announced that tax rates on oil company profits would be raised to 50 percent from 34 percent. However, he offered no details on when the new rates would go into effect.

In July the tax bills started to come in. Royal Dutch Shell was the first foreign operator to get hit. The total, including fines, amounts to roughly $131 million. When Shell contested the bill, Venezuela’s tax authority asked a local court to freeze Royal Dutch Shell’s Venezuelan assets, worth more than $130 million. In the government’s most aggressive move yet to force foreign oil operators to pay back tax claims, Venezuelan authorities also ordered the temporary closure of one of Shell’s offices in the country.

Houston based Harvest Natural Resources was the next to get hit. Earlier this month Harvest’s 80%-owned Venezuelan subsidiary Harvest Vinccler was handed an $85 million bill for unpaid income taxes between 2001 and 2004 and levied an additional $9 million in fines. According to Venezuelan authorities, if the company fails to pay the sum by next week, it could face fines of up to 125% of the original $85 million owed.

Although companies involved in Venezuelan development have tried their best to put a business-as-usual face on Chavez’s moves, the markets are starting to see through the guise. Harvest stock plunged nearly 18% on Monday after the company announced the back-tax claim and fine.

In addition to the actions against Royal Dutch Shell and Harvest, Venezuelan tax authorities issued a $24 million tax bill to Italy’s Eni for alleged unpaid income taxes on the 60,000 b/d production at the Dacion field. Eni has the option of appealing the ruling but could be forced to pay 250% of the total bill if tributary courts rule against it in the dispute. The Venezuelan government also reportedly seized documents from the offices of Chevron in Caracas.

CONCLUSION

The conflict between Chavez and the U.S. will not soon abate. It will most likely spread to surrounding Latin American nations as Chavez uses oil and other diplomacy to align his neighbors in an anti-U.S. stance. The U.S. will attempt to thwart Chavez’s efforts with economic diplomacy of its own –the recent passage of the Central American Free Trade Agreement being a case in point.

But what about oil? It remains unlikely that Chavez will curtail oil exports to the U.S. They are, after all, the life-blood of his economy. However, diplomatic games of chicken have a way of producing unintended consequences, and neither Bush nor Chavez has a habit of swerving out of the path of danger.

OPI WEEKLY: EU-3 POLITICS AND THE UNCERTAIN FUTURE OF IRAN'S AGING FIELDS

2005-08-07T14:18:00.000-05:00

Things are getting tricky in Iran. Just as relations with the West are taking a sharp downward turn, there are increasing signs of production trouble in several of Iran’s aging oil fields. The combination is a bad one. The oil markets are looking for an extra million barrels of oil from Iran by 2010 and if production problems continue or worsen, the Iranians will need Western help to maintain, let alone increase, production. To make matters worse, the newly elected president in Iran, who promised during the campaign to replace the country’s “oil mafia,” is set to name a new Oil Minister. All this put together spells trouble for one of the world’s stalwart oil producers and the market it serves.

NUCLEAR TALKS WITH THE EU-3

Iran’s nuclear talks with the Britain, France, and Germany are all but dead. Frustrated at the pace of the negations, Iran announced last week that it would once again resume processing uranium. Although Europe responded with a new package of economic and incentives to dissuade Iran from resuming uranium processing, Iran rejected the offer outright. The EU-3 has now joined the U.S. in insisting that if Iran resumes its nuclear program, the matter will have to be referred to the U.N. Security Council. Iran says that it will nonetheless recommence uranium processing as early as next week.

For Britain and Germany the collapse of the talks is practically a non-issue. Both countries are far too concerned with internal security (Britain) and internal politics (Germany) to care much about Iran. And neither has held out much hope or desire of late for a common European foreign policy.

For France, however, the collapse of the talks constitutes yet another embarrassing defeat. While France had hoped to use the talks to show itself it be an alternative global power-broker to the U.S. and as the leader of a (sort of) common European voice, they are now left with no choice but to echo the U.S. in calling for a Security Council referral.

As for Iran, it never cared much about the EU-3 talks in the first place. In fact, Iran is not as intrinsically concerned at the moment to become a nuclear state –although they would certainly relish the importance in the world generally, and the admiration in the Muslim world in particular, that possession of nuclear weapons would bring—as they are to use the nuclear issue as a pressure point with the U.S. to gain ground in the unfolding political order in Iraq. While Iran certainly does not wish for a confrontation at the U.N., it does want the attention of the U.S. in order to make headway in Iraqi politics.

While Iran said today that it does not fear referral to the Security Council, the move would have an immediate effect on the international oil company (IOC) involvement in the state. Even though Russia and/or China would almost certainly block any proffered sanctions package, European and Canadian firms in particular would be unlikely to buck the political pressure to withhold investment in Iran.

The possibility of such a freeze on investment in its oil industry comes at a particularly unwelcome time for Iran. As survey of Iran’s oil industry reveals, investment in expensive recovery technologies is exactly what Iran needs if it is to meet its production targets.

IRAN'S AGING OIL FIELDS

Cambridge Energy Research Associates released a report recently painting a relatively comforting picture of the prospects that oil supply through 2010 would be adequate to meet ever-increasing demand. Among the countries that its authors identify as the sources for this medium term production is Iran, which they say will increase production by a little over a million barrels per day from its current level of about 4 million bpd to 5.4 million bpd. A 20% plus increase such as this is a lot, but shouldn’t be too much to expect from one of the world’s most prolific producers. Or is it?

There are serious questions about Iran’s ability to maintain current oil production levels, let alone increase production by 1.4 million barrels per day in the next five years. Like Saudi Arabia, most of Iran’s production comes from aging super-giant fields that increasingly require maintenance to sustain production. Unlike Saudi Arabia, however, the geology of Iran’s fields is generally more fractured and complex, making field maintenance more difficult and ultimate yield percentages lower.

Industry analysts estimate that Iran is losing 350,000 to 400,000 bpd per year of oil production capacity. Decline rates are now about 8% per year for Iran’s onshore fields and 13% per year at its offshore production sites. Unless stemmed, the decline rate could increase to 500,000 bpd per year by 2010.

So where will Iran get the extra 1 to 2 million barrels per day of capacity to replace the declines and meet the increased production targets?

Outgoing Iranian Oil Minister Bijan Namdar Zanghaneh recently announced that Iran would bring three new fields online in the near-term in order to raise production from 3.95 million bpd to 4.2 million bpd. Those fields are Soroush and Norouz in the Persian Gulf (190,000 bpd) and the Darkhovin field run by Italy’s ENI in the southwest province of Khuzestan. Darkhovin is slated to add 160,000 bpd to Iran’s total output by year end 2006, although the field is currently producing only 55,000 bpd. Another offshore field, Sirri, also was also recently upgraded to make up for declines elsewhere.

Where the rest will come from, however, is less clear. According to the Energy Information Administration six fields, all in the prolific Zagros belt stretching through southern Iran and Iraq, make up almost three-fourths of Iran’s production:

	bbl/d	% Total Production
Ahwaz-Asmari	700,000	21%
Gachsaran	560,000	17%
Marun	520,000	16%
Bangestan	245,000	7%
Agha Jari	200,000	6%
Karanj-Parsi	200,000	6%
		72%

These fields, however, are not without their differences. The giant Ahwaz field, Iran’s most prolific producer, draws its oil from two disparate formations, the high permeability Asmari sandstone and the less porous reservoirs of the Bangestan group. While the Asmari sandstone formation is expected to yield as much as 64% of total oil in place, the often fractured, tight carbonates of the Bangestan group have yield percentages as low as 20%. The overall yield for the field may thus be a modest 40% of oil in place.

However, even that 40% can be recovered only with the assistance of aggressive recovery programs requiring substantial foreign investment. Production from the Bangestan group of Ahwaz, for example, has fallen from its peak 250,000 bpd to 160,000 bpd and is likely to fall to 60,000 bpd within one to two years without a massive gas injection program. While a successful injection program could bring production rates back up to over 200,000 bpd the steep and rapid decline it is a sure sign that the field is past its producing prime.

In fact, the National Iranian Oil Company has been forced to cut back and shut in some wells in most of its major fields due to rapid pressure drops and rising water cuts. This has occurred in all of the giant fields of the Zagros belt, including Ahwaz, Gachsaran, Marun, and Agha Jari.

The Agha Jari field is an instructive case in point. Initially discovered in 1938, the field continues to be on of Iran’s top five or six producers. However, almost 10 billion of the field’s 15 billion recoverable barrels have already been produced. Production from the field peaked in 1974 at 1 million barrels per day, after which the field produced a steady 850,000 barrels per day for 17 consecutive years. The field now clearly on its last legs, producing 187,000 barrels per day, with the help of a whopping 3 bcf per day of injected gas.

What is key here is not that Agha Jari field or any of the other Zagros fields are old and depend upon the application of advanced recovery methods –such is the fate of even the world’s greatest producers—but rather Iran recently identified the field as one upon which they are counting to meet their aggressive production targets.

One further source, the Darkhovin field run by Italy’s ENI in the southwest province of Khuzestan, is slated to add 160,000 bpd to Iran’s total output. However, the field is currently producing only 55,000 bpd.

Offshore production, which now stands at around 750,000 bpd is projected to increase to as much as 1.1 million bpd by 2010. The projected output boost would be made possible following extraction of oil from Sorush, Norouz, Dorud, Salman, Behregansar, and Hendijan fields.

NEW OIL

Iran has had some success in adding new reserves through exploration, particularly in the Abadan Plain bordering Iraq. The Azadegan and Yadavaran oil fields in southwestern Iran hold an estimated 10 billion barrels of estimated reserves.

However, these fields will be expensive and technologically challenging to produce. The reserves are contained within the fractured, low-permeability carbonates of the Bangestan group. In addition, the quality of the crude produced is relatively heavy low, with a gravity less than 28˚, as opposed to the 34˚ plus crude produced elsewhere in the country.

Regardless, once developed the fields could produce 50,000 bpd of crude oil by 2007, 150,000 bpd by 2008, and a final 260,000 bpd by March 2012.

A ROUGH ROAD FOR IOC'S IN IRAN

Given the complex and mature character of Iran’s mainstay fields, technology will make or break Iran in its ability to hit its production targets. Bijan Zanganeh, Iran’s Oil Minister, told reporters recently that “With heavy investment, there is capacity for one million barrels per day to come from unfinished projects.” But will that investment be forthcoming?

Barriers to foreign oil company involvement in Iran’s oil sector have been high. The Iran-Libya Sanctions Act has prevented U.S. companies and dissuaded many non-U.S. companies from developing fields there. In addition, the buy-back system that Iran uses to contract with foreign operators is complicated, inconsistent, and often does not yield attractive investment terms. Increasing uncertainty about Iranian production and reserve estimates has also softened interest in Iranian involvement.

Regardless, many foreign companies recently have entered into exploration, development, and production contracts with the National Oil Company of Iran, including ENI in the Darkhovin onshore and Doroud offshore fields. A Japanese consortium inked a deal in February 2004 to develop the recently discovered Azadegan and Yadavaran fields, and Royal Dutch/Shell, Petronas, Total, Repsol YPF SA, and ENI SPA have also expressed interest in Iranian projects.

There is increasing pressure, however, from Iran’s resurgent conservatives to curtail foreign involvement in its oil sector. Many claim that the oil ministry awarded contracts to foreign firms although Iranians could have done them just as well, but at a lower cost. In March 2005, a the potentially lucrative contract to revive the giant Bangestan field was awarded to Petro Iran Development Co., after having been delayed several times since 2001. Shell pulled out of talks on involvement in the project in 2003 saying that it was frustrated with the slow pace of negotiations, including numerous changes to terms of the project. France’s Total and BP also bid on the project before it was awarded to the Iranian firm.

Despite conservative claims to the contrary, the Iranian company alone does not have the technological sophistication necessary to salvage the aging field. This inability has been made clear by the rapid declines in Iranian production and is widely acknowledged within the industry.

THE NEW IRANIAN LEADERSHIP: POPULIST HYPERBOLE OR FUTURE POLICY?

The anti-IOC camp has been buoyed by the presidential election win of Mahmoud Ahmadinejad who vowed during the recent campaign to “cut off the hands of the mafias of power and factions which have a grasp on our oil.” The problem for Iran and the markets which depend on Iranian oil is that it is the “oil Mafia” in the country which is most cognizant of the need for IOC involvement in the country.

However, the extent to which such promises are populist bluster or indicative of future policy will be determined when he announces who will become his Oil Minister.

Deputy Oil Minister Hadi Nejad-Hosseinian was among the early frontrunners. He is well respected in the international oil industry and during an earlier stint as Iran’s Ambassador to the U.N. made a point of meeting with all the IOC heads. However, because of this identification with the old oil regime in Iran, he has faded from consideration for the top post.

Others on the short-list include Kamal Daneshyar and Hossein Nejabat, conservatives on parliament’s energy commission, and Ali Beheshtian, a highly experienced Iranian oil executive. Daneshyar has been outspoken in opposition of IOC involvement in Iran’s gas industry but has not suggested that current IOC contracts should be reconsidered. The same cannot be said of Nejabat who has unsettled investors by not only criticizing the buy-back structure of IOC deals but has suggested going back and reconsidering deals already signed.

Beheshtian, on the other hand, is an experienced executive who now manages the Iranian petrochemical industry’s investment company. However, his previous stint at the National Iranian Southern Oil Company ended in a spat with outgoing oil minister Zanganeh when the latter charged Beheshtian with surrendering too much in foreign contracts.

CONCLUSION

The coming week will be an interesting one in Iran. The new president in Iran will have to proffer a response one way or another to the U.S. and Europe, and his choice for Oil Minister will send important signals to the oil market. However, IOC involvement in Iran looks destined to decrease and given the current predicament of Iran’s oil industry the country seems destined to miss the production marks the oil markets are counting on.

OPI UPDATE: AL QAEDA, SAUDI ARABIA, AND THE DEATH OF A KING

2005-08-01T19:37:00.000-05:00

Reeling already from a spate of refinery shut-downs in the U.S. and Europe over the weekend, the last thing the oil markets needed was a shot of geopolitical instability. But that is just what it got with the death of King Fahd of Saudi Arabia on Monday. Although the King long has been ailing and his successor Abdullah long determined, no Saudi succession is without its share of risk and intrigue, and this risk and intrigue has already sent the price of oil to a record high over $62 per barrel. While it is unlikely that any serious instability –whether through risk or intrigue—will ensue, the oil markets will spend a nervous few days watching the headlines out of the Middle East.

On the risk side –the side of most immediate concern to the oil markets—the question is whether or not al Qaeda will be able to muster a reaction to the passing of the king. There is no question they would like to. The hallmark of al Qaeda’s attacks has been their coordinated, symbolic character, and times of government succession –especially in monarchies—are times of both weakness and symbolism. In addition, Saudi Arabia is second only to the U.S. in terms of importance as a target for attack. It is the land of the two holy cities, a lynch-pin in the world economy, and an ally of the west. Osama bin Laden and the al Qaeda leadership dream, no doubt, of one day taking control of Saudi Arabia and its vast oil wealth.

Indeed, al Qaeda has worked hard since September 11 to destabilize the government there. Scores of Saudi’s and over a hundred foreigners have been killed in the country in sporadic attacks and abductions since 2003. During the spring of 2004 there were gun battles on an almost daily basis between militants and Saudi Security forces, briefly forcing many foreign companies there to rethink there work in and for the Kingdom. There are still thousands of al Qaeda sympathizers sprinkled throughout the population with the potential to create serious instability should al Qaeda be able to create momentum with a successful attack on the government or infrastructure.

While al Qaeda never quite has been able to galvanize the population, they have not stopped trying. Al Jazeera broadcast a videotape June 17 in which, Ayman al-Zawahiri, al Qaeda’s second in command condemned the recent push for democratic reform in the Middle East, singling out the governments of Egypt, Pakistan, and Saudi Arabia and their recent democratic reforms. The terror attacks which killed dozens in Egypt in July testify to the seriousness of that threat. And al Qaeda desperately needs another big win to keep its recent momentum going. The attacks in London and in Egypt are likely a last gasp effort of sorts to regain credibility in its flagging struggle against the West.

If there is going to be an attack in Saudi Arabia we should know very soon. A coordinated, symbolic attack would be triggered by the King’s death. Either the cell and plan are in place, or they are not. If they are and the plan is successful, we can expect oil prices to jump to the mid $60 range. If in the very unlikely event that an attack seriously damaged the oil infrastructure, the price would obviously go much higher.

So, until this risk has subsided with a few weeks time the markets will be jittery. But what about intrigue? Is there any palace intrigue that could shake the oil markets as well? Much less likely so. The line of succession is clear. There are no sharp disagreements within the government. In the coming months and years, however, there will be tension as the Sudeiri clan –the direct descendants of the country’s founder—seek to ensure that line of succession stays with them, even though the King Abdullah is only the half-brother of King Fahd. This clan includes current Interior Minister Prince Nayef and his younger brother Prince Salman, along with Crown Prince Sultan.

But internecine intrigue such as this, as enthralling as it may be to the world’s Saudi watchers, will not impact oil markets nearly so much as the fear of attack in the weeks to come.

AN UNTIMELY HIATUS: OPI OFFLINE UNTIL SEPTEMBER

2005-05-22T19:40:00.000-05:00

Unfortunately OPI will not publish again until the first week in September. There will no doubt be much to reflect on at that time as the international oil and energy outlook becomes increasingly volatile. Among the factors that will shape the international oil landscape are the following.

1) Bush and Chavez are on a collision course and neither man has a history of flinching. While the war will remain one of words and policy, it is likely that Venezuela's already suffering oil industry and output will suffer even more. U.S. supplies in particular and world prices in general will feel the effects.

2) The next months in Iraq will be crucial, not only for Iraqi politics and hence Iraqi oil output, but also for regional politics and regional oil production. If the situation in Iraq deteriorates it becomes much more likely 1) that tensions between the U.S. and Iran will increase, possibly disrupting Iranian supplies, and 2) that al Qaeda will hang on and be a disruptive force in Persian Gulf states, especially Saudi Arabia.

3) The aggressive Bush policy vis-à-vis Russia will continue to create tensions that will reverberate through the international oil industry. Ukraine will increasingly seek energy independence from Russia by importing and transporting more Caspian oil, while other CIS states will struggle –sometimes violently, as in Uzbekistan—with democratic movements or and anti-democratic backlash. Most importantly, political-economic tensions within the Russian government itself will have adverse effects on Russia’s ability to grow or even maintain its oil production levels, putting a pinch on already tight world supplies.

4) Tensions within the Chinese government and economy are increasing. If China chooses to deal with the contradictions within its economy it has a chance to land softly, thereby continuing its impressive growth and demand for petroleum. If, on the other hand, the Chinese economy collapses, world oil price pressures will soften significantly. The coming months will reveal more about the likely direction the country will go.

I look forward to an interesting retrospective come September . . .

OPI WEEKLY: 'OPERATION BLACK GOLD': MILITARY MUSCLE IN VENEZUELA'S OIL FIELDS

2005-05-08T21:35:00.000-05:00

Yet again the most important news in the oil world this week came out of Venezuela. On Wednesday Venezuela’s Defense Minister, Jorge Garcia Carneiro, announced that the armed forces would take control of various oil installations in western Venezuela in order to prevent sabotage. Carneiro contends that recent sabotage has cost the country between 100,000 and 200,000 barrels per day in lost production. “Operation Black Gold,” he said, would involve over a 1000 soldiers, as well as military helicopters, vehicles, and boats to protect against sabotage and provide repairs.

Last week both Carneiro and Venezuelan President Hugo Chavez accused the CIA of infiltrating the state oil company’s western division in order to “provoke upheavals.” Unsurprisingly, the soldiers to man Operation Black Gold will come from the Venezuelan state militia recently created by Chavez and answerable directly to him.

On Friday, however, Venezuela’s Energy and Petroleum Minister, Rafael Ramirez, who is also President of Petroleos de Venezuela S.A. (PdVSA), downplayed foreign involvement, saying rather that the oil shortfall is the result of “a clear lack of management and poor use of funds.” Referring to the 2002-2003 PdVSA oil strike that nearly collapsed the Venezuelan economy, he claimed that “the people who destroyed the country during the national strike are once again trying to create a climate of uncertainty.” He also insisted that while security in the western region was being tightened, the western division of the company was in no way becoming militarized.

Consistent with that theme, PdVSA also announced this week that it would not renew contracts with 4,000 contract workers in the western region. Earlier this year 40 managers in the western region were fired for corruption and mismanagement in failing to reach production goals. It is also likely that any sabotage that has taken place is the result of these labor upheavals.

While the Venezuelan officials admit that production is down between 100,000 and 200,000 barrels per day, they still claim that the country is producing a total of about 3.2 million barrels per day. However, that figure is clearly exaggerated. Production has not been that high since the 2002 PdVSA strike. The Energy Information administration estimates January production from Venezuela to be approximately 2.6 million barrels per day.

Worse yet, the conflicting statements concerning the cause of the production shortfall reflect an increasing rift in the leadership of the country. Energy and Petroleum Minister Ramirez made his statements in Houston while trying to assuage foreign investors made anxious by the increasingly heavy-handed treatment that foreign oil companies have received from the Chavez government. Oil taxes were recently increased from 16 to 50 percent, and dozens of contracts were unexpectedly suspended pending further review. Ramirez, a political moderate by Bolivarian leftist standards, has come increasingly into conflict with the more radical Chavez and his military leadership. Operation Black Gold may indeed be an attempt to put pressure or even force out Ramirez by undermining his efforts and his ability to make decision within the huge company.

There also have been allegations this week in the Venezuelan media that foreign currency earned by PdVSA has not been turned over to the central bank. These rumors seem to suggest that as head of the company, Ramirez is to blame, although clearly such a scheme would have to involve government officials all the way up to Chavez himself.

Chavez has already made strategic moves within the oil industry to focus it more as a tool of is Bolivarian revolution. He recently appeared in Havana with Fidel Castro to open PdVSA’s first offices there. The two countries will cooperate in an operation involving PdVSA and Cuban oil company Cupet to build a lubricants plant, a shipping terminal and a storage facility as well as complete the Cienfuegos Soviet-initiated refinery. The purpose of the joint venture will be to lower the cost of fuel to the Caribbean region, as well as to assist the impoverished Cuban nation.

The increased militarization of PdVSA in the western Venezuela may also serve to further consolidate Chavez’s political hold on the country. The United States announced last week that it would shift to a more aggressive policy vis-à-vis the Chavez government by supporting and assisting opposition parties in the country. The western region happens to be home to the greatest concentration of anti-government politicians and activists. Today two opposition figures, Claudio Fermin, former mayor of Caracas, and Carlos Melo, a political activist, announced they will form a new party known as the Popular Assembly party in an effort to unite against President Hugo Chavez. Fermin said the party would field candidates in municipal elections to be held Aug. 7. It is likely that the new party has either already cooperated with the U.S. or hopes at least to do so by taking the initiative now. Chavez will certainly be aggressive in combating any such cooperation.

The situation in Venezuela is thus getting very complicated very fast. Chavez clearly intends to meet the aggressive U.S. policy toward his country head-on, using all the tools at his disposal, including the powerful oil company, as well as relations with Washington foes such as Cuba, China, and Iran. How far Chavez is willing to take it, likely depends on his own willingness to take risk, for clearly Chavez and Venezuela have much to lose.

OPI WEEKLY: SAUDI SECURITY AND A NEW POLICY IN THE SOUTH: THE GEOMETRY OF OIL IN THE YEARS TO COME

2005-05-01T14:54:00.000-05:00

U.S. President George Bush unveiled a new strategy this week for dealing with Venezuelan President Hugo Chavez. At risk are the 1.7 million barrels of crude oil that Venezuela ships to the U.S. each day. President Bush also held talks this week with Crown Prince Abdullah of Saudi Arabia. While there was no explicit link between the two events, they are crucially related none the less. Saudi security will be even more important than ever to the U.S. if the new Venezuela policy goes badly.

THE SAUDI VISIT

Saudi Arabia’s de facto ruler, Crown Prince Abdullah, visited U.S. President George Bush at his ranch in Crawford, Texas last week amid speculation that Bush would try to win a Saudi commitment to increase its production of oil in order to bring down record oil prices. There is increasing evidence that the high crude prices are starting to hurt U.S. economic growth.

The press was surprised, and many Americans perturbed, when the President emerged from the meetings holding hands (literally) with the Crown Prince, while extracting no new concessions on current production. Saudi Arabia has said for months that it would bring new crude supplies on line in the medium to long term, ramping up to 12 million barrels per day by 2009 and 15 million barrels per day by 2025. Saudi Arabia currently contributes between 9.5 and 10 million barrels per day to the crude oil market.

Such medium and long term increases, while helpful in the future, will do nothing to dampen oil prices now. Either the President failed in his goal for the meeting, or else there was something more to the meeting than met the eye.

The latter indeed is most likely the case. With the war against al Qaeda winding down successfully, the President has turned his attention to other strategic goals. Containment of the nuclear programs in North Korea and Iran are certainly high on that list. However, the Administration has also signaled its intention to deal more aggressively with Hugo Chavez, the increasingly popular leftist leader of Venezuela –especially as Chavez’s influence seem to be spreading. A populist revolt in Ecuador ousted the nominally pro-American leader there last week, and the Sandinista movement in Nicaragua may be gearing up for the same.

VENEZUELA ON THE FRONT BURNER

Last Sunday Venezuela announced that the 35 year old military cooperation, which had in any case dwindled in its extent, would come to an end. The remaining U.S. military personnel were asked to leave. It didn’t take the Bush Administration long to react. According to a story carefully leaked by the Administration two days later to the New York Times, the Bush Administration has concluded that further attempts to cooperate with the Venezuelan leader are doomed to failure. Instead it would adopt a tougher approach, including funneling more money to foundations and business and political groups opposed to Chavez and his left-leaning compatriots.

Chavez, however, possesses one critical weapon to wield against the United States should he so choose. That weapon, of course, is oil. Venezuela supplies 15% of the United States’ 11.8 million barrel per day of crude imports. Through its fully owned U.S. subsidiary, CITGO, it also wholly owns 756,000 barrels per day of refining capacity in the United States, and that does not include the Caribbean refineries that process Venezuelan crude almost entirely for U.S. consumption. The CITGO refineries alone produce 663 thousand barrels per day of gasoline. If Venezuela were to cease those supplies, the impact on the price of U.S. gasoline, and on the U.S. economy, would be significant.

If the ‘worst case scenario’ outcome of the new Venezuela policy took place and Chavez were to both stay in power and decide that he will starve the U.S. of crude, the change couldn’t happen overnight. For Chavez to do so would also be to starve the Venezuelan economy and government of the lion’s share of its national income. Ceasing U.S. supplies can be a medium-term goal for Chavez at best.

However, there already have been rumors that CITGO is seeking to sell all its U.S. based refineries –it announced earlier this month that two of the six are currently for sale—although CITGO officials deny the rumors are true. Venezuela has also recently strengthened its energy cooperation with China, a country which will increasingly demand foreign oil to feed its enormous and growing economy. A country as large and oil thirsty as China could provide adequate supply to replace sales to the U.S. down the road. However, China’s demand won’t ramp up until the medium-term at best—say by about 2009.

The timing thus works well: about the time that Venezuelan supplies to the U.S. might dry up, Saudi Arabia is set to bring about the same amount of increase onto the market. So did Bush and Abdullah talk about Venezuela in their Crawford meeting? Hardly. Saudi Arabia plans to supply those added barrels of oil regardless of what happens with Bush and Chavez. Furthermore, the extra Saudi barrels would easily be soaked up by the market in any case as both U.S. and North Sea crude supplies begin to run dry.

SAUDI SECURITY

But the timing of the ‘worst-case scenario’ outcome of Venezuelan policy does mean that those extra Saudi Barrels are especially important to the U.S. if it loses one of its primary supplies in Venezuela. Might Bush have sought a promise from Abdullah to reserve a certain amount of future supplies to the U.S.? Maybe. But it is more likely that much of this is understood while remaining unspoken.

What Bush had to tell Abdullah probably had more to do with assurances that the U.S. was dealing with Saudi Arabia’s primary security threats and that indeed the Saudi kingdom would indeed be around in the medium term to supply that oil. Even if Iraq and Russia are able to ramp up production –neither being a safe assumption given the political and economic environments in the two states—Saudi Arabia will continue to have the most capacity and the largest pool of oil to draw from. It sits on top of 26% of the world’s total reserves and has some of the lowest production costs in the world as well.

Saudi Arabia’s two greatest threats are al Qaeda and Iran. The U.S. is fundamental to the containment of both threats. Bringing down the House of Saud has always been one of al Qaeda’s primary goals since its inception. And for a time last year it seemed that al Qaeda was making good progress toward that goal. Gun battles between insurgents in the Kingdom were taking place almost on a daily basis and horrific attacks on Western business personnel threatened to cause an exodus of expatriate workers from the country.

Saudi and U.S. efforts to root al Qaeda out of Saudi Arabia, as well as the significant progress the U.S. has made in battling the al Qaeda network worldwide, has stabilized the Saudi situation. As the two attacks yesterday in Egypt make clear, Egypt has now become the primary target of the weakened terrorist group, much to the relief, no doubt, of the Saudi government.

Bush likely assured Prince Abdullah of this progress in their Crawford meeting, as well as his commitment to continuing the battle until al Qaeda ceases to be a threat anywhere in the region. The American President also, no doubt, assured the Crown Prince of his intention to keep Iranian influence in Iraq –not to mention its nuclear ambitions—in check. In essence, President Bush assured the Saudi leader that his country would be around in 2009 to deliver the much needed oil.

CONCLUSION

Although there are no longer U.S. troops on Saudi soil, and in some ways U.S.-Saudi relations are as strained as they ever have been, the two countries are more dependent upon each other than ever before. For Saudi Arabia, threats from Iran and al Qaeda will continue to make a U.S. security guarantee a necessity, even without troops on Saudi soil. For the U.S., oil from the Middle East generally, and from Saudi Arabia in particular, will be increasingly important. If Bush’s Venezuela policy goes badly and Venezuela stops supplying oil to the U.S., that dependence becomes even more acute.

OPI WEEKLY: A STATE IN HIS OWN IMAGE: CHAVEZ CONSOLIDATES HIS POWER OVER VENEZUELA

2005-04-24T19:39:00.000-05:00

Just three years ago, Venezuela’s President Hugo Chavez was ousted from office by a vibrant opposition movement. That ouster lasted only two days. Beset by confusion, the opposition failed to consolidate its newly won power and Chavez was able to regain control of the government.

Now at the height of his popularity –Chavez allies won control of 22 of the 24 regional governments and 75% of the 335 city governments in the October 2004 elections—Chavez is making bold moves to consolidate his power. He has tightened control over foreign oil companies operating in the country, created oil alliances with some of Washington’s greatest foes, and rapidly embarked on a military build-up. He has even created a Presidential militia answerable directly to him.

Chavez has always held extreme views. He is now creating a state capable of acting in the service of those views. While Venezuela’s economy and government are far too dependent on the U.S. to make a sharp break, Chavez has made clear that he will do as much as he can to move toward that ultimate goal.

A BAD DAY FOR FOREIGN OIL

On April 14 Venezuela’s Energy and Oil Minister Rafael Ramirez announced that the government would restructure 32 oil production agreements signed more than a decade ago. According to Ramirez, the agreements, which involve over a dozen companies from around the world producing oil in Venezuela, resulted in a loss of $260 million dollars in 2004. He also said that a majority of those companies had evaded paying taxes on the projects and would be expected to repay some $2 billion once the investigations are complete.

Although few details on the pending restructuring were released, the Energy Ministry said all foreign-run development projects would be reorganized into joint ventures in which the Venezuelan state run oil company Petroleos de Venezuela (PDVSA) will have a 51 percent stake. Foreign firms would also have a maximum income cap instead of the per barrel fee arrangement currently in place.

On April 18 Ramirez further announced that tax rates on oil company profits would be raised to 50 percent from 34 percent. He offered no details on when the new rates would go into effect, saying only that they would not go into effect “today.” None of the companies most effected by the change, which include ChevronTexaco, ConocoPhillips, Royal Dutch/Shell Group of Companies, BP Amoco PLC, Repsol YPF SA, Petroleo Brasileiro SA, Petro-Canada, Statoil, AB Nynas Petroleum, China National Petroleum Corp. and Japan's Teikoku Oil Co. Ltd., have commented on the announcement.

These changes –or at least changes along these lines—are not entirely unexpected. In November 2001 Chavez enacted the new Hydrocarbons Law to replace the 1943 law then in place. Under the new legislation private investors cannot own 50% or more of the capital stock in upstream joint ventures, with the exception of the four extra-heavy crude oil and bitumen development projects situated primarily in the Orinoco Oil Belt. However, Chavez announced in October 2004 that foreign oil company royalties of between 0% and 1% in Orinoco Oil Belt projects would be raised to 16.6%, in accordance with 2001 Hydrocarbons Law.

The motive and timing for the changes is clear. With oil prices maintaining near-record levels, Chavez is taking the opportunity to reap maximum windfall profits. He has said that he plans to raise Venezuelan crude production from its current 2.6 million bbl/d level to 5 million bbl/d by 2009. Given the current production in place and the condition of currently producing fields –many are old or damaged from Venzuela’s rush to resume production following the 2002 strike—this kind of increase will entail huge near-term capital investments. Chavez hopes to raise at least part of those investment funds by collecting higher the higher taxes and royalties.

However, Venezuela will still need the help of foreign oil companies in order to undertake expensive and technologically complex development projects. Chavez is thus walking a fine line between raising revenue and scaring away already leery foreign partners. One indication of how Chavez plans to realign Venezuela’s oil alliances will appear as the contract restructurings and tax investigations commence. Companies from more Chavez-friendly countries like France, Spain, China, and Brazil could fare much better than U.S. companies, allowing them a greater –and safer—share of the pending investment contracts. While it is unlikely that U.S. companies would be shut out –or entirely shy away—from Venezuelan projects altogether, Chavez now has the opportunity, and certainly the will, for a major realignment of the country’s oil alliances.

THE CHINA CONNECTION

The first step toward that realignment took place last October with Chavez’s announcement while on a visit to Beijing of eight energy agreements with China. A rapprochement between the two countries began in 2001 with the leftist Chavez’s election and has steadily progressed as the Venezuelan leader has consolidated power. In signing the eight agreements, Chavez said his country had taken the first step toward ending 100 years of U.S. domination over Venezuela’s oil industry.

The October agreements involve Chinese participation in Venezuelan oil production and the construction in Venezuela of new pipelines, refineries and petrochemical plants. The two countries hope eventually to build a pipeline from Venezuela to Columbia’s pacific coast in order to facilitate increased Venezuelan exports to China. Venezuela and Columbia resumed talks on the pipeline in February after they had stalled during an unrelated diplomatic rift.

Subsequent talks have arranged for China to receive 100,000 bbl/d of Venezuelan crude and 1.8 million tons per year of Orimulsion boiler fuel. However, there is more to these recent agreements than meets the eye. The Boscan crude slated to be shipped to China is usually sent to the U.S., which has the refineries tooled to process the heavy oil. China will have to undergo an expensive retooling of some of its current refining capacity in order to process the Venezuelan oil. Such a retooling would prove most cost effective if it planned to increase such shipments. Similarly, the Chinese will have to construct a specialized receiving port to handle the Orimulsion fuel deliveries, also suggesting a long-term and perhaps growing arrangement.

The two countries also announced plans for a joint project involving PDVSA and China’s National Petroleum Corporation (CNPC) in the development 14 marginal gas and oil fields in Venezuela’s eastern Zumano region. The fields currently produce 25,000 bbl/d of crude oil but hold an estimated 400 million barrels of oil and 3 Tcf of natural gas.

IRAN AND INDIA

Iran and Venezuela, while in many ways so different –Catholic and Muslim, Western and Eastern, tropical and arid— share two very important characteristics: they are both oil rich, and they both despise the U.S. While the two countries have talked about cooperation on energy development –Iran reportedly has expressed some interest in Venezuelan gas field development—the real strategic cooperation is more purely geopolitical. During a recent visit by Iranian President Khatami to Caracas, President Chavez went out of his way to lend his support to Iran in its battle with the U.S. and Europe over Iran’s nuclear program. Chavez described both Iran and Venezuela as victims of U.S. imperialism.

While the exact character of Venezuelan-Iranian cooperation is not clear –the two countries are still in the ‘getting to know you’ stage of alliance-building—they can only help each other. Iran can certainly assist Venezuela through petrochemical and other types of technology transfer and could even assist with military tactical training of Venezuelan forces. For Iran, an ally in the Western hemisphere –especially one that is one of the United States’ largest crude suppliers—is a strategic benefit. Chavez appears finally to be strong enough to invest in politically, and Iran will be happy to make that investment.

India is similar to China in its large and growing oil needs. Already the sixth largest oil consumer in the world, its demand will increase several fold as it enters a period of rapid growth and industrial development. With limited resources at home, India has aggressively sought foreign oil development opportunities, often competing for those opportunities with China. As Venezuela looks to diversify its oil production and export base, India is thus an obvious candidate. Chavez visited India in March, where he discussed future cooperation with the Indian leadership.

In fact, India and China may also have another ally in common: Iran. One of the primary ways that India will solve its domestic energy needs will be through imports of natural gas. Some of those imports could come from Turkmenistan, but most will likely come from gas-laden Iran. In January the the Indian State run oil company reached an agreement with the Iranian firm Petropars to develop a gas bock in the gigantic South Pars gas field, home of the world’s most abundant reserves. While India enjoys good relations with the U.S., it also has not shied away from doing business with Washington’s foes, including recent oil development projects with Sudan.

India, Iran, and China all constitute new allies for Venezuela, ones that maintain a significant degree of independence from –and in the cases of Iran and China, resistance to—U.S. power. It is likely that Chavez will seek to develop these relations as long as he remains in power.

A ONE MAN ARMS RACE

Last fall President Chavez announced a change in its military doctrine. Henceforth, the President said, Venezuela would focus on asymmetrical threats –i.e., an attack by the more powerful United States. In months since then, Chavez has completed with arms deals with Russia, Spain, and Brazil that have given at least a semblance of substance to the statements. From Russia, Venezuela will receive 100,000 AK-47 assault rifles and 10 military helicopters. They have also discussed the purchase of up to 50 Russian MIG fighters, but no deal has been reached. Spain has agreed to sell Chavez helicopters and airships, ostensibly to patrol the coast and assist in thwarting drug traffickers. However, some reports have claimed that the Spanish purchases will include four guided missile corvettes that will be equipped with Exocet missiles. From Brazil, finally, Venezuela will purchase two dozen military aircraft.

One may ask, as Donald Rumsfeld recently did, what the Venezuelans are going to do with all these new weapons. After all, Venezuela at present has only 82,000 individuals in its armed forces, and that includes reservists. Part of the answer is that Venezuela plans to increase the size of its military. In fact, Chavez announced recently the creation of a special Presidential Guard that will answer directly to him. In swearing in the leaders of his new guard, Chavez claimed that it was the first step in a ‘new military doctrine’ which will include local militias to help defend Venezuelan sovereignty against “imperialist aggression.” Chavez said the guard would ultimately grow to be 2 million strong. Not bad for a nation that has only 25 million citizens.

CONCLUSION

So where is all this going? Is this Venezuela’s bid to join the axis of evil, or is it merely the bluster of a lonely Marxist that finally has gained control over his state. The answer, of course, lies somewhere in between. Chavez would join the axis of evil if he could, but he can’t. His country and government are far too dependent upon the U.S. In 2003, 80 percent of Venezuela’s exports were oil and petroleum products and 60 percent of that went to the U.S. The petroleum industry, in turn, provides half of Venezuela’s government revenues. Venezuela is clearly dependent upon the U.S.

But that can change over time. As Iran has amply demonstrated, oil wealth can be had without the U.S. as a buyer. Venezuela’s recent dealings with China, Iran, and India are a step in that direction. Chavez also appears to be creating much more militarized state than previously indicated, which will allow him to back bluster with bullets if ever needed. Indeed, Chavez, always willing, is finally able to make the state more reflective of his own image.

OPI WEEKLY: RUSSIA'S SECESSIONIST SCARE

2005-04-17T10:21:00.000-05:00

Recent protests in the central Russian region of Bashkortostan have raised an ominous question: have the velvet revolutions come to Russia itself? Indeed, some sources suggest that the protests are likely to spread to surrounding Russian regions as well. Worse yet for Russia, these regions happen to be some of its most important oil production, refining, and transporting regions. The unrest could threaten not only Russian cohesion, but also the world's already shaky oil markets.

However, other evidence suggests that there might be less to the protests than meets the eye. Indeed, the unrest seems more likely the result of a well-meaning but irrational exuberance than the result of a lasting revolutionary spirit. If so, the protests in central Russia –to the relief of Vladimir Putin as well as the world’s oil markets—are likely to fade away as quickly as they came.

RUSSIAN UNREST

Anti-government demonstrations took place on March 26 in Bashkortostan, a small but vitally important central Russian republic located in the Southern Ural Mountains north of Kazakhstan. An estimated 20,000 demonstrators gathered in the central square of Ufa, the Bashkir capital. On April 7 Bashkir protesters took their demonstration to Moscow to further press their demands. Organized by a broad-based coalition of Bashkir opposition parties and supported by an array of NGO’s in the region, the demonstrators demanded the ouster of Bashkir President Murtaza Rakhimov as well as action on human rights issues. They also threatened to storm the Bashkir government offices.

Official Russian reaction to the protests was muted. President Vladimir Putin’s advice to the Bashkir leadership, to go soft on the protests, seemed only to further embolden them.

The Bashkir unrest marks the first sign that the ‘velvet’ revolutions that have swept through the former Soviet states of Central Europe, the Caucusus, and Central Asia may now be sweeping into the Russian mainland itself. Stratfor, a U.S. based intelligence firm, reported earlier this month that protests similar to –and perhaps larger than—those in Bashkortostan are now being planned in several other separatist-minded Russian republics, including Bashkortostan’s oil rich neighbor, Tatarstan.

If this is the case, the unrest may come at significant cost, not only to Russia’s economy, but also to the world economy. Most of the republics in question are key for Russia’s economy, in particular its prolific oil industry. During 2005, Russia is expected to produce approximately 8 million bbl/d of crude oil, with exports of 5.3 to 5.5 million barrels per day, second only to Saudi Arabia and over 10% of the world’s total. Russia’s Energy Ministry further forecasts that Russian oil exports will grow to around 5.8 million barrels per day by 2007. With prices already near record highs, Russia’s output is thus key to stabilizing oil prices and sustaining world economic growth. An interruption in the supply would undoubtedly rock the world’s oil market and put even more strain on the world economy.

RUSSIA, OIL, AND SEPARATIST STRIFE: THE CHECHEN EXPERIENCE

Russia, of course, is tragically familiar with separatist strife. Its war with Chechnya has come at a huge cost in both lives and wealth on both sides. In Chechnya we can also see the way in which oil might exacerbate any future separatist conflicts in Russia.

Historically one of Russia’s primary oil producing regions, under the USSR Chechnya became a major hub for oil transit and refining. This key industrial infrastructure is one of the reasons that Moscow refused to grant Chechen independence upon the collapse of the Soviet Union in 1991. The region increased in importance in 1999 when the pipeline carrying Caspian oil through Russia for export through the Black Sea port of Novorossiisk commenced operation. Although the government promised to pay the Chechen rebel party a sizeable portion of the transit revenues through the republic, separatists repeatedly sabotaged the pipeline in order to put increased pressure on the government and to steal oil for sale on the black market.

While disruption in oil supplies through Chechnya was not enough to seriously damage Russian exports, the same is not true of other oil producing regions which may soon experience political upheaval and perhaps violence. Bashkortostan, where protests took place last week and where demonstrators have threatened to occupy government offices is a major oil refining and transit point, while independent-minded Tatarstan produces and transits a significant amount of Russian oil.

THE FIRST SIGNS OF DANGER?: BASHKORTOSTAN

Like Chechnya, Bashkortostan had sought independence in 1991 and was refused. And like Chechnya, its importance as a major oil producer and refiner made it far too important for Russia to let go. Not only does Bashkortostan produce about 340,000 barrels per day of oil and claim over 2 billion barrels of oil reserves, it is also a primary refining station on Russia’s massive pipeline complex. Its state-owned oil and gas company refines 12 percent of all Russian oil and 18 percent of the country’s high octane gasoline.

However, given its distance from Moscow and its ethnically diverse population, Bashkortostan has managed since 1991 to retain a larger degree of independence from the Russian Federation government than most Russian republics. Indeed, Bashkortostan’s Rakhimov, is considered to be one of Russia’s most independent-minded governors, exercising tremendous power in the vitally important region. He repeatedly defeated Moscow-backed candidates by running on an anti-federalist platform and flaunting Federal court rulings condemning his election stance. However, increasing Kremlin pressure, and Putin’s 2004 decree stipulating that regional governors be directly appointed by the Federal President instead of elected regionally, has altered Rakhimov’s ability to exercise his independence.

Rakhimov increasingly has been identified with the ‘oligarchic’ and anti-democratic behavior characteristic of those in Moscow he had always opposed. Under pressure from a Kremlin backed opponent in 2003 Rakhimov was only able to survive that year’s Bashkir elections by swearing allegiance to Putin’s United Russia party. The current demonstrations accuse Rakhimov backed police of detaining and injuring several hundred people in a violent sweep of the town of the town of Blagoveshchensk in December 2004. Rights groups claim that over 1,000 men were taken into custody, beaten, and humiliated.

It is difficult to gauge, however, the extent to which the current Bashkir protests are reflective of active dissatisfaction wit the Bashkir leader, and how much of it is a more symbolic ‘spirit of democracy’ inspired by the ‘Tulip Revolution’ in Kyrgyzstan and fueled by increasingly prevalent NGO funds in the region. Rakhimov was a well known member of the Bashkir business community before being elected to the governorship in 1993 and has made his reputation on protecting a significant amount of Bashkir autonomy from the central government. Indeed, his political campaigns have always emphasized that stance.

It is more likely that the current unrest in Bashkortostan is a local mole hill turned temporarily into a national mountain by the prevalence of NGO funds and an exuberance following the 'tulip revolution' in Kyrgyzstan. While there is some dissatisfaction with Rahkimov. and real concern over the December violence, the Bashkir protestors are unlikely to risk serious disruption to the Bashkir –and Russian—economic base in order to press their dissatisfactions to the breaking point.

A LIKELY SECOND?: TATARSTAN

Tartarstan is another region often described as vulnerable to separatist strife. Tatars are one of the most prevalent and self-identified of the Russian minorities. However, in the Tatar case too, the separatism is not of the sort that is likely to lead to major disruption. The republic has had only one President, Mintimir Shaimiyev, since the end of the Soviet Union. Shaimiyev has always secured a significant amount of regional autonomy, while still cooperating in essential ways with Moscow.

Though not recognized by the Russian Federation, Tatarstan in 1990 became the first of the autonomous republics to adopt a declaration of sovereignty. In 1992 the republic even held a referendum on full sovereignty and 61% voted in favor. However, in 1994 Boris Yeltsin and Shaimiyev signed a bilateral power-sharing treaty which recognized extensive rights of self-governance for Tatarstan, though the document fell short of recognizing state sovereignty. In the years since, Tatarstan has privatized over a thousand companies, supplying about 75% of the consumer production within Tatarstan, including Tatneft, Russia's sixth largest oil company and the only one listed on the NYSE.

Oil form both Tatarstan and Bashkortostan is transported primarily via the massive Transneft pipeline system, the eastward extension of which runs through both Republics. The oil from the two regions is blended with oil produced at Russia’s Siberian oil fields to form the Urals blend crude. The Urals blend is a relatively light crude with an API rating of 32º, although it is also a sour crude with a sulphur content of 1.3%. While some of the oil is refined in the two republics’ refineries or transported via rail for export or consumption, most of it travels via pipeline for export via Russian ports at Novorossiysk, Odessa, or Ventspils. Urals blend exports go primarily to the CIS states and to Europe.

Tatarstan reported just over 6 billion bbl of proved reserves as of 2002, most all of it owned by Tatneft. In the first quarter of 2005 Tatneft produced 513,000 bbl/d in the region, bringing the total for Bashkortostan and Tatarstan to nearly 1 million bbl/d. In 2003, 53% of Tatar exports went to Europe, 27% was sold domestically, and 20% was exported to CIS states.

Clearly, unrest in Tatarstan could have a major effect on Russian exports, and hence the stability of the world oil markets. However, despite the historical proclivity of Tatars and Tatarstan toward self-governance, relations with Moscow, even under the more authoritarian Putin, have remained good.

The independent-minded Shaimiyev said recently that he “didn’t mind” the recent decision by Putin decreeing that the federal president, and not regional elections, will determine the regional governor. On the face of it, Shaimiyev’s statement of acquiescence is extraordinary. There are only two possible reasons why one of the most independent-minded governors of one of Russia’s most independent-minded regions would agree to such a pro-Moscow move: either political and economic interests are such that Tatarstan independence can flourish within a united Russian federation, or Shaimiyev has a proverbial gun to his head.

There is no reason to believe the latter is the case. While Putin summarily replaced several regional governors as soon as he announced his decision to change the laws regarding how regional governors are to be chosen, Shaimiyev was asked last month to stay on. There has been no insinuation, in contrast to the Bashkir case, that Shaimiyev had to sell his soul to Putin in order to remain in power, and there his been nary a protest from the residents of Tatarstan.

BORDERS, BREAD, OR RELIGIOUS BELONGING : EXPLAINING THE DIFFERENCE

How do we explain the different attitudes toward the secession found in Bashkortostan and Tatarstan on the one hand and Chechnya and other northern Caucasus regions? One obvious, if not determinative, factor is the character of the Islam found in the regions. While both the Bashkir and Tatars are predominantly Muslim, Islam has never dominated in political, economic, or ideological terms in these regions. It has few if any political ambitions. The historical development of Islam in the region sharply differentiates it from the political Islam characteristic of many Muslims, especially in the Middle East. Neither Tatarstan nor Bashkortostan have experienced religious influence in the political sphere.

In contrast, Islam in Chechnya is largely influenced by the Sunni Islam characteristic of Saudi Arabia and other Middle Eastern countries. This is a faith inextricably linked to politics and political ambitions. However, the extent of this influence in Chechnya is largely, if not primarily, the result of the war itself. The conflict at its outset was about secular political freedom, not political-religious freedom. However, once the war intensified, it increasingly attracted jihadists and took on a more radical bent.

However, the fact that the secessionist movement in Chechnya began as a secular, economic, and historically driven secessionist movement raises the question of whether or not a desire for independence in Bashkortostan and Tatarstan could become similarly religious and radicalized. Fortunately for the Russian Federation, the necessary ingredients don’t seem to be there to have to test the hypothesis.

There are other clear differences as well between Bashkortostan and Tatarstan and the more separatist states of the northern Caucasus. Both Bashkortostan and Tatarstan are economically well-off and integral to the Russian economy. In addition, both are land-locked by other Russian republics and not border states, although Bashkortostan is separated from Kazakhstan by a 30 mile corridor of land belonging to the Russian republic of Orenberg. At one point after the dissolution of the Soviet Union the leadership of the two Russian republics agreed on a land swap whereby Orenberg would get a swathe of Bashkortostan land in exchange for the land separating Bashkortostan from Kazakhstan. However, this idea was popular neither among the peoples of Orenburg, nor the Russian leadership. The idea was quickly dropped.

Finally, there is a higher percentage of Russians in Tatarstan and Bashkortostan than in Chechnya. This integration has no doubt moderated the two Republics. Conversely, in the Tatar case, 75% of all Tatars live outside of Tatarstan, primarily in other Russian regions. While not decreasing the Tatar identity, it likely has a muting effect on the Tatar desire to struggle for full secession.

CONCLUSION

A preponderance of the evidence suggests that recent protests in Bashkortostan are not of a seriously separatist character. Nor does its independent-minded neighbor, Tatarstan, appear to be a likely candidate for secessionist strife. However, the same may not be true of other independent-minded regions. Yakutia in central Russia and Kalmykia in the lower Volga region, both important oil producing regions, are potential candidates for conflict. Regardless, the notion that the velvet revolutions that have spread throughout the CIS states have now swept into Russia is, like the protests themselves, a bit of well-meaning irrational exuberance.

OPI UPDATE: CHINA AND JAPAN AWAKEN AN OLD CONFLICT OVER GAS AND OIL

2005-04-16T11:57:00.000-05:00

Protests in China against Japan have intensified. Now a controversy about oil and gas fields in the East China Sea has been thrown into the mix. While the oil and gas dispute is not new, it may be intensifying –not because anything has actually changed, but because it is in China’s interest to ratchet up anxiety overt he issue.

A TEXTBOOK CASE OF NATIONALISM

This week’s anti-Japanese protests in Beijing have intensified. Thousands turned out in Beijing and Shanghai this morning, marching on the Japanese consulates and smashing the signs and windows of Japanese owned businesses in the area. The conflict first arose earlier this month when China objected to textbooks just published in Japan that the Chinese say whitewash Japan’s wartime atrocities toward China. The unrest started in the southern and central China in the Guangdong and Sichuan provinces, and then spread to Beijing last week and now to Tianjin, Shanghai, and Hangzhou on the east coast.

Last week Beijing appealed for calm while doing little to quell the controversy. Beijing’s reaction was stronger today, fearing the protests were getting out of hand. “Express your patriotic passion in an orderly manner,” the Beijing police said in a statement on Friday as riot police turned out in force to protect the foreign consulates. Japan’s foreign ministry lodged a protest, saying the Chinese government failed to protect Japan’s diplomatic and commercial facilities and urging Beijing to act more effectively to prevent further damage.

JAPAN DRILLS BACK

The two countries have now added oil and gas drilling in the East China Sea to the controversy. While the issue of who owns gas and oil deposits in the East China Sea is not new –China and Japan have been negotiating the issue for more than a decade—Japan announced on Wednesday that Teikoku Oil Co. and Japan Petroleum Exploration Co. have been designated to conduct drilling on behalf of the Japanese government in the disputed waters. China’s Ministry of Foreign Affairs called the move a “serious provocation.”

In mid-January 2005 Japan Petroleum Exploration Co. and Teikoku Oil Co. began talks with the Japanese government on plans to drill for gas in disputed waters. Those talks finally came to a conclusion last week. The proposed drilling still must be approved by Japan’s Ministry of Economy, Trade, and Industry, which will likely take 2-3 months. However, the announcement constitutes a clear statement of ownership over a region and resources that have long been under negotiation. It also adds fuel to an already growing fire.

The conflict, which until recently had frozen exploration and drilling activities in the disputed waters, has stymied production and development of scant and badly needed resources. Japan and China rank second and third respectively in the world in oil consumption and both are among the world’s largest importers of oil

The East China Sea controversy concerns ownership of a set of small islets south of Japan (Senkaku islets in Japanese or Diaoyu in Chinese) and the precise extent of the two countries’ territorial waters there. In 2003 China began natural gas production in a region just inside their own claim, but close enough to the Japanese side that the Japanese argued that even if the Chinese line were the correct one, the field itself likely straddles the boundary, making the oil and gas partly theirs.

Where exactly the line should be drawn, is no easy problem to solve. Japan draws the dividing line an equal distance from the coasts of the two countries, while China claims its EEZ extends to the edge of the continental shelf. The Chunxiao gas field, which China began to develop in 2003, is located four km inside the Chinese side of the boundary claimed by Japan. In July 2004 Japan began its own preliminary explorations in the same area, sparking Chinese protest.

According to the UN Convention on the Law of the Sea, both sides are wrong, at least in how they have gone about the matter. The Convention stipulates that when there is disagreement on the demarcation of sea boundaries between any countries, the parties concerned should avoid anything that could undermine an eventual agreement –i.e. exploration and drilling. Tokyo’s original proposal, which Beijing rejected, was to divide the sea equally between the two countries. China declined and offered instead to jointly develop the fields, a proposal which Japan found unacceptable. The 2003 Chinese development followed shortly thereafter.

In mid-January 2005 Japan Petroleum Exploration Co. and Teikoku Oil Co. began talks with the Japanese government on plans to drill for gas in disputed waters near the Chinese development zone. Those talks finally came to a conclusion last week. The proposed drilling still must be approved by Japan’s Ministry of Economy, Trade, and Industry, which will likely take 2-3 months. However, the announcement constitutes a clear statement of ownership over a region and resources that have long been under negotiation.

Ironically, the whole argument may be much ado about little. It is not clear how abundant the deposits in the East China Sea actually are. Royal Dutuch/Shell and Unocal had originally contracted to develop the disputed Chunxiao gas field with Sinopec and CNOOC. It was the largest project that China had ever initiated with foreign partners. In September of 2004, however, the two Western companies pulled out of the deal, citing ‘commercial’ reasons. The pull-out cast doubt on the economic viability of the undersea fields. However, many speculated that the pull-out had more to do with politics than production. Shell and Unocal deny that claim.

Regardless, Sinopec and CNOOC continued with development and the field is set to come on stream in mid-2005 as scheduled. The Chinese expect it to produce 2.5 billion cubic meters of natural gas in the immediate two years after production begins. They continue to maintain that the field holds as much as 50 billion cubic meters of gas and will become a major producer in the next ten years. They project commercial operations to begin at a production rate of 1.9 bcm per year, rising to 7.8 bcm by 2010. The field may also contain less abundant, but still significant, deposits of oil.

CHINA’S NEED FOR NATIONALISM

The East China Sea dispute, while not new, has fanned nationalist flames on both sides of the current controversy over Japanese textbooks. The issue raises questions not only of the two countries’ war-torn history, but also of future security. Banners and tee shirts at this morning protests bore the slogan “Give back the Diaoyu islands” and similar references to the territorial conflict. Japan’s quest for a seat on the U.N. Security Council has also been brought up in the current dispute. Japanese Foreign Minister Nobutaka Machimura is due to meet his counterpart Li Zhaoxing on Sunday. How this meeting goes will say a lot about how relations between the two economic giants, who themselves have $178 billion in trade annually, will unfold in the coming weeks and months.

But China is likely in no hurry to reduce Chinese nationalist passions, for it clearly needs them in order to face serious issues brewing at home, namely the increasingly fragile state of its economy. Inefficient and unnecessary state-run enterprises have stayed alive for years on bad loans that are now threatening serious harm to the economy if the enterprises are not shut down. However, if China shuts down the dead-weight enterprises, thousands of Chinese laborers will be thrown out of work. Such large unemployed masses are threatening to the stability of any regime, but especially to one whose very reason for existence centers on the laborer.

China is thus likely to use the current nationalist surge to distract the population from the coming joblessness and economic hardship. The timing of the current conflict –as well as increased tensions over Taiwan—couldn’t be better for Beijing, and indeed may be more sly than serendipitous. China can make the desperately needed structural adjustments in its economy as long as Chinese eyes are focused outward.

OPI UPDATE: GERMANY AND RUSSIA SIGN ENERGY COOPERATION AGREEMENTS

2005-04-12T22:49:00.000-05:00

OPI wrote last week that Russia would reach out to Germany and France in an effort ally with the West while still balancing increased U.S. power in the region. No sooner said than done.

Meeting in Hanover Germany, Russian President Vladimir Putin and German Chancellor Gerhard Schroeder concluded a series of energy and transportation cooperation agreements, further enhancing bilateral relations between the two states. The agreements, worth about $4.9 billion, arranged for cooperation on Russian natural gas deliveries to Germany and for the construction of high-speed trains and rail lines in Russia. While $1.9 billion will go toward the rail lines, the remaining $3 billion is earmarked for energy.

For Russia the agreements constitute a sizeable and high-profile foreign investment commitment in the wake of Putin’s dismantling of one time Russian oil major, Yukos. The destruction of Yukos, which clearly took place for political reasons, has caused a steep reduction in foreign investment in the country as investors became jittery about the safety of money invested there. The agreements signed yesterday constitute a badly need vote of confidence by Germany in Russia's business climate —a vote Russia badly needs if it is to reverse the recent foreign investment trend.

For Germany the deal constitutes pay-back for its tacit support of Putin’s heavy-handed treatment of the Russian oil firm. While other countries criticized Putin’s handling of the oil company, Germany stayed quiet on the matter and even helped to bankroll the complicated process by which Yukos’ primary productions assets ended up in the hands of a now government-controlled Gazprom. Germany also hopes to get favorable treatment from Gazprom on its massive imports of natural gas.

The $3 million for energy is partitioned between two projects. $1 billion will go into the joint development by German industrial conglomerate BASF and Gazprom of one of Russia’s largest natural gas fields, the Yuzhno-Russkoye field in western Siberia. The field holds 500 billion-cubic-meters of gas, yet remains undeveloped and does not yet have easy access to the Russian gas pipeline network.

The agreement between the two companies to develop the field is thus an expensive and long-term venture. However, it constitutes Germany’s first foot in the door of upstream Russian natural gas development, something it would be pleased to do much more of in the future. Russia contains over 40% of the world’s natural gas reserves while Germany has the cutting-edge technology necessary to develop them quickly and efficiently.

The other $2 billion for energy cooperation is somewhat strangely earmarked for construction of a Baltic Sea natural gas pipeline –a project that many feel is not economically feasible. The pipeline would cost well over $5 billion to construct and millions of dollars to maintain. An amount less than half that much could be used to expand and improve the over-land pipelines running through Ukraine and Belarus that currently deliver Germany and Europe its natural gas.

So what is going on here? Is the $2 billion in Baltic Sea pipeline funds simply a PR move to make the total amount of agreements seem large while not really having to put up the money?

There is undoubtedly a large PR element to the deals. Putin wants to demonstrate to the West that it is once again a safe investment partner, and Germany regards its developing cooperation with Russia as part of its increasingly independent foreign policy. However, there may be another more important explanation for the earmarked funds.

A Baltic pipeline would allow Russia to use its energy relations with Ukraine –as it has in the past—as a tool with which to wield influence over the former Soviet state without at the same time threatening gas supplies to Germany and the rest of Western Europe. The greatest fear of the Russian military-security establishment is for Ukraine to join Nato or to otherwise station U.S. troops on its soil. Such a presence could once again put potentially hostile armies just hours away from the Russian capital, as was the case during World War II. A natural gas pipeline going straight from Russia to Germany, bypassing Ukraine, would allow Russia to use its role as Ukraine’s primary energy supplier to counter such trends should things move in that direction.

Indeed, Russia has often used its role as a primary energy supplier to surrounding nations as way to coerce those nations into cooperation with Russian aims. Earlier this month Russia made it quite clear, for example, that Moldova’s access to energy supplies were dependent upon its cooperation in the conflict over the Transdniester region.

While the Baltic pipeline project is still years at way at best, there are certainly those in both Russia and Germany who would like to see such an ‘insurance pipeline’ built. If the U.S. and Ukraine move toward any sort of expanded cooperation we can expect to see more money put into the project in a hurry.

Regardless, both sides clearly hope that these agreements constitute the beginning of a lucrative –and certainly very strategic—partnership.

OPI WEEKLY: A NEW DIVISION OF EUROPE: RUSSIA'S OIL DIPLOMACY AND THE WEST

2005-04-08T19:55:00.000-05:00

Russia is undoubtedly in crisis, albeit a quiet one. Pro-democratic forces supported by the West have taken hunks out of the traditional Russian sphere of influence. However, as one of the world’s largest exporters of oil and natural gas, Russia still has a measure of geopolitical power. It will use its now-recentralized energy industry to ally with an increasingly anti-American block of European states.

A KREMLIN DIVIDED

Pro-democratic (read: anti-Russian) forces supported by the West have taken hunks out of the traditional Russian sphere of influence –the Rose Revolution in Georgia, the Orange Revolution in Ukraine, the Tulip Revolution in Kyrgyzstan, a preemptive Western slide in Moldova, an anti-government demonstration in Uzbekistan, and now unrest within Russia itself in the autonomous Russian Federation republic of Bashkortostan. There are significant political forces within Russia –the so-called “siloviki”—that consider these losses of Russian power and influence to be unacceptable and dangerous. Comprised of former KGB and Military hard-liners, they contend that President Putin, cow-towing to Russia’s economic-liberal oligarchs, has sold out Russian security.

The conflict between the oligarchs and the siloviki is not new. Putin, whose connection to the hard-liners stems from his years in the KGB, has tried to walk a fine line between the two camps since his accession to power. Increasingly, however, the siloviki have gained strength. The 2003 jailing of Russia’s then-richest oligarch, oil executive Mikhail Khodorkovsky, changes in Russia’s election laws, and the Russian clamp-down on the media are most ominous manifestations of the increased hard-line power.

Khodorkovsky, who until his arrest was Chairman of Russia’s then-largest oil company, Yukos, earned siloviki wrath when he violated the unspoken rule that had tenuously kept the peace among Russia’s power elite –i.e., that oligarchs may amass wealth and economic power, but that they were to stay out of politics, both foreign and domestic. His ensuing arrest and the progressive dismantling of Yukos has rattled foreign investors who fear that no company is safe from such treatment. Furthermore, Yukos’ primary production assets landed in the hands of a now state-controlled Gazprom, giving the government a central place in the gigantic Russian energy industry. When the dust settles, the Russian government will control one of the largest energy companies in the world.

At the same time, there has been increasing curtailments on the freedom of the press. The majority of media outlets are now state-owned, and press reporting during elections is especially constrained. Journalists who have challenged the government have found themselves in jail on bribery and libel charges.

Furthermore, Putin recently pushed through a change in Russian election law such that regional governors are now appointed by the President, instead of being subject to regularly held elections. While this change was made ostensibly to help the Russian government fight terrorism in the country –the change was made in the wake of the Belsan school massacre and the downing of two Russian airliners by terrorists—the move was clearly a power-grab by Putin.

It now remains to be seen to what ends this power is used.

GEOPOLITCS AND THE RISE OF THE HARDLINERS

The conflict between the hard-line siloviki and the oligarchs is not only domestic. The two groups have divergent perspectives on Russia’s current geopolitical situation as well. The oligarchs, intent on building their own fortunes, would like to see Putin engage the West. They argue that such engagement will secure Russian security through participation and integration in Western economic, if not political, institutions, and the resultant prosperity could make Russia once again a world power. In pursuit of such ends, Russia has completed WTO negotiations with the countries accounting for some 80 percent of Russia's trade and Russian accession into the WTO is likely to take place soon. Perhaps more important, however, Russia is also Europe’s largest supplier of oil and natural gas, thus diminishing the chance of conflict. After all, good pipelines make good neighbors.

The siloviki, however, have a very different view on how best to protect Russia’s security. For them, the “loss” of Ukraine to the pro-Western Yushchenko was nothing less than a disaster. Not only is Ukraine viewed along with Belarus as the ‘heart’ of Russia, it also is strategically key. Given the lack of natural barriers between Europe and Russia’s largest cities, Russia’s security strategy for centuries essentially has been to push its borders outward in order to keep foreign armies as far away as possible. It is no wonder that after Hitler’s armies had stood at the gates of both Moscow and St. Petersburg before they were finally repelled, Russia was so keen on keeping the Warsaw pact countries as a captive buffer from the West. The same logic explains Russia’s attachment to the largely Islamic statelets of the Caucuses and Central Asia–often referred to as Russia’s ‘soft underbelly’.

The siloviki contend that Russia must challenge the encroachment of the West into these protective regions. Indeed, following the fall of the Berlin wall the west had promised (though not in writing, of course) that no Warsaw pact country would be included in Nato, let alone countries even closer to Russia itself, or a country so strategically key as Ukraine. As these barriers continue to fall, mostly due to American influence, the siloviki feel that Russia’s very security and independence are at stake. This is a bitter pill to swallow for a country that not long ago was deemed one of the most powerful on earth and one that still has intercontinental reach with enough nuclear weapons to destroy humanity several times over.

To the consternation of the siloviki, however, nuclear arsenals don’t always translate into translate into geopolitical power, and the decrepit state of Russia’s conventional forces can hardly be exaggerated. Although ICBM’s cant travel the world around, Russia’s conventional military has little ability to project power. Indeed, the condition of the military that Russia inherited from the Soviet Union was already poor, and it deteriorated quickly from there as the Russian economy collapsed following the dissolution of the Soviet Union. Unable even to put down a relatively small and ill-equipped insurrection in Chechnya, Russia simply does not have the military capability to credibly take a stand against any modern or well-equipped army.

So as Russia’s geopolitical position and security worsens almost daily, the siloviki gain the upper hand. The oligarchs fear a political-economic retrenchment that will curtail Russia’s chances for economic development. Between the siloviki and the oligarchs, Russia seems to be stuck between a rock and a hard-place.

However, there is somewhat of a geopolitical and economic middle-ground for Russia to occupy. The West itself is becoming increasingly divided into two different and partially opposed parts, the United States and the Franco-German block of the EU. Europe’s anti-American block first consolidated in the face of the U.S. invasion of Iraq. France and Germany openly opposed the war, followed by Spain’s newly-elected socialist leader, Jose Luis Rodriguez Zapatero. The EU’s central European members, joined by Italy, came out in favor of U.S. aims.

Since then, the division of Europe has intensified. Just last month the leaders of France, Germany, Spain, and Britain held a conspicuously non-EU summit with President Putin. While these countries played down the significance of the meeting, it was a clear signal that when it came to Russia, there was a clear divide amongst EU nations. While Britain will not buy into the anti-American sentiments held by the other three, Italy seems poised to take its place, announcing recently that it will pull its troops out of Iraq in the near future. These developments are powerful signals of a Europe divided when it comes to relations with both Russia and the U.S.

GEOPOLITICS AND OIL

The most obvious motivation for the consolidation of this anti-American block of European nations is the old-fashioned realist one –to create a counter-weight to U.S. dominance of world geopolitics. This is especially true of France, which has a long history of trying to balance U.S. power on the continent.

But there are also more immediately material motivations as well. Russia is the major supplier of oil and gas to Europe. This is particularly true of Germany, which gets 31.5% of its oil and 39% of its natural gas from Russia. Furthermore, Germany’s next two most important oil suppliers, Norway and Britain, which supply 21% and 10.9% of its oil respectively, are likely to export less in the coming years as their off-shore fields become depleted.

Indeed, Germany has tacitly supported Russia’s heavy-handed break-up of Yukos and the consolidation of its energy sector in government hands. They have also sought to mute EU criticism of Russia’s recent behavior, which has come largely from the new-entrant states of central Europe. These states’ view of Russia is still defined in large part by their long and bitter past as captive Soviet satellites.

Russian gas and oil are similarly important for France: as North Sea fields give out, Russia will supply an increasingly significant portion of its energy needs. While France historically has imported a large amount of its oil from the Middle East, those supplies are no longer so secure. The current U.S. influence on Middle East politics –particularly in France’s long-time ally, Iraq—makes France decreasingly likely to rely on Middle Eastern oil and more likely to turn to Russia for steady supplies.

But the dependence goes both ways: Russia counts on energy hungry Western European countries to purchase its oil and gas. Germany purchases 18.2% of all Russian crude oil, with Italy purchasing 12.6% and France 8.6%. For a state as dominated by oil and gas exports as Russia is –oil and gas account for roughly 25% of Russia’s GDP, 55 % of its export earnings, and 40 % of its total tax revenue—these are fundamentally important relationships.

However, all is not friendly between Europe and Russia –namely, the countries between Europe and Russia through which oil and gas must transit westward. Pipelines through Central Europe –the very countries who have sided recently with the U.S. and against France, Germany, Spain, and Russia—are the main suppliers of Russian oil and gas to Western Europe. Germany has been trying to engage Russia and Ukraine in a pipeline consortium to secure these supplies, but it has been slow-going. The only alternative for Germany to such a deal would be pipeline beneath the Baltic Sea, which would nearly double the cost of transit.

The states of Central Europe, unsurprisingly, are trying to free themselves of the intense external influences that their position between Russia and Western Europe provides. Not only are the states of Central Europe of intense interest to both East and West, but also they are themselves dependent on Russia for oil and gas, not to mention the revenues that accrue from transiting the Russian exports.

Recently Ukraine announced that it will reverse the flow of oil in the Odessa-Brody pipeline. Instead of transporting Russian oil south for export from a Russian pipeline connection in the Ukrainian city of Brody to Ukraine’s Black Sea port of Odessa, it will carry oil from the Caspian Sea through Georgia to and then North from Odessa to Brody. A further agreement was then reached that will extend the pipeline to Plock, Poland and further export to the West. This pipeline currently has a maximum capacity of 900,000 bbl/d, enough supply all of Poland’s 500,000 bb/d with the rest going westward. For Ukraine and Poland, at least, this would be a great step toward energy independence from Russia.

Should the states of Central Europe achieve this measure of energy independence from Russia, they are all the more likely to identify themselves with the United States and be less beholden to Russia and the Anti-American block of EU states. This new division of Europe will place tremendous strains on both Nato and the EU.

CONCLUSION

In many ways Russia is in desperate geopolitical straits, and the foreign policy hard-liners in the country know it. Oil and gas exports and the geopolitical power they convey are one of the few traditional foreign policy tools that Russia has left at its disposal. It is also one that benefits both the hard-line siloviki and the more-liberal minded oligarchs. Cooperation between Russia and the anti-American block of EU states, Germany in particular, is likely to be an increasing facet of international politics. Such relations will also worsen transatlantic relations and further fracture an already struggling EU.

OPI UPDATE: A PIPELINE CONSORTIUM AND THE EMERGING GEOPOLITICS OF EUROPE

2005-03-20T16:28:00.000-05:00

Russian President Vladimir Putin stopped in Kiev, Ukraine March 19th to meet with Ukrainian President Viktor Yushchenko. It was Putin’s first visit to Ukraine since the ‘Orange Revolution’ swept Ukraine’s pro-Russian government from power. The visit also took place just a day after Putin met with French President Jacques Chirac, German Chancellor Gerhard Schroeder and Spanish Prime Minister Jose Luis Rodriguez Zapatero in Paris, and a week after the Ukrainian president visited those countries in Europe as well. So what are all these leaders chatting about?

One of the announcements made in Kiev was an agreement to include European countries –primarily Germany—in a gas pipeline consortium bringing Russian gas through Ukraine to Europe. Russia is Europe’s primary source of natural gas, and Europe is Russia’s best customer. Ukraine sits between the two, allowing it to profit from the transit of gas across its borders.

Russia previously had wished to exclude European companies from the new project project; why get Europe involved, after all, when Ukraine, then led by the more Moscow-friendly Leonid Kuchma, was willing to cooperate with Russia on the details. The new government in Kiev, however, is likely to seek as much independence from Russia as it can while still maintaining civil relations. Having Germany –Russia’s largest natural gas customer—in on the project will help Russia to secure its interests. Ukraine too is happy to have Europe involved, increasing ties with the much wealthier west.

While energy relations between these parties are tremendously important, they are also microcosmic of larger geopolitical issues unfolding in the region. It is key, for example, that Putin met with the leaders of Spain, Berlin, and Paris: schisms within the European Union regarding foreign and security policy have pulled these three countries together in deeper cooperation, increasingly in opposition to Great Britain and the newly inducted central European states, which tend to be more cooperative with the United States' foreign policy aims.

Indeed, all of these key geopolitical actors –Russia, Ukraine, and the two sides of the EU schism—are at a turning point in their post-Cold War geopolitical decision-making. They are in the process of deciphering anew their fundamental geopolitical interests.

For Russia it is striving -albeit with limited success- to once again gain the status of a world power, a 'pole' in the system, to put it in geopolitical terms. In order to do this, it must first put a stop to the encroachment of the west --i.e. the U.S. influence, NATO, and sometimes the EU-- on its sphere of influence. Second it must become the senior partner alliances that enable it to counter U.S. power.

Ukraine’s fundamental interest is to increase its independence from Russia. Its interests are thus directly opposed to Russia’s, which means that Ukraine is forced to seek help from others to secure the independence it needs. It has, of course, two choices –not entirely, but primarily mutually exclusive—when it comes to that help: Western Europe and the United States. While the United States is ultimately much more powerful, and it assisted Ukraine during the ‘Orange Revolution’, it may be too far away and too disconnected to be a dependable friend. Western Europe, on the other hand, would be much more dependable, for one key reason: much of Western Europe’s oil and gas comes through Ukraine. Coincident interests is what being an ally is all about. While the U.S. has an interest in seeing Russia’s sphere of interest rolled back, it has no other need or love for Ukraine itself.

Unfortunately, the EU is almost worthless as a geopolitical ally. As an economic ally, they could be wonderful; geopolitically, not so much. They have no military muscle, they have no real foreign policy, and developing those things is far down on their list of things to do, even supposing they can do it at all. Fortunately for countries like Ukraine, this lack of an EU foreign and security policy has not eradicated the need for the individual counties within the EU to maintain bilateral relations the world over. A state isn’t a state without bi-lateral relations, at least with those with whom it shares borders.

There has therefore arisen a split within in the EU –seen most clearly during the recent war in Iraq—between a more pro-U.S. block of European states, including Poland, the Czech Republic, Great Britain, and to a lesser extent Italy, and a –for lack of a better term—anti-U.S. block, comprising the continent's largest states, Germany, France, and Spain.

It was with the leaders of the latter block of states with whom Putin and Yushchenko met this past week, and who will likely form an ally to Ukraine in its efforts to free itself increasingly from Russian influence. So what about Russia? Not only does it need Western partners for economic reasons, it would love to have those three western European countries continue to stick a thumb in the U.S. eye in geopolitical matters. Whether or not the German, Spain, and France can do this without fracturing the EU remains to be seen.

OPI UDATE: RISKY BUSINESS: IRAN, VENEZUELA AND THE RISK PREMIUM AHEAD

2005-03-14T23:06:00.000-05:00

The price of oil has remained above fifty dollars for the past several weeks as demand side pressures have kept prices strong. However, as winter recedes and the U.S. driving season is still weeks away, one might expect softer prices. In addition, there is some indication that OPEC will decide on a production increase at its meeting in Tehran on Wednesday. But all is not soft in the oil market. Supply side pressures may be just over the horizon as foreboding developments in Venezuela and Iran push up the ever-present risk-premium and keep prices high.

The price per barrel of oil topped $55 briefly today, before closing up 6 cents at 54.65. Most of that price pressure came on the demand side, as much of the northeastern U.S. continues to experience below average temperatures. The price finally eased on remarks by Saudi Oil Minister, Ali Naimi, who said the Organization of the Petroleum Exporting Countries should boost its output ceiling by 500,000 bpd at its meeting in Iran on Wednesday. Kuwaiti officials expressed a similar sentiment. Softening on the demand side should continue, barring any indication of increased world economic growth. An upward revision in Chinese growth estimates last week, for example, helped push crude prices further into the $50 bpd range.

Things aren't so sanguine on the supply side, however. The ‘risk premium’ in the price of oil --an increase in the price of oil based solely on the fear that a terrorist attack or other political event will disrupt supplies-- will likely increase in the coming weeks as events in Venezuela and Iran unfold. The tit for tat between the U.S. and Venezuela continued today as senior U.S. officials announced that the U.S. was creating a ‘containment’ policy for dealing with left-leaning Venezuelan President Hugo Chavez. According to Roger Pardo-Maurer, Deputy Assistant Secretary of Defense for Western Hemisphere Affairs, a ‘containment policy’ is being developed for Venezuela at the request of U.S. President George Bush and U.S. Secretary of State Condoleezza Rice. Pardo-Maurer said Venezuelan President Hugo Chávez was employing a “hyena strategy” in the region. The U.S. has charged Chávez with supporting followers of Bolivian indigenous leader Evo Morales in their attempt to force the resignation of President Carlos Mesa of Bolivia last week. Chavez is also accused of having supported Rebel forces in Peru.

Chavez has also been cultivating some friendships that the U.S. finds quite unfriendly. Chavez has continued his close relations Cuba's communist dictator Fidel Castro and it is probably no coincidence that the U.S. policy comes just one day after Iranian President Mohammad Khatami finished a three day visit to Venezuela to see President Chavez. Khatami and Chavez signed 23 agreements covering energy relations to tax issues -routine stuff as far as bilateral relations go.

However, Iran and Venezuela's respective relations with the U.S. couldn’t have been far from their minds. U.S. relations with Iran hit another low over the weekend as the U.S. in entered into the failed EU-3 (Germany, Britain, France) relations with Iran. Iran immediately rejected the U.S. proposal to diffuse the crises over its nuclear activities by promising to lift an embargo on aircraft parts and to support Iran's entry into the WTO. Iran was not impressed and said that its nuclear activities would continue unabated. Hugo Chavez immediately chimed in, supporting Iran’s claims that its nuclear program is peaceful only and calling the U.S. policy vis-à-vis Iran as “imperialist.”

With three U.S. carrier groups steaming back to the Mediterranean, an attack on Iranian nuclear facilities seems increasingly likely. While the U.S. will almost surely bring the issue to the U.N. Security Council before acting, the council outcome will not determine the U.S. decision. Win or not in the council, the Bush administration is likely to do use force if it deems it necessary to stop the nuclear program. Whether or not Venezuela will once again step to Iran's defense and attempt to punish the U.S. by slowing or halting imports to their largest buyer is not clear. As much as he may want to, he needs the U.S. as much, and likely more, than the U.S. needs him.

But a funny thing the risk-premium built into the oil market, nothing actually has to happen to push up the price. Simply the possibility of such a disruption -in either Venzuelan or Iranian supplies- will do the trick.

OPI WEEKLY: VENEZUELA'S STRATEGIC BIND

2005-03-06T22:47:00.000-05:00

Recent oil agreements with both India and China, as well as its flirtations with the sale of CITGO, show Venezuela’s desire to shift its strategic foothold away from the U.S. and toward markets in the Far East. However, the difficulties for Caracas surrounding a deal for CITGO, its U.S. based refining and distribution conglomerate, show that Venezuela is in a strategic bind that limits its ability to maneuver against the U.S.

THE TWO AGREEMENTS

India and Venezuela signed an agreement on Saturday to allow India’s state controlled Oil and Natural Gas Corp (ONGC) a 49% stake in the San Cristobal oil field and bidding rights for exploration and production on gas blocks off the coast of Venezuela. Venezuela’s offshore gas exploration and development is currently dominated by U.S. companies. As part of the agreement Venzuela’s state owned oil giant Petroleos de Venezuela (PdVSA) is taking a stake in ONGC's refining subsidiary, Mangalore Refinery and Petrochemicals Ltd. The refinery agreement will ease the way for future sales of Venezuelan crude to India. The agreements were signed on a visit to India by Venezuelan President Hugo Chavez.

Chavez signed a similar agreement with China in January. China’s National Petroleum Corp. (CNPC) will form a joint venture with Venezuela’s PdVSA to develop and manage 14 oil and gas fields in the Zumano area of the eastern Venzuelan state of Anzoategui. The fields hold reserves of 400 million barrels of oil and 3 Bcf of natural gas. In addition, CNPC will increase natural gas production in the Intercampo Norte and Caracoles oil fields it currently manages for Petroleos de Venezuela. Venezuela will also supply China with 100,000 bbl/d of oil, 3 million tons per year of fuel oil and up to 1.8 million tons of Orimulsion, an alternate boiler fuel.

Venezuelan officials also said the Bank of China may lend up to $ 4 billion to Venezuela for the development of energy and other projects in the country. Venezuelan Energy Minister Rafael Ramirez has said recently that PDVSA will invest $5.6 billion in exploration and production during 2005. If such a large hunk of PdVSA’s exploration and production funds comes from China we can certainly expect more agreements between the two countries as the money is spent.

TESTING THE WATERS

These agreements signal a testing of the waters for future energy relations for the countries involved. Both China and India are aggressively seeking to secure oil assets to fuel their enormous populations and booming economies, but have not ventured significantly into the western hemisphere for supplies. Besides the Middle East, China’s has looked to Russia and more recently Africa to ensure its energy security. India too relies primarily on the Middle East, but has recently signed an agreement

Venezuela’s motivations are much more geopolitical or even ideological. Venezuela’s socialist president is unhappy being so squarely within the U.S. sphere of influence and has been making moves to diversify its crude export base, which is dominated by the United States. Venezuela’s current production capacity stands at about 2.8 million bbl/d, 2.25 million of which are exported. 62% (1.39 million bbl/d) of those exports go directly to the U.S. This comprises approximately 12% of U.S. daily oil imports –not including oil sold to Caribbean refineries and then sold in the U.S. market.

U.S. relations with the leftist Chavez have always been troubled, but things have gotten palpably worse in the past several months. In January 2002 Venezuela’s new Hydrocarbons Law raised royalties charged to foreign oil companies operating in Venezuela from 1% to 16% to 20%-30% and guaranteed PdVSA at least a 51% stake in any project involving exploration, production, transportation or initial storage of oil. Then, in January of this year, PdVSA rejected ConocoPhillips business plan for the development of the huge Corocoro field, considered to be one of the most promising untapped oil fields in the country and a project that was widely expected to get the green light from PdVSA. PdVSA now says it will review 33 contracts with ChevronTexaco Corp., ConocoPhillips and other U.S. operators in the country that were signed prior to 1998 when Chavez initially became President. Also in January, PdVSA unexpectedly refused further drilling rights to Houston based Harvest Natural Resources Inc., which had long had exclusive rights to much of Venezuela’s field development.

And now the dispute has been brought to an entirely new level. Chavez has said recently that the U.S. is planning to have him killed as a pretext for invading the country and warned that any attempt on his life would result in a cut-off of oil supplies to the U.S. While U.S. officials describe the plan as nonsense, it is likely that Chavez really believes it. Chavez has also announced a shift in Venezuela’s military doctrine to a defensive posture aimed at thwarting a U.S. attack. The new doctrine will focus on “asymmetric war” wherein an inferior fighting force attempts to repel a superior fighting force by using guerrilla tactics such as those employed against the U.S. in Afghanistan and Iraq. Venezuela’s recent purchase of 40 Russian helicopters and 100,000 AK-47 assault rifles will further bolster its defenses.

SELLING CITGO: VENEZUELA’S CATCH-22

Venezuela’s agreements with China and India are a first very small step in possible strategic reorientation. On his travels abroad, President Chavez also invited Russian, Spanish, Iranian, Libyan and Algerian oil companies to invest in Venezuela. Clearly the primary issue that Chavez must consider in moving away from dependence on the U.S. for both production assistance and export markets is whether or not alliances with such countries –India and China included—will be reliable. The U.S. market is certainly reliable, and reliability is the crux issue of energy security. For Venezuela it is also the crux issue of national security, given the overwhelming importance of the oil industry for the Venezuelan economy.

As much as Chavez might be more ideologically comfortable dealing more with China and India, there are real problems with expanding such commitments. To facilitate oil exports to both China and India would take huge efforts and investments on the transport side. Venezuela is studying building new pipelines in either Colombia or Panama, which would take Venezuelan crude to Pacific ports -large supertankers can’t use the Panama Canal—but pipelines are expensive and take a long time to build.

But even more than these agreements with Far Eastern buyers, selling CITGO would be an expensive and significant move away from stability and energy security. CITGO’s U.S. refining capacity is over 1 million bbl/d, which is utilized to produce gasoline and other refined products. CITGO then supplies these products to approximately 14,000 independently owned and operated CITGO branded retail outlets located throughout the United States. PdVSA supplies CITGO with most of its crude oil through long-term supply contracts, some stretching as far forward as 2017.

And here’s where the catch-22 comes in. The book value of CITGO’s assets is $8 billion and some analysts put its market value as high as $16 billion. However, one of the reasons it is so valuable a company is because of its close relationship with PdVSA and Venezuela, one of the world’s largest crude oil producers. It’s crude contracts are long term and even come at a $1 to $2 per barrel discount off of market prices. If that relationship were threatened –which such a sale would clearly imply—the value of CITGO drops significantly. Crude supplies for CITGO refineries then becomes a problem, both of quantity and quality: not only would CITGO have to find almost 1 million bbl/d elsewhere, but also they would have to find heavy high-sulfur crudes similar to those produced in Venezuela, for which the CITGO refineries are tooled. While Mexican crudes are similar in quality, Mexico can not nearly provide the quantities purchased from Venezuela. These issues then effectively reduce the value company for sale, which would mean that Venezuela would be unloading his most valuable foreign asset at a loss.

TO SELL OR NOT TO SELL: THE CRUDE HARD TRUTH

PdVSA, through CITGO, clearly has a stable supply chain to a stable market that will only grow in coming years. Selling CITGO would clearly be a risky and destabilizing move for Chavez and Venezuela. It would also come at a financial loss. So would he actually do it?

In the end Chavez is unlikely to make such a move. The costs and risks are simply too high. So why all the talk of new markets in the east and of selling CITGO?

Chavez’s motivations are most-likely threefold. First, it is some pretty loud geopolitical saber-rattling. Although the U.S. could fairly easily replace Venezuelan crude supplies with supplies from the Middle East and elsewhere, it is no coincidence that most of U.S. oil comes from the Western Hemisphere, more closely within Washington’s geopolitical sphere of control. Caracas might use this bit of leverage to get unfavorable tax and royalty agreement between the two countries changed.

Second, Chavez and some in PdVSA feel as though CITGO operations had slipped out of their control of late, particularly during and after the 2002 strike by PdVSA employees. Paranoia seems to be running high these days in Caracas and Chavez to large extent does not trust the CITGO side of Venezuela’s oil business. It fears that there the U.S. business and its executives may have prospered at PdVSA’s expense. PdVSA thus recently replaced CITGO’s CEO and is currently auditing U.S. operations. These threats of sale are also meant to scare CITGO into getting back with the program.

Third, Chavez personally and ideologically would love to sell CITGO. He would love to stick a thumb in America’s economic and energy security eye. The rumors and musings of a pending sale are no doubt borne partially out of Chavez’s real desire to do so.

However, when all is said and done, the the logic of selling for Venezuela does not add up. Nor, at least for the foreseeable future, does a significant strategic orientation with China, India, or anyone else. Venezuela is strategically bound in its ability pull away from the U.S. The symbiotic relationship between producer and consumer, no matter how much either side might wish to deny it, is too functional to forgo.

That’s not to say that heads of state never do illogical things, but they do it is the exception and not the norm. In this case the norm is likely to prevail.

OPI UPDATE: THE END OF THE END FOR YUKOS

2005-03-01T23:24:00.000-05:00

In perhaps the final nail in the Yukos coffin, Russian officials said today in Moscow that criminal proceedings have begun against Sergey Shimkevich, general director of Russian oil and gas company Tomskneft. The company, a fully-owned subsidiary of beleaguered oil major Yukos, is the largest of only three primary production assets still owned by the once powerful parent.

While the method and timing of the madness remains to be seen, we can expect to see happen here what happened with Yukos’ primary production asset Yunkangsneftegas after Yukos’ CEO Mikhail Khodorkovsky was jailed. Tomskneft, Samaraneftegaz and Vostsibneftegaz, Yukos’ three remaining production assets, will be auctioned off by the state to pay government imposesed penalties. But this time not only Putin and the Russian government will benefit. China and India are likely to be primary beneficiaries as well.

Russian authorities claim that Tomskneft, under Shimkvich’s leadership, violated oil-field license agreements in 2003 by overproducing crude oil in the Kargasoksk and Alexandrovsk regions, generating more than $256 million in surplus revenues. Although $256 million is a large sum –and one can imagine the hefty fine that might go along with such an offense- the company may also face tax claims similar to those which landed former Yukos CEO in jail. If the government once again pursues tax claims against the company –Tomskneft already paid $82 million to settle 2002 tax claims—Yukos will no doubt be unable to pay, and the government can auction off its remaining assets for payment.

The move against Tomskneft comes just days after a Houston judge threw out Yukos’ attempt to seek bankruptcy in a U.S. court. That ruling no doubt emboldened the government to act against the first of the next of Yukos production assets. Putin would like the whole Yukos affair to be over with and to begin consolidating Russia’s powerful energy industry in Yuganskneftegaz’s new parent company, government owned Gazprom.

Ironically, the U.S. court action also received a favorable review by the international investment community. While some have considered the Russian government’s destruction of Yukos to be a threat to foreign investment in the country, Both Fitch and Moody’s raised Gazprom’s credit rating. Moody upgraded Gazprom’s ratings to the investment level, up from Ba2 to Baa3. Fitch noted that foreign banks and investors now face less risk in investing in Russia than before the ruling.

The question now is in whose hands Tomskneft, Samaraneftegaz, and Vostsibneftegaz will end up. While Putin might ideally have the assets end up in the government hands, those hands are most likely too full at the moment to hold them. Gazprom has enough of a task cut out for it in the integration of state run oil company Rosneft, which it purchased immediately after the latter took control of the recently auctioned-off Yuganskneftegaz. Furthermore, the Yuganskneftegaz dealings have already left Gazprom cash-strapped for the moment.

Putin will thus have two primary concerns in relocating. First, Putin will want to make sure that the assets stay, at least in majority, in Russian hands. Russia’s is a close second to Saudi Arabia in world oil production and may someday become a swing proudcer similar to the Middle Eastern state, with enough excess capacity to exert control over oil prices. It will certainly not give up this possibility by letting some of its key production potential fall into foreign hands.

Second, Putin will want to make sure that the assets do not go somewhere where they might form a power base for a politically overly-ambitious oligarch like Khodorkovsky. It is unlikely, therefore, that they will be kept together, either under Yukos’ umbrella, or with any other single Russian company. We can thus expect the three primary production assets to be separated among Russian oil producers, most likely Lukoil,

We can thus expect to see the production units end up with several of Russia’s current oil companies, most likely Lukoil, Surgutneftgas, Sibneft. These companies will be able quickly to integrate the production assets without at the same time become too powerful.

However, will also likely see large stakes of those assets sold to foreign investors, most notably China and India. Indian India's petroleum and natural gas minister, Mani Shankar Aiyar, concluded his talks in Russia last with a promise to invest $25 billion in the Russian economy. It was widely rumored that he sought to purchase a 15 percent equity stake in Yuganskneftegaz for some $2 billion. Even if such a deal with Gazprom/Rosneft is concluded, that would still leave India over $20 billion with which to shop.

Indeed, Tomsk Region Governor Viktor Kress said yesterday that India has recently displayed interest in “a whole number of large and promising oil projects in Russia.” While those projects remained unspecified, it is not long a leap to surmise that the Tomsk Governor was referring to Tomkneft.

China too has expressed interest in investing in Russia’s vast energy sector. The second largest oil consumer in the world behind the U.S., China has sought in the past several years to secure its crude supply by purchasing foreign assets as opposed to simply relying on the sometimes chaotic world crude markets. Late last year a subsidiary of China National Petroleum Corporation (CNCP) applied to the Russian Federal Anti-Monopoly Service seeking a sanction to purchase 100 percent of Tomskneft. While there is no way such an outright purchase will be approved –a federal law was recently passed in Russia banning even majority ownership of companies in strategically important Russian industries—China’s interest was made clear. They may now find that at least pieces of the Yukos pie will become available to them.

Regardless of where the pieces finally land, the end of the end of Yukos seems to be near. A watershed event in the post-Soviet history of Russian democratic capitalism, Yukos’ dissolution –helped along by $45 dollar oil that seems here to stay—may indeed mark the beginning of a more centralized and energy-centric Russia. In the short run, at least, and perhaps for longer, this appears to be a very good thing for Russia’s newest energy allies, India and China.