The ‘Russian oil miracle’ of the early 2000s was predominantly driven by the accelerated application of enhanced oil recovery methods, the efficiency of which had decreased substantially by the middle of the decade. In the Russian gas sector, capacity additions in the traditional areas are unlikely to be able to compensate for declining output at the giant gas fields beyond the medium term. Indeed, a visible gap had emerged between the brownfield and greenfield strategies in the Russian oil and gas sector by 2006. We call for it to be closed in order to ensure that production growth continues in the medium term.

While Russia’s reserves and resources form a serious base for production growth many years down the road, it is worth noting that future growth will have to come from fields that are more difficult to develop: they are characterized by being smaller, having deeper horizons, as well as being subject to extreme weather conditions and/or located in shallow and deepwater offshore. This, in our view, offers major potential opportunities for OFS companies. Our bottom-up analysis of cumulative capital expenditures into the O&G sector shows that i) they doubled between 2003 and 2006, to $43 bn, and ii) we expect them to increase at an average CAGR of 9% to reach $61 bn in 2010.

Oil industry dynamics

Production growth trends

Since 1999, Russian oil production has increased by some 57%, or the equivalent of 175 mn bbls per annum, making Russia the second biggest oil supplier globally after Saudi Arabia. Coming after the sharp decline in the wake of the dissolution of the Soviet Union, this growth has mostly come from developing the old fields, primarily in West Siberia, in a better and more intensive way.

Using data from the Ministry of Energy and Industry, CERA has split Russian production output into two categories:

i) new oil, or that produced from fields in the first five years of their operation and

ii) old oil, or production from older, existing fields.

For 1998-2005, the incremental production from new fields (new oil) represented only 16%

of total growth. The use of secondary and tertiary production methods has markedly increased since 1999. For example, the share of production from enhanced oil recovery (EOR) methods in LUKoil’s total production increased from 15% in 1998 to 26% in 2005. Surgut increased its application of EOR methods even more, from 14% in 1998 to 50% in 2005, while Tatneft showed an increase from 34% in 1998 to 44% in 2005.

The amount of fracturing jobs (the most popular technique for boosting well output at mature fields) has more than doubled since 2000. Simultaneously, the amount of development drilling stayed nearly flat over the same period. This signifies that a visible gap between brownfield and greenfield strategies had emerged in the Russian oil industry by 2006.

Paradigm shift: moving outside traditional areas

Russian oil companies’ recent preference for monetizing an existing reserves base over developing greenfield areas is, in our view, only a temporary development. Their traditional asset bases are maturing and production growth through EOR methods is reaching its peak. Still, we believe that West Siberia will remain the core of the Russian oil industry for years to come. At the same time, further growth cannot be achieved without moving to Greenfield areas and this move has to be made now. Without new additions from exploration activities, the overall quality of the existing developed reserves is slowly deteriorating. CERA cites the Duma’s Audit Chamber report for 2002, which estimates that more that 50% of proven (ABC1) reserves are classified as ‘hard to recover’. It has been estimated that the proportion of ‘hard to recover’ fields will grow to 70% by 2010. In addition, 82% of all recently discovered fields have been classified as ‘small’.

Reserves and resources potential

Russia’s strong reserves position ensures good production potential prospects many years from now. According to the Russian Statistical Agency, Russia’s total proved (ABC1) reserves stood at 134 bn bbls as of the end of 2001. The data for subsequent periods is not available as it was classified a state secret. Russia’s proved and probable reserves stood at 195 bn bbls (ABC1+C2). Furthermore, Russia has an estimated resource potential of 126 bn bbls, making the total of reserves and resources as much as 321 bn bbls.

The average depletion of Russia’s existing developed reserves base (as measured by ABC1 reserves) is estimated at 54%. West Siberia, the most important production area, is 48% depleted while the North Caucasus and Volga-Urals (where the history of the Russian oil industry began), are over 70% depleted. Even so, West Siberia has a huge reserves and resources potential, mostly from the satellites of existing fields and deeper horizons. The most promising areas are considered to be Eastern Siberia, Timan-Pechora and the offshore. Russia’s oil production has historically been quite concentrated, with several giant fields accounting for a significant proportion of output. Currently, 35% of Russia’s production comes from the 13 biggest fields, and half of this amount comes from fields that are more than 50% depleted.

We believe that Russian oil production will become less concentrated and that in the future it will mostly consist of medium- sized and small fields. Russia’s oil reserves and resources form a serious base for potential production growth many years down the road. However, future growth will have to come from fields that are more difficult to develop: they are characterized by being smaller, having deeper horizons, as well as being subject to extreme weather conditions and/or located in shallow and deepwater offshore. However, with rapidly developing technology, we have little doubt that developing such fields will become more and more feasible. This, in our view, offers great opportunities for OFS companies.

Russian oil production outlook

We estimate that Russia will be able to achieve average oil production growth of 3.6% through 2010 and about 1.0% thereafter until 2015. We expect oil companies to concentrate on stabilizing oil production, although this might require higher capital expenditures and additional fiscal stimulus.

Production from West Siberia currently accounts for 71% of Russia’s total. Given the importance of this area, Russia’s future levels of production will largely depend on how long the current upswing can be maintained, especially in the near term. We expect West Siberia to account for the majority of production growth until 2010.

In the longer term, we expect that the new provinces (Eastern Siberia, Timan-Pechora and the Caspian and Sakhalin offshore fields) will make an increasing contribution to Russia’s overall production growth. However, controlling the decline rates at the older giant fields will be a no less important factor in the

Russian oil story.

Gas industry dynamics

Production history

Gas is a newer fuel than oil, both globally and in Russia. Russian oil production reached its plateau in 1980, leading to a local peak in 1988. The Russian gas industry lagged in development by approximately ten years, reaching its historical plateau in the late 1990s.

Although the Russian gas industry is less mature than the oil industry and its initial reserves and resources base is bigger, the recent trends in the oil and gas industries are quite similar. Historically, most of Russia’s gas has come from three giant fields in the Nadym-Pur-Taz region of West Siberia. The region is very rich in gas and once output at these three fields passed its peak in the late 1980s- early 1990s, Russia started to commission smaller replacement projects (although we note that the majority of them would still be counted as big on the global scale) – the satellite fields.

Output from the three giant fields currently accounts for 43% of Russia’s total production. While resources in the Nadym-Pur-Taz region are still substantial, and in our view will mean that the fall in production at the old giants can be fully compensated from the same region for until 2015, Russia needs to start developing resources and constructing infrastructure in other areas so as to meet the growing global demand for gas in the longer term.

So, very much like with oil, we expect the Russian gas industry to see a massive acceleration of greenfield development in the coming several years. Reserves potential The reserves and resources potential of Russian gas is better than that of Russian oil. According to the last available reports (2001), Russia’s proved (ABC1 category under Russian reserves classification) gas reserves stood at 47 tcm, while proved and probable gas reserves were 65 tcm. In addition, there is an estimated 168 tcm of prospective resources (C3+D category). The total Russian gas reserves and resources are thus 232 tcm. The average depletion of Russia’s existing gas fields is estimated at 28%. That is the same as the average depletion of Russia’s biggest reserves basin in West Siberia, which accounts for roughly three-quarters of Russia’s proved reserves. Still, West Siberia is big and includes the remote Yamal region, which has yet to be developed. Adjusted for that, the actual depletion in the main production provinces is similar to that of Timan-Pechora and the Volga-Urals: about 50%.

Russian gas production outlook

Given that Russia’s gas reserves are less depleted than its oil reserves, we believe that the nation has an even greater production potential in gas than it does in oil. We forecast that Russia will increase gas production at a CAGR of 2.6% between now and 2010 and thereafter at a CAGR of 2.7% until 2015. In our view, Russian gas reserves and resources mean that it will be possible to increase production beyond 2015 (unlike oil), although that gas would come at a much higher cost.

West Siberia will undoubtedly remain Russia’s key gas production area, although the fields at the remote Yamal Peninsula will represent an increasing share. We expect that by 2015, Russia will be producing around 115 bcm of gas from Yamal (about 15% of Russia’s total) and that in the longer run this will rise to 250 bcma.

We also expect new production capacity to be launched in Eastern Siberia and in the Caspian onshore/offshore. We estimate that gas production from these two regions will be about 7% of the total in 2015.

Given the complexity of Arctic offshore development, we do not anticipate production there to start up before 2015 (including at the giant Shtokman field). Recent offshore projects with better geological and weather conditions, such as Kashagan and Sakhalin 1 and 2, saw start-up delays of several years.

Capex cycle

The total capital expenditures in the oil and gas industries largely mirror the underlying economic conditions, albeit with several years lag. This is particularly related to non-OPEC producers. The supply response from oil producers produces the consequent volatility in prices for OFS services. The prices for OFS services then normalise as more supply enters the market.

In our view, future capital expenditures can only be considered in conjunction with the level of oil prices. Given the increasing costs of oil production worldwide, the low scale and high expense of alternative fuels as well as the tightening supply/demand balance, we believe that the long-term average oil price will stabilise at a new level of $60/bbl real 2010. For Russia as a price-taker, higher long-term oil prices provide the rationale for more projects and mean continuously strong demand for oil services in the long run.

Russia capex outlook

The Russian oil industry has seen a substantial increase in its capital expenditures over the past couple of years, from an estimated $6.3 bn in 2002 to as much as $17.7 bn in 2006. This signifies a shift in the Russian production growth paradigm, from intensifying production at brownfield sites in the early 2000s to developing new production regions. We estimate that capital expenditures in traditional onshore areas increased by 140% between 2002 and 2006 (from $5.3 bn to $12.8 bn). It is our understanding, though, that the incremental effect of intensification has been decreasing recently and that Russian companies have had to increase the number of well operations and move towards developing smaller satellite fields in the same traditional production areas.

Capital expenditures into new production areas, both offshore and onshore, increased almost five-fold, from $1.0 bn in 2002 to $4.9 bn in 2006.

We have performed a bottom-up analysis of the forecasted total investments into the Russian oil and gas sector through 2015. We have considered both capital expenditures into infrastructure and the development of oil and gas fields, processing and LNG facilities. According to our estimates, total capital expenditures doubled between 2003 and 2006, reaching slightly over $47 bn. We expect capital expenditures (both OFS and construction) to continue to increase at an average CAGR of 11%, reaching $62 bn in 2010. Thereafter, we anticipate a mild decline of 5% on average until 2015.

Between 2006 and 2010, we see the biggest growth in onshore gas (about a 30% CAGR), the refining and petrochemical segment (a 27% CAGR) and gas pipelines (a 12% CAGR). Thereafter, we see the biggest growth in the offshore upstream (a 6% CAGR), LNG (significant growth from a low base) and oil pipelines. In the context of this report, we consider three major components of capital expenditures: construction (both materials and work), drilling and well operations (the latter two represent the OFS services industry). According to our estimates, drilling represents about a quarter of upstream capital expenditures in the oil industry, while capital workovers and other well operations represent another quarter. In the gas sector, we estimate that drilling and well operations together represent about a third of overall upstream capital expenditures. While we expect that total capital expenditures will trend downwards post-2010 (after the construction of major infrastructure in the new regions has been completed), we forecast that demand for oil field services will remain strong in that period.

Exploration

We expect the exploration spending of Russian oil and gas companies to increase markedly in the coming years, driven by the need of Russian oil and gas majors to deliver on their longterm production targets and the government’s increasingly tough stance towards reserves replacement.

Substantial drop in exploration after the break-up of the Soviet Union Following the break-up of the Soviet State planned economy, exploration in Russia decreased substantially and has still not recovered, even with the pick up in development expenditures in early–mid 2000. According to the Russian Statistical Agency, exploration drilling decreased from an average of 4.0 mn metres in 1980-1990 to as low as 1.0 mn metres in 1995-2006.

We strongly believe that the recent preference of Russian oil and gas majors to monetization of existing resource bases (as a lower-risk opportunity) can only be a temporary move.

Consequently, the expenditure on exploration in Russia after the break-up of the Soviet Union was well below that of international majors. We have calculated that in 1998-2005, Russian oil companies spent 7-11% of their total capital budgets on exploration. This compares with the 17-33% spent by international oil companies on exploration during the same period. The recent global trends, which reveal visible strains on majors’ long-term production profiles on the back of insufficient reserves replacement suggests that there is a need for a sustained up-tick in global exploration spend.

The Russian oil and gas industry entered the market economy with a huge cache of discovered but undeveloped fields, which were held in the State’s undistributed fund. Throughout the 1990s, lots of licences were auctioned by the regional governments. This allowed oil companies to add reserves while for the regional governments it was a way to overcome budget deficits.

In addition, there were a number of small companies formed on the basis of geological and exploration expeditions which held reserves on their balances. During the 1990s, the Russian oil industry came through the first wave of consolidation and those smaller companies were acquired by big vertically-integrated players. Thus, most of Russian oil and gas majors’ reserves additions in 1990-2000 came from acquisitions, which was a much cheaper option than exploration.

As of 2000, Russian oil companies started to apply new production methods to their traditional reserves base. This alone allowed them to ‘extend’ existing reserves and increase production levels, leaving little need for exploration. The reserves reports by the Russian oil companies showed that only a few new discoveries were really made during this period. Russian authorities increasingly worried about reserves replacement Now that production growth has slowed down, the Russian authorities have become increasingly worried about reserves replacement. The incremental growth from the further application of brownfield strategies seems to be reaching its peak and in order to achieve growth in the future, Russian oil companies will have to develop new oil provinces. According to the Ministry of Energy and Industry, the average oil reserves replacement in 1991-2004 for Russia was 86%, below the important 100% benchmark. The Russian government is toughening up the administration of development programmes for existing and new fields and the licensing regime in general. In addition, the government is implementing two sets of measures aimed at promoting exploration spend.

Increase state-sponsored exploration. The Ministry of Natural Resources has developed an ambitious long-term programme, which calls for $6.0-8.5 bn of budget money to be spent on exploration through 2020. Introduce differentiation system for the mineral extraction tax. Currently, the tax only takes into account a field’s depletion and provides tax holidays for greenfield development in Eastern Siberia. The list of differentiation criteria may be expanded at a later stage.

The situation with reserves replacement in the Russian gas industry is slightly more favourable as i) gas is a newer fuel type than crude oil and thus the Russian gas industry is less mature and ii) Russia is generally richer in gas reserves. Since 1990, the average reserves replacement has been 129%.

Bright outlook for the future

Over time, we expect the proportion of exploration spending by Russian oil and gas companies to come closer to global practices and the absolute level of exploration expenditures to increase. According to Former Deputy Minister of Natural Resources Petr Sadovnik, there should be a major expansion in exploration activity – up to 2.5 mn metres of exploration drilling per year, with geophysical and seismic activities to match – in order to overcome the recent negative trends in reserves replacement. Thus there is a very attractive niche for Russian OFS companies to benefit from an increase in exploration spending.

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