Russia Oil and Gas Guide: The Russian-American Energy Alliance

By S. Douglas Stinemetz, Haynes and Boone LLP

On July 2, 2002, the first shipment of Russian crude oil to North America reached Galveston. This symbolic shipment has been followed by many others, and more are planned.

These shipments have come to symbolize an evolving energy alliance between the Russian Federation and the United States. This alliance is a geopolitical turning point, as well as an economic one. The basis for this new energy alliance are some fundamental common interests which Russia and the United States are now able to pursue together.

The Russian oil industry is finally recovering from the breakup of the Soviet Union. Prior to 1991, Soviet exports of oil at their peak exceeded 12 million barrels per day. At that time, the Soviet Union was the world's largest oil exporter. Those exports sank significantly when the Soviet Union collapsed. At its ebb in 1992, Russia only exported about 3 million barrels a day and production as a whole in the early 1990's declined to only about 6 million barrels per day. Russians have since stabilized their oil production and by early 2002 oil exports were back up to 5 million barrels or more a day. This level of oil exports was second only to Saudi oil exports in the same period Russian oil export figures for 2002 as a whole are not released yet, but likely continued to increase.

This bounce back in Russian oil exports has been the work of the Russians themselves. Relatively little foreign investment in the Russian oil industry has been made, apart from the oil projects in Sakhalin. There are a number of reasons commonly cited for this relative lack of foreign investment - lack of a favorable regulatory and tax regime for production sharing agreements being the most notable excuse. The underlying truth is that the Russians did not need foreign oil companies to produce their oil - at least on the terms the foreign oil companies' desire. Chief among the foreign oil companies desires has been the ability to operate the fields themselves, like they do in the third world.

Russia, however, is not the third world. The Russians do not need to turn over their oil fields to foreign companies because they have an existing industry, with tens of thousands of well educated professionals who have successfully explored for and produced some of the world's largest oil fields. That technical basis notwithstanding, the Russian oil industry does have some notable flaws.

The two particularly significant areas in which the Russian oil industry has been deficient are financial planning and technological innovation. Financially, Russians have often produced oil with little regard for its ultimate profitably and certainly have had great difficulty managing cash flow. Technically, the Russian oil industry has simply lagged behind other oil regions in creating and applying new technologies to enhance production. Both weaknesses are direct results of the prior operating regime for oil development in the Soviet Union.

The Russian oil industry, however, is overcoming these weaknesses by hiring foreign assistance in financial planning and acquiring foreign technology, either directly or by hiring service companies with the requisite foreign expertise.

Today's Russian oil magnates have simply imported the expertise they require, much like Peter the Great imported Dutch shipwrights to build a Russian fleet in the early eighteenth century. As a result, they do not have to cede control of their oilfields to foreign companies outright (although they are open to partnering with foreign oil companies on a more equal basis).

What the Russian oil industry really needs now is access to cheap foreign capital from the capital markets and access to world markets. The major Russian oil companies are generating significant revenues given the current oil price of $30 per barrel or more, but need access to foreign capital markets to raise equity to expand their production. They are currently moving in that direction. Both Yukos and Lukoil are notable leaders in listing their bonds or shares on the London Stock Exchange and on the New York Stock Exchange (through American Depository Share programs).

Perhaps more pressing, the Russian oil industry needs access to world markets for its increasing production. Such access is critical for the long term profitability of the industry since Russian domestic oil sales are in rubles at prices about half the world market price, and dumping additional oil production on the Russian domestic market would depress prices even further. A glut of Russian oil in 2002 in its domestic market has already resulted in significant price pressure - and even calls to establish a Russian strategic petroleum reserve (to absorb excess production).

Access to world markets for this purpose means developing (1) infrastructure to transport increasing quantities of Russian crude to refineries abroad and (2) long term sales arrangements with foreign retailers of gasoline, lubricants and other hydrocarbon products to ensure that long term investments in expanding production can be recovered.

The Russian oil industry has been actively pursuing new transportation routes for its oil. The major Russian oil companies in the most notable recent project announced that they would build an oil terminal in Murmansk, on the Barents Sea near the Arctic Circle. The terminal will serve as the lifting point for loading deepwater supertankers, access to which Russian companies have previously lacked. This terminal will change the economics of Russian oil exporting to allow global deliveries to be more economically feasible. (The Russian government values this commercial deepwater port for its oil exports so highly that it is moving a contingent of its nuclear submarine fleet out of Murmansk to make way for the supertankers.) Other oil transportation pipelines are being completed as well, such as the Adria pipeline in Croatia which will give Russian oil exporters access to the Adriatic Sea at the port of Omisalj.

If the Russian oil industry further develops its capacity to transport its oil, it will also need ultimate markets for the oil. About 6 out of every 10 barrels of oil currently produced is exported. Most Russian crude deliveries currently go to European refineries from ports in the Black Sea or Baltic Sea, or via the Druzhba (Friendship) oil pipeline to Austria. These routes are reaching their capacity, tanker traffic on the Black Sea route in particular being subject to environmental limitations at the Bosphorus, and the markets they serve are already absorbing lots of Russian export oil. Western Europe in 2000 acquired 87% of net Russian oil exports. Some Russian oil from Sakhalin will go to Japan but most current oil delivery systems are pointed toward Europe and the Atlantic. The great untapped market for Russian crude, therefore, is across the Atlantic - North America.

In North America, the United States market for crude oil is growing. United States production of oil, even with new deepwater developments and production enhancements in the Gulf of Mexico, does not currently keep up with demand. As a result, much of the crude oil consumed in the United States is imported. The Cold War had previously precluded any exports of Russian oil to the United States.

Now, however, geopolitics in the new world order are encouraging such imports rather than discouraging them. The Bush administration appears to have decided that the Middle East is so inherently unstable that it is not a reliable source for crude oil. In particular, crude oil supplies may be interrupted once the United States takes some direct military action against Iraq, either by resultant economic dislocations or an actual embargo and/or terrorist attacks on tankers or pipelines. As a result, the United States has been looking for alternative sources of oil supply, just as the Russians are seeking new markets for their oil.

Some preliminary rapprochement between Russia and the United States to explore Russian oil supply to the United States appears to have take place. Both governments are publicly supporting development of Russian oil supply to the United States.

Whether this rapprochement ultimately will trigger a stream of Russian oil tankers to North America will depend on a number of factors. Chief among those factors are the economics of transporting the oil. Historically, the Russian oil industry has not had access to a deepwater lifting facility for lifting oil by supertanker. As a result, the cost of transportation of Russian oil to North America have been prohibitive. Given the recent rise in oil prices above $30 per barrel, those costs have proven less burdensome. Once the Murmansk terminal (or some similar project) becomes operational, then transportation costs for Russian oil will be significantly reduced.

Besides the economic benefits of this Russian-American energy alliance, there is an additional long term potential geopolitical benefit for both Russia and the United States.

Reintroduction of Russia as a pre-dominant oil exporter worldwide would seriously undermine OPEC's cartel pricing power. OPEC's oil quotas are essentially enforced by Saudi Arabia, which is the only OPEC participant with sufficient oil reserves to flood the market with enough oil on 90 days notice to depress oil prices significantly. This potential ultimate sanction is what keeps the other members of OPEC in line.

If large additional volumes of Russian crude were to come on the world market, then that production would not only drive down prices generally but also drive them to levels where Saudi sanctions might not be as effective. The Russian production would also impair OPEC's ability to reduce its overall production to raise prices. With less ability to raise prices and without the discipline supplied by the Saudis, OPEC might well collapse as its members sought to outproduce one another in order to keep their revenue streams from oil sales up to finance their respective domestic agendas.

The Russian government is at least as interested in undermining OPEC's pricing power as the United States government, perhaps more so. While the United States can restrain the Saudis somewhat because of the United States' global political position, the Russian government has little such influence. In addition, the Russian oil industry has openly chaffed at various attempts by OPEC in late 2001 and early 2002 to pressure the Russian government to rein in its own oil production - and which were for the most part rebuffed. While the Russian oil producers certainly appreciate higher prices, they will benefit little from higher prices if they cannot produce oil to sell at those prices.

In the end, the national interests of Russia and the United States in global energy are converging. As residual Cold War distrust ebbs, common interests such as these mutual interests provide a solid basis for a new Russian-American energy alliance in the future.

The United States can facilitate the growth of a Russian American energy alliance in a number of ways. First, the United States government can formalize the alliance at the governmental level - and appears to be working in this direction. Perhaps more important, the United States can encourage the development of the Russian oil industry, particularly its transportation infrastructure. Financial aid or guarantees for mega projects, such as the Murmansk terminal, would be most effective. Such assistance though needs to be in concrete forms, not just consulting services provided by beltway bandits. Finally, the United States could take some practical steps in opening its own markets to Russian oil and/or permitting Russian companies to acquire interests in US gasoline distribution enterprises. Marketing joint ventures between Russian oil companies and American gas station vendors for example are not out of the question by any means - one already exists. In the end, such an energy alliance would make the world a better place for both the United States and Russia.