Arctic oil: Putin's last chance

July 19, 2012 | 00:00

Arctic oil: Putin's last chance

President Putin is back, but this time he faces daunting challenges on the energy front. The easy times throughout the 2000s when prices were rising, production was steady, and petro-dollars kept rolling in, are gone. Russia is facing steep depletion rates on key oil fields in East Siberia, the Far East and West Siberia, a dynamic that has already seen the country slip back to second place on the international roster of oil producers behind Saudi Arabia. The only chance Putin has to retain his long term global energy stake is successful exploitation of Russia's Arctic reserves, but that's going to need serious foreign investment. The good news for Putin is that international oil companies have welcomed the initial 'policy certainty' his return has brought to the Kremlin, but if Russia wants to attract serious amounts of foreign capital, Moscow also needs to display very long term consistency.

The snag for Putin is that Russia neither has the capital nor expertise to develop the Arctic oil fields by itself (c) AP/Association of Russian Polar Explorers
Russia still depends on hydrocarbons for two-thirds of its exports, half its federal budget and 20% of its GDP - not to mention balancing its budgetary books at staggeringly high $120/b breakeven prices. President Putin is painfully aware of this. No oil, no political pedestal for him to stand on. Pumping the ‘black gold’ is literally the only way Putin can keep the Russian political system in balance, not just to fulfil the $320bn spending commitments he's made to the Russian electorate by 2018, but to ‘price in’ more significant payments needed to keep the security services, military and oligarchs on-board.

Ramping up investment into mature onshore fields (and 'shale oil' plays) might help to fill some short term gaps, but if Russia wants to maintain its production of 10.5 million barrels per day (mb/d), or increase its output to 11mb/d, as the government intends, it only has one option: to develop its enormous offshore potential in the Arctic. Estimates vary, but anything up to 100 billion barrels of oil equivalent is sitting under the Russian part of the Arctic ice - in ballpark terms, that amounts to 70% of current Russian reserves. The snag for Putin is that Russia neither has the capital nor expertise to develop the fields by itsef. State oil company Rosneft needs international oil companies (IOCs) to help it 'crack' the initial ice.

Some of them have already taken the bait. On 16 April 2012, Exxon Mobil was the first to sign a $ 3.2 billion cooperation agreement with Rosneft covering licenses in the Kara Sea and Black Sea. Italian ENI followed on 25 April with a deal with Rosneft covering the Barents Sea and Black Sea. Statoil signed up with Rosneft to jointly explore offshore fields in the Barents Sea and Sea of Okhotsk in early May. More deals are likely to follow from ambitious Western IOCs such as Shell, Total, Chevron and Conoco.

What's been interesting about the agreements signed so far, is not just that Putin had to bite the bullet and offer highly attractive fiscal terms, tax rates and export duty exemptions - but that they have all been brokered as swap agreements, tying Rosneft's Arctic concessions into international fields. That plays well towards Rosneft's 'internationalisation ambitions', but it has an important advantage for the IOC's

What's been interesting about the agreements signed so far, is not just that Putin had to bite the bullet and offer highly attractive terms, but that they have all been brokered as swap agreements
as well: it gives them far greater leverage to manage political risk emanating from their new-found Russian partners. IOCs have to stump up all the initial exploration and production costs for the uniform 33% Arctic stakes they've received. In return, Rosneft gets to access North American assets courtesy of Exxon, North Sea fields via Statoil and North Africa plays from Eni. Given previous experiences in Kovytka, Sakhalin and Shtokman that turned sour for Western players, IOCs want Rosneft tied to the hip before they sink serious cash into the Arctic. As resource rich as Russia is, when it comes to investor trust, it remains pretty much bankrupt.

Strongest grip

When you look at recent developments surrounding TNK-BP, the troubled Russian joint venture that BP is now trying to exit, such 'insurance' policies are with good reason. For behind the Arctic deals noted here, rests a far bigger battle being waged in Russia. The return of President Putin has unleashed an internal war over resource management: who pulls the political strings, how far should privatisation go, and which national champions will win out? Former President Dmitri Medvedev has tried to bring forward plans to privatise energy companies back in his 'traditional' Prime Ministerial role - a move that's been ably supported by the new deputy PM Arkadiy Dvorkovich - as much as it's been fiercely rebuked by Putin's long term 'energy confidant' - Igor Sechin. Having been left out of the Russian cabinet, Sechin now cuts an even more formidable figure as the newly anointed CEO of Rosneft, not to mention holding a pivotal role in Rosneftegaz (a state investment vehicle that owns 75% of Rosneft).

Sechin has already scuppered the privatisation of FSK & MRSK (power grids) and put the brakes on a RusHydro (hydroelectricity) spin off. Although internal battles are still being fought, Sechin has made quite clear that he expects Rosneftegaz to sink its own cash into the hydro-electric company and put his old coterie (including Sergei Shmatko) in charge of grids, all of which provides a good indication of where the former KGB man wants to take Russian energy policy: back into the hands of the Russian state, with Rosneft playing the core national champion role. Indeed, to square his 'energy circle', Putin has appointed himself head of a Special Presidential Commission for the strategic development of the oil and gas sector. This basically amounts to a parallel government beyond the confines of the Kremlin cabinet, with Putin playing his old games of 'divide, decide and rule' as the final arbiter of the Russian system. To outsiders looking in, Medvedev and Dvorkovich might appear to have a stake in the game, but it's ultimately Putin (and by implication Sechin,) that have the strongest grip on the energy sector.

What that means is that upstream competition from Russian players such as Lukoil, Bashneft and Surgutneftegaz will be inherently limited in the Arctic. More importantly, it also suggests Sechin is well placed to address BP's long term Russian nemesis, the AAR oligarch consortium that owns 50% of TNK-BP. That's where Sechin's biggest battle actually resides. As lucrative as the joint venture has been, BP wants a clean break from its oligarch past. If Sechin can bring the oligarchs to yield for a smooth sale, it will send a clear market signal that President Putin is fully back in control of Russian energy relations. Not to mention giving Rosneft (and the Russian state) precious receipts to pocket. But if he fails, serious doubts will be raised for future international upstream investment in Russia. If the Kremlin isn't able and willing to run the show, few will want to run the same gauntlet BP has endured.

Although BP has signalled it formally wants to sell its 50% in the acrimonious joint venture, it's still highly unclear who is divorcing whom. Estimates of the British firm's stake within TNK-BP currently range from $18 billion to $30 billion, and it's AAR that has the first right of refusal to buy BP's stake. Under the original Anglo-Russian agreement brokered in 2003, AAR has a 135 day moratorium on any sale. BP will obviously line up as many counterbids as possible, but more likely than not, this will come down to a straightforward fight between Sechin (Rosneft/Rosneftegaz) versus AAR oligarchs to claim the spoils. From last year's failed BP-Rosneft tie-up, Sechin is highly unlikely to work with AAR, which just leaves Gazprom as an interesting outlier if Alexey Miller (the gas giant's CEO) decides he wants to table some kind of counter (political) bid to Sechin's rise. Roughly translated, BP will either sell its stake directly to AAR; potentially look for a white knight bid from Gazprom; or more likely, try to cut a deal with Rosneft on the strict proviso if it exits TNK-BP, it wants an instant joint venture (if not outright equity swap) with Rosneft to explore the Arctic. The optimal outcome for BP, then, is actually for Sechin to go after AAR's 50% stake. 'BP-Rosneft' picks up the TNK-BP pieces and goes exploring in the Arctic as well.

That might be something of a long shot for Bob Dudley (BP CEO) to pull off, but the bigger point to register beyond BP's foibles is that Russia needs to get its political and legal act together to make sure

Russia needs to get its political and legal act together to make sure investment keeps coming Moscow's way
investment keeps coming Moscow's way. Seeing BP suffer at the hands of AAR isn't what international investors want - it's an all too obvious reminder of the enormous risk that pervades Russia. They want to know who they are dealing with, how policy is made, and who are the key individuals making them. In effect, Sechin's battles need to be waged, and need to be assertively won. No one is saying that would be politically pretty, but the stakes are too high to allow for much else in Moscow these days.

Useful hedge

If anything, the longer the TNK-BP saga goes on, the bigger the problem for Putin, precisely because the scale of the Arctic challenge is enormous. Hundreds of billions of dollars are needed just to scratch the Arctic surface, and in a new world of increasing unconventional oil and gas resources, Russian resources aren't quite the prize they used to be for IOCs. Moscow needs to display long term policy stability and play contractual ball if it's to stand any chance of bringing these reserves to market over the next decade or more. Oligarch meddling will never do that.

Even now, IOC pledges don't amount to taking a full 'Arctic plunge'; they are merely dipping their toes in the water to see how cold the temperature is. Putin still has the option of bringing smaller European players such as Gdf-Suez, BG Group, Repsol, Gas Natural, RWE, Eon or Centrica into the Arctic in return for European assets, but this would be more a case of cherry picking how many 'second tier' European flags the Kremlin wants lined up to balance competing Arctic interests and stakes in future. These companies do not have the clout to seriously enhance Arctic production.

Interestingly, emerging National Oil Companies (NOCs), notably the Chinese, have been conspicuous by their absence in the Arctic race so far. Part of the explanation is they simply don't have the technical prowess to be much use in the Arctic, but as China demonstrated with a $25bn loan for oil agreement to Rosneft in 2009, they certainly have the cash. Japan has limited Russian stakes via Mitsui and Mitsubishi, while India's ONGC is active in Russia through its acquisition of Imperial Energy in 2008. Given rapacious supply side activities elsewhere, it's surprising NOCs haven't been more active in the Arctic to date. Putin may well try to incrementally bring them into play for financing purposes, but if he's lined up any Western IOC's worth their salt in the meantime, it would be remarkably difficult for Russia to play its normal game of chucking them all out at a time of Moscow's choosing. Russia has never fared particularly well when it tries to go it alone - but imagine it's 2020 and Arctic fields start to look a good production prospect. Asian NOCs would provide a very useful hedge at that stage for Putin to rewrite contractual terms. Western IOCs do the heavy lifting, Asian consumers are the key recipients, Russia retains overall strategic control of its resources in the process.

Obviously that all remains to be seen, but for now, the Arctic script seems clear. US oil majors should have a relatively easy (and cheap) ride provided they give 'like for like' domestic reserves for Rosneft to develop. European majors can get in on the Russian act through swap agreements, albeit with BP likely to raise the stakes towards equity agreements if it manages to survive its TNK-BP exit. Second tier European outfits won't figure much in the debate, not unless Putin sees clear strategic value to make it worth the hassle. Meanwhile Asian NOCs will sit and wait. It will seem like an eternity, but it might prove to be the best decision they could make if they ultimately gain from Putin's underlying hedge.

Restive population

But there are still major risks to consider. If any of the high risk swap agreements brokered between Rosneft and IOCs hit environmental problems akin to the Macondo disaster, then all bets are off. More realistically, Rosneft has probably already outstripped its own internal capabilities to service contracts and develop fields at this stage. This could easily create an 'expectations-capability' gap for Russian exploration and production to produce the actual 'hydrocarbon goods', particularly as oil prices are slipping. The Arctic could become a difficult proposition to attract consistent investment beyond cyclical swings with price bands below $100 in play. Given the size of the potential prizes and lead times involved, some might be willing to invest through the cycle and bubbles involved, but they'll do so only on favourable terms. Putin could and should have got working far earlier on the Arctic when times were good. If Russian oil production was as healthy as it should be, the Kremlin wouldn’t be piling up $500 billion in cash reserves to try and buy their way through economic hard times if and when the oil price drops. Such oil receipts won’t last long if prices continue to plummet; ensuing political instability in Russia will hardly enhance Arctic investment either.

Although Putin will lean heavily on OPEC to firm prices, if he manages to weather pending oil market storms, then the Arctic offers his last chance to put Russia on a serious energy footing. That means investing resource wealth back into the Russian economy, following through on contracts rather than

Putin's 'iron law of politics' remains a better option than the 'Medvedev method' of mixing politics and law for IOCs to do business in Russia
shifting the goal posts on international players, not to mention opening up new export markets in Asia. Sadly the historical record doesn't bode well for Russia to break its rentier shackles -  and that's perhaps Putin's deeply ironic problem. His 'iron law of politics' remains a better option than the 'Medvedev method' of mixing politics and law for IOCs to do business in Russia, but even if Putin manages to bring competing rival blocs to heel in the Kremlin, such a method will struggle to secure Russia's long term energy future, let alone providing credible economic diversification for an increasingly restive population. In that respect, we should expect to still be writing about Arctic resource developments long after Putin has left the political scene, circa 2018, if we take him at his word.

This is an adapted version of an article to appear in Greenorbis Magazine.

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