Challenges in the Russian Energy Sector

Investors worldwide have their eyes on Russia, a global energy powerhouse. With 6 percent of the world’s oil reserves and a whopping 27 percent of gas reserves, the country ranks number two globally in hydrocarbons.

Its oil and gas industry is in transition, however, and foreign investors keen to garner the benefits of Russia’s huge energy wealth face considerable challenges and risks. This paper is a synopsis of research conducted as part of Kellogg’s Global Initiatives in Management program into the opportunities in this market; including those in the oilfield services and equipment manufacturing segment (OFS), which holds the greatest promise, while prospects in the exploration and production (E&P) segment are constrained by the government’s strategic interests. To succeed in either, investors must be adept at identifying and fulfilling the specific and often peculiar needs of Russia’s energy sector.


A Strategic, Yet Diverse, Industry

The oil and gas sector’s recent history and its definition as a strategic industry by the Russian government provide the backdrop for any opportunity analysis.

Russia’s oil and gas segments are distinct. The sheer abundance of natural gas outstrips the more limited oil supply. In fact, oil production plunged almost 42 percent between 1990 and 1998, plagued by overproduction, lack of capital investment, inefficient development of fields, and shrinking demand. The gas segment, sustained by strong demand in Europe and cheap supply in Russia, suffered no such decline.

The oil industry underwent a period of decentralization in the 1990s, followed by reconsolidation in the early 2000s. In 2005 five firms accounted for 71 percent of Russia’s oil output. In the gas segment, OAO Gazprom (Gazprom) remained strong throughout the period, and now accounts for more than 85 percent of the country’s natural gas production.

The government has invested heavily in both oil and gas companies, and has influenced the sector in other ways as well. Foreign capital is limited to less than a 50 percent stake. Enforcement of contracts remains a salient risk. The unstable political environment means that government involvement may change through what is necessarily a front-loaded, long-term investment horizon.


Gazprom as Proxy

Gazprom, the world’s largest natural gas company, embodies many of the traits of Russia’s oil and gas industry and as such may be considered a proxy for the country’s gas segment. The Russian government owns 50 percent of Gazprom, which is vertically integrated and active in both natural gas and oil. Gazprom supplies most of Russia’s energy demand, and holds a monopoly over gas exports to Europe and the countries of the Former Soviet Union (FSU). It also has several noncore businesses such as media and financial services.

Overall, Russia’s natural gas production increased at a mere 1 percent compound annual growth rate (CAGR) between 1999 and 2004. There are two main causes for this anemic performance: a lack of production incentives and weak execution. These two issues limit the country’s (and Gazprom’s) ability to expand production and, more ominously, to replace depleting natural gas reserves.

Gazprom has little reason to increase production: it has a virtual monopoly, its reserves are heavily concentrated in challenging Western Siberia, and there is an abundance of cheap gas in Turkmenistan that can be bought and re-exported to Europe at a very large profit. The company’s control over most of the Central Asian gas pipeline guarantees its pricing power.

Execution issues reflect the role of government. Many of the top executives have political rather than business expertise, contributing to the inefficiency of Gazprom’s organizational structure. For example, its noncore businesses are arguably undervalued within the diversified holding company structure.

Gazprom has been an active and increasingly successful consolidator, however, using acquisitions and partnerships to gain technological expertise. Its current strategy is to expand in midstream and downstream assets abroad and upstream domestically, including in power generation. It has the backing of the Russian government, which is focused on making Gazprom the world’s largest energy company by capitalization.


The Shifting Gas Market

Gazprom’s gas market is evolving, and the changes may ultimately help independent gas producers. The existing dual-price system, in which high prices in Europe provide Gazprom a tidy profit that offsets subsidized prices in the internal and FSU markets, has come under fire under the World Trade Organization (WTO) regime. Market forces are also changing the balance.

Gazprom faces growing competition in Europe, where natural gas from North Africa and the North Sea is gaining ground and liquefied natural gas (LNG) is an increasingly formidable force. This suggests that gas prices in Europe will decouple from oil prices in the next few years, and trend lower. On the other hand, the government is increasing prices within Russia gradually; by 2011, they will have tripled. Russia is also leaning heavily on FSU countries, which host Gazprom’s pipelines to Europe, demanding higher prices. The upshot is likely to be a change in the mix of Gazprom’s earnings, with the domestic market accounting for a larger portion of its revenues. Independent producers, limited to the domestic market, will also benefit from the higher internal prices.

Overall, Gazprom stands to gain the most. Independents will likely have to pay more to use the company’s pipelines, and thus will net only 53 percent of the price increase, whereas Gazprom will reap the full benefit.


Does Government Presence Change the Balance?

The impact of heavy government participation can also be seen in the performance of other Russian energy companies. Lukoil is a privately held partnership in which ConocoPhillips holds a 20 percent stake. The company has thrived by maintaining a low political profile and has benefited from ConocoPhillips’ technological and managerial expertise. Lukoil is increasingly turning its sights abroad, however, despite attractive opportunities for domestic growth. It is unclear if this is in support of its major foreign investor, or a reflection of Lukoil’s uncertainty about competing long-term with the likes of government-controlled Rosneft.

Like Gazprom, Rosneft has benefited from the stability associated with government ownership. Analysts forecast that its production will expand at a blistering 12 percent CAGR, compared to Lukoil’s 10 percent and the sector’s 3 percent average. The government has supported Rosneft’s consolidation efforts, and the company is likely to continue to receive tax breaks and access to new oil and gas licenses.


The Promise of Oilfield Services

Investors will likely find many more opportunities in Russia’s OFS market, a segment still in its infancy and growing rapidly. The government’s focus on oil and gas reserves as strategic assets will require greater financial and operational efficiency in the upstream segment. This, in turn, will lead to a major restructuring of the OFS market, creating attractive prospects for domestic and foreign investors.

While Russia’s OFS market is still dominated by the in-house units of major domestic oil and gas companies, this is changing rapidly. A focus on capital efficiency has pushed companies to commit capital to exploration rather than to the routine maintenance of oilfield service assets. At the same time, they must invest in well-servicing and workovers in order to maintain production levels in mature provinces such as Western Siberia. This demand for operational efficiency adds to the thrust toward a competitive services market that reduces risks and costs. Exploratory drilling in Eastern Siberia will require increased technical complexity and high well costs, leading to the need for Western expertise and most likely Western capital.

The divestment of internal service divisions by the Russian oil and gas producers, which began in 2003 and is expected to last well past 2010, is beneficial to the industry on multiple dimensions: the activity generates cash for exploration and improves efficiency by creating independent OFS businesses that serve multiple clients; these independent operators, which can gain scale through consolidation, will be keen to develop technologically, upgrading and replacing old equipment.


Key Success Factors

To become successful players in this dynamic market, companies must have not only up-to-date technology and management expertise, but also access to capital and local content or relationships.

There are three main sources of capital for OFS companies. Large Russian companies, such as consolidator Integra, have access to the rich western equity capital markets. Leading western firms, such as Schlumberger, are already in Russia through partnerships, and are interested in expanding their presence. And as the market evolves, private capital, both western and Russian, will likely be more willing to commit resources to new deals. For example, debt providers, the debt capital markets arms of major western investment banks, and hedge funds have all displayed interest in financing opportunities in this arena.

Given the political sensitivity of the Russian oil and gas industry, it is vital for OFS companies to have strong relationships with the various players. For foreign investors, the use of Russian personnel provides both local knowledge and access (commonly referred to as “local content”). In many cases, it is necessary to form partnerships with local companies. Shell’s Sakhalin Production Sharing Agreement, for example, requires that 70 percent of OFS and construction services be provided by Russian companies.

Once these larger questions are addressed, there are at least six keys to success for foreign investors in this arena:

1. Invest in a minority position with a good tax-paying Russian partner (majority control is preferred).

2. Ensure that both parties are working in concert by aligning incentives and goals.

3. Structure the deal to leverage the strengths of each partner.

4. Make large deals, which will attract and maintain the interest of top management.

5. Structure the deal to allow for international growth.

6. Attain the “blessing” of the Russian government prior to the investment.


The Russian government has not, to date, been active in the OFS segment, and will likely remain on the sidelines. The OFS market is non-strategic and requires technology and capital, which the government is content letting outsiders provide. Foreign investors must, however, remain attuned to any change in the government’s posture, just one of the many challenges associated with this opportunity-rich domain.