Why Russian Oil Production is on the Verge of Decline

Why Russian Oil Production is on the Verge of Decline

photo: Tim Whitlow

On March 1, Vladimir Putin delivered a workshop with the leaders of the eight largest oil companies in Russia, where participants discussed a preliminary agreement between Russia and OPEC. Oil industry representatives determined they had no choice but to freeze the oil production rate at the level of January 2016. They also expressed that they wanted to avoid raising industry taxes, which would make it difficult for them to develop new fields. The president promised to discuss this issue with the government.

Today there are no guarantees that industry taxes will not rise. The evidence is in the government’s decision to freeze the oil export duty rate at the level of 42%, which was taken in November 2015. This conflicted with the government’s plans to lower the oil export duty rate to 36% and increase the mineral extraction tax rate from 775 to 856 RUR per ton of oil. In 2016, the latter was risen, and the former was not reduced. The ruble devaluation that increased oil company profits laid the foundation for this decision.

In reality, the devaluation effect was largely compensated by the fall of oil prices and the rise of import costs. During the first 9 months of 2015, the average ruble exchange rate decreased by 69.3% on a year-over-year basis (from 36.02 to 60.99 USD/RUR), and the cumulative net income of the four largest oil companies (Rosneft, LUKOIL, Surgutneftegaz, and Gazprom Neft) increased by just 11.2% (from 965.6 to 1074 billion RUR).

The decision that was made in November, as well as the possible increase in industry taxes, will hurt the daughters of the oil companies that work in Western Siberia. Their oil production has already begun to slump. Thus, during the first 9 months of 2015, RN-Yuganskneftegaz lowered their oil extraction rate by 3.6% on a year-over-year basis, while RN-Samotlorneftegaz did so by 4.5%; RN-Orenburgneft lowered their oil extraction rate by 7.6% on a year-over-year basis, LUKOIL-Zapadnaya Sibir did so by 6.7%, and Gazpromneft-Noyabrskneftegaz by 3.9%.

Currently, the development of new production projects compensates for the slump. For example, in 2015, Surgutneftegaz managed to increase their production rate by 0.3%, thanks to the fields in Yakutia, where the oil extraction rate grew by 9%. The Yarudeyskoye oil field is another example; developed by Novatek, it reached its project capacity of 9,700 tons per day (3.5 million tons per year) in January 2016. The industry maintains its focus on sustainability due to the success of relatively small companies such as Bashneft (which grew by 11.9% in 2015) and Tatneft (which increased by 2.7%). Consequently, in 2015, the cumulative oil production rate grew by 1.4%.

However, in the medium-term, the oil production slump in Western Siberia will hide the effects of any new projects. The policy of the Ministry of Finance, which views the oil industry as a source of revenue, is largely responsible for this view. The other problem lies in the industry’s tax system, which was developed over ten years ago, and does not distinguish the tax rates of old and new fields. Between 1992 and 2001, Russian oil companies were paying three taxes, including royalty and excise duty for oil and gas liquids, and a mineral reserves replacement tax. In 2002, the government abolished these taxes and introduced the mineral production tax.

Tax rates have always been unified for all industry participants. As Yegor Gaidar later recalled, such a policy should have minimized the risks of corruption. As one of the architects of the tax reform from the early 2000s, he thought that the differentiation of the mineral production tax rate would stimulate bribery among government bureaucrats: they would provide tax rebates for those companies whose staff would illegally pay the bureaucrats themselves, which would hurt the federal budget.

There is no doubt that it is difficult to exclude the risks of corruption and the fall of budget revenues. However, experts should take into account that currently, the oil industry is experiencing more difficult times than it was 15 years ago. Between 1999 and 2004, the oil extraction rate grew one and a half times, from 305 to 457 million tons. This positive change was largely possible because by the early 2000s, private companies had gained control over 80% of the oil production capacity.

In the last 10 years, their role has diminished significantly. As a result of Russian nationalization policies, the government has gained control over the assets of Yukos, Sibneft, and TNK-BP. The industry is experiencing stagnation, and to overcome this immobility, the government should privatize oil companies and differentiate mineral production tax rates. Moreover, the Cabinet should avoid increasing industry taxes until the latter has gained higher growth rates.

To curb the budget crisis, the government should cut down its expenditures. For example, officials can cut the subsidies to any state companies that grew more than four times between 2007 and 2014 (from 730 billion to 3.1 trillion RUR). Any initiatives to boost the tax burden of the oil industry will lower the oil extraction rate and hurt budget revenues. The government, however, still has time to prevent this scenario from becoming reality.