What's Holding Back A Flood Of Russian Oil

Just a couple of years ago, energy analysts were marveling at one of the biggest changes to hit the international oil market in decades: the remarkable renaissance of the once moribund Russian oil industry. After slumping during the 1990s, Russian crude output has rebounded by 50% since 1999. Today, Russia boasts daily production of 9.3 million barrels, 11% of the world's total, just behind Saudi Arabia. But if Russia is pumping so much crude, why does oil cost $60 a barrel? One reason is that Russia's oil boom has been followed by a dramatic crunch.

After expanding by 11% in 2003 and 9% in 2004, growth in Russian oil production slowed to just 3.6% in the first half of 2005. Some deceleration was expected, but the scale of the recent slowdown has been more severe than predicted. "In the past couple of years Russia has surprised on the upside. This year it has surprised on the downside," says Stephen O'Sullivan, head of research at investment bank United Financial Group in Moscow.

The major reason for the dropoff is clear enough: The Kremlin's two-year legal assault on alleged tax fraud at Yukos, which dismembered Russia's No. 2 producer. But some argue that Yukos is not the whole explanation, and that what's crimping oil investment is a broader breakdown in Kremlin oil policy.

Unrefined Policy

There is still huge uncertainty, for instance, about whether the state's renationalization drive will end with Yukos. On July 8, President Vladimir V. Putin confirmed that Gazprom, the giant state-owned gas concern, is in talks to acquire No. 5 oil producer Sibneft. Not coincidentally, analysts say, Sibneft has curtailed capital investment. This year it will spend $884 million on exploration and new infrastructure, versus $938 million in 2003. It's still unclear, though, if the acquisition will take place.

Oil executives also blame the growth drought on recent hikes in oil taxes. Petroleum companies now pay 89 cents a barrel in taxes for every dollar they take in above $25 a barrel, up from 68 cents in 2003. Jeff Currie, head of global commodities research at Goldman, Sachs & Co. (GS ) in London, says it's this hike in costs, rather than the recent slowdown in production, that has had the most important impact on the global oil price. "This shift in industry economics is a very significant issue," he says, "as the cost of access to this oil has gone up tremendously."

It also doesn't help that rules governing foreign investment in the industry are still unclear. The government recently drafted legislation forbidding foreigners from owning more than 49% of natural resource assets defined as "strategic," including oil and gas. But the law is bogged down in Parliament. Until the issue is sorted out, most major foreign investment is on hold.

The real problem with government oil policy, critics say, is that there is none. "Russia unfortunately has an energy policy where everyone has a say, so no one knows who's in charge," says Adam Landes, a London-based oil analyst at Russian investment bank Renaissance Capital. With huge, cheap reserves, Russia's oil industry still has plenty of potential to attract investment. But if recent trends are any guide, no one should count on it.

By Jason Bush in Moscow

Edited by Michael S. Serrill

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