A New Opening in Russia's Oil Fields

Vagit Alekperov founded Lukoil two decades ago and built it into Russia's largest nonstate oil company, with $105 billion in revenues. Yet in a recent interview, Alekperov was daunted by prospects in Russia, where Lukoil's production may decline this year. He's more enthusiastic about Iraq and West Africa. "It is not easy to produce oil anymore in Russia," he says.

After the fall of the Soviet Union, Russia rebuilt oil production from about 6.2 million barrels per day in 1999 to over 10 million barrels per day in 2011. Many industry players and analysts say it now risks hitting a wall. Russia has mostly relied on oil fields discovered or developed in Soviet times. Production at once-rich fields, mostly in West Siberia and the Urals, account for close to 90 percent of Russian output, according to Russian investment bank Troika Dialog.

In those regions, production fell about 1.1 percent last year. The 2.2 -percent overall boost chalked up by Russia was largely a result of Rosneft's new Vankor field in the Siberian Arctic—a growth spurt unlikely to be repeated in 2011. "Russia's industry is going to have to move out beyond the perimeter of the Soviet legacy," says Thane Gustafson, a Russia specialist at consultants IHS Cambridge Energy Research Associates. Russia must move into far riskier zones such as the Arctic and the deepwater in the Black Sea and the Far East. That will require alliances with oil majors to obtain technology and spread the risk. Yet in the last few years Russia threw a scare into outside investors by forcing Royal Dutch Shell (RDS.A) to cede control of its Sakhalin II project to Gazprom and by selling much of Mikhail Khodorkovsky's Yukos to Rosneft.

Now a flurry of agreements is coming after a long drought. In January came BP's (BP) $7.5 billion deal to swap shares with state-owned Rosneft and hunt for oil in the Arctic in the South Kara Sea, considered one of the last great undeveloped oil provinces left. Though that arrangement is being challenged in arbitration proceedings in London, analysts think that Rosneft and BP will do their best to consummate the deal even if they get a negative ruling. Igor Sechin, the deputy prime minister and Rosneft's chairman, is a firm backer of the agreement.

At the World Economic Forum at Davos, Switzerland, ExxonMobil (XOM) unveiled a Rosneft pact for deepwater exploration in the Black Sea. The venture, 66 percent controlled by Rosneft, will focus on the Tuapse Trough, which may hold as many as 7.3 billion barrels. In March, France's Total agreed to pay $4 billion for a 12 percent stake in Novatek, a Russian independent, in a plan to build a liquefied natural gas facility in the Yamal peninsula. Russia is entering "an age of openness for Westerners with technology and capital," says Pavel Fedorov, Rosneft's first vice-president.

The government also has to offer tax incentives to companies to find and produce more oil. Although this may mean a temporary decline in tax revenues, top officials including Prime Minister Vladimir Putin, who on Feb. 9 urged the government to speed up its work on the tax breaks, are getting the message. "Is Russia being more realistic about how they are going to have to operate the oil and gas sector? Absolutely!" says Andrew Gould, CEO of Schlumberger, the oil services company, which has 13,000 employees in Russia.

The tax system, which gives the state 87 percent of incremental oil revenue from prices higher than $25 per barrel, discourages new projects and means that many existing oil fields produce at a loss. Peter O'Brien, a Rosneft vice-president, said recently that tax revisions must treat risky new projects "more along the lines of Brazil," whose production-sharing agreements allow companies to recover investment costs quickly. Despite Putin's support for reform, analysts predict a battle between energy authorities, who want to boost the industry, and the revenue-hungry Finance Ministry.

Courting the few majors won't solve all the local industry's woes. The U.S. success in reversing a decline of oil production stems largely from small- and medium-size companies, which produce about 55 percent of U.S. oil. Such nimble players have a place in Russia too. "The natural resource diversity of Russia is so large that greater access could support a much bigger industry," says Gould.

The bottom line: Russia could boost oil production if it abandons restrictive taxes and invites foreign majors in to share risk and provide expertise.

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