Extraction of oil

At the end of 2012 the volume of oil and gas condensate produced in Russia reached a record level of 517 million tons, according to Rosstat data. Compared to 2011, production growth was 0.9 percent. As such, 2012 was the fourth year in a row that positive dynamics in oil production persisted in Russia. In December of last year, oil companies produced 44.2 million tons, which is 1.1 percent more than in December 2011. According to another federal agency, the Russian Ministry of Energy, the volume of oil and gas condensate production in 2012 stood at 518 million tons, going up by 1.3 percent compared to 2011. Production growth was stimulated by the growth in domestic demand. The supply of oil to Russian refineries in 2012 reached 266 million tons, which is 103.6 percent of the figure recorded for 2011.

The largest increase in production from January to November 2012 in relation to the corresponding period of 2011 took place in the Irkutsk region (+56.4 percent with 9.1 million tons), the Republic of Sakha (+22 percent with 6.2 million tons), and the Krasnoyarsk region (+21.1 percent with 16.7 million tons). At the same time, the leading region in terms of production, the Khanty-Mansiysk autonomous district, was 1.5 percent behind its own performance results for January to November 2011. Extraction volumes there stood at 237 million tons.

In the corporate context, positive trends in production in January to November 2013 persisted at a majority of the oil companies. The leader in terms of oil production increase was Rosneft, which produced 2.7 million tons of oil more than in January to November 2011. Rosneft’s performance is mostly credited to good production results at the Vankor field.

TNK-BP for the same period reported a production increase of 0.7 million tons, in large measure thanks to increased production at the Verkhnechonskoye and the Uvat fields. In January 2013, the company announced that it will begin a pilot production project for extracting hard-to-reach oil in Russia in conjunction with Halliburton. TNK-BP plans to develop the Em-Egovskogo license area in the Khanty-Mansiysk district. In total, TNK-BP has identified seven sites for development in Western Siberia, with 2013 investment planned at more than USD100 million. Of TNK-BP’s 1.9 billion tons of reserves, about 600 million tons are hard-to-reach reserves. The development of those areas are a strategic priority for the company, even though the cost of production for hard-to-reach reserves is around USD20 a barrel, compared to USD7.03 for ordinary fields.

From January to November 2012, Lukoil’s production continued to decline. Production decreased 1.1 percent compared to the corresponding period of 2011, due to a decline in production at the South Khylchuyu field in the Timan-Pechora province.

In December 2012, Rosnedra conducted auctions for three hydrocarbon deposits of federal significance: Lodochnoe, Imilorskoe, and Shpilman. The Lodochnoe auction for a field in the Krasnoyarsk territory with reserves of 43 million tons of oil and 70 billion cubic meters of gas was held on December 11, 2012. The winning bidder was TNK-BP’s entity SNG that bid 4.66 billion roubles from the starting price of 3.585 billion roubles.

On December 18, 2012, Surgutneftegaz was declared the winner of the auction for the Shpilman field with oil reserves of 82 million tons. The company offered 46.2 billion roubles for the Shpilman field, which is located in the Khanty-Mansiysk district. The starting price was 14 billion roubles.

Lukoil won the auction for the Imilorskoe field that took place on December 25, 2012, offering for the license some 50.8 billion roubles. The starting price was 25.4 billion roubles.

At the same time, Rosneft and Lukoil filed their applications to participate in the 22nd bidding round for licensing offshore blocks in Norway. Other tender participants included Shell, ConocoPhillips, E.On, PGNiG, Statoil, RWE, and other companies. Regular licensing rounds for Norwegian shelf sections are held every two years. In the current round, the companies will bid for licenses for 86 blocks, including 14 in the Norwegian Sea and 72 in the Barents Sea. Previously, Rosneft said that it will participate in the tender together with its strategic partner Norway’s largest oil and gas company Statoil. In May 2012, the two companies signed a cooperation agreement. For its part, Lukoil formed alliances with the Norwegian companies Det Norske Oljeselskap ASA, Lundin Norway, and North Energy in advance of the auction. The winners will be determined in the spring of 2013. The Norwegian government compensates oil companies 78 percent of the costs of exploration, including exploratory drilling costs.

It is noteworthy that Russian private companies are denied access to Russia’s own continental shelf. The right to develop the Russian continental shelf is only granted to companies with state ownership of more than 50 percent and with offshore experience of at least five years. This effectively limits the companies with access to the Russian shelf to two state entities, Gazprom and Rosneft. While there is also Zarubezhneft, which technically meets all the requirements, it has not shown interest toward shelf projects yet.

The idea of allowing private companies to explore shelf areas was proposed in the middle of January by the Minister of Natural Resources Sergei Donskoy. He noted that in the case of large deposits, private companies would have to hand control over to the state. However, as reported by the media, the president of Rosneft Igor Sechin and the head of Gazprom Alexei Miller wrote a letter to Prime Minister Dmitry Medvedev, asking not to allow private companies to participate even in pre-licensing seismic operations offshore. Also, the heads of Gazprom and Rosneft offered to formalize the existing practice of attracting foreign investment to pay for exploration, while the license to the area itself would remain reserved for state-owned companies.

Gas production

In 2012, Russia’s gas production declined for the first time after two years of growth. According to Rosstat, the total volume of natural and associated gas produced in Russia in 2012 decreased compared to the results for 2011 by 2.7 percent, dropping to 653 billion cubic meters. However, in December, production volumes reached a new record at 64.8 billion cubic meters, increasing 2.7 percent against the figure reported in December 2011. What apparently sustained gas production at the end of the year was the seasonal increase in demand. As the head of Gazprom Alexei Miller reported in mid-December, the company has seen an unprecedented increase in supplies to the European market. It was during the month of December that the daily Russian gas supplies to Europe hit the historical record of 550.1 million cubic meters.

In line with the data of the Ministry of Energy, gas production in 2012 stood at 655.1 billion cubic meters, which is 2.2 percent lower than a year earlier. The decline in production was due to the reduction of both external and domestic demand. According to the Ministry of Energy, domestic gas consumption in 2012 decreased compared to 2011 by 7.4 percent to 459.5 billion cubic meters. Furthermore, in the reporting period, there was a reduction of gas exports. Production decline within the industry was attributable to Gazprom’s reduced volumes. Gazprom’s production in 2012 went down by 5.1 percent compared to the previous year, dropping to 482.251 billion cubic meters.

In the middle of 2012, Gazprom’s management planned to produce and sell 528 billion cubic meters of gas. By November, the forecast was lowered to 500 billion cubic meters, as declared by the deputy president of Gazprom Valery Golubev. In the end, the performance of Gazprom in 2012 came close to the level of 2009, when production was 461 billion cubic meters.

At the same time, other companies increased production. Thus, in 2012, NOVATEK extracted 51.034 billion cubic meters, which was 5.9 percent over the previous year’s results. The Russian oil companies produced 67.571 billion cubic meters, up 5.7 percent from the results of the previous year.

Because of the difficult economic situation, Gazprom was forced to cut its investment program for 2013. In December 2012, Gazprom’s board of directors approved the company’s total investment program for the current year in the amount of 705.41 billion roubles, which is 27.7 percent less than in 2012 (974.65 billion roubles). The volume of capital investment will be 658.455 billion roubles, against 890.007 billion roubles in 2012. The volume of long-term investment is expected to be 46.955 billion roubles against 84.642 billion roubles in 2012. Gazprom’s approved budget for 2013 contemplates revenues at 5.101 trillion roubles, and expenditures at 5.251 trillion roubles. External borrowing is estimated at 90 billion roubles. The company’s budgetary surplus is expected at 0.5 billion roubles. However, according to analysts, the investment figure could still be revised upwards. The original investment program in 2012 was 776.4 billion roubles.

Against this background, Gazprom has found a way to reduce the gas extraction tax burden for its subsidiaries and maintain control over those entities. The Federal Antimonopoly Service allowed Gazprom Neft to purchase 51 percent of shares of Nortgaz. At the end of November 2012, it was reported that Gazprom planned selling one percent of the shares in its Nortgas entity to NOVATEK. This would have allowed Nortgaz to pay much lower extraction taxes than what Gazprom and the companies it controls must pay. Reduced rates are extended to companies, in which the share of Gazprom is not above 50 percent. With Gazprom Neft’s receiving the controlling interest in Nortgaz, the deal with NOVATEK lost continued importance, as Gazprom Neft contended that it should be taxed as an independent producer.

The government has proposed another incentive to Gazprom in the coming years to stimulate its development of large fields in Eastern Siberia, particularly the Chayanda field and the Kovykta field. The Ministry of Energy proposed decreasing to zero the extraction tax on gas fields in the Far East and Eastern Siberia for 25 years, keeping the rate unchanged for the Yamal and the Gydan blocks, as well as for the fields in the European part of Russia (509 roubles per 1,000 cubic meters as of January 1, 2013 for Gazprom and 251 roubles for independent producers). As part of the same proposal, the tax burden on gas extraction from the Yamal-Nenets autonomous district (except Yamal and Gydan) is to increase one and a half times. However, the idea of a zero severance tax does not find support from the Finance Ministry. The formula for calculating the tax must be approved by March 1, 2013.

In terms of regional distribution, greatest production growth from January to November 2012 occurred in the Sakha Republic and the Tomsk region. At the same time, the Yamal-Nenets autonomous district, a major gas producing regions of the country, saw natural gas production decrease 4.6 percent compared to the results recorded in the period from January to November 2011.

Oil exports

In 2012, there was a reduction in oil exports. According to the Ministry of Energy, Russian oil exports in 2012 decreased compared to 2011 by one percent to 239.4 million tons. The export of oil to foreign countries decreased by 0.3 percent to 211.477 million tons. Of this volume, 28.167 million tons was delivered to the C.I.S. countries in 2012, a figure that is 5.7 percent less than the export volume reported in 2011. The decline in oil exports to the C.I.S. countries is attributable to reduced supplies to the Ukraine, which decreased 6.4 times to 0.725 million tons. As of March 2012, no Russian oil exports have been delivered to the Ukraine. In December 2012, oil exports decreased in relation to the corresponding period of 2011 by 3.8 percent to 19.7 million tons.

The volume of oil exports through the Kozmino terminal increased compared to 2011 by 7.2 percent to 16.23 million tons. In December 2012 alone, the volume of oil exported through the terminal increased by 28.4 percent to almost 1.8 million tons.

The oil export duty in January 2013 decreased by 0.2 percent to USD395.6 per ton. The reduced rate of export duty on oil for a number of fields in Eastern Siberia and the Northern Caspian was USD192.7 compared to USD193.3 per ton in December. As of February 1, 2012, the base export duty rate rose to USD403.3 per ton, and the preferential duty rate for oil increased to USD198.5 per ton.

Transneft in December 2012 launched the second stage of the Eastern Siberia to Pacific Ocean pipeline (ESPO-2), which is designed for oil exports to the east. The ESPO-2 route stretches from Skovorodino in the Amur region to the Pacific coast at the port of Kozmino in Primorsky krai. The pipeline’s initial capacity will be 30 million tons, which will ultimately increase to 50 million tons. The total cost of the project is estimated at 275.55 billion roubles.

The commissioning of new oil transportation routes worried the E.U. As such, in December, the European Commission requested Transneft to account for its investment program. Until now, the company revealed its investment program only to Gazprom. European officials are concerned that the launch of the second stage of the Eastern Siberia to Pacific Ocean pipeline could interrupt the supply of oil to the West. China has expressed a desire in the foreseeable future to buy up to 50 million tons of Russian oil a year. At this time, Rosneft and Transneft supply 15 million tons of oil per year to China under long-term contracts.

In addition, the E.U. is concerned with the decline in the export duty on oil in Eastern Siberia. The European officials argue that Russia will subsidize oil supplies to Asia at the expense of the European market. At a meeting in Brussels, representatives of Transneft put forward counterclaims to the E.U.

“The diversification of the export flow of oil carried out of Russia is a necessary measure,” the press-secretary of Transneft Igor Demin said. Unfortunately, we are repeatedly confronted with the use of the transit countries and restrictive measures against oil supplies from Russia, which infringe on the economic interests of Russian companies, and consumers in Europe.” Mr. Demin additionally noted that the Russian companies found no support from the E.U. in crisis situations. For example, the Third Energy Package was adopted without the approval of Gazprom, and the E.U. showed no support for the Burgas-Alexandroupolis project. There is also no effective mechanism for dialogue between the E.U. and the transit countries, including Ukraine and Belarus, on the settlement of rates and transit policy issues.

Gas exports

According to the Ministry of Energy, gas exports from Russia in 2012 decreased compared to 2011 by 8.7 percent to 186.103 billion cubic meters. The exports of pipeline gas to foreign countries in 2012 amounted to 112.74 billion cubic meters, which is only 96.5 percent of the level seen in 2011. The decline in demand for Russian gas on the international market was due to increased competition from other providers and a reduction in gas consumption in the eurozone.

Also, there was a significant decline in exports to neighboring countries. At the end of 2012, gas supplies to the C.I.S. countries decreased in comparison with the previous year by 12.3 percent, reaching 58.451 billion cubic meters. The decrease was mostly due to the reduction of gas supplies to Ukraine, whose government urged the Russian side to review the terms of the supply contract regarding volumes and the gas pricing formula. In December 2012, Russian gas exports totaled 19.748 billion cubic meters, a result that is 4.8% over the figure for December 2011.

Meanwhile, the European customers of Gazprom require more concessions. In January 2013, the company received an application for the revision of the terms of gas supplies from Russia to the French GDF Suez, the Austrian Econgas and the German Wingas and WIEH. In the past, Gazprom has already reduced gas prices to five companies, including the Austrian Centrex and GWH Gashandel, the Dutch GasTerra, the German E.On Ruhrgas, and the Italian Eni. Earlier, the deputy head of Gazprom Alexander Medvedev reported that the company has reduced the contract price for European consumers at an average of 10 percent.

In addition, the situation in Ukraine remains unclear. In December 2012, the media reported that the average price of gas for Ukraine in 2013 could reach USD352 per one thousand cubic meters instead of the budgeted USD420. However, according to analysts, the country will get a discount on gas only if it joins the customs union with Russia.

Also, in late January, Gazprom for the first time assessed a USD7 billion fine against Ukraine’s Naftogaz under take-or-pay contracts for not getting the volume of gas contracted for in 2012. At the same time, Naftogaz’s representative Elena Yureva argued that her company fully met its financial obligations toward Gazprom. As announced previously, Ukraine plans to cut gas purchases from Gazprom because of pricing issues to 18 billion cubic meters in 2013. In November of last year, Naftogaz started importing gas purchased from the German company RWE through a reversed supply scheme to Ukraine via Poland. In 2013, Ukraine plans to import five billion cubic meters of gas from Western Europe.

Despite the drop in sales, Gazprom continues investing in costly projects in the domestic and foreign markets. In December 2012, the construction of the new South Stream gas pipeline commenced. The pipeline will supply fuel to Europe, bypassing Ukraine, with a capacity of 63 billion cubic meters a year. However, some analysts consider the South Stream project to be economically unviable. Gazprom recently added a second line to Nord Stream, but even the first line is not fully loaded yet.

Some have suggested that Russia needs the South Stream project not only for profit, but also in order to strengthen its influence in the E.U. due to the ongoing dispute over the implementation of the Third Energy Package. Russia has long sought to bring Russian gas pipelines out of E.U.’s regulation. The standards of the Third Energy Package place limits on vertically-integrated companies in their ownership and management of energy transport networks. In line with the Third Energy Package, integrated energy suppliers would have to sell their transport capacities, transfer them to an independent operator, or ensure non-discriminatory access to other players, freeing up for them 50 percent of transit capacity.

Russia wants exemptions for gas pipelines South Stream and Nord Stream with its OPAL and NEL branches. Earlier, the E.U. Energy Commissioner Nicole Bokshtaller stated that pipelines that pass through two or more countries can apply for an exemption from the general rule. According to Ms. Bokshtaller, the rules allow countries that are parties to the Third Energy Package to make temporary exceptions, but in each case, the decision is to be made separately.

It should be noted that a number of European countries are actively implementing the Third Energy Package. In particular, Lithuania plans to divide the sale and transportation of gas by November 2014. Today, the major supplier of gas to Lithuania is Lietuvos dujos, 37 percent of which is controlled by Gazprom. According to the shareholders’ decision, Lietuvos dujos will be divided into three companies, so that the physical infrastructure will be separated from the activities involving the sale and transportation of gas. Gazprom is clearly against the division of Lietuvos dujos. As the director of the department of trade negotiations and economic development Maxim Medvedkov said, Gazprom is bound to confront significant losses as a consequence of Lithuania’s implementation of the Energy Package rules. Yet, negotiations in January 2013 did not bring the desired results.

Some fear that the position of Gazprom on the foreign market may be undermined even further. The Ministry of Energy, the Ministry of the Environment, the Economic Ministry, and the Federal Antimonopoly Service have expressed support for the initiative of NOVATEK to abolish Gazprom’s monopoly on LNG exports. Today, independent producers are obligated to enter into contracts for the supply of LNG from the Yamal Peninsula through Gazprom. However, NOVATEK wants to secure the right to supply the gas independently. While the Ministry of Energy recognizes the need of abolishing Gazprom’s monopoly, it proposes setting up an independent regulatory body for the coordination of Russia’s LNG exports. The Ministry itself has expressed its willingness to act as the regulator. The Ministry of Energy expects a decision on permitting NOVATEK to supply LNG abroad in the first quarter of 2013.

Domestic prices for oil and gas

In November 2012, the domestic price of oil from producers continued to fall, reflecting global trends. However, the average price of natural gas reached a record high at 1,091 roubles per one thousand cubic meters.

Changes to the government’s resolution no. 1205 of December 31, 2010 “On the improvement of state regulation of gas prices” were published in January 2013. The revised resolution omitted the earlier mandate directing the Federal Tariffs Service to start using a new method of calculating the price of the gas delivered by Gazprom and its subsidiaries for all industrial and commercial end users in Russia based on of the volumes of their purchases. It was assumed that industrial consumers that contracted for the supply of large volumes of gas spread out evenly through the year would get a discount of the price set by the Federal Tariffs Service, while clients with volatile consumption would on the contrary be forced to pay more. As it turned out, the most unstable buyers are small gas boiler stations that supply heat to various facilities of social importance, such as schools, hospitals, and kindergartens.

As a result, the FTS proposed abandoning the idea, and the relevant authorities have not yet come to terms on the size of discounts and premiums. The FTS explained that the changes that were made arise out of the need to contain the costs of municipal enterprises and optimizing the population’s rates for heat, electricity, and hot water within the guidelines set forth in the forecast of socio-economic development.

Electronic trading

In September 2013, Russia may begin trading gas on electronic platforms. Last year, government resolution no. 323 called for allowing the sale of natural gas on commodity exchanges. However, gas sales through exchanges have not yet been done in practice because a number of regulations have not been changed. The Ministry of Energy has now set up a working group to draw up amendments to the existing rules. As follows from the announcement of the Ministry of Energy, initially, the sales will be done both through the commodity exchange and through the electronic trading platform. Later, gas sales will be fully transferred to the electronic platform. Gas trading on the electronic platform is expected to start in September. In line with preliminary estimates, Gazprom and the independent producers will each sell around 17.5 billion cubic meters (for a total of 35 billion cubic meters) of gas per year, which is about 10 percent of domestic consumption.