Renaissance Capital oil and gas analyst Alex Burgansky, who ranks at the top of the list of sector analysts in Russia, shares his insights on the industry and its issues in this exclusive Energy Report interview. Russia's 2009 oil production is up a bit—contrary to the collapse many commentators had predicted—but issues remain. Alex expresses some worries that Russia's oil production will decline, for instance, unless its tax regime stops discouraging investment that taps into the strong reserve base in core producing areas. He also talks how Europe's infrastructure affects the gas it imports from Russia and other parts of the world.

The Energy Report: You focus on the oil and gas markets in Russia and the Commonwealth of Independent States. Can you give us your perspective on the oil market there?

Alex Burgansky: Russia is the biggest oil producer in the world, but the Russian domestic market is not as big as the oil production. Russia's consumption of hydrocarbons is only about 25% of the domestic oil production, so Russia exports the majority of oil it produces and whatever it refines.

I think the biggest issue that concerns most investors as far as Russian oil production is concerned is the growth rate or decline rate. At the start of the year, there were calls made by quite a large number of commentators that Russian oil production would decline this year by quite a considerable amount. The numbers published were between 1% and 5% and even 7%.

In actual fact, the Russian production is up this year. Year to date it is up 0.4% and we believe it will be up 0.3% for the full year. This growth has really surprised a lot of market commentators.

Although we probably will experience some decline next year because we're simply not going to see as many new projects launched as we have this year, I think we'll still end up with a relatively robust production. We certainly do not believe that it's going to fall off a cliff the way people had expected.

TER: You indicated that you expect some decline in Russian oil production because there aren't as many projects moving forward. Is that due to lack of good projects or lack of financing like we're seeing in the rest of the world?

AB: It's not really a lack of good projects. The Russian reserve base is very strong. The average life for proved reserves of oil is 22 years, which is a very lucrative figure compared to most other oil producers in the world. For most of the listed companies in Russia, the figures are even higher. For LUKOIL Company (LKOH), it's 24 years; for Rosneft (ROSN), 26 years; for Tatneft (LSE:ATAD), 30 years—very, very high numbers. They form the basis for continuing growth in Russian oil production.

There are plenty of projects in Russia, both, new projects and existing brownfield projects. Russia is a very mature producer. If you exclude all the drilling activity taking place every year, then Russian organic decline in production is close to 19%. To compensate for that organic decline, Russia drills somewhere between 5,000 and 6,000 wells every year.

And then there are two important questions. One, is there enough oil in Russia for 5,000 or 6,000 wells to penetrate? In my view, the answer is yes. As I explained, we are dealing with a very large reserve base. And the second question: is there enough money in Russia to do that, and can it be done economically? The answer to this question is not so obvious.

TER: Why is that?

AB: Certainly this year, particularly in the first half, coming from a significant financial crisis, the Russian oil companies did suffer from a certain lack of operating cash flow and, therefore, the amount of new activity came down. Thus, even with the existing brownfields, they haven't been drilling as many wells as required to keep production more or less flat. We did have the benefit, however, of new fields being launched. That not only offset the decline in the underlying production but also compensated for the insufficient number of wells being drilled.

But the Russian tax regime is unfortunately not very conducive to investment in the new projects. As a result, outside of five or six projects being launched this year, very little has been formed in the pipeline over the past few years. We need further action on the part of the Russian government, further relaxation of the tax regime to encourage Russian oil companies to invest in the greenfields.

TER: How likely is such action?

AB: The Russian government has made some significant changes already, but those specifically relate to the new production provinces. Instead of unifying the tax regime across the whole of Russian oil production, the government just gives certain tax breaks if the oil companies move into the specific territories. For example, tax breaks are in place for the East Siberian fields, for Timan-Pechora (which is far north) and certain other areas.

The problem is that those tax breaks do not really address the fundamental issue of the core producing areas. They are very mature, and additional investment is required to slow down or stop production declines. There are some deeper horizons, for example, that could be targeted in the existing production areas in West Siberia. Changing the tax regime to acknowledge and accommodate higher costs in the existing production areas would be very welcome by the oil industry.

At the moment, the Russian government tells the oil industry where the incentives are and where development should take place. So far, the government seems reluctant to give decision-making power to the oil companies themselves. But presumably the Russian oil industry is best positioned to identify where the incremental capex should go and whether it should go into the existing brownfield developments in West Siberia as opposed to the new production provinces. The greenfields might be too difficult to develop and too far away in terms of timeline, and infrastructure might be lacking. Instead of investing in those places, the decision might be to invest in the existing production provinces and try to drive production growth from there and just utilize the existing assets a bit better.

Going to the deeper horizons is certainly more expensive, oil quality is different, flow rates are much lower, the drilling costs are much higher and, in the absence of any tax changes, it will be very difficult for the oil companies to do that economically. Therefore, they are not now doing the work that otherwise probably would have made sense for them and we are waiting for the government to make some further decisions insofar as the regulation and taxation issues are concerned.

TER: Do you have a sense of when some decisions will be made?

AB: This is constantly on the government agenda. However, as the financial crisis erupted and the oil price collapsed to the point that it was hovering around $40 or $50 per barrel, Russia was not in the mood to change the tax regime significantly. Now that the oil price has recovered and prospects for it to stay at this level are a lot better than at the beginning of the year, I think the government is actually coming back to the idea of reforms in the Russian oil sector.

There is not a lot of clarity on whether harmonization can be achieved across the new fields and the old fields. That would be ideal. At the moment we're just looking for some additional tax breaks for the individual production provinces. In October and November, we expect some further tax breaks on export duties for oil produced in East Siberia. Then in 2011 we expect that the government might come up with a totally new taxation regime for the new fields. At this stage, that's unlikely to affect the existing fields but we certainly expect more incentives for the new developments.

TER: Are the potential tax breaks for the existing fields required to make current production companies profitable or more viable?

AB: No, not at all. They are very profitable as they are. If no more tax breaks are given, there will simply be less investment going into Russian oil production and therefore you will see production start to decline. We saw this last year when Russian production fell for the first time since the mid-1990s, certainly for the first time in more than 10 years. It declined last year by 0.8%.

This year, as I said before, some people expected production to collapse. We certainly never thought it would collapse, but we did think it would decline. Instead it's actually growing as a result of benefits from past investments in the new fields coming on stream this year. But we're simply running out of the pipeline of these new fields. Therefore, next year there will be a lot fewer fields coming on stream; in the absence of new incentives to put more money to work to grow Russian oil production, it will naturally start declining, with organic decline rates of around 19% and growing.

Every year, Russia will have to drill more and more wells to try to keep oil production flat and that requires more capex every year. If tax breaks are not forthcoming, the oil companies will simply not have enough cash flow to grow. In that case, their production will decline faster despite the fact that there are plenty of reserves for them to recover.

TER: What are some of the companies in Russia that investors in the West should consider?

AB: The two largest oil producers are LUKoil and Rosneft, which also are among the very few that are growing their production this year. We believe both of them are capable growing their production next year as well, as a result of new developments coming on stream. They have downstream operations in addition to upstream operations and Lukoil in particular also is quite well diversified internationally, both in oil production and refining. The company's key focus is still on Russia, which is by far the dominant part of its operations, but LUKoil has more international exposure than any other Russian oil company.

TER: Are there other companies that you follow?

AB: LUKoil, Rosneft, TNK-BP, Surgutneftegas, Gazprom Neft and Tatneft—these are the six that are listed and they are the six largest oil companies in Russia. And there are obviously gas producers we cover as well. Gazprom is, by far, the largest one—in fact the largest gas company in the world—and the second largest gas producer in Russia is Novatek. They are also listed and we also cover it.

TER: In addition to the major Russian plays, you follow Tethys Petroleum Ltd. (TSX:TPL). Can you give us some comments on that?

AB: Tethys is one of the most interesting exploration plays in our geography. Unlike Rosneft, Lukoil, Tatneft or Gazprom, it is a very early stage company focused more on exploration and less on development or production. Only a very small percentage of its reserves are currently represented by proved reserves; most of its portfolio is actually in resources.

The company's prime attraction, we think, is a significant, very large-scale exploration property in Tajikistan, where the company's current license covers over 35,000 square kilometers in an area where not a lot of exploration activity has been undertaken in the past. Tethys is utilizing new western technology in what is widely believed to be very prolific plays from the point of view of reaching more hydrocarbon resources. We think that is a very interesting opportunity.

Tethys also has two development properties in Kazakhstan, where they produce gas, and also an oil operation in Uzbekistan. They are actually a pretty well-diversified operation. They're focusing on Central Asia, which has very significant potential in hydrocarbons, in both oil and gas. We think significant exploration opportunities exist in this area, with Tethys being one of the largest exploration plays.

TER: When would you expect Tethys to have some proven reserves?

AB: The company is currently undertaking a drilling program, which consists of three deep wells, one each in Kazakhstan, Uzbekistan and Tajikistan. We expect some preliminary results from these wells to be announced over the course of the next few months—so by the end of 2009 or early 2010. If successful, they could convert a significant portion of resources into proven reserves.

TER: Are there any regional issues that Tethys—or any company—will face moving from proven reserves into production?

AB: Once the reserves are identified, the first key issue any company would face is funding. That's less of an issue for a large company like LUKoil, but it's certainly an issue for a small company like Tethys. They recently did a placement to raise money to continue with the exploration work, but if they are successful with proving some of the resources, they certainly would have to go back to the market to raise more money. I would say it would be a very good problem to have, though, because it would mean that they have increased the value of that opportunity significantly.

The second issue is the off-take, which could be an issue, particularly in Central Asia and particularly with gas. In general, Central Asia is producing more gas than it consumes. However, both Uzbekistan and Kazakhstan are importing gas at the moment. So they are short of gas on average and, therefore, Tethys has chosen those areas where they can actually find off-take agreements for their gas.

On top of that, there is a significant infrastructure available, built back at the time of the Soviet Union. There are some new pipelines built as well, going mostly into Russia, where the contracts can be signed to export gas from those areas in case of significant further discoveries—which is entirely possible.

As a matter of fact, plenty of producers in Central Asia already have agreements in place with Gazprom to sell gas to Gazprom or export it to Europe through Russia. So the gas off-take could be difficult; but I think in the case of Tethys, the risk is mitigated by the fact that, first of all, we are talking about a relatively small development and, secondly, because Tethys is located in regions that are short of gas.

As far as the oil is concerned, it's much easier to move, particularly in that we are talking about relatively small production. At the moment, Tethys is simply trucking oil from its field in Uzbekistan to the neighboring railway terminal, where then it goes by rail to the nearby refinery. In case of any significant discoveries in Tajikistan or further discoveries in Uzbekistan, other solutions certainly will have to be found, but there are plenty of oil pipelines in the region. Tethys could potentially connect to them and there are also other opportunities. They could continue to truck oil or ship it by rail; the infrastructure is in place in most of the areas where Tethys operates.

TER: Any other issues?

AB: Yes. The third issue is the economics, including taxes. The good thing about Tethys is the Tajikistan production-sharing agreements they have, where they are operating under the PSA rules with very benign taxation. That assures that if any commercial discoveries are made, it is very likely that tax won't be a material issue for them.
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