NATO Economic Colloquium 1997

The Role of Russia on the European Energy Market Alexander A. Arbatov Chairman, Committee for Productive Forces and Natural Resources, Russian Academy of Sciences, Moscow. A significant part of the post-war history of the USSR has been the growing export of energy resources to the European market. This was promted not only by large resources, boosted in the 1960s and 1970s by the discovery of huge oil and gas deposits in Western Siberia, but also by the fact that energy was one of the few competitive sectors with which the Soviet Union could compete in World markets. In Table 1, the export dynamics of this trade during the Soviet era is presented. Table 1 Fuel Exports from USSR from 1950 to 1991 (.PDF/9Kb) It is evident that exports of oil and gas grew at a much faster pace than for coal, exports of which had stabilised by 1970 with minor fluctuations thereafter. However, the start of accelerated growth in gas exports lagged behind oil by about 10 years. Not only has an absolute increase of physical volumes taken place, but a growth in the share of exported fuel as a proportion of total output was also noted. The fast growth in oil exports in the middle of the 1970's was explained by two circumstances, namely that prices rose on the world market and because of the development of West Siberian deposits that have entered their period of maturity. In the 20 year period from 1960, annual exports of oil and oil products have grown from 33.2 million tonnes (mt) up to 160mt, representing a 4.8 fold increase and annual average growth of 8.5%. In this period, oil production grew 4.1 fold (annual average growth rate of 7.6 %). Thus no sharp changes in the ratio between domestic consumption and exports were observed in this period. This picture changed during the next decade. Between 1980-1988, oil production increased to 624mt (annual growth rates averaged 0.4%) with export of oil and oil products reaching 205mt in 1988 (average annual rates of increase were approximately 3.2%). Thus the rate of growth in oil exports was 8 times greater than that for internal oil production, indicating essential shifts in the structure of oil utilisation. Growth in production costs due to a deterioration in the quality of the resource base and a lack of investment has resulted in a fast decline of oil export volumes, which dropped by 17mt in 1989 back down to the 1986 level. Exports in 1991 were just 60.5mt. The dynamic of gas exports was in many respects similar to that of oil, but with a 10 year delay and without the sharp decreases of recent years. In the decade 1970-1980, export gas deliveries grew 16.4 fold (annual average growth rates of 32%) whereas annual production growth was only 8.2%. In the beginning of the 1980's, gas exports were constrained by a shortage of transport capacity. But following the completion of the "Urengoi - Uzhgorod" gas pipeline, the growth of gas exports speeded up again. In the 1980s, annual growth rates in gas production averaged 7.5% in the USSR, while those of export deliveries were 6.3%. In other words, exports were already lagging marginally behind production. In general, gas exports have stabilised with a slight tendency towards a slow reduction in volumes emerging which could be explained by domestic consumption growth at that time. The export of coal remained stable for an extended period, marked only by a slight growth as a proportion of production volumes. The accelerating growth of energy production and export was closely connected with the internal economic and international political situations in which the USSR found itself during this period. Internally, there was a rigid system of centralised planning known as the "command" economy in which the only purpose of enterprises was to fulfill quantitative output targets. Production was then distributed in a centralised way at prices established by the state that reflected neither consumption value nor opportunity cost. Thus wide disparities between internal Soviet and external World market prices developed which led to widespread waste of resources. The main purposes of the Soviet economy were as follows: maintenance of the material and technical conditions military build-up; economic support for socialist countries and other friendly regimes; maintenance of minimal living standards for the population; provision and maintenance of nationwide infrastructures. Given these constraints, most industrial enterprises lost money. The situation was aggravated by the lack of incentives to promote enterprise efficiency. The Soviet economy was thus approaching a crisis whose features were already evident in the 1970s despite official efforts to hide reality behind falsely optimistic statistics. By the end of the 1980s, it had become impossible to hide the deep malaise within the Soviet economy. That this economy kept afloat for as long as it did can be attributed to the high level of fuel exports which were achieved in the 1970s and 1980s. These revenues counterbalanced a sharp deficit in foodstuffs and consumer goods whilst also making it possible to procure the sophisticated equipment and high technology needed to maintain top-grade military potential. Deliveries of fuel on very concessionary terms to a number of countries that followed the Soviet lead allowed the USSR both to expand its influence through creating dependencies whilst also allowing these client states to profit (at the USSRs expense) by re-exporting Soviet fuel at World prices. The export growth of Soviet energy took place under conditions of deformed pricing. Artificially low internal prices made export profitability very high compared to domestic sales thus intensifing the export effort. A real growth in production costs due in part to production complications became hidden, both behind the distorted and low prices for domestic industry, as well as behind the growing export revenues. By the end of the Soviet era, export of energy played a dual role. On the one hand, the existing regime could be preserved from collapse despite its economic inefficiency. On the other hand, the difficulty in maintaining production and export volumes as the best reserves became depleted due to their intensive exploitation demonstrated that a change of policy with regard to energy resources had become unavoidable. Such a change has now taken place. Russia has inherited the lion's share of the Soviet Energy complex. The structure of the primary part of this heritage - the Oil and Gas Complex (OGC) - is shown by Figure 1 below: Figure 1: Russian / other CIS shares of Soviet OGC (%) The new situation has developed in different ways for oil, gas and coal. Thus the problems of production and export for these three energy sectors should be considered separately. Oil Russia's oil economy has changed considerably due to the increased costs of production resulting from the accelerated exploitation and near exhaustion of the richest deposits. By the beginning of the 1990s, the share of exploited deposits with costs that far exceeded the industry's average production cost accounted for 11-12%. Regarding non-exploited deposits that had been discovered in the second half of the 1980s, the ratio is 38%. Among the probable category of reserves, the share of "superexpensive" certainly exceeds 50%. In the 1980s, average oil output per well has decreased 2.3 fold. In Western Siberia, the ratio was more than 5 fold. The average resource base in the West Siberian deposits has decreased from 149mt at the beginning of the 1980s to just 19mt at the beginning of the 1990s. Oil production growth rates have not corresponded to those of technical renovation and re-equipping of the oil industry, which has resulted in a significant physical depreciation of the equipment stock. By the beginning of the 1990s, one-half of all machinery and equipment in the oil industry was more than 50% worn-out and only 14% met World standards. About 70% of drilling installations were produced in 1950-1957 and are outdated. Moreover, conditions in the World oil market have also developed adversely for exporters in that stabilisation of demand by the main consumers has combined with the growth of oil production in non-OPEC countries to depress prices. The situation is aggrevated by Iraq, struggling to escape sanctions, which now has permission to sell limited quantities to ease humanitarian problems. Furthermore, some OPEC countries are pressing for quotas to be increased. Notwithstanding seasonal fluctuations, oil prices have developed in such a way that a levelling-off or even a small decrease could be the best that exporters can expect in the immediate future. These and other problems have resulted in a sharp fall in oil production in the 1990s now that centralised investments have been all but terminated and that old management structures have been partially or completely destroyed. See Table 2 below: Table 2 Total Oil Production and Exports to non-CIS in 1991-1996. (mt) (.PDF/6Kb) But, as can be seen in Table 2, oil exports to outside the CIS grew steadily over the same period due to the considerable drop both in domestic consumption and in exports to the CIS and the Baltic States. Table 3 below refers: Table 3 Domestic Oil Consumption and Exports to the FSU in 1991-1996 (mt) (.PDF/6Kb) Despite all these problems, the Russian oil industry still possess many strengths in terms of physical reserves, technical resources (in the form of existing production and refining capacities, transport and distribution infrastructure) and professional potential. These should allow Russia to stay among, and perhaps even move up the league table of, the leading oil producing nations of the World. An important and unique feature of the Russian oil industry is that it functions on the basis of two essentially different price systems for crude oil. For example, while retail prices on the internal market for non-ethylene gasoline A-92 have reached and even exceeded those in the USA, crude oil prices remain much below World levels. After numerous increases and having reached the maximum possible level given current demand, the domestic price still does not exceed 60% of the World price (including excise duties). Reaching the World price level is a remote prospect. Therefore, Russian oil companies and enterprises will have to work under conditions of economic reality, which, given the price differential, stimulates the maximisation of crude oil exports. However, the existing technical constraints of the transport system - which is already close to saturation and requires expansion - place a physical limit on the further expansion of oil exports. Besides, export-oriented oil production jeopardises the existing oil products supply system, the reconstruction of which is vital for the whole economy. The export opportunities of Russian oil refineries are also restricted by virtue of high industrial costs that make them uncompetitive, despite the fact that they buy crude oil at low internal prices. Thus, the average price of a set of oil products obtained from one tonne of crude oil at Russian oil refineries is 25-30% lower than the World average. The main problem facing the Russian oil industry is thus one of finding the optimum balance between exports (within the limits of transport provision) and domestic supply to refineries for the production of oil products both for domestic demand and profitable export. In 1995, the Russian oil industry began to stabilise as production and consumption came into balance. While the reason for the sharp fall in oil production was the reduction in investment between 1991-1993, in 1994 the decisive factor behind continuing decline had become falling domestic demand and export transportation constraints. This trend bottomed-out in 1995 when the decrease in oil production was only 3.5 % (10.2% in 1994) with export growth of 2.3%. In 1996, the fall in oil production remained about the same (3.8%), while exports increased by 9.8%. So the oil industry has obviously stabilised following such a dramatic production fall. But what of the future? This is especially important in view of the large potential natural resource base, which, with appropriate investment, could in time ensure considerably larger production volumes than at present. In theory, the Russian oil industry could in ten years time and under ideal economic conditions produce more than 400mt of oil per year. However, reality would suggest future oil production levels somewhat lower than this figure, in part because domestic demand is unlikely to recover rapidly. Even assuming that a return to a centrally-planned economy were possible, it would take place without its major driving force - centrally planned investment from the national budget. Any government attempt to revert to centralised state management would lead to another economic crisis and the continuance of industrial recession, including in the oil industry. Under this scenario, oil production could by the end of the Century drop to 200mt per year or even lower. Oil would be extracted only from the richest deposits whilst oil exports would be restricted to the level necessary to meet import requirements. But under a scenario of successful economic reform that brought rouble convertibility and World market prices, the total volume of oil production would be determined by the state of the investment market, i.e. by a comparative yield of investments made in the oil industry against that in other sectors of the economy. The emergence of industries in Russia more profitable than oil or raw materials is unlikely until the year 2000 at the earliest. But given a favourable course for reform, they could emerge in the first years of the next Century. At about that time, the first appreciable results of energy saving could be expected. Thus, by the beginning of the 21st Century, oil production could be constrained both by a reduction of investment and a slowing down in internal demand. But, to counterbalance these factors, a reviving economy with growing demand (although, as mentioned above, demand could be less than otherwise expected) combined with technical renewal of the industry (which would lower real operating costs) could encourage production growth. The counterbalance of these two tendencies should limit internal consumption to 200mt per year until 2000. Only by 2010 could the growth in domestic consumption to a maximum of 240mt per year be expected. Total demand will be determined both by the opportunity to export at World market prices along with the level of deliveries to former Soviet republics. Exports to the World market are now limited by the existing transport system, which is at present capable of transporting only about 110mt of oil per year to customers outside the FSU. Table 4 below refers: Table 4 Export of Russian Crude Oil in 1994 (.PDF/7Kb) This system could be expanded and exports thereby increased. However, the growth in production costs and competition for capital from other emerging industries could push investment away from projects to expand transport infrastructure, as well as from the repair and maintenance of the network which is necessary to keep exports at or close to existing levels. Thus it is more likely that annual export volumes will remain steady at about 100mt, and these would mainly comprise products produced by joint ventures and foreign companies. Annual deliveries to the former USSR republics upto 2000, given their continuing poor economic situation, are expected to remain steady at between 20-30mt, maybe 35mt at most. Some growth in deliveries could be expected thereafter, but they would be at World market prices. Thus existing oil exports to the West could in the future be diverted to CIS markets. In brief, the most probable upper level for oil production in Russia is 330mt in 2000 and 360mt in 2010. These figures could of course alter due to the influence of both negative factors (such as the continuing fall of production and demand, the shortage of investment resources and slow progress with energy saving) and positive factors (such as greater investment in more efficient industries, the success of energy saving, and an increase in solvent demand both in Russia and elsewhere in the FSU). Natural Gas Following the disintegration of the USSR, the gas industry has found itself in the best situation, not only among Russian fuel-energy sectors but also relative to all other industries. This was due to the largest proven reserves in the World (35% of global total) combined with the Unified Gas Supply System which integrated natural gas production and transport to a uniform technological and economic system throughout Russia. This system was also connected with the gas supply systems of a number of states to the south-east and to the west, including twenty European countries. In the first half of the 1990s, Gasprom did not require serious investments either for the development of new natural gas producing regions, or for the construction of new transport infrastructure facilities. Against the background of a general investment crisis in Russia, the opportunities for stable output within the gas industry were quite good. Thus gas exports to Europe have increased in recent years. (See Table 5 below) But at the same time, gas exports to the CIS and Baltic States decreased considerably. Table 5 Russian Gas Exports (excluding FSU) in 1992-1995 (bn m3) (.PDF/7Kb) Despite export success, overall gas production fell slightly over this period because of the reduction in internal consumption and a fall off in deliveries to former USSR republics due to their indebtedness. See Table 6 below. Table 6 Russian Natural Gas Deliveries to the FSU in 1992 and 1995 (bn m3) (.PDF/7Kb) The decrease in internal consumption by 3% in 1993 and by 5% in 1994 did not affect production by very much, basically owing to increased exports. In 1994, production was only 1.8% below that in 1993. Available capacities will permit production to increase when growth in demand and consumption occurs, which is expected after 1997. Indeed, a stabilisation of consumption could occur this year. As distinct from the world oil market, the gas market has a regional character and is based on large long-term agreements. This is explained by the high costs of gas transportation which requires large investment projects. These can only be justified if long-term stable and reliable deliveries are ensured. This also explains the significant involvement of the government in gas projects and agreements. It is common practice for gas importing countries to diversify their sources of supply, both for political (ie. strategic) and economic reasons. The lack of such a choice is a crucial factor for some countries. In the case of the newly independent states of the former USSR and some East European countries, the Russian export option is to some extent the only one. For the countries of Central Europe, economics works in favour of Russian supply. In West European countries, the stategic need to diversify supply assumes greater importance. A new phenomenon has appeared in the international gas market, that of a growing discrepancy between contractual and actual physical volumes of gas deliveries. Such a discrepancy makes the compromise between the economic efficiency of gas deliveries and their reliability (in case of political upheaval) difficult to achieve. This is why the international gas supply system involves support, agreements and guarantees at the multinational level. Indeed, the gas trade is now the most important aspect of regional international co-operation in the energy sector. The price of gas, though connected with that of oil, does not have a direct correlation in that it depends upon the ratio between prices for crude oil and mazut (or gasoil). Usually, the price of gas is established pursuant to market value, i.e. having regard to the price of the closest competing fuel, which, depending on the particular market, could be gasoil, mazut or coal. Thus gas prices do not wholly depend upon the interrelation between supply and demand, and do not therefore fully reflect gas production and delivery costs. In some cases, the price is established in response to costs and includes the price on the border (which is agreed between the importer and the exporter), transport charges, and distribution and storage expenses. There has recently appeared a new factor in gas pricing - a so-called type of competition known as 'gas-gas', under which a competitive transit market between the sellers to replace non-flexible long-term contracts on gas deliveries can be created. This is now well established in North America, although not yet in continental Europe. When comparing competitive kinds of fuel used in the power sector, gas has recently been quite frequently compared with coal, whereas oil products continue to be the main competition. Forecasting gas prices must also take account of mutual relations between supply and demand. The driving forces behind the demand for natural gas in Europe are as follows: use of natural gas for power production since it has some advantages over competing fuels; lower capital investments compared to coal or nuclear fuel, shorter term of realisation, more flexible production process; advantages of gas over other fuels as a lesser pollutant of the environment; socio-economic development in Eastern Europe, which requires expansion of gas use and the further replacement of other types of fuel. Future supply will be based on the expansion of existing production capacities, the commissioning of new facilities, the construction of new pipelines, and the implementation of liquefied gas projects. Surveys recently financed by the EBRD show that from 1994 to 2000, demand for gas in Europe will be provided largely by local production at a price of US$2-3.25/mBTU as well as by imports from the former USSR and Northern Africa at a price of US$2.50-3.00/mBTU. However, when evaluating additional demand for natural gas of 57 billion m3 by 2005 and 100 billion m3 by 2010, gas supply costs might increase considerably since this demand can be only met by gas transported through expensive new systems. Even allowing for low production costs (of US$0.50mBTU), long-distance delivery cost (to the European market) can be as much as US$2.50-3.50/mBTU and even more, particularly for new projects which could range up to US$4/mBTU, thus matching the LNG price in Asia. Table 7 below gives an evaluation of future Russian gas prices on the Ukrainian border: Table 7 Future Russian Gas Prices (on Ukrainian border) (.PDF/5Kb) Taking into account these price factors and the possible development of supply and demand, Russian natural gas supply would be as in Table 8 below: Table 8 Future Russian Gas Supply (in billion m3) (.PDF/6Kb) Coal The coal industry is in the most depressed state of all fuel industries in Russia. This is explained both by problems of transition which have accelerated the growth of production costs, and by the changing role of coal in the Russian power industry. For several years the demand for coal has continued to decline, although employment in the coal industry has remained steady. Subsidies granted to the coal industry even now account for 1.2 % of Russian GDP and rank second after agriculture as heavy burdens on the national budget. According to the World Bank, the future "viable core" of the Russian coal industry would be about two-thirds its current size with total employment being less than half of today's level. Before its demise, the USSR was not the World's largest coal exporter, but was nonetheless a large and stable provider for global markets. However, both production and exports have fallen since 1991. See Table 9 below; Table 9 Russian Coal and Coke Production and Export (non CIS) - 1991-1996 (.PDF/6Kb) Within this overall decline, exports to the Far East, especially to Japan, have increased rapidly. The fastest decline was in deliveries to European countries, explained by the geographical location of the main coal producing centres in Siberia and the Far East. (See Table 10 below). Increased railroad tariffs, even under conditions of subsidy and the need for hard currency, make deliveries to the West competitive only if made to neighbouring countries. Moreover, the geographical location of the main Russian centres of coal consumption makes exporting coal even less attractive, hence ensuring some stability of internal demand as overall production falls. Table 10 Russian Export of Coal and Coke by Destination - 1992 to 1995 (.PDF/9Kb)