Russian Energy Sector At The Crossroad: New Challenges

Russian Energy Sector At The Crossroad: New Challenges Dr. Tatiana Mitrova Head of Oil and Gas Department Energy Research Institute of the Russian Academy of Sciences Washington 13 September, 2013

The role of oil and gas for the Russian Federal budget is huge Oil and gas taxes and duties in the Federal budget 6000 50% 5000 43% 42% 41% 41% 45% 40% Gas export duty 4000 38% 33% 35% 39% 35% 30% Gas MET 3000 25% Oil export duty 20% 2000 15% Oil MET 1000 0 2005 2006 2007 2008 2009 2010 2011 2012 10% 5% 0% Share of oil&gas MET and export duties in the Federal budget incomes Source: http://www.roskazna.ru/reports/fb.html 2

Not only energy sector, but the whole Russian GDP growth is based on the oil prices Oil price and Russian GDP dynamics $ Bln. $/bbl 1800 120,00 1600 1400 1200 100,00 80,00 1000 800 600 60,00 40,00 ВВП, GDP, млрд. $ bln. долл. Brent, долл./барр. $/bbl 400 200 20,00 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 0,00 Sources: ERI RAS, BP Statistical Review of the World Energy 2013. 3

Russian economy is facing recession GDP and industrial value added growth (as % to the corresponding quarter of the previous year) 15 10 5 0-5 GDP (in market prices) Mining -10-15 Manufacturing -20-25 IQ IIQ IIIQ IVQ IQ IIQ IIIQ IVQ IQ IIQ IIIQ IVQ IQ IIQ IIIQ IVQ IQ IIQ IIIQ IVQ IQ IIQ IIIQ IVQ IQ IIQ 2007 2008 2009 2010 2011 2012 2013 Source: Rosstat 4

Global markets transformations are unfavorable for Russia Slowing demand (crises, structural changes, energy efficiency) and shrinking market niches for the traditional suppliers (shale revolution, new market participants). Growing supply and increasing competition with Australia, Brazil, East Africa and North America, which will target Russian core markets in Europe and Asia. Stagnant prices shale revolution has already decreased prices in North America and Europe, additional shale oil will limit oil prices growth. In all scenarios oil prices do not exceed 100-130 $/bbl, gas prices stay at the current levels. 5

Directions of the international energy trade are changing considerably International energy trade, mtoe Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 6

1 CHANGING GLOBAL GAS MARKETS: IMPLICATIONS FOR THE RUSSIAN GAS EXPORTS AND DOMESTIC GAS MARKET 2 CHANGING GLOBAL OIL MARKETS: IMPLICATIONS FOR THE RUSSIAN OIL EXPORTS AND ECONOMIC GROWTH 3 HOW TO BREAK THE DEADLOCK? 7

Global gas market development: incremental demand will be concentrated in the non-oecd countries The balance of gas supply and demand in 2040 Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 8

In the long-term average weighted regional gas prices are not expected to increase significantly on the Russian main export markets Equilibrium gas prices in the three scenarios Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 9

Russian gas export might be 70 bcma lower if there would be new breakthroughs in the shale technologies Changes of gas net export and import volumes in 2040 relative to 2010, Baseline and Shale Breakthrough Scenarios Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 10

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Global LNG supply is expected to boom by the end of this decade with Australia, USA and Canada becoming the largest market players Mln. tonnes 600 Global liquefaction capacities (existing and planed) 500 400 Other East Africa 300 US 200 100 0 Canada Australia Existing Source: ERI RAS 11

Situation on the European gas market during the last years did not favor Russian exports Growing supplies of LNG Diversification of pipeline supply sources Supply Demand Lower than contracted volumes Recovers very slowly In the power sector gas is strongly competing with coal Spot volumes are increasing very fast (30-40% p.a.) Majority of the European stakeholders support transition to the spot pricing Pricing Regulation Unbundling Gas Target Model requires all gas to be supplied at the virtual hubs 12 12

but European gas market is going to be tight until 2015-2016 as LNG is diverted to Asia; post 2016 very limited new supplies will become available and there will be an additional call on the over-take-or-pay volumes: good opportunity for Russia to enhance its position bcm 700 European gas balance 600 500 400 300 200 100 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Indigenous production (IEA 2013) Pipeline contracts MCQ Russia Pipeline contracts MCQ North Africa LNG contracts MCQ delivered LNG contracts MCQ diverted New LNG supplies Available ACQ-TOP volumes Demand (IEA 2013) Source: WEO2011, IEA; Cedigaz; ERI RAS. 13

Russian position in Europe will largely depend on gas pricing: traditional Groningen model is questioned now, as even renegotiated oil-linked contract prices are higher than spot-based $/1000 m3 500 European spot and oil-linked gas prices 400 300 200 Delta NBP Russian gas on the German border 100 0-100 Source: Bloomberg; ERI RAS. 14

Gazprom could give further price discounts and increase its market share, but Russia s strategic choice is in favor of the short-term profit maximization «We were faced with the choice of whatever was to maintain the supply volumes and the market share, or make the profit our high priority. As a public and commercially oriented company, Gazprom is interested in increasing profits to provide income to shareholders. Therefore, the choice was made, the correct one, in favor of the revenues, and the year results confirmed that. Alexander Medvedev, Gazprom Export» 15

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 ensured by the existing portfolio of the long-term contracts, which guarantees stable sales volumes for Russia until at least 2022 bcm Contractual quantities and real supply volumes of Russian gas to Europe 200 180 160 140 120 100 80 ACQ Fact MCQ 60 40 20 0 Sources: Cedigaz, Gazprom, ERI RAS. 16

Oil indexation vs. gas indexation: "a bird in hand is worth two in the bush approach Oil indexation Disappearing gas glut on the European gas market in the medium term gap between oilindexed and spot prices already started to narrow Gazprom will face next price reopening only after 2015, and contract expiration only by 2022 With high oil prices even lower volumes are providing high revenue New projects demand high prices (they have negative margins under spot prices, given that they have to pay export duties) and oil indexation is more convenient for the project financing Russian Government needs the money right now Spot indexation Strong pressure from the customers side Investigation of the European Commission against Gazprom`s pricing Gazprom could demand financial compensation for contract review + 3rd Package exemption for the South Stream and NEL + transitional period for price adjustments + European-level financial support for its mega-projects (like EBRD and other European financial institutions) Gazprom could become a dominant player manipulating the spot market by adjusting its supply volumes There are strong commercial reasons for Gazprom to protect the oil indexation at least during the next 3-5 years 17

Everybody is expecting new opportunities on the booming Asian gas markets, but by 2020 there is already no market niche in China... bcm 450 Chinese gas contracts and gas balance 400 26 350 Uncontracted market niche 300 Central Asia 250 Other LNG supplies 200 Australia 150 100 50 Qatar Indigenous production Chinese demand 0 2010 2015 2020 2025 Sources: IEA, Cedigaz, Enerdata, ERI RAS. 18

and OECD Asia is quickly contracting the North American LNG bcm 200 Japan and South Korea contracts and gas balance 180 160 140 34 32 65 Uncontracted market niche USA and Canada Others 120 Russia Qatar 100 Other Middle East 80 Papua New Guenia Malasia 60 Indoneisa 40 Brunei Australia 20 0 2010 2015 2020 2025 Indigenous production OECD Asia demand Sources: IEA, Cedigaz, Enerdata, ERI RAS. 19

Russian Eastern Gas Program is moving on, but as there are still no SPAs, the window of opportunities is becoming smaller and price negotiations have now to take into account Henry Hub pricing of the potential US LNG Sources: Gazprom 20

There are 7 Russian LNG projects under consideration currently, but all of them face commercial, technical and regulatory challenges Shtokman Gazprom 7,5-15 mln t Baltic LNG Gazprom 15 mln t Pechora LNG ALLTECH Group 2,6 mln t Yamal LNG NOVATEK 15 mln t Sakhalin-1 LNG ROSNEFT 5+ mln t Vladivostok LNG Gazprom 10-15 mln t Sakhalin-2 LNG Gazprom 10 mln t + 5 mln t potential expansion LNG export permissions might be approved only for special cases and only under very strict control of the State. Due to the limited volumes and long lead time these LNG projects will not significantly affect Russian and global balance during this decade. In the longer term Russian LNG export could reach up to 50-70 bcma. 21

Independents are improving their positions on the domestic market, though complete market liberalization and Gazprom`s ownership unbundling are not currently under discussion bcm Russian gas production structure * Other producers include PSA and APG Sources: CDU TEK, ERI RAS 22

But at the same time the industry is consolidating, now there are only three major non-gazprom players left on the market: NOVATEK, Rosneft and LUKOIL bcm Natural gas production by the companies with access to the UGSS Sources: CDU TEK, ERI RAS 23

Limited demand growth on the domestic market enforces competition between major players for the most attractive market segments Russian gas demand by sector until 2020 (optimistic scenario) 600 500 400 GAGR 2,3% GAGR 0,3% GAGR 1,1% Residential 2012 2020 AGR 2012-2020 300 Industry and feedstock Total consumption 428 468 40 1,12% Power generation 188 201 14 0,88% 200 100 Centralized heating Centralized heating 72 64-7 -1,36% Industry and feedstock 79 94 15 2,17% 0 2000 2005 2010 2015 2020 Power generation Residential 75 86 11 1,78% Sources: Rosstat, ERI RAS. 24

At the same time the Government frightened by the industrial output decline is ready to slow gas prices growth down to the rate of inflation, which is justified by lower European prices and weak domestic demand 3,00 Different proposed dynamics of the domestic gas price increase (compared to 2010 = 1) 2,50 2,00 1,50 1,00 Netback price (forecast 2011) Netback price (forecast 2013) MED forecast up to 2030 0,50 Gas price growth in line with inflation 0,00 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Sources: MED, ERI RAS. 25

There are tremendous shifts expected on the liquid fuels market, with declining demand in OECD and booming unconventional liquids production Liquid fuel supply and demand balance by 2040, Baseline Scenario Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 27

Unconventional oil will reach 16% of total liquids production by 2040 Dynamics of liquid fuels supply structure, Baseline Scenario Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 28

Equilibrium oil prices decrease up to 2020 and afterwards do not exceed 130 $/bbl Equilibrium oil prices in the three scenarios Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 29

Russian oil export could decrease even stronger than expected by additional 50 mln. tonnes per annum - if there would be new breakthroughs in the shale technologies Changes of oil net export and import volumes in 2040 relative to 2010, Baseline and Shale Breakthrough Scenarios Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 30

Taking into account global environment changes dramatically expectations for the Russian energy and economy Official MED scenario and Outlook-2013 scenario of Russian economy and energy development, % 2010 г. 2015 г. 2020 г. 2025 г. 2030 г. 2035 г. 2040 г. 1 2 1 2 1 2 1 2 1 2 1 2 GDP 100 121 119 150 143 185 168 222 192 266 219 316 248 Share of the energy sector in GDP 28,5 25,6 25,5 22,9 23,1 20,0 20,4 18,4 18,8 17,0 17,3 15,6 15,9 GDP energy intensity 100 87 88 74 77 64 69 56 62 49 57 43 52 Energy consumption 100 106 105 112 110 118 115 125 120 131 125 137 129 Energy export 100 103 95 103 89 105 84 104 85 104 86 100 87 Investments in the energy sector as a share of GDP 5,0 5,9 7,2 5,0 4,7 4,5 4,1 4,9 4,8 3,8 3,7 3,4 3,5 1 official MED scenario, 2 Outlook-2013 scenario Source: ERI RAS. 31

Decreasing competitiveness of the Russian energy resources due to depletion of the old fields and tax system makes Russia most sensitive to the market changes among all the suppliers Russian energy export by fuel in the official MED scenario and in the Outlook-2013 scenario MED scenario Outlook-2013 scenario Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 32

Limited export opportunities might reduce Russia`s economic growth by 1% per annum compared to the official scenarios: the economy cannot any longer count on the hydrocarbons-driven growth Russian GDP in the official MED scenario and in the Outlook-2013 scenario Source: Global and Russian Energy Outlook up to 2040. ERI RAS-AC. 2013. 33

Main measures to support competitiveness of the Russian energy resources Cost control together with a thorough evaluation of cost-effectiveness of the new projects and their potential risks. It is advisable to rank investment projects and reject or postpone the implementation of inefficient ones. This is confirmed by the results of work done by foreign and Russian experts, who analysed the cost of domestic energy projects, showing that they were typically several times more expensive compared to existing analogous projects found elsewhere, while those projects that were completed were underutilized for years. Taxation system reform: currently an efficient break-even point for the Russian upstream oil projects is fixed at 25 $/bbl due to outdated volume-based taxation. International consortia development attracting foreign partners into the consortia engaged in resource development (this refers especially to the eastern part of the country, the coastal shelf, and deposits of unconventional hydrocarbons). If properly managed, it would enable the country to: attract foreign investment and apply advanced technology; develop types of business activities with potential, under new conditions; ensure tight control over costs and other business results; obtain additional assurances for product sales; and facilitate access to logistics and adapt to the rules of international markets. Energy saving. Russia has a huge potential, but it is limited by inappropriate regulatory framework and lack of access to financing 35

Main part of the Russian conventional oil is concentrated in the declining Soviet-time fields Structure of the Russian oil production 518 mln.t 512-535 mln.t* Conventional oil Oil deposits with low recovery factor Heavy oil and bitumen Oil from gas deposits 30% 4% 3% 4% 2%3% 12% 8% 2012 2030 59% 34% Other Shale and tight oil 41% * According to the Energy Strategy-2030 and Social-Economical Development Forecast Up To 2030 Source: ERI RAS. 36

In order to sustain production, Russia needs to develop new fields, which, however, are not competitive under the current tax regime. Higher production estimates are justified by the vast resource base, but require completely different taxation system Mln t Forecast for the liquid hydrocarbon production in Russia Sources: CDU TEK, LUKOIL. 37

Russia has a huge potential for Enhanced Oil Recovery: best practices would provide additional 4 bln t without the need to build new infrastructure, but adjustments of the tax regime are the must Potential for increasing ORF in Russia Sources: Energy Ministry, LUKOIL. 38

Unconventional oil and Artic: huge potential, but high costs and lack of technologies make these projects marginal under the current taxation Unconventional oil reserves Mln. t Arctic production volume forecast Sources: Energy Ministry, LUKOIL. 39

The normal Mineral Extraction Tax and export tax require much lower breakeven costs, then all sources of new supply have; the Government is not ready to change the system for profit-based taxation, therefore all the exemptions are currently adjusted in the manual regime $/bbl 250 200 150 100 50 0 Affordable breakeven under the current taxation EOR Bazhenov rock Arctic Source: ERI RAS. 40

Mtoe Russia has huge potential to use energy more efficiently: energy consumption could be decreased by 30% 700 Primary energy savings potential in Russia based on comparable OECD efficiencies, 2008 600 500 400 300 200 100 Gas Other fuels 30% Source: WEO 2011. IEA. 0 Russian primary energy demand Raising Russia s energy efficiency to the levels of comparable OECD countries would save the amount of primary energy used in a year by the UK 41

Conclusions More competitive external environment and domestic challenges are creating less favorable conditions for the Russian oil and gas industry. It will hardly be ably to provide the same high share of the budget incomes in the future. ERI RAS estimates show, that unfavorable situation on the export markets could lead to lower export volumes and slow down Russian GDP growth by 1% p.a. Russian gas industry still has a huge potential for export growth, but without strict costs control, cautious evaluation of the export projects and more flexible pricing system these opportunities could be lost. Under current conditions, oil production in Russia can be maintained through development of the following areas: enhanced oil recovery at existing fields development of unconventional reserves development of the new frontiers: new provinces in the Eastern Siberia and Arctic offshore But to develop these areas, the Government has to change the whole taxation system, not just to give few exemptions. 42

Contacts Energy Research Institute of the Russian Academy of Sciences "Global and Russian Energy Outlook up to 2040" http://www.eriras.ru/files/global_and_russian_energy_outlook_up_to_2040.pdf Nagornaya st., 31, k.2, 117186, Moscow, Russian Federation phone: +7 985 368 39 75 fax: +7 499 135 88 70 web: www.eriras.ru e-mail: mitrovat@rambler.ru 43