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Dalan McEndree

Dalan McEndree

Dalan McEndree has a BA in history, MA in European History, M.Phil. in Russian and Soviet history, Soviet economics, and International economics, and MBA in…

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Putin’s Dilemma: To Sell Or To Nationalize Oil Assets

Putin’s Dilemma: To Sell Or To Nationalize Oil Assets

According to a March 11 Bloomberg article, the Russian government is considering changes in the tax regime for the Russian oil and gas industry in order to bolster government revenues.

Should Vladimir Putin consider nationalizing this industry as one of the alternatives?

Possibly—if the U.S. shale revolution represents a paradigm shift that will result in sub-$50-$60 crude prices and substantially lower natural gas prices well into the future. Should this be the case, without significant changes in its approach to generating revenue from this industry—which historically has funded ~50 percent of the government’s budget—it seems the Russian government could consign itself to perpetual budget revenue penury and Mr. Putin to punishing pressure on military spending, his priority.

The 2016 Budget Debacle

As 2016 approached and crude’s price fell toward $30 per barrel, the Russian government found itself in a desperate search for revenue to balance a budget it had developed based on $50 per barrel crude. The Finance Ministry initially proposed to extract the necessary incremental revenue from Russia’s oil and gas industry through an increase in the mineral extraction tax. Immediately, the industry and its supporters in the Russian government (the Energy and Economic ministries) vociferously objected and warned of dire consequences: reduced investment, stalled output growth, and eventually production cuts.

While the two sides eventually agreed instead on postponing the planned reduction in the export customs tariff rate from 0.42 to 0.36, crude’s continued fall into the New Year renewed pressure on the budget. Finance Minister Siluanov in mid-January projected that an additional $20 billion in revenue was needed to close a deficit that his ministry estimated could grow to 6 percent of GDP.

This forced the Russian government to renew its search for revenue. The search included heretofore sacrosanct sources. Government officials broached the possibility of selling government shares in such national champions as Rosneft and Aeroflot. A February 19 Reuters article reported that the Finance Ministry, with several other ministries’ support, had proposed cutting 2016 military procurement 5 percent, or ~$1.29 billion–a proposal which Putin repeatedly and recently has denied. Related: Which Presidential Frontrunner Is The Best For Energy?

In the last few weeks, hoping to exploit a loophole it perceives in the U.S. and European economic and financial sanctions, the Russian government announced its interest in raising $3 billion through the sale of Eurobonds (the U.S. Treasury has warned U.S. banks against participating. Whether European governments will follow suit is not yet known).

Such measures may help the Russian government close the 2016 deficit. However, each is a one-time in nature and will provide little if any relief in future years. For this, the Russian government requires a source or sources that steadily will generate revenue.

Russia’s economic predicament limits the government’s options. In its fall 2015 World Economic Outlook edition, published October 6, the IMF forecast that the Russian economy, in constant (inflation-adjusted) Ruble terms and in current U.S. dollar terms, will remain in recession until 2017 and that growth will remain subdued through 2020.

The IMF data also forecasts, in current U.S. dollar terms, a ~$280 billion decrease in government revenue in 2015 from 2014, a further ~$23 billion decrease in 2016, and revenue in 2020 still below revenue in 2014. Since Urals crude may average less than $50 in 2016, the IMF’s October 2015 revenue estimates for 2016 may turn out to be optimistic. (In the chart below, 2013 and 2014 crude prices are actual prices, 2015-2016 prices are estimates, and for 2017-2020, the IMF assumed that crude prices would remain stable in real terms).

(Click to enlarge)

The Government Funding Crisis

As noted above, the Russian oil and natural gas industry generates ~50 percent of Russian budget revenues. The bulk of these revenues come from three levies: the mineral extraction tax; customs duties on hydrocarbon and hydrocarbon product exports (except exports to countries in the Russian-led Eurasian Customs Union (EACU)-Belarus, Kazakhstan, Armenia, and the Kyrgyz Republic, which are customs-duty free); and excise taxes on domestic sales of refined petroleum products. (According to a March 14 Bloomberg article, Gazprom and Rosneft, Russia’s natural gas and crude national champions respectively, alone account for 30 percent of the budget. In 2014, the two companies generated ~$109 billion in such taxes).

The following table displays the current Russian government methodology for calculating the mineral extraction tax and the export customs duty on crude. (The tax code offers breaks in some cases on the mineral extraction tax depending on the cost/difficulty of extracting crude). The base tax rates for export customs duty are set at $29.2 per metric ton (the Russian government sets a metric ton equal to 7.3 barrels, hence the per barrel rate in the table). The export customs duty rate on the difference between the Urals market price and the floor price for crude above $25 per barrel was scheduled to decline to 0.36 in 2016, but the reduction was suspended, and to 0.30 in 2017. It was 0.59 in 2014, 0.60 in 2013.

(Click to enlarge)

The customs duty on petroleum products exported to non-EACU countries is set as a multiple of the crude rate. The following table, from Lukoil’s 3Q Management Report, shows the multiplier rate and the US$ amount collected per metric ton for the first three quarters of 2015 and 2014:

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The following table illustrates the sharp decrease in actual revenue flowing to the Russian government from these levies in 2015 from Russia’s two largest domestic crude producers—Rosneft and Lukoil. (The mineral extraction tax is the primary component of taxes other than income—~92 percent. The other components are property, social security and other social contributions for both Rosneft and Lukoil. Rosneft reports excise tax in this category, while Lukoil reports it with export customs duty). Through 2015’s first three quarters, when Urals crude averaged $54.61, these two companies generated ~$65 billion less for the Russian government versus the $109 billion they generated in full-year 2014, and ~$44 billion through 2015’s first nine months). Since the Urals crude price averaged below $50 per barrel in 4Q, these two companies likely delivered less in 4Q than the $15 billion they generated on average in 2015’s first three quarters.

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Theoretical Mineral Extraction Tax and Export Customs Tariff Revenues

How much can the Russian petroleum industry generate for the Russian government given the current tax structure and tax rates from the mineral extraction tax and the export customs duty? For the sake of simplicity, the following estimates assume that Russia exports crude only, not petroleum products (which would require estimating the export volume of each petroleum product and tax rate multiplier), and that all crude exports are subject to export customs duty (i.e., including those to EACU countries). The estimates also ignore the impact on individual oil companies and their financial situation (for example, on an overleveraged Rosneft).

The IEA estimates that Russian crude output averaged 11.06 million barrels per day in 2015—according to most observers, the Russian domestic industry’s peak level. The following table projects mineral extraction tax revenues at current mineral extraction tax rates (assuming no tax breaks for difficult-to-extract resources):

(Click to enlarge)

The IEA estimates that in 2015, Russian domestic consumption averaged 3.59 million barrels per day; thus, assuming Russia exports only crude, it exported 7.47 million barrels per day:

(Click to enlarge)

Combined, and without tax breaks, the mineral extraction tax at current domestic output levels and the export customs duty at current crude export levels at $50 per barrel crude would theoretically generate less than $100 billion overall in revenue—and just 27.50 percent of the $348.72 billion the crude industry contributed to the Russian budget in 2014 based on budget revenue calculations using IMF data. (Part of the $114 billion difference between the estimated revenue of $234 billion at $100 crude and the estimated $348.72 billion collected in 2014 results from the lower export customs duty rate, 0.42 versus 0.60 in 2014 ($37 billions) and the contribution from natural gas—Gazprom paid $34 billion in 2014 in these taxes). Related: Is The Latest Rally Yet Another False Start?

(Click to enlarge)

Alternative Approaches to Increase the Government Stake

Increasing mineral extraction and export customs duty tax rates could substantially increase the Russian government’s take from the Russian oil industry. Reverting to 2014 export customs duty rate of 0.60 on the difference between Urals market price and the $25 floor price and raising the mineral extraction tax rate on the difference between the Urals market price and the $15 floor price to 0.75 would generate revenues equivalent to ~45 percent of the $348.72 billion collected in 2014 at $50 per barrel crude. At $100 per barrel, the take would be 77.61 percent of the $348.72 billion.

How much revenue would the Russian government collect from the mineral extraction tax if the Russian government set the mineral extraction tax rate on difference between the Urals market price and the $15/barrel floor price at 100%--in effect paying Russian companies a fixed $15 per barrel fee to extract the oil and limiting their revenues to that the $15 floor price generated (plus, of course, what they generated from petroleum product sales)? In this case, the mineral extraction tax alone with $100 per barrel crude would generate some 67% of the revenue the Russian government collected in 2014 from both the mineral extraction tax and the export customs tax generate at $100 per barrel crude.

(Click to enlarge)

Data from Lukoil’s 3Q financial and management reports (which reports in U.S. dollars) can illustrate what this would mean in practice, while keeping the export customs duty on the crude price differential at 0.42. According to Lukoil’s 3Q financial statement, Lukoil paid the Russian government $7,747,000,000 in mineral extraction taxes, and $6,998,000,000 in “taxes other than income taxes”, or $14,745,000,000 in total. This was 19.7 percent of revenues of $74,712,000,000. Since Lukoil produced 647,670,000 BOE domestically and internationally in 2015’s first three quarters, these taxes generated $26.63 per BOE in revenue for the Russian government, while generating revenues of $134.92 per BOE in revenues for Lukoil (since Lukoil also produced 43.5 million tons of refined products in 2015’s first nine months).

The following table displays Lukoil’s 9 months 2015 operating totals results and results per BOE:

(Click to enlarge)

The $37.487 billion in Purchased crude oil, gas and products, which included $23.116 billion in inter-segment (i.e., intra-company) sales, constituted the greatest expense. The following table, from Lukoil’s 3Q 2015 Financial Report, provides Lukoil’s results per operational segment (with Elimination eliminating duplication through inter-segment sales). The E&P segment sold $3.520 billion in BOE equivalent to third parties and $21.222 billion to Lukoil’s Refining, Marketing, and Distribution (RM&D) segment, which it turned into $70.239 billion in revenue, including $69.610 billion from sales to third parties, and $629 million in inter-segment sales.

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Since Lukoil’s E&P segment produced 647,670,000 BOE and generated $24,742,000,000 in revenue, its revenue per BOE sold to third parties and Lukoil’s RM&D segment was $38.20. (Lukoil’s methodology for pricing E&P crude is as follows: As a result of certain factors considered in the “Domestic crude oil and refined products prices” section on page 9, benchmarking crude oil market prices in Russia cannot be determined with certainty. Therefore, the prices set for inter-segment purchases of crude oil reflect a combination of market factors, primarily international crude oil market prices, transportation costs, regional market conditions, the cost of crude oil refining and other factors).

(Click to enlarge)

In 2015’s first three quarters, Lukoil’s RM&D segment generated $70.239 billion in revenues. Assuming that the RM&D segment purchased all the purchased crude oil, gas, and products, it netted $63.97/BOE from the 567,000,000 BOE it purchased from Lukoil’s E&P segment (assuming the E&P segment charged the same price to third parties that it charged to Lukoil’s RM&D segment):

(Click to enlarge)

Using this approach—the Russian government claiming through the mineral extraction tax all revenue above the $15 floor price and leaving the export customs duty rate on the price differential at 0.42, the Russian government would increase its take some $10 billion, from $14.7 billion to $24.3 billion (the difference between the reported revenue and the revenue in the below table derives from inter-segment eliminations). 

(Click to enlarge)

Kto Kogo Who Whom

If it’s likely that the U.S. shale revolution means that crude prices will remain subdued well into the future, should Vladimir Putin nationalize the Russian energy industry?

Kto kogo (pronounced kto kovo) is a political principle that Vladimir Lenin made famous in 1921 and other Soviet leaders, notably Trotsky and Stalin have used. It translates as who whom and means who [defeats] whom, or whose interests will dominate whose interests (see Wikipedia for a discussion).

The principle accurately describes the relationship between Vladimir Putin (and the Russian government) and the Russian energy industry: whose interests will prevail—which side will take the lion’s share of the still-considerable revenues the industry generates? On one side, the Russian government desperately needs revenues, yet faces an indefinite period of subdued economic activity and therefore subdued revenue. On the other side, Russian energy companies want to remain independent, to develop the most lucrative resource plays, no matter where they are, grow production, and increase profitability and absolute profits.

At first glance, nationalization might not seem to be a necessary, practical, or attractive solution to the Russian government’s financial pressures. As the foregoing discussion indicates, the government significantly could increase the resources it extracts from the industry through the existing tax system’s structure. Related: Massive Protests Over Chinese Coal Closure

In addition, nationalization might be interpreted as a desperate step by a panic-stricken government. Also, existing shareholders, company management, and others likely would object strenuously. Moreover, buying out shareholders also would be expensive (although less expensive if preceded with tax increases): according to the Bloomberg article cited above, Rosneft’s and Gazprom’s combined market value is about $100 billion.

Yet nationalization could offer significant benefits. The Russian government would capture all the revenue crude and natural gas sales generate—in particular all the revenue it currently exempts from taxation below $15 per barrel floor for the mineral extraction tax and the $25 floor for the export customs duty.

Nationalization could be useful in focusing the Russian energy industry on developing Russian rather than foreign energy resources. At present, Russian companies continue to invest outside of Russia (and, as taxes rise in Russia, investing overseas could become more attractive than investing in Russia). For example, Rosneft recently borrowed $488 million from Gazprombank to finance natural gas-related projects in Venezuela—this at a time when Rosneft faces declining production in Russia. Lukoil invests in E&P outside Russia ($2.623 billion 2015’s first nine months). In 3Q 2015, its output in Iraq averaged 190,000 barrels per day—and each Lukoil-produced barrel produced in Iraq rather than Russia competes with domestically-produced barrels for sales to China and deprives the Russian government of mineral extraction tax or export customs duty.

Nationalization could help rationalize and simplify the industry and increase its financial foundation. Presently, the Russian energy industry is riven with rivalries and conflict. Rosneft and Novatek are constantly at war with Gazprom over its monopoly on natural gas exports, which consigns them to selling natural gas at significantly lower domestic Russian prices. Lukoil invests in Iraq as Rosneft searches for capital to develop expensive crude resources in Eastern Siberia. Rosneft borrows $488 million for natural gas projects in Venezuela as Novatek searches for capital to complete the first train of its Yamal LNG facility in 2017 and capture first-mover advantage in Europe and Asia over U.S. LNG producers.

Gazprom continues to generate substantial cash flow, which, in a nationalized energy industry, the Russian government could use to pay down some of the ~$24 billion in net debt that remains from Rosneft’s TNK-BP acquisition.

Were the industry restructured into two verticals—crude and natural gas—E&P investment could be concentrated on the most lucrative crude and natural gas resources in Russia, and thus Gazprom would not be loath to use the natural gas Rosneft now produces to supply China under its Power of Siberia contract and reduce the volume it will have to extract from new, expensive-to-develop resources in Eastern Siberia and therefore capital expenditures. The Russian government likely could borrow at lesser rates than Russian energy companies, given its sovereign status, and the potential cash flow from a consolidated energy industry.

By Dalan McEndree for Oilprice.com

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