Over the next several weeks, Gateway2Russia will present highlights from this year’s Expert 200, Expert RA Rating Agency’s annual rating of Russia’s 200 biggest and most dynamic companies.

Oil and Natural Gas

If companies do not invest in modernizing oil refining, the Russian fuel industry will remain a captive of world market conditions.

Oil and natural gas companies earn more than half the total revenue of the Expert 200 companies. It would seem the oil business in Russia was growing very successfully. Despite the Iraq crisis, the situation on the world oil market remains favorable to Russian oil companies. After a decline in the first quarter, oil prices grew steadily for most of the year (Chart 20). The announced alliance between TNK and British Petroleum and the YUKOS-Sibneft merger piqued investor interest in oil stock. In a year, their capitalization increased by more than 70%. However, the oil companies would operate far more efficiently if they had invested more in developing oil refining and export infrastructure at the right time.

Created according to the principles of vertical integration following the model of Western oil giants, the majority of Russian oil companies nonetheless have not become full-fledged vertically integrated corporations.
Business activity at transnational companies is focused primarily on intensive oil refining. Sales of refined petroleum products such as gasoline, jet fuel, and engine oils generate the majority of their revenues. Around 60% of ChervonTexaco’s earnings come from petroleum product sales. The share of these products in Shell’s earnings is more than 75%. With this approach, control over the entire production chain (extraction-refining-sales) gives the best results.
Russian experience has been very different. Naturally, the structure of Russian oil holdings involves vertical integration. However, essentially their main emphasis has always been on exporting crude oil or, in the best case scenario, low-quality refined petroleum products. 56.2% of YUKOS’ revenues and 51.4% of Sibneft’s revenues, for example, came from oil sales. The share of oil in their export revenues exceeds 70%. LUKoil is much closer to world standards, earning 59.4% of its total sales revenues from the sale of refined products.
Refining is very much the stepchild of Russian oil companies. In the years when the oil market is favorable, oil companies will increase their export supply of crude oil and skimp at their refineries. As a result, the increase in the rate of oil production in the last few years has exceeded that of oil refining by at least three times in recent years (Chart 21). There is, however, a minor tendency to increase refining, but it can be explained very trivially. The technology at Russian refineries does not allow them to substantially increase their production of high-quality motor oil. Yet Russian fuel oil is in high demand on the international market. Foreign buyers prefer to process it into more valuable products and use it as a raw input for petrochemicals, for instance. Fuel oil makes up around half of Russia’s petroleum product export. In 2002, its export increased by almost 20%, while oil exports as a whole only increased by 7.4%.
Oil companies’ excessive increase of crude oil export results in insufficient investment in refining. In 2002, only $854 million was invested Russian refineries. That was only 15% of the investment in oil production. Depreciation of fixed assets in oil refining is significantly higher than in oil production (52.5% versus 46.7%). With this amount of investment, the oil refining industry is doomed to remain technologically obsolete. The efficiency at Russian refineries is extremely low. Even in the best years, Russian refineries cannot convert more than 71% of crude, while the average level at Western companies is 85-90%.
Oil companies are now encountering a decline in business efficiency. The Expert 200 bears witness to the fact that profitability at oil companies fell from 24% to 18.9% (Chart 22), despite increases in world petroleum prices. The companies themselves explain this decline as the result of increased taxes on oil production and increased oil export tariffs. If, however, oil companies had shown some generosity toward their own refineries at the right time, these losses might have been fully compensated by increased earnings from petroleum product sales.

Inefficiency in oil refining is not the only reason for reduced profitability at Russian oil companies. The decline in profits is also connected to increased expenditures on transporting oil for export. The existing Transneft pipeline system is not capable of handling the larger volumes of oil being pumped abroad. The deficit in pipeline capacity forces oil companies to use alternative means of transportation. This in turn leads to additional costs. In order to optimize export, oil companies are willing take on huge costs. For example, YUKOS and Transneft are currently working on a project to build a pipeline to China to the tune of $2.5 billion.
However, building new pipelines does not always allow oil companies to solve their problems, at least if the company in question is Gazprom. Low natural gas rates inside Russia force the company to look actively for new ways to expand export, especially as Western Europe is the main consumer of Russian natural gas and competition from Northern European countries is intensifying. However, Gazprom’s attempts to enter the promising Turkish market ended in scandal. The Goloboi potok (Eng. Blue Stream) pipeline built specially to export gas to Turkey cost $3.2 billion. But after it came on line in February 2002, Turkey refused to accept and pay for Russian natural gas, Gazprom was forced to take the matter to an international arbitration court. Only in August of last year did Gazprom succeed in getting some concrete concessions.
The problem of exporting natural gas would be easier to solve if Russia had factories for condensing natural gas. The US, China, Japan, and South Korea would all be willing buyers of Russian liquid gas. Their markets are expanding very dynamically. However, Gazprom has not been able to find the money to make such a project a reality. According to industry experts, Russia will not be able to enter the liquid gas market before 2010.

Energy and Electricity

Higher rates have led to increased earnings for Russian energy companies, but not to increased production.

In revenue terms, Russian energy companies have been growing fairly dynamically over the past two years. This year, the total earnings at energy companies that made the top 200 (and practically almost every company in the industry did, either directly or indirectly) grew by 10.4%.
Increased energy earnings are most likely the result of long-awaited rate increases for electricity and steam heat, and not due to increased production. The amount of electricity generated in 2002 for Russia as a whole remained at the same level as the year before. Heat output actually decreased by 2.0%.
On the other hand, energy companies make some clear progress in price regulation. Rates that were very behind the times are catching up. The cost of electricity for consumers increased on average by 47.9% in 2002 and for large users by 20.9%.
Alarmed by rising rates, large electricity users are beginning to seriously think about alternative sources of electricity. Several leading Russian companies are now building their own generating capacities. For instance, Surgutneftegaz intends to invest $125 million in building power plants by 2004. This trend is only gaining strength with time. For example, Energomash has already begun a program to create a network of mini power and heat plants and foresees building at least 26 of these small power stations. Making this plan a reality will restrict the growth of big energy companies. But it will be the new electric companies, created from the reformed RAO EES, that will have to deal with these problems.