Russian oil companies are ready and willing to increase production over the next ten years. But only on two conditions: the state has to figure out, or let oil companies figure out, how to fundamentally expand the export infrastructure and the state cannot aggressively increase taxes on the industry.

Alexander Ivanter

In recent years, the Russian oil industry became the Russian economy’s main cash cow. In 2003, the taxes paid by oil companies made up almost a quarter of the entire budget of the Russian federal government and oil and petroleum products made up 40% of total exports. In contrast to the Boston Matrix’s classic definition of a cash cow (meaning an industry with typically high profitability and low growth rates), the oil industry is demonstrating enviable growth. Over the past five years production has increased by 40% to 420 million tons and shows no signs of falling.
What is the industry’s development strategy for the next 10-15 years? Is it worthwhile to continue increasing production or does it make more sense to increase the value added to petroleum products? What is the optimal taxation approach to oil industry? These questions were the focus of a roundtable discussion, “Evaluating the Effects of the Tax System on the Development of Russia’s Oil Industry,” where the Expert Analytical Center gathered oil execs, leading industry analysts, academics, tax officials, and financial experts.

Taxes
The tax reforms of 2002 led to a dramatic increase in the fiscal burden on the oil industry. Budget revenue increased significantly, though neither tax officials nor oil industry managers think that the current system is all that rational, let alone optimal. Tax officials complain that today’s taxes are not meeting the aim of extracting the notorious natural resource rents due to the state as the owner of all mineral and natural resources. “Mineral resource taxes are a means of getting a predetermined amount into the federal budget,” says Andrei Fedorov, Director of Administration at the Russian Tax Ministry. “But it does not correspond to its actual function, but acts as natural resource rent. We have always insisted that it is necessary to set firm rates for this tax for all other minerals, first and foremost for those that are exported, such as copper, aluminum, tin, and gold.” Generally speaking, according to Fedorov, it is impossible to pay natural resource rent in one lump sum, but that an optimal system of oil taxation would include auction bonuses, rental payments, up-to-date versions of excise-type mineral taxes, perhaps with some elements of differentiation (for example, depending on oil quality and the estimated value of oil fields), and finally an additional income tax, the last component of rent dependent on market prices. However, the majority of experts, not to mention the oil company representatives, did not share the tax authorities’ fiscal enthusiasm.
PricewaterhouseCoopers partner Mikhail Klubnichkin was firm and terse: “Oil reserves and fields will unavoidably be depleted by 2010-2012. The industry needs a dramatic increase in investments, which are very sensitive to the tax burden. We should carefully study Western practices for stimulating investment, for example, royalty breaks, calculated so that investors can fit themselves into a project’s planned payback period.”
Nonetheless, for the time being the government is exhibiting assault tactics on the tax front. In May 2004, it once again resolved to raise the main taxes on the industry, the mineral tax and export duties.
It is clear, though, why the fiscal authorities have gotten so hung up on the oil industry. It minimizes risks to the federal budget and closely resembles the socialist idea of “hunting down rent.” The comparatively transparent nature of the oil industry also plays a significant role. Oil execs are not only concerned about the level of taxes, but also about their regressive quality. The flat-rate tax on mineral resources is applied to companies with completely different natural resources at their disposal. Radik Davletshin, Department Director at Tatneft, thinks that “The existing tax system does not allow companies to produce oil at a profit until they select the projected volume of reserves. It pushes companies to selectively exploit only highly productive sources. The flat rate means that one company pays out hefty dividends while others operate at minimal profitability.”
However, it came to light that there are even more outrageous oddities in oil industry taxation. The only thing needed to eliminate them is the political will to get rid of the duty on petroleum product export immediately. Otherwise, Russia should forget about modernizing and developing domestic oil refining. “The government needs to eliminate export duties on light oils immediately,” Vladimir Milov, President of the Energy Policy Institute, stated categorically. “These duties are hampering the development of oil refining. Sure, these will be a short-term gasoline deficit on the domestic market, but gas can always be imported.”

Transportation
The taxation issue is not nearly as pressing as that of oil transport and the growing dearth of export pipeline capacity. As Andrei Gaidamaka of LUKoil explained, “Russia is practically the only oil producing country on the continent and oil has to be transported 2500-3000 km overland to be exported. This weighs considerably on the economic status of oil companies. According to our estimates, LUKoil alone now pays more than $2.5 billion in export costs and $5 billion in taxes a year. Of this 2.5 billion around 1-1.2 billion could become taxes, if only the state would let us develop the infrastructure enough to make this happen. The government also needs to sign off on the Murmansk project. Why it refuses to do so is a mystery to me. We are now handing out around $8 billion a year to our neighbors due to discount oil prices. This is a lot, and the federal budget loses $3-4 billion a year because of it.”
Other roundtable participants were not so confident that the Murmansk project would prove efficient. Galina Antonova, Director of the Economic Analysis Administration at YUKOS, recommended taking a broader look at the project that would take into account the size of Russia’s key export markets for crude oil: “Today the most economically effective markets for Russia are Europe, our close neighbors, and the CIS countries. Neither Europe nor Russia’s close neighbors are increasing their oil consumption. In fact, over the last ten years oil consumption on those markets has fallen. All of the pipelines undergoing reconstruction or being built, including the Murmansk project, are all supplying oil to the same market. But it can’t expand endlessly. I believe that the east is the most promising direction. Territorially, our markets are China and the Far East. But transport costs total $95 per ton, and without a new pipeline system, these markets are economically unviable.”
Alexander Nekrasov, the Deputy Director of the Institute of Economic Forecasting of the Russian Academy of Sciences (IEF) and an experienced specialist in fuel and energy issues, leaped into the discussion. Nekrasov believes that the oil industry does not need to increase the total volume capacity of export pipelines as much as it needs to avoid certain “bottlenecks.” “The most obvious example is the Bosporus, where Russian tankers lose as much as $400 million a year,” stated Nekrasov. The researcher also believes that pipelines to Murmansk and the east are not necessarily mutually exclusive. Both need to be built. Specialists at the Forecasting Institute have estimated that it would make the most sense to extend the pipeline to Nakhodka and then build an oil refinery right in the Nakhodka region targeting the East Asian and Pacific market, which does not have its own refineries.

The future
The way the export infrastructure will expand directly depends on the oil industry’s growth in the next ten years. There are still several unknowns in the equation: world oil prices and tax rates. The balance of energy at home in Russia also has an important role in oil production. This factor, however, is subject to extreme inertia. “It is completely obvious that there is no reason to expect a significant increase in the domestic demand for oil,” stated Vladimir Milov, also of the Institute. “Consumption in Russia is steady at 125 million tons and according to all projections it will stay at that level. By 2020 the most that Russia will consume is 165 million even if the GDP doubles. The fact of the matter is that the oil makes up only 20% of the Russia’s primary energy resources, while its main energy resources are natural gas and coal. For this reason any increase in production will be export oriented in one way or another.”
Milov was the only roundtable participant who tried to discuss other very possible alternatives to the aggressive development scenario taken up by oil execs and by the government in its program documents for industry development and Energy Strategy. However, according to Milov, this scenario which involves increasing oil production 2010-2012 to at least 550 million tons a year and emphasizing continuing export of crude is perhaps not the optimum plan. A second scenario is more modest, and suggests balanced development of the sector without any substantial quantitative changes but with qualitative changes, for example, moving to export of higher quality oil and refined petroleum products. Investment in oil refining could be made in any convenient location—in Ukraine, the former Eastern Bloc countries, or the Baltics—just not in Russia. The level of refined oil products will stay embarrassingly low (around 70% for the industry as a whole). “A moderate scenario would involve abandoning the ridiculous increase of crude oil exports and creating the conditions to increase the attractiveness of refining, exports of refined petroleum products, and the quality of petroleum products on the domestic market,” Milov argues. “The general level of production would remain 400 million tons a year.”

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