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Cablegate: Russian Oil Production: Stagnating Under Heavy Tax

VZCZCXRO8462
PP RUEHAG RUEHAST RUEHBW RUEHDA RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA
RUEHLN RUEHLZ RUEHPOD RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHMO #1295/01 1291156
ZNR UUUUU ZZH
P 081156Z MAY 08
FM AMEMBASSY MOSCOW
TO RUEHC/SECSTATE WASHDC PRIORITY 7968
INFO RUCNCIS/CIS COLLECTIVE PRIORITY
RUEHZL/EUROPEAN POLITICAL COLLECTIVE PRIORITY
RUEHXD/MOSCOW POLITICAL COLLECTIVE PRIORITY
RHEHNSC/NSC WASHDC PRIORITY
RHMFIUU/DEPT OF ENERGY WASHINGTON DC PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY

UNCLAS SECTION 01 OF 03 MOSCOW 001295

SIPDIS
SENSITIVE

DEPT FOR EUR/RUS, FOR EEB/ESC/IEC GALLOGLY AND WRIGHT
EUR/CARC, SCA (GALLAGHER, SUMAR)
DOE FOR FREDRIKSEN, HEGBORG, EKIMOFF
DOC FOR 4231/IEP/EUR/JBROUGHER

E.O. 12958: N/A
TAGS: EPET ENRG ECON PREL RS
SUBJECT: RUSSIAN OIL PRODUCTION: STAGNATING UNDER HEAVY TAX
BURDEN

SENSITIVE BUT UNCLASSIFIED. NOT FOR INTERNET DISTRIBUTION.

-------
SUMMARY
-------

1. (SBU) The rate of growth in Russian oil production has
dropped significantly in recent years and output may actually
decline in 2008. Production growth has slowed as declines in
output from existing fields have not been adequately replaced
by production from new fields. Investment in these
"greenfields" has been hampered by an onerous tax regime that
takes 90% of the revenues above $25 per barrel of exported
crude. Industry insiders believe that the GOR will have to
use tax relief to boost production. The GOR recently
proposed some limited upstream tax relief but most analysts
believe these are insufficient to restore growth. With
Russian production stagnant or declining and domestic demand
rising, global markets are likely to see a loss of Russian
crude oil supplies in the near term. End Summary.

--------------
SLOWING GROWTH
--------------

2. (SBU) Worries about Russian oil output have finally hit
the headlines with a spate of recent articles in the Wall
Street Journal and elsewhere noting slowing growth. This
follows months of analysts' projections that Russian oil
production was stagnating. In fact, this year may be the
first in a decade to see Russian oil production decline.
Russia's oil production of 9.76 million barrels per day (mbd)
in March 2008 is down more than one percent from a year ago.
Moreover, all major oil companies except Rosneft are
predicting declining output from their companies in 2008.

3. (SBU) After the fall of the Soviet Union, Russian
production initially plummeted amid economic collapse but
then rebounded dramatically as privatization took hold and
Western management practices and technology were implemented.
In the early years of the decade oil production was growing
at a double digit rate every year, from 6.5 mbd in 2000 to
9.2 mbd in 2004. In 2005, however, with the government
increasingly interfering in the sector, growth began to slow.
Investment lagged and output from old and declining fields
wasn't adequately replaced by new production. The rate of
growth dropped to about 2% per year from 2005 to 2007.

--------------
TAXES TO BLAME
--------------

4. (SBU) Although excessive state control in the sector
remains an obstacle to increased production, most industry
insiders with whom we have spoken point to the tax regime as
the major impediment to boosting output. Russia has some of
the largest untapped reserves in the world. However, most of
its current production is from old fields that have already
peaked and begun to decline, even with the successful
application of new technologies. The resources that hold the
key to Russia's future production lie largely in unexplored
areas, including East Siberia and offshore. Tapping these
reserves requires billions of dollars of investment in
exploration and production (E&P) as well as in physical
infrastructure such as roads. However, the country's onerous
tax structure severely limits the potential return on the
investments required to exploit new fields.

5. (SBU) An analysis British Petroleum (BP) shared with us
shows that when the price of the Urals blend (Russian oil
mix) is above $25 per barrel (it is currently about $107 per
barrel), the effective marginal tax rate of the combination
of the Mineral Extraction Tax (MET, 22%), the export tariff
(65%), and the tax on profits (3.1%), is over 90%. That
means that a rise of $10 in the oil price adds only $1 per
barrel to an oil company's bottom line and $9 to the state's
coffers -- indeed, this structure is the main source of the
huge cash surplus the Russian government has socked away in
recent years. Given the already-challenging commercial
uncertainties involved in exploiting Russia's oil and gas

MOSCOW 00001295 002 OF 003


resources, this tax burden is a major disincentive to new
production.

6. (SBU) A senior executive at one major Russian producer,
explaining the fiscal policy behind the oil tax regime, told
us the government is "just out to maximize revenue," with
little regard for the industry as a whole. An oil analyst at
a major investment house bluntly said the system was created
"to screw the oligarchs," and that now the government doesn't
really know how to fix it. Our contacts at another major
Russian oil company were more generous, observing that the
politicians writing the laws simply do not understand the
complexities of oil industry economics and have created a
system that is "not well thought out." They added that
taxing production is easier than taxing profits, and it
provides a more reliable revenue stream for a government
distrustful of industry's inclination to pay taxes fairly.

7. (SBU) Given maturing fields, rising costs, and high taxes,
oil producers face a grim future without enlightened
government actions. Industry sources specifically point to
the rapidly rising costs of exploration and production inputs
-- from engineers to steel to management talent -- and a
weakening dollar as squeezing margins and making it more
difficult to profit under the tax regime in Russia. For
example, one major oil company shared with us an internal
analysis showing that given current cost inflation and the
tax structure, their profit per barrel at a given price
declines to zero in just five years. And the head of a small
international joint venture here told us that while small
investments in existing fields can still pay off, the tax
structure is a project killer for the major long-term
investments needed to develop greenfields.

-----------
TAX REFORM?
-----------

8. (SBU) Under pressure from oil companies, most prominently
Lukoil and Rosneft, the government is considering steps to
ease the tax burden. Under the current tax regime, the MET
is applied at a Urals' price above $9 a barrel; in March, the
GOR announced a proposal to raise that threshold to $15. The
industry and the investment community welcomed the proposal,
which industry insiders tell us is likely to be implemented.
However, most also deemed the measure inadequate and question
whether it reflects government understanding of the depth of
the problem. One industry contact speculated that the
Ministry of Finance may have only agreed to the proposed MET
cut in acknowledgement that the rate should "at least be
adjusted for inflation".

9. (SBU) More promising from the industry's point of view,
was the announcement in April by Minister of Industry and
Energy Viktor Khristenko that the government is planning
additional tax relief, possibly including a further cut in
the MET rate. However, despite these inklings of
understanding by the state, the debate over tax relief is
continuing. Easing the burden on big corporations with large
profits remains politically unpalatable. A Duma leader was
recently quoted in the press as opposing proposed tax cuts
because "oil companies are doing fine." One TNK-BP economist
told us the industry needs to simplify the complicated
situation to a few key points so politicians and the public
can understand what's at stake.

----------------------
STAGNATION TO CONTINUE
----------------------

10. (SBU) Absent fundamental tax reform, industry insiders
and analysts tell us significant production growth will not
resume anytime soon, and that output may indeed begin to
decline. Moreover, even if the government implements reform
this year, there will be a lag before it begins to affect
production. A senior executive of a major international oil
company told us that with production at existing fields
beginning to decline, "it will be hard to bring new fields
online quickly enough to replace those lost barrels." Leonid
Fedun, the Executive Vice President of Lukoil, Russia's

MOSCOW 00001295 003 OF 003


second largest oil company, summed up the situation when he
told us he didn't foresee much change in production for the
"next few years."

11. (SBU) Russia is the second largest oil producer in the
world after Saudi Arabia. Even minor declines in output take
large absolute quantities of oil off the world market. A 1%
drop in output in Russia means roughly 100,000 fewer barrels
per day of oil for global consumers. Moreover, with a
booming economy driving rising domestic demand, Russia's
exportable surplus can be expected to decline without
production increases. Given the obstacles posed by the tax
regime as well as the long lead times for projects capable of
significantly altering this reality, the world could see a
meaningful loss of supply if Russian oil production continues
to stagnate and even greater loss of supply if it begins to
decline.
BURNS

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