Russia Needs Exploration Technology; America Needs Oil Reserves

29-Sep-2011

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An eternal optimist, Liu-Yue built two social enterprises to help make the world a better place. Liu-Yue co-founded Oxstones Investment Club a searchable content platform and business tools for knowledge sharing and financial education. Oxstones.com also provides investors with direct access to U.S. commercial real estate opportunities and other alternative investments. In addition, Liu-Yue also co-founded Cute Brands a cause-oriented character brand management and brand licensing company that creates social awareness on global issues and societal challenges through character creations. Prior to his entrepreneurial endeavors, Liu-Yue worked as an Executive Associate at M&T Bank in the Structured Real Estate Finance Group where he worked with senior management on multiple bank-wide risk management projects. He also had a dual role as a commercial banker advising UHNWIs and family offices on investments, credit, and banking needs while focused on residential CRE, infrastructure development, and affordable housing projects. Prior to M&T, he held a number of positions in Latin American equities and bonds investment groups at SBC Warburg Dillon Read (Swiss Bank), OFFITBANK (the wealth management division of Wachovia Bank), and in small cap equities at Steinberg Priest Capital Management (family office). Liu-Yue has an MBA specializing in investment management and strategy from Georgetown University and a Bachelor of Science in Finance and Marketing from Stern School of Business at NYU. He also completed graduate studies in international management at the University of Oxford, Trinity College.







By the Casey’s Research,

Put yourself in Putin’s shoes. During his presidency (from 2000 to 2008), Russia accounted for 80% of the growth in oil production outside of the Organization of Petroleum Exporting Countries (OPEC). Russia’s increased output matched the growth in demand by China and India almost barrel for barrel. But about four years ago, Mother Russia’s oil production plateaued at just over 10 million barrels a day and has failed to increase appreciably since. Now production is starting to decline.

The problem is entirely manmade. Russia has the world’s eighth-biggest oil reserves, at 60 billion barrels, and geologists reckon there are another 100 billion barrels waiting to be discovered. But poor fiscal management is choking out new production. The government levies an export duty of 65% when prices are above US$25 a barrel; when one adds in the various corporate, payroll, and production taxes, the state’s take comes in at as much as 92% of profits. Combined with rising production costs, taxes of that level make it pretty hard to make a profit on new investments.

The government does give tax breaks on production from older fields, but that has simply encouraged oil firms to concentrate on squeezing every last drop out of operational fields. And that made sense until recently, because oil fields that had fallen into disrepair after the collapse of the Soviet Union could be revived cheaply and easily. It was this focus on reviving old fields that lifted Russia’s production from 6 million barrels per day to almost 10 million barrels per day in the early 2000s.

This strategy has been yielding diminishing returns for some time now. To maintain production today requires new investments, while to increase production demands huge investments to develop new fields in remote areas. And it is not just money that is needed – these remote fields also present a raft of technical challenges in areas where Russian companies have little experience.

Oil and gas were the foundation of Vladimir Putin’s reign and have preoccupied his successor, Dmitry Medvedev (who was previously chairman of Gazprom, the state-controlled gas giant). The flow of petrodollars into Russia during Putin’s presidency created a sense of stability in a country plagued by economic woes and gave Russia more clout on the world stage. Not surprisingly, Putin (who many say continues to control the country and who is expected to announce his candidacy for the 2012 presidential race soon) wants Russia’s oil and gas industry to get back to growth.

From that perspective, it was no surprise to see Putin happily posing for pictures with Exxon Mobil CEO Rex Tillerson after news broke that Exxon had inked a US$3.2-billion deal with OAO Rosneft, Russia’s biggest oil company, to jointly explore the vast tracts of Russia’s arctic region that geologist believe could hold somewhere between 30 and 100 billion barrels of oil.

Exxon has what Russia needs: deep pockets and expertise in new exploration methods tailor-made for difficult terrain. And it turns out Russia offers what Exxon needs too: the potential to greatly increase its reserve count.

The Challenge of the Kara Sea

The blocks in question are in the south Kara Sea, part of Russia’s continental shelf. Known as East-Prinovozemelsky, the area is thought to hold a gigantic but underexplored oil and gas field. If it does hold tens of billions of barrels of oil, it would be one of the largest oil discoveries in the world in the last 50 years, though it remains to be seen how much of the oil is economically recoverable.

The challenge is the location. Water depths in the target area range as deep as 350 meters; storms sweep across the waters churning up huge waves; and in the winter Kara Sea temperatures drop as low as minus 50° F, creating massive ice floes that would threaten any oil platform.

It is precisely because of these challenges that Rosneft sought international help in exploring East-Prinovozemelsky. Exxon has experience exploring in such conditions – the company’s Hibernia offshore project in Canada faces similar climatic challenges – while Rosneft does not.

On a grander scale, the Exxon-Rosneft deal signals a recognition by the Kremlin (spearheaded by Putin) that Russia needs at least some Western involvement in its energy sector. To reverse its sliding oil production, Russia needs an infusion of exploration expertise and capital. And those are two things Exxon has in spades.

Exxon will solely fund the initial exploration states of the projects, to evaluate the blocks’ commercial potential. As part of that effort the partners expect to collar their first exploration well in 2015, once Russia finalizes its new tax regime for offshore projects. They then hope to start producing oil early in the next decade.

The joint venture extends beyond Russia’s arctic. Rosneft will also start participating in Exxon’s deep-water projects in the Gulf of Mexico and its unconventional tight oil projects in Texas. Those deals will be finalized in the first few months of 2012. The partners have not yet specified which projects are under consideration, though they did indicate that most of the contenders are in the exploratory stage.

BP’s Loss Is Exxon’s Gain

If the Exxon-Rosneft deal sounds vaguely familiar, it’s because BP signed a similar one last year… only to have the agreement fall through when the British company’s other Russian joint venture partner challenged it in court.

BP announced its US$16-billion Rosneft deal with much fanfare in January, saying the arctic venture would underpin its future growth. The deal was also a much-needed bit of positive news for the beleaguered British company, still reeling from the Deepwater Horizon explosion and massive oil spill in the Gulf of Mexico.

However, the BP-Rosneft deal soon found itself tangled in a legal web. The problem was that BP already had a joint venture in Russia with a company called TNK, which is owned by a group of Russian oligarch billionaires. The TNK partners filed for a court injunction blocking the Rosneft deal, arguing that their deal with BP identified TNK as BP’s exclusive vehicle for investments in Russia. The court agreed and granted the injunction. In May BP made a final effort to save its Rosneft deal, teaming up with Rosneft to try to buy out the TNK partners for more than $32 billion in cash and stock. When that transaction fell apart at the last minute, BP was forced to pull the plug on the Rosneft deal.

It is important to note that neither the Kremlin nor Rosneft had anything to do with the deal’s demise. It really was BP’s mistake – BP’s management thought it could violate the terms of its TNK deal, assuming that Putin would sweep in and make the TNK partners suck it up. But the Russian prime minister did nothing of the sort, which left BP hung out to dry and with no one to blame.

Kudos to Exxon

Exxon’s share price barely moved on the news, but that belies its importance. Sure, US$3.2 billion represents less than 1% of Exxon’s market cap, and any cash flows from potential discoveries are years away. But exploring for oil is a long-term game, especially when a company is looking for the next Big One. Just as importantly, the deal validates Exxon as an industry-leading operator when it comes to massive, technically challenging projects.

And it shows that Exxon has proven it has what it takes to operate in Russia and partner with a state-owned company. Exxon has already been working with Rosneft for 15 years on the major Sakhalin-1 offshore project in Russia’s far east. The partners have put two fields at Sakhalin-1 into production since 2005; the operation now produces more than 250,000 barrels of oil and 140 million cubic feet of natural gas per day.

As an interesting side story, the need to negotiate a new deal may have pushed Exxon and Rosneft to agree on a long-standing issue at Sakhalin-1. For years, the partners have been at odds over how to develop one of their other huge resources: the Chayvo field, which contains 17 trillion cubic feet of natural gas. Exxon has always wanted to sell the gas directly to China, which conflicts with Gazprom’s desire to control all of the gas from the Sakhalin projects (there are others, including Sakhalin-2, which was majority owned by Royal Dutch Shell until the Kremlin forced Royal Dutch to sell half its stake to Gazprom – a less successful Russian gamble). In June, Gazprom said it expects to reach an agreement with Exxon on Sakhalin-1 by the end of the year… a deal that we can be sure Exxon ironed out ahead of signing its new deal with Rosneft.

Exxon’s agreements with Rosneft share one key trait: Neither involves Exxon taking a stake in its Russian partner, a situation that invites trouble when the shared projects are in Russia. And Exxon added another layer of protection in its new Rosneft deal – by inviting Rosneft to take stakes in US projects, Exxon bought itself some extra insurance against political meddling down the road, as Rosneft will too have something big at stake.

So Exxon and Rosneft have found themselves able to work together, which in itself is significant. And they share a common goal – the desire to use new technologies to unlock massive new offshore reserves. It is hard – given Russia’s history of changing the rules to suit its needs – not to wonder whether Exxon has signed a deal with the devil. But for now let’s focus on the fundamentals: The buy-in is cheap (relative to Exxon’s bank account), and the potential pay-out is enormous. On top of that, the Russian oil industry (in cahoots with the Kremlin) essentially plays by whatever rules ensure they win the game. From that perspective, Exxon’s best bet is to put itself on their team.


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