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Analysis & Opinion
17.01.11 Energy Addiction Relapse
By Graham Stack

For a sober explanation of the strategic alliance between Russian state-owned oil company Rosneft and the multinational energy major BP, announced at a surprise press conference in London on January 14, one can turn to an unlikely quarter – Nikolai Patrushev, the former long-term head of the FSB and now the chairman of Russia's Security Council.

The fact that a top security official with an anti-terrorism remit is talking on energy policy says a lot about the real business of politics in Russia. Writing in the state-owned newspaper Rossiyskaya Gazeta on January 14, in advance of the announcement of the deal, Patrushev described the dilemma facing Russia’s energy industry. Noting that 30 percent of Russia’s GDP and 40 percent of budget revenues come from the hydrocarbon sector, he warned: “Our traditional energy potential is really declining continually. More than 75 percent of fields are already under exploitation, on average up to 50 percent have been exhausted. The main problem is the deterioration in the quality of reserves and the exhaustion of the traditional West Siberian fields. Under these conditions, the continental shelf is our key main reserve of hydrocarbons. Its opening has huge strategic and economic significance.”

No wonder then that all of Russia's big guns – with the notable exception of President Dmitry Medvedev – seem to have been involved in laying the groundwork for the Rosneft-BP deal. Beyond a share swap worth $7.8 billion that will see Rosneft take five percent of BP, in exchange for BP taking 9.5 percent of Rosneft, the tie-up targets not only the Arctic shelf exploration and production, but also downstream involvement in German refineries and potentially a deal involving the export of gas to China.

The BP-Rosneft deal thus involves energy diplomacy with Venezuela, the United States, Britain, Germany, and potentially also China. In fact, even Norway was involved: as Foreign Minister Sergei Lavrov remarked on January 13, summing up foreign policy results for the past year, the treaty between Russia and Norway on Maritime Delimitation and Cooperation in the Barents Sea and the Arctic Ocean signed in September of 2010 “exerted positive influence on the situation in the Far North as a whole.”

The deal proves again that Russia’s global diplomacy is focused on business operations and economic modernization, as described in detail by a Foreign Ministry document leaked last year on “Employing Russia’s foreign policy toward long-term development." And pulling the strings behind the deal-making is Russia’s energy tsar, Deputy Prime Minister Igor Sechin, who is also the chairman of the board of Rosneft and a close associate of Prime Minister Vladimir Putin, the former president.

So while there is much hot air blown about modernization at Dmitry Medvedev’s Kremlin, it is only when it comes to action on the hydrocarbon front that anything actually get done – by the government in the White House. “We have seen time and time again that even as the president and prime minister talk about wide-ranging reforms and investment priorities, the only real progress is in those areas where the most senior members of government are personally active,” said Chris Weafer, chief analyst at the UralSib investment bank.

It also proves that when it comes to diversifying Russia’s economy away from dependency on crude oil prices, the path actually trod is that of diversifying Russia’s existing energy business into downstream capacities, new markets and new technologies, rather than nurturing new non-resource sectors.

Regarding technology, while the media talks a lot about BP’s deepwater expertise as demonstrated in the Mexican Gulf, BP CEO and Russia hand Bob Dudley made it clear that BP's Alaska experience is the critical competitive advantage when it comes to drilling on Russia’s Arctic shelf. “This is not deep water,” Dudley told newswires on January 14. “This is shallow water. It's very cold. It requires the kind of experience that we have from operating in Alaska.” So Alaska, former Russian territory, has come full circle in the form of BP. As former BP Chairman John Browne described in his autobiography “Beyond Business,” it was BP’s successful exploration in Alaska that made the company what it is today – producing five percent of the world’s oil. Moreover, the Alaskan frontier oil experience of the 1970s equipped BP mentally for its pioneering entry into post-Soviet oil in the 1990s.

Now the technologies BP developed in Alaska, for shallow Arctic seas that freeze up over half the year, will come home to Russia: an intrinsic of the BP-Rosneft tie-up involves a technology transfer to the Russian side, specifically an Arctic technology center in Russia to apply BP’s offshore experience to develop extraction technologies for the Russian context.

The BP-Rosneft joint exploration venture is to be weighted 70 percent to 30 percent in favor of the Russian side, and this should exclude the problems faced by the TNK-BP 50 – 50 joint venture originally headed by Bob Dudley. That project ran into major difficulties in 2008 due to accusations by private Russian shareholders that BP was not trying to grow the company’s value independent of BP. In particular, the Russian investors accused BP of failing to train up Russian staff in top positions, relying instead on expensive expat imports.

As Putin commented on January 14, “wit once bought is worth twice taught.” Rather the lessons of the Deepwater Horizon disaster that BP suffered in the Gulf of Mexico in April of 2010, it is the lesson learned by BP in 2008 that may make the company a good partner for Russia, in Igor Sechin’s view. Sechin expects international collaboration and access to resources in Russia to involve technology transfer and the opening up of international upstream and downstream opportunities. “We expect this joint venture to assist Rosneft in its recently announced plans to expand its international presence, and it could potentially become the first step in transforming Rosneft from a leading national company to a leading global player,” said energy analyst Ildar Davletshin at Renaissance Capital investment bank.

The downstream opportunities are already clear as of fall 2010, when Venezuelan national oil company PdVSA agreed to sell Rosneft its stake in its German oil-refining joint venture with BP, with BP's consent. The joint venture, Ruhr Oil, comprises major stakes in five German oil refineries that together supply around 25 percent of the giant German market for oil products. This downstream deal gives the Russian oil national champion a foot in the door of the strategic European market for oil products. According to Kremlin strategists, with Europe buying around four-fifths of Russia’s crude exports, any Russian hopes to move up the value-added chain and diversify away from exposure to the fluctuating crude price depend on building up refining capacity and moving toward the end customer.

Financial analysts are skeptical about the returns to Rosneft from European refining, with margins currently close to zero. But there is no doubt for Igor Sechin that downstream expansion on the European market is a crucial part of the vision. In 2009, in his first Western media interview, he told the Wall Street Journal of his "dream” for Russian oil. “I think that oil should be refined. Of course we can't do it all at once, but in ten, 15, 20 years, I would really like for Russian crude to be refined on Russian refining assets or those with Russian ownership. If we're talking about Russian hydrocarbons, the maximum effectiveness will be attained when they're refined on our assets."

Besides Arctic technologies and downstream capacities, the alliance with BP may pave the way toward another development trajectory for Rosneft, which could seal the company's transformation into a real diversified energy holding: natural gas exports to China. In parallel with the BP negotiations over the Arctic and downstream, the protracted story of the rights to exploit the giant East Siberian Kovykta oil field has gathered pace. BP’s Russian joint venture, TNK-BP, owns the license holder to the field, Rusia Petroleum. However, Rusia Petroleum was unable to proceed with exploitation because gas pipeline monopolist Gazprom had blocked access to the gas pipelines. As a result, Rusia Petroleum is now undergoing bankruptcy, with a decision on the license expected soon. TNK–BP shareholder Viktor Vekselberg told newswires in March of 2010 that the company would sell the license to Rosneft for $700 to $900 million.

The gas field has strategic significance for Russia because it will most likely supply the Chinese market. Russia has been negotiating gas export contracts, and the construction of the necessary infrastructure, with China for some years now, but the two sides have failed to reach a deal. According to analysts, for reasons of supply security China is known to want a direct pipeline link to a dedicated gas field rather than simply plugging into the Gazprom network, and the Kovykta field may have been earmarked for this purpose. Were Rosneft and BP to cooperate on the field, it would expand Rosneft's role as being China's energy partner, after the company closed a huge oil supply deal in 2009. Rosneft's leverage in price negotiations would be greater.

So while, from his ivory tower, president Medvedev pursues lofty goals of modernization – and diversification away from natural-resource dependency, tangible modernization is being stamped out deal-by-deal by the same old Putin crowd as before, using the same old box of tricks. Coincidentally, on the same day the deal with BP was announced, the price for Brent oil breached $100 for the first time since the global crisis started in October of 2008. Whether modernization a la Sechin will decrease or increase Russia's vulnerability to fluctuating crude oil prices remains to be seen.
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