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Four New "Profit Routes" Emerge in Oil

by | published December 18th, 2009

MOSCOW – Sergei Kudryashov likes pizza, poker, and American jazz. He's also deputy head of the Russian Ministry of Energy (Minenergo) and former VP at NK Rosneft OAO (LSE:ROSN), the No. 1 state-controlled producer.
I've known Sergei for almost two decades now. We compare notes whenever I'm in Moscow. This time, I briefed his team on key developments in the international oil markets. And, as usual, I came away from the meetings with some incredibly valuable information – information the public simply can't get on its own.

So let me share what I've just learned. It's a tremendous opportunity to profit from Russian oil – without investing a dime in the country itself . Indeed, as you'll see in a minute, there are several ways to make money right here at home.

First, here's what's going on.

's Oil Heyday is Ending, and That Means Profits for You…

Russia's traditional oil fields are maturing rapidly. Production declines are accelerating. I just witnessed this in my travels to Timan-Pechora, where I met with executives from several major Russian oil companies. For those unfamiliar, this region is the western Siberian center for Russian oil production.

And it's drying up.

Even with substantial secondary recovery programs (water, associated gas, and even carbon dioxide injections), extractable oil volume will continue to drop.

Rosneft and LUKOIL (OTC:LUKOY), Russia's No. 2 producer and largest private oil company, matter-of-factly estimate a decline of up to 7% by 2012.

At current levels, that translates into almost 257 million barrels in lost annual production.

Having less oil to sell will be catastrophic to central planners. That's because taxing oil and gas production and exports comprises more than 65% of the federal budget. So, as I explained last week, Russia needs to move production into new and more expensive locations – north of the Arctic Circle, into eastern Siberia and out onto the continental shelf.

This isn't so easy, though.

All three regions require considerably greater investment commitments, application of updated technology and access to foreign infrastructure and transport systems. Having made a statement last year with new legislation aimed at retaining the larger, more promising fields for Russian-only control, the Kremlin now finds itself between a rock and a hard place.

Under that law, only a handful of companies can run shelf projects – companies that are controlled by the Russian government and have at least five years of offshore experience. That leaves just two – Rosneft and and Gazprom OAO (OTC:OKZPY). Or three, if we consider Gazprom's oil unit, JSC Gazprom Neft (OTC:GZPFY), which is likely to bid separately for projects.

What's more, only Russian companies (state-controlled or private) can be the majority owners of strategic onshore deposits. Majority owners are defined as those having more than 50 million tons (366 million barrels) of crude or 500 billion cubic meters of natural gas.

When the law emerged, of course, oil was racing beyond $120 a barrel. And the government wanted to keep profits at home. But now that it needs foreign help, the Kremlin will be making changes to the law.

There's no way around it.

Major international oil companies simply don't enter a foreign project if it can't book a percentage of field reserves. In other words, if it won't make their stock go up, they won't do it.

I'll let you know as the Kremlin begins to phase in their changes to the law.

In the meantime, there are several ways to profit.

The Four “Profit Routes” to Russia's Oil

  1. Outside companies will benefit as a minority partner in a large Russian producer. ConocoPhillips (NYSE:COP), which owns a 20% position in LUKOIL, is the best current case in point. But others are quickly developing. China National Petroleum Corp. (accessible over the counter via CNPXF [CNPC Hong Kong]), for example, has parlayed $20 billion in bank credit for Russia's East Siberia-Pacific Ocean (ESPO) oil pipeline into a likely position in Rosneft.
  2. Foreign majors will continue to profit as minority partners in specific projects. Despite its acrimonious departure from controlling the Sakhalin II project, Royal Dutch Shell ADR (NYSE:RDS.A, RDS.B) is nonetheless well positioned for solid profits in its minority status in the project. Other majors finding a similar niche are Exxon Mobil (NYSE:XOM) in Sakhalin I and Total SA (NYSE:TOT) at Kharyaga.
  3. Majors have signed on to provide services for huge, carefully selected projects. That virtually guarantees discounted volume, Russian market access and the possibility of future involvement. Norwegian StatoilHydro (NYSE:STO). They both provide extensive technology and expertise to the giant Shtokman deposit in the Arctic.
  4. Finally, a number of well-structured and intentionally limited smaller companies are positioning themselves to become field owners below the strategic threshold – those that foreigners can still control outright. Several leading the list trade on the London Stock Exchange (LON: LSE), or the LSE's Alternative Investment Market (AIM) – for instance, Timan Oil & Gas PLC (LSE:TIMAN), Sibir Energy PLC (AIM:SBE), or Swedish Lundin Petroleum (LSE:OGYK).

Unlike they did in the past, these four “profit routes” will benefit from protection under Russian law. And they'll get considerable support from large Russian companies interested in developing joint ventures and sharing technical and infrastructure expertise.

That's great news for these companies… and their stocks.

Kent

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  1. Tomas
    December 18th, 2009 at 08:55 | #1

    How could you leave out TNK-BP, in a better position than most?

  2. Andrew
    December 18th, 2009 at 12:07 | #2

    I carefully select any oil/gas investments to avoid those which provide assistance to Russian firms. LET their oil “dry up”, and they will be much less powerful on the world stage. Witness how the Russians block every move proposed against Iran in the form of sanctions, because they LIKE the high price of oil, as it increases Russian revenues. Your article points out how the Russian government lives off of oil / gas taxation.

  3. bpw
    December 18th, 2009 at 12:12 | #3

    I work in the oil and gas industry and was surprised to see such a bullish position being taken for the Independents who are all suffering from a lack of reserves replacement. Annual declines are around 6% for most, which means earnings potential is reducing not increasing. If you look carefully at the terms being granted to the IOCs in places like Iraq you will realize that many are being forced to accept Technical Services Agreements and not Production Sharing Agreements. The former are far less profitable and its only a matter of time before high-end service companies find themselves in the grey area between contractors and operators. If my hunch is right then the cost structures of the IOCs are going to have to change before they start being a worthwhile bet.

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