Why Russia's Oil Fields Will Soon Be Crawling with Westerners

Western oil majors are about to help Moscow solve its energy problem. And that could be a boon for investors.

The traditional Russian oil fields in Western Siberia are well past peak production. Some satellite fields in the region remain, but the extraction gains will be marginal.

My sources in Russia's Ministry of Natural Resources and Ecology (MNRE), the government entity responsible for distribution and oversight of development leases, now acknowledge that the country's overall crude oil production could decline by more than 7% over the next several years.

That's a staggering total. And the Kremlin is not about to accept such an extraction rate decline, especially now that prices are rebounding on the global market.

Officials from Prime Minister Vladimir Putin on down are pushing a bold plan to move into three regions known to have significant resources:

  • North of the Arctic Circle.
  • Eastern Siberia.
  • Out Onto the Continental Shelf.

All three are very expensive areas in which to work and will require billions in exploration and production (E&P), capital expenditures (capex) and new technology.

That has led to Russian administrators talking for the first time in years about allowing more foreign investment into the sector. There will be opportunities for production companies, especially those prepared to develop smaller fields (those below the "strategic" level of 50 million tons, or 365 million barrels, for which new laws require Russian majority ownership).

But the real opportunities will emerge elsewhere.

A Ton of New Business for Oil Field Services

To pull off this massive production shift into regions that are difficult to develop, Russia will need considerable help in oilfield services (OFS) - everything from seismic and geological to drilling, well maintenance and workover provisions, wellhead operations and technical support.

As Moscow readies major new pipeline systems to the Pacific coast - bypassing the Bosporus and increasing flow to expanding port facilities on the Black and Baltic Seas - it needs to rev up new production as quickly as possible. That will require OFS provision.

A lot of it.

Russia will experience significant financial and credit constriction well into 2010, since the international crisis hit there later than elsewhere. Thereafter, however, new production will need to be coming on line, especially since Moscow depends upon the export of hydrocarbons for over 60% of its budget revenue.

That sets the stage for a dramatic increase in OFS demand.

In fact, the Russian OFS sector will experience significant growth over the next decade, clearly outstripping the ability of domestic providers to keep pace. This has already surfaced as a problem in the Duma, the national parliament.

Some political forces are worried that actions of the last several years, in which the state progressively came to take control of oil and gas production within the country, may be undone by an inability to service the government-owned and administered extraction companies. As a consequence, some legislative moves have begun to limit foreign access to the Russian OFS market.

Some politics will play out here, but more bark than bite.

The Kremlin reaction has been cool to such moves in the legislature. Officials recognize that they need the technology and cannot match that need with domestic services in the short-term. Nor do they have the investment available to develop the OFS sector in a few years.

New programs have been introduced to increase local production of rigs and offshore platforms, and the country retains much of its OFS infrastructure. But the manufacturing steps are too little, too late, and the infrastructure is hardly competitive with the technical sophistication of outside providers. The Russian government and the major operating companies it controls - Rosneft Oil Co. (PINK: RNFTF) and OAO Gazprom (OTC ADR: OGZPY) - require foreign help.

Western OFS Providers See the Major Opening

The Russian approach now is to favor outside service companies while discouraging majority ownership of the actual production.

That does not help a major vertically integrated oil company seeking reserves to book. But it fits quite nicely with how OFS providers operate. The know-how and technical base being brought in will also help the Russian sector upgrade its own activities. Given the increasing need for OFS services, the risk of government barriers to foreign involvement is quite low.

Major companies such as U.S.-based Schlumberger Ltd. (NYSE: SLB), Halliburton Co. (NYSE: HAL) and Baker Hughes Inc. (NYSE: BHI) have been in Russia for some time and have developed a market presence to benefit from the sector expansion. Foreign companies in the aggregate currently do not control more than 15% of the total Russian OFS market. That means there is upward movement remaining before any political reaction becomes a genuine issue.

Even then, acquisitions of local companies may improve the situation even more. Once we reach this time next year, as one of my Russian contacts recently told me, "there will be more business than the companies can handle."

Investors can ride the outside companies into the market. However, there is another way to participate in the moves to come.

A significant consolidation has been underway in the Russian OFS sector. Two large and rapidly expanding holdings have emerged. Both have undergone initial public stock offerings (IPOs) on the London Stock Exchange (LSE), where they now regularly trade. This is becoming the norm among developing market oil-related companies, with London emerging as the preferred place to raise operating cash.

Eurasia Drilling Co. Ltd. and Integra Group together now control the largest OFS base in Russia. They are certain to become involved in additional merger-and-acquisition (M&A) activity, become preferred joint venture partners for foreign players and continue to receive governmental preferential treatment (since the Kremlin wants to consolidate as much ongoing OFS work as possible in Russian hands).

Rather than competing with them, there is considerable flexibility developing. As a British OFS colleague of mine observed during a Moscow chat last month, "there are no Russian companies capable of servicing the sector, regardless of how large those companies become."

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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