Putins Dilemma: To Sell

Or To Nationalize Oil
Assets
By Dalan McEndree
Posted on Tue, 15 March 2016 23:36 | 0
According to a March 11 Bloomberg article, the Russian government is considering
changes in the tax regime for the Russian oil and gas industry in order to bolster
government revenues.
Should Vladimir Putin consider nationalizing this industry as one of the alternatives?
Possiblyif the U.S. shale revolution represents a paradigm shift that will result in sub$50-$60 crude prices and substantially lower natural gas prices well into the future.
Should this be the case, without significant changes in its approach to generating
revenue from this industrywhich historically has funded ~50 percent of the
governments budgetit seems the Russian government could consign itself to
perpetual budget revenue penury and Mr. Putin to punishing pressure on military
spending,
his
priority.
The 2016 Budget Debacle
As 2016 approached and crudes price fell toward $30 per barrel, the Russian
government found itself in a desperate search for revenue to balance a budget it had
developed based on $50 per barrel crude. The Finance Ministry initially proposed to
extract the necessary incremental revenue from Russias oil and gas industry through
an increase in the mineral extraction tax. Immediately, the industry and its supporters
in the Russian government (the Energy and Economic ministries) vociferously objected
and warned of dire consequences: reduced investment, stalled output growth, and
eventually production cuts.
While the two sides eventually agreed instead on postponing the planned reduction in
the export customs tariff rate from 0.42 to 0.36, crudes continued fall into the New Year
renewed pressure on the budget. Finance Minister Siluanov in mid-January projected
that an additional $20 billion in revenue was needed to close a deficit that his ministry
estimated could grow to 6 percent of GDP.
This forced the Russian government to renew its search for revenue. The search
included heretofore sacrosanct sources. Government officials broached the possibility of
selling government shares in such national champions as Rosneft and Aeroflot. A
February 19 Reuters article reported that the Finance Ministry, with several other

ministries support, had proposed cutting 2016 military procurement5 percent, or

~$1.29 billiona proposal which Putin repeatedly and recently has denied.
Related: Which Presidential Frontrunner Is The Best For Energy?
In the last few weeks, hoping to exploit a loophole it perceives in the U.S. and European
economic and financial sanctions, the Russian government announced its interest in
raising $3 billion through the sale of Eurobonds (the U.S. Treasury has warned U.S.
banks against participating. Whether European governments will follow suit is not yet
known).
Such measures may help the Russian government close the 2016 deficit. However, each
is a one-time in nature and will provide little if any relief in future years. For this, the
Russian government requires a source or sources that steadily will generate revenue.
Russias economic predicament limits the governments options. In its fall 2015 World
Economic Outlook edition, published October 6, the IMF forecast that the Russian
economy, in constant (inflation-adjusted) Ruble terms and in current U.S. dollar terms,
will remain in recession until 2017 and that growth will remain subdued through 2020.
The IMF data also forecasts, in current U.S. dollar terms, a ~$280 billion decrease in
government revenue in 2015 from 2014, a further ~$23 billion decrease in 2016, and
revenue in 2020 still below revenue in 2014. Since Urals crude may average less than
$50 in 2016, the IMFs October 2015 revenue estimates for 2016 may turn out to be
optimistic. (In the chart below, 2013 and 2014 crude prices are actual prices, 2015-2016
prices are estimates, and for 2017-2020, the IMF assumed that crude prices would
remain stable in real terms).

(Click to enlarge)
The Government Funding Crisis
As noted above, the Russian oil and natural gas industry generates ~50 percent of
Russian budget revenues. The bulk of these revenues come from three levies: the
mineral extraction tax; customs duties on hydrocarbon and hydrocarbon product
exports (except exports to countries in the Russian-led Eurasian Customs Union (EACU)Belarus, Kazakhstan, Armenia, and the Kyrgyz Republic, which are customs-duty free);
and excise taxes on domestic sales of refined petroleum products. (According to a March
14 Bloomberg article, Gazprom and Rosneft, Russias natural gas and crude national
champions respectively, alone account for 30 percent of the budget. In 2014, the two
companies generated ~$109 billion in such taxes).

The following table displays the current Russian government methodology for
calculating the mineral extraction tax and the export customs duty on crude. (The tax
code offers breaks in some cases on the mineral extraction tax depending on the
cost/difficulty of extracting crude). The base tax rates for export customs duty are set at
$29.2 per metric ton (the Russian government sets a metric ton equal to 7.3 barrels,
hence the per barrel rate in the table). The export customs duty rate on the difference
between the Urals market price and the floor price for crude above $25 per barrel was
scheduled to decline to 0.36 in 2016, but the reduction was suspended, and to 0.30 in
2017. It was 0.59 in 2014, 0.60 in 2013.

(Click to enlarge)
The customs duty on petroleum products exported to non-EACU countries is set as a
multiple of the crude rate. The following table, from Lukoils 3Q Management Report,
shows the multiplier rate and the US$ amount collected per metric ton for the first three
quarters of 2015 and 2014:

(Click to enlarge)
The following table illustrates the sharp decrease in actual revenue flowing to the
Russian government from these levies in 2015 from Russias two largest domestic crude
producersRosneft and Lukoil. (The mineral extraction tax is the primary component of
taxes other than income~92 percent. The other components are property, social
security and other social contributions for both Rosneft and Lukoil. Rosneft reports
excise tax in this category, while Lukoil reports it with export customs duty). Through
2015s first three quarters, when Urals crude averaged $54.61, these two companies
generated ~$65 billion less for the Russian government versus the $109 billion they
generated in full-year 2014, and ~$44 billion through 2015s first nine months). Since
the Urals crude price averaged below $50 per barrel in 4Q, these two companies likely
delivered less in 4Q than the $15 billion they generated on average in 2015s first three
quarters.

(Click to enlarge)
Theoretical Mineral Extraction Tax and Export Customs Tariff Revenues
How much can the Russian petroleum industry generate for the Russian government
given the current tax structure and tax rates from the mineral extraction tax and the
export customs duty? For the sake of simplicity, the following estimates assume that
Russia exports crude only, not petroleum products (which would require estimating the
export volume of each petroleum product and tax rate multiplier), and that all crude
exports are subject to export customs duty (i.e., including those to EACU countries). The
estimates also ignore the impact on individual oil companies and their financial situation
(for example, on an overleveraged Rosneft).
The IEA estimates that Russian crude output averaged 11.06 million barrels per day in
2015according to most observers, the Russian domestic industrys peak level. The
following table projects mineral extraction tax revenues at current mineral extraction
tax rates (assuming no tax breaks for difficult-to-extract resources):

(Click to enlarge)
The IEA estimates that in 2015, Russian domestic consumption averaged 3.59 million
barrels per day; thus, assuming Russia exports only crude, it exported 7.47 million
barrels per day:

(Click to enlarge)

Combined, and without tax breaks, the mineral extraction tax at current domestic
output levels and the export customs duty at current crude export levels at $50 per
barrel crude would theoretically generate less than $100 billion overall in revenueand
just 27.50 percent of the $348.72 billion the crude industry contributed to the Russian
budget in 2014 based on budget revenue calculations using IMF data. (Part of the $114
billion difference between the estimated revenue of $234 billion at $100 crude and the
estimated $348.72 billion collected in 2014 results from the lower export customs duty
rate, 0.42 versus 0.60 in 2014 ($37 billions) and the contribution from natural gas
Gazprom paid $34 billion in 2014 in these taxes).
Related: Is The Latest Rally Yet Another False Start?

(Click to enlarge)
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Increasing mineral extraction and export customs duty tax rates could substantially
increase the Russian governments take from the Russian oil industry. Reverting to 2014
export customs duty rate of 0.60 on the difference between Urals market price and the
$25 floor price and raising the mineral extraction tax rate on the difference between the
Urals market price and the $15 floor price to 0.75 would generate revenues equivalent
to ~45 percent of the $348.72 billion collected in 2014 at $50 per barrel crude. At $100
per barrel, the take would be 77.61 percent of the $348.72 billion.

How much revenue would the Russian government collect from the mineral extraction
tax if the Russian government set the mineral extraction tax rate on difference between
the Urals market price and the $15/barrel floor price at 100%--in effect paying Russian
companies a fixed $15 per barrel fee to extract the oil and limiting their revenues to
that the $15 floor price generated (plus, of course, what they generated from petroleum
product sales)? In this case, the mineral extraction tax alone with $100 per barrel crude

would generate some 67% of the revenue the Russian government collected in 2014
from both the mineral extraction tax and the export customs tax generate at $100 per
barrel crude.

(Click to enlarge)
Data from Lukoils 3Q financial and management reports (which reports in U.S. dollars)
can illustrate what this would mean in practice, while keeping the export customs duty
on the crude price differential at 0.42. According to Lukoils 3Q financial statement,
Lukoil paid the Russian government $7,747,000,000 in mineral extraction taxes, and
$6,998,000,000 in taxes other than income taxes, or $14,745,000,000 in total. This
was 19.7 percent of revenues of $74,712,000,000. Since Lukoil produced 647,670,000
BOE domestically and internationally in 2015s first three quarters, these taxes
generated $26.63 per BOE in revenue for the Russian government, while generating
revenues of $134.92 per BOE in revenues for Lukoil (since Lukoil also produced 43.5
million tons of refined products in 2015s first nine months).
The following table displays Lukoils 9 months 2015 operating totals results and results
per BOE:

(Click to enlarge)
The $37.487 billion in Purchased crude oil, gas and products, which included $23.116
billion in inter-segment (i.e., intra-company) sales, constituted the greatest expense.
The following table, from Lukoils 3Q 2015 Financial Report, provides Lukoils results per
operational segment (with Elimination eliminating duplication through inter-segment
sales). The E&P segment sold $3.520 billion in BOE equivalent to third parties and

$21.222 billion to Lukoils Refining, Marketing, and Distribution (RM&D) segment, which
it turned into $70.239 billion in revenue, including $69.610 billion from sales to third
parties, and $629 million in inter-segment sales.

(Click to enlarge)
Since Lukoils E&P segment produced 647,670,000 BOE and generated $24,742,000,000
in revenue, its revenue per BOE sold to third parties and Lukoils RM&D segment was
$38.20. (Lukoils methodology for pricing E&P crude is as follows: As a result of certain
factors considered in the Domestic crude oil and refined products prices section on
page 9, benchmarking crude oil market prices in Russia cannot be determined with
certainty. Therefore, the prices set for inter-segment purchases of crude oil reflect a
combination of market factors, primarily international crude oil market prices,
transportation costs, regional market conditions, the cost of crude oil refining and other
factors).

(Click to enlarge)
In 2015s first three quarters, Lukoils RM&D segment generated $70.239 billion in
revenues. Assuming that the RM&D segment purchased all the purchased crude oil, gas,
and products, it netted $63.97/BOE from the 567,000,000 BOE it purchased from
Lukoils E&P segment (assuming the E&P segment charged the same price to third
parties that it charged to Lukoils RM&D segment):

(Click to enlarge)

Using this approachthe Russian government claiming through the mineral extraction
tax all revenue above the $15 floor price and leaving the export customs duty rate on
the price differential at 0.42, the Russian government would increase its take some $10
billion, from $14.7 billion to $24.3 billion (the difference between the reported revenue
and the revenue in the below table derives from inter-segment eliminations).

(Click to enlarge)
Kto Kogo Who Whom
If its likely that the U.S. shale revolution means that crude prices will remain subdued
well into the future, should Vladimir Putin nationalize the Russian energy industry?
Kto kogo (pronounced kto kovo) is a political principle that Vladimir Lenin made famous
in 1921 and other Soviet leaders, notably Trotsky and Stalin have used. It translates as
who whom and means who [defeats] whom, or whose interests will dominate whose
interests (see Wikipedia for a discussion).
The principle accurately describes the relationship between Vladimir Putin (and the
Russian government) and the Russian energy industry: whose interests will prevail
which side will take the lions share of the still-considerable revenues the industry
generates? On one side, the Russian government desperately needs revenues, yet faces
an indefinite period of subdued economic activity and therefore subdued revenue. On
the other side, Russian energy companies want to remain independent, to develop the
most lucrative resource plays, no matter where they are, grow production, and increase
profitability and absolute profits.
At first glance, nationalization might not seem to be a necessary, practical, or attractive
solution to the Russian governments financial pressures. As the foregoing discussion
indicates, the government significantly could increase the resources it extracts from the
industry through the existing tax systems structure.
Related: Massive Protests Over Chinese Coal Closure
In addition, nationalization might be interpreted as a desperate step by a panic-stricken
government. Also, existing shareholders, company management, and others likely
would object strenuously. Moreover, buying out shareholders also would be expensive
(although less expensive if preceded with tax increases): according to the Bloomberg
article cited above, Rosnefts and Gazproms combined market value is about $100
billion.
Yet nationalization could offer significant benefits. The Russian government would
capture all the revenue crude and natural gas sales generatein particular all the
revenue it currently exempts from taxation below $15 per barrel floor for the mineral
extraction tax and the $25 floor for the export customs duty.

Nationalization could be useful in focusing the Russian energy industry on developing

Russian rather than foreign energy resources. At present, Russian companies continue
to invest outside of Russia (and, as taxes rise in Russia, investing overseas could
become more attractive than investing in Russia). For example, Rosneft recently
borrowed $488 million from Gazprombank to finance natural gas-related projects in
Venezuelathis at a time when Rosneft faces declining production in Russia. Lukoil
invests in E&P outside Russia ($2.623 billion 2015s first nine months). In 3Q 2015, its
output in Iraq averaged 190,000 barrels per dayand each Lukoil-produced barrel
produced in Iraq rather than Russia competes with domestically-produced barrels for
sales to China and deprives the Russian government of mineral extraction tax or export
customs duty.
Nationalization could help rationalize and simplify the industry and increase its financial
foundation. Presently, the Russian energy industry is riven with rivalries and conflict.
Rosneft and Novatek are constantly at war with Gazprom over its monopoly on natural
gas exports, which consigns them to selling natural gas at significantly lower domestic
Russian prices. Lukoil invests in Iraq as Rosneft searches for capital to develop
expensive crude resources in Eastern Siberia. Rosneft borrows $488 million for natural
gas projects in Venezuela as Novatek searches for capital to complete the first train of
its Yamal LNG facility in 2017 and capture first-mover advantage in Europe and Asia
over U.S. LNG producers.
Gazprom continues to generate substantial cash flow, which, in a nationalized energy
industry, the Russian government could use to pay down some of the ~$24 billion in net
debt that remains from Rosnefts TNK-BP acquisition.
Were the industry restructured into two verticalscrude and natural gasE&P
investment could be concentrated on the most lucrative crude and natural gas
resources in Russia, and thus Gazprom would not be loath to use the natural gas Rosneft
now produces to supply China under its Power of Siberia contract and reduce the
volume it will have to extract from new, expensive-to-develop resources in Eastern
Siberia and therefore capital expenditures. The Russian government likely could borrow
at lesser rates than Russian energy companies, given its sovereign status, and the
potential cash flow from a consolidated energy industry.
By Dalan McEndree for Oilprice.com
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ABOUT THE AUTHOR

Dalan McEndree
Dalan McEndree has a BA in history, MA in European History, M.Phil. in Russian and Soviet history,
Soviet economics, and International economics, and MBA in full bio
More articles from Dalan McEndree
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