Foreign Capital Russian Oil Infrastructure Needs Is Not Coming

August 8, 2004 - TheStreet.com: Street Insight

In my mind there are two issues that are of concern. First, interruption of much-needed oil flow from Russia (a very valid and important question since Yukos is responsible for 20% of Russian's oil production). Second, the question in my mind that is even more important, is the impact of the Yukos scandal on the future investments in Russia.

It is most likely that in whatever legal form Yukos emerges from this fiasco it will be pumping oil. The more immediate issue here though, since Russian government froze most of Yukos' assets, is that it could potentially cause a stop of oil production. Interruption of oil production for a couple of days, even weeks is not good for the world markets, but they can definitely handle that. The more crucial issue here is would Yukos be able to produce oil at the same level after oil wells were idle for a period of time?

After talking to the old oilman and engineer (and may I mention a hedge fund manager at the same time) Ed Stavetski, I was advised that temperature is a key factor to the resumption of oil production. Currently, temperature in Siberia is about 42-60 degrees Fahrenheit, which is warm enough to make it unlikely for wells to freeze. Ed advised that in case of interruption, additional pressure and heat may be necessary depending on oil viscosity and surface temperature to pump oil to the surface -- all of which cost large amounts of money to supply, thus hindering the profitability of oil wells and requiring additional investment. Also, one needs to understand the Russian psyche. Russians get compensated in two ways: in rubbles and in "hope" (though dollars are preferred). After the collapse of the Soviet Union, hope was the currency of choice for the Russian government; it has experienced such huge budgetary deficits that it delayed paying workers for six months or longer. This currency (not paid on time) is not familiar to western countries where inflation is running in very low single digits. Hope runs deep in Russia. At that time (in the early 90s), inflation was running 20-30% a year. Imagine getting paid six months or a year later and being able to buy a third less with the money than you could when you earned it. Though Yukos' employees under current management have not received "hope" compensation for awhile, they will take it since their options are limited. So even with the funds frozen, it is unlikely that the oil wells will stop producing oil. However, this is where the "positive" story ends. This scandal will have a long-lasting impact on Russian oil production. It is very likely that this scandal will scare foreign investors from Russia. If I was an executive with Exxon, BP Amoco or Royal Dutch, I would think twice about committing any new capital to Russia or I would demand a rate of return that would factor in a significantly higher political risk. So the foreign capital that is much needed to develop oil (especially pipelines) infrastructure, will not be arriving anytime soon. In my opinion, we will not see an increase in oil production from Russia, thus current world supply/demand imbalance may remain where it is.

Vitaliy N. Katsenelson, CFA

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