Russia steps up oil production

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Beginning in February, the Kremlin will reduce Russia's oil-export tariff by two-thirds in order to maximize the expansion capacity of the country's oil firms. Look for Russian companies to become more aggressive in their foreign-asset acquisition plans and for relations with OPEC to get downright nasty.

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The Russian Economy Ministry announced Jan. 4 it would slash its oil-export tariff by about two-thirds to around $1.25 a barrel. The reduction will take effect Feb. 1, pending the near-certain approval from Prime Minister Mikhail Kasyanov.

Bloomberg News, citing the investment bank Alfa, reports that the move will give Russian oil firms about $150 million a month in extra income, which should allow those companies to rapidly expand their operations at home and abroad. Increased oil production will lead to a stronger international presence for Russia both economically and politically, as well as damage the ability of the Organization of Petroleum Exporting Countries to function effectively.

In the aftermath of the country's 1998 financial crisis, Russia's oligarchs realized there were few of the Soviet Union's assets left to strip, so they began developing what they had stolen. Nowhere is this more apparent than in the lucrative oil industry. After production fell to about 6 million barrels per day in 1998, Russia ratcheted back up to 7.1 million barrels per day in 2001 and expects year-on-year gains for the next decade.

The Kremlin's decision to reduce the oil tariff reflects three underlying realities. First, the single largest barrier to sustained Russian development is a lack of investment, a problem that is exacerbated by high tariffs.

Second, a lower tariff will discourage the development of competing oil-pipeline projects that try to minimize Russian participation. Three such pipelines -- one from Azerbaijan to Georgia, one tapping Kazahkstan's Tengiz field and one heading south through Iran -- have already entered operation. Russia needs to block the others for economic and political reasons.

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Third, Russia needs to maximize its oil production both to improve revenue and make itself more valuable to Europe, as increased exports from Russia will allow European countries to decrease their dependence on OPEC. Lower rates allow Russian firms to reinvest in their operations in order to ramp up production levels.

In the countries of the former Soviet Union and Central Europe, an extra $150 million a month goes a long way toward purchasing assets. LUKoil, Russia's largest oil firm, is already heavily invested in the Balkans and Kazakhstan. Yukos, the second-largest oil company, is linking up two of Central Europe's pipeline networks to enable direct exports to the Adriatic Sea. Other Russian firms do business in the Baltic states, Central Asia and the Caucasus.

Russian President Vladimir Putin has proven time and again that he is a master of using such economic links to broaden Russia's foreign policy reach. But the increase in Russia's oil production due to the lower tariff will have an even bigger global impact. If Saudi Arabia holds to OPEC's Jan. 1 production cut of 1.5 million barrels per day, Moscow will emerge in 2002 as the world's largest oil producer, a title it has not held since the Soviet days.

OPEC correctly fears that Russia will shift its massive production capabilities into massive export capabilities. Moscow currently exports about one-third of its production; subsidized power ensures the rest remains in country. But that is changing.

As Russia dismantles its subsidies -- the government is raising electricity prices 32 percent this year alone -- and begins using more nuclear power, more oil will flow from Russia to international markets.

It is not like Russia gets along particularly well with OPEC as it is. The Saudi-engineered, mid-1980s price war is a factor behind the financial crunch that broke the Soviet Union. Moscow also has repeatedly pledged to OPEC to cut production in order to shore up prices. However, after making these promises the government would then go back on its word and raise production to steal market share.

The 2002 production "cuts" of 150,000 barrels per day that Russia announced in December are no exception. Moscow called them "export cuts." Russia has violently cold winters, forcing the government to withhold exporting some oil to prevent freezing Russians from becoming frozen Russians. Such seasonal concerns would have forced the government to make the recently announced cuts anyway.

By May, Russian exports will be back up to their normal highs at the same time that global demand will reach its seasonal low. Whatever surplus oil is left after the winter will be refined and exported. Kasyanov halved the export tariffs on gasoline, kerosene and diesel fuels Jan. 3 to facilitate this plan.

Moscow isn't stopping with merely lying about cutting exports. It is rapidly stepping up production as well. Just before the new year, Putin inaugurated a new export line on the Baltic Sea, increasing exports by another 250,000 barrels per day. Russia's second- and sixth-largest oil firms, Yukos and Sibneft, plan to increase their production in 2002 by 22 percent and 26 percent, respectively. The tariff cut is only icing on the cake.

Russia maintains the fiction that it is participating with OPEC only so the cartel can save face. OPEC has a vested interest in not calling Russia's obvious bluff. If it did, the oil markets would immediately react to the true level of Russian cooperation (none), and prices would plummet accordingly. However, despite OPEC's best efforts, they still will plummet this year.

The global-demand picture is soft at best. European growth remains flat, dampening demand for oil throughout the continent. Japan won't have any growth until at least mid-2003, even by Tokyo's overly optimistic and thoroughly cooked figures. Other Asian states hope to hitch a ride with a steadily recovering United States, but Washington's newfound focus on security means there simply is not room for all of them. As competitive devaluations sweep the region, the cost of imported oil -- indexed in dollars -- will drive all of Asia to consume even less.

Meanwhile, U.S. reserve stocks continue to build, with reserves of crude oil, heating oil and diesel fuel all spiking sharply in the first week of 2002, according to the U.S. Department of Energy's Energy Information Administration. Even slower refinery activity and lower fuel imports -- down 10.5 percent from a year earlier -- have yet to reverse the trend toward higher stocks and lower prices.

On the supply side, Russia is not the only state bringing new projects on line. The EIA expects Angola's production to increase by 250,000 barrels per day by July, mostly from the Girassol field. Kazakhstan plans a 15 percent output increase over 2002, Interfax reported. The Financial Times even reports that Mexico, one of the non-OPEC states cooperating with the production cuts, may be pulling the same trick as Russia, simply cutting exports and not production.

Even within OPEC, supplies are set to rise despite the quota system. Iraq plans to boost oil-output capacity this year by 300,000 barrels, or 10 percent, to 3.1 million barrels per day, the Middle East Economic Survey reports. Algeria, Kuwait, Libya, the United Arab Emirates and Venezuela also are taking steps to expand their production, according to the EIA. That will effectively shatter OPEC's existing quota structure, leading to a crisis of both confidence and leadership within the cartel.

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