VZCZCXRO8462
PP RUEHAG RUEHAST RUEHBW RUEHDA RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA
RUEHLN RUEHLZ RUEHPOD RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHMO #1295/01 1291156
ZNR UUUUU ZZH
P 081156Z MAY 08
FM AMEMBASSY MOSCOW
TO RUEHC/SECSTATE WASHDC PRIORITY 7968
INFO RUCNCIS/CIS COLLECTIVE PRIORITY
RUEHZL/EUROPEAN POLITICAL COLLECTIVE PRIORITY
RUEHXD/MOSCOW POLITICAL COLLECTIVE PRIORITY
RHEHNSC/NSC WASHDC PRIORITY
RHMFIUU/DEPT OF ENERGY WASHINGTON DC PRIORITY
RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY

UNCLAS SECTION 01 OF 03 MOSCOW 001295 
 
SIPDIS 
SENSITIVE 
 
DEPT FOR EUR/RUS, FOR EEB/ESC/IEC GALLOGLY AND WRIGHT 
EUR/CARC, SCA (GALLAGHER, SUMAR) 
DOE FOR FREDRIKSEN, HEGBORG, EKIMOFF 
DOC FOR 4231/IEP/EUR/JBROUGHER 
 
E.O. 12958: N/A 
TAGS: EPET ENRG ECON PREL RS
SUBJECT: RUSSIAN OIL PRODUCTION: STAGNATING UNDER HEAVY TAX 
BURDEN 
 
SENSITIVE BUT UNCLASSIFIED.  NOT FOR INTERNET DISTRIBUTION. 
 
------- 
SUMMARY 
------- 
 
¶1. (SBU) The rate of growth in Russian oil production has 
dropped significantly in recent years and output may actually 
decline in 2008.  Production growth has slowed as declines in 
output from existing fields have not been adequately replaced 
by production from new fields.  Investment in these 
"greenfields" has been hampered by an onerous tax regime that 
takes 90% of the revenues above $25 per barrel of exported 
crude.  Industry insiders believe that the GOR will have to 
use tax relief to boost production.  The GOR recently 
proposed some limited upstream tax relief but most analysts 
believe these are insufficient to restore growth.  With 
Russian production stagnant or declining and domestic demand 
rising, global markets are likely to see a loss of Russian 
crude oil supplies in the near term.  End Summary. 
 
-------------- 
SLOWING GROWTH 
-------------- 
 
¶2. (SBU) Worries about Russian oil output have finally hit 
the headlines with a spate of recent articles in the Wall 
Street Journal and elsewhere noting slowing growth.  This 
follows months of analysts' projections that Russian oil 
production was stagnating.  In fact, this year may be the 
first in a decade to see Russian oil production decline. 
Russia's oil production of 9.76 million barrels per day (mbd) 
in March 2008 is down more than one percent from a year ago. 
Moreover, all major oil companies except Rosneft are 
predicting declining output from their companies in 2008. 
 
¶3. (SBU) After the fall of the Soviet Union, Russian 
production initially plummeted amid economic collapse but 
then rebounded dramatically as privatization took hold and 
Western management practices and technology were implemented. 
 In the early years of the decade oil production was growing 
at a double digit rate every year, from 6.5 mbd in 2000 to 
9.2 mbd in 2004.  In 2005, however, with the government 
increasingly interfering in the sector, growth began to slow. 
 Investment lagged and output from old and declining fields 
wasn't adequately replaced by new production.  The rate of 
growth dropped to about 2% per year from 2005 to 2007. 
 
-------------- 
TAXES TO BLAME 
-------------- 
 
¶4. (SBU) Although excessive state control in the sector 
remains an obstacle to increased production, most industry 
insiders with whom we have spoken point to the tax regime as 
the major impediment to boosting output.  Russia has some of 
the largest untapped reserves in the world.  However, most of 
its current production is from old fields that have already 
peaked and begun to decline, even with the successful 
application of new technologies.  The resources that hold the 
key to Russia's future production lie largely in unexplored 
areas, including East Siberia and offshore.  Tapping these 
reserves requires billions of dollars of investment in 
exploration and production (E&P) as well as in physical 
infrastructure such as roads.  However, the country's onerous 
tax structure severely limits the potential return on the 
investments required to exploit new fields. 
 
¶5. (SBU) An analysis British Petroleum (BP) shared with us 
shows that when the price of the Urals blend (Russian oil 
mix) is above $25 per barrel (it is currently about $107 per 
barrel), the effective marginal tax rate of the combination 
of the Mineral Extraction Tax (MET, 22%), the export tariff 
(65%), and the tax on profits (3.1%), is over 90%.  That 
means that a rise of $10 in the oil price adds only $1 per 
barrel to an oil company's bottom line and $9 to the state's 
coffers -- indeed, this structure is the main source of the 
huge cash surplus the Russian government has socked away in 
recent years.  Given the already-challenging commercial 
uncertainties involved in exploiting Russia's oil and gas 
 
MOSCOW 00001295  002 OF 003 
 
 
resources, this tax burden is a major disincentive to new 
production. 
 
¶6. (SBU) A senior executive at one major Russian producer, 
explaining the fiscal policy behind the oil tax regime, told 
us the government is "just out to maximize revenue," with 
little regard for the industry as a whole.  An oil analyst at 
a major investment house bluntly said the system was created 
"to screw the oligarchs," and that now the government doesn't 
really know how to fix it.  Our contacts at another major 
Russian oil company were more generous, observing that the 
politicians writing the laws simply do not understand the 
complexities of oil industry economics and have created a 
system that is "not well thought out."  They added that 
taxing production is easier than taxing profits, and it 
provides a more reliable revenue stream for a government 
distrustful of industry's inclination to pay taxes fairly. 
 
¶7. (SBU) Given maturing fields, rising costs, and high taxes, 
oil producers face a grim future without enlightened 
government actions.  Industry sources specifically point to 
the rapidly rising costs of exploration and production inputs 
-- from engineers to steel to management talent -- and a 
weakening dollar as squeezing margins and making it more 
difficult to profit under the tax regime in Russia.  For 
example, one major oil company shared with us an internal 
analysis showing that given current cost inflation and the 
tax structure, their profit per barrel at a given price 
declines to zero in just five years.  And the head of a small 
international joint venture here told us that while small 
investments in existing fields can still pay off, the tax 
structure is a project killer for the major long-term 
investments needed to develop greenfields. 
 
----------- 
TAX REFORM? 
----------- 
 
¶8. (SBU) Under pressure from oil companies, most prominently 
Lukoil and Rosneft, the government is considering steps to 
ease the tax burden.  Under the current tax regime, the MET 
is applied at a Urals' price above $9 a barrel; in March, the 
GOR announced a proposal to raise that threshold to $15.  The 
industry and the investment community welcomed the proposal, 
which industry insiders tell us is likely to be implemented. 
However, most also deemed the measure inadequate and question 
whether it reflects government understanding of the depth of 
the problem.  One industry contact speculated that the 
Ministry of Finance may have only agreed to the proposed MET 
cut in acknowledgement that the rate should "at least be 
adjusted for inflation". 
 
¶9. (SBU) More promising from the industry's point of view, 
was the announcement in April by Minister of Industry and 
Energy Viktor Khristenko that the government is planning 
additional tax relief, possibly including a further cut in 
the MET rate.  However, despite these inklings of 
understanding by the state, the debate over tax relief is 
continuing.  Easing the burden on big corporations with large 
profits remains politically unpalatable.  A Duma leader was 
recently quoted in the press as opposing proposed tax cuts 
because "oil companies are doing fine."  One TNK-BP economist 
told us the industry needs to simplify the complicated 
situation to a few key points so politicians and the public 
can understand what's at stake. 
 
---------------------- 
STAGNATION TO CONTINUE 
---------------------- 
 
¶10. (SBU) Absent fundamental tax reform, industry insiders 
and analysts tell us significant production growth will not 
resume anytime soon, and that output may indeed begin to 
decline.  Moreover, even if the government implements reform 
this year, there will be a lag before it begins to affect 
production.  A senior executive of a major international oil 
company told us that with production at existing fields 
beginning to decline, "it will be hard to bring new fields 
online quickly enough to replace those lost barrels."  Leonid 
Fedun, the Executive Vice President of Lukoil, Russia's 
 
MOSCOW 00001295  003 OF 003 
 
 
second largest oil company, summed up the situation when he 
told us he didn't foresee much change in production for the 
"next few years." 
 
¶11. (SBU) Russia is the second largest oil producer in the 
world after Saudi Arabia.  Even minor declines in output take 
large absolute quantities of oil off the world market.  A 1% 
drop in output in Russia means roughly 100,000 fewer barrels 
per day of oil for global consumers.  Moreover, with a 
booming economy driving rising domestic demand, Russia's 
exportable surplus can be expected to decline without 
production increases.  Given the obstacles posed by the tax 
regime as well as the long lead times for projects capable of 
significantly altering this reality, the world could see a 
meaningful loss of supply if Russian oil production continues 
to stagnate and even greater loss of supply if it begins to 
decline. 
BURNS