Russian Energy Outlook – Implications for Strategic Investments

Vladimir Milov

The New York Energy ForumNew York City, May 15th, 2008

Basic current trends

• Crude oil output stagnation, with a clear decline perspective

• Natural gas output stagnation, development of new fields delayed

• Power sector reform ending up with but a redistribution of ownership in power generation, mostly in favor of Gazprom

Russian crude oil output: stagnation

Average daily Russian crude oil output, million barrels per dayAverage daily Russian crude oil output, million barrels per day

9,809,85

9,88 9,89

9,79 9,829,87

9,90 9,919,87

9,94

9,85 9,839,78 9,79

9,69

9,81

9

10

Dec

.06

Jan.

07

Feb

.07

Mar

.07

Apr

.07

May

.07

Jun.

07

Jul.0

7

Aug

.07

Sep

.07

Oct

.07

Nov

.07

Dec

.07

Jan.

08

Feb

.08

Mar

.08

Apr

.08

In 2007, oil production growth brought down to zero

2,1%

0,1%0%

1%

2%

3%

4%

5%

Nominal growth Not accounting output growth atSakhalin-1 and Salym projects

Crude oil output growth in 2007 as compared toCrude oil output growth in 2007 as compared to 2006 2006, %, %

Share of the state in crude oil output grows

Crude oil output in Russia by state-affiliated and private Crude oil output in Russia by state-affiliated and private companies, %companies, %

11,5%

39,0%

88,5%

61,0%

0%

50%

100%

2004 2007

State-affiliatedPrivate

Worst results are shown by companies affected by current and potential ownership redistribution

• Slavneft, Surgutneftegaz, Gazprom Neft demonstrate 5-7% output decline this year

• Surgutneftegaz accumulates about $20 billion in cash and financial investments, not investing these funds in development of the upstream segment

• Slavneft and Gazprom Neft are clearly affected by mismanagement from Gazprom’s side

• Gazprom, with its lack of experience in the oil industry, obviously failed to successfully enter the oil sector

Is private sector investing enough? (The case of TNK-BP)

Source: TNK-BP

2,1

1,6

1,4

0,0

0,5

1,0

1,5

2,0

2,5

Net earnings Dividends Capital expenditures

TNK-BP’s use of cash for investment and financing activities in the TNK-BP’s use of cash for investment and financing activities in the first half of 2007 (latest public financial statements available), $ first half of 2007 (latest public financial statements available), $ billionbillion

At the same time: oil production at Samotlor field

25

26

27

28

29

30

31

32

33

34

35

36

37

2003 2004 2005 2006 2007 2008 2009 2010

Projected

Actual

Crude oil production at Samotlor field (around 43% of TNK-Crude oil production at Samotlor field (around 43% of TNK-BP’s total production), million tons per year BP’s total production), million tons per year

Source: TNK-BP, Institute of Energy Policy projections

Gas: Gazprom’s production back to 2003 level

546

523

512

526

548

553555 556

548

490

500

510

520

530

540

550

560

1999 2000 2001 2002 2003 2004 2005 2006 2007

Gas production by Gazprom, bcm/yearGas production by Gazprom, bcm/year

Gazprom: after commencement of the South Russkoye field, daily production slightly went up…

50

51

52

53

54

55

56

57

58

59

60

October November December January February March April

2005

2006

2007

Average daily winter gas production by Gazprom, bcf/dayAverage daily winter gas production by Gazprom, bcf/day

…but what’s left after South Russkoye had been launched?

0,5

2,0

2,0

2,0

15,0

16,2

30,0

Yareyskaya area ofYamsovey field

Gubkinskoye field(Northern cap)

Nydinskaya area ofMedvezhe field

West Pestsovaya area ofUrengoy field

Neocomian strata ofZapolyarnoye field

Achimov strata ofUrengoy field

Kharvutinskoye

Potential of new gas output in the Potential of new gas output in the current gas production areacurrent gas production area, that , that would be relatively easy to launch in the coming years, bcm/yearwould be relatively easy to launch in the coming years, bcm/year

Source: presentation by Gazprom’s deputy CEO A.Ananenkov, Moscow, June 14th, 2007

That’s it?

At the same time, gas demand is growing – underground gas storages dried out in early 2008

Gas outtake from UGS, bcmGas outtake from UGS, bcm(October-March)(October-March)

Peak daily gas outtake from Peak daily gas outtake from UGS, mcm/dayUGS, mcm/day

43,2

48,3

32,4

50,1

30

35

40

45

50

55

2004-05 2005-06 2006-07 2007-08

572,3

455,9

583,6

400

450

500

550

600

2005-06 2006-07 2007-08

Source: Gazprom

Bovanenkovo field: key hope for the near future?

Key facts• Expected gas production –

115 bcmpa (further – up to 140 bcmpa)

• Railroad length 540 km

• Swamps occupy 50-60% of the area across the railroad route

• Railroad capacity 30 million tons of cargo per year, total cargo required for delivery to site – 80 million tons

• Ukhta-Bovanenkovo gas pipeline length – 1100 km

• Total estimated investments for Ukhta-Bovanenkovo pipeline construction (full capacity) – USD 45 bn (2002)

Bovanenkovo investments 2008

• Total investments allocated for Bovanenkovo field development 2008 – $4,3 billion:

• Upstream development – $2,3 billion

• Gas transportation system – $1,2 billion

• Railroad Obskaya-Bovanenkovo – $0,8 billion

• At this pace, field will probably not be able to provide large scale gas supplies before 2015

• Railroad construction apparently stalled after 270 of 540 km reported as built

• Cause for delay – ongoing construction of technically complicated 4-km long bridge across Yuribey river

“Face control” access to “strategic” oil & gas fields

• Federal law of April 29th #57-FZ on restrictions for foreign investments in “strategic” sectors of the economy – finally adopted

• The law includes “federal level subsoil allotments” in the list of assets requiring Government approval to be acquired by foreigners

• What is meant by “federal level subsoil allotments” is totally unclear

• Foreign investors are obliged to obtain individual permits for investment in any specific case of acquiring control in “strategic” fields

Will new upstream partnerships with foreign investors be successful?

• So far, only the Gazprom-Wintershall partnership had delivered some results

• Gazprom and E.ON had failed to reach an upstream deal in Russia

• Gas production at Enineftegaz (ex-Yukos assets bought by Italian-led consortium) were shut down in October 2007 due to lack of access to Gazprom’s gas pipelines, and are not supposed to be resumed until 2010

• The future of Shtokman consortium is very unclear

Power reform: market liberalization delayed, power generation ends up in Gazprom’s hands

Generation capacity ownership structure Russia (Europe + Urals, excluding Siberia and the Far East)

19,6

21,518,8

13,2

26,9The state (nuclear, hydro)

Gazprom

Russian industrial groups (Norilsk Nickel, Lukoil, Renova)

Foreign investors (E.ON, Enel, RWE, Fortum)

Other (including not yet privatized)

• The state and Gazprom would control about half of the power generation (most competitive baseload and peakload stations) at the new power market

• Some other owners (Norilsk Nickel, E.ON, Enel) may yet further resell control to Gazprom

Conclusions

• Russian energy sector passes through dramatic stage of ownership redistribution

• Until that ends, favorable investment climate can hardly be expected

• The state adds up the heat by playing on the side of affiliated companies, thus destroying the institutional environment, and introducing restrictions for foreign investors

• New partnerships with foreigners largely do not work yet

• Production stagnation (and potential decline) is the only result that can be expected under such conditions