June 22, 2008

Hope Springs Eternal but the Oil Won’t: a Russian Lament

By David Strahan

BP should have seen strife coming, but more pressing is the exhaustion of fields on which we've come to depend, says David Strahan

It must be lonely being Tony Hayward. As the oil price continues to soar, there is a gathering consensus that global production of the black stuff is nearing fundamental geological limits. Yet BP's chief executive continues to argue valiantly that the causes of the current oil shock are "not so much below ground as above it, and not geological but political".

Since his company's Russian joint venture, TNK-BP, is under ferocious assault from both its Russian shareholders and the Russian state, Mr Hayward can be forgiven for thinking the industry's problems are man-made rather than natural. But this is a false distinction, and closer analysis suggests BP's predicament is itself evidence of looming geological constraints to global production, or "peak oil".

On the face of it, BP's problems in Russia are entirely above ground, even if the company claims its tormentors are far from above board. TNK-BP is owned 50:50 between BP and AlfaAccessRenova, a consortium of Russian billionaire tycoons led by Mikhail Fridman. The two sides are now locked in a vicious dispute. BP claims the Russians are trying to seize control; the oligarchs insist they are only defending their rights. Last week Mr Fridman said the British company's allegations were "in the best traditions of Goebbels' propaganda".

Wherever the truth lies, there is not much doubt how the dispute will end. The Russian shareholders have resorted to law both in their own country and Sweden, but the real pressure on BP comes from the state. In recent months TNK-BP has been subjected to raids by the FSB security service investigating claims of industrial espionage, along with the launch of an environmental probe into its largest oil field. Meanwhile, the company's BP-appointed chief executive has been questioned by the interior ministry over alleged corporate tax evasion, and summonsed by the Moscow prosecutor's office over suspected labour code violations.

It all seems wearily familiar. In 2006 Gazprom, Russia's state- owned gas giant, took control of Shell's Sakhalin 2 project after a campaign of official harassment by environmental agencies. And last year TNK-BP was forced to sell a majority stake in its plum Kovykta gas field in east Siberia, also to Gazprom, after government claims that it had broken the terms of its licence.

Many observers interpret the latest campaign against TNK-BP as a similar softening-up exercise, intended eventually to deliver control of the company to Gazprom or Rosneft, the state-owned oil group.

This would be a major blow for BP, but the company should have known the risks all along - not least because when Mr Hayward's predecessor, Lord Browne, formed TNK-BP in 2003, he had already done business with Mr Fridman and come off worst.

The earlier encounter began in 1997 when BP spent $500m (250m) on a 10 per cent stake in the Siberian oil firm Sidanco - and then lost much of it when the company promptly went bust. Shareholder Mikhail Fridman manipulated the arcane insolvency process to his own advantage: BP was first forced to write off $200m and then to invest another $375m just to protect its position. Asked why BP hadn't simply cut a deal with Mr Fridman, one executive reportedly said: "You don't talk to someone who's stolen your wallet."

Yet just a few years later Lord Browne committed $7bn to Mr Fridman and his associates to form TNK-BP. (During the negotiations, he felt compelled to ask his new friends: "Are you going to take the money and run?" Yet still he signed the contract.) It was a fabulously risky deal but what propelled him was the fact that nowhere else on earth could BP have secured reserves and production potential on such a scale. This was fundamentally due to petroleum geology around the world.

The basic problem for BP was that international oil companies (IOCs) are largely excluded from the countries that control most of the world's known oil: the 13 members of Opec. In the rest of the world, by contrast, oil resources were already far more depleted. Most prospective regions had been thoroughly explored and exploited, and in most non-Opec countries output had already gone into decline. Opportunities for growth were severely limited, but Russia was an exception.

With the fall of the Soviet Union at the end of the 1980s, the Russian economy had slumped and oil production collapsed from 11.5 million barrels per day in 1987 to just over six million in 1998, as fields were mothballed or simply not maintained. But as confidence returned so did the necessary investment, and output began to recover - rising almost 60 per cent by 2007. It was this wave that Lord Browne wanted to ride.

The TNK-BP deal quickly boosted BP's oil production by half a million barrels per day, and growth in Russian output continued to offset declines in the British company's operations in the North Sea, Europe and America. A glance at BP's quarterly figures shows that had Lord Browne flinched and not done the deal, the company's output would by now have fallen by almost as much. Instead of averaging 2.4 million barrels per day in 2007, BP's output would have been less than 1.6 million. Given the absence of such opportunities elsewhere, it seems Lord Browne had little choice.

But still that gamble is poised to backfire, with BP now looking set to lose up to a third of its oil production capacity in the fight with TNK-BP's Russian shareholders backed by their government. However, this is not simply an example, as Mr Hayward might like to imagine, of the oil industry's man-made tribulations above ground; it is a direct consequence of the tightening constraints below.

Those constraints are starting to emerge in Russia itself - where the decade-long boom came to a halt last year and production has now begun to fall. Some pundits blame the high level of tax levied on oil profits by Russia, but the deeper cause is that the easy gains achieved by refurbishing existing fields have now been exhausted. Future increases in production capacity will require the development of new fields in frontier provinces such as east Siberia and the Arctic, where working conditions are especially hostile. Analysts agree that it gets very much harder from now on.

But Russia's faltering production should come as no surprise. As long ago as 2005, the then oil minister Victor Khristenko predicted that output would plateau at just over 10 million barrels per day - slightly higher than today's level - from about 2010. More recently Leonid Fedun, a vice-president with the independent oil firm Lukoil, declared that Russian production would not exceed current levels in his lifetime.

This matters hugely because it was only the rise in Russian output over the past decade that satisfied soaring demand from Asia. Now this rapid growth is over and it is widely expected that aggregate non-Opec output will peak by around the end of this decade. From then on, the only thing standing between us and global peak oil is the Opec cartel, and many analysts doubt whether even they have the oil resources to raise production by much.

This weekend all eyes will be on the oil summit in Saudi Arabia, perhaps more in hope than expectation.

David Strahan is the author of 'The Last Oil Shock: a Survival Guide to the Imminent Extinction of Petroleum Man', published by John Murray. www.lastoilshock.com

(c) 2008 Independent on Sunday, The. Provided by ProQuest Information and Learning. All rights Reserved.