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Russian Oil: Playing a Nonrole in the Iran Crisis

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Stagnating oil production means Russia misses a chance to be the good guy.

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The high-stakes face-off between the West and Iran, with Tehran threatening to choke off Persian Gulf oil supplies if the US and Europe stick to their latest economic sanctions, should bring a golden economic and political opportunity for Russia.

The country is just about tied with Saudi Arabia for world's top oil producer, and ranks No. 2 in exports. Its immense geography offers direct overland access to both Europe and Asia with no worries about what Iran might do at sea. With the mullahs ratcheting up their blockade rhetoric, the big Russian oil companies like Rosneft (RNFTF.PK) and Lukoil (LUKOY.PK) should be set to save the day, or at least garner some much-needed positive publicity.

But alas. Years of bad policy by Vladimir Putin and his minions have sucked the vitality from Russia's energy sector, curtailed output growth, and left the country without the pipelines it needs for a new surge in exports. The Kremlin, to recall the famous phrase about the Palestinian Liberation Organization, will not miss the opportunity to miss this latest opportunity.

Russia's oil production, after a severe contraction in the immediate post-Soviet period, went on a rampage following the financial crisis of 1998, increasing by 55% over the next seven years. Then it basically plateaued, adding just 7% between 2005 and 2010. (See graph here.) The annual growth rate peaked in 2003 at nearly 10%, a dizzying figure when it comes to pumping crude.

Not coincidentally, that was the year Mikhail Khodorkovsky, boss of the independent oil company Yukos, was arrested, and the Kremlin began its reconquista of the oil patch. (Khodorkovsky is still in prison and likely to stay there so long as Putin retains power in Russia.) Over the next few years Yukos was dismantled and most of it folded into state-owned Rosneft. Another dynamic private company, Sibneft, was taken from oligarch Roman Abramovich in a forced sale to state gas monopolist Gazprom (OGZPY.PK).

Putin also worked to alienate the largest multinational oil companies. His government forced Royal Dutch Shell (RDS-A) to cede control of a huge gas project on Sakhalin Island in the Pacific to Gazprom at a knock-down price. It bullied and harassed ExxonMobil (XOM) over another multibillion-dollar Sakhalin venture, though Exxon hung on in Russia and lately entered a strategic cooperation agreement with Rosneft. BP, the third global super major, experienced abundant problems of its own with its TNK-BP joint venture, though these are not really the Kremlin's fault. The London-based giant has had a noisily dysfunctional relationship with its private Russian partners.

After Khodorkovsky's downfall, Putin squeezed Russia's domestic oil industry with windfall taxes that reaped most of the benefit from rising prices for the state and sapped incentive to explore new reserves. The government has signaled in recent years that it wants to shift tax burdens from the energy sector to other industries like metals, or to consumption. But little has come of it so far.

The result is companies with reliable profits (an oil company could hardly help making money at today's prices) but anemic growth. Lukoil's output actually shrank by an estimated 5.5% last year, while Rosneft's, the proclaimed national champion, expanded by less than 3%. Share performance has been equally uninspiring. Rosneft has lost 9% of its value over the past year, Lukoil 14%. By comparison, Shell is up 4% and Exxon 12%.

Yukos, Lukoil, and other private partners also wanted to build a new pipeline from their own pockets in the early 2000s that would have greatly expanded Russia's shipping capacity to Europe. Putin rejected the project and maintained the monopoly of state pipeline operator Transneft, which has been content to tinker with the existing network going West.

The idea here is not to join in the misplaced canonization of Khodorkovsky. He provoked Putin by defending oil company taxes that were comically low at the time, and boasted publicly that he was bribing legislators to keep them that way. But the Kremlin went far beyond a reasonable assertion of its rights over Russia's golden goose. It is paying the price now. The much uglier regime in Saudi Arabia gets to play savior in the looming Iran crisis, while Russia reinforces its image as an autocratic backwater.
No positions in stocks mentioned.

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