Operators must apply hard lessons learned in Russia

After the Soviet Union dissolved in 1991, many Western companies jumped too quickly into Russia’s upstream sector, often with disastrous results. By heeding their mistakes, today’s operator still has a chance to succeed

H. Merle Myers, Principal, HMM Oil Management, Houston

n the early 1990s, the who’s who of the Western oil industry could be seen in Moscow’s hotels. It was not uncommon to run into delegations from major and independent oil companies, as well as promoters, in all corners of Russia. To date, there have been few if any successes in Russia, and a generation of oilmen have packed up and gone home.

Why have so many oilmen, who were successful in other parts of the world, found it so difficult to do business in Russia? The simple fact is that the norms that they learned in other parts of the world did not apply in a society that had been closed for 75 years. The Russian and Western oilmen, as well as the Russian government, had to go through a learning experience. The question now is, have both sides learned enough to make business deals workable in the future? This article discusses some of the factors that, if learned earlier, might have changed the results of many ventures in Russia and should be carefully considered when new ventures are pursued in the future.

Soviet Practices

	Perhaps the greatest problem with early Russian deals, particularly for rehabilitation of old oil fields, has been a lack of accurate reserves data.

Prior to the 1990s, Russian oil companies produced all the oil they could and shipped it to the central government. The government, in turn, sent them oil field equipment and other materials to keep the oil communities running. When Western oilmen first made contact in the early 1990s, the Russian oilmen were looking for someone to provide the equipment and supplies needed to keep their oil fields and towns working. However, they had no idea how to pay for what was needed.

The solution seemed to be to form a joint venture, in which the Western oil company would put up the money to refurbish a field for half of the proceeds of the incremental oil (oil produced above some historical level) that would be sold through export. These joint ventures did not work well for a number of reasons.

First, Russian oilmen feared that they might give too much of Mother Russia to the people that, not long ago, were considered their enemies. Therefore, only poor fields were offered as joint venture prospects. The recoverable reserves carried on the Russian books had little basis in fact. Because of poor production records and practices, reserves were not checked easily, and Western oilmen did little to check the reserves. The result was that, in many cases, reservoirs did not contain recoverable oil in sufficient quantities to be extracted economically.

	Russian state exploration companies were reasonably competent at calculating oil in place, but records kept by production associations (after they developed fields and put them onstream) have proven to be highly inaccurate. (Photo courtesy of LUKoil.)

Second, oil that was to be sold by export required a permit. In some cases, these export permits were given and then taken away. In other cases, the export permit was never granted. The difference in domestic and export oil prices was large in the early days, as compared to now.

Another problem was that refineries took oil in the early 1990s and simply did not pay for it. Therefore, the ability to get paid for oil produced by early joint ventures was poor, at best.

Particularly aggravating to Westerners was the fact that the Russians lived up to agreements when they felt it offered them some advantage. However, when they did not see the advantage, they ignored the terms of the agreements. Hand-in-hand with that problem was the conflict of interest permitted to exist in many enterprises. This cut into the ventures’ potential profits and was done to the advantage of those very few individuals who were more interested in their own personal gain. It also occurred to the detriment of the joint ventures and the Russian economy.

Finally, for generations, false information was passed to and from the Russian government, until it became a way of life. When Western oilmen came to Russia, many were enamored with Russian hospitality, in the form of dinner parties, trips to saunas, and toasts that pledged mutual cooperation and friendship. They trusted the Russians to the extent that they accepted information that was false or did not dig deeply enough to get at pertinent information. The lack of credible information hurt many joint ventures.

Changes In The Post-Soviet Era

By the mid-1990s, the larger Russian oil companies had become joint stock companies, and export permits were no longer required to export oil. The federal government established export levels at approximately 30% of total production. Federal, provincial and local governments collectively had established a tax burden on all oil companies that amounted to more than 60% of gross revenues.

Russian oil companies still needed capital to refurbish existing oil fields and to develop new ones. They raised capital by selling their stock and borrowing money from Western banks. The firms pledged their oil exports as security for these loans. The other method used to raise funds was to form a separate stock company for a specific oil field. In this case, a Western partner was brought in to put up the money required for approximately a 50% interest in the prospect.

	Equipment costs during the early days of Western participation in Russia were low, but now they have risen to levels very close to those in the U.S.

With more than 60% of gross revenue going to the government for taxes, less than 40% of this revenue remains to cover operating costs before any profit can be split between the partners. This is a very tough deal and not competitive with other deals that have been made in various parts of the world. Under the current Russian fiscal arrangements, most of the Western joint ventures, to date, have found that earning such slim profits has not justified the original investment, let alone a continued outlay.

It is apparent that, if a Western oil company is to succeed in this type of venture, there is little room for error. In addition to understanding the political risk (alterations to tax laws, changes in the government and its policy, ensuring access to transportation for production, etc.), knowledge of field geology, recoverable reserves and operating costs — both now and into the future — is an absolute necessity. In addition, it is necessary to work the best and latest economic technology into operations, so that ultimate oil recovery can be achieved at minimum cost. In short, the oil venture partner must do an outstanding job of due diligence before committing to a prospect.

The place to start due diligence is in the determination of recoverable reserves in a given field. This is not an easy task. It certainly is not as easy as contacting one of the reservoir engineering companies in Houston and sending their personnel over to Russia, to confirm that the reserves the Russians show on their books are correct.

Sorting Out The Reserves

To understand why it is so difficult to determine the reserves that might be produced from a given field, it is necessary to look at the how the Russians have calculated reserves. One also must examine some of the production practices that result in less-than-ideal recovery of an acceptable percentage of original oil in place.

During the Soviet era, new Russian fields were delineated by state exploration companies. Wells were drilled on wide spacing, cored, logged and tested, so that porosity, permeability, sand thickness and water levels were pretty well understood. This data allowed the original oil in place to be calculated accurately.

However, before the field was turned over to a separate state production company, the Oil Ministry determined the recoverable reserves that were assigned to the field. The ministry made these reserves a part of the license given to the production company charged with developing the field. Recoverable reserves were set more as a target, with little basis in scientific fact. Nor were the targets based on any historical data. The result was that recoverable reserves carried on the books were overstated by 20% to 40%.

When a field was put onstream, the production company did not keep good records that showed individual well production of oil, water and gas. The most common secondary recovery technique used was water flooding. Because injection water was not treated, the injection pressure would exceed formation fracture pressure on most wells, early in each well’s life. The result was that injected water did not go into the zones for which it was intended. In addition, production records from specific reservoirs in a field were not reliable, because so many wells had poor cement jobs. Since all production was going to the state, oil output that was attributed to specific reservoirs was not always accurate.

Without good reservoir data and/or historical models to use as reference points, reservoir engineers at Western oil companies could only guess at what the remaining recoverable reserves might be in a field. Few, if any, oil companies got the necessary data needed to determine what the recoverable reserves were in a given field before they entered into a venture. The decision to proceed without good information was disastrous in many cases.

Other Factors To Consider

	Companies contemplating new Russian E&P deals must conduct proper due diligence that thoroughly covers crucial items, such as workovers.

Before the economic projection for a venture can be made, a development plan must be created that shows the well(s) to be drilled, workovers to be done, pipelines to be laid, facilities to be installed, and the staffing required to develop and operate the prospect. It is necessary that the cost for all of these items be forecast accurately. In the early days in Russia, equipment, when available, was inexpensive, as were labor costs.

Today, however, equipment and services cost as much in Russia as they do in the U.S. Oilfield workers are still poorly paid, as compared to workers in the U.S., but their salaries have been going up at a very fast rate in recent years. The number of workers assigned to a given oil field operation is about 700% higher than would be experienced by a Western company in other areas of the world. This is a holdover from the old days, and management seems to be powerless to do much about the problem.

Currently, the Russian economy is a catastrophe. Most of the oil export revenue has been taken from Russian oil companies, and they cannot pay their bills. After more than three years, the Duma (Russia’s parliament) has not turned out a workable Production Sharing Agreement (PSA). Hopefully, this mess will improve some day, and Western oilmen can return to try again. Should they do so, they need to learn from the mistakes made in the last eight years.

How To Structure An Agreement

Several major points must be incorporated into any new agreement to greatly improve the probability of success. First, Russian oilmen do not understand economics. They must be educated to the fact that capital will go to projects that offer a rate of return that is competitive and consistent with risk in other parts of the world. Russian oilmen fear that they will enter into an agreement that is not to the advantage of Mother Russia. They seem to think that money should be put into a project, because they need it.

After being a closed society for so many years, it will take Russia time to understand how business generally, and the oil and gas business specifically, is conducted in other parts of the world. However, this understanding must be achieved, if real progress is to made in the development of natural resources that are so vital to Russia’s economy.

As alluded to earlier, another necessity for successful agreements is for the Duma to approve a workable PSA law. This would limit taxes and provide a competitive rate of return to investors, when compared to other parts of the world.

A third point is the need to conduct due diligence. Before committing to a project, due diligence must include an independent forecast of recoverable reserves, the production schedule, development plans for a field, a timetable to accomplish plans, costs of goods and services, and staffing levels for development and operations. Only when there is good data for these elements available can a good economic forecast be made for the project. It may be necessary to collect new basic field data, such as production logs, well tests, seismic, etc., before recoverable reserves can be forecast with an acceptable degree of accuracy.

Western firms looking to put together deals also must have a cadre of Western experts involved in the development and operation of an oil venture, if the latest technology is to be incorporated at minimum cost. Russian specialists and oil field workers have learned a lot in the last eight years. They are the best in the world at getting a job done with limited resources. However, habits of a lifetime are hard to break — the way things were done in the past will not accomplish the results needed to make a project successful.

Still another point is the need to control expenditures, so that there is no room for conflict of interest to exist. Profits in Russian oil ventures are not sufficient to allow a select few to receive money at the project’s expense.

Last, but not least, each contract should be negotiated from a position of strength, so that it is beneficial to both sides. The Russian oil industry needs capital. The Western oilman should not agree to spend money, other than on due diligence, until the terms and conditions of an agreement have been finalized. Contract negotiators need to be aware of cultural differences that exist and how these differences are routinely used to give the Russian side an advantage in negotiations.

Many scholars believe that former U.S. President Franklin Roosevelt and former UK Prime Minister Winston Churchill were out-negotiated by Soviet dictator Josef Stalin at the end of World War II. This same phenomenon certainly has happened to Western oil companies in more recent years, as they’ve dealt with Russian counterparts.

Attitudes must change — when investors become disenchanted with a portion of the world, or a nation, they are slow to come back. If they ever do go back, it will be because the Russians recognize they need them and are willing to offer deals that are beneficial to both parties. There is a lot of oil in Russia, and the country needs to not only sustain, but enhance, its production and develop new fields for the benefit of the people and the nation. When the day comes for investors to return to Russia, both Western oil company investors and their Russian counterparts need to have learned from mistakes made in the past for new ventures to be mutually beneficial.

The author

H. Merle Myersis the owner of HMM Oil Management in Houston and has been a consultant for the last 10 years. He has over 34 years of oil industry experience in engineering, operations, and senior management for Exxon, Shell Oil, Zapata, Conquest Exploration and others. He has extensive experience in international operations and has worked on a number of Russian projects in the last eight years. He holds BS and MS degrees in mechanical engineering from the University of Kentucky.

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Copyright © 1999 Gulf Publishing Company