Stabilizing World Oil Markets: Russia's Role in Global Recovery

MIKHAIL KHODORKOVSKY,
CHAIRMAN AND CEO OF YUKOS

"STABILIZING WORLD OIL MARKETS"

(PLEASE NOTE: ALL OF MR. KHODORKOSVKY'S REMARKS ARE TRANSLATED.)

ANDREW KUCHINS: It's a great pleasure to introduce today's speaker, Mikhail Borisovich Khodorkovsky, who will be speaking about "Stabilizing world oil markets: Russia's role in global recovery." As I'm sure you all know, Mr. Khodorkovsky is chairman and CEO of Yukos Oil Company, a position he's held since 1996, and under his leadership Yukos has grown into Russia's second largest company, and indeed a world class oil company.

Mr. Khodorkovsky is also increasingly recognized, I think, as a leader in the transformation of Russian business practices in the direction of improved corporate governance and full transparency. Some recent initiatives of Yukos include harnessing the potential of the Priobskoye field in western Siberia, and signing agreement in the fall with the state plant committee of the PRC and the Chinese National Petroleum Corporation for the development of a Russian-Chinese oil pipeline.

Yukos and Mr. Khodorkovsky gained quite a bit of notoriety fairly recently, at the end of last year for their objections to OPEC's desires for production cuts by Russian oil companies. Indeed, I would say that the past year, 2001, was a very good one for the Yukos Company, and a year that the RTS, the Russian Stock Exchange, appreciated by more than 80 percent. The Yukos Company in 2001 appreciated by nearly 200 percent. It has continued to grow apace in the year 2002.

It's really a great pleasure for me to present to you one of Russia's most remarkable, successful -- and yes, wealthy -- businessmen, and all before the age of 40. The floor is yours.

MR. KHODORKOVSKY: I welcome all of you and I am grateful to you for coming here to listen to me today. I hope you didn't come here just for the lunch.

First of all, the economic state of affairs in Russia. On the whole, Russia's economy is liberalizing quite quickly. Last year saw the adoption of quite progressive amendments to tax legislation. We can safely say today that the tax legislation that exists today is not bad at all. Let's hope it doesn't change in the next five years.

Right now pension reform is being undertaken, which for the first time in the history of the country is creating a cumulative pension system. Should this reform go through successfully, this will provide the potential for an increase several-fold in the size of the Russian stock market. We are beginning to address the problem of monopolies. This is not an easy problem. I will speak more about it later.

Also on the agenda is utilities reform, which is also very important for the energy sector because it creates an opportunity for a new market, a market to provide energy to the newly formed utilities market.

Now let me pause a little further on the development of the energy industry. First let's talk about oil. The industry is highly competitive. There are a large number of Russian companies that are in it as well as a certain number of foreign companies. Production volumes are increasing by an average of 7 percent a year or so. Russia's total oil reserves need to be reexamined. The number should be larger than it is stated. Indeed, a serious reassessment is required. The number that you hear bandied about most often is that Russia's reserves are about 50 billion barrels. Actual, I think it is at least 150 billion barrels.

The production costs for this oil are not very high, about $3, $4 a barrel lifting costs. But the key factor that needs to be included, and an expensive one, is the cost of transporting the oil from the wellhead to the consumer. The average distance is more than 2,000 miles on land. Plus a certain amount by sea as well.

The second issue is gas. Russia has even more gas reserves than it does oil reserves. At the same time, though, this is industry is monopolized. The result has been a steady drop or decline in the amount of gas produced over the last few years. I am hoping that in the next few years, as the question of the natural monopolies is dealt with and solved, concurrently we will see the question of liberalization in the gas market dealt with as well.

The oil companies are preparing for this to take place. They are forming gas reserves for themselves. Once the gas market is liberalized in Russia, the opportunities for this gas market are going to increase many-fold in Russia. Significantly.

A third area is power generation. In terms of where it is in terms of liberalization, it's somewhere in between the oil industry and the gas industry. We're hoping that liberalization will continue apace there as well because currently the rate at which this industry is growing does not meet the needs of Russian industry as a whole.

Now I'd like to say a few words about Russia's influence on world energy markets. As recently as half a year ago, US energy policy did not regard Russia as a significant player. Now a re-evaluation has taken place, but I'd have to say that the re-evaluation is a little bit excessive. Russia is not going to be able to replace Saudi Arabia. Russia has a very clear role to play on the world energy market, based on the unique natural climatic conditions of Russia.

I've already mentioned that a large part of the cost of Russian oil is the transportation component. So given reasonable oil prices, by which I mean between $20 and $25 a barrel, you're not going to see much Russian oil making its way to the American market because the bulk of the price will be eaten up by the transportation costs. At prices like that, our natural market is Europe. Here there is scope for further development. Here I venture to say that Russia is capable of producing as much as 8 or 9 million barrels a day, compared to today's level of about 7. This doesn't mean that there won't be any Russian oil on the American market, but at such prices its share will be marginal.

Russia is not able to have oil wells that operate only on a periodic basis because it is cold. A well that's not used freezes and blows up. Therefore, the only markets to which we can sell oil are those markets that buy it on a steady basis from us. But naturally Russia is capable of playing the role of a back-up source of oil for the United States if for whatever reason the oil price shoots up above the $25 a barrel threshold. Russia's traditional oil market immediately begins to contract, and at the same time the transportation costs become less significant in the total price. At this point, Russian oil can start appearing on the American market, thereby smoothing the price peaks. At the same time, in order to have this back-up energy source, it's very important for us to reduce the volatility of the market.

The Russian government budget can withstand an oil price as low as -- and I'm going to convert this into Brent prices -- $16 a barrel. At $20 a barrel, Russia is doing just fine. But if the price falls any lower, down to $14 or $12 a barrel, production in Russia is going to decline. Perhaps not immediately because Russia has built up a large potential, but it will decline. In this light, the American consumer needs to ask themselves the following question -- do they want to have oil from only one source, or do they want to ensure that they do have two viable sources of energy.

I should also mention that several decades ago the oil market was a market of long-term contracts. That was not very good. Therefore, the market became a market of spot contracts. I have to say that that wasn't very good either. For some producers, that's fine, those producers that are freely able to turn the taps on or off whenever they need to. Other producers, Russia among them, simply do not have this possibility of being able to turn the taps on and off at will, even though they do have huge reserves.

Therefore, I feel that the time has come to revisit the question of what is the right balance between long-term contracts and short-term contracts. Perhaps this is the key to ensuring reliable energy supply rather than the more expensive option of building up strategic reserves.

Now I'd like to say a few words about the role of foreign oil companies in Russia and what opportunities they have there. As I've already mentioned, the problem for Russia today, it's not investments. It's finding markets, customers. I feel that foreign international companies ought to re-examine their approach to Russia. For 10 years the international companies have been looking for opportunities to establish production-sharing agreement relations.

This production sharing structure creates an unlevel playing field for different players in terms of their tax treatment. The only case where this is justifiable is if there's an acute need to attract investors in the absence of a national tax regime. Some of the international companies were successful and they got those coveted production-sharing agreements. Others have not yet been able to do so. I feel that the window of opportunity for this has practically closed already.

Today the Russian oil industry doesn't need investment; it needs markets. Some of the international oil companies have indeed taken a second look at their Russia policy and have decided to start working under national treatment rules as far as taxes go. They've also decided that they need to acquire Russian oil companies. I think that this is the right approach because right now Russian oil companies are cheap. If a major buys a Russian oil company, it's buying at the same time reserves and markets.

Another opportunity available is that of oil field services. This is a huge market in Russia today and there is no competition in it. So far unfortunately with perhaps the exception of Schlumberger and to a smaller extent Halliburton, the foreign oil service companies are adopting a wait and see attitude. I feel that this is missing a market opportunity.

Now if we look forward by 10 years we see the Russian energy market being fully integrated into the world economy. Russian oil and gas will be a significant part of the entire European energy scene, and part of China's as well. Perhaps part of Japan's. Russia will play the role of a back-up energy source for the United States. Most production in Russia will be done by foreign international companies. Nevertheless, I feel that one or two Russian companies will be capable of becoming international companies. So the world oil market will have one or two Russian international companies on it, and the rest of Russia's reserves will be developed by other international companies. My hope is that our company will be one of those.

I thank you for your attention, and I'd be glad to answer any questions you may have.

MR. KUCHINS: Thank you very much, Mikhail Borisovich. We have quite a bit of time for questions and discussion, so if you like I will acknowledge people in the crowd, and please everybody, simply identify yourself before you make your comment or question.

JOHN HARDT: You've emphasized reduction of costs and increased output as a means to develop success for your enterprise, and in your discussion you mentioned the importance of the market in developing more output and production. To what extent is the development of more effective production methods elsewhere within Russia -- that is, adoption of best practices elsewhere in Russian fields -- going to be related to the development of the market as you indicated? In other words, is the cost of production and the high cost of production throughout much of the industry the constraining factor in developing a larger market and not only domestically but foreign? And do other companies have to follow your example in order to be competitive?

MR. KHODORKOVSKY: It would please me very much to be able to say that the reductions in cost our company has accomplished -- we've been able to outstrip all the other Russian oil companies in terms of competitiveness. Unfortunately this is not so. Indeed, we do have the lowest costs in the entire industry, but the difference between our costs and those of our colleagues, in percentage terms it's high, 25 percent sometimes. But in money terms we're talking about $1. Three dollar lifting cost or $4 lifting costs.

Transportation costs are identical for everyone. The taxes are the same for everyone. So the cost of the oil in the port, the difference in the price of the oil in the port is $1. So if we are speaking of expanding the markets for Russian oil, this primarily refers to expanding the existing pipeline network, therefore pushing aside other producers. For example, we are very interested in that place in Europe that is now held by the North Sea. That market share is going to be slowly shrinking. Yet, this market remains constrained.

LILIA SHEVTSOVA: Imagine you're the Russian president. What would be your priority just now? What would you like to do just now in the economic field? What would be your policy toward Iraq in the current circumstances?

MR. KHODORKOVSKY: If I were the president of Russia, what I would say is, for questions of the economy, that's what I have my cabinet of ministers for. There are three acute problems and I will give them to you right now. Pension reform, monopoly reform, and utilities reform. For the next three years, until the end of the current term of the president, that's more than enough. Indeed, maybe it's something that could carry over into the next presidential term.

As concerns Iraq, I always like to give gifts to friends, after all, but Iraq really doesn't worry me. I don't have a border with Iraq. I don't buy anything from Iraq. I don't get anything from Iraq. And I am no longer a global superpower.

MR. ELKIND: I'm Jonathan Elkind, from the University of Maryland, and I'd like to ask you a question following up on the theme of natural monopoly reform. Could you say a word about how you think liberalization of the Russian gas market would affect domestically Russia's gas usage and the availability of gas at affordable prices within Russia.

MR. KHODORKOVSKY: A very good question because we have had some very heated discussions on this very question. Part of our cabinet, including the liberal wing of it, feels that the price for gas in the domestic market should be liberalized and raised to world prices. I agree that the domestic price does need to be raised, but I don't think it needs to be raised to world prices because from a market standpoint this is unjustified.

The production costs of Russian gas are quite low. This may not be so for Gasprom today at some of its new fields, but if the market will be liberalized, I guarantee you it will be so. The market for Russian gas is likewise limited. It's not going to increase significantly just because the price is lower. I speak of the export market.

At the same time, raising domestic prices kills off some of the consumers of gas. Let's say I'm a gas producer. I look at mineral fertilizer producers. I apologize, I'm going to use metric system here but you'll get the relative picture anyway. My production costs are $20 for 1,000 cubic meters. In the west, I could sell it for $100 for 1,000 cubic meters. My net back would be $60 per 1,000 cubic meters. But I can't sell any more because there is no more demand, even if I lower my prices.

Now let's look at the domestic market. If I offer to sell my gas at $30 per 1,000 cubic meters, it will be processed and turned into mineral fertilizers and I do have a market for mineral fertilizers. If, however, I try to sell this gas at $60, there won't be a market for these mineral fertilizers any more. That means I'm going to have to close down my gas well. But, remember, my production cost is only $20, so I'm making money at $30.

So my position is that the Russian domestic price for gas should be significantly lower simply because we have the capability of producing gas at a very low price and we have no opportunity to sell any more outside of Russia than we already do.

BILL MAYNES: The American press has been reporting that Russian oil companies may be interested in participating in the Baku-Ceyhan pipeline. I wondered if you'd comment on that, and in light of your last statement, how you see the rise of a much more serious oil and gas industry in the Caspian area affecting your desire for larger markets in Europe.

MR. KHODORKOVSKY: Personally, I am for the Baku-Ceyhan pipeline. In recent times the Russian government has also looked somewhat more favorably upon this project. Why do I view it favorably? For the Russian oil industry the main problem is markets, customers. The Baku-Ceyhan pipeline takes some of the Caspian oil and moves it away from our traditional markets. If not for that pipeline, we end up over-filling the Black Sea basin, thereby reducing the opportunities for expansion of Russian production.

I am not convinced of the economic soundness of the Baku-Ceyhan pipeline project. I just don't know. I have heard that the geography is quite complicated, but that's just a pure economics question. As concerns the interest of Russian companies to participate, if a Russian company has an opportunity to produce oil in the Caspian, this pipeline is of interest for us. I'm talking in a purely practical sense. If a Russian company is not producing oil in the Caspian, then we're just fans on the sidelines supporting this idea.

Caspian oil is indeed competition for Russian oil. We are working on the same market. Indeed, when I speak of that market, I speak of Russian-Caspian oil together as a single thing. That's why I say that what is needed is vision on the part of both producers and consumers in order to divide the flow of the oil from these two sources in two different directions. Only in that case will these two regions be able to improve the geopolitical energy situation, stability in the world. If Russian-Caspian oil both go in the same direction then you might as well consider that instead of having acquired two alternative sources of energy, you've basically acquired only one.

MARTHA OLCOTT: Martha Olcott, Carnegie Endowment.

When you talked about what the Russian oil industry would look like in the next five years, you predicted the probably there would be two Russian firms of global significance, two Russian multinational oil companies. How is the development of Russian firms as multinational oil companies hindered by the continued existence of purely state-owned oil companies, such as Rusneft and Zarubezneft? Do they have to be broken up for your vision to be achieved?

MR. KHODORKOVSKY: I personally believe that maintaining Rusneft as a state company has no economic basis. It's another matter that the government still hasn't done the numbers and come to this conclusion. Once the government does the numbers and does come to this conclusion, I think that the decision to get rid of it will be unanimous.

As concerns, Zarubezneft, that's a little bit different situation. This is, after all, not so much an oil company as an agency that performs certain special tasks that the government assigns to it. For example, to serve as an agent in the name of the government in participation in production-sharing agreements. That's a normal enough function that exists in one form or another in many oil producing countries. What Zarobesheft does need is a more clear-cut definition of what its functions are, and I think that's something that will take place in the forseeable future, but the need for such a company is perfectly clear.

ITAR-TASS : To continue on this question of what the Russian oil market will look like in the future, you mentioned you see international companies coming in to buy Russian oil assets, and I'd just like to get your sense of how you think people in the state apparatus might view this prospect. Is there going to be a difference to buy a 25 percent stake in TNK versus BP Amoco, buying TNK altogether, and making it a completely controlled subsidy?

MR. KHODORKOVSKY: Again, it's difficult for me to speak for the government. My viewpoint as I seek to grow my business, my feeling is that the Russian government will react rather calmly to the sale of significant portions of oil company assets to foreigners. This process is not going to occur quickly. At first the government will react with caution to it. But since there are a lot of companies, they won't interfere. They will see what happens, and I'm convinced that nothing bad will happen, and subsequently the government is going to stop paying attention at all until the share of foreign ownership in the Russian oil industry as a whole starts creeping towards 50 percent.

It's just a psychological thing, and at that point the government will re-examine the issue again. In growing my business, I am forecasting that this is how the government will react. What the actual reaction will be, I can't say.

ED CHOW: If Russian government and the major Russian oil companies follow the strategic course of increase of production and export of Russian oil on international markets, what do you think should be their approach to consultations and negotiations with OPEC countries?

MR. KHODORKOVSKY: I think that we need to consult with OPEC, just like we need to consult with our consumers. We need to convince OPEC that Russian production increases are not a threat to OPEC's own markets, which in fact is true. I explained the reasons earlier. I am getting the impression that the position of OPEC in general and Saudi Arabia in particular is becoming more liberal in this regard.

I think that a mutually beneficial understanding, one that's good for all parties, including consumers, within a price band of probably $20, $25 a barrel is perfectly possible.

NICK GVOSDEV: I have two very different but hopefully short questions. The first is, you've been quoted in the press as having accumulated a war chest to make acquisitions outside of Russia. I'm sure your objectives are many, but do they have more to do with your immediate concern of access to markets, or the longer-term ambition of being a true global multinational?

The second question is, the bottleneck on export capacity, the obvious one cause is the monopoly of Transneft, but the other factor that I'm sure that you've thought about is when is Russia going to institute quality banking in this pipeline system, and when do you predict that would happen, and would that have a significant impact on the level of exports?

MR. KHODORKOVSKY: The acquisitions that we're planning to make outside of Russia are oriented primarily towards expanding our customer base, which is why we're primarily looking at downstream and midstream assets in Europe. At the same time, we do want to acquire some international experience in upstream operations. But for now, at any rate, we're going to be taking some very modest steps in this direction and only in partnership with majors who do have experiences.

As concerns export bottlenecks, they really don't have all that much to do with Transneft restrictions. It has much more to do, again, with customer base. The market that we have is expanding only very slowly. In light of that, the second part of your question becomes very significant, the quality bank, because a significant limitation on Russia's potential to sell oil has to do with the sulfur content of Russia's oil. Our government right now is dealing with this issue on a very practical level. There are a number of both economic and political contradictions that have to be dealt with. I'm sure you understand them.

Nevertheless, economically this question is so important that I'm sure a solution will be found. Russia loses between $2 (billion) and $2.5 billion a year because of this question. We are assuming that at the fall session of the Parliament a law on pipeline transport will be on the agenda. I think that by that time the quality bank issue will have been crystallized.

The Russian oil blend has high sulfur content. Meanwhile, Europe is introducing more and more stringent restrictions on sulfur content in fuels. So what they do is they blend Russian oil with Arab oil that doesn't contain any sulfur in order to sweeten it. In doing so, we're reducing our market and are losing part of the price.

The highest sulfur content from Russian fields comes from fields in Tatarstan and Baskordistan, Bashkyria. But our company too has some fields that have a high sulfur content. Currently Russian law doesn't have any mechanisms to encourage to produce lower sulfur content oil. The creation of such a mechanism is what the quality bank is.

TOBY GATI: Most of your talk has spoken of oil as if the market were the only consideration, but we know that politics and oil do mix. The decision to decrease production in Russia, the decision on the division of the Caspian, Baku-Ceyhan, which were earlier opposed, for example, by the Ministry of Foreign Affairs and now are not. Can you say something about the role of commercial factors? Are they playing a larger role in Russian foreign policy? And that gets back to the earlier question about Iraq.

Secondly, how do you make your concerns known to the government, now that you're not an oligarch?

MR. KHODORKOVSKY: I find it amusing that I'm being asked this question in Washington.

I always say this, and it remains true, we are mere children compared to your corporations. But we're learning. I am actually very glad that our president, our government have finally formulated this position in, for example, any sort of international negotiations, that economic aspects do figure into the formula, that it is important for Russia to consider what is good for Russian companies as well as other issues. And that it's not all that important whether these companies are currently privately owned. It seems obvious in the United States. In Russia it wasn't too long ago that they finally came to this point. I'm glad that this has finally become noticed.

MR. KUCHINS: Unfortunately I've been advised we're going to have to close a little bit earlier today so we only have time for one more question. I apologize to all the other questioners we won't be able to get to.

KHODORKOVSKY: Would you please amplify what you said about production-sharing agreements with foreign participation? As you know, there's been very little progress in the last few years in getting the legislation through, in tying up all the accompanying supporting legislation, and at the moment Chapter 24 of the tax code is stuck, I gather, with the Duma. It would be very unfavorable to PSA, to foreign participation.

KEITH BUSH: Did you say there's no need for foreign participation in PSA's, or there's no -- the oil companies feel there's no future in it apart from perhaps the Sakhalin project? And what is the government position? You do consult often with the government. Would you say the Russian government is against further PSA projects?

MR. KHODORKOVSKY: Once again, I will speak not in the name of the government, which I can't, but in the name of the manager of a company. I feel that if an agreement has been signed, it needs to be fulfilled. A PSA was signed for Sakhalin. Carry it out. There were a number of other PSA's that have been signed in Russia; continue carrying them out.

As concerns subsequent agreements, I think they need to be re-thought. The terms of the PSA correspond to the national tax regime. That is, first a PSA is established. It is applied to a particular field, and then the field is put out to auction. If a Western company wants to buy into that license, fine. If a Russian company wants to, also fine. This is perfectly normal. The only thing is, I don't see why this is needed in the first place. If it is needed, though, fine.

If by PSA what you're actually referring to is the creation of preferential terms and conditions for one or another company, then I immediately ask the question. I've got shareholders in my company. Some of them are the same shareholders as the shareholders in some international company, including I've got some US pension funds that are shareholders in my company, international investment funds. These same organizations are shareholders of international oil companies.

Why should my shareholders get worse terms and conditions wearing their hat as my shareholders than they do wearing the hat of shareholders of the other company? I don't think that's exactly normal. Previously the justification for why preferential terms and conditions ought to be granted was that it was impossible to work in the Russian tax environment, while the domestic Russian oil industry did not have enough money to invest. Nowadays the situation is different. We have perfectly acceptable tax system. We have enough investment within the system itself. So if you want to honestly play on this market, you can get exactly the same terms and conditions as we have, neither worse nor better.

I recently had a talk here with a representative of an international oil company -- not an American one. They asked, well, how can we possibly work in Russia if the domestic price for oil right now is $5 a barrel on the domestic market? I asked him, how do we work? This is just ordinary competition. We knock each other out of the market. The customer wins. So why do you want to have different terms? If you want to play, play by the same rules. That's what I can say on this.

Where I do agree with you is that all oil companies, not just international ones and not just Russians, both of them need to be confident in the stability of the tax system. This is the most important thing. Here I'm hoping that we, together with our colleagues at the international oil companies, will be able to convince our government that it is important for the government to maintain those rules of the game that have been established.

MR. KUCHINS: The local rules tell me that we must conclude our discussion for today. Thank you very much for sharing your thoughts with us.