Oil prices will leap again -- blame Russia

At issue, from the Russian government's point of view, are production-sharing agreements dating back to the 1990s, when Russian oil production had collapsed, falling some 40% from levels in the 1980s. Desperate for Western expertise and technology, the Kremlin signed contracts that exempted Western oil companies such as ExxonMobil (XOM, news, msgs) and Total (TOT, news, msgs) from all taxes until they had recouped their investment costs.

Now that Russia's oil industry is back on its feet and the price of oil has soared in the past decade, these contracts don't seem like such a great deal to the Kremlin, especially when Western companies say their development costs have climbed far beyond earlier estimates. ExxonMobil, for example, recently announced that costs had climbed to $17 billion from an original $12.8 billion, and Royal Dutch Shell (RDS.A, news, msgs) reported costs of $20 billion rather than the original estimate of $10 billion. Western companies have been told to accept less-favorable deals or bring in a Russian partner (usually Gazprom), or both.

And if the Western company demurs? It can suddenly find itself looking at the withdrawal of its permit to operate because of environmental violations. That's exactly what has happened to Shell at its Sakhalin 2 project and to ExxonMobil at its oil terminal designed to process oil from Sakhalin 1. Given the lackluster (at best) record of the Russian Ministry of Natural Resources in enforcing pollution controls at Russian companies, the move seems a clear act of governmental intimidation.

The pattern is clear and has been repeated again and again recently, whether it's in pressure on BP's (BP, news, msgs) joint venture in Russia to force the private Russian investors in the deal to sell out to Gazprom, or in the recent decision by Gazprom to cut out all foreign partners and go it alone in developing the country's massive Shtokman natural gas field.

The coming oil shock

So why should this produce a supply shock and why in 2008? Two reasons.

First, the Russian government's energy grab now is based on a confidence in its own oil-field engineers. Gazprom can operate the fields, expand production and explore and develop new fields with its own know-how. What technology it doesn't have, it can buy from companies such as Schlumberger (SLB, news, msgs). It doesn't need ExxonMobil or Shell as a partner.

I certainly don't think that the Western oil companies have any monopoly on engineering skills, but Gazprom is entering unexplored territory. Any signs that Russian production is beginning to falter will be blown up into major catastrophes by those many Western oil industry analysts who have a belief in the unmatched technological prowess of "our" oilmen.

And there is certainly the chance that Gazprom and the Kremlin have overplayed their hands. A recent World Bank study concluded that "policy instability" has cut down the amount of global capital flowing into Russia. Despite its huge oil profits, Russia still needs foreign investment.

Second, there's a downside to creating companies that are creatures of the state, as Gazprom clearly is. In any uncertainty over who wields power in the Kremlin, Gazprom will be one of the major spoils the challengers fight over.

It may seem silly to even mention uncertainty about control in the Kremlin. Russian President Vladimir Putin has consolidated power in his hands not only at the center -- where, for example, Gazprom now owns the NTV television channel that once dared to criticize Putin -- but also in the provinces, where Putin loyalists have gained control. The United Russia parliamentary party that backs Putin controls more than 300 of the 450 seats in the Duma and is likely to gain even more in the next election, in 2008.

Even though there's no doubt about who will win that election, it's still a major problem for Putin-style capitalism. According to the Russian constitution, Putin can't run for president again in 2008. His options are to amend the constitution (he's certainly got the votes) or to pass leadership on to someone else in his circle.

You're not off base if either or both of those sound like a return to the good ol' days of one-party rule in the Soviet Union. And it's my memory of how traumatic those transfers of power used to be that leads me to pick 2008 for a Russian oil supply shock. That year will be filled with uncertainty and rumor, as the question of who will run the country rises to the top of the agenda for overseas investors and purchasers of Russia's oil. Even if, as I think is almost certain, power remains with Putin or someone in his circle, the uncertainty will be enough, with oil supply and demand in such precarious balance, to give the oil speculators plenty to work with.

Again.

New developments on past columns

3 stocks for a world running out of oil: OPEC has finally publicly announced that it will meet in emergency session on Oct. 19. There's only one item on the agenda: a cut in OPEC's oil production. There seems to be general agreement on the size of the production cut -- about 1 million barrels a day or about 4% of OPEC's current production. But the organization is deeply divided on how to allocate the cuts. Countries such as Saudi Arabia, Libya and Algeria, which have been producing more than their allotted quota to meet supply shortfalls, want the cuts to be divided among cartel members based on actual production. That would lessen the effect of any cuts on these overproducers. Countries such as Venezuela and Iran, which have seen production fall well below their quotas, want the reduction to be based on quota numbers. That would force the overproducers to take the brunt of the cuts and leave the underproducers facing very small reductions, if any. The fact that OPEC has announced the meeting at all makes it extremely likely that an agreement will be reached. A public meeting with no result would do immense damage to the cartel's efforts to set global oil prices. We'll know in two days.

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E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Schlumberger. He does not own short positions in any stock mentioned in this column.

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