Has Russian oil output peaked?

The Kremlin often touts Russia's image as an "energy superpower," but now the country's oil production is declining. Some say Russia may have already reached peak oil output.

Underscoring the urgency of the issue, Prime Minister Vladimir Putin's new cabinet made its first order of business on Monday the approval of a package of measures to relieve the oil-production crisis.

"It's a good first step," says Natalia Milchakova, an oil and gas analyst for Otkritiye, a Moscow-based brokerage firm. But she adds that "rapidly slowing" oil production, which was growing by more than 10 percent five years ago, isn't "something that can be quickly fixed with political declarations."

As the world's second-largest oil exporter, Russia joins a growing number of top oil suppliers wrestling with how to address declining or peaking production. Like Venezuela and Mexico, Russia is heavily dependent on oil, which accounts for more than two-thirds of government revenue and 30 percent of the country's gross domestic product. Now, Moscow is trying to remedy a situation caused in part by outdated technology, heavy taxation of oil profits, and lack of investment in oil infrastructure.

The Presidium of the Cabinet, as it is officially known, in its inaugural meeting Monday approved tax holidays of up to 15 years for Russian companies that open new oil fields and proposed raising the threshold at which taxation begins from the current $9 per barrel to $15. Oil companies welcomed the measures, but experts say that after almost two decades of post-Soviet neglect, which have seen little new exploration, it may be too little, too late.

After rising steadily for several years to a post-Soviet high of 9.9 million barrels per day (bpd) in October, Russian oil production fell by 0.3 percent in the first four months of this year, while exports fell 3.3 percent – the first Putin-era drop. Russia's proven oil reserves are a state secret, but the Oil & Gas Journal, a US-based industry publication, estimates it has about 60 billion barrels – the world's eighth largest – which would last for 17 years at current production rates.

Energy Minister Viktor Khristenko recently admitted the decline, but suggested it might be overcome by fresh discoveries in underexplored eastern Siberia or in new Arctic territories recently claimed by Russia. "The output level we have today is a plateau, or stagnation," he said.

But Leonid Fedun, vice president of Russia's largest private oil company LUKoil, went one step further in an interview with the Financial Times last month.

"Russian oil production has peaked and may never return to current levels," he said.

That poses problems for Russia, which has talked of expanding beyond its main oil market – Europe – to China, Japan, and the US. In 2006, then-President Putin approved construction of an $11 billion pipeline across Siberia to the Pacific Ocean to carry eastward exports. Putin and his successor, Dmitri Medvedev, have insisted Russia can meet demand by increasing output but oil analysts around the globe are pessimistic that oil supplies can meet rising consumption in the coming decade.

No supply squeeze applies to Russia's natural gas industry, which has both vast reserves and a favorable tax regime. Gas prices have been rising on world markets in lockstep with oil, but in Russia only one company, the state-owned giant Gazprom, enjoys a monopoly on exports. "Gas producers are comparatively well off. The export tax for gas is fixed and does not rise when the price goes up," says Ms. Milchakova.

Oil profits, on the other hand, are taxed at nearly 90 percent, which has filled the state's coffers as prices for crude oil have risen from $10 per barrel a decade ago to more than $130 last week. Petrowealth was a key factor enabling Mr. Putin to concentrate political power in the Kremlin, which he used to take over huge slices of the formerly private oil and gas industry. The looming production crunch, therefore, suggests a need for sweeping political reforms as well as economic adjustments, some experts say.

"As long as energy prices keep going up and the easy money keeps rolling in, there is no incentive to liberalize," says Yevgeny Gavrilenkov, chief economist at Troika Dialog, a Moscow investment bank. "If the golden goose stops laying eggs, then they'll start to recognize the need for change."

A sharp debate is breaking out among economists, some of whom argue that the crisis is an opportunity for Russia to develop a long-term strategy to husband its remaining energy resources and diversify its economy.

They point to figures showing that gas and oil exports have risen since 2000 from under half to over 60 percent of Russia's gross domestic product and say that to continue trading nonrenewable resources for rapidly devaluing dollars is a big mistake.

"Russia should not be a colonial country that provides raw materials to more developed countries," says Nodari Simonia, director of the Center for World Energy Studies, an independent Moscow think tank. "We don't need to export more crude, we have to invest resources in our manufacturing base."

Russian oil profits, taxed by the state, have been accumulating in a special 'stabilization fund' that now totals about $130 billion. Earlier this year the government put another $32 billion into a sovereign wealth fund that is expected to begin investing in Russian infrastructure and social welfare schemes. "Russia's economy so far can't absorb the oil cash that's coming in. That, not increasing oil output, is our biggest worry," says Sergei Glaziev, head of the National Institute for Development, a Moscow think tank. "We urgently need to diversify our economy away from this dependence on natural resources."

Others say Russia's gas-and-oil sector can continue to grow, but only if there are massive new investments and critical reforms to an industry that under Putin became dominated by two state-owned behemoths, Gazprom and Rosneft. Both companies have accumulated huge debt in an ongoing campaign to take over formerly private assets that have returned nearly half of Russian oil and gas reserves to state control in recent years.

"Ten years ago the bulk of our oil resources were held by private companies, and growth rates were very high," says Michalkova. "Growth rates have become sluggish for complex reasons lately, but political interference and battles over ownership have not been helpful."

Major investments will be needed to eke out further production from the largely exhausted Soviet-era oil fields of western Siberia, experts say. "Production costs have more than doubled in the past six years, and the current tax regime makes additional output at older fields unviable," says Valery Nesterov, an energy expert with Troika Dialog.

Even if new finds are made in Russia's uncharted east, they are likely to be much smaller, more remote, and difficult to access. "In the early '80s a typical new oil field held reserves of up to 50 million tons, but today a company celebrates if it finds a field with 3 million tons," says Mikhail Krutikhin, an analyst with Russian Energy, a Moscow-based consultancy. "Therefore we need more small oil companies, which are best for operating small fields. But Russia has a few giant companies, whose fixed costs and attitude are all wrong.

Russia's new president, Mr. Medvedev, has talked about a need to encourage small business, but Krutikhin is skeptical given Medvedev's background as former chairman of Gazprom. "To reinvigorate our oil and gas industry, Russia needs dramatic tax reform, antitrust measures, and strong support for small enterprises," says Mr. Krutikhin. "But Medvedev comes from Gazprom, which is the biggest enemy of small business in Russia, so I really don't have any high expectations."