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Interview

with Colin Smith, Head of Energy Research, VTB Capital

07.03.2013 / Energyboardroom

An overlapping theme for the 2012 VTB Capital conference in Moscow ‘Russia Calling’ has been the desire for Russia to decrease its dependency on the oil and gas sector. How do you see this impacting the future of the Russian Federation?

Russia’s industrial infrastructure for oil and gas production is overwhelmingly dominated by domestic companies, some of which are private but many of which have large government stakes. The bulk of production today still comes from onshore, although offshore production has been on the rise in areas around Sakhalin for instance, which has mainly been driven by international oil and gas companies. The offshore area is also the main direction for the future of Russia’s oil and gas sector, as the country aims to increasingly tap into its more challenging
reserves. Especially with regards to offshore Arctic production, there is a need for new technologies that Russia currently does not have domestically. This is why we have begun to see significantly new transactions between Russian and global companies. Over recent years, we have seen Rosneft entering into deals with ExxonMobil, ENI, Statoil, Total, etc. as well as a consortium for the Shtokman project.
As Russia continues to progress on developing resources in its less accessible areas, we will continue to see new pathways of international connections to bring in the much needed technology from abroad. This can even include bringing the market too; in the case of LNG for example. As part of this process, Russia itself is also gaining a better understanding of these technologies.

Is the need for these more complex technologies a global trend as the world looks deeper into unconventional resources?

The story of the oil and gas industry has always been one of pushing technical barriers, which is why the idea of peak oil keeps being pushed back. There is a vast amount of hydrocarbons that are currently not being produced, while a large part of the industry is now looking at how this can be produced in a commercially viable manner. The idea behind a reserve is not only about its volume, but also about its commercial feasibility and the required levels of investment.
The story of shale gas is one of the biggest stories in the oil and gas industry today. It is worth pointing out, however, that countries like Russia are still endowed with large reserves of conventional oil and gas, which makes both shale oil and shale gas rather expensive resources for them. It still is a lot cheaper to produce at conventional field level in Russia than to engage in shale oil or gas. A country requires a specific set of circumstances to make the whole process work, which has for instance been the case in the USA. From a shale perspective, it is almost inevitable that Russia has an enormous potential, yet no one is particularly looking at this because the country already has the huge potential in conventional resources.
In terms of the future of technology in Russia, a large part of today’s discussions in the country are about heading offshore including the Arctic region. This is a much less developed process anywhere in the world and there is no general well defined way on how to operate in this area. Moreover, the process is one of a controversial nature requiring quite a number of different steps. Russia probably has the largest untapped potential, yet has a very limited level of offshore development in Arctic conditions. Therefore, there will be a strong need for adapted technology to be able to work in those areas. Moreover, as Rosneft’s agreement with ExxonMobil has shown, it is not only about seismic drilling but also about the setting up of a framework for technology transfer, which will be required within a Russian domestic setting.

A number of industry players, such as Tullow Oil, have recently succeeded in remarkable discoveries in locations previously thought to have no hydrocarbons at all. Do you expect to see many new ‘oil provinces’ develop in the coming years?

The largest untapped potential today probably sits in the Arctic region, so from this perspective the answer certainly is yes. Over the last five to ten years, some oil provinces have been discovered completely out of the blue. Discoveries such as the pre-salt layers in Brazil have often come forth out of the use of modern technologies. A lot of eyes are now turning towards the other side of the Atlantic, to find analogues with was has traditionally been found on the West Coast of Africa. On the East Coast of Africa, apart from Uganda and Tullow’s success there, one of the largest gas discoveries in recent years has certainly been the gas finds offshore Mozambique. This is beginning to lead the industry to believe that there is a lot more hydrocarbon potential in that less developed area.

It has drawn significant attention to gas worldwide. Have you seen gas taking a new role within the global energy scene?

Gas has been a coming fuel for quite a while, partly because of its increased feasibility through LNG as well as the completion of new pipelines and a greater use in power generation. Globally, even if its transportation has become much easier, gas is still far harder to transport than oil however. As a result, we see that gas is now mainly used in countries that already have it. While there is the view that LNG can become a truly global market, it is my view that such market will be much more compartmentalized than what we see today.
It has often been discussed whether shale gas imports into Europe are a threat for Russian gas. If you think that US gas prices are going to stay at USD 3/mbtu, then US gas could probably be brought in at USD 300 to 350/kcf which certainly is competitive. It is much more likely, however, that US shale gas requires around USD 5/mbtu, which is why much of its drilling has collapsed there. Such rate will result in USD 400/kcf, which equals the rate Russian gas will be settling at. Therefore, shale gas imports into Europe are unlikely to become the game changer it is often referred us.
The bigger question for LNG is what is going to happen with LNG cost. The price of building capacity in Qatar in the mid 2000s was around USD 500 per ton, while today’s projects in Australia stand at around three times that cost. This difference has a considerable impact on the economics of such projects. If one were able to construct capacity at Qatar prices, one could sell such gas at USD 3/mbtu –or higher– and make a profit. At the costs the Australians face, one would lose money. For the future, the big question will resolve around what price these new African discoveries can be brought to market. Will it be closer to the Qatar prices or to the Australian prices? This will have its impact on the international gas flows.
Another aspect is the location of the actual market, for which one clearly needs to look at the East today. At the time that Russia was studying Shtokman, the USA was considered to be a major importer of that gas, which is obviously unlikely today. This means that most of this gas will be piped into Europe through existing pipelines. At the same time, Russia is studying the potential to construct LNG capacity to serve the high growth markets in Asia. While this will be a more competitive market, it will trade at higher prices and likely justify such investments. Sakhalin–operated by Gazprom and built by Shell– for instance has one of the highest running rates of any LNG plant in the world and has been a tremendous record from an operating perspective.

Current estimates for GDP growth in Japan amount to 1-2%, for China 7%, for Russia 3.5-4.5%, for Europe 0-1%, and for the USA 2-3%. How are these rates reflected on the global energy scene?

We spend significant time forecasting through to the years 2020-2030, in line with studies of major companies such as BP. The broad idea is that energy grows at a lesser rate than GDP. In other words, energy intensity per unit of GDP is considered to be less than one. This makes global energy use a relatively low growing piece of the market. With that, we also see fuel substitution happening at the moment with gas being increasingly favored over oil and perhaps even coal at some point.
Some of these trends are being driven by the regional economics of the powerhouses delivering this growth. China, in this regard, is the key anchor which remains relatively short on oil and gas but continues to have a great deal of coal. As history shows, it is expected that the country will first use its own resources before switching to imports, which in turn will depend on their relative prices. As a total of primary energy, gas still only accounts for roughly four percent in China, while the plan is to bring this figure up to 8 percent or higher.
One can remain skeptical about China’s ambitions to reach such growth rate for gas, seen the number of challenges they may face. Nonetheless, these ambitions do indicate the direction China is heading in. Even more so, it represents how the world is currently looking at gas as a primary energy source. Although transport is still difficult, gas is fairly abundantly present, efficient and much cleaner.
At the same time, the development of gas will also depend on the phasing out of other sources such as nuclear. The more nuclear will be phased out, the more the world will currently look at a hydrocarbon alternative which is more likely to be gas today.

In countries like Russia, nuclear is set to grow increasingly strong however…
I personally think that nuclear energy has a strong future. It is always worth bearing in mind that a country like Germany –where around one third of the installed capacity has been shut down– will keep its remaining sites until 2021. Until nuclear stations are being shut down and actually dismantled, a change in policy may still reverse future developments in that sector. In Japan for instance, the industry has realized that a shutdown of nuclear will significantly increase energy costs in the country. This, in turn, may encourage companies to not invest or actively disinvest in the country. How societies will balance these challenges will be an interesting process in the future.

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