New Russia.Economic overvew for UNESCO board on EU.

Vagit Alekperov, Kirill Pokrovsky, Alan Sarkisjan.

Russia: New Sources of Growth.We have it, we don't have to "go to war "for it, and we are Europe(at least till the Ural mountains:)

Russia’s economic and political development, as well as its foreign relations, are a topic for incessant

discussions in the mass media worldwide. Most contribution to these discussions comes from politicians

and public figures while the business world viewpoint receives insufficient coverage.

It is worth noting that the current economic growth is provided

by launching new production facilities, rather than more intensive

operation of the existing ones. In the past years, capital investments

have shown a record-breaking rate of over 20%.

One of the main questions today is whether these trends are stable

enough. Will Russia be able to maintain a high growth rate for its

economy under a changing global environment of declining economic

growth rates and falling oil prices?

Answers to these questions are of paramount importance for Russia’s

relations with the USA and the European Union. Any attempt to

transform the discussions about the future of these relations into

a purely political or ideological issue is a trick aiming to evade the

discussion of real problems.

In the past years, Russia’s government has done a lot to secure a

long-term development of the country. Russia has settled its external

sovereign debt before maturity. The national gold and currency reserves

have come close to 500 bln US dollars, giving Russia a strong place

among the world’s top three countries in this ranking. Such measures as

separation of the budget into the general and the oil-and-gas segments,

establishment of the reserve fund and the national welfare fund have

paved the way for an effective financial policy for decades to come.

These measures enable Russia’s new government to focus on creating

incentives for further economic development, including tax burden

reduction, improving investment climate and fighting corruption.

Russia has already made its first steps towards these goals. A few days

ago Aleksei Kudrin, Russia’s Minister of Finance, disclosed The Main

Trends in Tax Policy until 2011 which envisage a reduced value added

tax and mineral resources tax, tax preferences for companies incurring

significant social expenditures, changes in the depreciation policy to

incentivize rejuvenation of the fixed assets, improved efficiency of

tax administration.

The proposed changes will have a positive impact on the development

of Russia’s oil and gas industry. It is common knowledge that the

industry has been stagnant in the recent years due to the poor condition

of the raw material base in the traditional areas of production. Over the

last three decades, the greater part of Russia’s oil and gas was produced

in Western Siberia. Today, we face the necessity to look elsewhere to

replace this major but depleted raw material base of Russia.

This has happened before its time – a consequence of unreasonably

fast development of Western Siberian fields in the Soviet era. There

have been a number of cases when accelerated production policies were

used even after the privatization of the oil industry. Naturally, this has

brought a slump in oil production growth rates in Russia from 9 – 11%

at the beginning of the current decade to 2% in 2006-2007.

Positive changes will become even more evident as the tax load on

the oil and gas industry decreases. Everyone, including government

officials, understands nowadays that it is essential to create conditions

to attract investments for development of new production areas.

According to the Ministry of Natural Resources, the amount of

investments in exploration required to ensure long-term additions of

hydrocarbon reserves is at least 55 bln US dollars, out of which 52 bln

is to come from the corporate sector.

Whether our country likes it or not, it will have to start competing

for investments in the coming few years. Otherwise it won’t be able to

retain its leading energy superpower status.

The actions of the Russian government indicate that the creation of

a favorable investment climate in the oil and gas industry is one of its

mid-term priorities.

On January 1, 2007, amendments to the Tax Code of the Russian

Federation came into effect establishing a reduced rate of the Mineral

Extraction Tax (MET) for fields with a depletion degree of 80 percent

or more. Additionally, to incentivize the production of ultra-heavy and

Eastern Siberia’s oil, the tax authorities have introduced the zero MET

rate for such fields.

1. Promotion of International Activities. The majority of Russian

companies have only begun their acquisitions overseas. This process

is hindered by several factors, the main ones being shortage of

profitable assets and state protectionism, which not infrequently has

political roots.

I am convinced that this process can be accelerated if cooperation in

the corporate sector is based on international covenants. It does not

necessarily have to be formal agreements. The essential idea is that

partners should be able to trust one another and be sure that their

national interests will not be infringed upon.

In light of this, an extremely positive signal for the Russian business

was the statement made by the then presidential candidate and now

President-elect of the Russian Federation Dmitry Medvedev, who spoke

about the necessity to offer state support for international activities

of Russian companies, above all in highly competitive global markets,

such as the energy sector and high-tech engineering.

2. Tight Control over Production Costs. Due to a number of objective

reasons the costs incurred by Russian companies in oil production are

about 50% lower than the respective costs incurred by the international

majors. This is, above all, connected with the specificities of the raw

material base, the bulk of which is comprised by onshore fields situated

in the regions with developed transportation infrastructure.

Depreciation of the US dollar exchange against the Russian ruble,

which in the last 5 years exceeded 100%, has become the basic factor

contributing to the escalation of costs.

In order to retain their competitive advantage in terms of costs Russian

companies should select exploration and production projects with the

utmost care.

The majority of the Russian companies, does

not develop remote reserves. The Company has only recently started

participating in deep sea projects in West Africa, as well as in a project

for bituminous oil production in Venezuela.

The fact that all the fields which are to be commissioned by the

Company in the near future are located either onshore or in shallow

waters has a positive influence on the upstream costs.

3. Gas Business Development. At present, the greatest part of Russian

oil and gas companies’ earnings (with the exception of Gazprom) come

from the oil business segment. Firstly, it is accounted for by the high

level of concentration of assets in the gas sector and, secondly, by the

state regulation of the gas market.

Nevertheless, now is a favorable moment to invest in gas projects.

According to the latest data, the Mineral Extraction Tax will remain

unaltered for gas at least until the year 2011, i.e. the moment when the

domestic gas prices are completely liberalized. It means that gas projects

are going to enter a phase of steady growth in profitability in the next

three years.

Here, Russia will retain its advantage over the competitors as holder

of considerable gas reserves both in Russia and abroad. Uzbekistan is a

key region for the Company in terms of gas production. The maximum

production level for the projects to be implemented in this country will

come to an annual 15 bcm. At that, gas will be sold at market prices.

The contribution of the Uzbek projects in Russians’s overall operating

results can hardly be overestimated: these projects will raise the

Company’s gas production in 2008 by 17%, while the net profit for gas

activities will be doubled.

4. Investments in Oil Refining. In the conditions of increasing

global oil prices the export duty system currently effective in Russia

contributes to a higher profitability of refining. At present, Russian

companies’ profits from refining one ton of oil exceed the oil export

profits by one hundred US dollars.

All these factors contribute to an increase in refining volumes in Russia.

In the past five years, this figure (applicable both to LUKOIL and

Russia in general) has grown by 24%. Within the same period the

share of the refining sector in Russian’s net profit has increased from

10 to 25%.

At present the Russian Government is elaborating amendments to

the tax legislation aimed to promote production of high quality

motor fuels.

The Technical Regulations, requiring Russia’s transition to the

European fuel standards between 2009 and 2013 have come into effect.

It is planned to differentiate the motor fuel excise rates based on quality

and environmental safety.

Russian has a vast experience in manufacturing and marketing of

petroleum products compliant with the European quality standards.

The Company operates in 12 EU-countries, where two of the

Company’s seven refineries and over 1,200 filling stations are located.

Within the next 10 years,

5. Business Diversification. For Russian oil and gas companies,

investments in energy assets will become the main source of business

diversification in the coming years. The favorable conditions have

been created – the spin-off of the heat generating companies formerly

incorporated in the RAO UES of Russia has been completed, their

shares are traded on the Russian stock market.

LUKOIL took an active part in the privatization of energy generating

facilities. The Company purchased a controlling interest in the Eighth

Territorial Generating Company (TGK-8), a major electric power

generating company in South Russia. The acquisition price was about

30% lower than the market price.

Annual gas consumption of TGK-8 comes to about 7 bcm and will

grow along with the implementation of new investment projects.

According to the Company estimates, the synergy effect from gas

supply from North Caspian fields to TGK-8 power stations will reach 2

bln US dollars.

The South Russian energy assets will become the core of LUKOIL’s

new business sector, which will also comprise the power stations located

in the Company’s fields and oil refineries. Development of the new

business line – the electric power segment – will enable the Russia

to simultaneously attain several objectives including enhanced

efficiency of raw materials utilization, providing electric power to own

facilities and business diversification.

It is evident that the above-mentioned list of challenges confronted

by Russian oil and gas companies is not exhaustive. However, it helps

assess development prospects for the coming decade.

It is of utmost importance that these plans meet support of the

Russian Government, whose priorities for the near future comprise

enhancement of Russian economy’s global competitiveness and Russia’s

integration in the international labor division system.

Today, business and the state speak one language in Russia, and

the basic concepts are law abidance, economic feasibility and social

responsibility. And this is the best basis for sustainable economic

and social development irrespective of any changes in external

business environment.

Vagit Alekperov, Kirill Pokrovsky, Alan Sarkisjan.

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