2009-E-7
The Impact of Nationalization and Insecure Property Rights on
Oil and Gas Developments in Russia’s Asia Pacific
Judith Thornton
University of Washington
Waseda University
November 20090

The Importance of Energy
The dependence of the Russian economy on oil and gas is well-known.
Conditions in world markets for oil and gas have long played a determining role inRussia’s economic growth and level of income. Writing in a series of articles, Clifford
Gaddy and Barry Ickes detail the historical importance of oil and gas to the Russian
economy, documenting how volatility of revenues from oil created volatility in Soviet
and Russian economic performance and contributed to the collapse of the Soviet
Union.1 They argue that, in recent years, the Putin government has succeeded incentralizing and managing resource revenues using a strategy based on insecure
property rights. Although this strategy stabilized the economy and centralized resource
rents, it did little to foster diversification. Moreover, this strategy creates opaque,inefficient institutions for administering the larger economy.2 They characterize Putin’s
control of property rights as a protection racket, since the agent receiving payment forprotection is also the source of threat.
Insecure property rights impede structural change, diversification, and the
productivity improvements that Russia urgently needs.

They generate ubiquitous

corruption. Nevertheless, in a period of rising resource revenues between 2000 and
2007, these structures provided the federal government with stability and control.
In September 2009, President Dmitry Medvedev raised resource dependence
and corruption as the central issues for Russia’s development strategy.3 His essay
published in Gazeta.ru and posted on the presidential web site begins: “In a few
months Russia will enter a new decade of the twenty-first century. …First, let’s answer a1

simple but very serious question. Should a primitive economy based on raw materials
and endemic corruption accompany us into the future?
“The global economic crisis has shown that our affairs are far from being in
the best state. Twenty years of tumultuous change has not spared our country fromits humiliating dependence on raw materials. Our current economy still reflects the
major flaw of the Soviet system: it largely ignores individual needs….
“To sum up, an inefficient economy, semi-Soviet social sphere, fragile
democracy, negative demographic trends, and unstable Caucasus represent very big
problems, even for a country such as Russia.”Thus, President Medvedev addresses the Kremlin elite with the same questions
posed by Western observers: Do the federal institutions developed for centralizing
resource rents block the Russian government’s ability to modernize its economy? Do
they impede modernization built on a healthy, well-trained population, which can takeinitiative in an environment that provides them with rule of law and safeguards themfrom hold-up by criminals or bureaucrats?
Until Russia diversifies its economy, future public and private investment in
Russian energy will depend on uncertain future conditions in energy markets. Private
investment will depend, as well, on the overall Russian environment for investment. In
the short-run, both high levels of market uncertainty and Russia’s insecure environment
for property rights impede investment and growth of energy production.
Gaddy and Ickes refer to the political economy of Russian resource dependence
as “Russia’s addiction to oil.” Measured in constant dollars of 2006, energy revenues
2

peaked in the early 1980’s at more than $350 billion, or about 40 percent of GDP. Then,they plunged in 1986, threatening the ability of the Russian government to earn foreignexchange and import foodstuffs. Writing in Collapse of an Empire, Yegor Gaidar details
how falling foreign exchange revenues in 1989 contributed to the growing crisis andultimate collapse of the Soviet economy.4
It was only after 2000 that burgeoning demand for oil in developing countries
contributed to rising oil prices and a recovery of Russian oil production. World price ofoil rose from $13 per barrel in 1999 ($17 per barrel in constant 2008 prices) to $97 perbarrel in 2008.5

Between 2000 and 2004, production of private oil firms expanded

rapidly. Then, after the expropriation of Yukos and its sale to Rosneft, growth slowed
and stagnated again. Still, in 2007, production of oil, oil products, and natural gas were
estimated to account for more than one-fourth of GDP, 60 percent of the value ofexports, and almost half of government budget revenue.6

The Political Economy of Resource Dependence
Does Russia suffer from a “resource curse?” Other things equal, natural wealthtends to be positively related to per capita income. Still, availability of resources may
have negative consequences for other sources of growth. For example, a resource
exporter will import other products, such as manufactured goods for domestic
consumption and investment. When manufactured products enjoy rapid technologicalprogress, then a resource exporter may lose out on this source of modernization.

3

There are political reasons, as well, why resource abundance does not always
lead to development. If the government is the resource owner, then government use ofresource revenues will determine whether rents are spent in support of growth—for
example, for infrastructure, health, and education—or if the revenue is distributed tofavored groups in society. When the government becomes a source of rent-seeking,then interest groups will tend to compete for control of the power to capture andredistribute rents. When this occurs, government policies are likely to be detrimental toefficiency and economic growth.
Since the onset of reform, Russian institutions for managing resource wealthhave been subject to conflicting forces. In the natural gas industry, many of theinefficient and opaque institutions of the Soviet command system were perpetuated in
Gazprom. As in the former Soviet system, the domestic prices of natural gas remained
low and financial flows were opaque, affording resource managers numerous
opportunities for private benefits.
In the oil industry, oligarchic ownership emerged. Between 1992-1995, insider
privatization of vertically-integrated production and refining networks created a dozen
independent oil companies.

As oil prices rose after 2000, these independent oilcompanies committed substantial investment to the rehabilitation of their mature oilfields and the development of new fields, mostly in the West Siberian basin, generatinga rapid growth in the volume of oil production.

However, aware that their property

rights were hostage to the whims of the Kremlin, private investment by oligarchs
focused on short-term gains that could be realized by oil-field re-engineering, well4

repairs, and well stimulation. As the sum of the tax on mineral extraction and export
taxes rose and the federal government’s marginal taxes on each barrel of export
approached 90 percent, oil production stagnated again.
Since 2004, with the rise of national oil companies in Russia, a new, but familiar,
model is emerging. In 2003, Rosneft took control of Yukos. Then, Gazprom purchased
Sibneft. Next, government forced Royal Dutch Shell and its partners to sell a controllingstake in Sakhalin-2 to Gazprom and forced TNK-BP to give up its giant Kovykta gas fieldin East Siberia. By 2008, the share of state-owned companies in oil production had
grown from about 27 percent to almost 40 percent of oil output.
Anders Aslund refers to Putin’s model as “state capitalism, noting that Putin’s
peculiar form of state capitalism involves a heavy dose of implicit taxes and subsidies.”7
It is a world in which Putin requires Roman Abramovitz to subsidize remote Chukhotka,
forces Oleg Deripaska to pay wages to unemployed workers at Pikalevo, and compels
the largest industrial firms to construct infrastructure for the Olympics in Sochi.
The consequences of Russian nationalization are best described by a simple
model of hold-up, or risk of expropriation.

The risk of expropriation reflects theuncertain rights to future income faced by a multinational investor. At each point in
time, the host country weighs the gain from expropriating the current investment
against the loss of future streams of investment and management know-how. In a basicmodel, a multinational firm (M) is considering an investment in a host country (HC),which is capital constrained. (For example, we might apply our model to Exxon’s
investment in oil and gas on Sakhalin Island.)5

If M invests K ≥ 0 in an initial period 0 and takes action a in period t, then the
project generates a net revenue of•

Rt = R(K, at).

•

There are two possible actions in any period, engage in the efficient rate ofproduction, ā, or shift resources out of HC, ă.

•R(K, ā) > R(K, ă), K>0•

Note that the action, at, also changes profits realized elsewhere, denoted by r(at).

•This first-best allocation of K and ā generates a surplus•δ[ R ( K FB , a ) + r (a )] − K FB > 0
1− δ

where δ is the risk-free discount at which M discounts future income. The parties can't
commit on how to share the returns once investment costs are sunk. HC is tempted to
expropriate the "quasi-rents" by imposing additional taxes, import or export duties, or
unnecessary "costs."
The timing of agreement implies that there is an agreement on an implicit
contract specifying K, at, and tax, Tt. Then, M invests K, chooses action, at, after which
the return R(K,at) is realized. At this point, HC chooses the tax, Tt. With this agreement,
the expected returns are:•

UM = -K +∞∑ δ T [R(K, at ) + r (at ) - Tt]
t =1

t

t

∞

•

UH = ∑ δ tTt
t =1

6

For this agreement to persist, it must meet participation and incentive conditions. The
host country must be better off imposing a tax, T in every period rather than(
expropriating the entire return R(K, a ) in one period and R(K, a ) thereafter. M prefers((
to take action a a pay tax, T, rather than choosing a and paying T= R(K, a ) if R(K, ā) + r(ā) - T > r(ă) . The project must be sufficiently profitable for M to cover its initial capitaloutlay. However, if K has been sunk, the maximum per period return M can get is given(by R(K, ā) – R(K, a ).

Otherwise the host country cannot be prevented fromexpropriating M. After the fact, the host country will expropriate whenever the gains
from current expropriation exceed the loss of expected future revenues frominvestment and technology. Note that M can reduce the benefits to the host country of
expropriation if the initial capital stock is financed by debt attached to project assets.
Russian policies as to whether to nationalize its energy production seem to be influx, given that Russia badly needs both foreign direct investment and technology. A
new Energy Strategy of Russia to 2030, published by the Ministry of Industry and Energy,
sees the Russian government playing a key role until 2014, as a source of investment
funds and credits. After that, the financing of investment and infrastructure, totaling
more than two trillion dollars, is to come from energy companies themselves and fromfinancial markets, with the government playing a regulatory role.8 Will this investment
be forthcoming? At the moment, the investment for private FDI into oil and gas islimited.
The target figures for domestic energy production and consumption in Russia’s
Energy Strategy posit modest change, with relatively little reduction in Russia’s high7

energy to output ratios. The largest shift in this forecast is a planned rise in the state's
export of energy to the Pacific. The shares of oil exports to China and Asia will increase
from the current 6 percent to 20-25 percent, natural gas, from almost none to 20
percent of export.9

Russian Energy in the World Economy
To achieve the planned increases in energy exports, Russia must develop new
Asian sources of supply. However, its eastward expansion of production is constrainedby location, logistics, and the immense investment costs of bringing Asian energy tomarket.

Russia’s ability to attract this investment, in turn, will depend on theconstraints that the government places on foreign business and on Russia’s protectionof property rights.
Russia’s resource stocks are vast. Today, Russia and the CIS together provide 15
percent of world oil output, compared with the Middle East share of 29 percent. In
2008, Russia’s oil production of 9.9 million bpd was second only to Saudia Arabia’s.10 In
2009, Russian oil production ranks first. On the other hand, Russia’s share of proved oil
reserves (6.3%) is dwarfed by OPEC reserves—76 percent of the total.
Russia’s endowment of natural gas is still larger. It has 23.4 percent of world
reserves and provides 19.6 percent of production.

8

Figure 1: World Share of Oil Production
Share of World Oil Production 2008

Asia Pacific
10%

North
America16%

Africa13%

South
America8%Former S U
16%

Middle East
31%

Europe6%

Source: British Petroleum 2009.

Figure 2: World Share of Gas Production
Share of World Natural Gas Production
2008

Asia Pacific13%
Africa7%

North
America27%

Middle East
12%
Europe10%

South
America5%Former SU
26%

Source: British Petroleum 2009.

9

Figure 3: Crude Oil Output by Region 1990 and 2007
Crude Oil Output by Region 1990 and 2007
350000300000Thousand tons

25000020000015000010000050000

0Khanti-Mansiisk

Yamal-Nenets

Volga

NW

E Siberian

Far East

South

Region1990

2007

Source: Regiony Rossii, various years.
Figure 4: Natural Gas Output by Region 1990 and 2007
Natural Gas Output by Region 1990 and 2007
600000500000Million m3

4000003000002000001000000
Yamal-Nenets

Khanti-Mansiisk

Volga

E. Siberian

Far East

NW

South

Region1990

2007

Source: Regiony rossii, various years.
The regional structure of Russia’s resource wealth has been remarkably constantover the past twenty years. The West Siberian Basin is Russia’s major energy producing
region, accounting for 71 percent of oil output and 92 percent of gas output. It is a low10

lying, flood-prone marsh. A line of low hills divides the region. South of the divide, in
the Khanty-Mansiisk Autonomous Okrug are found the major oil resources, extracted byvertically-integrated majors such as Surgutneftegaz, Rosneft’, and LUKoil. North of thedivide, is the Yamal-Nenets Okrug, where the bulk of natural gas is extracted.11

Initial Conditions and Recent Developments in the Oil Industry
Russia entered the transition era with a large energy infrastructure in both
Khanti-Mansiisk and Yamal-Nenetz. However, the Russian oil industry suffered from low
technology and the short-run orientation of past extraction. James Smith estimates that
Russian producers lost approximately 40 percent of the total economic value ofresource stocks compared with similar fields in the West.12 Moreover, the low quality of
infrastructure resulted in physical losses of product and immense environmental
damage. In an interview conducted by editors of Petroleum Economist in 1996, senior
executives of Rosneftegazstroy, Russia’s larges oil and gas contractor commented:“…the majority of the pipeline construction projects, except for the trunk ones,
did not comply with, or meet, world standards… The inappropriate use of
corrosion inhibitors and electrochemical protection units has resulted in highcorrosion rates in pipelines… The lack of on-line pipeline diagnostics has meant it
has been difficult to detect damage and to prevent leakage of gas, oil and oil
products.
“As a result, the number of registered accidents at pipelines runs to thousands ayear. The number of ‘insignificant’ leaks exceeded 40,000/year…
11

“Instead of the design service life of 15 to 20 years, many in-field pipelines
become unserviceable, due to internal corrosion and erosion, within as little as
two to five years.13
In September 1999, this author talked with the head of an environmentalremediation firm who reported that, in Komi, en route to inspect a major oil spill, hecounted 16 other pipeline leaks in the space of 30 kilometers.14
Thus, at the start of transition, the Russian oil industry had much to gain fromaccess to state-of-the-art foreign equipment and practices. There were large potential
gains to be reaped from both oil field re-engineering of existing fields and new fielddevelopment.
Early in transition, Western oil majors and oil service firms entered into a
number of attempted joint projects in Russia, but the uncertain status of control ofresources, a chaotic business environment, and difficulties in gaining access totransmission infrastructure rendered these early efforts unprofitable—sometimes,
spectacularly unprofitable.
Multinational energy companies attempt to maintain a presence in any country,
like Russia, that is both a major producer and a major market for energy. Nevertheless,international energy executives found the Russian environment uniquely difficult. In
industrialized countries, they argued, the oil producer finds strong physical andinstitutional infrastructure, a strong network of suppliers and services, developed
financial markets, and an effective legal framework.
competitors.
12

But there are also manyIn developing countries, there is little local infrastructure or industrial support, aweak capital market, and an incomplete legal framework. But, in these markets, policy
makers are eager to establish state-of-the-art industry and willing to construct physicaland institutional infrastructure to foster development. While developing countries arelikely to impose domestic price controls and high taxes, the formation of strong
relationships can create a relatively stable business environment for the firm andprovide some barriers to competition.
The Russian environment represents a third case in which there is a large andpolitically powerful domestic oil and gas industry that has incentives to block foreigncompetition. Initially, a body of legislation informed by international practice promised
to provide a predictable framework for energy development. However, as a system ofcrony capitalism emerged, both formal administrative practices and informal practices
contradicted formal laws, creating an environment in which corrupt practices and holdup problems were common.

Since 2003, as the Russian government extended

government control over “strategic” firms, the constraints on foreign participation in
the energy sector loomed large.
In the 1990’s, the one apparent exception to Russia’s difficult environment forenergy development was Sakhalin Island.

Western multinationals were willing toundertake investment in Sakhalin’s off-shore resources because it appeared that
Russian firms lacked the technology or investment funds to develop them. On Sakhalin,
producers expected to have direct access to the Pacific market without facing potential
hold-up by Transneft’ or Gazprom. They expected production-sharing legislation to13

guarantee access to the world market and to establish a secure framework of taxation,
eliminating some of the opportunities for creeping expropriation.

On Sakhalin,multinationals formed strong, cooperative relationships with the regional government
administration, in a region that faced high levels of unemployment and which valued
both the infrastructure investments provided by the multinationals and the strict
framework for environmental protection that they established.
Elsewhere, in other, traditional oil-producing regions of Russia, the collapse of
production to half of former levels between 1986 and 1997 was followed by a rapid
recovery in the period 2000 to 2004. After the ruble devaluation in August 1998,
Russia’s nine largest vertically-integrated private oil firms undertook substantial oil-field
re-engineering to bring idle wells back into production.15 They undertook new fielddevelopment, accessing smaller reserves in established fields.16 Between 1998 and2005, the Russian oil majors increased their production from 279.3 million tons to 448.6
million tons.17 Since then, crude oil production has been approximately constant at
about 488 million tons, as new production at Sakhalin-1 offset modest declines in older
fields. Although the quantity of oil produced and exported showed modest growth after
2005, the value of exports surged in response to rising oil prices that went from $156
per ton to $684.3 per ton between 2001 and 2008.18 Then, the collapse of oil prices inlate 2008, led to a collapse of federal budget revenue and capital flight. Yet, as oil prices
have risen again in 2009, Russian oil exports have grown rapidly again.

14

Figure 5: Crude Oil Production 1985-2008
Production of Crude Oil
14000

12000

thous bpd

10000

8000

6000

4000

2000

0
1980

1985

1990

1995

2000

Russian Federation

2005

2010

Total FSU

Source: Promyshlennost’ various years.

Figure 6: Export of Crude Oil and Oil Products 1992-2008
Russian Export of Crude and Oil Products
6000

5000

thous bpd

4000

3000

2000

1000

0
1990

1992

1994

1996

1998

2000

2002

2004

Year
crude

products

Source: Russian Statistical Handbook, various years.

15

2006

2008

2010

Looking ahead, changes in oil production and export will depend crucially on
world prices and domestic export tariffs, but, with national oil companies playing thelead role, the regional structure of production is likely to show only a modest shift
toward East Siberia and the Russian Far East (RFE). Much of the expansion of oil output
will continue to come from legacy fields in West Siberia and new resources in the TimanPechora Basin, the Caspian. If the government is serious about implementing an
ambitious new Energy Strategy, which promises to increase Asia’s share in oil exports to
20-25 percent, they will have to commit or attract a huge volume of investment. Eachof the proposed new projects—further development of fields on Sakhalin, Rosneft’s
Vankor field in northern Krasnoyarsk, and development of reserves in the Evenki
Autonomous Okrug, northern Irkutsk, and southern Sakha—will require major up-front
commitments.
In 2009, construction of the first leg of Transneft’s East Siberian-Pacific Ocean
pipeline network is underway. Now, industry observers ask what potential fields will
provide oil to fill the pipeline and when. We discuss these individual projects, below.

16Figure 7: Major Russian Oil Basins

Source: International Energy Agency
Initial Conditions and Recent Developments in the Gas Industry
Russia’s initial conditions in the natural gas industry were more favorable than in
the oil industry, and, yet, natural gas production contributed little to recent growth ofenergy production.

In 1990, Russia had the world’s largest gas production andtransport industry, largely centered in four giant fields—Medvezh’ye, Urengoy, andYamburg, and, recently, Zapolyarnoye—located in Yamal-Nenetz district in West
Siberia.19 However, as output from Gazprom’s super-giant fields declined during the1990’s, so did Gazprom’s production.
Initial arrangements for ownership and control of the gas industry created
opportunities for rent-seeking instead of growth. In an inflationary era, domestic gas
17prices were below variable costs. Moreover, since Gazprom had no control over pricing
and was not allowed to cut off non-paying customers, huge payment arrears
accumulated in the domestic gas and electric power industries. In 1996, 57 percent ofgas payments were settled by mutual offsets or barter.20 Gradually, beginning in 1999,
non-paying companies were disconnected and Gazprom took over indebted municipalgas distribution systems.
Nevertheless, in the 1990s Gazprom’s finances remained opaque and the statemonopoly provided a major channel for income and asset stripping. In 2001, Rem
Vyakhirev was replaced by Alexey Miller, Deputy Ministry of Energy, and by 2005, theformer managers had been replaced by managers with close ties to President Putin.
Nevertheless, sales through trading intermediaries still create opportunities for rentextraction.
Even now, domestic gas prices are regulated to just cover variable costs. In
January 2005, average domestic price was just $38 mcm compared with an averagecontract price of $155 in Western Europe. With price controls, Gazprom provides
annual allocations of gas to domestic customers at regulated prices, with residential
customers enjoying lower prices. Industrial customers then bid for additional gas at
higher prices, accessing supplies from independent producers.

Today, a growing

percentage of gas supply—currently about 16 percent--is provided by independent
producers.

These companies are generally vertically-integrated oil majors—LUKoil,

Surgutneftegaz, and TNK/BP—which produce associated gas. This gas may be sold in18

the domestic economy, but Gazprom retains a monopoly on export, selling to Europe
through a wholly-owned subsidiary, Gazexport.
During the 1990’s Gasprom established joint venture marketing companies
throughout Europe, holding 30-50 percent of the equity in each. Today, Gazprom seeks
to maintain a monopoly of export delivery, limiting access of Central Asian producers to
non-Gazprom transit. However, Gazprom’s attempted monopoly is a source of conflictin Russia’s negotiations of WTO membership with the European Union. The EU wishes
to eliminate Russian gas export tariffs, domestic price controls, and restrictions on gas
transit for Central Asian gas. It seeks non-discriminatory transit tariffs for gas deliveries,
the right of foreign investors to access Gazprom’s network, and private rights toconstruct their own pipelines. These issues remain unresolved.
The financial significance of gas export sales is substantial. In 2003, Europeansales accounted for 30 percent of gas volume but 65 percent of total revenue. European
gas revenues are estimated to have increased from $16.6 billion in 2000 to $43 billion in
2006, and to $66.4 billion in 2008.21 However, unlike oil exports, gas exports were down
substantially in 2009.
In the past decade, Gazprom has directed relatively little of its revenue toexpansion of its upstream reserves and production. Instead, it maintained deliveries bypurchasing gas from other Russian producers and from Central Asian producers, using
its European revenues to acquire downstream distribution systems. In the future,
Gazprom will have to turn to new fields to offset the steady decline of production fromits mature fields. There are large reserves in the Yamal Peninsula, the giant Shtokman
19field in the Barents Sea, off-shore Sakhalin, Kovykta, and other, smaller fields in
Krasnoyarsk, Irkutsk, and Sakha. Yet, the cost of production and transportation ofnatural gas from each of these sources is considerable, and Gazprom is ill-equipped tocarry out these projects. Its domestic costs are far higher than costs of independent
producers, such as Novatek. Hermitage Capital reports that Gazprom’s construction
costs for the Blue Stream pipeline were three times higher per kilometer thanconstruction on the Turkish side of the border.22 Still, in the current environment,
Russia’s national energy companies, Rosneft’ and Gazprom, are slated to play a crucialrole in the supply of Russian energy to China and all of Asia. The form of Westernparticipation in these efforts is still unclear.

Figure 8: Production and Export of Natural Gas
Russian Natural Gas Production and Export
700.0

600.0

500.0

bil cm

400.0

300.0

200.0

100.0

0.0
1988

1990

1992

1994

1996

GAS Production BP

1998

2000

2002

Gas exports grossSource: Promyshlennost’ various years.

20

2004
Gas export net

2006

2008

2010

Figure 9: Major Russian Gas Basins

Source: International Energy Agency
Figure 10: Value of Energy Exports
Value of Energy Exports
160000140000120000$ Million

100000

80000

60000

40000

20000

0
1990

1992

1994

1996

1998
Oil

2000
Products

2002

2004

2006

2008

2010

Gas

Source: Institute for Economies in Transition. Russian Economy in 2008; Trends andOutlooks. Moscow, p. 300, http://www.iet.ru/ru/ob-institute.html.

21

Expansion of Energy Production in Asian Russia; the Case of Sakhalin
The substantial transfer of effective ownership from private firms to government
control since 2003 provides a cautionary example for Western multinationals. Surging
prices for oil and gas between 2002 and 2008 created incentives for the Russian federal
government to recapture control rights to natural resource stocks.

This re-nationalization of resource ownership takes many different forms. It involved the
expropriation of Yukos and the sale of Yuganskneftegaz to Rosneft for $9.35 billion, thepurchase of Sibneft by Gazprom, the sale of 50%-plus one share in Sahkalin-2 toGazprom, the sale of TNK-BP’s interests in the Kovykta gas field to Gazprom, and thetransfer of development rights to several off-shore fields on Sakhalin to state-owned
Rosneft’ and Gazprom. Two projects, Sakhalin-1 and Sakhalin-2, originally developed byWestern multinationals, now face uncertain prospects with substantially changed rulesof the game. Most of the rights to additional fields on Sakhalin have been assigned tostate-owned Rosneft’. In the case of Sakhalin-3, Rosneft’ is conducting exploration on
the Veninskii block of Sakhalin-3 with China’s Sinopec.

Gazprom is engaged inpreliminary exploration of the Kirinsky block of Sakhalin-3.
After the fact, did Western multinationals misjudge the risks of investment in
Russia? In the 1990’s investment on Sakhalin seemed to benefit all parties. Sakhalin’s
location on Russia’s periphery, only 60 kilometers from Japan, gave it strategic
importance to Moscow. Moreover, the island faced high unemployment and a fall of
population from 715,000 to 526,000.

In the mid-1990’s energy prices were low,domestic energy companies had few resources for investment, and Sakhalin’s
22remoteness from Moscow weakened the interest of competing domestic oil companies
to undertake development there. There were technological reasons, as well, for theRussian government to involve Western companies with experience in offshoredevelopment in difficult environments such as Alaska and the North Sea. Russian
domestic firms had little such experience.
Western companies went ahead with two projects after Russia put in place a Law
on Production Sharing, signed in 1995. The Russian Production Sharing Law granted aninvestor exclusive rights to prospect for and extract mineral raw materials from a23

designated site.

Licenses were issued jointly by the Federal Agency for State Mineral

Resource Management and the territorial administration.

However, international

contracts were subject to parliamentary approval, and there were strict domestic
content conditions. The Law provided that investors and the Russian government would
share the output produced by a project after investors had covered the up-front
investment costs of the project.

During the initial investment period, investors

committed to make specific payments to the regional government and to undertake
substantial investment in regional infrastructure.
The Production Sharing Law explicitly exempted the investors, their contractors,
and subcontractors from taxes, fees, excises, and other obligatory payments except for
profits tax, royalty payments, bonuses, exploration payments, land use payments, andinsurance coverage of Russian employees. However, the Russian side reserved the rightto make unilateral changes in arrangements in response to changes in world markets.
There were few safeguards for the foreign investor in the event of a dispute.
23

A number of enabling laws and regulations followed, which capped the numberof sites that could be developed under production-sharing rules. Gradually, increasing
constraints were placed on production-sharing contracts until, by 2005, production
sharing arrangements were no longer available.
Sakhalin-2 was the first firm to undertake production. Since 1999, it has been
producing and exporting oil on a seasonal basis from one of its fields, Piltun-Astokskoye,
using an offshore platform. By 2006, the Western partners in Sakhalin-2, Shell, Mitsui,
and Mitsubishi had much to celebrate. Revenues to the Russian government exceeded$460 million in bonus payments, royalties, and taxes. With full production, the Russian
government would receive $300 million per year in royalties, which would rise to $2
billion after cost recovery. Russian contractors had received $8.3 billion in contracts and12,000 workers were employed.
However, a major ownership change was in the offing. Just as Gazprom and
Shell entered into negotiations to swap some Gazprom assets for a 25% stake in the
project, Shell announced that estimated capital investment cost would rise to nearly $20
billion.

Following a period of intense pressure on the international partners, anagreement was reached in 2007 for Gazprom to acquire a 50% + 1 share of theconsortium for a total of $7.45 billion. Thus, today, the shareholder structure of
Sakhalin Energy is Gazprom 50% + 1 share; Shell, 27.5% + 1 share; Mitsui, 12.5%; andDiamond Gas Sakhalin, founded by Mitsubishi, 10%. In return for government approvalof a revised budget of $19.4 billion to 2014, the shareholders agreed to make a special

24

payment of $1 billion per year to the Russian government, beginning in 2010, with theexact dividend depending on the price of oil.24
Investment in Sakhalin-2 continued on schedule in spite of the ownership change.
Phase 2 of its project involved installation of two further platforms, 300 km of offshore
pipelines connecting all three platforms to shore, more than 800 km of onshore oil andgas pipelines, an onshore processing facility, an oil export terminal, and the constructionof Russia’s first liquefied natural gas plant. In 2008, the project began producing andexporting oil from a second platform at Piltun-Astokskoye. In January 2009, it produced
first gas from its Lunskoye platform, 15 kilometers off the northeast coast of Sakhalin.
Gas is routed to an Onshore Processing Facility from which it goes to Sakhalin Energy’sliquefied natural gas (LNG) plant in ice-free Aniva Bay at Prigorodnoye in the south of
Sakhalin Island.
The LNG plan consists of two complexes capable of producing 9.6 million tons of
LNG per year.25 Most of that gas is contracted to various Japanese electric power andenergy companies. Plans call for delivery of about 8 million tons per year to Japan and1.5 million tons to KOGAS in South Korea. Within Russia, Gazprom’s ownership gave theproject considerable protection from the multiple bureaucracies that earlier createdhold-up problems on every margin for the international investors. With its widespreadparticipation in oil and gas markets and its ownership of infrastructure for liquefaction
and re-gasification of natural gas in the Pacific market, it appears that Shell has beenable to manage costs and prices to integrate Sakhalin’s supply into the international LNG

25

market. However, as Pacific LNG supplies have increased rapidly, leading to falling
prices, the project now faces price pressures.
In contrast to Sakhalin-2, the prospects for Sakhalin-1, which brings together
Exxon (30%), Japanese-owned Sodeco (30%), Indian state-owned ONGC Videsh (20%),
Rosneft-Sakhalinmorneftegas (11.5%), and Rosneft-Astra (8.5%), seem less certain.
Sakhalin-1 controls three fields, Chayvo, Odoptu, and Arktun-Dagi with total recoverable
reserves of 307 million tons (2.3 billion barrels) of oil and 485 bcm of gas. After 10 years
in development, first production flowed from the Chayvo field in October 2005 and,with completion of on-shore processing facilities, production reached 250,000 barrels ofoil a day in February 2007 (12 million tons per year), although production is currently
reported to be 200,000 barrels per day. This first phase of development used a
revolutionary, onshore drilling rig with numerous extended-reach wells and an offshore
drilling and production platform. “Standing 230 feet tall (70 meters), the Chayvo landbased drilling rig, Yastreb (Hawk), is the largest and most powerful land rig in theindustry, designed to withstand earthquakes and severe Arctic temperatures. Yastreb
drills down and then horizontally under the sea floor a total distance of more than 11
kilometers, making these extended-reach wells the longest in the world, minimizing
marine impacts.”26
When it began production, Sakhalin-1 had access to existing oil and gas pipelines.
An oil pipeline ran to the Komsomol’sk refinery and to an export node at DeKastri on themainland and a gas pipeline extended to Komsomol’sk. In 2006, the project constructed
a new 600 mm oil pipeline paralleling the first.
26

A new gas pipeline was underconstruction by a Russian consortium that included Rosneft and the Khabarovsk regional
administration. Initially, a contract was signed to deliver about 2 bcm of gas per year to
the region, with the prospect of increasing to about 3 bcm within five years.27
In 2005, production of natural gas and oil began simultaneously. In the first year,
1.5 bcm of gas was delivered to Khabarovskenergo and Khabarovskraygaz in
Khabarovosk region. However, delivery prices of gas at $45 per mcm were reported tobe below variable costs, thus constituting an in-kind tax of the project.
Sakhalin-1 has the capacity to produce considerably more natural gas. In 2006, it
signed an agreement with China to supply 8 bcm of gas per year to China. Under its
Production Sharing agreement it has the right to export all of its gas to the international
market. However, the Russian government blocked project plans to construct a pipeline,
and, in 2007, Gazprom purchased the existing pipeline between Sakhalin andKhabarovsk.
Under the current gasification program for the Far East, natural gas is to be
directed primarily to domestic use.

Gazprom plans to construct an LNG plant in

Vladivostok from which Gazprom might export to the international market. According
to recent statements by Gazprom executives, pipeline deliveries to China will come from
elsewhere.
At the moment, it appears that the partners of Sakhalin-1 are unlikely to pursue
development of the project’s remaining fields, Odoptu and Arktun-Dagi. The mainsticking points are resource prices. Gas prices on offer from Gazprom appear to be afraction of the prices that were agreed with China. In the case of sales of crude, terms
27

of access for delivery to the world market and transfer prices also have to be negotiatedfor delivery of oil to Rosneft’ as sole owner of the Khabarovsk refinery.
Gazprom currently holds a monopoly of international deliveries of natural gas
from the Far East. Construction of a further extension of that gas pipeline from
Khabarovsk to Vladivostok began in August 2009. Gazprom announced that it would
commit $1.6 billion during 2009 toward construction of the Khabarovsk-Vladivostok legof the pipeline and promised a total of $3.2 billion to gas investments in the Russian Far
East during 2010.

Assuming that construction costs of Gazprom pipelines run

approximately three times higher than similar Canadian or European pipelines of a given
size and distance, a 1200 mm trunk line running 1350 km would cost $4.5 billion,
compared with about $1.6 billion for a similar pipeline in Canada.28 However, at an
inauguration ceremony for the Sakhalin-Vladivostok pipeline in Khabarovsk, Energy
Minister Sergei Shmatko estimated that the total pipeline cost would be $11 billion, oran amazing $6 million per kilometer. The initial capacity of the pipeline is 6 bcm peryear, with plans to increase the capacity later to 30 bcm, a goal that would require
additional supplies from Gazprom’s Kirinsky field or other sources.
What are potential sources of supply of gas to Vladivostok in the long-run? The
new strategic industries law passed in May 2008 limits the share of ownership that may
be held by international investors. Thus, national energy companies Rosneft’ andGazprom and their subsidiaries will play the lead role in developing Siberian oil and gas.
On Sakhalin, current interest of both companies is focused on blocks of the Sakhalin-3
field. The four blocks, together are estimated to contain 5.1 bb of oil and 1.3 tcm of gas.
28

The Veninsky block will be developed by a Rosneft-Sinopec (China) consortium, while
Gazprom is to develop the Kirensky block. Other long-run plans include a gas pipelinerunning from the Chayanda gas field in Yakutia on a route to parallel the East SiberiaPacific Ocean oil pipeline.
Table1 : Sakhalin Fields
Sakhalin Shelf Projects
Project

Sakhalin-1

FieldsReserves
Oil

Reserves
Gas

Members

Investment
to DateTotal
Investment

485 bil m³

Exxon (30%),
Sodeco (30%),
ONGC Videsh (20%),
Rosneft'Sakhalinmorneftegas
affiliates (20%)$7.7 bil$17.8 bil (total all
fields)

150 mil t

93 bil m³

Gazprom (50%+1),
Shell (27.5%),
Mitsui(12.5%),
Mitsubishi (10%)$15 bil$22 bil

Chayvo

310 mil t

Odoptu70 mil t

Arkutun-Dagi

Sakhalin-2

Piltun-Astokhsky

Lunsky3.8 mil t

642 bil m³

Sakhalin 3

Kirinsky

452 mil t

970 bil m³

Gazprom$15 bilAyashsky

114 mil t

513 bil m³

Rosneft'- SINOPEC$13.5 bil

800 mil bbl

19 tcfRosneft(51%),
BP (49%)5.7bil bbl

16 tcfRosneft (51%),
BP (49%)200 bil m³

Petrosakh, Alfa Eco$15 bil

East Odoptinsky
Sakhalin-4

Pogranichny
Okruzhnoye

Sakhalin-5

KaigaskoVasukansk

30 mil t con
Sakhalin-6

Pogranichny

600 mil bbl

Source: Author’s Summary.

29

Figure 11: Russian Far East Production of Oil and Gas Condensate
RFE Production of Oil and Gas Condensate
16000

14000

12000

thous tons

10000

8000

6000

4000

2000

0
1988

1990

1992

1994

1996

1998
Sakha

2000

2002

2004

2006

2008

Sakhalin

Source: Regiony rossii, various years.
Figure 12: Russian Far East Production of Natural Gas
RFE Production of Natural Gas
8000

7000

6000

mil cm

5000

4000

3000

2000

1000

0
1988

1990

1992

1994

1996

1998
Sakha

2000

2002

2004

2006

2008

Sakhalin

Source: Regiony rossii, various years.
Expansion of Energy Production in Yakutia and East Siberia; the Case of Oil
Traditionally, only small amounts of oil were produced in East Siberia--in Sakha,
Irkutsk, Evenki Autonomous Okrug, and Taymyr Okrug. However, the construction of30

the East Siberia-Pacific Ocean (ESPO) pipeline will allow Siberian oil to reach Pacificmarkets, including China, at substantially lower cost. The total ESPO system is to be a
4,700 km pipeline system. State-owned Transneft’ is constructing the pipeline in twophases. The first phase of the pipeline consists of a 2,757km section from Taishet in
Irkutsk Oblast to Skovorodino in Amur Oblast, along with a subsequent branch to Daqing,
China. This construction work began in 2006 and completion of the first Russian sectionis scheduled for the end of 2009. On this section, the pipeline consists of 1,220 mm
diameter pipe with a capacity of 80 million tons of crude oil per year. The branch to
China is expected to have a capacity of 30 million tons per year and is scheduled forcompletion in 2010. Transneft’ estimates that construction cost of this first phase will
total about $14 billion. From Amur, crude oil will be transported by rail to the Pacific.
The second phase of the ESPO pipeline will involve the construction of a 1,963 km
section from Skovorodino to a Pacific Ocean terminal at Kozmino. Capacity of the phasetwo section has been estimated at 30 million tons of crude oil a year and completion isplanned for 2014.29

31

Figure 13: East Siberia Pacific Ocean and Other Planned Pipelines

Source: International Energy Agency
With extension of the ESPO pipeline, several prospective East Siberian fields are
candidates for rapid development.

Matthew Sagers singles out the Talakan,

Verkhnechonskoye, and Vankor fields as major suppliers to ESPO.30 Talakan, in Sakha
was acquired in 2004 from Yukos by Surgutneftegaz (one of Russia’s most opaque andpolitically-connected companies).

In northern Irkutsk, oil production began at

Verkhnechonskoye in 2005 under the operating partner and majority owner, TNK-BP,
which holds 62.71 percent of shares. Rosneft (25.94%) and East Siberian Gas Company(11.29%) hold minority shares. Verkhnechonskoye contains between 4 and 5 billion
barrels of oil equivalent, with about 1 billion barrels recoverable. In 2009, the field
produced just 20,000 bpd, with production expected to rise gradually to 150,000 bpd.
32

A TNK-BP publication describes production conditions in remote northern fields:“What is it like to work at Verkhnechonskoye? The field lies in permafrost where the ice
penetrates deep into the ground and never melts. On only about 60 days a year does
the temperature venture above zero.

In winter it may average well below minus

30 degrees Celsius. Transportation is mainly by helicopters, which according to safety
rules are only allowed to fly in daylight, which itself is in extremely short supply so far
north. It’s a land of solitude – the density of population is less than one person per
square kilometer.”31
Vankor, in northern Krasnoyarsk, is the largest of these oil fields. In 2009,
Rosneft’ completed an investment program totaling about $6.6 billion to place Vankor
into operation. With reserves of 520 million tons of oil and 95 bcm of gas, Vankor willproduce 2 million tons of oil in 2009. Rosneft said production in 2009 was 18,000 tons aday, increasing to 30,000 tons in 2010. In the future, it is to produce about 25.5 million
tons of oil per year (510,000 bpd), or about one-fourth of Rosneft’s total oil output.32
Although development costs are almost 50 percent higher in East Siberia than in West
Siberia, Vankor and other fields in the far north enjoy a preferential resource extraction
tax rate. Now, the Russian government has promised that new projects in East Siberia
will enjoy a zero customs duty on export as well—a substantial concession.
Initially, oil is flowing south to feed into the Transneft’ West Siberian pipeline
network, but, ultimately, Vankor’s oil is to flow into the ESPO pipeline for delivery to
China and the Pacific. China has agreed to lend $15 billion to Rosneft and another $10

33billion to Transneft’ in exchange for delivery of 300 million tons of oil over 20 years, alarge part of which is to come from Vankor.
Russia has long provided China with crude oil and products. In 2007, Russia sent
12.97 million tons of crude and 3.3 million tons of refined products to China by rail.33
With construction of a spur from the ESPO pipeline to Daqing, oil deliveries from Russia
to China are likely to grow rapidly. However, the prospects of natural gas deliveries by
pipeline between Russia and China appear to be less certain.

Expansion of Energy Production in Yakutia and East Siberia; the Case of Gas
Based on its reserves, Russia has great potential to supply natural gas to the
Pacific market. However, that potential continues to be limited by government policies,
giving Gazprom a monopoly over gas exports to the world market, which it has
exercised to eliminate international producers. Thus, Gazprom blocked Sakhalin-1 andTNK-BP’s Kovykta field from delivering pipeline gas to China. Then, using TNK-BP’s low
production as an excuse, the government withdrew the Kovyka license.

Using

environmental regulation as an excuse, the government forced the transfer of acontrolling share in Sakhalin-2 from a Shell-led consortium to Gazprom.
Supply of LNG to the Pacific market is beginning. Currently, two LNG trains
owned by Sakhalin-2 have the capacity to deliver up to 9.6 million tons of LNG per year
to Asian customers, with most of it contracted to customers in Japan. In September
2009, Gazpromexport announced that they were talking to Japan about co-funding the
Sakhalin-Vladivostok pipeline and a proposed LNG plant located in Vladivostok.
34

According to Kommersant, Japan was discussing a loan of $2 billion on condition thatthe money would be spent on Japanese pipe. However, the major source of uncertainty
regarding Russia’s supply of gas to the international market is the 2007 Order of theIndustry and Energy Ministry, which established the Eastern Gas Program.
The Eastern Gas Program, recently amended by a new Energy Program to 2030,
envisions investment of 2.4 trillion rubles ($80 billion) in eastern gas development.
More than half of the funds would be spent on gas production and processing, one-thirdon gas transmission and storage. Work would focus on four gas-producing areas—
Sakhalin, Sakha, Irkutsk, and Krasnoyarsk. The key principles of that program were: a)priority of domestic customers for the use of natural gas; b) pricing of natural gas basedon competition with alternative fuels without direct administrative price regulation; andc) an export policy based on a single exporter, Gazprom.

Gazprom was named

coordinator of the program. According to Gazprom, the Eastern Gas Program would
provide capacity to produce up to 55.7 bcm of gas from eastern fields by 2020. About
30 bcm of this output would be directed to Pacific export and the remainder would
serve domestic consumption.
In 2007, Gazprom held 45 license areas in Siberia, the RFE, and the Barents Sea.
In 2008, they received licenses for development of the Kirinsky deposit on Sakhalin and
the Chayanda field in Sakha. They hoped to receive concessionary tax arrangements for
Chayanda. However, in late 2009, Gazprom reduced its forecast rates of gas production
at Chayanda and asked the federal agency for subsoil resources to provide a list ofalternative fields.
35

The Eastern Gas Program gives priority to completion of the Sakhalin-Vladivostok
pipeline and its later extension by a Sakha-Khabarovsk-Vladivostok pipeline. In addition,in 2009, Gazprom is to continue development of several small sources of gas on thewest coast of Kamchatka and to construct a pipeline and distribution system for the cityof Petropavlosk.34
There is significant uncertainty, as well, regarding further development of the
giant Kovykta field in Irkutsk, with 1.9 mcm of gas reserves. The Eastern Gas Program
blocked the original license-holders of the Kovykta field from constructing a pipeline todeliver gas to China, forcing transfer of the field from TNK-BP to Gazprom. In 2009,
Kommersant reported that declining gas revenues would mean the postponement of
Kovykta development by Gazprom until 2017. Sources at TNK-BP suggested that rights
to develop Kovykta might instead be transferred to Rosneftegaz, the state holding
company, which owns 75.16 percent of Rosneft’.

Russian Access to Energy Markets in the Asia PacificEven with its planned rapid increases in deliveries of oil and natural gas to the
Pacific, Russian supplies will constitute a relatively small share of Asian energy markets.
Japan, which pays relatively high prices for energy, is likely to be Russia’s largest
customer for LNG. However, Japanese GDP has experienced relatively low growth forthe past several years and its economy enjoys high levels of energy efficiency, so its
total demand for energy is likely to show relatively little growth. In contrast, both the36

PRC and South Korea are enjoying high rates of economic growth. Looking at the size ofthe two energy markets, South Korea’s total energy demand is only 12 percent ofChina’s. However, current consumption of LNG in South Korea is approximately half ofChina’s consumption. So, both could be significant markets. Still, China is the energy
user that would enjoy the greatest gains in efficiency and environmental improvementfrom a shift to natural gas, whether as LNG or as pipeline gas.
Figure 14: South Korea Shares of Primary Energy 2008
South Korea Shares of Primary Energy

Hydro
1%

Nuclear
28%
Oil
36%

Coal
23%

Gas
12%

Source: BP Statistical Review 2009.
China’s rapid economic growth has generated rapid increases in Chinesedemands for all forms of energy and raw materials, but some underlying sources ofChina’s rapidly-expanding energy demand reflect substantial inefficiencies in that
economy. During the past decade, China’s energy intensity, measured in tons of oil
equivalent per million dollars of GDP has been falling rapidly, and, yet, an international
comparison for 2007 shows the following energy intensities:

37

OECD Asia (Japan,

Australia, New Zealand), 160 tons of oil-equivalent per million dollars; Developing Asia,
189.6; China, 274.4; Russia 383.7.35 Thus, China’s energy intensity is 70 percent higher
than OECD Asia’s, while Russia’s energy use per dollar of GDP is 2.4 times larger.
Figure 15: China Shares of Primary Energy 2008
China Primary Energy 2008

Nuclear
1%

Hydro
7%

Oil
19%

Gas
4%

Coal
69%

Source: BP. Statistical Review 2009.
China’s high demand for energy reflects growing industrial use and, surprisingly,
use in heavy industries, such as steel production. To the economist, the growth ofChinese production in capital-intensive heavy industry appears to be inconsistent withthe country’s labor-intensive factor proportions and low wages. This industrial structure
seems to reflect several sources of inefficiency—the artificially low prices of energy
imposed by the government, the extraordinarily high share of saving and investment in
Chinese GDP, much of which reflects governmental and state bank financing of highrates of investment in infrastructure and industrial capacity, and the desire of policy

38makers in separate regions to create their own bases in heavy industry. If this rapid
expansion of capacity in heavy industry is excessive, then much of it will prove relatively
unprofitable in the future. That said, once created, the costs of industrial capacity are
sunk costs, which implies that Chinese industrial producers are likely to bring products
to market as long as their sales cover their variable costs; so Chinese demand forindustrial inputs will remain strong in spite of an inefficient structure of industrial
production.

Looking ahead, China’s access to Russian oil is fostered by China’s

willingness to extend loans of $25 billion to Rosneft’ and Transneft’ in exchange forguaranteed deliveries of oil.
In the cases of oil and LNG, Russia will face relatively competitive markets,
which will determine long-run prices. It is only in the case of pipeline gas that Russia
and China will interact as bilateral monopolists. Currently, Gazprom and China arereportedly far apart on an agreement for a delivered price of natural gas, with China
holding out for approximately half of the Gazprom-offered price. In the meantime,
Exxon, which was blocked by Russia from delivering pipeline gas to China, has now
entered into an agreement with Petro China to export 2.25 million tons of LNG per year
to China from Australia’s Gorgon gas field. The Exxon-Petro China agreement, which isvalued at $41 billion, will begin deliveries in 2015. Chevron, another partner in the
Gorgon field is negotiating with China’s CNOOC to supply a similar quantity. Thus, thebottom line for Russian energy supply is that the access of demanders to competitive
alternatives will impose market constraints on Russian market power.

39

Energy Policy and Potential Russian Energy Supplies to the Pacific
What do recent developments in Russia’s energy sector tell us about the futurerole of Russia as an energy supplier to the Asia Pacific? In the past decade, thegovernment’s desire to regain control of its energy wealth has been achieved throughthe use of governmental measures that have created a highly uncertain businessenvironment. Domestically, the exercise of tax and regulatory authority has been used
to transfer assets from private to state control in the cases of Yukos, Kovykta, andSakhalin-2. In other cases, such as Sibneft, Surgutneftegaz, and Gazprombank, opaque
governmental actions have transferred assets to the control of Kremlin insiders. Foreign
investors, such as the investors in Sakhalin-1, have seen the value of their investments
partially confiscated through changes in the rules of the game.
In East Siberia and the Russian Far East, state-owned Rosneft’ and Gazprom
appear to be engaged in complicated negotiations with the center as to the control
rights that each will acquire to develop valuable oil and gas fields.36 These negotiations
will determine the implicit governmental subsidies, costs, and economic obligations thatthe national energy companies will enjoy and, thus, will determine the division of rents.
While it is unclear how the national champions will resolve their potential competition
with each other, it is clear that future arrangements are likely to be monopolistic andthat the property rights of private owners, such as TNK-BP, will depend on their ability
to manage relationships with Kremlin insiders.
So, the political economy of energy development in Russia confirms thearguments of Aslund, Ickes, and Gaddy. In energy, the economic arrangements seem to40

be evolving in the form of centralized monopoly structures, which can serve to capture
and redistribute wealth but are inimical to efficient production and development.37 The
exercise of Putin’s energy policy provides ample support for the Ickes-Gaddy hypothesisthat the Kremlin’s strategy to centralize resource rents is based on insecure property
rights.38 These administrative institutions prolong some of the worst features of thecommand system, impeding structural change, diversification, and the productivity
improvements that Russia urgently needs.
In the short run, the implication of Russia’s weak institutional environment isthat engagement of multinational companies and foreign investors in Russia will dependon their ability to address these institutional risks. Investors will seek investment
insurance from their governments, hold collateral, or find ways to share risks. Foreign
multinationals will alter contract governance or they will simply direct their investment
to less risky alternatives. National energy companies, Gazprom and Rosneft’, will try todevelop Siberian resources independently, operating as general contractors andemploying energy service companies.
What policies should the governments of energy importers pursue? For morethan two decades, policy-makers in the Asia Pacific have argued for the value of an Asia
Pacific Energy Charter modeled on the European Energy Charter. Although Russia never
became a signatory to the European Energy Charter, its policies have generally
conformed to Charter rules. With the production and trade of oil and LNG in the Pacificexpanding rapidly, it is likely that an emerging network of energy contracts will evolve
into a similar, consistent international framework. However, in the near term, it is41unlikely that Russian institutions will evolve in a manner that allows Russia to participate
in this framework.
We began this survey with President Dmitry Medvedev’s recent essay, “Go,Russia!” In that essay, Medvedev asks how long the Kremlin can continue to pursue aform of state capitalism in its strategic industries that deprives it of many of the benefitsof international investment, technology, and know-how. Medvedev is frank about the
problems that Russia faces.39 He identifies three major institutional ills:
1. Economic backwardness and the habit of relying on the export of raw materials;
2. Centuries of corruption… Until today this corrosion has been due to theexcessive government presence in many significant aspects of economic andother social activities.
3. Paternalistic attitudes are widespread in our society, such as the conviction thatall problems should be resolved by the government.
Medvedev proposes to address these weaknesses with a program of technologicalmodernization and innovation, but more importantly, he recognizes that economic
modernization will require fundamental institutional changes—democracy, civil rights,
rule of law, and independent courts. “We need to eliminate attempts to influence
judicial decisions for whatever reasons. Ultimately, the judicial system itself has tounderstand the difference between what it means to act in the public interest or in theselfish interests of a corrupt bureaucrat or businessman. We need to cultivate a taste
for the rule of law, for abiding by the law, respect for the rights of others, including such

42

important rights as that of property ownership. It is the job of the courts with broad
public support to cleanse the country of corruption.”
All this is heady stuff coming from the President of Russia—particularly when we
consider that President Medvedev was Chairman of the Board of Gazprom during an eraof exceptional corruption in that company. The words of his speech might have been
ghost-written by Boris Nemtsov, co-founder of the liberal opposition party, Solidarnost’.
Many Western observers will agree with both Medvedev’s diagnosis and his proposed
remedies. If the Russian government hopes to keep its skilled people and enjoy thebenefits of a modern, efficient economy, it will need to create rule of law, restore
federalism, and direct its government spending to the welfare of its population and thecreation of modern, market-supporting institutional and physical infrastructure.
Russia’s debility reflects not the existence of resource rents but the manner in which
Kremlin elites capture and use these rents.
Russia’s difficulty in expanding economic cooperation in Asia is simply an
example of Russia’s awkward engagement in the international community in general.
Russia’s current difficulty in using its energy wealth to modernize is simply an exampleof the Kremlin’s lack of incentives to establish efficient, market-supporting institutions.
Perhaps Medvedev’s recent essay will motivate government authorities to reform
Russia’s underlying economic institutions.

However, the example of Gorbachev’s

attempted administrative reforms in the former Soviet Union provides a counterexample. Until market-supporting institutions improve, investors will continue toapproach the Russian environment with skepticism.
43Notes1

Clifford Gaddy and Barry Ickes, “Addiction and Withdrawal: Resource Rents and theCollapse of the Soviet Economy,” Pennsylvania State University, Economics Working
Paper, December 2006.
2
Clifford Gaddy and Barry Ickes, “Resource Rents and the Russian Economy,” Eurasian
Geography and Economics, 2005, Vol. 46, No. 8, pp. 559-583.
3
Dmitry Medvedev, “Go, Russia,” President of Russia Web Site,
http://eng.kremlin.ru/speeches/2009/09/10/1534_type104017_221527.shtml
4
Yegor Gaidar, Collapse of an Empire; Lessons for Modern Russia. Washington D. C.:
Brookings Institution, 2007, p. 184.
5
British Petroleum, BP Statistical Review of World Energy 2009.
http://www.bp.com/statisticalreview.
6
Bank of Finland, “The State of the Russian Economy,” Russian Analytical Digest, No. 38,
8 (April 2008), p. 11.
7
Anders Aslund, Russia’s Capitalist Revolution; Why Market Reform Succeeded and
Democracy Failed. Washington D.C.: Peterson Institute, 2007, p. 247.
8
Ministerstvo Promyshlennosti I energetiki Rossiyskoy Federatsii. Energeticheskaya
strategiia Rossii no period do 2030 goda (Energy Strategy of Russia to 2030),
http://www.minprom.gov.ru/docs/strateg/1.
9“Energy Strategy 2030,” Izvestia, August 27, 2009, http://www.izvestia.ru.
10
Data in this section from British Petroleum, BP Statistical Review of World Energy
2009, http://www.bp.com/statisticalreview.
11
Matthew Sagers, “The Regional Dimension of Russian Oil Production: Is a Sustained
Recovery in Prospect?” Eurasian Geography and Economics, 2006, Vol. 47, No. 5, p. 518.
12James Smith, “Cost of Lost Production in Russian Oil Fields,” Energy Journal, Vol. 16,
No. 2, pp. 25-28.
13“Seeking Western Involvement for Rebuilding and New Developments,” Petroleum
Economist, January 1996, pp. 10-14.
14Interview, Sakhalin Island, September, 1999.
15
Rudiger Ahrend and William Tompson, “Realising the Oil Supply Potential of the CIS:
the Impact of Institutions and Policies,” OECD Economics Department Working Paper
484 (2006), p. 22.
16
Matthew Sagers, “The Regional Dimension of Russian Oil Production: Is a Sustained
Recovery in Prospect?” Eurasian Geography and Economics, 2006, Vol. 47, No. 5, p. 511.
Sagers lists the nine vertically integrated companies in 2003 as: Rosneft’, LUKoil, Yukos(now Rosneft’), Surgutneftegaz, Sibneft’ (now Gazprom Neft’) TNK-BP, Slavneft’,
Bashneft’ and Tatneft.
17
Op. cit., p. 512.
18
Institute for Economies in Transition, Russian Economy in 2008; Trends and Outlooks.
Moscow, p. 301. http://www.iet.ru/ru/ob-institute.html.

44

19

Matthew Sagers, “Developments in Russian Gas Production Since 1998: Russia’s
Evolving Gas Supply Strategy” Eurasian Geography and Economics, 2007, Vol. 48, No. 6,
p. 652.
20
Stern, Ibid., 54
21
Institute for Economies in Transition. Russian Economy in 2008; Trends and Outlooks.
Moscow, Vol. 30, p. 301, http://www.iet.ru/ru/ob-institute.html.
22
Anders Aslund, “Gazprom’s New Weakness Offers Opportunity,” Moscow Times, May
27, 2009 (cited in David Johnson).
23
Russian Federation Law No 224-FL on Production Sharing Agreements, Moscow,
December 30, 1995; Passed by the State Duma on December 6, approved by theFederation Council on 19 December '95 (cited in Rossiiskiya Gazeta, January 11, 1996,
pp. 3-4).
24
Matthew Sagers, “Developments in Russian Gas Production Since 1998: Russia’s
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25
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26
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27
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28
At current prices, a benchmark estimate of pipeline construction in a remote region
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times $1,000 per kilometer.
29
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30
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31
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32
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34
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35
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36
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37
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GIARI Working Paper Vol. 2009-E-7,
November 2009
Published by Waseda University Global COE Program
Global Institute for Asian Regional Integration (GIARI),
Waseda University, Nishiwaseda Bldg. 5F#507 1-21-1
Nishi-waseda, Shinjuku-ku, Tokyo 169-0051 Japan
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