In October, I was invited to speak at the Chicago Natural Resources conference and had the privilege of hearing Jim Rogers give the keynote address. After graciously sharing slides and interesting details of his millennial trip around the world, Mr. Rogers took several questions from the standing-room-only crowd. One of the first questions asked was about the future of Russia. Mr. Rogers replied with the following:

“Russia is a disaster going on a catastrophe.”

Rogers, who prides himself on acquiring first hand knowledge of a country through ground level research, is not a believer in the “new Russia” that gets so much attention these days. He went on to say that “the Russians have learned how wear the right suits and to say the right things to attract Western capital.” Rogers explained how the country’s system of capitalism is flawed and big problems lie ahead for Mother Russia. To get a better understanding of Russia’s oil industry, I will start with a little history on the subject.

Russia’s modern oil industry was born in 1846 with the drilling of the world’s first oil well at Bibi-Aybat near Baku. This well pre-dates the first well drilled in the United States by more than a decade. In the mid-1800s, the Rothschilds and the Nobel families used the rich oil fields around Baku to build a couple of the world’s most respected oil companies. The Nobel brothers founded a firm that led the world for numerous decades in oil field drilling and construction. The Rothschilds’ initial business (Shell Transport and Trading) was shipping oil to Western Europe.

While Russia’s oil industry was born in Baku, it was not long before oil was discovered in other parts of the country. In the 1860s, oil was discovered in Krasnodar Krai and in the 1870’s, commercial oil production began from what is now Turkmenistan.

A blossoming oil industry was one of the many good things that came to an end with the Communist Revolution of 1917. In 1920, the Communist party nationalized all of Russia’s oil fields. It was not until 1923 that Russian oil output recovered to pre-Revolution levels. I point out this fact because in every instance of violent political upheaval in an oil producing country, oil production has dropped significantly and taken several years to recover.

The Soviet-era oil industry kicked into high gear with the outbreak of World War II. With demand for oil going through the roof, the Soviet oil industry stepped up production to meet demand with a majority of production coming from the Caspian and North Caucasus regions.  After the war ended, Soviet oil production continued to accelerate with significant increases in production from the Volga-Urals region.

By the early 1960s, the Soviet Union had replaced Venezuela as the second largest producer of oil in the world -- the United States being the largest producer. The significant increase in Soviet production led to a glut of oil on the world market. This in turn led to Western oil companies slashing the prices they would pay for imports from the Middle East.  In an effort to shore up prices, OPEC was born in 1960.

By the mid-1960s, production from the Volga-Urals was nearing its peak at 4.5 million barrels of oil a day. Many leaders in Moscow were searching for solutions to replace declining production from the region. In the early 1960s, several significant large fields were discovered in Western Siberia and in 1965 the granddaddy of all Soviet oil fields was discovered. The discovery of the Samotlor field, home of 14 billion barrels of recoverable oil, ushered in a new era for oil production. Total production from the Soviet Union hit 7.6 million barrels a day in 1971 and continued to ramp up to 9.9 million barrels a day in 1975. It should be noted that these production levels were achieved through large increases in Siberian production and falling production in the Volga-Urals region.

Much of the growth in Soviet oil production was a result of over-production of its fields. For example, Soviet engineers drilled too many wells without proper spacing and injected massive amounts of water into many wells. This caused significant spikes in short term production but reduced the total amount of oil that could be recovered from the reservoir. The only way to overcome these poor reservoir management techniques was to invest increasing amounts of money.

1988 marked the peak of Soviet oil production at 11.4 million barrels a day. The Soviet Union was the largest oil producer in the world with output that was significantly higher than that of the United States or Saudi Arabia. 1988 also marked the year that production in Western Siberia peaked at 8.3 million barrels of oil a day.

Years of over production and poor reservoir management techniques, along with the fall of the Communist party, were behind the steep decline in oil output from the early 1990’s through 1997. At its nadir, the former Soviet Union’s output was slightly above half its peak levels. The privatization of Russia’s oil industry was directly responsible for halting the country’s production declines. The newly privatized Russian oil companies were able to stem the decline by spending vast sums of money on drilling new wells and working over existing ones. Since the new owners of Russia’s oil assets paid a pittance for control of what are now some of the world’s largest oil companies, investing capital to keep their firms from wasting away was an easy decision.

Times have changed significantly in Russia’s oil patch since the late 1990’s.  Despite the fact that in 1998 Russia became one of the few counties to ever default on its sovereign debt, Western oil companies have, until recently, been tripping over themselves to get involved in Russia. The soap opera that is going on at Yukos changed the attitude of many potential investors in Russia’s oil sector.

I see several significant problems facing Russia’s oil industry. Far and away the biggest problem in Russia’s oil patch is capital investment. The arrest of Mikhail Khodorkovsky, the CEO of Yukos, slammed the door shut for foreign capital investment in Russian oil companies. Without fresh capital from Western oil companies, I seriously doubt that Russian oil companies will make the capital investments necessary to keep production flat, much less grow it from current levels.

Old and declining fields are another large barrier for Russia to overcome in its efforts to grow its oil production. There has not been a super-giant discovery in the Soviet Union since Samotlor was discovered in 1965. With this field well past its peak and in steady decline, it will become increasingly costly to keep production flat.

Another important reason Russian oil production is unlikely to grow from current levels, is that Russian reserves are vastly overstated.    In his recent book titled “The Hydrogen Economy”, Jeremy Rifkin does an excellent job of comparing how reserves are accounted for in Russia versus the US.

“Petroleum engineers estimate that there is a 90% chance that this field (Norway’s Oseberg field) will yield 700 million barrels of oil, but only a 10% chance that it will yield 2,500 million barrels. The lower figure is called the P90 estimate and the higher figure is the P10 estimate. In the United States, the Securities and Exchange Commission only allows companies to refer to reserves as proved “if the oil lies near a producing well and there is ‘reasonable certainty’ that it can be recovered profitably at current oil prices, using existing technology. This is a P90 estimate….

If the U.S. underestimates proved reserves by using a P90 estimate, countries like the former Soviet Union have consistently overestimated proved reserves by using P10 assumptions.”   - - page 18 “The Hydrogen Economy” Jeremy Rifkin 2002

Due to the poor petroleum data that is available from the former Soviet Union, it is impossible to estimate Russia’s reserves using any available metric. However, we can infer from President Putin’s wooing of Western oil companies that most of the easily produced reserves are long gone.

What does all of this mean for investors? Since nearly all of the world’s non-OPEC production growth in the past several years has come from Russia, stagnant or declining Russian oil production will provide support for higher world oil prices.  Astute investors should adjust their portfolios accordingly.

Canadian Dollar Hits 10 Year High

On Wednesday November 12^th, the Canadian dollar hit a 10-year high against its American counterpart. One Canadian dollar will now buy $.77US dollars and one US dollar can be exchanged for $1.30C dollars. Positive economic data out of Canada in the past couple of weeks, including a strong jobs report, have dampened hopes that the Bank of Canada will reduce its targeted overnight lending rate -- currently at 2.75%. The Canadian dollar has appreciated 21% against the US dollar so far in 2003.

China’s Oil Demand Continues to Grow

China’s booming economy has created incremental demand for nearly every natural resource, especially oil. The International Energy Agency recently reported that China will become the largest consumer of oil in Asia (Japan is currently the largest) in the second half of next year. According to the report, China's oil use is expected to rise from 4.95 million barrels a day in 2002 to 5.39 million barrels a day this year, and to 5.70 million barrels a day in 2004. Nearly, 100% of this additional consumption will come from increased imports. This news from China is another data point that supports the bullish case for oil.

Venezuela Heats Up

During the last week of November, opposition leaders in Venezuela will once again attempt to collect millions of signatures in an effort to recall President Hugo Chavez. The upcoming signature drive is just the most recent effort to remove Chavez from office. In 2002, Venezuela witnessed two oil strikes that were designed to force Chavez from office. The first one in April led to a military coup that lasted for two days. Seven executives of PDVSA (Venezuela’s national oil company) were fired by Chavez once he returned to office.  The second strike by workers at PDVSA, which dragged on for two months, resulted in a complete shutdown of the country’s oil industry. Once the strike was over, Chavez sacked all of PDVSA’s technical staff (20,000 workers) and replaced them with clerks. Chavez believed the middle class managers and technical staffs were opposition sympathizers and should not be employed at PDVSA.

Regardless of whether the upcoming signature drive results in a work stoppage at PDVSA, enormous damage has already been done.   Production continues to fall in Venezuela and will do so for the foreseeable future at rates approaching 20% per year. We are already witnessing significantly reduced exports of crude oil and refined products to the US (Source: US Department of Energy).

© 2003 Bill Powers, Editor
Canadian Energy Viewpoint
See Mr. Powers' Cover Page for Bio and Archived Editorials

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Bill Powers
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Information presented in this newsletter was obtained from sources believed to be reliable, but accuracy and completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editor may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.