Russia is destined to become a global energy superpower: it is the world’snumber one producer of both oil and gas. But will Moscow succeed inmaintaining its image as a reliable supplier? How forcefully will it playits energy card to gain the upper hand on the international stage, andwhat consequences are in store for the rest of us?

In January 2006, Europe watched its natural gas stocks fall as Russian state-con-

trolled Gazprom cut gas supplies to Ukraine amid a price dispute. In January 2007,

Russia halted 1.5 million barrels a day (m b/d) of oil to Europe for three days as a re-

sult of another escalating gas-price fight, this time between the Kremlin and Belarus.

While both events have led pundits and EU officials

to question Europe’s pronounced dependence on

Russian oil and gas, a lack of stable resource-rich

country alternatives means there is little the conti-

nent can do to diversify. As Russia has begun to flex

its muscles as the premiere global energy super-

power – trading in uranium for hydrocarbons and in

intercontinental ballistic missiles for pipelines – Europe will likely have to submit to

Russian geopolitical desires in its foremost spheres of influence. The Baku-Tbilisi-

Ceyhan (BTC) pipeline notwithstanding, we expect Russia will continue to shore up

its negotiating position with private international oil companies, former Soviet re-

publics, and all of the great powers over the coming year.

SOURCES OF RUSSIAN ENERGY POWER. Russia’s emerging energy su-

perpower status derives fundamentally from four factors: its oil and gas exports, pro-

Growing pains:Russia’s new muscle

Edward L. Morse and Adam J. Robinson

Edward L. Morse is managing director and

chief energy economist at Lehman Brothers

Inc. in New York. Adam J. Robinson is an

oil and gas research analyst at the same

organization.

110-119 Morse n. 32-33-34 23-01-2007 12:48 Pagina 110

duction, and reserves; its stability and friendliness to foreign investment relative to

other resource-rich country alternatives; its existing pipelines, which connect it to the

oil and gas producing former Soviet republics of Central Asia; and its unique rela-

tionship with Iran. These elements work together in different ways to give the Krem-

lin leverage over its near-abroad as well as over the US, Europe, and Asia.

Oil and gas exports, production and reserves: Russia was the world’s number one

producer of both oil and gas in 2006 as well as the number one exporter of gas and

number two exporter of oil. Total Russian oil production in the first eleven months

of 2006 averaged 9.64m b/d – 11% of the world total – compared to 9.2m b/d for

number two producer Saudi Arabia. Russian natural gas production was also the

largest in the world at over 10 million barrels of oil equivalent per day (m boe/d),

15% larger than the US, the world’s number two producer. Through Gazprom and

Rosneft – both majority Kremlin-owned public companies – Moscow directly con-

trols 2.7m b/d of oil production (3% of world) and 9.7m boe/d of natural gas pro-

duction (20% of world). Beyond direct ownership, the Kremlin essentially controls

total Russian oil and gas exports of about 7m b/d and 4m boe/d, respectively, through

monopoly ownership of all oil and gas export pipelines by Gazprom and another

state-owned company, Transneft.

Most of Russia’s hydrocarbons flow to Europe and the former Soviet Union. Europe

as a whole receives over a quarter of its gas and about a third of its oil imports on a

gross basis from Russia. The Baltic States depend on Russia for about 90% of their

oil and gas supply, while Ukraine imports 70% of its oil and 85% of its gas from

Russian pipelines. Belarus is in a comparable situation to Ukraine, surviving eco-

nomically through oil and gas transit fees and by refining and re-exporting Russian

crude. Also feeling the pain of Russian gas dependence, Azerbaijan and Georgia re-

cently watched Gazprom double their gas prices. This actually makes it cheaper for

Azerbaijan to burn fuel oil instead of gas until winter fades or until the large Azeri

Shah Deniz field comes online.

Provided the investment dollars are there, Russia’s resource base is adequate to sus-

tain and even increase its levels of oil and gas exports in the long term. In the short

term, however, as key gas development projects in the Barents Sea, the Yamal Penin-

sula, and Sakhalin Island have been delayed, Russia will have to re-export gas it re-

ceives from Turkmenistan, Uzbekistan, and Kazakhstan, in order to meet its Euro-

pean export obligations.

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Russian relative stability: Arguably, the main chink in Russia’s armor is the gargan-

tuan foreign investment that will be needed to sustain the Russian energy sector. The

International Energy Agency (IEA) estimated this necessary investment at just over a

trillion dollars before 2030. However, a lack of investment alternatives – combined

with American, European, and Asian growing oil and gas import needs – will make

Russia an essential destination for foreign energy investment in the future. William

F. Browder, CEO of Hermitage Capital Management in Russia, asserts the following:

“When [Europeans] look for alternatives, they’ll find Libya, Iran, Algeria, Qatar,

burning coal again or nuclear power. They may conclude: perhaps Russia isn’t such

a bad partner.” The Kremlin realizes this and is taking advantage of a tight oil mar-

ket and the country’s relative stability by increasing the government’s overall take

and ownership of the Russian energy sector. For instance, Gazprom recently pushed

Shell out of a majority stake in Sakhalin-2, one of the largest oil and gas develop-

ments in the world, with current capacity to produce 80,000 boe/d and expected ca-

pacity of 340m boe/d by 2009. Gazprom is also rumored to be eyeing a stake in the

250,000 b/d Sakhalin-1 project, which 30%-owner Exxon leads, although Rosneft is

already a 20% stakeholder. Despite these actions, there is certainly no shortage of

Asian, American, and European companies that are willing to pay hefty premiums for

minority stakes in Russia’s giant energy potential. In a world where almost 50% of

non-OPEC production has peaked, and where the vast majority of growing regions are

off limits to foreign investment, Western and Asian oil and gas importers cannot af-

ford to withhold energy investment from Russia.

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Super-major hydrocarbon production in 2005

Russia’s oil and gas production and reserves

Proven oil and gas reserves as of January 1, 2006

Source: Lehman Brothers estimates, Gazprom Annual Report 2005. Source: Lehman Brothers estimates, Oil and Gas Journal.

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110-119 Morse n. 32-33-34 23-01-2007 12:48 Pagina 112

Existing Russian pipelines in Central Asia: The Caspian countries of the former So-

viet Union comprise the hottest non-OPEC exploration and development play in the

world, with the potential for oil production to increase from 2.4m b/d now to 3.1m b/d

by 2010 and 6.6m b/d by 2025. Kazakhstan is currently responsible for more than

half of Caspian oil production, and the vast majority of Kazakh oil exports transit

Russian territory through the Caspian Pipeline Consortium (CPC) and Atyrau-Samara

pipelines. Azeri oil supply, the second most important growth source in the Caspian,

113

has stopped flowing through Russia altogether as a result of Gazprom’s 2007 gas price

increase. Capacity on the only significant pipeline in the region that does not transit

Russia – the 500,000 b/d BTC pipeline – will increase to 1m b/d by 2008-09, and will

compete for incremental Caspian barrels with CPC, which is expected to increase ca-

pacity from 560,000 b/d to 1.34m b/d over the same time period.

With respect to natural gas, Gazprom dominates Central Asia through control of the

3.5 trillion cubic feet per year (tcf/y) Central Asia Center pipeline. Essentially all of

Turkmen, Uzbekistani, and Kazakh gas exported out of the region flows through this

pipeline, which was built in 1974 under the Soviet system. In a deal made last Octo-

ber, Moscow will import at least 2 tcf/y of Central Asian gas in 2007, sapping over

90% of Turkmenistan’s exports, the largest Caspian gas exporter. Most, if not all, of

this gas will be re-exported to Ukraine, with Gazprom taking a hefty transit fee be-

cause of its current monopoly over Central Asian gas exports.

110-119 Morse n. 32-33-34 23-01-2007 12:48 Pagina 113

In Kazakhstan, gas exports are expected to grow from 0.3 tcf/y (2005 figure) to 1.2

tcf/y by 2015. Gazprom handles all of Kazakhstan’s current gas exports through its

Russian lines and has signed an agreement to jointly develop and process an addi-

tional 0.25 tcf/y of gas from the giant 2.4 billion barrel Karachaganak field. Gazprom

last year also agreed on the basic terms of a 25-year production sharing agreement

for developing three key fields in Uzbekistan through a joint venture with state-run

Uzbekneftegas. While China has been making a significant push to break into Cen-

tral Asian gas markets, proposed pipelines would have to run over 6,000 km, making

any Chinese gas penetration difficult before well into the next decade. Until then,

Russia will continue to develop Central Asian gas production and link it into its So-

viet-era pipeline infrastructure.

Russia’s relationship with Iran: Since the Soviet Union’s demise, the Kremlin has

viewed its relationship with Iran as a manifestation of its own independence from the

West. Just as important, Moscow has badly needed a market for its lucrative missile

and nuclear technologies, as well as for its more low-technology armaments. Most rel-

evant today are the broad nuclear agreements made in 1992 between the two coun-

tries. Specifically, Russia agreed to construct the $840 million Bushehr nuclear pow-

er facility in Iran, which was more than 80% complete by the end of 2005. Plans are

also in place for Russia to build five more reactors over the next decade at an addi-

tional windfall to Moscow of $10 billion. It is unclear whether the Bushehr facility has

been completed in the wake of the latest round of sanctions passed against Iran; how-

ever, Moscow has made a point of not conceding to US pressures to stop working on the

facility. Rather, as negotiations between Iran and the EU broke down in late 2005, the

West looked to Moscow’s special relationship with Tehran to help diffuse the situation.

Russia offered to enrich uranium on its own soil and then to transport it for process-

ing at Iranian nuclear power facilities, but Iran rejected the proposal. For a wide va-

riety of reasons, we believe it is unlikely Moscow wanted that offer to be accepted.

THE SHIFTING BALANCES OF POWER. Russia is using its oil and gas ex-

ports, pipeline system, relative political stability, and special relationship with Iran to

raise its standing and relevance in great power affairs. Utilizing its emerging energy

power, Russia has already reversed Ukraine’s drift towards Europe; it may be able to

inhibit Western oil and gas supply diversification strategies in the Caspian; and it will

soon increase volumes to Japan and China, playing each importer off of the other and

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off of the West to sweeten future export deals. All the while, Russian international en-

ergy power and the leverage it implies bolster the Kremlin’s standing at home, ensur-

ing continuity of current leadership once President Putin steps down in 2008.

The 2004 “Orange” and “Rose” revolutions in Ukraine and Georgia were stark re-

minders to Russians of their country’s decline as a world power since the Soviet col-

lapse. However, they were by no means the first reminders. Moscow has watched its

power over Eastern Europe dissolve for a decade, initially with the invitation of the

Czech Republic, Poland, and Hungary to join NATO in July 1997, and later with the

accession of Bulgaria, Romania, Slovakia, Slovenia and the Baltic States in March

2004. Many of these countries have also joined the EU, drifting further to the West

from Moscow’s strategic grasp.

Vehemently supported by the United States, the Ukrainian and Georgian revolutions

marked the rise of Western leaders in key Russian geostrategic satellites, with parts

of Ukraine only 300 miles from Moscow and Volgograd. Ukraine and Georgia also

border the Russian Caucasus, where the Russian army is currently suppressing sev-

eral rebellions. If the Orange revolution eventually led to NATO or EU accession for

Ukraine, Russia’s defensibility and strategic coherence would weaken substantially.

With the ascendance of East German Angela Merkel – who lived under Soviet com-

munism – to the chancellorship of Germany, it seems as if European and US views

around the Europeanization of the former Soviet Union are converging, despite pro-

nounced Western European energy dependence on Russia.

RUSSIA PLAYS ITS ENERGY HAND. In this context, Russia’s Deputy Prime

Minister Dmitri Medvedev – who also happens to be chairman of Gazprom – has

sought to remind Western Europeans of their dependence on the Kremlin. Gazprom

cut off gas supplies to Ukraine on January 1-2, 2006, knowing full well that Ukraine

would siphon off gas meant for Europe and that this would thus translate into a gas

supply cut-off for Berlin, Prague, and Warsaw. The standoff with Ukraine forced Eu-

ropean countries to pressure Kiev into an agreement with Gazprom that doubled gas

prices, increasing Russian gas revenues. More importantly, however, it also drove a

wedge between Kiev and Brussels. Western-leaning Ukrainian President Yushchenko

paid an almost immediate price, with Ukrainian voters in the next parliamentary

elections electing the same pro-Russian party which Yushchenko had beat in the De-

cember 2004 Orange revolution. Now that a pro-Russian party controls a sizeable

block of parliament, Russia has achieved its immediate goal of making it impossible

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to move forward on Ukraine’s NATO succession. Yushchenko has also realized that Eu-

rope cannot protect Ukraine from the Russian Bear. Most assuredly, he will be much

more careful not to cross the Kremlin in the future.

Moscow, however, is not only counting on the 2006 gas supply cut-off to push Ukraine

back into line and to sour relations between Europe and Kiev. Putin may also hope

to drive a wedge between Europe and the US – a special relationship which many

Russians view as the true architect of their country’s ills since the Soviet break-up.

The 2006 and 2007 oil and gas supply cut-offs were more than anything reminders

to Germany that it depends on Russia for some 20% of its oil consumption and 40%

of its gas consumption. As Germany has realized it has something to lose – namely,

Russian energy export reliability – it may be forced to re-evaluate the net benefit to

Europe of the Rose and Orange revolutions which America so strongly espoused. By

inflicting a small amount of pain, with a brief drop in energy supplies this January

and last, Putin has brilliantly reminded Berlin that it must be careful not to allow the

US to infringe too much on Moscow’s interests. With Europe’s respect, moreover, the

Kremlin has a better chance of beating out the US for control of incremental energy

production and export out of Central Asia.

Evidence that Putin is pursuing a wedge strategy is embedded in the details of the

January 2006 gas deal between Ukraine and Gazprom, now extended until 2010.

While quadrupling Gazprom’s prices, the compromise allows Ukraine to receive a

significant amount of discounted supplies from Turkmenistan, Kazakhstan, and

Uzbekistan. Factoring in lower prices for this gas, the blended price Ukraine pays

will go up by a factor of only two instead of four. Its nearly 100% reliance on Russia

for natural gas, however, will not decrease: just as Russia’s pipelines to Europe tran-

sit Ukraine, so do the pipelines from Central Asia transit Russia. Thus, European gas

supplies will now depend not only on Russia’s relations with Europe and Ukraine, but

also on its relations with Turkmenistan, Kazakhstan, and Uzbekistan. As Russia ex-

pert Peter Zeihan points out: “Suddenly Europe has a vested, if reluctant, interest in

ensuring that Moscow is satisfied with its level of influence in the bulk of the largest

former Soviet territories.”

Specifically, Moscow wants to help produce as much future oil and gas from the

Caspian region as possible and for it then to flow through pipelines that transit Russ-

ian soil. European leaders will therefore have to tread lightly in supporting the

500,000 b/d expansion of BTC pipeline and any future pipelines which attempt to cir-

cumvent Russia. If significant Central Asian oil volumes were diverted from Russian

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pipelines, it would be easy for Moscow to retaliate by reducing these countries’ ac-

cess to gas pipelines transiting Russia. This would then trigger another crisis further

down the pipeline in Kiev, which would again pass the problem on to Europe by si-

phoning gas meant for Warsaw, Prague, and Berlin. In other words, in exchange for

increased reliability of Russian-produced or transported oil and gas, Europe will

likely have to keep quieter about its own supply diversification strategy and proba-

bly cannot support Ukraine’s accession to NATO. By removing Western obstacles to ca-

pacity expansions of Central Asian oil and gas pipelines transiting Russia, further-

more, the Kremlin hopes to build upon its current status as the dominant power in

Central Asia during the first half of the twenty-first century.

FRIENDLY WITH THE PERSIANS. In addition to leveraging its European ex-

ports and existing pipeline systems, Russia can also use its special relationship with

Iran to push back on the West in its primary spheres of influence. We believe that the

Kremlin’s ties and cooperation with Iran are critical to the preservation of Russian in-

terests in Eastern Europe and the Caspian. The US, first and foremost, needs Russia

to wield its political influence over Iran to prevent nuclear proliferation and to help

contain Iran’s rise in the Middle East. As long as Russia is not on board with US plans,

the transfer of civilian nuclear technology to Iran continues and the UN becomes a

non-functional vehicle for dealing with the rogue state.

Ironically, Russia stands to lose the most should there be a rapprochement between

Tehran and Washington. Not only would the US be less concerned with appeasing

Russia in Eastern Europe and the Caspian, but Iran would pose a significant long-

term threat to Russia’s gas supply and transit dominance. Importantly, Iran has the

second largest natural gas reserves in the world and is by far the cheapest route for

Caspian oil to reach export markets. However, as long as US pressure curtails invest-

ment in Iran’s natural gas industry (Iran is currently a net gas importer) and the coun-

try is perceived as an even worse transit alternative than Russia, Moscow does not

have to worry about any viable low-cost threats to its energy dominance.

In light of this situation, while Russia does not likely want Iran to develop nuclear

weapons, we do believe it will actively work to keep Iran destabilized and unfriend-

ly to Washington. Nevertheless, Washington knows it cannot afford to alienate

Moscow completely on its Iran policy. One way to elicit the Kremlin’s cooperation

would be for the US to limit its encroachment upon Russian interests in Eastern Eu-

rope, the Caucasus, and the Caspian.

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LEVERAGE OVER THE EAST. While current Russian oil and gas exports to

Asia are low, volumes from Sakhalin Island and Siberia have the potential to supply

China, South Korea, and Japan with over 2m b/d of oil and at least 1 tcf/y of gas. Rus-

sia’s leverage here is entirely related to its wealth of oil and gas resources in relative

proximity to Asian markets as well as in the poor diversification of Asian oil imports

away from OPEC.

Competitive bidding has already been taking place between China and Japan over

bringing 1.6m b/d of crude through the East Siberian Pacific Oil Pipeline (under con-

struction) from Irkutsk (in Russia) to either the Chinese Daqing oil hub or a port close

to Japan on the East China Sea. With hefty Japanese development assistance as an

incentive, Russia has so far opted for the coastal route, but a pipeline spur to China

is still possible if the price offered to Moscow is right.

Meanwhile, the Kovykta Gas Pipeline (0.7 tcf/y) was originally proposed from Ir-

kutsk to Beijing with a potential spur to South Korea. However, development of the

Kovytka field is dependent on TNK-BP reaching an export agreement with Gazprom,

who won’t proceed without an upstream stake. TNK-BP stands to lose its lease on the

Kovytka project if it does not begin field development over the next several months.

In our view, Gazprom will soon take over a majority stake in this project, and will con-

tinue its discussions with China over meeting the country’s burgeoning natural gas

import needs. The main stumbling block to Sino-Russian gas negotiations is Beijing’s

repeated attempts to index gas prices to the Chinese domestic price of coal, which is

very cheap. However, with China liquid natural gas imports already estimated to in-

crease from 0.2 tcf/y in 2006 to 1.4 tcf/y in 2010 – almost 50% of 2010 consumption

– China will not likely find another import source that is large enough, forcing it to

accept harsher price terms from Gazprom.

PUTTING IT ALL TOGETHER. If construction goes as planned and the Krem-

lin has the ability to play swing supplier between China, Japan, and the West, Rus-

sia could find itself in a sweet spot negotiating oil and gas development deals with

foreign governments in the coming years. Moreover, Moscow and the rest of the world

will increasingly understand what it means for Russia to have become a truly global

energy superpower. In the past couple of years, there have clearly been growing pains

associated with Russia’s new role. The first piece of Putin’s strategy was to consoli-

date the energy sector under government control, which the Kremlin has pursued by

taking over Yukos, buying Sibneft, and assuming a majority stake in Sakhalin-2. We

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expect the consolidation will continue in 2007 with Gazprom’s entry into Exxon-led

Sakhalin-1 as well as into the Eastern Siberian TNK-BP Kovytka field. The second

piece of his strategy has been to not so subtly remind Europe and key former Soviet

Union countries of their dependence on a reliable Russian oil and gas supply. The

third piece of his strategy will undoubtedly be for Russia to use this reminder to de-

fend its once-dominant sphere of influence in the Caspian from Western incursion.

Moscow will also defend its Caspian position by utilizing its relationship with Iran to

gain leverage over the US, and will likely compete vigorously to develop and transport

new Caspian oil and gas supply on its existing pipeline system. The final piece of

Putin’s strategy will come into place in the next decade when Europe and Asia de-

pend strongly on Russia for their energy.

While this is our view of Russia’s energy strategy, we must also admit that Putin is

bound to meet with some difficulties in implementing it. One risk he faces is further

delays to gas development projects in the Barents Sea, the Yamal Peninsula, East

Siberia, and on Sakhalin Island: these will slow the Kremlin’s desired simultaneous

eastward and westward expansions and make it difficult for Gazprom to meet its ex-

isting gas export obligations, let alone make new ones. A second major risk is that

Russia’s overproduction and mismanagement of its oil and gas fields during the So-

viet era will come back to haunt the Kremlin in the form of severe decline rates. Sev-

eral analysts – including ourselves – believe Russia is not putting enough investment

dollars or attention into preserving reservoir pressure and quality at its maturing gi-

ant fields; if Moscow is not careful, declining Russian oil production could under-

mine any expansive energy superpower strategy. The same care and maintenance is

needed for Russia’s domestic natural gas pipeline system, which at 150,000 kilome-

ters is the longest in the world. That system is often already transporting more gas

than its nameplate capacity would indicate possible. Fifty-eight percent of the sys-

tem is more than 35 years old and only 11% of the system was built within the past

decade. In order to renovate the system and add the necessary lines for new gas proj-

ects, Gazprom will likely have to invest around $40 billion – not including the $5 bil-

lion it spent on pipeline renovations in 2006.

Assuming Russia does not ignore these fundamental issues and succeeds in attract-

ing the necessary investment to address them, we believe that Russia’s emerging

global energy superpower status is here to stay. Due to its enormous oil and gas ex-

ports and reserves, relative political stability, existing Central Asian pipeline system,

and special relationship with Iran, Russia is a force to be reckoned with.

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