Vladimir Putin has grand designs for the Russian oil and gas industry. In the post-Cold War era, the design should be based on the huge hydrocarbon reserves that could return Russia to its past glory. Russia's energy sector could be a source of power and prestige, to replace its once great military, now a shadow of its former self.

Like many Russians, President Putin does not trust private businesses, domestic or international, to be good stewards of Russia's energy patrimony or to serve national interests. He believes the state must play the dominant role in certain strategic industries, particularly oil and gas. After all, oil and gas revenues and taxes are as much as 50 percent of government revenues, generate most of the country's foreign exchange and subsidize domestic industry and agriculture. Many Russian industries are extremely inefficient Soviet-era relics; cheap energy, primarily natural gas at below world-market prices, is essential to subsidize their operations.

Gazprom: National Energy Champion?

Putin's original plan--to merge Gazprom, the giant gas monopoly, with Rosneft, the state oil company--did not come to pass, but he remains intent on establishing the state's dominance in Russia's oil and gas sector. The problem is that the Kremlin runs the risk of unnecessarily damaging its petroleum sector, instead of building national champions.

The tactics employed by the Kremlin to impose its control over Yukos, Russia's largest independent oil company--including arresting former CEO Mikhail Khodorkovsky and some of his associates, driving the firm into bankruptcy by the imposition of massive back taxes, and taking control of its best asset, Yuganskneftegaz, via a "managed" auction--had a chilling effect on both Russian and domestic investors. The legal process appeared to be a ruthless effort to crush Khodorkovsky and seize Yukos's best assets. New tax claims by the government appear almost on a daily basis. Politics has taken precedence over the courts' impartiality. When necessary, the rights of Yukos shareholders--though some were hardly blameless--were trampled. Now the state's interest in seized Yukos assets must be held separately.

In the midst of the Yukos debacle, infighting broke out between the Kremlin patrons of Gazprom and Rosneft. Most observers regarded it as a battle over power and wealth, not strategy or efficiency. Questions linger over how the two would merge. Even though the Kremlin now controls key parts of the Russian oil and gas sector, monumental problems remain.

First, Gazprom is a huge, Soviet-style bureaucracy that is unresponsive to senior management and has special-interest fiefdoms. Concerns over corruption, poor management and lack of transparency come at a very bad time, because Gazprom must fund billions of dollars in new investment to replace maturing gas production with new reserves from the more distant Yamal region in northern Siberia. Simultaneously, the Russian government wants to create a new gas pipeline corridor to Europe, with a new system under the Baltic Sea from northern offshore fields, in order to bypass Ukraine. Billions more are required for this.

Second, the oil sector is equally precarious. The surge of Russian production from 6.2 million barrels per day (bpd) in 1999 to 9.2 million bpd in 2004 was largely a function of enhanced recovery techniques at existing fields. Continued production growth will require exploration for new resources, often in remote areas such as the Arctic and eastern Siberia. Again, this will require substantial capital, different skills and a new appetite for risk. But the Russian oil companies, largely privately owned, are more attuned to short-term optimization for the benefit of management and shareholders--who are often the same people.

The obvious solution is to introduce international oil companies, which have the skills and capital to manage the exploration risk. But the Russian companies do not want the competition, and the state is wary of foreign companies and lacks experience in managing international investors. The result is that Russia itself is the loser. Recently, officials announced a policy of limiting foreign investment by barring companies without Russian majority ownership from bidding on "strategic" projects, although no formal regulations have been issued. More confusion has resulted, discouraging Western investment even further.

Russia may have large oil reserves, but without massive investment and better management, the oil from these reserves will not flow. For all the hype, cumulative foreign direct investment in the Russian oil sector since 1992 has been small, estimated at less than $15 billion. West Africa, by comparison, has seen over $113 billion. Only BP has a large joint interest called TNK-BP, while ConocoPhillips has a smaller joint interest with Lukoil. All the other majors have struggled to get substantial positions while constantly being gamed by indigenous companies and sometimes corrupt officials manipulating vague laws and regulations.

In the last four months, the Russians have been courting the Indians and Chinese, who are eager for access to reserves to fuel their surging demand. Both were rumored to have financed the Rosneft purchase of Yuganskneftegaz. The Chinese reportedly made a $6 billion loan for the long-term pre-purchase of oil. Tapping inexperienced international energy companies, even if cash-rich, to directly participate in developing Russian oil fields may not be the way to efficiently optimize Russia's huge resources. Neither Chinese nor Indian companies have sophisticated exploration experience, and they have no experience whatsoever in the Arctic or deep-water exploration.

Finally, Russia is also unique in the vast distance from its oil production, largely in western Siberia, to its borders and international markets, reached mostly via Black Sea ports. A huge web of pipelines is controlled by the state company, Transneft, which manages the movement of oil. Transneft has a powerful position, which it protects aggressively. Pipeline capacity is limited, creating constraints on the amount of oil that can be moved to export markets, so new production will be bottlenecked. In addition, Transneft is a state bureaucracy, with the attendant problems of accountability and efficiency.

International Implications

The risks in Russia are large and could mushroom. The impact of the Yukos affair, combined with under-investment and the poor management of the Russian petroleum sector in general, is serious. PFC Energy estimates that Russian production, now 9.3 million bpd, will peak at just over ten million bpd in 2008. Without a huge infusion of capital, technology and management for further exploration and production, Russian production may hit a lower peak and begin declining sooner. Billions will also be needed to expand export capacity. Without a stable legal and operating environment, Russia will fail to meet its production targets. This in turn could damage the Russian economy and the prestige of the Putin Administration.

The world needs every barrel of Russian oil. With growing Chinese and Indian demand and the insatiable appetite of the United States, markets will be tight and even more reliant on the Middle East. Given today's high oil prices, Russian companies and the Russian government believe that they can fund a good part of new developments and even infrastructure projects themselves. Additionally, Chinese and Indian companies, with the strong backing of their governments, are ready to do business with Russian companies and the Russian government. Their investment criteria are more in line with the approach favored by their Russian hosts. Skills as well as money will be crucial, however, and they bring few. If as a result Russia cannot sustain its current oil production level, this will negatively impact world oil markets.

A faltering Russian oil sector would be a disaster for the world economy as well as for Russia itself. President Putin must recognize that he needs a petroleum sector with well-managed and well-capitalized oil, gas and pipelines. He is well within his rights to want the state to dominate it, but it must be managed efficiently. The Yukos affair, as well as in-fighting in the Kremlin and a lack of transparency and predictability, indicates that he is going in the opposite direction and could hurt Russia's interests as well as the world's if he does not correct his course.