Why the future of the Russian oil and gas industry is in the Caspian

Russia’s leading energy companies are now eyeing the Caspian Sea as a source of high-volume, high-quality hydrocarbon reserves.
The Caspian Sea is known for its sturgeon caviar, the rare Caspian seal, its beautiful yet unexposed beaches, and, last but not least, for its oil. The five littoral states – Azerbaijan, Iran, Kazakhstan, Russia and Turkmenistan – are all leading oil-producing countries.

Unlike other post-Soviet nations, Russia is a latecomer regarding the development of its Caspian offshore deposits. Despite the late start, a pioneering breakthrough of the Russian company LUKOIL has revitalized the Northern Caspian region and placed it at the center of public interest. The stakes remain high, as a significant portion of Russian sector’s recoverable reserves, predicted to amount to 270 million tons of oil and almost 500 billion cubic meters of gas, is still up for grabs and waiting to be discovered.

A short history of exploration efforts in the Caspian

Until the 1980s most of the exploration efforts were carried out in the Turkmen and Azerbaijani shelf deposits, as they were initially deemed most promising. It is noteworthy that the northern and central parts of the Caspian Sea, i.e. the ones to which Russia has disposition rights, were considered to be of little promise. The Azerbaijani exploration effort proved to be the most fruitful, with the discovery of the Azeri-Chirag-Gunashli (ACG) field some 120 kilometers (74.5 miles) off the mainland coast.

The ACG field has proved to a discovery par excellence as it still represents more than three-quarters of Azerbaijan’s oil production. In stark contrast to this, up to the 1990s the Russian Caspian shelf knew only one relatively small oil and gas field off the Dagestani coastline. When one of the largest Russian oil companies, LUKOIL, launched its Northern Caspian exploration program in 1994, it was the only major company to establish its presence in what was perceived as a zone with little profit potential.

The discovery of the Kazakh supergiant Kashagan field in 2000, the largest oil find in the last four decades, was the harbinger of things to come in the Caspian region
The discovery of the Kazakh supergiant Kashagan field in 2000, the largest oil find in the last four decades, was the harbinger of things to come in the Caspian region. Reportedly, the shallow-water Kashagan contains 1.7 billion tons of recoverable oil reserves, more than all the other known Caspian fields combined.

2000 marked the success of oil exploration in the Russian Caspian, too. First, LUKOIL reported the discovery of the Yuri Korchagina field in 2000, which was followed by seven other fields within eight years: Rakushechnoye and 170 km in 2001, Khvalynskoye and Sarmatskoye in 2002, Vladimira Filanovskogo in 2005, Morskoye and Tsentralnoye in 2008. In all but one (Morskoye), LUKOIL was the sole or part owner of the license. Despite numerous discoveries, the Russia’s Caspian shelf is far from being fully prospected – formations around the Yuri Korchagin field alone are alleged to contain almost 1.9 billion barrels of oil.

Russia, advocating a principle of demarcation that would be proportional to the countries’ coastline lengths, concluded separate offshore delimitation deals with Kazakhstan in 2001 and Azerbaijan in 2003. In such a way, Moscow has eliminated virtually all possible risks that its exploration would lead to a territorial dispute.

Thus, absent an all-encompassing multilateral offshore demarcation deal, Russia is nonetheless imperturbably pushing ahead with the development of its own Caspian deposits.

To a large extent, LUKOIL was forced to find a viable alternative to replace production levels from its aging Western Siberian fields. The LUKOIL abbreviation itself is derived from three landmark oil production hubs in the Khanty-Mansi Autonomous Region – Langepas, Uray and Kogalym – all of which are long past their peak production periods. Western Siberia in general, having constituted 69 percent of total Russian oil production in its peak year of 2007, is witnessing a gradual yet unavoidable decline (currently at 58 percent of total production). Therefore, the oil company has decided to break new ground in other parts of Russia – the Timano-Pechora region, the Caspian and the Baltic.

Leading Russian oil and gas companies have also joined the race for the resources of the Caspian. Russia’s energy giant Gazprom, which joined LUKOIL in the development of the Tsentralnoye field, could make good use of its already existing infrastructure and solid standing in the Astrakhan Region, home to one of the largest sour gas fields in the world.

Russian oil producer Rosneft also declared interest in gaining a foothold in the Caspian Region, as it acquired the Laganskiy drilling block in 2013 and began joint drilling operations with LUKOIL on the Ribachya structure a year later. Perhaps the discovery of the onshore Velikoye field in 2013 not far away from Astrakhan will spur leading Russian companies to take a closer look at the North Caspian.
Challenges facing new Caspian production

Despite the obvious appeal of the region, there remain numerous impediments to fully develop the Caspian Sea’s hydrocarbon potential. Above all, when developing an oil or gas field, it is important to think about potential market outlets and ways to transport goods there. In contrast to Kazakhstan, which intends to sell its Caspian oil and gas to China, Russian production will most likely be fully diverted to its Black Sea ports.

Although the Caspian region has a tradition of transporting oil northbound to energy company Transneft’s pipeline system core, to be subsequently marketed as Urals blend, the producers would be quite unwilling to perpetuate it, as the Caspian oil is by far superior in quality. Utilizing the Caspian Pipeline Consortium’s (CPC) link to Novorossiysk, a port city on the coast of the Black Sea, seems the most plausible alternative, although it is still uncertain whether the incremental oil production volumes from the Caspian could fit even into CPC’s increased 67 million tons per year throughput capacity as Kashagan production begins to ramp up.

Using the Makhachkala – Novorossiysk pipeline would be feasible, too, although Transneft has been having major difficulties in curbing the appropriation rates in the Dagestani port. As for the gas, it would most likely be used in Gazprom’s Astrakhan and LUKOIL’s Budennovsk gas-processing plants.

The Caspian Sea is known for its fickle environmental conditions, which significantly hinder the oil production process. Scientists are still grappling to explain the seesaw changes in the Caspian Sea’s water level, which after two decades of decrease in the 1960-1970s, went on to robust growth between 1978 and 1995, only to settle down for another 20 years.

Seasonal weather conditions are just as wide-ranging. The Northern Caspian Sea freezes in the winter for several months, while in the summer, oil workers need to cope with desert-like conditions. These climatic fluctuations have to be taken into account when constructing oil rigs. For instance, the $1.4 billion Yuri Korchagina field is developed by means of ice-resistant platforms (IRP) – one for the drilling itself, the other for personnel – equipped with a helicopter deck.

Notably for a Russian offshore field, most of the equipment used in the development of Caspian fields is of Russian origin; for example, the IRPs were built at Astrakhan’s shipyards. The unusually high rate of local content is mostly due to the complexity and costliness of transporting foreign-built infrastructure down the Volga or via some other corridor.

The current oil price environment represents the most significant impediment to development of the Caspian offshore fields. Since the overwhelming majority of fields are located dozens of kilometers away from the mainland, usually at the depth of 12-15 meters, their production cost levels are well above the Russian average of $19 per barrel, at $40-50 per barrel. After the Russian government introduced tough anti-flaring rules in 2012, it became harder to deal with associated gas. As the Caspian fields contain a considerable amount of it, operators had to invest in additional gas-utilization capacities, thus further raising the project costs.

In view of this, LUKOIL has decided to concentrate on its oil-producing Caspian assets at the expense of similarly, if not more, ambitious gas-bearing projects. As a consequence, the development of the Sarmatskoye field was postponed well into the future to 2024, whilst that of the Khvalynskoye field (initially expected to come on-stream in 2016) was adjourned for an indefinite period.

Given the Caspian’s unique flora and fauna, oil producers have to go to extraordinary lengths not to endanger its endemic species. For instance, the population of Caspian seals fell fifteen-fold during the 20th century, to its current level of approximately 100,000 specimens, primarily due to sea and air pollution, as well as habitat shrinking.

As the seals’ bodies seem to contain an increasing number of metallic elements, one can assume that the ongoing sea pollution affects fish species further down the food chain that are consumed by these seals. Even an unexpected rise in the sea level, washing away all the uncleaned remnants of 150 years’ oil production across the region, could jeopardize the Caspian’s flora and fauna. One may look at sprawling oil films covering the Caspian Sea’s waters not far away from Baku to understand how the future will look if littoral nations do not adopt an extremely cautious stance vis-à-vis environmental damage.
Four factors in favor of Caspian production

Many years will pass before the Caspian Sea reaches its full hydrocarbon production potential. Yet it is inevitable that Russia will experience its own Caspian renaissance.

First of all, there is a substantial amount of oil and gas waiting to be extracted from the seabed subsoil.

Secondly, Russian authorities seem to adhere to their current policy of maintaining tax breaks for Caspian projects. This favorable internal fiscal regime includes a zeroing out of export duties and a reduction in mineral extraction tax for the first seven years of oil production.

Thirdly, oil in the Russian sector of the Caspian, unlike the Kazakh one, has very low sulfur levels, which, coupled with an American Petroleum Institute (API) gravity of approximately 44°, makes for a high-quality grade that will be sought after. [API gravity refers to a measure of how heavy or light a petroleum liquid is compared to water – Editor’s note]

Lastly, oil prices will eventually rise to the level where almost all Northern Caspian projects would be economically profitable. Alas, only one question remains – when?
Source: Russia Direct

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