The pot-holed road

Thoughts about India, the United States, and occasionally, the world at large.

GAZPROM AND PUBLIC SECTOR INEFFICIENCY: IS IT A POINT CARRIED TOO FAR?

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By Ranjan Sreedharan
13 Sept. 2008

It is not unfair to say that the present Russian Prime Minister (formerly the President) Vladimir Putin is widely detested in the west. Indeed, some of us would be tempted to add ‘Yes, particularly after Georgia.’

I believe that is unnecessary. Even before Georgia (and without getting into the complexities of the crisis in the Caucasus), Putin was a figure of hate in the US and as much so in Britain.

The British attitude displayed by its politicians cutting across party lines and its media — including the voices on the centre-left like those of the Guardian and the Independent — has its origins in the perceived injustice meted out to British oil companies like BP and Shell. It became particularly shrill during the time the Litvinenko murder case was front page news, with allegations that the polonium trail led all the way to Moscow (and by implication, the Kremlin and Putin). Moreover, hordes of extremely wealthy but unloved Russians have descended upon London in recent years, buying up premium property and much else.

As for the Americans, they are clearly nostalgic for those days under Yeltsin when Russia did more or less what it was told to do.

The extraordinary lengths to which the media and the academic establishment on either side of the Atlantic can go to – or the depths to which they are willing to descend to – in order to deny Putin any credit for Russia’s post Yeltsin revival, has to be seen to be believed. There is now something of an industry engaged in producing lengthy papers and dissertations seeking to prove that Russia has not done so well under Putin as the world tends to believe (never mind that 80% of Russians think the same as well) and that had it not been for the revival in oil prices, Russia would by now be an economic basket case. Once the oil price boom goes bust … so this theory goes (very close to wishful thinking, if I may add), Russia will be left with nothing more substantial than a begging bowl.

Okay, I’m exaggerating, but there was a recent article in the Guardian where the author – a respected journalist (Edward Lucas) from the Financial Times – called Russia a ‘fascist kleptocracy’. I did not bother to check on what he had said about Russia under Yeltsin when loot and plunder of state resources was the order of the day.

Much of the diatribe against Russia is political and has to do with the perceived roll-back of democracy and democratic freedoms under Putin as compared to the Yeltsin era, which for many in the west, was the golden age of Russian renaissance.

There is also harsh criticism of the economic record of Putin which claims that whatever has been achieved in Russia in recent years was despite Putin and facilitated entirely by the boom in energy prices. It does not matter that when Putin came to power in 1998, Russia had a GDP of US$ 200 billion and when he stepped down from the Presidency this year, it had increased manifold to US$ 1,400 billion.

One of the main planks on which the criticism of Putin’s economic record rests is the role he has played in expanding the state sector in the economy, particularly in energy. State owned companies with a proven track record of inefficiency have expanded and displaced an efficient and well run private sector. At this point, the example is given of Gazprom, the state owned oil and gas company which under Putin has become a behemoth and succeeded in wresting back control of much of Russia’s oil wealth from the oligarchs and from the western (unhappily for Britain, mainly British) oil giants.

We are told that this has led to a sharp decline in efficiency whose long term consequences are now beginning to tell with a stagnation in output levels to be followed in the near future with a real decline in production.

So far, it’s all very good. I like to believe I am second to none in my faith in a market driven economy where the means of production are owned predominantly by private hands. I think it is easy to understand why government ownership of a manufacturing concern can have such disastrous consequences. The negative influences are many and begin with a bureaucratic culture that shirks responsibility and avoids hard decisions. There is a lack of responsiveness to market demands and an inability to adequately reward innovation and achievement (or punish the lack of it). The overpowering bureaucratic culture also throttles your risk-taking ability without which no business can flourish. The result is a company that slowly bleeds and bleeds the public exchequer.

But, and this is the moot question, is it all just the same for an oil company? Here is why I believe it is not.

To begin with, there is the question of quality of output. This is a simple point. In the case of crude oil (and unlike in the case of a manufactured product), it cannot be any different. Whether drilled by Gazprom or by the efficient western oil conglomerates, what comes out of the ground is black gunk, without anything in it to distinguish the inefficient Gazprom product from the hi-tech western product.

Then we come to the question of efficiency, which in the oil industry can be of two types, ‘exploration efficiency’ and ‘extraction efficiency’.

Exploration efficiency: As the name implies, this is essentially the success rate in discovering new oil fields, in striking oil within a given exploration area. No doubt about it, the private sector has a clear advantage over the state owned entities. For example, in India, for a long time the state-owned ONGC had a monopoly over drilling and exploration rights and the last time they did anything worthwhile was Bombay High, way back in the seventies. Once exploration was opened up to private and foreign participation, there has been a spate of discoveries, from oil in Rajasthan to gas (and lots of it) in the Krishna-Godavari basin.

Having said as much, it is worth noting that while inefficient exploration leads to output below what should have been achievable, it really may not harm the country in the long run. Because the undiscovered oil remains below the ground for discovery by, and for benefit of, a future generation, it may well be doing a favour to the next generation. In a sense, in India, we were lucky that ONGC was inefficient in discovering new oil fields. True, this compelled us to import more oil but we did so mostly when the price was about US$ 30 per barrel.  Now that we are face to face with crude prices of US$ 100 and more, the new discoveries will allow us to substitute for a much more expensive import.

Extraction efficiency: This is the efficiency with which you operate an oil well. Given the recoverable reserves in a particular well, how much of it are you able to extract and get above ground. The western oil companies possess superior technology that enables them to recover more from a given well than what a state owned outfit like Gazprom can manage. Now, unlike as in the case of exploration inefficiency, the loss on account of extraction inefficiency is a real, quantifiable loss to the country and to the world economy at large because what is lost here is lost for good.

So, how much does the country concerned (be it Russia with Gazprom or Venezuela with PDVSA lose on account of this inefficiency?

Here is my conclusion. Not a whit.

Because the superior technology of the western oil companies comes at a price, extracted by way of a share of the total production. Very often this goes up all the way to a fifth or more of the total output, and this, after all the initial costs have been recovered. Now, if Gazprom operates an oil well with 60% extraction efficiency, there may well be western oil companies which can improve it to say 75% extraction efficiency, but if the price for that is a 20% share of the total output, it becomes a price worth not paying.

Therefore, in order for the country (be it Russia or Venezuela or Iran) to be a loser from state control of its oil sector, the loss on account of extraction inefficiency has to exceed the share that would otherwise accrue to the western oil company.

In real life, my own guess is that this does not happen. This partly explains why in recent years so many of the western oil companies have been compelled to renegotiate their production sharing contracts with various governments around the world and settle for reduced terms.

There is another side effect too. By acting as a constraint on supply at a time of surging demand, the lower output from inefficient extraction can possibly lead to higher prices in the international markets, thus additionally compensating the countries concerned.

Put it all together, and here is a case where conventional wisdom is turned on its head.

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Written by Ranjan Sreedharan

November 19, 2008 at 6:14 pm

Posted in Uncategorized

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