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Integra brochure
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February 01, 2009

Unanticipated nosedive

Dmitry Zavialov

Due to the crisis, the markets for oil and gas field services and oil and gas equipment manufacturing are shrinking.
Benjamin Franklin: Buy what thou hast no need of and ere long thou shalt sell thy necessities.
The financial crisis which had a negative impact on the fuel and energy industry has also hurt other related sectors such as oil field services and machinery manufacturing for oil and gas industry. In 2007 Russian oil and gas field services market was estimated between 10 and 15 billion dollars with 2008 forecasts being 14 to 15 billion dollars. Still, preliminary year-end results show the loss of at least 2 billion dollars and the final figure of some 12 to 13 billion dollars. 2009 projections anticipate the market may drop by half down to 7 or 8 billion dollars. Thus, engineering and construction industries engaged with oil and gas sector will have to live through even harder times.

Not expected

Even in October 2008 at the 3rd International Conference Oil and Gas Field Services in Russia the service companies were quite optimistic, and no one anticipated a severe drop in their business, even though President of Integra Management Felix Lubashevsky who had initiated the conference, noted, that “The next [2009] year will be hard for the oilfield services market and only strong and large companies capable of investing in their development will survive.” AN alternative view was presented by Commercial Attaché of the US Embassy in Moscow Jane Kitson who said that no decline in cooperation of Russian and US oilfield servicing companies was observed and that “Nobody is leaving Russia, but quite the opposite, there come new players willing to operate in the Russian market of oilfield services.”
President of Eurasia Drilling Company Alexander Bogachev said he expected the oilfield services market to shrink by 20 to 25%. Nevertheless, Eurasia Drilling Company had plans of investing about 360 million dollars in its development in 2009. According to Eurasia Vice-President Vadim Bayanov, the company invested in expanding its production more than 550 million dollars over 2005-2007 and about one third of the amount in 2008 which enabled it to actively expand its operation to new regions in Russia and to international markets. For example, it is now active in Kazakhstan and has taken part in a tender for drilling in Uzbekistan. The company intends to annually upgrade 8 to 10 drilling rigs and buy 10 new ones (in 2008, it purchased 8 rigs).
Still, the crisis made itself quite evidently felt at the conference. The decline which started in 2008 and will further continue throughout 2009 will bring the oilfield services market back to the level of 1999-2000 in terms of the orders, prices and quality. Over 2002-2007, investments in oilfield services amounted to billions of dollars allowing for an essential technical renovation of the industry comparable in scope to that of the 1980s. Given the current situation, the investments will take long to pay back as the new equipment is not used to its full capacity.
Some hardships can already be seen. According to ROSSTAT [Federal State Statistics Service], between January and November of 2008 production of oil and gas condensate in Russia declined by 0.7% against the same period a year before, having amounted to 446 million tons. In November 2008 oil production dropped by 0.8% as compared to November 2007 and by 4% as compared to October 2008. Liquid hydrocarbons production went up 2.1% in 2007 and was forecasted by the Ministry of Energy to increase by 3.1% in 2008.
In late 2008 a dramatic reduction was experienced by exploration drilling resulting in an extremely limited number of sites available to the oil producers being ready for exploitation drilling this year. The crisis reached out to hit drilling-related technological services such as well-cementing, telemetering, etc. Seismic prospecting has been barely affected though, as major seismic acquisitions are mainly made over winter season, while servicing companies made their contracts back in summer thus overpassing the point of no return.
Despite the current background, Integra Group demonstrated good performance. Over the first nine months of 2008 its revenues grew by 45% while EBITDA increased by 50%. Besides, over the same period - and primarily in the third quarter of the year - it generated operational cash flows of 82.2 million dollars. True, it had to face personnel and expenses cuts, reduce its working capital and suspend some investment programmes. According to preliminary estimates, Integra 2008 year-end proceeds amounted to 1.5 billion dollars.

Nonprofit partnership is needed

What may be the way out of the current situation and how may it be improved for the oilfield services? One of the options was named by Natalia Andreeva, Hydrocarbons Field Facilities Construction Complex Design Institute who pointed out that “Economy’s innovative development is impossible without a substantial inflow of new technologies and professional engineers and technicians. It has been a long-lasting global trend that new ideas for oil and gas industry are generated by servicing companies. In our country, approaches to the technological services rendering evolutionised along with the free market taking root. At the time economic transformations commenced, there were thousands of companies in the country which had accumulated technical and technological solutions for every aspect of oil and gas production, while a vast database had been compiled containing geological and production information and details on oil provinces and oil fields features. Research institutes, companies improving oil recovery, engineering plants, etc. were the first ones to adapt to the market environment and to establish service companies.”
Still, disintegration of the centralised management system in the industry resulted in services sector atomization and lack of transparency. There is no direct link between innovative developments and their commercialization by service companies, and that is why the market structure has remained unchanged since 2005. The domestic market is dominated by Russian businesses which receive 70 to 80% of all orders, but it nevertheless witnesses expansion of foreign companies with Schlumberger holding a 10% market share and Halliburton showing 250 to 300 million dollars annual sales. Besides, independent service providers have failed to challenge subsidiaries of the vertically integrated oil companies and have therefore been losing their market and facing lower profits due to inflation and higher costs of credit resources.
The current oilfield services market structure results in practices when large oil producers buy some 10% of oilfield services from Western corporations at overrated prices and further 60% from their own subsidiary or affiliated servicing companies. Given the deteriorating structure of reserves, insufficient supply of advanced oilfields exploitation methods and technologies causes oil production decline. According to Natalia Andreeva, “The impacts of the global crisis have not yet hit the oilfield services industry. Fluctuations in the global oil market will evidently bring about cuts in corporate investment programmes at the expense of primarily independent service providers.”
“Who generates sound demand for the services market technological development today? Nobody,” she says.
The government, who is the owner of the subsurface resources, is incapable of offering clear mechanisms for managing rational exploitation of hydrocarbon reserves, for supporting domestic hi-tech servicing and engineering companies, and for directing the industry into the innovative way of development. An efficient and technologically advanced structure of the market for servicing oil and gas sector may only be built if the economic interests of its major players are harmonized. Therefore, the government must actively employ the technical regulation system in the industry thus stimulating use of certified domestic machinery by oil companies.
Natalia Andreeva suggested that a nonprofit partnership should be launched involving service companies as contractors, producers, and a rating agency. Such an entity would compose a database of suppliers to be referred to by customers when selecting their counteragents. According to Ms Andreeva, this will “allow to ‘technologically shift’ the market toward higher quality of services, lower costs for oil companies in identifying and selecting contractors, and smaller risks of ‘defaults’ in services rendering.”

Preserving mechanic engineering

The sector of engineering machinery for oil and gas sector is also confronting a difficult situation. According to expert assessments, the state of the industry will be most alarming in 2009. It appears, that production of minerals will continually decline and hence oil companies will most likely halt exploitation of marginal wells thus reducing the equipment in operation. The reasonably serviceable machinery will therefore be employed at good capacity wells while acquisition of new equipment will be postponed until better days are back. For the oil producers, that will be a good way to save, as the price of a conventional pumping unit ranges between 500 thousand and 1 million dollars.
Manufacturers of pipes will also be hurt. Between January and October 2008 their aggregate output amounted to 6.9 million tons or 93.8% compared to the same period a year earlier. Seversky Tube Works was the only company which experienced growth (by 9.8%) while all other manufacturers saw a dramatic decline.
For example, Pipe Metallurgical Company (TMK) which includes Volzhsky Pipe Plant, Sinarsky Pipe Plant, Seversky Tube Works, Taganrog Metallurgical Works, TMK IPSCO in the U.S., TMK-ARTROM pipe manufacturer and TMK-Resita metal works in Romania, TMK-Kaztrubprom tubings producer in Kazakhstan, and a number of subsidiaries engaged in oilfield services, found itself in a grave situation. As TMK CEO Alexander Shiryaev admitted, “Over the past 10 months, demand for large-diameter pipes fell by over 40% due to postponement in launch of such major projects as the Nord Stream and East Siberia - Pacific Ocean pipeline.” As a result, by the end of 2008 TMK accumulated a significant outstanding debt of about 3 billion dollars and had to request assistance from Vneshtorgbank (VTB) which extended to TMK a facility of 7 billion rubles.
Alexander Romanikhin, President of the Association of Oil and Gas Equipment Producers, argues that the companies of the industry should be supported by the government, but not financially. “There is no need for direct cash injections, - he says, - but rather for coordinated measures for the equipment not to be purchased abroad for some while.” In his opinion, the threat of a further increase in imports of equipment is quite real. He was perplexed to learn, in particular, about the agreement made between Export-Import Bank of China and Gazprombank under which a 300 million dollar loan would be extended to the latter and directed toward purchasing in China machinery for oil and gas industry thus allowing drilling rigs worth millions and millions of dollars to be imported to Russia without any fair and competitive tender.
In the meantime, Russia has at its disposal comprehensive facilities for drilling rigs manufacturing at Tyumen Shipbuilding Plant, Kungur Machine-Building Plant, Volgograd Drilling Equipment Plant, Uralmash-Burovoye Oborudovaniye, etc. There are many domestic suppliers of various materials, elements and units whose performance is dependent on the above specialized companies. Russian drilling rigs have successfully competed with those of foreign make and have been bought by Western companies implementing gas production project in Yamal peninsula. Therefore compulsory purchases of machinery manufactured in China seems to be totally absurd.
Another example of the kind may be mentioned. On November 25, 2008 Russian Prime-Minister Vladimir Putin visited Vyborg Shipyard and examined floating drilling rig under construction, intended for development of Shtokman gas-condensate field, but most probably he was never told that the equipment at that semi-submersible floating drilling rig was all imported. 
According to the experts, for merely prospecting resources under the bottom of the Arctic seas in the north of Russia domestic companies will need to buy ten fully equipped drilling rigs. Where will these rigs come from? So far, the trend has been quite worrisome with 80% of 2008 orders for drilling rigs placed with manufacturers outside Russia.
Given the lack of financial resources, every effort should be made to encourage placement of orders for the manufacture of products for the needs of fuel and energy industries, in Russia rather than abroad. Such a policy would allow maintaining more jobs and preventing the overall decline of the industry.
Alexander Romanikhin believes the goal may be achieved by granting preferences to the purchasers of Russian-made machinery. Besides, it is suggested by the Association of Oil and Gas Equipment Producers that license agreements on subsoil use should incorporate requirements for technical modernisation of the oil and gas industry based on the nationally produced machinery. “That would be the most reliable mechanism allowing us to move from pure declarations to the practical protection of national manufacturers. If oil companies request amendments to their license agreements, the government must come up with counter demands regarding consumption of domestic equipment and services. We must develop the market of our own, rather than that of China or the U.S. It is essential that such a mechanism is fully applicable to private oil companies as well,” Mr Romanikhin says.
In his opinion, a new practice should be introduced as well, that of making long-term contracts of 3 to 5 years with machinery manufacturers. He cited the example of OOO Gazcomplectimpex and Uralmash-Burovoye Oborudovaniye and their agreement on the supply of 11 heavy duty drilling rigs.
Cooperation should also be extended in developing new domestic technologies. Tyumen Shipbuilding Plant, Stromneftemash (Kostroma) and a Gazprom subsidiary Burgaz set an example for that by jointly designing new drilling rigs and cementing outfits.
Besides, domestic machinery manufacturers should be more active in involving themselves with implementation of complex projects such as exploitation of Shtokman gas-condensate field, Sakhalin shelf and others which require unique technologies. They should also advance to the international markets, supplying their products to Uzbekistan, Libya, Venezuela and other countries where Gazprom is actively present.

System failure

Unlike other countries, Russia regretfully has no special federal programmes facilitating mechanic engineering development, while natural monopolies and oil companies are offered no incentives for investing in development of new technologies.
In Norway, the projects of extracting hydrocarbons on the shelf boosted development of domestic facilities manufacturing equipment for the needs of oil and gas industry. In Kazakhstan, mechanic engineering support programme was launched with KazMunayGas National Company now financing development of new technologies which must be employed by both domestic and foreign companies operating in the country. In China, national Export-Import Bank extends subsidized loans to domestic equipment manufacturers and consumers. In Russia, a special financial corporation, Eximbank of Russia, was set back in 1994 for the same purposes, still, so far the equipment manufacturers have obtained no practical aid, as the machinery exports support measures failed.
It is noteworthy though, that there have been some positive examples of cooperation between authorities and businesses in mechanic engineering development. In Tyumen Region, annual growth in manufacture of equipment for the needs of oil and gas sector amounts to 20%, all due to the regional government guaranties to partially reimburse royalty to oil companies purchasing equipment from local manufacturers. Besides, regional budget covers costs of training employees for such companies, and partial interest payment at two thirds of the Central Bank discount rate, on the banking loans obtained by manufacturers for upgrading their facilities. 
At the Oil & Gas Field Services and Equipment international conference held in Tyumen in December of 2008, Vadim Shumkov, director of a department within regional government, noted that relevant decisions on priority buildup of the oil and gas equipment manufacturing sector were made back in 2002 and 2003. Since then, various statutes were approved to further expand capacities of the sector. Regional authorities intend to shape within some three to five years a comprehensive and competitive pool of service companies able to offer diverse top quality services to the oil and gas producers operating in West and East Siberia, Kazakhstan and other CIS nations. Unfortunately, the experience of Tyumen Region in facilitating domestic mechanic engineering through targeted support of the authorities is hardly followed anywhere else.
Given the escalation of the competition between domestic and foreign manufacturers in the Russian market of machinery for oil industry, Russian companies will have to adjust their strategies and focus on oilfield services rather than on manufacturing. Integra Group has been following the path for a few years having acquired a number of assets in oilfield servicing.

The positive of the negative

In the currently difficult situation larger and more experienced companies would generally consolidate their positions. Oil producers would be interested in contracting best professionals offering most advanced technologies for oilfields exploitation. Thus, the crisis may become a positive factor for the market of oilfield services which will most probably see the smaller and insufficiently professional players leave while major companies will grow further. It is likely that up to 70% of the market will be shared by some 10 to 12 big companies including, among others, Eurasia Drilling, Siberian Service Company, Integra, Rimera (a ChTPZ [Chelyabinsk Tube Rolling Plant] Group subsidiary), and Geotech.
Stagnation in the oil market and the tax benefits promised to be introduced resulted in some increase in mergers and acquisitions. In mid 2008, some acquisitions were accomplished by Integra (which paid 54 million dollars for NKRS well workover company) and ChTPZ Group (which bought Yuganskneftegazgeofisika, Tomskneftegazgeofisika, and Taimyrnefterazvedka) with further assets being increasingly offered in the market due to two major factors.
First, smaller companies go bankrupt in the circumstances of financial instability. Second, major oil corporations sell out their subsidiaries which are not part of their core business. It appears that in 2009 TNK-BP will fully accomplish the process of selling its service companies. Rosneft and Gazprom-Neft had already separated such companies by establishing RN-Burenie and Gazpromneft-Nefteservis, respectively. They do make contracts with these subsidiaries and try to maintain their scope of operations, but they at the same time cooperate with other companies too. It may be therefore expected that by the end of 2009 Russian market of oilfield services will revive.