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«SIBUR» LLC is the managing organization of PJSC «SIBUR Holding».

117218, Moscow, Krzhizhanovsky st., 16/1

In Siberia, a firm finds gas flares can be good business

Less than five years ago, travellers flying into Surgut could be forgiven for thinking they were entering Dante‟s Inferno. Planes often began their descent towards the West Siberian city through clouds backlit by an eerie red and orange glow which stretched towards the horizon. On clear evenings, tongues of flame -- flares burning off associated petroleum gas (APG) from the region‟s vast oilfields -- lay scattered across the earth below, licking at the night sky.

Today, the view from the window seat is slightly less apocalyptic, but APG flaring continues, and for Russia, especially, it is a continuing problem.

West Siberia is the workhorse of Russia‟s oil industry. The district surrounding Surgut, Khanty-Mansiysk okrug, is its heart. Last year, Russia surpassed Saudi Arabia to become the world‟s largest oil producer. According to official data, of the 10.5 million barrels a day (b/d) produced by Russia in 2011, more than half was pumped from Khanty-Mansiysk. As oil volumes increased, so did APG production. Last year, Russia produced 67.8 billion cubic metres (cm) of APG; 37 billion cm of that in Khanty-Mansiysk. In late March this year, then-prime minister Vladimir Putin (now the country‟s president) said Russia‟s total APG output for 2012 is expected to be in the region of 70 billion cm, adding that, “unfortunately”, almost a quarter of this will be flared.

Historically, oil producers treated APG, which is comprised of alkanes, including methane, ethane, propane and butane, as well as carbon dioxide, nitrogen and other compounds, as a by-product of oil extraction. Some volumes were reinjected to boost recovery; if gas processing was available nearby, a proportion was processed and generally used for on-site power generation. Most APG, though, was burned off as waste. This is the crux of Russia‟s problem.

According to World Bank figures, 134 billion cm of APG is flared globally every year, a volume equivalent to 33% of the EU‟s average annual gas consumption. This volume of flared APG releases an estimated 400 million tonnes of greenhouse gas into the atmosphere. Just 10 countries account for the bulk (70%) of these emissions, and that league table is topped by Russia. Estimates compiled by the World Bank‟s Global Gas Flaring Reduction (GGFR) partnership from satellite data provided by the US National Oceanic and Atmospheric Administration puts Russian flaring volumes for 2010 at 35.2 billion cm, or 26% of the total. Nigeria is in second place, accounting for 11% of global APG flaring, with 15.2 billion cm. (The GGFR‟s figures for 2011 were not available as Petroleum Economist went to press.) In 2007, when the first GGFR report was released, Russia‟s flaring was estimated at 50 billion cm; Nigeria‟s at 18.6 billion cm.

Russia disputes the GGFR‟s figures, considering them “grossly over-estimated”, and puts last year‟s flaring volumes at 15.5 billion cm. The Russian authorities point out that accurate measurement of APG production is difficult, as this requires metering at every wellhead on every field across the nation‟s entire oil sector. There is no requirement for Russian producers to measure APG volumes at the wellhead, so domestic figures are calculated via self-reported figures and compressor station data.

The dispute over actual flare volumes aside, the Russian authorities admit APG flaring is a significant problem and maintain a determination to address it. In August 2007, shortly before becoming prime minister, Putin, then president, declared that Russian oil producers would have to slash APG flaring to just 5% by 2011. In 2009,

acknowledging that the scale of flaring and the steps needed to address it made this target impossible to achieve, the deadline was extended to 2014. However, then-president Dmitry Medvedev stressed that Russia‟s oil sector would, in that revised timeframe, achieve APG utilisation levels of 95% or more.

In an address given at the time to Russia‟s federal assembly, Medvedev said: “(APG) gas flaring is an outrageous fact, an example of inefficient use of energy resources. It pollutes the environment, while dozens of billions of roubles simply turn to smoke. The government has pledged to put an end to this mess. We need resolute and quick action, and we will not accept any excuses from oil producers.”

While the Russian government has not yet endorsed a comprehensive legislative regime to tackle APG flaring levels, it has imposed a package of measures designed to limit the practice. Both Putin and Medvedev have stated that third parties will be granted access to state-run gas monopoly Gazprom‟s domestic pipeline network, provided there is capacity and the processed gas is of suitable quality. In March this year, Putin again gave his backing to plans to channel volumes of processed APG into the domestic power-generation grid. Fines for emissions have been increased -- in 2008, operators were charged 250 roubles ($8) per tonne for methane emissions above limits agreed in their production licences and regulators can levy fines on producers exceeding those flaring limits. In 2008, this fee was $0.77 per thousand cm (/‟000 cm). Until recently, the total fee could not exceed $1,540 a year. These regulations have, however, been amended and new, stiffer penalties are set to be introduced. Some regional governments are also taking steps to reduce APG flaring: operators in Khanty-Mansiysk, for example, could have their licences revoked if flaring levels are deemed unacceptable.

Russia‟s determination to reduce flaring firmly places the burden to cut volumes on producers. There were suggestions that the authorities could offer fiscal incentives to encourage increased utilisation, via tax breaks for example, but such moves did not eventuate. Indeed, Dmitry Konov, the chief executive of Russian petrochemical producer SIBUR, says: “Look at the nature of APG. It is essentially free for them and they can monetise it. Why should you give them incentives?”

One of the most cost-effective ways of reducing APG flaring is to process the gas. This separates it into stripped dry gas, suitable for domestic consumption, which operators can sell into the country‟s gas grid, and natural gas liquids (NGLs), which can be fractionated and used as feedstock for petrochemical production. Over the past five years, the country‟s petrochemical players -- and privately-held SIBUR in particular -- have been able to make a virtue of Russia‟s APG problem by expanding their gas processing capacity, and, subsequently, their feedstock base.

“We promote ourselves to oil companies as a service provider for APG processing,” says Konov. “We supply feedstock to petrochemicals via the APG chain: the purchase, processing and transportation of NGLs. This used to be a significant part of our business and still will be. But another part (of SIBUR‟s business) is directly buying NGLs; transporting them, fractionating them and creating feedstock.”

For SIBUR, an increase in APG utilisation brings a number of advantages. Increased demand for gas processing from oil producers has meant expanding its processing capacity - the firm operates a chain of seven gas processing plants (GPPs) in both West and East Siberia, close to some of Russia‟s largest producing oilfields – makes sound commercial sense. The firm now handles the processing of about half of Russia‟s APG. This, in turn, has given SIBUR access to increased volumes of feedstock, allowing the company, already Russia‟s dominant petrochemicals player, to further expand its production, ahead of an expected increase in Russian petrochemical demand.

The timing of the government‟s efforts to curb APG flaring could not have come at a better time for SIBUR, which unveiled plans to boost its feedstock business in 2004-5.

Konov says: “When we launched the programme to grow our feedstock business, a regulation was in place which basically fixed the price of APG across all regions. That was revoked (in 2005-06) and allowed the negotiation of an APG price which reflects an equilibrium for both oil companies and gas processors.

“The liberalisation of APG pricing means you can negotiate prices according to location, available volumes of APG, the distance to the nearest GPP, transportation costs and who incurs it. Free pricing allowed producers and processors to negotiate a solution and make more APG available for processing.”

He adds: “When the APG price was fixed, it may not have been economically viable for us to take the gas at that price, nor for the oil company to produce it.”

Price reform is, perhaps, one of the crucial elements Russia needs to address if it is to meet the 95% utilisation target. According to a study carried out for the World Bank by PFC Consulting in 2007, if oil producers could achieve a netback price of around $50/„000 cm, close to 80% of Russia‟s APG could be economically recovered. This, however, depended on price liberalisation across the gas chain. Reform is under way, but progress has not been as rapid as envisaged by the consultancy.

For SIBUR, however, the decision to allow market forces to determine APG prices is already paying dividends. Konov says: “SIBUR has increased the actual volume of APG processed at its GPPs from 8 billion cm in 2003 to more than 18 billion cm in 2011.” While he points to the debottlenecking of the firm‟s existing gas processing capacity, the construction of a new GPP (SIBUR‟s seventh), an expansion at the Yuzhno-Balyksky GPP and the upgrade of its Vingapurovsk compressor station to a GPP as factors driving this increase, Konov admits that oil producers‟ “increasing caution” about flaring has also played a part.

For oil producers, the impetus to enter into processing deals with firms such as SIBUR is, in part, a negative one. “The government has not incentivised oil companies not to flare,” Konov says. “It has offered no stimulus. Instead, it has imposed strict regulations and high penalties for flaring. The greatest monetary risk for oil producers is that their licences may be revoked.”

From the processor‟s side of the equation, the considerations are different. Konov says: “We don‟t look at APG from a flaring perspective, we consider how much feedstock we can obtain for our petrochemicals.”

This, in turn, helps inform the company‟s investment decisions. Last year, SIBUR‟s investment totalled more than 58.6 billion roubles ($2 billion). Over the past few years, it has channelled “dozens of billions of roubles into expanding its gas processing and transportation capacity”. A large proportion of this investment has been in West Siberia, where the bulk of Russia‟s APG is produced and flared off. In Khanty-Mansiysk, the firm has spent $250 million expanding the Yuzhno-Balyksky GPP, south of Surgut. The GPP, which now has a total APG processing capacity of 3 billion cm a year, handles gas from fields operated by Rosneft‟s Yuganskneftegaz unit. Most of the volumes come from the Priobskoye field.

“Oil companies lack the scale we possess, so the investment in APG processing and transportation chain is greater for them than us,” Konov says. “Infrastructure is a big competitive advantage, but we do spend money to expand. We use this infrastructure to buy NGLs from companies and incorporate them into SIBUR‟s existing NGL stream for processing.

“This adds scale and a competitive edge when we are discussing the purchase price for the product. Their volumes (in their raw state) are not marketable, while we

have fractionation capacity. The situation creates an opportunity for the petrochemicals business.”

However, Russia‟s need to cut flaring, and the need to do so quickly, does not necessarily mean that the petrochemicals sector is the accidental beneficiary of closer official scrutiny of oil producers‟ operations. “To process APG you need to buy it, to have or increase gas processing capacity, invest in NGL transportation, expand fractionation and find a market for the product,” Konov explains. “It may seem like a free play between APG and natural gas prices, but the price we pay for APG fluctuates from place to place. You also need to look at the whole chain and it‟s not just the price for APG, there is also the cost of the necessary investment to get APG from what it is to an end product.”

He adds: “The ability to transport NGLs is important, as well as the costs of processing. The margins on this chain don‟t allow for investment (without agreements being in place).”

APG utilisation clearly creates opportunities further down the production chain, but at a price. South of the Yuzhno-Balyksky GPP, at Tobolsk, SIBUR has spent $1.99 billion on a 500,000 tonnes a year (t/y) polypropylene production complex, which will process feedstock derived from APG processing. The plant will be complete in the second half of the year. In the Nizhny Novgorod region, a joint venture between SIBUR and Belgium‟s SolVin is building a $1.7 billion, 300,000 t/y PVC production facility. And at Ust-Luga, south of St Petersburg, construction is under way on SIBUR‟s $680 million liquefied petroleum gas and light oil products export terminal.

A further method of increasing APG utilisation comes from Saudi Arabia. Efforts similar to those employed in the kingdom in the mid-1970s, which resulted in the creation of Sabic and saw oil producers recover NGLs to maximise their value, could be adapted for Russia, Konov suggests. Another option would be to encourage work to maximise the ethane content of APG. Ethane is a component of APG, but in Russia there is no economic incentive to extract it and sell it as a feedstock. Konov adds: “It would be complicated to structure such an incentive package, but APG can be used to stimulate the petrochemical chain, and it is something the government may consider.”

In Khanty-Mansiysk, the push to cut flaring has gained traction. Despite seeing a drop in APG production as oil output has declined over recent years, APG utilisation in the region has risen to 87%. According to official data, this level is almost 10 percentage points higher than the nationwide index, and comes from the concerted efforts of oil producers, gas processors and okrug officials.

The results are almost palpable. Surgut, its streets coated in early-spring dust and the last stubborn, grubby snowdrifts slowly melting into mud, recedes. The road heads further into the taiga. Stands of birch are coming into leaf. Past Nefteyugansk, signs of the region‟s reliance on oil are everywhere. Christmas trees, tangles of pipelines and wellheads line the side of the road. But while flares still warm the night air, gradually, their glow is dimming.

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