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Sunday, September 19, 2004

IF YUKOS CAN'T PAY WHO WILL?

Russia's Interfax news reports this morning that Russia’s besieged oil major Yukos has refused to fulfill its export obligation to China National Petroleum Corporation (CNPC), China's largest state oil company. A Yukos spokesman told Interfax that the company was forced to suspend the rail exports because they could no longer pay the $150 to $170 per ton rail transportation costs for the projected 1 million tons (approximately 81,400 bbl/d) of oil they were to deliver to CNPC before years end. However, Yukos says it still plans to fulfill its export obligation of 750,000 tons (approximately 61,100 bbl/d) to Sinopec, China's second largest state oil company. Forced to suspend deliveries to one company or the other, the Sinopec deliveries were favored for continuation over the CNPC obligations, the Yukos spokesman said, because they are "more critical".

So will Yukos' oil finally stop flowing? The most likely answer is 'no'. It is in nobody's interest for the oil to stop flowing, including Russian President Vladmir Putin's. This is precisely Putin's difficulty in his destruction of Yukos: how do you destroy a company without reducing its production? Not only does Russia need the income generated from these oil deliveries, but also world oil markets are counting on Russian production to continue at its current or even increased levels. With oil still hovering around $45 per barrel and world production capacity at or near 100%, traders will start getting jittery if Yukos' 2 million bbl/d start to disappear from the market, further pushing up oil prices and taking an increased toll on world economic growth.

China too is clearly quite concerned about its precarious energy situation. China's crude consumption is second only to the U.S., while its strong economic growth will only increase Chinese demand. Furthermore, 30% of China's domestic oil production comes from the huge Daqing field in northeastern China which has been tapped since 1963 and is showing signs of decreased production. While China receives a steady supply of crude from the Middle East and West Africa, there is a problem there: these crude shipments much come via sea past countries allied with the U.S. and thus vulnerable to an oil embargo should a military conflict with the United States ever erupt. Not long ago China looked to oil delivered via pipeline from Russia as the answer to this strategic energy problem. However, plans to build just such a pipeline collapsed recently when Russia chose instead to go with a pipeline terminating in Japan for its exports to market.

So who will step up? Despite the weeks of warning, neither side has actually agreed to pay to transport Yukos' oil. Chinese traders are confident that Russia will find a way to pay the transport costs, no doubt presuming that Russia has the most to lose should the exports stop. On the other hand, Gennady Fadeyev, CEO of Russia's state-owned railway said on August 18th that the Chinese government had agreed to pick up the tab should there be any problems. However, it is not clear to what agreement he was referring. He may have been referring to a clause in the original agreement with Yukos that states that the buyer must bear the costs and risks of transportation. However, such clauses typically refer only to transportation from the Chinese border to the final destination. Who will pay for the oil to get to the Russian border?

If Putin knows what's good for his country, he will indeed find a way to pay the bill. In fact, he has much more than revenues, Sino-Russian relations, or the futures market to worry about here. Putin's and Russia's credibility among foreign investors and oil traders is suffering terribly because of the Yukos affair, although he has insisted repeatedly that Yukos' oil would continue to be delivered to market. Should he choose here to break that word, oil markets and foreign investors will reach a new level of distrust in the Russian leader. Despite Russia's westaward tilt on any number of geostrategic issues, he could lose the western constinuency that he most needs: western businesses and investors.

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