Eurasian Customs Union: Implications for Oil and Gas

Astana, Kazakhstan  2 October 2012 Dr. Matthew Sagers, IHS CERA Senior Director, Head of Russian and Caspian Energy; and Eurasian Transportation Forum Eurasian Customs Union: Implications for Oil and Gas

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Major Messages • Customs Union between Russia, Belarus, and Kazakhstan went into effect January 2010; became functioning entity when formal customs and border controls between member states abolished in July 2011 • Outgrowth of previous attempts at economic integration in post-Soviet space, led largely by Russia • CU member countries are each others’ most important trade partners within CIS region • General CU trade rules not applicable to most trade in energy commodities between CU members, probably because of its overall importance • Trade in energy commodities governed largely by special bilateral trade agreements between members • Making for a “Potemkin” Customs Union? Because most important trade relations between member states not covered

Customs Union for Three Eurasian States • Customs Union between Russia, Belarus, and Kazakhstan went into effect January 2010 (legally established in October 2007); but became functioning entity when formal customs and border controls between member states abolished in July 2011; created common trade zone based on: • Customs Code of the Customs Union (effective July 2010) as core legal code • No customs clearance and border controls between members • Unified common customs tariffs on imports and exports with non-members • Import duties credited to single account and distributed between budgets of Russia, Kazakhstan, and Belarus in ratio of 87.97%, 7.33%, and 4.7%, respectively • Harmonization of different import licensing regimes ongoing • No customs duties on trade between member states • VAT assessed only at borders of Custom Union • Custom Union Commission represents institutional structure; decides tariff regulations and supervises elimination of tariff controls • Russia holds 57% of total votes in Commission decision, while Kazakhstan and Belarus have 21.5% each • Outgrowth of previous attempts at economic integration among former Soviet states, led largely by Russia: • 1992: Commonwealth of Independent States • 1995: Declarative customs union formed between Russia and Belarus; later joined by Kazakhstan, then Kyrgyzstan and Tajikistan • 2000: Same 5 countries agree to establish Eurasian Economic Community (EEC) • 2007: Russia, Belarus, and Kazakhstan proceed to form real Customs Union • .

Eurasian Customs Union: Small Compared to NAFTA, EU-27 Source: World Bank, Kazakh Statistical Agency Note: GDP measured at current market exchange rates.

Russian Exports to Customs Union Partners CU members not particularly important in Russia’s overall exports, but dominant destination for Russia’s exports within CIS region; two CU members typically account for ~45% of Russia’s exports to CIS countries. Million US$ Percent

Russian Imports from Customs Union Partners A similar picture emerges for Russia’s imports: CU members small in terms of overall imports, but loom large within CIS region, accounting for 45-50% of Russia’s imports from CIS region. Million US$ Percent

Kazakhstan and Belarus Have High Shares of Their Overall CIS Trade with Russia

Russia: Energy Products Generate 69.5% of Russia’s Total Export Earnings; Energy Products also Important in CIS Trade: Account for 36.1% of CIS Exports and 10.7% of Imports from CIS (comprised largely of Kazakh coal and Karachaganak gas and condensate)

Belarus: Energy Products Comprise 12.0% of Overall Exports and 29.4% of Total Imports, But Energy Represents 63% of Imports from CIS(mostly comprised of Russian crude oil and gas)

Kazakhstan: Mineral Products (Including Hydrocarbons) Comprise 77.7% of Total Exports, 13.8% of Total Imports; But Largest Single Category of CIS Exports at 57.9%(comprised largely of Kazakh coal and Karachaganak gas and condensate going to Russia); Mineral Products = 36.1% of Kazakhstan’s Imports from CIS Region

But Most Energy Trade within Customs Union: Essentially Excluded from General Trade Rules • Most trade in energy commodities between CU members, because of its overall importance, largely excluded from general CU trade rules • Trade in energy commodities governed largely by special bilateral trade agreements between members; key examples: • Russia’s exports of crude oil and natural gas to Belarus (set quantities and pricing provisions, no export duties) • Exports of refined products from Belarus (same export duties as in Russia; revenue shared with Russian budget on products derived from Russian crude) • Kazakhstan’s imports of crude oil (quantities set by quotas, re-export limitations) • Kazakhstan’s exports of raw gas from Karachaganak (volumes and trading scheme; included by Commission on list of fields having preferential export duties with special customs code) • Pipeline, rail access (volumes, quotas, conditions) subject to existing bilateral agreements rather than all members’ production considered in same categories as domestic production • But most specific provisions relating to hydrocarbon trade and issues not yet finalized • Customs Union integration calls for eventual harmonization of energy sector policies for effective functioning of common market across broader economies: • Alignment of domestic energy pricing mechanisms and convergence of domestic prices (essentially at Russian levels because of relative market sizes) • Harmonization of export duties outside CU: e.g., Kazakh crude export duties will have to rise from ~$40/ton to Russian rate of ~$400/ton. • Harmonization of railroad and pipeline tariffs

Not Much of a Stretch for Belarus to Harmonize Its Energy Sector with Russia … • Russian Fuels Dominate Belarusian Supply • Indigenous energy production represented only 7.5% of primary energy consumption in 2011 • Gas accounts for 58.3% of primary energy consumption; Russian gas met 99% of domestic supply • Russian crude oil imports (18.1 mt in 2011) provided for 88.3% of Belarusian refinery throughput, allowing 15.6 mt of refined product exports • Refined product exports generated $12.5 billion in revenue in 2011 • $3.07 billion in product export duties transferred to Russian budget in 2011 • Belarus = second-largest market for Russian gas in CIS (after Ukraine); bought 21.6 Bcm of gas in 2011 • Special pricing rules apply because of sale of gas transmission network to Russia • Belarus also Important for Transit of Russian Fuels • Bulk of flow in Belarusian pipelines is Russian fuels under agreed tariffs • 58.4 mt of transit crude flowed on Druzhba Pipeline to Eastern Europe in 2011, generating $337 million • 44.2 Bcm of Russian gas transited Belarus in 2011, including 21% of Gazprom’s exports to Europe (31.3 Bcm) • Gas transit generates $570 million annually

… But More Problematical for Kazakhstan to Shift • Kazakhstan: Indigenous Production Dominates Domestic Supply • Kazakhstan = large energy exporter; imports cover only 13.4% of primary energy consumption • Main energy import: Russian crude oil for Pavlodar refinery • Pavlodar accounted for 34.3% of total Kazakh refinery throughput (4.7 mt ) in 2011 • But Kazakhstan’s crude oil imports much higher that just Pavlodar fill: 7.1 mt in 2011; balance used to also fill Kazakhstan-China pipeline • Total Kazakhstan-China oil pipeline shipments in 2011 = 11.2 mt; “official” Russian shipments only 0.2 mt; but another 2.4 mt of Russian oil apparently “imported” by Kazakh refineries and diverted into pipeline (21% of pipe fill) • Sizable refined product imports from Russia: ~1.5 mt/year (meeting about 14% of domestic consumption); imports compete with domestic supply, especially in north • Some Russian gas imported for north; mainly to supply iron-ore mining area of Kostanay Oblast • 1.6 Bcm in 2011: 39% of Kazakh gas imports but only 15.8% of domestic (end-of-pipe) consumption • Kazakhstan’s Domestic Gas and Power Markets Largely Autonomous from Russia’s • Russian gas imports in north and Uzbek imports in south • But most of domestic gas supply comprised of indigenous production • Average domestic gas price for consumers only about half that in Russia • Bulk of Kazakhstan’s electricity generated from domestic coal • Kazakh-Russian Coal Trade Already “Commercialized”, so Largely Unaffected by Advent of Customs Union: No Special Bilateral Agreements • Kazakhstan ships 27-28 mt of coal annually to Russia (~25% of production) • Mostly steam coal from Ekibastuz for Russian power plants in southern Urals • Average export price = ~$35/ton; about same price as for international markets on quality-adjusted basis

Other Customs Union Energy Impacts Kazakhstan agrees to “compensate” Russia for loss of export tax revenues on crude oil supplies: • June 2012: 1.5 mt of crude to be delivered to Russia in compensation for Kazakhstan’s duty-free deliveries to Pavlodar refinery (estimated to be worth some $780 million per year) • Kazakhstan does not export refined products, so compensation mechanism different than for Belarus • Agreed after discussing several other possible compensation mechanisms: e.g., export duty payment to Russia on other Kazakh oil exports, but still not clear who (KMG?) will provide the oil, and to whom Other energy provisions of Customs Union, including transportation, still being worked out, but we expect to see: • Unified rail tariffs: In 2013, common system of rail tariffs slated to go into effect across customs union; this will include tariffs for freight such as oil and coal • Higher oil and gas pipeline tariffs for Kazakh transit via Russia: preferential tariffs for Kazakh crude transiting Transneft system to be eliminated as tariffs harmonized for all shippers; substantial increase in transit tariffs for Kazakh crude with move to Russian tariff levels • Harmonization of domestic oil and gas prices: As members of customs union harmonize domestic energy prices, prices in Kazakhstan slated to eventually (by 2015?) rise to Russian levels • But Kazakh policy aimed at maintaining much lower price in Kazakhstan than in Russia for “social reasons” and industrial competitiveness • Higher export duties for Kazakh crude … at least in medium term: Kazakhstan’s export duty on crude (currently $40/ton), slated to rise to level of Russia’s export duty (currently $393.8/ton); however, long-term goal is for Russian export taxes to decline, with their ultimate elimination, perhaps by 2020

Transneft Transit Tariffs for Kazakh Crude Oil Stayed Relatively Flat, While Tariffs for Russian Oil Doubled Between 2005 and 2011 Comparison of Transneft Transit Tariffs for Russian and Kazakh Crude Oil • Kazakhstan has enjoyed stable transit tariffs for its crude oil owing to intergovernmental agreements with Russia • In contrast, tariffs for Russian oil almost doubled due to need to cover high capital expenditures for new capacity • With introduction of Customs Union, tariffs to be unified for all shippers • In December 2011, Russian FTS unilaterally announced unification of tariffs • But FTS rescinded decision; Kazakh transit tariffs increased only with inflation adjustment (+8.5%) • Kazakhstan not yet signed “Agreement on Common Oil Markets” tariffs • Under what terms will Kazakhstan ratify this addendum? • Russian transit tariffs include significant ESPO cost recovery component; Kazakhstan will be reluctant to help pay for a pipeline it will not use • Long transition period for harmonization?

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Eurasian Customs Union: Implications for Oil and Gas