By Nicholas Trickett
Igor Sechin must be happy with Rosneft’s overall position on China’s oil market. Thanks to his efforts, Russia has beaten out Saudi Arabia as China’s biggest supplier and will send even more oil eastward over the next few years. As with most of Sechin’s endeavors, Rosneft’s success forging stronger energy ties hasn’t come free for the Kremlin. Russian Railways (RZhD) is now losing out on sorely needed revenues that help prop up the state’s inefficient monopoly on the rail system.
The expansion of pipeline capacity for oil exports to China over the last two years is expected to deny RZhD 24.5 billion rubles – roughly 2% of its annual revenues – for 2018-2019. This is not a new issue for the Ministry of Transport (MinTrans) and RZhD. Both lobbied aggressively to preserve a large role in oil deliveries to China before the Eastern Siberia-Pacific Ocean (ESPO) pipeline was completed between 2003 and 2006. Both were affected by the Yukos affair given that then CEO Mikhail Khodorkovsky’s unsanctioned negotiations with Chinese partners would have cost them billions in revenues that could have helped finance rail development in the Russian Far East. Oleg Belozyorov, current head of RZhD, has inherited the same problem. 25 billion rubles may not sound like much, but every kopek counts.
Captain Kopeikin (of Industry)
Those familiar with Nikolai Gogol’s work Dead Souls may recall the figure of Captain Kopeikin. Captain Kopeikin is a veteran of the Napoleonic wars who’s lost an arm and leg and, after being refused hospitality by his father, trots off to St. Petersburg to collect his pension. Every time he tries, he fails, receiving perhaps some money – his surname is a play in kopeck, the equivalent of a cent – to blow on vodka and cutlets and all that Nevsksy Prospect offers before ultimately dying in ignominy, pensionless. RZhD isn’t much different, artfully wasting much of every large cash infusion it receives and appealing for funding, frequently to no avail.
The parallel goes further. Whereas Dead Souls featured a character looking to buy dead serfs to inflate the appearance of his wealth on paper, RZhD is stumbling around for profits to sustain the mirage of its unrealistic development goals so as to attract investment.
Even small declines in revenues threaten the company’s long-term financial plans. Operating profits before subsidies declined 63.7% from 2012-2016, a drop from 105.99 billion to 38.41 billion rubles. The unaudited figures released for the first half of 2017 show a rebound to 96.68 billion rubles, but the company’s books show persistent adjustments the year after. Here’s a visualization of pre-subsidy profits:
The 2017 figures are not finalized, have only been published on the website from the first half of last year, and have not been audited by the company’s preferred partner, EY. Net profits were reportedly up 260% last year but only reached 17.5 billion rubles. The company’s website shows that aside from a good year in 2010, net income has not broken more than last year’s figure since 2008. That’s quite low and speaks to how narrow the margins are for revenues needed to sustain strategically vital investments into rail infrastructure.
This offers some perspective on the scale of company’s overall capital investments:
Over the same time period, spending directed by state mandates rather than corporate management at RZhD has risen:
Between 2013 and 2016, spending plans led by the company’s management dropped 46% and have only just recovered most of their 2013-levels based on 2018 targets. However, the growth in state-directed spending suggests that more and more projects are backed by state guarantees, not producing profits, and frequently interrupted. In other words, the company is either increasingly inefficient in guiding its own spending, fails to lobby for effective regulatory changes, or else has to offer cargo discounts for one of the Kremlin’s political objectives.
For example, the Trans-Siberian route (Transsib) and Baikal-Amur Mainline (BAM) – a flagship project for the Russia’s trade with China and pivot east – would require over 652 billion rubles of investments as of last October. The looming threat of a further devaluation of the ruble will undoubtedly affect cost estimates. Between 2013 and 2018, the company committed 330.67 billion rubles to Transsib and BAM. No one knows how it can effectively increase its annual investments despite setting higher targets without the state directly providing funds or else guaranteeing loans through the banking system.
The company is adopting a policy through 2025 that will commit literally every ruble of net profits towards investment into projects like Transsib and BAM. Any revenue losses will eat into that, though the company’s paltry net profits and numerous spending priorities make for an ineffective policy. How much of that program is mandated by the state remains unclear so it’s difficult to riddle how much is being spent out of company coffers, covered by federal budgets, or else financed via cheap credit through state banks.
Well oil be damned
The loss of oil revenues speaks to a structural challenge for the rail operator just as its corporate-led capital investments are increasing. The Institute for the Problems of Natural Monopolies (IPEM) closely monitors the rail sector. At a recent conference, they published this graphic detailing the decline of RZhD’s oil and petrochemical exports – a cash cow based on Russia’s tariffs.
*Graphs show the transport of oil (нефть) on the left and petrochemical products (нефтепродукты) on the right in millions of tons. The top two show rail transport figures, the lower two show pipeline figures. Timelines at the bottom show pipelines and petrochemical projects by completion year.
All of the relevant pipeline capacity lies in Eastern Siberia and the Far East. The problem will be compounded in coming years given that Arctic oil fields are much likelier to feed into Arctic oil ports via pipeline than the rail network. Fields in Eastern Siberia would more effectively be linked to pipelines directed towards China and the Pacific Ocean rather than rail deliveries, further complicated by the fact that oil and gas companies will likely retain rights over stretches of the rail system that serve their projects.
Tariff on something else…
The energy market props up RZhD. Oil and petrochemical products provided about 7.47 rubles for every 10 ton-kilometers in 2016 followed by ferrous metals providing 7.28 rubles per 10 ton-kilometers. The next highest category was wood products at 4.99 rubles per 10 ton-kilometers, much less important to the economy. Ferrous metals are used for major pipeline projects, giving RZhD a window to earn off pipeline projects. But once online, they take away revenues. That’s happened in the Far East, hurting one of the company’s most important revenue streams.
The loss of revenues to pipeline exports once pipes are completed also affects the company’s needs for tariff regimes. For example, RZhD offered 25% discounts on exports of fuel oil and diesel fuel exports from refineries in Saratov, Samara, and Ufa. The move threatened 55% of shipping companies’ shipping base from the refineries. RZhD appealed to the Federal Anti-Monopoly Service (FAS) by arguing that pipelines stole their own market share as well. It’s a never-ending cycle.
Tariffs for the rail network were indexed to rise 3.9% for 2018, with a 1.5% surcharge designed to help RZhD raise money for its infrastructure spending. RZhD wanted 1.9% and expects to raise 19 billion rubles via the slightly lower surcharge. But lost revenues for oil and petrochemical products are prompting a new round of talk regarding tariff deregulation from FAS along with the country’s oil pipeline monopoly Transneft. Deregulation dovetails with existing bottlenecks for other resource exports. IPEM estimates that due to limits to coal export capacity in Russia’s Far East and production in Russia’s Kuzbass region, Kazakhstan’s coalers have to sell through Russia’s northern ports, costing RZhD 10 billion rubles a year. That forces those coal loads to travel farther, denies RZhD revenues from more profitable freight over shorter distances, and adds to the many economic distortions created by Russia’s tariff system.
The situation is akin to a dam constantly on the verge of being overwhelmed. Small holes form here and there, only to be plugged by fingers or whatever is lying around. But every intervention ultimately weakens the structural integrity of the system without more support for the things plugging each new hole.
There aren’t any good options. RZhD needs to lower its tariffs to compete for more oil and petrochemical loads given the growth of pipeline capacity in the last six years. Petro-freight helps preserve a necessary financial instrument to raise money for infrastructure investments. But doing so slices into its profit margin. The company has announced a 14-fold increase in net profits for 2017 – 139.7 billion rubles – but higher profits are explained by higher tariffs and, more directly, a roughly 100 billion ruble “reduction” in losses from fixed and intangible assets due to long-term planning and a stable tariff outlook through 2025. In short, there’s little reason to think this year’s good news continues. They likely “earned” 100 billion rubles by writing off canceled contracts for projects they can’t afford and called it a profit increase.
Svelte and Road
While RZhD has been forced to tighten its belt and ostensibly improve its efficiency, some hoped that rising Europe-China freight transit volumes could supply RZhD with extra revenues. It’s likelier that even with the Belt and Road, the company’s pants will fall down given how much fat it has to cut.
In 1Q last year, RZhD increased its freight haulage by 7%, yet revenues weren’t affected. For one, tariffs were indexed to rise 6% for 2017. Sustaining revenue growth for freight the sector is difficult given shaky performance in the economy at large. For January-February, the domestic freight container market grew 5.9% year-on-year, but transit volumes grew 40.8%. However, these cargoes barely register for RZhD’s revenues. Long-term discounts as high as 50% for tariffs on the transport of freight remain in place to keep the country’s remote resource-producing regions afloat. Transit cargoes fall into similar schemes. But China is impacting revenues in other ways.
Coal, fertilizer, and grain exports by rail showed strong growth through the first nine months of last year – 10.6%, 10.4%, and 46.7% respectively. But none of those categories contribute nearly the same revenues as oil, petrochemical products, and materials used for construction in pipeline and energy projects:
*Graph shows tariff rates in kopecks (100 kopecks per ruble) per 10 ton-kilometers. From left: Grain and Ground Products, Coke, Timber Cargoes, Construction Materials, Oil and Petrochemical Products, Metal Ores, Coal, Fertilizer, Ferrous Metals
Coal in particular offers little revenue, but these figures also don’t show the ways in which the railcar fleet reflects the various economic incentives driven by the energy sector, and the subsidies that mitigate Russia’s massive size. Many of these less-profitable loads happen to be headed towards China’s market. The economic gravity of the East is changing the tariff revenue structure for RZhD over time.
Declining profitability has also triggered a potential regulatory sea change for passenger traffic. The Duma has introduced a bill to end RZhD’s monopoly on passenger traffic, aiming to introduce competition to improve the quality of the country’s elektrichkas. These commuter trains are vital for those living on the edges or just outside Russia’s cities.
Between 2011 and 2016, the company earned between 7.4 billion and 17 billion rubles a year on passenger transport. Higher ticket prices would make it more sustainable, but the legacies of central planning and the need to make transport across great distances accessible persistently undercut changes. It’s too early to know what change would look like, but smashing RZhD’s monopoly on passenger transport would open up a host of new rent-seeking opportunities and potential improvements in urban and local transport.
None of these effects should be taken as a direct result of the loss of 25 billion rubles of revenues via oil pipelines. Rather, even a small push on the complex system of tariffs, exemptions, formal and informal arrangements, and creative accounting at RZhD ripple out into the economy. All told, the Kremlin’s Pivot to Asia has not been kind to Russia’s rail sector.