Economic development of the Russian Federation during the past 15 years has been spectacular following an overhaul of its entire socio-economic and political fabric. From a declining centralized economy built upon a sclerosis-struck political system to a fast-developing, emerging industrial country, with a fledging democracy, many older Russians struggle to comprehend the changes. Despite stalling after the 1998 financial crisis, Russia's gross domestic product (GDP) has grown for six consecutive years, surpassing average growth in all other G8 countries and achieving an impressive 7.1% in 2004. Although encouraging, this growth cannot mask that there is still a great deal of room for improvement in Russia's institutions, its economic diversification and the lot of its 145 million inhabitants. GDP is $2,140 per person; a large number of Russians live in poverty. Most of the country's economic development base and mooring lines to the market economy were provided by both Russia's large heavy industrial tool and by the Russian Federation's immense subterranean wealth. From steel to aluminum and heavy machineries to aeronautics, Russia has a long history of industrial excellence, featuring extra-large production capacities and a recognized technological and scientific know how. But the real catalyst of the country's fast recovery from the abysses of the early 1990s has been its natural resources, from precious metals to diamonds, coal, industrial minerals and, above all, hydrocarbons. Exploited since the early 1920s, Russia's oil and gas sector-a pure product of the Soviet economic drive-has long been one of the world's leaders in terms of production. In the 1980s, the Soviet Union was the world's largest producer, thanks to the combined outputs of powerhouses like Azerbaijan, Western Siberia and the Ural region. With the demise of the Soviet Union, the sector fell into disarray, facing depressed world prices, aging fields and production tools, and murky privatization processes driven by prevarication and violent dealings. It took some years for the Russian sector to emerge from the shadows and regain its place on the global stage. After ownership structures were streamlined, assets gathered under unified control, management control firmly established and the violence subsided, the sector began its in-depth reform, applying progressively more modern management techniques, accelerating the use of yield-increasing technologies and pushing production upwards. Production was some 6 million barrels per day in 1996-97, down from a Soviet peak of 12 million in the early 1980s, and 1.6 billion cubic meters (Bcm) of gas in 1995. The figures have soared to 9.45 million barrels of oil and 1.73 Bcm of gas per day today. Oil production seems to have reached a plateau, triggering comments on the complacency of the Russian energy sector, which has been pampered by high oil prices during the past three years. Nevertheless, the Russian Federation is sitting on the world's largest gas reserves (1,680 trillion cubic feet or one-third of the global total) and oil reserves total 51 billion barrels. Moreover, the Russian Federation holds yet more undiscovered potential-in East Siberia, offshore Pacific (with the Sakhalin Archipelago as a point in case) and along its continental shelf, in its Arctic regions. These are besides the relatively well-mapped reserves of Western Siberia that make the bulk of Russia's output today, plus the reserves in the older provinces of the Urals, Tatarstan and Bashkortostan, which are now in decline. Future discoveries should accelerate development of the industry, which already accounts for more than 20% of the federation's GDP and, some years, provides more than 40% of federal revenue. Entry opportunities Today's picture might appear challenging to potential entrants. For the majors, the infamous Yukos affair is still felt outside of Russia in perception of investment risk and business protection. The many changes in the tax regime, subsoil laws, conditions of access to export infrastructure, and the general erratic legal climate of the country can still be perceived as detrimental to investment. Nevertheless, the world's majors are jockeying for positions and assets, and rumors of deals are reaching climactic levels. For independents, the situation is also far from straightforward, as predatory Russian majors remain threatening, access to capital is still far from easy, and operating conditions remain challenging, from harsh winters to export-pipeline access and an unforgiving tax structure. For the service industry, the situation is also peculiar-most of its components are either part of oil majors, providing services to their mother companies, or former parts that are trying to reinvent themselves and their markets. This leaves some room for Western service operators, which have been reasonably successful. The sector is now initiating a very active concentration and restructuring movement that should re-shape durably. This in turns opens many opportunities for partnerships and acquisitions, and the Russian service sector should look radically different in a couple of years. Ultimately, the transitional Russian energy industry is illustrated by changes under way now and instigated by the Russian state itself. The legal regime should witness a major upheaval when a new subsoil law comes into effect at year-end, further to its amendment by the federation's Duma (lower chamber). The industry is waiting for a number of key dispositions that should streamline and simplify E&P, but very wary of forthcoming restrictions of access to "strategic reserves" for foreign investors, a limitation that is being monitored with apprehension by the global hydrocarbon industry. A possible revival of the production-sharing agreement law could boost levels of greenfield development, after the previous law was scrapped notably on Yukos' former boss, Mikhail Khodorkovsky's, injunction. Meanwhile, Russia is busy trying to create a national oil company to protect its sovereign interests. A stalled merger between state-owned oil company Rosneft and state-controlled gas giant Gazprom paved the way for the Russian government to increase its direct participation in Gazprom, now controlled 51% by the state, while Rosneft, after having acquired on the cheap Yukos' main production unit, Yuganskneftegas, has since been rumored to be in merger talks with Shell and fifth-largest Russian oil company Sibneft. Since then, Gazprom and Shell have entered agreements to swap assets and there are obvious indications that the public-owned oil and gas companies in Russia are there to stay, and will play very central roles in the future development of the industry. The movement towards reasserting state control signaled by the onslaught against Yukos and its subsequent dismantling is highlighted by the efforts exerted in developing state-owned operators. It is further confirmed by the groundbreaking projects nurtured by state-controlled pipeline transportation monopoly Transneft. A 4,130-kilometer (2,566-mile) pipeline to the Pacific will transport some of Russia's oil wealth to Asia and should provide a major boost to the development of East Siberia. Meanwhile, gas pipelines to the Northern Europe pipeline and to, again, China and Asia should increase Russia's role as the world's largest gas supplier. Turning point At times of skyrocketing oil and gas prices, an inextinguishable global thirst for energy, and uncertainties over Middle Eastern energy supply, Russia is poised to play an ever-increasing role on the global energy stage. This calls for a vigilant state presence, and for controlled development. Should Russia go the right way, treading carefully between national interests and global responsibilities, the country will surely be the hot spot for the next two decades. The risks of backtracking to an erratic, unsafe and unwelcoming environment are slimming, despite frequent hiccups involving nationalism and protectionism. The stage is set for a responsible, rewarding and secured development of to-be-discovered reserves, and a responsible development of known resources. Russia, as so often throughout its history, is at a turning point. The country's oil and gas sector is reaching a critical time in its life cycle, and seems to be heading towards a conventional model, opened to foreign investment, yet encompassing large state-controlled organizations. The dust has settled over the challenging years following the demise of the Soviet Union. The global industry is carefully looking at what is emerging in this Eastern giant. Global Business Reports met with Russian industry leaders to prepare this report. It is intended to present the challenges at stake.