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The Russian surge

Rising oil production in the past two years defied expectations. The market should expect more of the same in 2017

Russian oil output has shocked the market over the past two years. Many analysts expected depletion at Soviet-era fields in Western Siberia - home to more than 60% of the country's production - to lead total supply lower. Weak oil prices, an economic crisis and sanctions would also conspire to crimp production.

Wrong. In 2015, Russia's producers pumped 10.7m barrels a day, a 1.4% rise on the year. In 2016, the growth accelerated and will come in at 2%, leaving output above 11m b/d, a post-Soviet record.

The outlook for 2017 is similarly rosy. Production will stay slightly above 11m b/d. Three reasons explain why. First, upstream investments made when oil prices were higher, especially in so-called "next-generation" fields, will yield fruit. This includes some fields launched in the past couple of years and some not yet producing. Look to Novoport and the Prirazlomnoe expansion (Gazprom Neft), for example, or Yarudeiskoe (Novatek), Suzun, Messoyakha, Labaganskoe (Rosneft), Trebs and Titov (Bashneft and Lukoil), and others. All of them will sustain high Russian output next year. The next-generation greenfields are especially important - together with more gas-condensate production, they will offset any declines at older, brownfields.

Meanwhile, although decline rates at legacy fields have sped up in the past four years, those in Western Siberia remain profitable even at $20 a barrel. Indeed, their total production cash costs (lifting costs and capex for drilling and infrastructure) average $7/b. As for the new fields, 80-90% of the investment they need has already been made, so the costs are almost all sunk.

And none of the developers are going to cut production from these young developments - doing so at such an early stage of their operation could result in massive flooding and loss of the future capacity. So even if the Kremlin hits up these producers for higher taxes, or oil prices remain low, these fields will keep plugging away, bolstering Russian output in 2017.

A second reason is that the ruble's weakness has helped out producers. Russian firms pay their costs in rubles but earn export revenue in dollars. So the Russian currency's 60% devaluation since 2014 has, in ruble terms, raised profits for Russian oil producers. Salaries, prices of metals, Russian equipment, domestic services and, of course, taxes - all these inputs have shrunk in dollar terms. In fact, the devaluation fully offset the oil-price drop, sheltering Russian firms and keeping them competitive. If oil prices retreated again in 2017, the same thing would happen.

A third factor keeping output so resilient was the tax code. Exemptions for new fields - mainly introduced in 2013 - have benefited many producers. Nearly every new field in Eastern Siberia, for example, has taken advantage. Their breakeven price is set at the level of operating expenditure plus capital expenditure (without tax payments, which are often twice the amount of direct production costs). This means that even if, as expected, the government increases the mineral-extraction tax and raises excise duties in 2017, these fields will remain profitable. They'll keep pumping oil, adding to the total.

American and European sanctions on Russia aren't much going to affect production, at least in 2017 - so long as further deterioration in relations doesn't bring a tightening or expansion of the measures. If that happened, it would further limit capital available for Russian firms and could, in some cases, delay development. (This happened already with the Yuzhno-Kirinskoe field in Sakhalin.) Even so, it won't lead to an overall production decline in 2017 - output growth is reacting to different forces.

Russian oil exports will remain strong in 2017 too - partly because the economy remains weak. This might sound odd, but the rationale works in the following way. Demand for oil products within the country is a function of macroeconomic growth: the correlation between GDP and motor fuel consumption in Russia is 97%. In 2017, Russia's economy is expected to emerge from recession, but expand by just 0.6-1%. If so, domestic oil-consumption growth will be pretty much flat next year.

This combination of persistently high production and modest domestic demand growth means exports will rise. That's what happened in the past two years, when shipments to Europe and Asia rose at a record pace. It's reasonable to think this will continue in 2017: oil exports should rise by 4-10%.

That's directly relevant to Moscow's discussions with Opec - especially if Russia observed a freeze on output, but was still actually shipping more crude. In any event, freezing output at 11m b/d wouldn't be a hardship for Russia, or difficult. And, in fact, this freeze will come automatically in a year or two anyway. In the short term, if Moscow truly wished to freeze immediately it would be a matter only of kindly asking several companies not to launch current projects too quickly. Actual cuts in output are another matter. As 40% of Russia's production is in the hands of private companies this would be tricky. Russia's legal system doesn't allow for such a mandate either.

Another theme of Russian oil in 2017 will be its shifting corporate landscape. In October, state-controlled Rosneft sealed a $5.35bn deal to buy the state's controlling 50% stake in Bashneft, Russia's sixth-largest producer. As a result, more than 60% of the country's output is now controlled by the state. The next much-discussed deal will be the long-awaited sale of part of Rosneft itself. The government wants a strategic investor to buy a 19.5% stake, and hopes to raise at least $11bn. Indian and Chinese companies are the likeliest buyers. But no one should be mistaken: the sale is driven only by the needs of the rapidly emptying state budget - not by some urge to reward private investment and competition. Even if it sells the stake, the government will still keep its control of Rosneft through a 50%-plus-one-share stake. A change of company leadership or strategy is not under discussion.

But some other foreign investment in Russian energy can be expected in 2017. In 2016, this was limited mainly to ONGC's purchase in May of a 15% stake in Vankor, Rosneft's second-largest producing field, accounting for 4% of Russia's total. The Indian firm followed up in September with an agreement to buy another 11%. As Moscow tries to reset its relationship with Tokyo, similar deals with Japanese companies are probable in 2017.

This article is part of Outlook 2017, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here

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