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Russian supply vs production

Extending the deal with Opec is the only barrier to oil-output growth in 2017. But Russian exports should keep rising whatever is decided in Vienna

Despite financial and technological sanctions, lower oil prices and the depletion of mature fields, Russian oil firms lifted output in 2016 by 2.6%, to 11m barrels a day—within touching distance of the Soviet-era high. This year, the only real obstacle to further growth is not found beneath the soil, but above it: an extension of the deal with Opec to restrain supply. Either way, exports will remain strong.

The agreement struck last year involved energy minister Alexander Novak pledging a 300,000-b/d cut from Russia. It prompted some scepticism—not least about the government's ability to enforce this on Russia's producers: private companies produce 40% of the country's oil but no legal methods exist to compel them to hold back output. Given the sheer size of Russia's oil sector and its output, meanwhile, 300,000 b/d is more or less the volume of statistical mistake.

According to International Energy Agency, Russian output fell by 56,000 b/d in March. Government officials have said the 300,000 b/d reduction will be met by the end of April. In March, Russian output was 11.423m b/d, according to the IEA, having cut almost two thirds—174,000 b/d—of the 300,000 b/d reduction it had pledged.

Much of it has been achieved through the kind of natural declines that occur every winter (in 2014, 2015 and 2016, the decline between January and February each year amounted to 10%, 10% and 7%, respectively). State-controlled Rosneft accounted for most of the cuts by end-February, and Lukoil, Gazprom Neft and Surgutneftegaz also chipped in. According to official government data, Russsia's average output in February came in at 11.109m b/d, just slightly lower than in January. Novak's deal all along said the full cuts would only be met by end-April. Delivery on the agreement therefore remains questionable. What can be said, though, is that the deal at least brought a halt to the Russia output growth seen in 2016.

Even if there is another Opec deal, it makes much more sense—in terms of market impact—to look at Russia's export volumes

Now much hinges on whether Russia agrees to an extension of the agreement in late May. Without one—and had there been no agreement in November—Russia can keep adding supply between 2017 and 2019. Three factors explain the upward trajectory: past spending; ruble devaluation; and tax breaks. Investments in greenfields, made before 2014, including those launched within the past couple of years or not yet in production (such as Novoport and the Prirazlomnoe expansion, Yarudeiskoe, Suzun, Messoyakha, Labaganskoe Trebs and Titov, Tagulskoe, Kyumbinskoe, and Urybcheno-Takhomskoe) together with increasing gas condensate production are able to offset declining output in Western Siberian brownfield production. These investments can be already regarded as sunk costs—so whatever the price, they can provide production growth.

Meanwhile, since Russian companies incur most costs (salaries, metals, equipment, domestic services, taxes) in rubles and their exports are priced in US dollars, the ruble's 60% devaluation in 2015-16 translates into higher profits for producers, making brownfield development more attractive. Finally, tax breaks for new fields, adopted in 2013, are sustaining production volumes. Nearly every new field in Eastern Siberia, for example, has enjoyed such tax breaks over the past three years. For the next few years these factors will be able to overweight financial, technological and geological constraints, allowing output to keep rising. Only another Opec deal stands in the way—and there is no clarity yet on whether Russia will agree to one.

But even if there is a deal, it makes much more sense—in terms of market impact—to look at Russia's export volumes. The past two years saw an unprecedented rise in Russian supplies to both Europe and Asia. Even now, despite the production cuts, Russian exports are increasing, rising from 400,000 b/d in January to 420,000 b/d in February, according to the Russian Federal Customs Service.

There is nothing unusual about this. Russian crude export volumes are the product of two factors: production (which is supposed to be more or less flat in 2017—depending on the arrangements with Opec) and domestic consumption, which highly correlates with GDP growth.

The World Bank and Russian economy ministry are both cautiously optimistic about the country's GDP in 2017, expecting the recession to end and growth to come in at 1.5-2%. But that leaves us with a nearly flat forecast for domestic consumption in 2017. Furthermore, continued modernisation of Russia's refineries and the resulting increase in processing efficiency will reduce demand for crude oil. According to the energy ministry, in 2017 primary crude oil processing capacity will fall from 5.6m b/d to 5.4m b/d.

This combination of flat production, modest domestic demand and a decline in primary refining inevitably leads to export growth. In 2017, it is reasonable to expect prolongation of this trend with Russian oil export growing by 3-10%. Given Opec's hopes for the market to rebalance, this steady growth in Russian exports will be annoying. And it will really challenge the ability of the market participants to negotiate further deals.

Tatiana Mitrova is director of the Energy Center at the Skolkovo Business School in Moscow. Ekaterina Grushevenko is an Ex-
pert in the Energy Center at the Skolkovo Business School in Moscow

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