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Tough times set to persist for Russia's oil sector borrowers

Western sanctions are harming the industry causing foreign investments to slump

The operations of Russian oil and gas firms may be in robust enough shape to survive the impact of low oil prices, but Western sanctions in response to the Ukraine crisis have targeted some of the most strategic Russian companies - and they are hurting the sector's ability to raise finance.

The government's prognosis for oil output is resolutely bullish. Alexander Novak, the energy minister, said in March that production would remain stable at around 10.5m barrels a day (b/d) until 2035, and there is no sign of an immediate impact from sanctions: the 10.7m b/d produced in January was the highest level since the collapse of the Soviet Union.

Some factors are on Russia's side. A fall in the value of the rouble - down by more than 40% against the dollar and by more than a quarter against the euro since mid-2014 - has reduced capital expenditure and made equity investments cheaper for foreign firms operating the country. Oil production costs in Russia are among the world's lowest.

A slide in Russian equity prices has also made some oil and gas companies that aren't on the sanctions list look even more attractive from a financial point than they were a few months ago. While some analysts are suggesting Russian equities have fallen sufficiently to offset the economic and political risk, many doubt they are cheap enough to merit big investments if sanctions are broadened in the future.

However, the hydrocarbons sector's ability to draw in enough investment to maintain oil and gas production at the level foreseen by the government looks highly uncertain, while sanctions remain in place. Lack of access to funding because of the sanctions, said Fitch Ratings in March, is now a greater threat to the industry than the low oil price. While many could withstand $55/b oil for several years, the drying up of credit would leave producers struggling to make the investments needed to maintain production.

Indeed, sanctions have 'virtually eliminated' access to Western capital markets for all Russian oil and gas companies, said Fitch. Not only is it almost impossible for banks to structure financing deals with companies on the sanctions list, but even those not subject to an embargo are tricky to deal with. If sanctions are broadened, those firms might suddenly be off limits too.

Unsurprisingly, foreign investment in Russia has slumped. According to the Financial Times' FDI Markets service, the value of new foreign investment projects across the economy fell to $13bn in 2014, compared to $23bn in 2011.  

Domestic banks have been able to provide some support to the oil sector. But increasingly this will be restricted largely to extension of existing debt repayments, rather than large new cash injections for fresh investments.

Oil companies have called on Russia's sovereign wealth funds (SWFs) to help finance projects, but the duration and financial durability of that support remains to be seen. In December, Russian finance minister Anton Siluanov estimated that the country's two SWFs, which held around $170bn between them at that point, would be exhausted in three years unless the government revamped its spending plans across the economy. The country's international reserves, including the two SWFs and those held in the central bank, were worth almost $400bn in December.

China helps fill the gap

Financing from countries not involved in sanctions will help fill the funding void. Chinese firms remain heavy investors in parts of Russia's upstream sector and also supply cash through growing oil and gas purchases. Most of the $27bn or more of funding for the Yamal LNG project in the Russian Arctic is sourced from Chinese firms. In February, deputy prime minister Arkady Dvorkovich said Russia was contemplating allowing Chinese firms to take 50% stakes in some strategic oil- and gasfields. 

Two blockbuster 30-year gas deals agreed last year between Gazprom and Chinese firms, the first of which was estimated to be worth some $400bn overall, will also help, especially for Gazprom. The state-controlled Russian firm is struggling to maintain its dominant position in Europe's gas market in the face of rules designed to stop it keeping a monopoly on export pipelines to the continent. 

Even some of Russia's biggest projects are losing momentum because of the financial impact of sanctions. Drilling by an ExxonMobil-Rosneft venture operating in the Kara Sea - home to some of the world's largest oil and gas reserves, was halted last year. Rosneft sources told Reuters in January that the company would be unable to proceed with drilling there on its own in 2015, as it had been unable to secure a rig.  

Big deals still possible

But, while western financial support has been severely curtailed, it is still available in some circumstances for companies not directly targeted by sanctions. Swiss-based commodities and mining giant Glencore said in March it had agreed to take a 49% stake in oil producer Russneft in a debt-for-equity deal, following a restructuring at the Russian firm, so no cash will change hands. 

The deal is the realisation of a refinancing arrangement agreed in 2013, under which Glencore agreed to convert at least $900m of debt owed to it by the Russian producer into Russneft shares. Russneft says its output totals around 360,000 b/d.  

Not all big foreign firms think the sanctions will devastate the Russian oil sector in the long term. Schlumberger, for example, announced in January that it was paying $1.7bn for a 46.5% stake in London-listed Eurasia Drilling, Russia's largest drilling firm. If the deal pays off, the French-US services company will be able to claim it has made a canny investment, given Eurasia's shares lost almost two-thirds of their value in the seven months before the announcement.  

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