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Russia needs investment as the economy struggles

To build on recent success in its energy sector, the country needs more Western capital and technology. Vladimir Putin is putting that in jeopardy

Six years ago, during a briefing to journalists in the sleepy French resort of Deauville, Gazprom’s boss Alexei Miller had a message for the world’s energy consumers. Oil prices, then above $130 a barrel, would hit $250/b within a year, he said, and the price of the company’s gas in Europe could triple, to almost $1,200 per 1,000 cubic metres (’000 cm). Gazprom, he added, would be the world’s largest company within “seven to 10 years”, with a market value of $1 trillion.  

Less than a year later, oil prices had lost $100/b, sending Russia into recession; Gazprom had shed two-thirds of its market value and was worth less than $100 billion; another gas war between Moscow and Kiev had seen Gazprom cut supplies to Europe; and EU gas demand began a slump that has not yet ended. By 2013, Gazprom had been forced to cut the price of its gas to defend its market share in the continent.  

If late 2008 was a low point for Russian energy, 2014 should have been a time for celebration. The years of brutal consolidation that started with the destruction of Yukos in 2003 and culminated with Rosneft’s purchase of TNK-BP last year are now over. However cynical, it worked. Defying many forecasts, Russian oil production grew during the period and remains above 10 million barrels a day (b/d) – keeping the Russian economy afloat.  

Until recently, Western majors had never been more enthusiastic to invest in the country. Even BP, repeatedly humiliated by sharp business practices in Russia over the past few years, says Russia is a key part of its future. ExxonMobil, Total and Shell are all investing huge sums in the country’s upstream, where the Arctic, East Siberia and Russia’s tight oil plays hold unrivalled potential resources. 

At last, too, China’s market is open to Russian gas. The Shanghai deal signed in May isn’t just about the 60 billion cm a year of gas Gazprom will supply to the country. It is also a fundamental infrastructure project that will underpin new liquefied natural gas (LNG) exports from Russia’s far east. The $400 billion deal hardly looks profitable for Gazprom – but its strategic value for the Kremlin is unquestionable. “Psychologically this deal has also demonstrated that, despite the protracted nature of the negotiations, Gazprom is able to successfully open up new avenues for its gas in an increasingly competitive global market,” wrote James Henderson, of the Oxford Institute for Energy Studies, of the agreement. 

Close to the edge

All this should have been cause for celebration at the World Petroleum Congress in Moscow this month. Instead, Russia’s economy now teeters again on the edge of recession, the ruble has weakened sharply and the wealthiest citizens have pulled their money out of the country – at least $60bn is thought to have fled Russia in the past few months (the European Central Bank says the number could be four times higher). Fitch and Standard & Poors, the ratings agencies, have both downgraded Russia’s debt, which is now barely above junk status.    

Russia’s meddling in Ukraine – the annexation of Crimea, the Kremlin’s on-off support for separatists in the east of the country, the troop movements near the border – and the West’s response are the cause of all this. It could get worse soon, too. As Petroleum Economist went to press, Gazprom and Ukraine had reached a tentative deal to keep gas supplies intact, but the problem could easily flare up again soon: Kiev is broke, and Russia in no mood to keep sending it gas at bargain prices that aren’t always paid. EU politicians, meanwhile, are once again talking of ways to carve Russia out of their energy market.   

The deterioration in relations between Moscow and the West threatens to unravel Russia’s strategy to keep moving its energy industry forward. Sanctions are already making things awkward. At the WPC, Western executives hoping to press the flesh of influential Russian officials must remember which of them is not subject to either US or EU sanctions, which now apply even to Rosneft boss Igor Sechin, a confidant of Putin and the country’s most powerful oilman. Reuters quoted one Western executive who said his firm had checked the legality of dealing with Sechin. “What we cannot do is deal with him as an individual but we can deal with him as president of Rosneft,” the executive said.  

BP owns 19.75% of Rosneft and the UK firm’s American boss Bob Dudley sits on a board with Sechin, who also signed the huge joint venture with ExxonMobil to explore the Kara and Black Seas. Total is building the Yamal LNG project with Novatek, a company part owned by Gennady Timchenko, targeted by US sanctions for his close financial ties to President Vladimir Putin.  

Business as usual

The oil industry is used to getting around these kinds of political problems. All those firms, like many other European ones, say they are pushing ahead with their investments. The majors see their ability to handle political risk as a badge of honour. Total’s chief executive, Christophe de Margerie, said: “My message to Russia is simple – business as usual.” Total has already increased its presence in Russia since the Ukraine crisis: on 23 May it signed a deal with Lukoil to explore tight oil resources in the Bazhenov. Senior executives from Shell, ExxonMobil, Eni, Schlumberger and GDF Suez were at the St Petersburg economic forum to discuss projects with Gazprom last month. BP even used the occasion to deepen its role in Russia, signing a deal with Rosneft to explore unconventional oil deposits in the Volga-Urals region. “We are very pleased to be a part of Russian energy complex,” Dudley told the forum.  

With Western majors refusing to play ball, the West’s strategy of isolating Russia isn’t getting much momentum. Nor is there great substance to EU threats to cut Russia out of its energy sector. 

Gazprom exported 167 billion cm to OECD Europe last year, or a third of its demand. In the short term, the EU has no way to replace this quantity of gas, given the strife in North Africa, upstream problems in Norway and paucity of other import routes. In the medium term, the EU would either have to abandon its climate change goals and burn coal, reverse the phase-out of nuclear power in countries like Germany, or stomach a doubling (or more) of its fuel costs to bring in LNG already destined for Asia’s premium markets. It would be economic suicide – just as China swaps expensive LNG for cheaper Russian gas, Europe would be doing the opposite.  

The longer-term outlook may be different, if Russia continues to antagonise its Western partners. European shale gas, greater pipeline interconnections, energy efficiency, renewables, carbon capture (allowing for more coal) and, yes, more LNG, could all eat away at Gazprom’s market share in the EU, which will still far exceed China as a consumer of Russian energy. Gazprom and Russia cannot afford that.   

There are other threats to Russia’s energy sector. Thanks to its easier oil deposits in West Siberia, Russia has been able to invest much less in the upstream than the global average. Russia accounts for 15% of global oil and gas output, calculates Wood Mackenzie, a consultancy, but only 7% of it capital expenditure. As Petroleum Economist’s survey this month shows, however, another period of flux is under way in Russian energy – and the investment needs are going to grow rapidly. 

As West Siberia’s big oilfields deplete, the Arctic, tight oil and LNG will be the new drivers of Russian energy. Capex in those three areas alone will be more than $100bn by 2025, reckons Wood Mackenzie.  

Recent moves to open Russia’s gas market, including breaking Gazprom’s monopoly on exports, will help by providing an impetus for independent producers to develop the upstream. Tax breaks, including exemptions from the mineral extraction tax and export duty, are already supporting some projects, such as Yamal LNG. Development of the East Siberian gasfields to supply China will also likely be exempt from tax.  

But Russian companies will not be able to launch the next phase of costlier Russian energy on their own. The government’s tight oil target, for example, calls for output of 1 million b/d by 2025 – this will need both the expertise of Western firms already operating in tight oil plays elsewhere, and the services companies and technology to complete long horizontal wells and multi-stage fractures. 

In the US’ Bakken, lateral wells typically stretch three kilometres and may include up to 30 fractures; in Russia’s Bazhenov, the wells run for just a fraction of that distance and may be fractured just a handful of times. Exploiting the Bazhenov, which could hold 75 billion barrels, will need a massive influx of capital and oilfield services. The recent deal between BP and Rosneft, and a handful of similar agreements already in place, are a good start. But not nearly enough. 

Technological desert

Russia’s political adventurism in Ukraine could yet jeopardise these deals – and further restrict the country’s access to the Western capital and expertise it needs if it is to develop such plays. A further round of sanctions from the EU and US, according to reports, could target exactly the kind of technology that would be used in unconventional and Arctic reserves. Timchenko told journalists in St Petersburg last month that Russia could instead import the technology from China. But this is nonsense. China’s companies have even less experience of unconventional oil than Russia’s.    

This leaves Russia in a tight spot. For all the country’s energy successes since the low point of 2008, future production growth – on which Russia’s oil revenue-addicted economy depends – is in the balance. 

Western firms, knowing how great the potential rewards are, have been willing to keep spending money in Russia, despite widespread corruption and the chequered experience of the majors in the past decade. But the political risks are rising. Russia and its friends among the majors are putting on a brave face. But Putin is once again making it much harder for his country to secure the foreign investment Russia needs. 

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