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Russian output growth to hit a wall in 2016

Production defied expectations last year. But weak prices, sanctions and higher taxes will start to hinder the country’s oil sector in the coming months

Russian oil output again hit another post-Soviet high in December – more evidence that the Kremlin’s policy on production seemingly knows no reverse gear. But as low prices, sanctions and a potential windfall tax squeeze cash flows, a change is coming. Russian production will hit a wall this year.

The country’s crude and gas condensate output increased to 10.825m barrels a day in December, outpacing the previous record set in November, by 0.4%. Annual output for 2015 climbed 1.4% to 10.726m b/d compared with 2014, according to the Energy Ministry.

Russian crude producers have been setting post-Soviet records even amid plunging prices and US and EU sanctions that curb access to international credit markets and technology. Companies have managed to coax more oil out of ageing fields in West Siberia and even brought a few mid-sized new projects on stream.

“Despite sanctions, a low oil price and ruble in the dumpster, Mother Russia is still pumping out the oil – more than ever,” says Kim Iskyan, founder of Truewealth consultancy. “If you don't have a lot to be proud of, well, that’s something.”

National pride may have partly led Russia to ignore Opec’s calls for it to support prices by pumping less. The lack of consensus at the Opec meeting in Vienna in December, when the cartel failed to reach an agreement on limiting production and abandoned its output target, helped send oil into freefall.

Russia’s oil output is expected to dip this year although nobody believes it will fall off a cliff seeing as the plunge in prices has in one way actually helped producers. As the ruble’s value has plummeted in line with the oil price, this has slashed producers’ costs in dollar terms, as 80% of their spending is in rubles.

“There will be no output collapse as, perhaps, Opec had hoped for,’’ says Chris Weafer, co-founder of Moscow-based consultancy Macro Advisory. “As Churchill one said ‘you don't defeat people who enjoy eating ice-cream in winter.’ Time and again foreigners misinterpret Russian wastefulness during good times as a sign of ineptitude and are constantly surprised with how resourceful and resilient the country and its people are when faced with no other choice.”

Russian oil producers didn’t pay too much attention to best practices and efficiencies during the boom oil price years. By the end of 2013, many were less efficient in terms of output than their global peers.

But over the past year, there has been a greater focus on "fixing leaking valves" and tightening up management of existing oilfields. That has yielded a lot of extra oil, just as it did in 2000-01 when Vladimir Putin first came to power as oil traded at $25 a barrel. Putin supposedly told oil executives to “stop playing corporate politics and fix the damn pipes” after output had sunk to a low of 6.25m b/d.

Russian oil firms had a lot of spare parts and equipment in storage so have not suffered because of the slow delivery or suspended deliveries of equipment from the West. The sanctions are also sufficiently vague in the oil sector that it is relatively easy to work around them, especially as western equipment suppliers have been keen to engineer such work-arounds for fear of losing out to Asian or local competitors post-sanctions.

Protecting margins

A big problem for Russian oil companies has been the squeeze on cash flows, insofar as they have had to repay foreign debt and can’t replace it. That has cut the available financial resources for brownfield capital expenditure and new project developments. Rosneft, Russia’s largest oil producer, partially got around that by selling equity in some projects to China and Indian buyers. India’s ONGC bought 10% of Rosneft’s Vankor project in December for $1.2bn while Novatek, Russia’s second-largest gas producer, sold 9.9% of its Yamal liquefied natural gas project to Chinese investors in September.

So, a little bit of plugging the holes, prioritising resources and selling assets allowed the companies to raise oil output in 2015.

This year, things will be a bit different. Difficulty in accessing new debt and credits at competitive rates will be a recurring issue in 2016. Lukoil raised new debt in late 2015 as the Eurobond market reopened for Russian issuers, but at usurious rates. “It will be the tightening cash flow position plus the fact that efficiency improvements are now all done which will start to slightly squeeze output this year,” says Weafer.

Macro Advisory estimates that output may slip by about 200,000 to 300,000 b/d from present levels in what it calls a “worst-case” scenario.

The biggest threat to the sector is from extra taxation. If the oil price remains low, the Ministry of Finance will again try to hit oil producers with a windfall tax. That move this time will most likely get Putin's support – windfall taxes, which will slow production, are regarded as the lesser of the two evils. The less palatable option would be an expanding budget deficit or cuts to social programmes in an election year. The oil sector is politically powerful, but as Rosneft's failure to get any money from Russia’s sovereign-wealth fund showed last year, its place in the pecking order is well below that of the voters.

The big question is how companies will respond to the possibility of tax hikes if the oil price remains low. “Some may opt not to drill marginally profitable wells and then the brownfield decline will be even higher, potentially threatening overall production growth,” says Alex Fak, head of oil and gas research at Sberbank CIB.

If oil remains within the range of $30-35/b and the ruble doesn’t weaken below R80 a dollar, analysts at UralSib Financial Corporation expect “a major revision in capex plans” and a possible decline in production rates by the third quarter. The ruble was trading at about R78.50 to the dollar in mid-January.

“We do not rule out a decline in exports in favour of higher refining throughput as the impact of the tax manoeuvre on export netbacks has been wiped out by the weak oil price,” says Alexei Kokin, senior energy analyst at UralSib. “The important question is whether the government will put a hold on all efforts to switch to profit-based taxation in the sector in the low-price environment.”

Unease ahead

Hubris from the industry about maintaining production levels is abating in the face of growing opposition. Energy minister Alexander Novak said recently that Russian oil companies plan to further hike oil production in 2016 but admitted that output may decline if the government has to hike the industry’s tax burden to narrow the growing budget gap.

Transneft, Russia’s oil-pipeline monopoly, expects to transport 1% less crude in 2016 and has forecast a 6.4% decline in export shipments, based on applications submitted so far by Lukoil, Rosneft, Gazprom and other producers. This amounts to a cut of 460,000 b/d, enough to eliminate a third of the excess supply flooding the global market.

Maxim Oreshkin, Russia’s deputy finance minister, has said falling oil prices may force the government to shutter some of its production. “The current oil prices may lead to quite hard and fast closures of certain oil producers in the coming months,’’ Oreshkin said in comments cited by Tass on 13 January.

Low prices are already causing difficulties for some producers. At $40/b, production at half of Russneft’s fields could be halted according to Mikhail Gutseriev, chairman of the privately-owned oil producer. “Heavy oil, low horizons, mature horizons are all unprofitable at a price of $40-45,” Gutseriev told state television in December. “We are waiting for better times.”

While output at the country’s largest fields, in West Siberia, started tapering off last year, smaller new projects have so far offset them. Novatek’s Yarudeiskoe oilfield, launched in December, has already reached its plateau level of more than 70,000 b/d with 32 wells drilled. The field is expected to be eligible for a zero mineral extraction tax rate thanks to its Arctic location. “This is Novatek's first venture devoted exclusively to crude oil,” says Sberbank CIB’s Fak. “We cannot recall such a fast ramp-up – in just one month – to peak output in any other oil development.” Yarudeiskoe is expected to be the biggest single contributor to Russian production growth this year and could account for half of the net gain in liquids output in the country, he says.

Of the majors, Rosneft saw its oil output decline by 0.9% last year to 189.2m tonnes (about 3.8m b/d), with its main extraction asset, Yuganskneftegaz reducing output by 3.3%. The biggest decline in brownfield output continues to come from the former TNK-BP fields now owned by Rosneft, especially Orenburgneft. In 2015 as a whole, TNK-BP's legacy fields accounted for half of the 132,000 b/d Russian brownfield decline.

Lukoil, Russia’s second largest producer, recorded a decline in output of 1.1% to 85.7m tonnes (1.72m b/d) in 2015, with older oilfields in West Siberia also posting 4.4% output contraction to 41m tonnes (0.82m b/d). Like many other Russian oil executives, Lukoil chief executive Vagit Alekperov has typically blamed the country’s extreme cold for their inability to shut down production. Once closed, some older fields in Russia’s north would be difficult to restart. 

Political expediency will overrule mother nature when the Kremlin realises it has to reduce energy production to help rally prices in the midst of an economic quagmire. The oil sector is crucial to the country’s economic wellbeing, accounting for about 40% of revenues.

Government departments have already been ordered to submit proposals for 10% cuts in non-essential spending, totalling more than R500bn ($6.4bn). The budget for 2016, adopted late last year, assumes a $50/b oil price and a deficit of 3% of GDP. The finance ministry says that $40/b oil would inflate the deficit to around 5% and exhaust Russia's $59bn reserve fund by the end of this year.

“The budget was creaking at $40/b and straining at $30/b,” says Oleg Kouzmin, chief economist at Moscow’s Renaissance Capital. “This is the trigger to rebalance the oil market.”

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