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What will Russia do?

The country's big producers have met most of the terms of the deal with Opec. But patience with the cuts is wearing thin

Russia's participation in the supply deal with Opec last year was essential to getting it across the line—without Moscow's agreement and, in the months after, Russian firms' unexpected adherence to the cuts, it didn't stand a chance.

After eight months of cuts, oil prices are back beneath their level on the eve of the pact last November. Russia's producers, itching to get back to growth, may be getting cold feet about an agreement that is undermining their investment case, while plainly not yet yielding the boost from higher prices.

The agreement, which was extended in May for another nine months, is curbing the operational performance of the Russian oil industry. Rosneft, which accounts for about 40% of Russia's crude output, has a large pipeline of greenfield projects at the final stages of completion and the Opec extension is delaying their launch.

Russia is not just cutting 300,000 barrels a day (b/d), as decided under the terms of the agreement with Opec. Before November last year, the country was consistently breaking post-Soviet production records. So the deal also means it is forgoing organic growth.

Igor Sechin, Rosneft's boss and a key ally of President Vladimir Putin, is far from an admirer of Opec and had to be coerced into cooperating with the deal. Just days after the cartel announced the extension, Sechin told investors that the agreement wouldn't stabilise the crude market over the long-term.

Speaking at the St Petersburg Economic Forum on 2 June, Sechin said the deal, at best, had given the market "a breather," but was not a true solution for the market because US shale is filling the supply shortfall.

Sechin's prophecy seems to have been borne out even more quickly than he anticipated with prices falling sharply in the past month, while the US rig count (and output) has steadily risen.

Other executives at Lukoil and Tatneft say they remain committed to maintaining cuts, but their reservations are getting louder too.

Russia's been on the brunt end of US shale before. Gazprom, it's gas monopoly, spent the first few years of this century dismissing the threat of American shale gas and predicting sharply higher natural gas prices. By 2010, the US had overtaken Russia as the world's biggest gas producer and Gazprom has shelved a host of costly development plans, while watching American supplies start to land in its main market, Europe.

Sliding output

The latest oil-production data in May show Russian crude output had fallen in that month by 2.3%, or 256,000 b/d, compared with the pre-deal level in October—still less than its 300,000-b/d commitment under the deal, but more than many sceptical analysts predicted. State-controlled Gazprom Neft has contributed most, proportionately, as its seven-month average daily production has declined 2.5% since October, despite production at the Prirazlomnoye and Novoportovskoye Artcic oil fields ramping up.

Still, analysts at VTB Capital calculate that the cut in oil production has been distributed equally among oil majors, as their declines in output range from 2.7% for Lukoil to 3% for Rosneft. The only outlier is Rosneft-controlled Bashneft, which has reduced production by just 0.8% since October.

Most of the reduction in Rosneft's output is believed to have come from a decline at the company's greenfields, such as Vankorskoe, Verhknechonskoe and Suzunskoe oilfields. Lukoil, Russia's second-biggest producer, decreased its crude production at a number of its brownfields in Western Siberia.

Russia creamed about $250bn a year from oil exports in the boom years, but that sank to about $60bn in 2016. Revenue will be further depressed by the prolonged Opec deal.

Oil prices were surprisingly high in the first quarter and imports low, leading to a current account surplus of $23bn. But imports are expected to rise later this year and that surplus could wither to next to nothing.

Commentary by Russia's Central Bank (CBR) in mid-June highlighted Opec's failure to arrest the decline in oil prices as a key risk factor for the economy over the medium-term. Oil revenues make up about 40% of Russia's budget revenues, while six of the 10 biggest Russian stocks by market capitalisation are energy companies.

Elvira Nabiullina, who heads the CBR, may now have to wind down her cycle of gradual monetary easing. The bank had previously increased its base oil-price scenario from $40 a barrel after the Opec extension, but that policy may now require a rethink.

Russian oil producers now trade at an average price-to-estimated earnings ratio, or P/E, of 5, near the lower end of the historical valuation range.

Investors have started to vote with their feet. Russia-focused equity funds are cutting their exposure to the big oil names, while the benchmark Micex Index was down about 4.5% in June.

The combination of falling commodity prices, allied to the renewal of EU sanctions against Russia and the introduction of additional US sanctions, has once again consigned the local equity market to the doghouse. Hopes that Donald Trump's US Presidency would help rekindle relations with Moscow have all but evaporated.

Rather than horse-trading with Opec, the Kremlin would have better served trying to work with Ukraine to adhere to the Minsk peace accord—a minimum requirement before Western sanctions can be relaxed.

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