Why Russia’s oil exports aren’t about to fall
Under almost any economic scenario, the country’s supply to the global market will keep rising
THE RESILIENCE of Russian oil output and the growth of its exports over recent years surprised a market that, mindful of the country’s painful economic transition, has been much more pessimistic. The economic downturn that struck in 2012 worsened in 2014 after the dual external shocks of falling oil prices and sanctions that undermined investment and the technological capabilities of Russian oil companies.
But more surprises are in store. Past investments in greenfields, the ruble’s weakness, a targeted taxation system and depressed domestic demand for liquids – itself an outcome of economic fragility – will ensure record high production and exports, at least for 2016-17. Later on, the decline will become inevitable. In the next few years – likely to be painful ones for an oversupplied global oil market – Russia will not reduce its exports. And there’s an unexpected twist under way. The weaker the oil prices, the weaker Russia’s economy; and the weaker Russia’s economy, the lower its domestic oil demand; the lower its domestic oil demand; the more oil will be available for the global market.
It’s not hard to see why so many analysts have expected Russian oil output to decline. One of the country’s main challenges are the high decline rates in older, Soviet-drilled fields in Western Siberia, responsible for more than 60% of Russian crude output. But the data haven’t lived up to expectations. Despite low prices, economic crises and sanctions, last year producers lifted output by 1.4% – growth that will continue this year too.
Several factors explain this startling rise. The biggest contribution to production came from gas condensates (primarily from Novatek) and from new greenfields, such as Talakanskoe, Verkhnechonskoe, Vankor and Uvat. Major investments were made in those projects when oil prices were high, before 2014. Now the fields are reaching their plateau, and the price is irrelevant – they won’t be stopped at any price.
Another factor is the fall in production costs, largely due to the ruble’s devaluation. Russian companies pay for their costs in rubles, but earn export income in dollars. So profits rose as the ruble fell. Salary costs, for example, nearly halved in dollar-equivalent terms – a significant factor, given that Russian managers are among the highest paid in the world. The same applied to the prices of metals, Russian equipment, domestic services and, of course, taxes. In fact, the ruble effect fully offset the oil-price collapse, and let the country keep its costs.
Russian oil taxes helped too. They go down when the crude price falls. So it was mainly the Russian federal budget that took the heat of the price collapse. The progressive nature of the export duty means that the state is the main beneficiary of high oil prices, but loses revenue at lower oil prices – while producers retain the same earnings.
Tax concessions also sustained production – especially those introduced in 2013 to help new fields in Eastern Siberia. The break-even cost for new fields is calculated by a specific formula accounting for both operating and capital expenditure costs, which even before tax can often be twice the amount of direct production costs. This makes new fields viable at $40 a barrel. That’s even more so for the projects that have already been launched; and which will be responsible for the bulk of production increases until 2020.
This year, gas condensate from greenfield projects will be a main source of output growth, driven by Novatek as well as Gazprom’s Achimov development, a highly productive geological layer. The momentum from earlier investment will also carry on, meaning Russian output will continue to rise in 2016 – even if the government increases taxes or oil prices remain low.
The contribution from four big new projects, so-called “old greenfields” launched in 2008-09 (Vankor, Verkhnechonskoe, Uvat, and Talakanskoe) will more likely stay flat through 2016. Yet already a large number of next-generation fields, including those launched in the past couple of years or not yet in production. These include Novoport and the Prirazlomnoe expansion (Gazprom Neft), Yarudeiskoe (Novatek), Suzun, Messoyakha, Labaganskoe (all Rosneft), Trebs (Bashneft) and Titov (Lukoil), and others – and it is these fields that will sustain output levels through to 2017. In fact, these fields have already added twice as much to output growth in 2015 as the big four did. Sberbank CIB calculates that these newer fields will take over as growth leaders and, together with increasing gas condensate production, will offset any declines from brownfields. For their part, the brownfields are hanging on. Their decline rates have accelerated in the past four years, but the brownfields in West Siberia are still profitable at $20/b. Their production cash costs (lifting costs and capex for drilling and infrastructure) average just $7/b.
But that’s all in the short term. Beyond 2018-20 steep production decreases are inevitable. Fast decline rates in mature fields will come into play, as will delays in the commissioning of new projects – an outcome of current capex cuts and sanctions. In this time frame, Russian oil output will be mainly influenced by the tax regime and the availability of financing – and both of these depend on oil prices and sanctions.
Three scenarios are possible. The first is positive – fiscal conditions would not deteriorate, greenfields would get more tax breaks, oil prices would recover to their 2012-14 level, sanctions would be lifted and Russian GDP would return to growth of 3-4% a year.
The second, baseline scenario, assumes a stable fiscal regime, a price recovery to $50-60/b, sanctions kept in place, and GDP growth of 1-2% a year. The third, critical, scenario would see Brent soft at $30-35/b, more taxes imposed by the state to cover the budget deficit, new technological and financial sanctions, and negative or nearly zero GDP growth.
Under favourable conditions, production would at worst remain stable and probably even increase after 2017 to 0.56bn-0.57bn tonnes a year (about 11.25m-11.4m b/d). If oil prices and taxation are less advantageous, 2017 would see the start of the decline, because big Russian oil firms are already cutting investment programmes. According to the energy ministry, they have already postponed the development of new oilfields with combined production capacity of 26m t/y (equivalent to about 5% of current output). With recessionary pressures growing, the likelihood of further tax increases is greater. Also, inflation is likely to offset some of the downward pressure on lifting costs, and companies’ export netbacks will be affected by higher transportation charges and additional taxation. All this would see output decline. Over time, sanctions will exacerbate problems associated with declining production from cheap-to-produce Soviet-legacy resources and depleting financial resources. Lingering sanctions would also make development of Russia’s offshore and unconventional resources difficult, and affect enhanced oil recovery. In the critical conditions of low oil prices, macroeconomic challenges and additional taxes, production would start falling as early as the second half of this year, and then accelerate.
In short, Russian oil production can be expected to fall, but the speed of the decline is uncertain. It could be -0.2% a year, on average, in the favourable scenario (a cumulative fall of 1.7% over 10 years), or 1.3% a year in the critical scenario, yielding a 12% drop in Russian oil output by 2025.
But the impact for the global market is not obvious, because even if output declines, more Russian oil may reach international buyers. The country’s domestic oil demand is a function of its macroeconomic growth: as statistical analyses show, the correlation between GDP and motor-fuel consumption in Russia is 97%. For example, in 2015, Russia’s GDP contracted by 3.9%; and so did its demand for oil products. Demand for gasoline and diesel, which grew faster than GDP before the crisis, has almost ceased to grow in recent years. In 2015, it contracted by 1.3%.
Recent months have been instructive too. As the oil price has increased this year, Russia’s GDP has seen some minor recovery and oil demand has risen too. The baseline scenario would see Russia’s economy keep shrinking this year, but only by 1.6%, and then grow by 0.7% in 2017. That would result in growth of 1.5% in oil demand in 2016. (This factors in the renewal of an old-car scrappage programme and subsidised car-loan and leasing programmes established last year, which have eased the downturn in car sales.) In the longer term, efficiency gains across the Russian road-vehicle fleet curb both prospective gasoline and diesel demand. That trend might also be aggravated by some other structural changes in motor-fuel consumption. For example, if the government’s programme to promote natural gas vehicles is successful, natural gas might replace 4m-5m t/y domestic motor fuel demand.
All of this has important implications for Russia’s crude-oil export potential, and the global market.
During the past decade, growing domestic consumption and stagnant production cost Russia about 15% of its crude exports. But 2015 saw an unprecedented reversal, as production growth combined with a fall in domestic demand. Exports to both Europe and Asia leapt higher.
All of this means that, whichever way you dice it, Russia’s export potential is much more stable and certain than production. Domestic demand, in essence, now plays the role of an automatic stabiliser. In the mid-term, a slight increase in oil exports can be expected – in all scenarios – simply on the back of stagnating domestic consumption.
The great irony of this is that ideas about freezing output would actually have the opposite impact that they intend. It would freeze Russian production at an historical high – while thanks to stagnating domestic demand its exports would increase. For all kinds of unexpected reasons, therefore, Russia’s oil will remain hugely significant for the global market.
Tatiana Mitrova is a member of the Centre on Global Energy Policy, Columbia University, Energy Research Institute, Russian Academy of Sciences
This article is part of an in-depth series on Russia. Next article: Gazprom's trouble at home.