East/west tug-of-war for Russia’s barrels
Challenges and costs increase as ageing oil fields reach the ‘babushka’ stage
Russia’s upstream oil sector has seen easier times, as oil fields start to age and the cost of extraction climbs. Many of the country’s conventional producing assets are reaching, or indeed well into, the natural decline stage, which means maintaining volume and quality of oil production are becoming challenging.
One stop-gap remedy has been to raise investment. Capital spending on production by major Russian oil companies has almost doubled since 2011, reaching RUB1.4tn ($22.3bn) last year. Although oil output has risen steadily in that time, it has not kept pace with capital invested–capex per barrel has jumped by 80pc since 2011.
Matters are made worse by the effect of climate change on Russia’s ‘permafrost’, that is, permanently frozen ground, according to recent reports. Rising temperatures are thawing the permafrost in key oil producing regions, causing damage to oil infrastructure and, inevitably, increasing costs. The potential economic loss could be between RUB50bn and RUB150bn each year, Alexander Krutikov, the country’s deputy minister for the Far East and Arctic development, said in a recent interview with Bloomberg.
Sanctions bite in the Arctic
Russia, it is true, still has tremendous resource potential, albeit in more remote or technologically complex regions, such as the Arctic. But such resources can only be accessed with more advanced technology, not all of which Russia possesses domestically.
In the past, these needs could be outsourced via joint ventures with international oil companies (IOCs). But sanctions imposed on Russia explicitly restrict foreign investment and access to technology for deep-water, shale oil and Arctic projects.
The rouble has lost more than half its value against the US dollar since sanctions began
Sanctions against Russia prompted IOCs to pull out of ongoing joint venture projects in the country when they were first imposed. ExxonMobil, for example, suspended its cooperation with Russian state-controlled producer Rosneft on a project in the Arctic. Suspension of these projects damaged balance sheets, production estimates and, crucially, cut off access to much-needed technology. Russian oil companies are now prioritising research and development into, in particular, enhanced oil recovery and hydraulic fracturing–a key technology for shale extraction.
Rouble to the rescue?
The rouble has lost more than half its value against the US dollar since sanctions began. As oil prices are denominated in US dollars, this has, conversely, created something of a boon for Russian majors. Their rouble-denominated income from exports has essentially doubled. This, along with heavy government support, has given Russia’s upstream sector some resilience against both sanctions and low oil prices and, in turn, provided the financing underpinning their strong production growth over the past five years.
BloombergNEF expects the favorable exchange rates to continue to support profits for oil exporters, as sanctions will be an ongoing drag on the Russian economy. However, a weak rouble alone will not be enough to maintain production. Russia’s ministry of energy foresees a period of declining production in the next few years, citing rising costs and deteriorating oil fields as the main challenges.
The government is piloting a new tax system it hopes will lessen the burden on companies with high extraction costs, as well as stimulating investment. State-owned Rosneft has been particularly vocal in its demands for greater government support for expensive and risky projects in the Arctic.
Another complexity is growing demand in Asia. Russia is pivoting its export focus eastward, aiming to strengthen its position as a major oil supplier to the region.
Transneft, the state-owned pipeline monopoly, carried out expansions of the two Eastern Siberia-Pacific Ocean (Espo) crude pipelines to China in 2019 to increase their capacity by roughly 10pc to 130mn t/yr. This equates to roughly half of Russia’s total 2018 oil exports. Rosneft is using international partnerships to gain market share in key Asian markets. Having acquired Indian downstream player Nayara Energy in 2017, it plans to grow a retail presence in India. It also has agreements with PetroChina in China and Pertamina in Indonesia for refining and petrochemical projects.
War and peace with crude quality
Ageing oilfields mean that maintaining consistent crude quality is becoming a big challenge. In order to maintain steady metrics for Russian domestic refineries, more heavy-sour oil has been diverted towards blending for export. The average sulphur content of Russia’s exports has steadily risen from 1.51pc in 2014 to 1.64pc in 2018 (see Figure 1).
It is likely that more sweet crude will be diverted east
What is more, data suggests that the quality of exports going west is deteriorating at an even faster rate. Although the overall average sulphur content of exports is being pushed higher, the volume in Espo blend (going to China) has remained remarkably constant, at 0.5pc sulphur, since 2014.
As Russia ups exports to Asia, it is likely that more sweet crude will be diverted east, further compromising the quality of oil moving west. Westward exports via the Druzhba pipeline are expected, over 2019 as a whole, to hit the maximum permitted sulphur content of 1.8pc, compared with 1.61pc in 2014. This dynamic is likely to be exacerbated in 2020 with the additional Espo pipeline capacity being available for the full 12 months.
With European exports already near their maximum permitted sulphur levels, Russia’s ability to blend away their quality issues is reaching its limit. BloombergNEF expects that Russia will need to boost both investment in technology and in exploration to maximise its resource potential if it hopes to maintain export dominance as well as growing its footprint in rapidly expanding Asian markets. What remains to be seen is whether Russia can keep up with Asia’s growing appetite, without souring relations, literally, with its western buyers.