As the combined hit of fresh financial sanctions and voluntary boyotts on the Russian economy take their toll, one thing is becoming clear: Russia is unlikely to remain an «energy superpower» for long. Daniel Yergin, one of America’s leading energy pundits, believes Putin has «signed the death warrant» on Russia’s ability to leverage exports for political gain. In a similar vein Mikhail Krutikhin, a Russian energy commentator, notes that as much as 50% of crude oil exports are at risk from importers’ and banks’ refusal to deal with Russian cargoes due to reputational or secondary sanctions risks. Wherever that figure ends up, the stability of the regime’s political economy, and the influence and power afforded Moscow by dint of its oil wealth are up in the air.
Inevitably, oil production in Russia will decline in 2022 likely permanently. That means the Russian economy will have enjoyed «peak oil» in 2019. The political choices facing the regime in a world of diminishing production are starkly different than one where stagnation or production growth are possible. Underlying challenges predating COVID will intensify. What is perhaps most surprising yet unsaid about the speed of events is Russia’s own quixotic, haphazard, and frequently clumsy handling of oil politics at home and abroad.
Betting the Farm
Igor Sechin, the head of Russia’s largest oil company Rosneft, has never liked OPEC nor does he like the US Federal Reserve. The former cannot be trusted — Saudi Aramco has been locked in a struggle with Rosneft for market share in China since 2013 — and the latter are principally to blame for the financial bonfire that fueled the explosive growth of US shale production. Confronted with steadily falling prices in the second half of 2014, Sechin dragged his heels with OPEC counterparts and doubled down on temporarily winning the policy fight. Russia would flood the market to knock out the upstarts in America’s shale basins and restore order. It failed spectacularly. They cut costs, kept borrowing, and kept drilling. Russia agreed to coordinate production cuts with Saudi Arabia and OPEC on December 10. The next day, the Duma passed the federal budget.
Sechin’s personal crusade against production coordination never ended behind closed doors. Financial speculation was as much to blame for the collapse of oil prices as any market ‘fundamentals’ in his worldview, and Russia should act accordingly. Years later, in February 2019, Reuters got its hands on a letter from Sechin to Putin arguing that the deal benefited both the United States and OPEC to Russia’s detriment. He repeatedly lost out in Moscow, but then COVID struck. Everything was up in the air.
Russia’s refusal to join in deeper production cuts with the Saudis and OPEC at the March 5−6 OPEC+ ministerial in Vienna blew back in Russia’s face quickly. For all the financial carnage from waves of defaults hitting US shale drillers, the Saudis had a considerable advantage over their Russian counterparts: significant crude oil storage capacity, a large tanker fleet, and a wider set of relationships in the US and other major importing markets with midstream and downstream firms. Lacking storage, Russian firms had to sell every barrel produced on a market. By April 12, Russia had fallen back in line supporting OPEC+ cuts to take a collective 9.7 million barrels a day of production off the market.
Rather than drive a stake into the heart of the US oil industry, the price war accelerated oversupply to the point that futures prices for oil went negative within days of the new OPEC+ agreement. The speculators Sechin hated so much went wild as companies couldn’t find buyers for their production. The Federal Reserve did its job once more. Shale survived at the cost of consolidation and a drastic refocus on shareholder returns. But the repeated past efforts to expand Russia’s market share in price wars left collateral damage to the broader economy and oil sector.
Neft and Taxes
The post-Crimea oil price shock reshaped the regime’s fiscal system as did the decision to float the ruble, but new fiscal rules, the devaluation of the ruble, and import substitution efforts failed to reduce Russia’s dependence on oil. The two price wars advocated by Sechin and his coterie exacerbated problems facing the state and oil sector going back to the mid-2000s. Fiscal and broader economic independence are intwined in them.
A 2010 IMF review of the oil fiscal regime adopted in 2001 showed that the progressivity of taxes on crude oil exports and production was such that high-cost projects in Russia were effectively being taxed at or above 100% as prices surged towards and past $ 100 a barrel. No wonder Russian oil output declined between 2007 and 2008. Rising production costs and high tax takes weighed on investment as did underspending by the state on exploration via Rosgeologiya. Even if one believed the Arctic offshore could become a new oil province that would offset any expected declines in Western Siberia, the state would have to diminish the tax burden facing firms. This was especially urgent with the aging reserve base of Soviet-era finds in Western Siberia still providing a majority of Russia’s production.
After sanctions and the oil price shock in 2014−2015 killed interest in Arctic offshore development, the strategy Sechin preferred to continue maximizing output relied on the extensive use of horizontal drilling at older fields. While the macroeconomic managers in Moscow sought fiscal stability after the price shock by turning to austerity budgets and raising non-oil & gas revenues, oil companies were seeing costs at older fields rise as they increased output. Tax relief became even more important.
In 2013, approximately 28% of Russian oil output received tax breaks of various kinds. By 2020, over half of Russian oil production received tax breaks. Based on calculations from the Ministry of Finance, nearly 37% of the EBITDA earned by firms in the sector in 2019 came from tax breaks, a sum effectively equivalent to the entirety of the capital expenditures made by oil companies that year. The «oil tax maneuver» begun in 2015 was chiefly concerned with replacing export duties with mineral extraction taxes, a ploy that would protect revenues in the event exports fell. Policymakers seemed to be planning for «peak oil» even if they weren’t admitting it. The biggest beneficiary from this shift was Sechin and his empire at Rosneft with its large batch of Soviet-era fields in its portfolio.
Resource Code
At the same time the oil sector needed more tax relief to maintain output, the Russian economy’s dependence on oil and the extractive sector increased. Progress reducing the federal budget’s dependence on oil & gas revenues reduced demand and investment elsewhere in the economy, worsening the effect of the ruble’s devaluation in 2014−2015. As of 2019, real investment levels in oil & gas were 15% higher than they had been in 2013 according to Rosstat. In barrel terms, output increased 7% over that time. An IHS Markit study from 2019 commissioned by Saudi Aramco estimated that breakeven production costs for Russian projects had risen to $ 42 a barrel onshore. The study was by no means a purely «objective» exercise, but it captured a ground truth about the industry in Russia after 2014. The costs of maintaining higher output were rising faster than output. Further, real investment in manufacturing lagged economy-wide investment levels. Manufacturing investment in 2019 was nearly 9% lower in real terms than it had been in 2013. The oil sector was sucking up more capital without enough redistributive spending to boost non-resource or commodity sectors.
Pre-COVID, these two competing pressures created a serious dilemma since decreases in oil revenues would have to be made up through higher taxes on consumption, corporate profits, incomes, or else higher tax burdens for other resource sectors. Higher taxes elsewhere tend to weaken demand or weaken investment for industries that serve domestic demand worsening the problem. Russian economic policy ended up increasing the economy’s exposure to fluctuations in energy prices when COVID hit while the costs of production for aging and newer, often harder-to-find oil grew. The inter-sectoral demand created by oil companies had become more important to the rest of the economy, yet the state had to find ways of relieving the burden of distributing rents from the oil sector to elsewhere. Austerity simultaneously hid the problem and worsened it.
Shiftless when idle
If increases in oil production were increasingly costly for companies and the fiscal system from 2013−2019, the 2020 price war raised the stakes. Massive cuts were inevitable no matter Russia’s decision in February 2020 given the scale of the demand shock but the sector was over a barrel in April when it was agreed they would cut a whopping 2.5 million barrels a day of output. Rosneft, Lukoil, Surgutneftegaz, Gazprom Neft, and the few smaller players left all had a gun to their heads. They’d have to idle hundreds of productive wells, the issue being that the longer a drilled well is idle and not permanently ‘capped,’ the likelier it is that the cement casing surrounding that well fails due to shifts in the ground, cracks from deep freezes, and more.
2015 Data compiled by researchers from comparative study of well casing failure rates found that Rosneft’s fields had failure rates above 4% and Lukoil had failure rates of around 3% with other firms that provided data ranging from 1.7−4%. That is to say that 1 in 25 of the wells Rosneft drills failed as of 2015, a figure that would likely rise at any given field as its wells became increasingly depleted and more dependent on injections of water and chemicals to maintain the pressure necessary to lift oil from any given well. The surge in output in 2015−2016 worsened this dynamic as firms had to increase capital expenditures to maintain output levels without raising them due to OPEC+ cut requirements. In March 2020, they were lighting money on fire increasing productivity at existing wells while drilling new ones, then hoping they could limit the financial damage later by idling older, more depleted wells instead of newer ones. Attempts to increase production then increased the risks of idling wells.
Crude Boys
The imposition of various financial sanctions on Russia, particularly the freezing of the Bank of Russia’s external assets and denial of access to US dollars and Euros, speedily amplified the idling risks facing the oil sector. The problems of March 2020 have quickly returned. Transneft has begun restricting flows of crude that have yet to find buyers into its storage network as a result of falling purchases from self-sanctions. The scale of the decline is unclear — Russian sources warn of as much as a 40% decline in exports for April since March figures were softened by available tanker storage at sea — but it will force companies to idle a very large share of production.
Idling issues are compounded by leading western oilfield service providers pulling out or else refusing to make new investments or transfers of technology. Though they account for a comparatively small portion of the services market, they’re the leading edge for know-how and technology when it comes to horizontal drilling and well management. If production falls by 1 million barrels a day for an extended period, a growing share of that production will be lost for good. The costs of replacing lost wells with new ones are likelier to be higher in terms of capital expenditure, a problem further compounded by the collapse of Russian imports of western goods, technology, repair parts, and services. Declining investment into production will reduce demand for steel, construction services, and labor across oil producing regions as well as hurt regional and federal tax revenues. If more than 1 million barrels of production come offline, then the knock-on effects will be immediately comparable to April 2020. They’ll then worsen because of the degree to which imports of vital inputs across industries are restricted or affected. Whatever oil is being exported is also being moved at discounts of $ 25 or greater currently, a stunning situation where the size of the market for Russian crude is a function of how much Russian firms can lower the price.
Worst of it all, the only systemic instrument available to address rising production costs, the exit of western oil firms like BP, Exxon, and Shell, and loss of access to top-quality technology and know-how is tax relief. But lowering taxes on the oil sector is not feasible. If cutting taxes for businesses and subsidizing credit is the main short-term solution for the current economic shock with a paltry 1 trillion rubles of spending on top, there’s little cause to believe that oft-delayed systemic tax reforms for the oil sector will be forthcoming. Since 2015, Rosneft and Igor Sechin have successfully won tax breaks at the expense of systemic reform lowering extraction taxes and focusing on profits. The result has been to reduce firms’ ability to invest into production, and as a consequence reduce the additional demand they generate across an economy that has grown more dependent on resource extraction in the last 8 years. The regime needs new rents. Who knows where those are to be found.
