Russian oil after the embargo

Vladislav Inozemtsev analyses the transformation of the oil market in 2023

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Photo: Scanpix

Russia, which its leaders have often preferred to call ‘the small island of stability’, is indeed a stable patch of land in a sense: in early 2023, much as in early 1999, 2009 or 2016, economists and politicians focused steadily on the question of oil prices, which was, and still remains, fed through the drip that has kept the country alive for the past half-century. However, since the second half of the 1980s, the Soviet Union’s and Russia’s problems stemmed from global economic cycles, held hostage by ineffective government policies, while the new crisis has been entirely man-made: despite a more than comfortable price above $ 80/Brent barrel, Russian oil has been quoted at almost half the price and is being driven out of the most attractive markets solely because Putin has decided to wage a full-scale war against Ukraine.

Therefore, the challenges facing Russia today seem very particular. For the first time ever, the leading countries announced an embargo on Russian oil (the USA, Canada and the UK from early March 2022, and most EU countries from 5 December 2022), while the G7 imposed an unprecedented price ceiling at $ 60/barrel. As a result, even before the introduction of the European ban on imports of Russian oil products (since 5 February) and the multilateral price ceiling (its terms are still being debated), Urals prices plummeted from $ 75/barrel in November to $ 42/barrel in December, and the volume of daily exports more than halved by the end of 2022. What are the implications of this news for the Russian economy?

Government officials remain generally optimistic, recognising the almost inevitable reduction in production by 5−6% in 2023 and the reduction in oil & gas budget revenues to 8 trillion roubles, which were set as a benchmark by the President and the Russian Ministry of Finance. Critically-minded independent experts expect that oil bans will provoke a major collapse in production, which could reach 50% (the latter seems extremely unlikely: for the sake of comparison, no such decline in Russia’s production ever occurred, even between 1988 and 1998). As readers will know, predicting oil prices is as successful as crystal-ball gazing, but in this case we are not dealing with purely market-driven processes, but with the results of political decisions made by major players, and we are interested less in the price itself and more in the prospects of the Russian economy. Therefore, we believe there is a reasonable chance to ‘hit the bull’s eye’ in forecasting.

First of all, one should assess the profitability of oil exports from Russia under the new circumstances. Considering that the cost of oil at Russian fields is up to $ 40 /barrel including tax dues to the budget and that no serious transport problems are expected with prices naturally falling below the ‘ceiling’, I would assume that at the price of $ 40−45/barrel the volume of oil supplies will not decrease and proceeds to the budget will continue (although one should not dream of getting 8 trillion roubles in oil & gas revenues). Readers may remember that in the second half of 2021 Russian officials said that they saw a price of $ 55−60/barrel as balanced and trouble-free, even though they acknowledged that if it fell below $ 50/barrel, the development of almost half of Russia’s oil wells could become unprofitable. In our view, the price trend in the first half of 2023, which initially saw Urals prices plummet, will moderately go up in the spring due to lower crude exports from Russia and a widening gap in the oil products market, which will eventually stabilise prices around $ 50−55/barrel at a 40% discount to benchmark grades. At such price levels, the demand for Russian crude oil—primarily in Asia—will prove quite sustained and the price ceiling will be seen as an effective measure and will not be revised downwards in the course of 2023.

In our view, the main problem lies in the oil products market as those products held the largest share on the EU market when it comes to the supplies from Russian oil companies (91.1 million tonnes in 2021 compared to 108.1 million tonnes of crude oil, or 45.8% with an average of 37%), and the decline in demand for those products cannot be offset by an expansion in domestic consumption (in 2021, having recovered from the COVID shock, it reached 33.3m tonnes of petrol and 35.9m tonnes of diesel fuel but there has been no growth in these figures for about ten years). Considering that exactly two thirds of Russian oil products (144.1 million tons) were exported in 2021, it means that the refining rate may decrease by 25−35% at the end of 2023, which will be a serious problem for the vertically integrated oil companies and regional budgets (while Asian consumers may significantly increase their oil purchases, they are not likely to buy oil derivatives; while Turkey and India are already preparing to divide the European oil products market). Consequently, one of the outcomes of the current shifts will be an even greater ‘primitivisation’ of Russian exports, dominated by crude oil, as was the case in the 1970s and 1980s (in 1989, for example, the Soviet Union exported 127.3 million tonnes of oil and only 57.4 million tonnes of refined oil products).

The fall in exports of refined oil products will lead to an integral decline in production, which could reach 20% in Q1, but will be significantly lower at year-end as companies adapt to the new conditions. This assumption is based on the fact that global economic recovery will accelerate starting from the second half of 2023 as inflation declines and China starts to grow, and demand for oil will increase, while full substitution of Russian supplies cannot be achieved within one or two years. Therefore, Russian fuel, sold at dumping prices, will find eventually its way to consumers. In fact, this has been already noted by many observers: after a sharp drop in shipments during the period of legal uncertainty caused by the embargo and the ‘ceiling’, as well as the Christmas week, the Russian oil supplies by sea rose during the week of 7−13 January by almost 30% versus the previous week (and more than twice versus mid-December), and the recovery of demand leaves no room for fantasies about a price drop. Thus, our overall forecast boils down to the fact that by the end of 2023, the average price of Russian crude oil will be around $ 50−55/barrel, oil & gas revenues to the budget will reach 6.5−7 trillion roubles, and the production decline will not exceed 12−14% of the 2021 levels.

How is the Russian government going to respond to this? In our view, the biggest mistake would be to hope that the Kremlin will try to ‘get off the oil drip’ and reform the country’s economy. As we know, nothing of the kind happened in 2015−2016 or even in 2009, when incumbent president Dmitry Medvedev announced his modernisation programme. Russia’s relatively cheap oil could evolve into an industrial breakthrough only under two conditions: on the one hand, with the presence of Western investors interested in producing their goods in Russia at substantial cost savings; and, on the other hand, if Russian companies benefiting from the new conditions were to compete with Western players in foreign markets, or at least on the domestic market. However, the foreign policy environment has completely cut Russia off from investment resources (in the late 2010s, over 80% of investments in the industrial sector came from European and North American companies, a small share was held by Japan and South Korea, while entrepreneurs from China and India invested only in raw material projects) and external markets (the only chance for Russian industrial products to enter those markets was to supply goods with labels of Western industrial giants to other countries). And if we assume that Putin turns into a new Stalin in terms of initiating a ‘new industrialisation’, it would also be impossible, since the successes of the 1930s were based on unprecedented imports of equipment and engineering personnel, and this cannot be repeated. All this means that it would be impossible to transform a decline in energy exports into an increase in domestic consumption: worth recalling is that in 1989, the USSR used 70.2% of all oil produced for its own needs, while Russia used less than 29% in 2021.

Therefore, in our view, the Kremlin’s only response to what is happening will be to siphon the resources lost by the exporters from the country’s own population, which can be done in two ways. The first one is already happening: raising taxes charged directly from oil & gas companies (taxes were increased last year in the hope of getting about 1 trillion roubles into the budget) and (almost certainly) the maximum seizure of their profits into the budget through dividend policy decisions (this method has already been tested on Gazprom). The second method is likely to be attempted if the slump in export revenues turns out too serious: then I would expect a significant increase in excise taxes on motor fuel (from 1 January, they rose ‘unjustifiably’ below the inflation rate: only by 4%, or up to 14,736 roubles/tonne for petrol below Euro-5 brands), which now make up less than a quarter of its retail price. An increase of the excise tax by 50% would drive the cost of car fuel by about 10 roubles/litre, or 13−14%, which will not cause shocks on the markets (suffice it to say that in 2022 petrol prices rose by 3.3%, with inflation at 11.9%, although in 2021 they increased by 6.6%, while inflation was 8.4%). Considering that excise taxes generated 842 billion roubles in 2021, such a measure could increase treasury revenues by 0.5 trillion roubles. Similarly, raising taxes on fuel for power plants could help reduce the budget deficit. All this will ultimately be financed by consumers. Redistribution of at least 1% of GDP into the treasury by using similar methods will be the basic scenario in the authorities’ response to the changing situation on the oil market. Of course, other taxes, connected with domestic consumption of commodities in one way or another, will also rise in the spirit of the slogan ‘People are the new oil’.

However, patching up budget holes is one thing while the fundamental trends in the development of the Russian oil industry are quite another thing. Since the late 2000s and early 2010s, the Russian oil & gas industry has needed serious development, as the share of hard-to-recover reserves has been growing steadily: according to officials from the Russian Ministry of Fuel and Energy, by the end of the 2020s this category may include almost all production from oil and gas fields that are currently being developed. At the same time, since the late 2010s, the main goals for the current decade have been to intensify geological prospecting and exploration, and to bring new fields into production, including those on the Arctic shelf. While the pandemic effect, which dramatically reduced the likelihood of such a scenario, turned out to be short-lived, the sanctions imposed by Western countries make a disaster in the Russian oil industry very likely — perhaps not ‘here and now’, but within 7−12 years (incidentally, it should not be forgotten that during the years of Putinism the share of oil & gas revenues in the budget increased from 9−10% to 35−40%, while budget spending, even when converted into dollars, has increased more than ten times).

To recapitulate, the changes in the Russian oil market in 2023 (and most likely in 2024) will not be fateful for the country: sanctions by Western governments will significantly reduce budget revenues, but will not kill the oil & gas industry in the country. At the same time, the shortfall in revenues will be compensated from an increase in the tax and tariff burden on citizens, and a likely industrial degradation of the country rather than its accelerated industrial development. At the same time, the sanctions, which cannot be expected to be lifted even in the medium term, will prevent any development of the industry. The war in Ukraine has not only destroyed half a century of cooperation between the USSR/Russia and Europe in the energy sector, but it has also put an end to Russia as an ‘energy superpower’, even though this fact may not be evident as yet.

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