The Fuse

Amid Talks of Production “Freeze,” Russian Oil Already Facing Decline

by Nick Cunningham | March 31, 2016

Russia’s oil production hit 10.9 million barrels per day (mbd) in January 2016, the highest level since the collapse of the Soviet Union. But that could mark the peak for Russia’s oil production as it enters an extended period of gradual decline.

Rosneft, which at 3.8 mbd accounts for more than one-third of Russia’s total production, stated that its output would fall in 2016. Left unsaid, however, was whether that will come from natural decline or a more intentional effort. On March 29, Russia’s energy minister Sergei Donskoi said Russian oil companies are adjusting their 2016 production plans, suggesting that they are doing so because of the upcoming April 17 meeting in Doha with several key OPEC members regarding their tentative production “freeze” agreement. “Rosneft, as it told (us), is planning to lower (output),” Donskoi said, according to Reuters.

Rosneft, or Russian officials, may be trying to take credit for a fait accompli.

Russia’s production freeze already a reality

Russia’s three largest producers—Rosneft, Lukoil, and Surgutneftegaz—account for about 60 percent of the country’s oil production. But their combined total is declining. In February, output was down 92,000 barrels per day from the same month a year earlier. The declines are expected to continue gradually throughout this year and beyond. According to IEA, Surgutneftegaz’s output will fall by 0.4 percent in 2016, while Rosneft’s output will drop by 2 percent.

The state-run giants like Rosneft are sitting on declining oil fields, but some private companies are posting marginal gains. Novatek, for example, brought its Yarudeyskoye oil field online in December 2015, adding 70,000 barrels per day. Bashneft, a small producer, saw production rise 12 percent in 2015. These smaller companies are credited with helping Russia to hit a record high in production in January. But with few additional projects in the pipeline, output is not expected to rise any further this year.

In some ways, the production freeze that Russia and OPEC members are meeting to discuss in Doha on April 17 is largely symbolic. Out of the main countries currently involved, including Saudi Arabia, Russia, Qatar and Venezuela, only Saudi Arabia has real scope to increase production.

Expectations are low that the freeze deal is likely to grow into something more substantial: Saudi oil minister Ali al-Naimi effectively ruled out production cuts. “That is not going to happen,” he said at the CERAWeek conference in Houston in February. Media buzz surrounding the Doha meeting has contributed to a rally in oil prices, which are up about 50 percent since early February. The IEA said recently that “it is rather unlikely that an agreement will affect the supply/demand balance substantially in the first half of 2016.”

Much more important to oil markets is the rate of global oil demand growth, the pace of decline in U.S. shale production, and Iran’s success in bringing back latent oil production capacity. “[T]here are clear signs that market forces—ahead of any production restraint initiative—are working their magic and higher cost producers are cutting output,” the IEA wrote in its March Oil Market Report, taking a swipe at the pending OPEC-Russia production freeze deal.

Russian oil in decline, investment choked off

In 2015, Rosneft doubled its drilling volume through its subsidiary, Yuganskneftegaz, yet saw production decline by 3.2 percent

Stagnant output at Russia’s largest companies is not due to a lack of effort. In a profile of Rosneft on March 23, The Financial Times reported that in 2015 Rosneft doubled its drilling volume through its subsidiary, Yuganskneftegaz, yet saw production decline by 3.2 percent. Yuganskneftegaz oversees oil fields in Western Siberia and it makes up Rosneft’s largest source of production. The plight of Yuganskneftegaz is indicative of many aging Russian oil enterprises today: Investment needs to increase just to keep production flat.

In fact, Rosneft said that it would spend 1 trillion roubles (US$15 billion) per year through 2018 in order to maintain output. Across the company’s entire portfolio, Rosneft stepped up drilling volume by 36 percent and commissioned 1,839 new wells in 2015. But overall output grew by just 1 percent, a figure that is only positive because it includes natural gas production.

russia total oil supply

Russia’s decline won’t be swift, though. In the short run, Russia’s oil and gas industry is somewhat mitigated by the rapid depreciation of the rouble, lowering domestic costs while revenues stay the same in dollar terms. At about 68 roubles to the dollar, Russia’s currency has lost roughly half its value since mid-2014. The FT reports that Lukoil’s drilling costs, as a result, plunged by 35 percent in the first nine months of 2015 compared to the same period a year earlier.

usd rouble

In addition, there is a backlog of 1 mbd in new output that could come online by the end of the decade from greenfield projects.

Beyond that, however, there are huge questions about Russia’s ability to keep production aloft. High levels of debt, financial pressure from low oil prices, and western sanctions have cut into Russia’s ability to invest in long-term projects, which are critical to boosting total output. The FT says that the Russian oil industry has delayed about 29 projects as of late 2015, amounting to 500,000 barrels per day in peak production.

Without technology and finance from western companies, the Arctic and Russia’s vast shale resources could remain locked away. In fact, Russian companies have not started a major new oil project since 2014. Technically challenging and expensive projects will struggle to move forward, such as the 1.3 billion barrel of oil equivalent discovery made by Rosneft and ExxonMobil in 2014 in the Kara Sea, one of the northernmost wells ever drilled. Exxon was forced to abandon the venture after the West slapped sanctions on Russia following its incursion into Ukraine.

The long lead times on Russia’s more challenging resources are deterring the investment that is needed now. “The oil companies are not investing at all in exploration of new deposits because profits on these projects will only come in 10 years. Nobody will invest in these projects,” Mikhail I. Krutikhin, an energy analyst at Moscow-based consultancy RusEnergy, told The New York Times.

Even in the Russian Energy ministry’s most optimistic scenario, Russian oil production would only grow until 2020 before declining thereafter.

A report from the Russian energy ministry admitted that the future of Russian energy looks bleak. The ministry said that oil production could fall by half by 2035. Even in the ministry’s most optimistic scenario, Russian oil production would only grow until 2020 before declining thereafter. The rate of decline, however, varies significantly, ranging from 1.2 percent to 46 percent by 2035, depending on taxation, oil prices, and the fate of western sanctions.

Tax reform and potential Rosneft IPO show fiscal strain

The tax regime is one of the few variables in Russia’s control, and also one of the most critical to the industry’s fate. Russia’s government is facing a budget deficit equivalent to 4.4 percent of GDP and the Kremlin is considering a tax hike to close the gap. The industry will see $2.9 billion in increased taxes in 2016 after some planned tax cuts were scrapped while another tax was increased. Additional tax increases could be forthcoming as financial planners scramble for new sources of revenue.

More to the point, however, is how the taxes are structured. Taxes rise significantly as the price of oil increases, creating a disincentive to invest in new projects. Russian oil companies as well as the energy ministry are lobbying against the additional tax hikes that are currently under consideration.

“This country has the potential to produce for 20-plus years at this level,” Vladimir Drebentsov, chief Russia and CIS economist at BP, told the FT in an interview. “It’s all a function of the fiscal regime. If they try to squeeze too much, oil production will collapse.”

Karen Kostanian, analyst at Bank of America Merrill Lynch, concurred. “By 2018 you either have to change the tax system or see a production decline,” Kostanian told the FT.

But Russia has to close the budget somehow. It has already cut spending by 8 percent in real terms compared to 2015 and still faces a large deficit this year. Next, the Kremlin could move forward with a partial privatization of Rosneft, a move that the government hopes will raise 1 trillion roubles (USD$13 billion) for the treasury.

For a company as strategically important as Rosneft, such a move speaks volumes about Russia’s current predicament.