Poor outlook for the Russian oil industry

Drilling at the Russian Arctic shelf (Rosneft, Public domain)

In August 2018, Nikolai Patrushev, the Secretary of the Security Council of Russia, stated that the Russian oil sector was plunging into a deep crisis. One year later, the Minister of Energy Alexander Novak informed Prime Minister Dmitry Medvedev that Russia would soon experience a sharp decline in oil production.

The prospective crisis in numbers

In 2018, Russian oil companies extracted 553 million tons of crude oil (11.2 million barrels per day, which exceeds the record-high levels achieved in 1987), and in 2021 oil production will peak at 570 million tons. However, production will begin to decline in 2022, and is projected to drop by a half within 14 years. By 2035 oil production could fall to 310 million tons, which means a decline by 243 million tons.

Meanwhile, the cost of extraction of a ton of oil has increased 2.4-fold, while the expenditures have grown 2.8-fold. This applies in particular to West Siberia, which currently accounts for more than half of Russia’s overall oil production. If the situation there does not change, then production will fall from the level of 330 million tons in 2015 to 180 million tons in 2035. In the pessimistic scenario, the decline in production will be more than twice larger and will reach 146 million tons.

This means that the Russian budget will not obtain the same level of revenues as before, and it will be necessary to reduce taxes imposed on oil&gas companies in order to mobilize the funds necessary for the development of the oil deposits where production is more costly. Oil&gas companies currently pay 68 per cent of their incomes to the budget, which is one of the highest tax burdens in the world.

The effects of Western sanctions

The problem lies not only in the Russian budget’s dependence on the oil&gas revenues, which account for 40 per cent of all revenues. Tatiana Mitrova, the Director of the Energy Centre at the Moscow School of Management “Skolkovo” points out that Western sanctions have cut off the domestic oil and gas industry from modern technology. According to the data from the Ministry of the Environment, over the past two years not a single new gas field has been put into use in Russia, and no large oil deposits have been discovered. Meanwhile, the exploration works in the Arctic shelf had to be suspended.

The inability to continue production at the existing, increasingly depleted oil fields is becoming a key problem, as Russian companies do not have the appropriate technology and equipment to develop non-traditional and offshore reserves. In the period following the sanctions, the country has not been able to create its own fleet required for such operations. Ms. Mitrova emphasizes that the weak, short-term effects of the sanctions are misleading. In the long term, the sanctions could affect Russia’s ability to maintain the current levels of production and to develop infrastructure for the transport of oil and gas through pipelines. This could gradually drive Russia out of foreign markets and limit the available channels for obtaining export revenues, thus threatening the stability of the Russian economy.

According to Ms. Mitrova’s forecasts Russia, due to sanctions, will have lost approximately 5 per cent of the profits from the current production by 2025, and approximately 10 per cent of profits by 2030, which is equivalent to 1.1 million barrels per day. Based on the current prices of crude oil, the estimated financial loss would amount to USD28.5bn per year.

The oil&gas industry is among the branches of the Russian economy that are the most vulnerable to Western sanctions. They threaten the very existence of the raw-materials sector. According to Vygon Consulting, two-thirds of the oil extracted in Russia is located in aging oil fields or in deposits that are difficult to recover. “In order to launch oil production from these deposits, it would be necessary to hire foreign contractors, and to use foreign software and technology provided by companies such as Schlumberger and Halliburton,” says Daria Kozlova of Vygon Consulting. The planned legislation known as the Defending American Security from Kremlin Aggression Act (DASKA), introduced in the US Congress by Bob Menendes and Lindsey Graham, limits Russian imports of equipment necessary for shale projects and projects implemented in the sea shelf, but also in all the other resource extraction projects.

The upper ceiling for the permitted leases and sales of technology will be USD1m. Russian experts believe that with such limits, the development of oil deposits in Eastern Siberia and in the Arctic shelf will not be possible. According to the assessment of Vygon Consulting, this threatens the extraction of approximately half of all the oil that Russia could produce until the years 2030-2035, which is equivalent to all of the oil that could be exported and that could provide budget revenues.

The Western sanctions have especially affected the Kirinskoye gas condensate field in the Sea of Okhotsk shelf, which was designed as a resource base for the third line of LPG production plants on the Sakhalin Island. Gazprom was forced to postpone the commencement of works from 2021 to 2023. Works on the Yuzhno-Tambeyskoye field in the Yamal Peninsula, which are carried out by the company Novatek, were subsequently suspended as a result of the sanctions. This gas field was supposed to supply the raw material for the “Jamal-LPG” project (read more). Similar case is the suspension of Gazprom’s LPG terminal in the Kaliningrad Oblast. Sanctions also resulted in a decrease in gas production by Lukoil, and a drop in the production volumes of the Exxon Neftiegaz Ltd. Consortium, which is active in the “Sakhalin-1” project. At the same time, Rosneft has announced that it could suspend the launch of production at the Russkoye field, as well as other projects, which is associated with the implementation of Russia’s commitment to limit production in accordance with the OPEC+ agreement, as well as the sanctions. Rosneft has suspended its projects on the Arctic shelf, which includes the following areas licensed for development: Yuzhno-Prinovozemelsky, Pomorsky, Severno-Pomorsky-1, Severno-Pomorsky-2, Russky, Zapadno-Matveevsky, and Vostochno-Sibirsky.

Current resources

While Russia is still among the three world leaders in oil production (with more than 11 million barrels per day, or 14 per cent of the global production), it only ranks 8^th in terms of the total reserves (80 billion barrels), while the degree of depletion has already reached 79 per cent in the Ural region and 50.9 per cent in Western Siberia. There are no new, significant oil deposits that would be cheaper and easier to extract, and that would not require the use of foreign technology. The still available undeveloped resources include 433 deposits, but their total size only amounts to 1.6 billion tons, which would only be enough for 3 years at the current production levels.

These reserves include the oil deposits in the Khanty-Mansi autonomous district (i.e. the Prirazlomnoye, Salymskoye, and Pravdinskoye fields), which are very large but difficult to recover. However, the majority of these reserves are small or very small. There are only 28 average-sized deposits and the only large deposit is the Rostovtsevskoye oil field in the Yamal autonomous district. The oil reserves in that field are classified in the C1+C2 category and amount to 61 million tons. However, there are no plans for the development of this deposit, as it is located within the “Yamalsky” nature reserve.

The head of the Russian Ministry of Natural Resources and Ecology Yevgeny Kiselyov concluded that not a single tender for rights to develop large hydrocarbon deposits was announced in Russia in 2017. “There is nothing left, the stock of discovered deposits has been exhausted,” said Kiselyov.

Mikhail Krutichin from RusEnergy points out that the average size of the deposits discovered in the last two years is 1.7 million tons. This is not significant, because Russia’s current monthly supplies to China are 3.5 times larger than that. The scale of investments in oil prospecting activities has been dramatically reduced after the drops in oil prices. There has been a paradigm shift. The authorities decided to sell everything that can be sold at the current price, and to pump out everything from the existing oil fields. “New holes are being drilled right next to the first one, as long as the oil keeps flowing, without searching for optimal solutions,” says Mr. Krutichin.

As a result of these strenuous efforts, Russia was able to match the previous record-high production levels of 1987 (11.2 million barrels per day), but that will only accelerate the end of the oil boom. According to the “Strategy of development of mineral resources base until 2035”, Russia can only maintain the current production levels for a maximum of 3-4 years. The main problem is that 70 per cent of the Russian oil resources are very difficult to extract. The production costs amount to USD70 per barrel onshore and USD150 per barrel in the Arctic. Moreover, extraction of these resources requires technologies that are unavailable due to the sanctions. The production is projected to peak in the years 2020-2022, and after that the production volumes will start falling at the rate of 10 per cent per year. As a result, by 2035 oil production will have dropped from the current level of 11 million barrels to 6 million barrels per day. This is equivalent to Russia’s own internal needs, which means that its oil exports would fall to zero.

According to Andrey Movchan, an economist at the Carnegie Moscow Centre, this would mean a disaster for the Russian economy. According to data presented by the Russian central bank, oil sales bring in 26 per cent of all foreign revenues. In total, oil and gas exports provide 60 per cent of the state revenues. Oil and gas revenues are directly responsible for about 40 per cent of Russia’s federal budget, but if all indirect revenues were considered (e.g. the imports of goods financed with money derived from oil sales), that share would increase to 84.3 per cent. The Russian government will likely try to fill this budget gap by printing money, closing down channels for the outflow of capital, reducing foreign exchange transactions, and introducing price controls. One example of such processes can be observed in Venezuela, which has lost almost two-thirds of its potential crude oil production capacities in 10 years and now has to purchase oil abroad.

Andrey Movchan believes that the Russian economy will retain some degree of resilience for 6-10 years. After that, urgent and decisive changes will become necessary in order to preserve the integrity and governability of the state.

The strategy pursued by the Russian authorities

Despite such dire forecasts, President Vladimir Putin wants to continue the old economic strategy based on the exports of hydrocarbons. “We are well-informed about what is happening on the global energy markets, but it is clear to everyone that due to economic growth, the demand for energy resources will keep growing unconditionally, both in our country and in the world,” said Mr. Putin.

In October 2018, while discussing the problems of fuel and energy industry at a meeting of the Security Council of the Russian Federation, Mr. Putin stated that Russia’s hydrocarbon production not only brings tangible revenues, but also allows the country to remain one of the main providers of energy security in the world. He admitted, however, that the sanctions were creating certain threats and challenges. During the meeting the Security Council approved a new “Energy Security Doctrine”. The document assumes that a technological “breakthrough” is needed in the oil sector. “We need our own technology, equipment, materials and software,” said Nikolai Patrushev, the Secretary of the Security Council.

In general, the projections of Russian leaders, based on the assumption that the oil sector will continue to grow over the coming decades, may prove to be unrealistic. This view is taken by the experts from the International Energy Agency, as well as the World Energy Council, and the largest French energy company Total SA. According to the estimates of the International Energy Agency, over the next five years the global economy will undergo a renewable energy boom. As early as in the upcoming year, up to 60 per cent of the newly generated electricity in the world will come from renewable sources. Meanwhile, the total capacity of solar and wind power plants will reach 7.6 TW, which is equivalent to all the electricity generated in the United States and the European Union combined.

The hydrocarbon era is coming to an end. The demand for oil will start to decrease within the next 15 years. According to the World Energy Council, by 2030 internal combustion engines will increasingly be the exception rather than the rule, which will inevitably affect the demand for oil. According to Mikhail Krutichin, a partner at RusEnergy, even if these predictions turn out to be wrong, it’s highly doubtful that Russia will be able to maintain its share in the global hydrocarbons market, let alone to increase it.

The experts from the Russian State Commission on Mineral Reserves have unofficially confirmed that the government’s plans to maintain oil production at the level of 525 million tons until 2035 are unrealistic. In their opinion, after 2020 oil production in Russia will start to decline rapidly, by approximately 10 per cent per year.

Russian experts and policymakers are starting to search for solutions that would enable the country to break free from its current dependence on hydrocarbons. Pavel Zavalny, the Chairman of the State Duma Committee on Energy, believes that the exports of energy resources cannot remain the main source of state revenues forever. Therefore, it is necessary to examine all the existing natural resources in Russia as soon as possible and to obtain the maximum possible profits from selling them. “In the current situation we should be trying to extract all of our resources and sell them,” said Zavalny. “This is because no one will need them later. And during this time, while there is still demand for these resources, we have to transform our economy and our state in order to prepare for the future,” he added.

According to Zavalny, it is necessary to squeeze out as much money as possible out of the country’s natural resources, using these funds for the diversification of the economy and the development of other industries. “The stone age did not end because we ran out of stones,”  ironically notes Zavalny. He uses this metaphor to illustrate his opinion on the coming end of the oil era. Looking even further ahead, Zavalny believes that in 40-50 years the main branch of the energy sector will not be renewable energy but nuclear and thermonuclear power.

Wiktor Ross, PhD, is an expert on Russia and former Poland’s ambassador to Armenia and Moldova.

Drilling at the Russian Arctic shelf (Rosneft, Public domain)

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