Today, Russia is the world’s largest oil producer and also one of the leading exporters of the fuel, nearly five million barrels a day. Russia alone accounts for 12% of world oil output. Very recently, it yielded its leading position in natural gas reserves to the United States. Unsurprisingly, Russia’s economy is highly dependent on the oil and gas exports. “More than 40% of Russia’s budget comes from oil-and-gas related duties and taxes”, says Tatiana Mitrova of the Russian Academy of Sciences’ Energy Research Institute. The Russian Federation relies on oil prices to remain at or above $110 dollars per barrel to balance its federal budget. The combination of high production and relatively high world oil prices have propped up both the Soviet and Russian economies for decades, however, such a situation cannot last forever. The country’s “known oil reserves”—primarily located between the Ural Mountains and the Central Siberian Plateau—are enough to sustain current production levels for just 20 years, according to a study in December by the European Bank for Reconstruction and Development (EBRD), vs. 70 years for Saudi Arabia and 90 years for the United Arab Emirates. Many experts have suggested that falling energy prices could prove fatal to Russia’s economy. Until Russians adopt a smart approach to managing its energy sector and start developing new sources for sustainable economic development, the future of Russia’s economy remains highly uncertain.
On October 28th, North American Brent crude oil on the spot-market closed at $108.90 a barrel, reported Reuters. Russia’s Urals oil has been balancing at $107.60 per barrel. Texas WTI traded modestly lower at $96.70. Germany’s BND intelligence agency said it is possible that crude oil prices will fall to about $80 per barrel. In the next three years, “black gold” will cost around $100 per barrel, said experts at Russia’s Ministry for Economic development. With regard to the 2014-2016 budget, the Ministry of Finance estimates rely on $93-95 oil prices. Energy Research Institute at Russian Academy of Sciences predicts that Russian oil exports could fall 25% to 30% after 2015, reducing gross domestic (GDP) product by more than $100 billion.
The price declines anticipated are mostly the result of newly unveiled oil reserves in the United States. The American Petroleum Institute (API) recently summarized the growth in energy fuel reserves in the country. According to the API, the oil reserves in the U.S. have increased by 2.9 million barrels in October alone. According to the EIA report, “since 2008, U.S. petroleum production has increased by 7 quadrillion Btu, with dramatic growth in Texas and North Dakota. Natural gas production has increased by 3 quadrillion Btu over the same period, with much of this growth coming from the eastern United States. Russia and Saudi Arabia each increased their combined hydrocarbon output by about 1 quadrillion Btu over the past five years.” The surplus production in the energy market can be observed from the increasing oil stockpiles in China. As the Chinese information agency Xinhua reports, in September, China increased its oil stockpiles by 1.43%, up to 237.6 million barrels, as compared to August this year. “Steven Pifer, a Russia expert at Brookings Institute and a former U.S. ambassador to Ukraine, says that Gazprom is becoming increasingly wary of the changes taking place around it in the global energy market.”
According to predictions by BP, the U.S. will outpace the world’s largest oil-producers, Russia and Saudi Arabia by the end of 2013. The catalyst for this change is American adoption of new technology enabling the exploitation of non-conventional oil. Thus far, over the past five years, oil outputs from low-permeability shales in the U.S. has increased by 20% and is now 2.1 million barrels a day. The cumulative daily oiloutput in the U.S. in 2012 was 8.9 million barrels. Thanks to horizontal drilling and hydraulic fracturing technology, the U.S. oil production would increase by 46%, equivalent to the entire output of Nigeria, says Daniel Yergin, vice chairman of consulting firm IHS. “Think of it like a non-OPEC country appearing in North Dakota or southern Texas,” Yergin told executives at the St. Petersburg forum in June.
Similar trends have been seen in gas industry. The U.S. last year tapped more natural gas than Russia for the first time since 1982, according to data from the International Energy Agency. America’s unexpected return as an energy superpower with its rapidly developing pipeline-free liquefied natural gas (LNG) market may cause a drastic shift in pricing power from suppliers to consumers. The latter poses a direct threat to Russia’s interests in Europe. Gazprom, the state-owned energy giant, is seemingly losing its grip on the European energy market, where it used to supply about 25% of the gas. According to a recent Bloomberg Business Week interview, “Yergin predicts natural gas, both conventional and liquefied, will be the No. 1 energy source by the end of 2030.” Meanwhile, Russia has only one operational plant with LNG capacity – in Sakhalin. Any potential competition in the energy supplies market would lower prices and thus cause Europe to seriously consider other options to its not-so-friendly gas supplier, Russia. Europe has not forgotten the freezing winters of 2006 and 2009, when Russia tried to gain the upper hand in pricing negotiations with Ukraine by cutting off natural gas exports for days. “Europe is certainly looking for alternatives,” says Pifer.
The European Commission recently approved a list of 250 projects in energy infrastructure, that qualify for funding of €5.85 billion in 2014-2020. None of the projects from Russia got nominated, says the Kommersant, Russian business newspaper. Thus, two major Russian pipeline projects, Nord Stream and South Stream received no grants from Europe. The European Union is switching its policy toward the South, yielding preference for three projects – “the Southern Corridor” (annual supply of 23 billion cubic meters of gas from Turkmenistan and Azerbaijan), the Algeria-Italy pipeline (7.5 billion cubic meters), and the Cyprus-Greece pipeline (8 billion cubic meters). However, Turkmenistan has already agreed to sell significant supplies of gas to China, and the idea to build the pipeline westwards, across the Caspian seabed , has been vociferously opposed by Russia. Thus, only Azerbaijan will be able to supply gas via the Southern Corridor, and its volume will be restricted to 10 billion cubic meters a year. Meanwhile, the European Union’s natural gas production is falling due to the exhaustion of the North Sea reserves. By 2020, production is expected to drop by more than 40 billion cubic meters per year, down to 250 billion cubic meters, according to the International Energy Agency. Europe is going to compensate for this decline by importing large quantities of liquefied natural gas (LNG) and some coal.
Former Russian Energy Minister Igor Yousoufov, currently a member of the board of directors of Gazprom, believes that there is nothing to worry about. Gazprom can satisfy domestic consumption and export needs without turning to shale gas. 28 trillion cubic meters of gas under Gazprom is sufficiently enough to last for decades – to satisfy both the domestic needs of Russia’s economy and to comply with our obligations to our allies and foreign partners. While Russia’s position as a dominant energy player has been undermined by the West, the country needs to at least secure its stance in faster-growing Asian markets. “We are really behind the curve and need to accelerate,” says Ildar Davletshin, an oil and gas analyst with Renaissance Capital.
China – Cooperate and Be Alert
Even though Russia still controls the majority of Central Asia’s energy exports, its strategic position is being overtaken by China. Russia, which for years has tried to exploit the former Soviet republics using exclusive contracts and unfavorable oil and gas prices, has effectively pushed those countries into China’s arms. Kazakhstan and Turkmenistan with their ample energy reserves are now more prone to cooperate with China over their gas supplies. In this context, Russia’s recent $85 billion deal to supply oil to China comes as quite a surprise. Instead of concentrating its own efforts to build strong industry in the remote eastern regions as a counterweight to China’s rapid expansion north- and westward, Russia’s government agreed to jointly construct an oil refinery, in which 49% will be owned by the Chinese and 51% by Russians, and to jointly extract oil in Eastern Siberia. Under the agreement, Russia’s biggest oil producer, Rosneft, will supply an additional 70 million barrels of crude oil a year to China for 10 years. The Chinese government, for its part, is eager to obtain Russian supplies, as it fears a potential security weakness coming from the current China’s reliance on crude oil supplies from unstable Persian Gulf. In June, the two countries signed an agreement for Russia to supply 2.5 billion barrels of oil valued at an estimated $270 billion to China over the next 25 years. Russia’s second-biggest natural gas producer, Novatek, also announced a deal to supply liquefied natural gas (LNG) to China’s largest oil and gas company, CNPC, for the next 15 years. Most importantly, the terms of the deal, including pricing, are being kept secret.
At first glance, it might look like Russia has a giant client who is eager to consume its oil and gas and is willing to pay hard currency, lessening its reliance on exports to Europe. However, if we look at the structure of exports from Russia to China in 2012, we will see that the share of technology and machinery was only 0.7%, with the rest being mineral resources (such as hydrocarbons – around 69%). In hindsight, the first significant agreement between Rosneft, Transneft and CNPC to supply 300 million tons of oil until 2030 ended in scandal. The two parties each calculated the transportation rates differently. The potential loss for Russia’s Rosneft and Transneft could have amounted to $16.9 billion and $11.3 billion, respectively. The parties could not settle the dispute for over a year, during which CNPC underpaid for the Russian oil. In the end, the Russian companies agreed on an intra-state discount of $1.50 per barrel. Thus, given the aggregate volume of Russian oil supplies to China at the rate of 760 million tons per annum until 2038, Beijing could technically save up to 56.8 billion.
So, for now, the both parties seem to be in a win-win situation: China secured supplies of oil (lessening a reliance on maritime routes the U.S. could easily blockade) and Russia has found an offset to the new reality in Western Europe (including “gas conflicts” with Belarus and Ukraine). However, Russian government should not get too excited about the new contracts with China and millions of dollars they got from China in loans. Given the persistent presence of Chinese business in Central Asia and its further expansion to the north and west, the Russians should look two or three decades ahead and think where the current dynamics could ultimately bring the country. One of the possible perspectives is that Russia will gradually yield its economic sovereignty to China’s ambitions, turning into its mineral resource fringe in the East and into an object of Chinese expansion overall. The Chinese have already started exploring Russian market. The largest construction corporation, China State Construction Engineering Corporation (CSCEC), won a tender to build 1.5 million square meters of housing in the Far Eastern city Khabarovsk. China massively invests both human and economic capital in Russia’s Far East, and the Russian government endorses such investments since it itself has no available funds for the region’s development. As Sergey Sanakoyev, responsible secretary at the Russian-Chinese chamber for assistance in trade of machinery and innovations, says “as we can see from the current debate around the sources for the Far Eastern region development, there is no 5 billion ruble available in the budget as it requires. This means that the budget funding is going to be less while the remaining expenses could be covered by private funds. The only place the state could borrow money is Asia”. For all its profitability, such a close cooperation with China could result for Russia in both financial dependence and total loss of control over the remote territories.
Russia’s Oil Industry is in Decline
Given that Russia views its natural gas and oil as the main gears for its economic development, it should probably ensure that its energy industry infrastructure should always be modern so that its resources could be most efficiently utilized. However, the reality is the opposite. “The industry’s traditional core, the giant West Siberian fields inherited from the Soviet Union, has been in decline since 2007.” The reason that oil production still goes upward (by about 1.6% in 2012 and 1.4% in 2013) is that Russia continues infill drilling in the older fields and developing new sites on Russia’s periphery. The domestic energy market in Russia appears to be scarce. As Maxim Barskiy, a joint holder of an independent company Matra, says “almost all more or less attractive assets have gone over the past few years, whereas the Soviet reserves have been running short, yet the new sites are not being developed”. He says that there are only two or three assets in the market that could be of interest to an investor.
Russia has not started extracting oil from low-permeability formations as the preparations are still in progress. Large oil reserves, about 22 billion barrels, are in the Bazhenov shale in Western Siberia. Rosneft holds a license for 50% of the reserves. In 2012, Rosneft started cooperating with ExxonMobil, using its technology and experience.
At a high level, Russia’s oil and gas industry is its main resource, yet its infrastructure remains in dire condition and needs to be renovated, in addition, new sites and technology should be exploited. With the notable exception of the military and defense sector, most other areas of the Russian economy have been poorly maintained and are in need of modernization. Worse, few new industries have grown at all. Such a situation is dangerous for the country’s economy. Oksana Dmitrieva, economist, deputy chair of the Just Russia party (Spravedlivaya Rossiya), says “if the Federal budget’s zero growth is balanced by the oil export revenues, regional budgets do not get “oil money”. Hence, “the current stagnation causes a huge budget hole of $12.5 billion in regional budgets. The Federal budget has no solutions to how to make up this regional budget deficit yet,” says Oksana.
Russia needs to innovate and modernize
Since the country’s economy is still predominantly commodity-driven, Russia’s oil-rentier state is in urgent need of dramatic modernization. The most sustainable and safe new oil sites should be prioritized in terms of investments; oil development in climate-impacted and geologically more complex zones demand more knowledge and sophistication. The government should therefore channel investments into research and technology, including partnerships with other energy-rich states, subsidize the development of energy efficient and less carbon-intensive fuels. Russia could start exploring offshore Arctic fields and develop unconventional sources like oil sands, shales and deep marine shelves. According to some estimates, if Russia takes this path, it will potentially be able to extract 1.4 million barrels of shale oil per day by 2030.
By and large, the next generation of Russian oil will have to be extracted from places that are colder, deeper, less accessible, and more complex. To be able to tackle these challenges, Russia should stimulate the innovations in the industry today. Alas, innovation is a long-term business that rarely brings quick profits, and often results in failures that never pay back. Russian oil oligarchs show little incentive to invest their oil income back into the modernization of the oil industry. This is a notorious example of short-time preference whereby they would rather invest in offshore ventures, foreign real estate, bonds and gold, etc., all things that would bring relatively quick benefits. “The major demand for innovations will most likely take place when the oil prices are no longer high,” said Russia’s vice-president Igor Shouvalov at the World Economic Forum in Moscow in October 2013. Thus, consistently high energy prices have allowed the country to survive but not to develop. In fact, high commodity prices have created stagnation in Russia’s economy: by propping up the ruble, they have rendered Russia’s non-oil exports less competitive and hampered increases in productivity. triggered inflation. In other words, high oil prices have held the country off the path toward advancement and innovation.
Another mechanism to encourage Russian shale oil activity is a more favorable taxation system. In September 2013, the government introduced long-awaited tax breaks. As Platts, McGraw Hill Financial reports, “the stimulus gives oil producers a reduction of between 20% and 100% in the mineral extraction tax (MET) rate, depending on reservoir permeability and layer thickness. In particular, crude produced from the most promising Bazhenov oil play in West Siberia will enjoy an MET rate of zero. Other shale and more broadly tight oil reserves will see tax reductions at between 20% and 80% from the standard rate.”
In the long run, Russia’s economy should stop being dependent on favorable oil prices. Hydrocarbons should gradually become a back-up plan. Russia, as well as all other oil-producing nations, should start thinking about a post-oil economy and diversify its economy into high-tech industries (e.g. renewable energy, semiconductors, chemicals, and aerospace). Innovation is important not only in the energy sector but also in manufacturing where Russia lags far behind the countries with developed economies. Investment in advanced manufacturing and increasing labor productivity would render Russia’s economy more sustainable and competitive. Siberia, besides its oil and gas reserves, is rich in other natural resources (timberland, fresh water reserves, etc.) that could be practically utilized if efficiently organized and managed. Thus, Russia has large potential for economic growth based, not necessarily on its hydrocarbons, but other forms of capital (human, intellectual, land) in which Russia is rich.