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SAINT PETERSBURG – As Russia emerges tentatively from the darkest hours of its Covid-19 outbreak, the pandemic’s effect on global energy demand and a confluence of other factors may permanently impair the country’s chief source of vitality: the oil and gas industry.
The oil market crisis, where prices have recently plumbed historic lows, has inflicted a heavy blow on the Russian economy, compounding the negative impacts of lockdown measures and raising bigger questions about the country’s dependence on fuel exports for its future prosperity.
Revenues from oil and gas contribute around one-third of Russia’s state budget. The collapse in global oil prices has strained national finances at a time of extreme economic vulnerability caused by the pandemic.
On the fiscal surface, Russia would seem relatively well-positioned to survive the twin health and economic crises, thanks to its rich stockpile of cash and gold reserves and relatively low national debt.
But below the surface, a seismic global transition away from fossil fuels poses a far bigger threat to the country’s future prosperity and geopolitical influence. And that transition has arguably been accelerated by the coronavirus pandemic.
The per-barrel price of Russia’s Urals oil was pushed to a 20-year low on April 1, which redounded into a 20% decline in Russia’s gross domestic product (GDP) year on year, as Covid-19 quarantines drove a collapse in global demand at a time of massive oversupply.
The price crash drove Russia, Saudi Arabia and other oil-exporting OPEC+ countries into an unprecedented preliminary deal, which saw their collective output reduced by 9.7 million barrels per day (bpd) in May and June period. The agreement has since been extended for another month through to July but no agreement has been reached beyond then.
It represented the first time Russia agreed to cut production on such a large scale, representing about a quarter of the cartel’s total agreed to output reductions. The record cuts have already put extraordinary stress on Russia’s extraction facilities that have exposed wider weaknesses in the industry’s structure.
Unlike Saudi Arabia, the world’s largest oil exporter which can fulfill the agreement’s obligations by cutting production at a few large wells, Russia has needed to impose cuts across a larger number of small wells that dot its vast territory.
That wider-reaching shutdown has for logistical reasons alone come at a higher cost. As many of Russia’s oil production facilities are located in the Arctic region, where the process of regulating production output is significantly complicated by permafrost.
“Due to their lack of flexibility, it will take around four years for Russian companies to restore production to previous levels,” claims Mikhail Krutikhin, partner at independent Moscow-based consulting firm Rus-Energy.
Dmitry Marinchenko, lead analyst for oil and gas at Fitch Ratings, is more sanguine about the industry’s outlook.
“Considering that production cuts will be tapered gradually, most Russian companies will be able to go back to previous production levels without major problems,” he said.
Russian oil companies are arguably among the best positioned to survive a prolonged price crisis among OPEC+ members, given their relatively low operating costs and access to government-granted tax exemptions during times of low global energy prices.
“Russian and Middle East companies will feel the stress caused by low prices much less than their American and European competitors,” Marinchenko told Asia Times. “Even with prices at $15 dollars per barrel, Russian companies can guarantee a minimum cash flow.”
The OPEC+ deal has so far produced the desired results. Russian oil prices rose to over $40 dollar per barrel in early June, and most analysts agree that demand is sufficient enough to prevent oil storage facilities from filling up and prices falling back to below breakeven points.
But as long as fears of a second wave remain, oil prices aren’t expected to return to pre-crisis levels any time soon. A price collapse could easily occur again if major producers are not able to come to a longer-term production agreement, opening the door to a new round of price wars.
According to estimates from Russian rating agency NKR, unless a new agreement on production cuts can be reached or more countries join the deal, the oil sector’s price crisis could continue for over the next five years.
The Kremlin’s natural gas exports face even stiffer challenges. Last year, Russia’s Energy Ministry estimated national gas resources were worth $178.6 billion, a rich bounty of the super-cooled fuel.
Together with oil ($626.4 billion), coal ($31 billion) and other mineral resources ($26.8 billion), the resources made up roughly 60% of Russian GDP in 2017, the latest available statistics show.
Even if the natural gas sector hasn’t been as hard hit as oil by lockdown measures, analysts expect it to see its biggest decline in market history, with global demand expected to fall by 4% in 2020, according to the International Energy Agency.
Spot gas prices in Europe already touched historic lows in May at $26.4 per thousand cubic meters. As a result, prices in European gas importing hubs are now lower than in the Russian domestic market. For giant Gazprom, Russia’s monopolist gas exporter, shipping the fuel to Europe is now less profitable than selling it at home.
“Considering the export taxes and the costs of transportation, exporting gas to Europe is now unprofitable for Gazprom,” said Marcel Salikhov, president of the Institute for Energy and Finance think tank.
Lower gas prices have been driven by a number of factors that preceded the Covid-19 pandemic.
The 2020 winter was the warmest since 1979 according to the EU Copernicus Climate Change Service. As a consequence, gas demand in Europe in January and February was already 20% lower than the corresponding period in 2019.
Because of the further demand drop caused by lockdown measures, Europe’s gas storage facilities have quickly filled up – around 72% of their capacity is currently being used, according to Gas Storage Europe, the association representing the interests of European gas storage operators. This is an over 10% increase compared to the same period last year.
Gazprom, moreover, has faced increasingly fierce competition on the European gas market, mainly from Qatar and US liquefied natural gas (LNG). Since 2018, American LNG exports to Europe have increased by 181%, making the US into Europe’s third-largest supplier.
That same year, Russia’s privately owned Novatek responded by launching the Yamal LNG gas plant, becoming the region’s largest LNG supplier. With an annual production volume of 16,5 million tons, Novatek accounts for around 5% of global LNG markets.
In response to falling global prices, Gazprom reduced its export volumes by 21.4% in the first quarter of 2020 compared to last year. However, unless other competitors also agree to cut their outputs, that alone won’t be enough to stabilize prices, say industry watchers.
Indeed, some analysts believe European gas markets might soon become the theater of a gas price war, similar to the row that pitted Russian against Saudi oil companies back in April.
“Unlike the oil markets with OPEC+, there is no international framework capable of bringing the main gas exporters to the negotiation table,” points out Sergey Kapitonov, gas analyst at the Energy Center of the Moscow School of Management Skolkovo.
“If the main gas exporters don’t agree on production cuts, there is a significant chance that gas prices will go negative.”
As part of a “Pivot to the East” strategy aimed at reducing its dependence on European exports, Gazprom launched Power of Siberia, a 3,000-kilometer-long pipeline connecting Siberian gas fields to China’s northeastern border in December last year.
According to the contract, Russia has committed to deliver up to 38 billion cubic meters (bcm) per year to China until 2030. The gas will be delivered to China’s northeastern region, easing its historical dependence on coal.
From there, the fuel will be transported all the way to Beijing and destinations further south.
However, given that construction of the pipeline is in its early stages, the project won’t be able to compensate for shrinking export revenues from Europe in the short term. Power of Siberia will begin operating at full capacity only in 2025; this year it is expected to deliver only 4-5 bcm to China.
“That is around 40 times less than the volumes exported to Europe last year,” Kapitonov pointed out. As such, Europe will remain Gazprom’s core market for the foreseeable future.
Reduced energy exports in 2020, including gas, oil and coal, will result in a 30% reduction in state revenues and anywhere between a 5-13% drop in GDP, depending on how fast global demand recovers, depending on Skolkovo Energy Center, a consultancy.
That said, Russia looks fairly well-positioned to face the crisis, given its relatively low level of public debt and large gold and cash reserves. In recent years, the country has taken advantage of high oil prices to establish a $157 billion National Wealth Fund.
Those funds are now being deployed to help meet state budget shortfalls. But at the rate it is currently being utilized for crisis management, some analysts predict the fund could dry up by the end of 2021.
To prevent the national fund from depleting too quickly, Finance Minister Anton Siluanov has said that state borrowing will double this year, possibly reaching $64 billion.
There is arguably, however, an even darker cloud over the far horizon. According to some experts, the global transition from hydrocarbons towards renewables is likely to accelerate depending on how protracted the coronavirus crisis becomes.
Most analysts agree that oil demand is expected to peak between 2035 and 2040, though some contend that the Covid-19 pandemic might accelerate the process of shifting to renewables, as evidenced by the European Union’s push for a low-carbon recovery plan.
“These decarbonization initiatives create uncertainty about how much hydrocarbon demand there will be 10 years from now,” said Anton Usov, head of Oil and Gas at KPMG Global.
At the same time, global investors are increasingly put off by the price and demand instability of oil markets. “The oil and gas industry is increasingly perceived as toxic by some investors,” added Usov.
Despite these glaring signals, Russia has been hesitant to reduce its dependence on fossil fuel exports, which still play a crucial role in its energy strategy through 2035.
“Despite much official talk about the need for diversification, Russia’s dependency from oil and gas has barely decreased in the past 20 years,” pointed out Salikhov.
According to most experts, Russia still doesn’t have a precise strategy to diversify its economy. On the contrary, according to Russia’s doctrine on energy security, the global transition towards renewables is viewed as an “external challenge”, rather than an opportunity.
But if Russia’s energy policies fail to adapt to the upcoming transition, Moscow will face a prolonged stagnation with growth limited to 0.8% over the next twenty years, according to analysts at the Skolkovo Energy Center.
The downsides will arguably be more than economic but also geopolitical as Russia will gradually lose influence over countries dependent upon its energy exports.
“As the global demand for hydrocarbons will gradually decrease, the political weight of its major exporters will be reduced too”, said Marinchenko. That process seems to have already started.
“Europe is already less dependent on Gazprom’s gas than it was a few years ago,” points out Marinchenko, referring to the EU’s growing gas import diversification.
Earlier this year, Russian oil giant Rosneft sold all of its assets in Venezuelan oil companies amidst languishing oil prices. That move, analysts say, represents a step back from Russia’s earlier attempts to establish a geopolitical foothold in South America.
“In the current crisis conditions, oil and gas projects aimed at advancing Russia’s geopolitical ambitions will have to wait,” Salikhov said.