Ensuring short and long-term future of Russian oil output

In March 2016, Russian oil production hit a post-Soviet high of 10.91 million barrels per day (MBPD). This represented the pinnacle of a decade-long growth in productivity and production has remained close to that level since then. Based on such a strong profile, it might initially appear the country’s oil sector suffers no internal flaws nor external challenges. However, that perception couldn’t be further from the truth.

(Photo credit: Wikimedia)

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Ensuring short and long-term future of Russian oil output

In March 2016, Russian oil production hit a post-Soviet high of 10.91 million barrels per day (MBPD)[1]. This represented the pinnacle of a decade-long growth in productivity and production has remained close to that level since then. Based on such a strong profile, it might initially appear the country’s oil sector suffers no internal flaws nor external challenges. However, that perception couldn’t be further from the truth. The decline in production in old western Siberian fields, which account for over three quarters of total Russian oil output, is expected to double from 1.5% to 3% in 2016[2]. Regional operators such as Rosneft and Lukoil have already reported corresponding declines from their mature production centers[3], and this downward trend is expected to further accelerate if no countermeasures are introduced promptly and effectively.

The chances of remedying this situation are, however, strongly undermined by two main factors. First, a 70% drop in post-2014 oil prices and subsequent cuts in capital expenditures limit operators’ ability to apply expensive enhanced oil recovery (EOR) techniques to reverse the continuous declining rates. Second, the prospects of propping up oil production by promoting exploration and production (E&P) activities in yet unexplored regions have been hurt by Western sanctions put in place to punish Moscow for annexing Crimea in 2014 and supporting anti-government rebels in eastern Ukraine. The measures include a ban on the delivery of foreign technical and financial support in the areas of shale, deep-water and Arctic exploration and have forced companies such as ExxonMobil and Shell to postpone their joint ventures with Russian counterparts in the Arctic shelf and the Far East. Considering that the Russian Ministry of Natural Resources estimates that as much as $100 billion and highly advanced technological know-how will be necessary to render unexplored resources recoverable, these sanctions have been particularly damaging to Russian hopes of gradually introducing new centers of production[4].

According to the International Energy Agency (IEA), these challenges pose significant danger to the Russian oil industry. The country’s ability to maintain its output above 10 MBPD in the years to come will depend on how the Kremlin addresses the declining oil production, the complexity of which is further exacerbated by low oil prices and limited access to foreign capital[5]. If the current situation continues unaltered, the IEA forecasts a decline of around 500,000 BPD in Russian output by 2020, which might later accelerate to an even greater pace and reach around 1.5 MBPD by the mid-2020s[6].

Are there consequences for the EU?

Although Russia is the leading oil exporter to the EU (providing 30 % of its oil supplies), the expected decline in Russian oil production should not really impact the security of the EU oil supply due to several factors. European oil demand has long remained flat and is expected to drop with the future transition towards a low-carbon economy. Combined with the fact that the global oil market is expected to remain well-supplied until 2020, this should ensure that there will be no oil supply threat but also that the continent will not suffer from a significant uptick in petroleum prices. Furthermore, the return of Iranian oil to the market will create fiercer competition among the EU’s traditional suppliers. This should compensate for any loss in Russian crude while putting a ceiling on any potential price rise. Finally, although the global market is expected to return to its pre-2014 position of a ‘sellers’ market’ by the mid-2020s, the negative impact of any potential decline in Russian deliveries should still be limited at that time due to the growing decarbonisation of the EU’s economy, which is progressively decreasing the crude demand.

The only complication that might arise is if Russia fails to make itself an attractive destination for international oil companies, as this would have a negative impact on the future profitability of European majors such as Total, BP and ENI. With the strength of their shares dependent on the amount of reserves in their possession, it will be very important for these companies to take advantage of the huge unexplored resources that lay present in Russian Arctic, shale oil areas and the Far East.

What are the options for Russia?

In order to overcome the gloomy outlook for its oil output, Moscow will need to implement a combination of short-to-medium and long-term strategies.

In terms of the short-to-medium-term solutions, a greater focus will need to be placed on operational fields that are still in early stages of production and have yet to reach their full capacity. Accordingly, united governmental and corporate efforts will have to ensure a timely realisation of respective fields’ peak productivity. This should help offset the expected decline from mature fields by bringing around 500,000 BPD to the market by the decade’s end. The primary targets of such an approach must be projects such as Gazpromneft’s Prirazlomnoye and Novy Port offshore fields in the Arctic, both of which sold their first oil in 2013 and have the potential to reach outputs of around 100,000 BPD[7] and 170,000 BPD[8] respectively by 2020. Bashneft and Lukoil also operate newly-commenced fields in the Timan Pechora region that can attain a peak output of 100,000 BPD by 2020[9], while Severenergia can add an additional volume of 160,000 BPD by 2019 from its Samburgskoye license[10].

Beyond these operational fields with significant productive capacity, there are other onshore projects that have already received considerable financial input and thus are expected to gradually come on-stream despite current low oil prices. This category includes Lukoil’s Imilorskoye, Novatek’s Yarudeiskoye and Surgutneftegas’ Spielman fields, which together are scheduled to introduce more than 180,000 BPD by the decade’s end[11]. The combination of these and similar projects can provide a total peak output of 1.8 MBPD by 2020, demonstrating a high available capacity from fields identified as ready for production[12].

In order to implement these measures, both governmental efforts (tax breaks and provision of funds from the National Welfare Fund) and corporate navigation (securing funds through the domestic market and prepayment agreements) will be essential to overcome the current cash-strapped environment and ensure that incremental production appears in a timely manner to compensate for production losses from mature fields. The success of this strategy will be crucial if Moscow wants to maintain production at its current rate until the early 2020s, as well as to provide itself with more time to appropriately plan for the implementation of a long-term approach[13].

In order to guarantee the industry’s long-term future and profitability, Russian legislators will have to transform the nature of the country’s upstream fiscal regime. In its present form, the tax regime in Russia revolves around export duties on crude oil and mineral extraction tax (MET). The high rates and regressive nature of this tax make it difficult for operating companies to profitably apply enhanced oil recovery (EOR) and pursue challenging exploration activities in unexplored fields. More specifically, the current framework prolongs the period required to recuperate sunk investment and as such does not allow companies to benefit from a shorter payback period. Furthermore, the fact that the MET is calculated on the basis of ‘revenue’ (income without cost-deduction), makes the existing regime insensitive to different extraction costs and the varying complexity of fields. This strongly undermines the commercial viability of geologically challenging prospects and makes high oil prices essential to secure a suitable rate of return. Ernst & Young reports that 80% of Russia’s proven reserves, all of which are located in fields that have already been developed, are made unviable for exploitation due to these deficiencies in the tax framework[14]. As for resources located in yet undeveloped areas, official calculations estimate that the current upstream fiscal regime prevents over 70 billion barrels of conventional and unconventional oil to be economically exploited[15].

To remove these obstacles and make the country’s abundant resource potential more accessible, it would be necessary to base the calculation of MET on ‘profit’ (income with cost-deduction), instead of ‘revenue’. The advantage would be to introduce a higher level of progressivity in the system, making the fiscal regime more cost-aware of the different stages of a field development process. Thus, the tax burden on project would be lowered during the capital-intensive stage of initial development, increased after the start of production and would go back down in the last stage to make the EOR economically viable[16].

Despite its obvious advantages, such a proposition has its fair share of detractors, especially in the Ministry of Finance where it has long been decried as having the potential to cause greater tax evasion and decrease governmental revenues. Nevertheless, the Ministry of Energy has recently expressed its interest and proposed to experiment on several fields, where the benefits of a ‘profit’-based MET will be carefully evaluated. If such a reform is implemented, it would represent a highly positive step towards more widespread transformation of the fiscal regime. The long-term sustainability of Russian oil production will be determined by the pursuit of such initiatives.

[1] Reuters, “Russian oil output highest in 30 years ahead of Doha meeting”, 2016.

[2]International Energy Agency, “Medium-term oil market report”, 2016, p. 53

[3]Fitch Ratings, “Russia’s brownfield oil output faces further declines”, 2015.

[4]Interfax, “Boosting tight oil production in W. Siberia to 1mmbpd by 2025 to cost $100bn”, 2015

[5]International Energy Agency, “World Energy Outlook 2013”, 2013, p.482.

[6]International Energy Agency, “Medium-term oil market report”, 2016, p.52

[7]Reuters,“Russia ships first oil from disputed offshore Arctic platform”, 2014

[8] J. Henderson, “Key determinants for the future of Russian oil production and exports”, in Oxford Institute of Energy Studies (OIES), 2015, p.15

[9]Rigzone,“Lukoil, Bashneft start oil production at Trebs/Titov fields”, 2013

[10]J. Henderson, op. cit. 8, p.15

[11]Ibidem, p.17

[12]Ibidem, p.16

[13]Ibidem, p.19

[14]Ernst & Young, “Enhanced oil recovery methods in Russia: time is of the essence”, 2013, p.9.

[15] D. Graeber, “Siberian oil output to be supported by tax overhaul”, on upi.com, 2015.

[16]Lukoil, “Global trends in oil and gas market to 2025”, 2013, p.52.