Russian oil and gas: headed for long-term decline?

Boasting a quarter of the planet’s gas reserves and more than 5 per cent of its crude oil, Russia’s economy has long been dominated by the energy sector. As the country’s isolation intensifies following the invasion of Ukraine, the question now is what next for its most important industry?

Key foreign partners BP, Shell and ExxonMobil have made exit plans, international oilfield service companies have promised no more investment and scores of buyers have started to shun Russian crude.

Gas has continued to flow to Europe and oil production, though down, has not collapsed. But even if Russia’s own energy companies are able to sustain operations, a shrinking market for exports, reduced access to international expertise and the need to redirect billions of dollars of infrastructure investment toward Asia threaten to usher in a period of long-term decline.

“It could still grow if everything worked wonderfully, but it doesn’t look like that’s on the cards for the foreseeable future,” said Michael Moynihan, an expert on Russia’s upstream oil and gas sector at consultancy Wood Mackenzie.

Russia’s biggest energy companies trace their origins to the early 1990s and the collapse of the Soviet Union, when the country’s oil and gas reserves, then the sole property of the state, were divided up.

State-owned Rosneft, formed in 1993, has benefited from the full backing of the Kremlin as it snapped up competitors’ assets to become the country’s largest oil producer responsible for 40 per cent of crude output.

The second-biggest, Lukoil, which last month agreed to buy Shell’s retail and lubricants business in Russia, was formed from three state-owned businesses in 1991 by Vagit Alekperov when he was still a deputy minister.

Gazprom was privatised in 1992 and towers over the global gas market, producing 540bn cubic metres of the fuel last year — more than BP, Shell, Chevron, ExxonMobil and Saudi Aramco combined.

While Rosneft and Gazprom have joint ventures with the likes of BP and Shell to develop new assets in the far north and far east of the country, they and Lukoil have tended to operate their main producing fields in western Siberia and the Urals-Volga region with little foreign support.

“The big Russian players are more than capable of maintaining production,” said Moynihan. “They have a vast portfolio of oilfields and they can bring on new production.”

Russian oil and gas companies generally entered the crisis in “pretty good financial health” with manageable debt levels and low production costs, according to Eric Mielke, head of Wood Mackenzie’s corporate research team. As a result, even with Russia’s flagship Urals crude trading at a $20 to $30 discount to Brent, Russian producers were still generating “significant” cash flow, he said.

Rosneft reported its best-ever net income in 2021 of $11.7bn, while Gazprom, buoyed by record gas prices, hit a record $29bn in net income.

As they have grown, Rosneft and Gazprom have also invested heavily in the development of the domestic oil and gas industry’s services sector, particularly since an earlier round of European and US sanctions targeted the Russian oil industry in 2014 following Moscow’s annexation of Crimea. Rosneft’s in-house oilfield services company had 344 drilling rigs by the end of 2020, according to its annual report.

What the domestic industry lacks is the ability to do some of the more sophisticated technical analysis required to develop complex new oil reservoirs, particularly in remote offshore locations such as the Barents Sea.

“Russian service companies can replicate a lot of the equipment but they can’t really replicate the interpretation software,” said James Henderson, a Russia expert at the Oxford Institute for Energy Studies who is writing a book on the history of Rosneft.

As a result, projects such as Rosneft’s Vostok Oil — a vast Arctic project backed by commodity traders Trafigura and Vitol — were now less likely to advance, he said.

Alekperov, who stepped down as president of Lukoil last month after he was placed under sanctions by the UK, described the cessation of new investment by the largest international oilfield service companies as a “big blow”.

But he brushed off concerns about the sector’s future. “[Russia] has well-developed technologies of its own,” he told the Financial Times. “Of course, there will be some shifts in timeframes, but overall, the Russian oil industry has the potential to develop as normal.” Rosneft and Gazprom did not respond to requests for comment.

Despite Alekperov’s confidence, the prospects for the industry depend less on companies’ ability to continue to produce and more on whether there remains a market for their product, say analysts.

The EU, which received more than half of Russia’s crude exports in 2021, has agreed to cease seaborne imports of the country’s oil by the end of the year and hopes to phase out gas by 2027.

A growing boycott of Russian exports since the invasion has already started to weigh on oil output. Production averaged 10.05mn barrels a day in April, down from 11.01mn b/d in March, according to OilX, a data provider that uses government statistics and satellite imaging to measure activity at oilfields.

Anton Siluanov, Russia’s finance minister, warned in April that Russia’s oil production might fall 17 per cent this year, which would mean a drop of about 2mn b/d. Deputy prime minister Alexander Novak has since presented a more optimistic outlook, telling Russian media that production increased in May by between 200,000b/d and 300,000b/d and that he expected a further recovery in June.

The hope in the Russian oil industry is that supply previously sent to Europe can be diverted elsewhere. “If you remove Russia from the European market, this crude will simply turn up in India, China and other countries,” Konstantin Simonov, head of Russia’s national energy security fund, told the FT.

India has significantly ramped up imports of seaborne Russian crude since the start of the war and China is expected to import more as its large cities emerge from the most recent round of Covid-19 lockdowns.

But despite assumptions that fleeing western companies might find willing Chinese buyers for their Russian assets, no deals have been done.

Moynihan at Wood Mackenzie suggested that Chinese companies might feel they no longer needed to invest in Russian projects to secure offtake given there were likely to be fewer competitors for Russian crude in the future. “Is it necessary for Chinese players to go in when they know that they are going to buy the crude anyway?” he asked.

But redirecting energy exports from Europe to Asia will be complicated. There is insufficient shipping capacity for all exports to flow by sea and seaborne traffic will be further constrained if the EU and UK implement a ban on insuring vessels carrying Russian crude.

“It is not impossible for Russia to put in place measures to swing production supply towards China but it is going to cost them,” said Moynihan, adding that there would also be little incentive for China to help carry the cost of new pipeline infrastructure, knowing Russia had few other options.

The situation will be particularly difficult for Gazprom, given almost all its gas infrastructure points toward Europe and there is no pipeline connecting the main gas-producing regions in the west of the country to eastern Russia and on to China.

Russia in February agreed a 30-year contract to supply gas to China via a 2,600km pipeline connecting gasfields in the Yamal peninsula, which at present supply Europe, to China via Mongolia, but it still needs to be built.

Alternatively, Gazprom could aim to convert more production into liquefied natural gas and transport it by sea. But Russia’s ambitions to secure 20 per cent of the global LNG output by expanding annual output from 30mn tonnes to at least 120mn tonnes by 2035 have been the hardest hit.

European sanctions prohibit the delivery of goods and technologies required for gas liquefaction, on which projects under development, including Novatek’s $21bn Arctic LNG 2 and Gazprom’s Baltic LNG, depend.

Developing the local expertise necessary to replace European LNG technology would take years, said Oxford’s Henderson. “The future of Russia’s LNG strategy is in serious doubt.”