Corporate Debt Review

Moscow and Riyadh Move Closer to Accord

An Expanding Partnership

Sources at both the Russian Ministry of Energy (Minenergo) and Saudi oil giant Aramco confirm that the two countries are in substantive discussions over an energy accord that could alter global energy dynamics.

I have been tracking this one for the past six weeks. It involves a Saudi commitment to providing both finance for Russian far northern (Arctic and Yamal) natural gas projects and an agreement on non-competitive access to the rapidly expanding Asian market.

In return, the Kremlin will sign on to some longer-term (and perhaps deeper) cuts in crude oil exports along with support for Riyadh increasing domestic unconventional gas and oil production.

I have also been advised by one Russian that Moscow is interested in acquiring a non-market-priced minority stake in Aramco. The source further indicates this transaction would either be as part of the upcoming 5% Aramco IPO or as a side deal, perhaps involving a swap of a similar portion of shares in Russian state oil leader Rosneft.

As of this writing, no adequately placed Saudi source will either confirm or deny the current negotiations involve an Aramco stake or swap. However, I do have confirmation that talks have begun on swapping export contracts for oil consignments.

Limited Options

There are a few interrelated elements in this rapidly unfolding development.

Russian interests involve the following.

Natural gas behemoth Gazprom is facing an accelerated decline in traditional Western Siberian field production. This has been the primary source for exports and, as a result, revenues.

But the likely fall in extractions is expected to reach 8% annually by 2020, just about matching crude oil declines from the same basin. In response, Moscow has known for some time that it must move north above the Arctic Circle, out onto the continental shelf, and into Eastern Siberia.

Even restricting Russian access to those areas widely acknowledged to be within its economic control (Moscow has been claiming it controls the Arctic region all the way to the North Pole and has filed such claims before the UN commission), the latest US Geological Survey estimates place up to 80% of the hydrocarbons within Russian offshore control.

But extraction requires significant capital outlay and access to very expensive technical expertise. Moscow has christened and deployed the first ice-resistant production platform. However, the cost of production will be quite high.

There are also significant deposits on the shelf and in Eastern Siberia. Shelf projects have begun but require additional commitments from international majors like ExxonMobil, a step less likely given the expanding US sanctions. When it comes to pushing further into Siberia, the cost of introducing nonexistent physical, power, and operational infrastructure is quite high.

There are also additional strata below current production horizons in Western Siberia. But these tend to be unconventional tight gas and heavy oil. The usual steam methods for extraction don’t work here. They merely collapse the surrounding tundra.

Rosneft has been gaining valuable technical familiarity at almost two dozen heavy oil projects outside Russia. These minority positions are part of its multiyear agreement with ExxonMobil. That took place when Rex Tillerson was still Exxon CEO. But the technical transfers prized by Moscow are under pressure in light of the new sanctions overwhelmingly passed by Congress and signed by President Trump.

This is the most important point to remember from all of this. The Russian central budget remains heavily dependent on revenues obtained from the export of natural gas and crude oil. When it comes to Gazprom specifically, the company needs to increase exports of gas beyond the expected decline in Western Siberian production.

Yet, increasing alternative sourcing, primarily consisting of competing liquefied natural gas (LNG) into Western Europe and Asia, is forcing Gazprom to discount prices and revise its established long-term, take or pay, crude oil price-based contracts.

This has already become a serious problem for the Kremlin.

And that makes access to the Asian market even more crucial for both oil and natural gas. Therein lies the other main Russian objective.

Chinese Checkers

When OPEC first decided in late November 2014 to hold the line on market position rather than price, much attention was directed toward competing with upstart US unconventional (shale and tight) oil production. For the Saudis, on the other hand, a main object was also to cut Russian exports into Asia by driving down the “premium” (what an importer would traditionally pay above rates for exports to Europe or the Gulf Coast of America) to prices below those allowing Moscow to expand volume to Asia.

By the end of 2012, Russia had completed the East Siberia-Pacific Ocean (ESPO) export pipeline. Exports are moving from the Pacific port at Kozmino and into northwestern China via a spur line south from Skovorodino in Siberia. By the first quarter of 2017, some 70% of exports from Kozmino by tanker were also moving to China.

Russian intentions are to establish an oil benchmark (also called ESPO) that would trade independently from its existing Urals Export Blend grade. ESPO not only has a lower sulfur content than Urals Export (thereby allowing it to sell at a higher price); it is also sweeter than Saudi export moving into Asia.

And that’s what drew the Saudi concern. Asia is the driving powerhouse of global demand. Every study indicates it will be the focus for at least the next three decades. The combat over market share happens there.

The end result of the OPEC November 2014 action was to close the door on effective Russian exports to Asia, solidifying the Saudi hold on that market. Other cartel members, including Iran and Kuwait, also benefitted from the move.

In the case of Iranian exports, India has been the primary Asian target, since the largest refineries there are designed to process Iranian crude.

Moscow was quite bitter over the Saudi move and refrained from entering into any commitments to cut export levels following an eleventh-hour decision by Riyadh to scuttle export caps at the Doha meeting in April of last year. Russia had agreed to cut only to have the Saudis at the last minute demand that an absent Iran agree.

By September and Algiers, all parties were on board and a cut/cap agreement was forged to take effect in January of this year. That accord has been recently extended with additional cuts now under consideration.

Russian contacts have told me Minenergo (and, thereby of course, the Kremlin) in principle has indicated it would be amenable to further limitations on exports. Last night’s reports of Saudi export cuts to Asia next month may spur goodwill toward that end. But Russia is also moving for a parallel agreement with the Saudis on other energy matters, which brings us back to the current round of talks.

Next Steps

For the Saudis, two considerations are paramount. First, the Aramco IPO requires a higher price for crude oil since it is the overall value of reserves that will essentially determine the value of the 5% being floated. Russian assent to deeper export cuts will facilitate that objective.

Second, heavier oil is already comprising a greater percentage of overall Aramco production. While the company provides no figures, anecdotal information indicates it is reaching 17% of total production.

In addition, the Saudis are eying an increase in natural gas production with more of that coming from unconventional sourcing. It had contracted with Russian private oil producer LUKOIL a while back to develop what are (at least on paper) some significant extractable reserves.

While that contract is still operating, sources indicate Aramco leadership have not been satisfied with progress.  A more direct connection with Gazprom may be in the offing. For that, a broader bilateral consensus may be emerging.

A month ago, Minenergo announced that Saudi Arabia had been invited to participate in the finance of Russian Arctic gas projects. For its part, the Saudi Ministry of Energy, Industry and Mineral Resources has indicated the offer is under review.

However, more recent information seems to point toward a broader discussion underway between the two energy heavyweights.

And any breakthrough here will have some major consequences for the more expansive global energy picture.

About the Author

KentMoors

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk management, emerging market economic development, and market risk assessment.

He serves as an advisor to the highest levels of 27 countries, including the U.S., Russian, Kazakh, Chinese, Iraqi, and Kurdish governments, to the governors of several U.S. states, and to the premiers of two Canadian provinces. He’s served as a consultant to private companies, financial institutions and law firms in 29 countries, and has appeared more than 2,300 times as a featured radio-and-television commentator. He appears regularly on ABC, BBC, Bloomberg TV, CBS, CNBC, CNN, NBC, Russian RTV, and the Fox Business Network.

A prolific writer and lecturer, his six books, more than 2,700 professional and market publications, and over 650 private/public sector presentations and workshops have appeared in 47 countries.