Corporate Debt Review

Saudi-Russian Rift Emerging?

Trouble in Paradise

Indications have emerged that Russia and Saudi Arabia will once again move to restrain oil production. The accord will set a new benchmark level to offset a noticeable slide in crude prices.

However, despite the “positive” political spin from Moscow and Riyadh extolling a breakthrough in relations between the two oil producing majors, what is underway below the surface is far less encouraging.

Multiple sources in both capitals confirm that forward Russian oil production has become a primary concern for the Saudis. This has hardly been helped following comments made by Saudi Crown Prince Mohammed bin Salman (MBS) in a recent interview to the effect that, within the next 19 years, Russia’s role in global oil market trade could substantially decrease.

He even suggested Moscow might stop exporting oil. In contrast, MBS praised Saudi reserves and claimed that they would allow his country to remain as a primary market participant for decades.

It’s hardly surprising that the comments produced a quick and pointed rejoinder from Moscow. Russian Energy Minister Alexander Novak dismissed the concerns and noted that Russia “is a leader of the global oil industry and, from the long-term perspective, it will retain this status. Our strategy is to keep oil production at the current level” and perhaps even increase it slightly.

As is frequently the situation, observers have been quick to point out that there is some credence in both arguments. Yet, on balance, there are multiple signals that MBS may have the stronger case.

Cold Comfort

I have previously outlined the evidence for that position. A month ago, I wrote the following:

Moscow has increased exports as production has grown to more than 12 mbd. Contacts at both state oil company Rosneft and the state transport monopoly Transneft have been floating the contention that Russia is becoming the worldwide swing producer. For decades, the assumption has been that Saudi Arabia occupied that role – offsetting the meeting of international demand with OPEC aggregate supply; as such, preserving the balance in the market.

Rosneft has said it could increase production further, adding to the export flow should the travails in Venezuela and Iran further constrict available crude. Yet that belies information emerging from other quarters.

Put directly, unless there is a rapid change, even present levels of production will not be maintainable in the near future.

Russian extraction levels remain dependent on the traditional Western Siberian Basin. This is a very mature drilling location. Reservoirs have further been significantly damaged with a widening amount of oil slipping beyond commercial extraction due to multi-decade “creaming” practices.

This latter dynamic refers to taking off the easily available oil, accentuated by indifferent usage of secondary recovery, followed by premature capping of wells without sufficient allowance for reproduction later.

By 2016, internal reports at Minenergo (the Russian Ministry of Energy) had warned about a Western Siberia rapid decline curve amounting to a loss of some 8.5% in volume by 2022. Some of this is already underway. One of the reports, labeled such a precipitous decline an неизбежность (neizbezhnost, “inevitability”).

To offset this, four alternatives are being pursued. These involve moving operations: (1) north of the Arctic Circle; (2) out onto the continental shelf; (3) into Eastern Siberia; and (4) to strata below the current pay zones in Western Siberia. All of these approaches are inordinately expensive. There is some promise that major reserves are present in Eastern Siberia. But all basic infrastructure (roads, transit, communications, power, supply routes, pipelines, etc.) need to be built virtually from scratch over thousands of miles. If the development on the Yamal Peninsula in north central Siberia is any indication, these expenses will have huge excess runovers beyond initial estimates.

All four targets also require technology and expertise Moscow does not currently have, and a market price for oil higher than current levels to recoup the added costs. The existing US sanctions against Russia have certainly not helped.

This was the primary reason Rosneft entered into a joint contract with ExxonMobil. It is essential that the company have access to outside technology and expertise. Much of the possible onshore additional crude is heavy oil, quite difficult to extract and move.

Of primary concern, virtually all of the reservoirs thought to be located below the mature Western Siberian deposits are heavy oil. The only economic production is using steam-assisted gravity drainage (SAGD) drilling. SAGD involves running parallel lines. A lower line has steam pumped through it, warming the oil above. The upper line then “harvests” the heated oil through perforations.

Unfortunately, when applied in Siberia, SAGD collapses the tundra thereby destroying the wells. The Rosneft-Exxon agreement provided for a Rosneft minority interest in 22 Exxon projects outside Russia. It is hardly a surprise that every one of them was a heavy oil operation.

That Rosneft-Exxon accord has been a casualty of the US sanctions against Moscow. Rosneft has belatedly moved to secure joint venture agreements with European majors such as France’s Total, but the effectiveness of these alternatives is unknown.

There is an additional factor to consider. Even if the reserves are there and can be tapped, much of what has been identified in the Arctic, the shelf, and Eastern Siberia are primarily natural gas, not crude oil. Additionally, even in those cases where oil is the primary target, the condition of associated natural gas pressure is likely to determine the amount of oil extracted.

Now there are caveats in all of this, as my Rosneft and Minenergo contacts have maintained. We may have an opportunity to discuss this and other matters in a meeting being scheduled shortly to take place in Nicosia, Cyprus.

That meeting in Cyprus is now tentatively scheduled for March. I’ll let you know what transpires. Nonetheless, as I concluded last month, Russia remains under greater production pressure than the Kremlin is letting on.

The bottom line had actually been acknowledged by Novak even before MBS made his statements. In September, the Russian minister said that Russian production could reach 570 million tons (slightly over 4 billion barrels) per year, compared to the 553 million tons expected this year. However, Novak acknowledged that the extraction volume would then begin to decline sinking as low as 10 million tons in 2035.

Even before MBS laid down the gauntlet, therefore, Novak’s view was even more pessimistic than that coming from the crown prince. Additionally, some of my well-placed Russian oil contacts have been privately telling me than the decline could begin as early as 2020.

Less Money, More Problems

My contacts base their estimates on figures used for some time internally. Over the past decade, Western Siberian production effectively declined 4% while cost of production more than doubled. That combination would put the actual Western Siberian Basin annual production at between 146 and 180 million tons by 2035. That would put the best-case scenario at about 55% of current aggregate basin production.

This would adversely impact Russia’s central budget, integrally tied to the taxes on production and exports. But that negative pressure is already being felt. The current system of oil taxation in Russia discourages active oil exploration, technological research and development of new oil fields in areas with difficult extraction conditions. Unfortunately, these are the regions essential to reverse the coming overall volume decline. The secondary and enhanced oil recovery techniques required demand a more favorable tax structure.

And then there are the problems developing on the investment side. Russia currently spends between $22 and $26 billion a year on oil production. Minenergo estimates that an investment commitment increase of 5% per year is required to keep extractions at 2018 levels. By 2035, the ministry’s own internal views say that would mean a doubling of domestic and foreign investment sources just to keep the current 2018 levels.

Given the sanctions, Moscow will have to rely more on its own capacities than on foreign investments. And that’s where problems start. On the one hand, economic problems, sanctions pressure and a budget deficit seriously limit the Russian government’s ability to provide additional financial benefits and tax exemptions to the national oil business. Moreover, current tax reform is expected to increase the tax burden on oil producers. As a result, the Kremlin has limited maneuvering space.

On the other hand, the main Russian players such as Gazprom and Rosneft already have external debts in the billions of dollars. Re-crediting and borrowing from foreign banks have become more complicated for Russian oil producers. Foreign sanctions have either limited their access to external funds or raised the cost of credit. In addition, leading ratings agencies have lowered Russian oil producers’ credit ratings. The Russian banking sector is also not an option, as one Russian bank in four is questionable. Even then, most of those who might have the ability nonetheless prefer not to credit large Russian industries.

Well, what do these considerations mean for ongoing Saudi-Russian cooperation? Several veteran Russian sources argue that the vision of Russia as a declining oil power will prevent the Saudis from seeing Moscow as a strategic partner. Instead, any interaction with Russia will be limited to tactical and case-by-case cooperation.

The Saudis are also aware that the negative outcomes they predict are hardly the first time Russian oil has encountered serious challenges. Both foreign and domestic analysts have predicted the drastic fall of oil output in Russia several times since 1991. Yet, when necessary, Moscow can be quite inventive in handling difficulties. Therefore, Saudi leadership will not make any quick and blunt decisions.

And, as a Saudi confidant notes, even cooperating with a Russia declining in production can be beneficial. As such, I regard what happens by the end of this year as illustrative. By then, Riyadh and Moscow are expected to finalize a series of joint investment projects in oil, natural gas, and the broader energy sector. Some signals might emerge then about how serious the Saudis regard ongoing cooperation with Russia

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.