from Macro and Markets

New Energy for Russian Sanctions

September 15, 2014

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Time will tell whether new sanctions on Russia announced by the United States and European Union last week will be a game changer. The most significant development concerns oil, as the new measures go much further than previously understood to shut down ongoing exploration and production of new Russian supply. While triggered by events on the ground in Ukraine, from a policy perspective this is a catch-up action, closing loopholes and bringing market practice more in line with the harsher intent of earlier measures. As such, I view the steps as an incremental, if logical, next step in the effort to punish Russia for its actions in Ukraine. Still, compared to what some energy companies thought they would be allowed to do, the new measures look to be material in terms of their effect on ongoing exploration, development and investment in securing new oil.

Descriptions of the new measures are here and here. A few points

1. The Russian invasion of Ukraine, and continued efforts to at a minimum create a frozen conflict, should be seen as the primary trigger for the sanctions. Both U.S. and European officials have stated that these sanctions could be removed if the current peace process takes hold—a 12-step plan that would involve the complete removal of Russian troops and hardware from Ukraine. But few are optimistic on this score.

2. U.S. and E.U. energy sanctions do differ in scope and definition, but the core principle is to make clear that sanctions affect the provision of technology, goods or services for exploration and production of new deep-water, arctic or shale oil. An existing well can still pump, but efforts to develop new sources of oil are broadly affected. The U.S. also goes further than Europe in requiring that U.S. operations affected by the sanctions be wound up in 14 days, and since no major EU companies are drilling in the Arctic it seems the U.S. rules are of central importance.

3. Several commentators have noted that U.S. energy companies had been seen as sidestepping earlier sanctions, and in particular continuing exploration efforts that began prior to sanctions. Exxon’s continued and highly publicized joint venture with Rosneft in the Arctic Circle may have raised the ire of policymakers (apparently, because the rig was already in place, they earlier were able to provide services for the drilling to start—now it appears that is ruled out), but it’s not the primary reason for additional sanctions at this time.

4. The new financial measures look modest. The U.S. catches up with Europe in sanctioning Sberbank, the largest Russian bank, and both the U.S. and Europe have extended the ban on new debt and equity to include energy companies directly (not just their banks). It also may be meaningful that the term of allowed finance is reduced to 30 days (from 90 days). I continue to believe that comprehensive financial sector sanctions are where we are (and should be) headed, which would include exclusion from the payments system. That action would cause substantial and upfront pain on Russia, and have systemic implications for global markets, but we are a long way off from that.

5. Russia will help affected energy companies with limited financing from its sovereign wealth fund (subject to a cap on fund investments that is low relative to the investments affected) and the central bank will spend reserves defending the exchange rate. Still, it’s reasonable to expect further market disruption and ruble depreciation as these sanctions sink in. Analysts expect Russian oil production to slip as soon as 2015.

6. There remains inevitable momentum for additional sanctions, both to deal with evasion and because events on the ground will provide triggers for harsher action. Sanctions are “working” in the sense of imposing long-term costs on Russia, and these measures could add significantly to the cost. However, there continues to be a disconnect between a sanctions approach that aims to impose long-term costs and events on the ground that are moving at a much faster pace. At the same time, the Ukrainian IMF-backed program is veering off course and a widening financing gap is emerging that even debt restructuring may not fill. This creates a tension for policymakers that these measures do not resolve.

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