This is a guest post by Hunter Kornfeind, intern for Energy and Climate Policy at the Council on Foreign Relations and current student at Temple University.
Russia is coping with a new reality from the lasting effects from the brief crude oil price war with Saudi Arabia this past spring and the ongoing COVID-19 pandemic that has left Russia’s domestic energy industry in its most difficult position since the breakup of the Soviet Union. Delivering an unprecedented production cut – around 2.5 million barrels per day (b/d) in May and June according to the terms of the recent agreement between the Organization of the Petroleum Exporting Countries (OPEC) and other major oil producers – in an accelerated manner left Russian oil companies with the difficult decision to select what wells to keep going and what wells to idle. Depending on how long oil production reductions are needed, cutbacks in specific Russian regions could potentially lead to some permanent shut-ins due to operational challenges across an industry with little storage capacity and natural geological constraints in a large number of maturing fields. Production curtailments could also affect the quality of Russia’s main crude oil Urals export blend, which is a mix of oils coming from different production streams. Variability of quality can alter the desirability of a crude oil in the export market, thereby influencing its value to refiners. These challenges are exacerbated by the fact that Russia’s oil trade faces strong competition from Middle East exporters in its key markets in Asia and Europe amid flagging demand caused by economic slowdowns. A deterioration in domestic consumption also poses headwinds, so much so the Kremlin recently banned certain oil product imports to protect the Russian market from a wave of cheap fuel.
Russia is fully committed to the historic 9.7 million b/d production cut agreed by the OPEC+ producer coalition of which it is a member. The Kremlin reaffirmed that commitment in announcing publicly today that there was “close coordination” between Saudi Arabia and Russia on oil output restrictions. The Kremlin is hoping its constructive role in fostering the final agreement to stabilize global oil markets could create a diplomatic opening to improve relations with the United States, which took an unprecedented public diplomatic role in pressuring the parties for the oil agreement, ultimately fostering cooperation between top Russian and Saudi leaders. Russian Energy Minister Alexander Novak recently met with major Russian oil companies to discuss a possible extension of the current level of production cuts past June. Much will depend on market conditions in Europe, where demand is beginning to recover. A longer period of curtailments could pose operational or geological difficulties for some Russian producers, including Russian flagship oil and gas firm Rosneft PJSC. Russia has been angling to get some U.S. sanctions eased, especially those applied to Rosneft PJSC, which is no longer trading Venezuelan oil. The technical challenges in Russia’s oil sector could give impetus to Moscow to want to gain access to capital markets for its oil sector as well as U.S. technology and industry assistance. It is unclear where diplomatic progress can be made in the complex U.S.-Russia bilateral relationship that ranges from concerns about future nuclear proliferation agreements to the difficulty of reaching a diplomatic solution to the humanitarian crisis in Venezuela as well as Russia’s continued military presence in the Ukraine, among other active hotspots. This week, the United States chided Russia for its alleged role in escalating conflict in Libya, in an indication that tensions remain on a wide range of issues.
Still, other geopolitical conflicts aside, Russia has a point in noting the significance of its contribution to global oil market stability. The 10 percent year-over-year decline in Russia crude oil production, described in April by Russian Energy Minister Novak, would make 2020 the first year of a double-digit decline in crude oil production since the early years of the Boris Yeltsin presidency. Following the collapse of the Soviet Union in 1991, Russian crude oil production reached a low of about 6.0 million b/d in 1996 according to the BP Statistical Review of World Energy, declining from about a record 11.4 million b/d in 1987. The state suffered from sharp declines in oil production from 1991 to 1994 when the Russian oil sector was under reorganization and little to no capital investment was made in new wells. Only after more than two decades of strong oil company investment, equating to hundreds of billions of dollars, has Russia able to restore its crude oil production capacity to return to its Soviet-era highs.
Russia currently has about 200,000 active wells, more than most other crude oil-producing states. Compared to Saudi Arabia’s lower per barrel cost of production, Russia’s hydrodynamic methods – including horizontal drilling, sidetracking, and hydraulic fracturing – are capital and labor intensive, especially with the country’s older wells. Reactivating a well that is throttled back can be challenging. For some wells, the longer a reservoir remains idled, the higher the chance pressure, water content, and clogging could affect future production. Experts say curtailment decisions will ultimately hinge on the characteristics and geological constraints within production regions. Companies have to assess where it makes the most technical and economic sense to make the cuts, either in brownfields – fields that have matured to a production plateau or even progressed to a stage of declining production – or in greenfields – a new oil and gas field development – throughout Russia. Increases in COVID-19 cases at Russian crude oil assets could also lead to production difficulties in select regions due to quarantines.
West Siberia, an oil producing region in central Russia that extends from the northern border of Kazakhstan to the Arctic Ocean, continues to be Russia’s dominant producing region and contributes more than half of Russia’s total crude oil production. Most fields operating in the region are older, conventional reserves. They are facing permafrost melting and rising associated water levels, which reached 86 percent on average in 2018. According to a study from the SKOLKOVO Energy Centre, Russia’s largest active Siberian brownfields reported a 22 percent increase in drilling rate penetration from 2012 to 2016 but recorded a 5 percent decrease in total crude oil production, demonstrating how Russia’s older fields require more intensive methods to keep production growing. Yuganskneftegaz, Rosneft PJSC’s largest unit with operations in West Siberia, cut crude oil production by about 289,000 b/d between May 1 and 11 from February levels, according to Bloomberg News. Lukoil PJSC, the second-biggest Russian operator, decreased output by about 312,000 b/d compared to February with almost half of the production cuts originating from fields in West Siberia.
Before the OPEC+ cuts, Russian companies were actively exploring greenfield development in remote onshore regions like East Siberia and the Russian Far East, attempting to offset declining production elsewhere in Russia. The shift had been successful – greenfields continue to yield higher production growth compared to legacy brownfields. According to analysis from the SKOLKOVO Energy Centre, Russian greenfield crude oil production grew 77 percent from 2012 to 2016, reaching 21 percent (roughly 2.3 million b/d) of total crude oil production.It remains unclear whether the current oil price environment will hamper continued greenfield investment and production in Russia. So far, Russian oil companies have not abandoned their large-scale investments, instead deferring them in hope of a rebound in global oil prices and eventual relief from the OPEC+ production limitations. State-owned giant Rosneft PJSC announced plans to continue the development of new fields but is "postponing short-term less economically viable projects" and “…high risk long-term projects, including joint ventures.” Russia could have difficulties staying the course, however, given the departure of some Western majors, who continue to slash capital expenditures. Royal Dutch Shell recently withdrew from its proposed onshore joint venture with Gazprom Neft in the Arctic, citing a “challenging external environment.” The current low oil price environment may discourage future Western investment in Russia’s upstream, which also continues to face complications from Western sanctions.
In addition to cash flow consequences and possible damage to oil fields or equipment, Russia’s continued oil production cutbacks could create a marketing headache for Russian firms. Russia’s most popular crude oil blend for export, Urals, is a mix of different grades of crude oil from different regions in West Siberia. As production cuts occur, the mix of crude streams going into Russia’s export pipelines can change, shifting the quality of the export blend and thereby its value to refiners.
Already, amid slumping petroleum demand due to COVID-19 pandemic lockdowns, Russia faces lower demand for its crude oil exports. Rystad Energy estimates crude oil demand in Europe declined 38 percent year-over-year in April and expects demand to slump 13 percent year-over-year for 2020. Chinese demand is slowly recovering following the easing of stringent lockdown measures, helping Russian export sales.
Russia sells roughly three-quarters of its total crude oil exports to just two markets Europe and Northeast Asia, much of it by pipeline delivery. In China, Russia has gained market share since the COVID-19 crisis began, replacing curtailed oil from Iran and Venezuela which recently reached all-time lows. China imported about 1.7 million b/d of crude oil from Russia in April, about a 14 percent year-over-year increase. That compares to about 1.2 million b/d in Chinese imports from Saudi Arabia. Shipments along the East Siberia-Pacific Ocean (ESPO) oil pipeline to the Kozmino export hub near the port city of Nakhodka in the Russian Far East point to a 24,000 b/d month-over-month gain to about 757,000 b/d in May to customers including Japan, South Korea, and Singapore, according to Energy Intelligence Group. In addition to linking to the Kozmino export hub, the ESPO pipeline connects directly to China via the Skovorodino-Daqing spur, an about 660 mile long pipeline transporting oil from Russia’s Far East to China’s Northeast province of Shandong, home to half of China’s teapot refineries and nearly 70 percent of teapot refining capacity.
The recent success in oil sales to China contrasts to struggles in Europe and domestically. Seaborne crude oil shipments from the Baltic Sea ports of Primorsk and Ust-Luga are set to see a 620,000 b/d month-over-month decline in May due to reduced refinery runs and lackluster demand across Europe. March crude oil shipments via the Druzhba pipeline, the longest pipeline in the world, fell about 125,000 b/d month-over-month in April and may experience more headwinds in the coming months. Domestic demand for crude oil has also cratered amid the COVID-19 pandemic. Deputy Energy Minister Pavel Sorokin explained in April that domestic gasoline, diesel, and jet fuel consumption has fallen by 40 percent, 30 to 35 percent, and more than 50 percent, respectively, due to the shutdown of the Russian economy in light of the pandemic. Data shows gasoline production for the first six days of May declined to about 572,000 b/d, down about 40 percent from March levels as about a third of Russian products output is consumed domestically.
Although the OPEC+ agreement is finding very successful implementation, Russian and Saudi Arabian exports are still competing for similar customers going forward. Now, the United States could be added to the mix as the Trump administration is calling upon China to honor its bilateral trade pact, which included increased purchases of U.S. crude oil by China’s refiners. The negotiated increase in U.S. energy purchases, however, has been hampered by China’s economic contraction in the first quarter of 2020. Rebounding oil demand may help paper over such differences when the OPEC+ coalition meets again in less than two weeks, but there will be a lot to navigate beyond June as oil producers try to build on momentum created by the historic deal made in April.