The crisis in Ukraine has drawn fresh attention to Russia energy policy and the future of its energy sector. The Center on Global Energy Policy sat down with The Oxford Institute for Energy Studies’ James Henderson, who has been analyzing the Russian energy sector for 20 years, to discuss the impact of Western sanctions on Russia’s joint ventures with foreign companies and oil production, the risks of using Gazprom to forward Moscow’s political goals, the challenges Russia faces from U.S. LNG exports, and the recent gas deal with China.
Center on Global Energy Policy: Russia will very likely need to rely heavily on unconventional resources to compensate for the decline in oil production from easily recoverable reserves, and this implies the need for partnerships with international oil companies. What risks do the sanctions imposed from the Ukraine crisis pose to these joint ventures?
James Henderson: I think there is a fundamental shift going on in the Russian oil industry away from Soviet-era assets that have sustained the country for the past 20 years. Soviet-era assets, particularly in West Siberia, are moving into a decline phase. There is a move to greenfield development in more difficult reservoirs: deeper reservoirs, more tightly packed reservoirs, unconventional reservoirs, the offshore, or in more remote areas like East Siberia. All that implies a need for more advanced or new technology, particularly in the offshore where Russia has very little experience.
It requires operational management expertise, particularly in the unconventional sphere, where there clearly is an industrial process that needs to be managed.
I’d say the first risk of sanctions is one that is actually being felt right now and has to do with financing, the ability to raise finance for these greenfield projects. It’s a current issue for the LNG projects, in particular the Yamal project in Northern Siberia which is in the process of raising financing as we speak and is seeing banks become more nervous about making commitments. Not because current sanctions prevent them from doing that, but because they are nervous about future sanctions forcing them to unwind deals and to take steps which would be much more difficult if they have already made commitments. Financing is also a problem for other Russian companies, particularly Rosneft, which has a high debt burden that it needs to refinance and is starting to think about how it can do that.
Looking forward, all talk of undermining the Russian economy just using the oil price or the gas price is a bit far fetched because it would impact a lot more than just Russia. I think the more realistic issue would be targeting the transfer of technology in the energy sector, targeting international participation in the energy sector that was helping Russia to solve its medium-term problems.
I think if that happened, that would have a short-term as well as a medium-term impact because it would be a concern if the Kremlin could see that its long-term production prospects were being undermined by a lack of activity that needs to occur in the next year or two. A good example of that is the drilling of a well in the South Kara Sea, which is being done by a joint venture between Rosneft and Exxon Mobil. Exxon is paying for 100 percent. It’s a very expensive well, $700 million, and really only Exxon has the expertise in that joint venture to get the job done in a safe, efficient, and cost effective manner.
Importantly new sanctions could impact not just the longer term prospects for Arctic oil production, but could also undermine, from a public relations and geopolitical perspective, what could be a very significant industrial event but also a political event for Russia.
CGEP: How does the Kremlin take the prospect of more sanctions by the U.S. and Europe into account?
JH: I think the Kremlin is relatively sanguine about the prospect of more sanctions, but I think it also has a realistic assessment of the situation. They are aware that the sanctions could be imposed, but would obviously prefer that they are not because they want the industrial situation to remain stable in order to support the faltering Russian economy. However, they are also fully aware that the international companies involved are lobbying rather hard for these sanctions not to be imposed and that there is a split in the West, with European countries much less keen on these sanctions being imposed than perhaps the U.S. might be. Even in the E.U. there are different views on how these sanctions might be imposed.
I think they are hoping that the lack of a consistent view amongst the international community will mean that ultimately these sanctions aren’t imposed. However, they do clearly realize that they are at risk and I think that the threat of them may already be having some influence in terms of modifying Russia’s more aggressive tendencies. However, at the moment, the sanctions are not strong enough to definitely win Russia over.
CGCP: How important is development of unconventional oil to maintaining or increasing Russian oil production and what are the major risks it is facing beyond potential future sanctions?
JH: The unconventional is an old and a new story in Russia. The geological layers where the unconventional tight oil are found have been drilled by Russian companies before, but they have met with very mixed results because they have not been using horizontal drilling and much fracking, but the opportunity is enormous. It has been estimated by the United States Geological survey at 75 billion barrels, which is the largest unconventional oil resource estimated in the entire world.
Estimates produced by the Ministry of Energy and also the Ministry of Natural Resources in Russia would suggest that between 600,000 to 700,000 barrels per day to 1.5 million bpd of unconventional oil could be produced within a decade. That would be an optimistic estimate because there are a number of problems to be fixed.
We’re only at the pilot project stage with the joint ventures that are being formed with international companies, and as they move ahead we’ll get a better understanding of what the rocks are really like, what the productivity of the wells is like, what is the cost of drilling. The region is very heterogeneous and you get very different well results within a kilometer of one another.
I think what is then going to happen is that the other major risk, which is a fiscal risk, is going to be addressed because these companies are going to come back and tell the government what kind of tax regime would be required to make this work. The government has already made some concessions in terms of tax holidays, but I think that international companies are going to come back and say ‘If you want this to go ahead we need x, y, and z, in terms of tax regime’ and then the government is going to have some decisions to make.
I think we are going to know the answer to those two questions by 2016. That will mean full-scale development won’t start until 2017 or 2018. That means that production forecasts are probably a little optimistic for 2025, but you can see that the potential for growth is significant.
CGEP: Russia’s gas sector is facing an increasingly competitive global market, and has made development of energy ties with Asia a priority, recently signing a deal with China. How is the threat of rising competition – especially from U.S. LNG — being viewed, and what impact will it have for Russia?
JH: The Russian gas sector is adjusting to the emergence of a global gas market for the first time. The advent of increasing amounts of LNG is really connecting the gas world in a way that we hadn’t seen before. Another major change in the global gas world is that the historic price formation mechanism, which has been to link gas prices to oil prices, is being challenged. This is particularly true for consumers in Europe where there is now an emerging hub-based gas market, with hub prices being set in many of the price levels across the continent. The prospect of U.S. LNG exports arriving soon is emphasizing this trend as U.S. gas is priced on a hub basis.
All new developers of gas are having to face the fact that consumers are now coming to them saying: ‘It’s all very well you coming back to us with your old oil-linked contracts and prices which command a premium and we’ve watched your cost basis rise over the last five years as a result, but look, we can now potentially access this lovely gas via LNG from the U.S. at Henry Hub $4 (per million Btu) plus costs and transport and it looks a lot cheaper. What are you going to do about it?’
Russia has been faced with that dilemma by default over the past three or four years even before LNG exports have left the U.S. The impact of the rising U.S. gas production has meant that LNG that had been previously thought to be going to the U.S. has been diverted because the U.S. does not need it anymore. That gas has arrived in Europe, causing a price impact. Not only gas has arrived, but cheap U.S. coal has arrived that has been displaced by gas in the U.S. and has caused energy markets in Europe to reconsider its gas options. So Russia has already been forced to face this issue, and has now finally adjusted its marketing strategy to take into account market prices in Europe.
In Asia, the signing of the recent deal with China’s CNPC reflects also the generally lower price expectations that are being set by the prospect of U.S. LNG arriving in Asia at around $12 to $13. The price that we can surmise from the recent deal would allow Russian gas to compete with that price level for U.S. LNG exports. So it’s having an impact. It hasn’t stopped Russian gas from being very important in Europe and now, increasingly, important in Asia, but it has, to an extent, reset price expectations and it certainly has increased the competitive threat in the global gas market, but it has done that for all gas producers, not just Russia.
CGEP: So how important is the recent gas deal signed between Russia and China for the global gas market?
JH: I think it is very important from a number of different perspectives. From Russia’s point of view it achieves some commercial and political goals. It provides an outlet for gas reserves that were otherwise stranded in East Siberia and which had no other realistic market for China, and in doing so it also will catalyze the building of an export pipeline that can be the foundation for the economic development of Russia’s eastern regions.
For Gazprom, the deal not only provides an important source of future revenue but also re-asserts its role as the dominant gas player in Russia, a role that has been under some threat from Rosneft over the past year or so. The deal also provides important diversification away from the stagnating European gas market and towards the rapidly growing Asian market, which is also a theme that President Putin can usefully use politically to show his European counterparts that he has alternatives if they decide to try to undermine Russia’s business in the West. From a global gas perspective, the deal also reminds gas producers across the world, who are all targeting the Chinese market, that Russia is a serious rival offering competitive gas in large volumes. Although this deal certainly does not exclude other gas, in particular LNG, from the Chinese market, it does nevertheless show that Russian gas offers another longer-term option for Asian buyers that needs to be taken seriously by the global gas market.
CGEP: Gazprom has been increasingly forced to balance its commercial interests with Moscow’s political objectives. What risks does this carry for the energy sector and for resource development?
JH: I think this is very much a gas issue. The oil sector is the revenue generator in Russia. The gas sector is more of a political tool because domestically the gas pipelines and general gasification allow the Kremlin to have influence via its state controlled company over the economy, industry, the population, providing heat in winter, which obviously gives it huge leverage over regional governors and the local population.
Balancing commercial and political objectives is a key issue for the gas sector. What has happened as a result of global gas markets becoming more competitive is that Gazprom’s ability to balance its political and commercial objectives has been made more difficult because it is finding that it can no longer afford to prioritize political considerations in every situation. In order to just survive it has to be more commercially competitive and I think that what we’ve seen since the crisis of 2008 is a situation where the Russian government was faced with the prospect that over time Gazprom could have really been on a significant decline curve and that its ability to fulfill any political objectives could have been undermined by the fact that it was becoming commercially unviable.
Gazprom has responded to that commercial threat gradually, but as a result perhaps its ability to fulfill its political objectives has been reduced. In general, I think there is always a commercial angle in any decisions it makes. I think that increasingly now its political objectives have had to an extent to be given a slight backseat, particularly in the domestic market where gas prices have been rising significantly because Gazprom needs the money to develop its new fields. Those prices rose so fast that commercial forces encouraged competition and competitors have entered the market and have undermined Gazprom’s position such that shortly it will likely be selling less than half the gas in Russia. That was a scenario that was unthinkable even five years ago. Already that ability to dominate even within Russia has been diminished by commercial forces.
The risks for resource development are that the Kremlin does try to play the political game too much and really does undermine Gazprom’s business. It appears to have understood that risk, but examples like Ukraine show how what is actually a commercial dispute but with clear political overtones is being played out. It’s quite clear there is a commercial argument as well as a political argument and that finding that balance is becoming increasingly difficult.
CGEP: What risks does Gazprom’s declining market share in Russia create?
JH: It means that the Kremlin via its state controlled company has less direct influence over both the domestic economic and political situation that it can exert. For example, prior to an election you could freeze gas prices and that would be a vote winning thing to do. Now we’ve got to a situation where we’ve found the kind of a kind of quasi-equilibrium in the market, the price is actually being set by independent producers who aren’t constrained by the regulated price and therefore that kind of lever has been diminished. The third party producers are now dominating some regions of Russia and have quasi monopolies in those regions. The lever of political influence that is inherent in the provision of energy has been reduced and so Gazprom becomes a slightly less useful tool. It’s not useless, it’s still a huge producer. It’s just seeing its role diminished.
CGEP: Beyond political risk we’ve discussed, what are the major challenges facing international oil companies in doing business in Russia?
JH: The major challenge is actually finding a way to maneuver through the very difficult business environment and to partner with companies in a mutually beneficial way. In a very weak institutional state and a weak institutional environment, one has to rely on one’s domestic partner to negotiate a path through both the formal and the very informal processes that make up an economy like Russia’s.
I think that what we have seen in the history of international involvement in Russia is that unless you can find a balance between your need for your domestic partner to just survive in Russia and your ability to add value as a foreigner you very quickly find that your partnership is not a partnership — it’s a competition. That competition is for knowledge, and the knowledge that you’ve got is your management skills, your technical skills, and in some instances your financial skills – your money. What your domestic partner has is the ability to find a way through the very asymmetric business environment in Russia.
History has told us that the foreign skills are rather easy to learn, and in fact the foreign partners often encourage the learning process. Unfortunately once those skills are learned, the value of the foreign partnership diminishes rather rapidly and the foreign company is left with a partner that has often decided that his domestic skills can be turned to his own individual advantage and against the foreign partner. We’ve seen foreign partners disenfranchised, losing their place in the partnerships.
We’ve been through a cycle in Russia of various stages of Russian partnership. Now we’re back at the situation we had in the early 1990s where foreigners are being welcomed in for their management skills, their technical expertise, and their finance. They need to find a way to ensure that what we saw in the 1990s doesn’t re-emerge as a problem in the 2010s and the 2020s because we are at a very early stage in redevelopment of partnerships between international oil companies and Russian oil companies, where it’s all very amicable and everyone wants everyone else to be around. The risk is that as we move through these projects we start to revert to where we got to in the late 1990s which is that foreigners were seen as competitors for Russian assets, not as partners in their development. I think that what the foreign companies need to do most actively is make sure they continue to remain relevant and reinvent themselves as people who can bring skills. They also so need to make an attempt to integrate themselves into what is a very difficult business environment, and rather than relying on the domestic partner, to take active steps to inform themselves, to be rigorously analytical about how Russia really works, about what their domestic partner’s value really is and about how they can acquire some of the local knowledge that is essential to s urvival.
They will never be able to do without the domestic partners, but they need to play a more active role in the business environment in order to continue to create balance in their joint ventures and not be overwhelmed by the mismatch of value added going forward as their own skills perhaps become less relevant to the joint venture.
James Henderson, Senior Research Fellow for The Oxford Institute for Energy Studies, has been analyzing the Russian oil and gas industry for 20 years. He was based in Moscow from 1997 to 2002 as the head of oil and gas research and later as the head of equity research for Renaissance Capital. Henderson spoke at Columbia University to discuss his new book: International Partnership in Russia: Conclusions from the Oil and Gas Sector. Watch the video of the talk here.
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