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Categorized | Equities

Russian oil: Between a rock and a hard place


Posted on October 29, 2014

Salym Petroleum Development's Siberian Oil Fields...An employee adjusts a valve wheel at the central processing plant for oil and gas at the Salym Petroleum Development oil fields near Salym, Russia, on Tuesday, Feb. 4, 2014. Salym Petroleum Development, the venture between Shell and Gazprom Neft, has started drilling the first of five horizontal wells over the next two years that will employ multi-fracturing technology, according to a statement today. Photographer: Andrey Rudakov/Bloomberg©Bloomberg

One of Russia’s most powerful men stood on stage at New York’s St Regis Hotel with a conciliatory message for America.

“The relationship between the US and Russia has been severely hampered by historical stereotypes,” said
Igor Sechin, a former Soviet intelligence officer and now the dominant force in the Russian energy industry. “But we have long ceased to be adversaries. It is time for us to become strategic partners.”

    It was April 2012. With those words, Mr Sechin signed a wide-ranging partnership between Rosneft, Russia’s state oil company, and ExxonMobil – in the process throwing open the doors of Russia’s vast oil wealth to the western energy industry.

    Today, the partnership envisaged by Mr Sechin, Rosneft chief executive, is in tatters. Under pressure of western sanctions, Exxon has frozen all 10 of its joint ventures with Rosneft, and other western companies – from majors such as Shell and Total to smaller oil services and engineering groups – are stepping back from Russia.

    The implications are far-reaching. Mr Sechin heralded an era of co-operation that would help Russia develop new frontiers in the oil industry – a “re-industrialisation of Russia”.

    While his words were heavy with hyperbole, no one could doubt the urgency behind them: Russia’s oil industry was facing a creeping crisis of existential proportions. The enormous Siberian oilfields developed during Soviet times were ageing, and without the development of new resources – from the frozen Arctic in the far north to Siberian shale deposits – Russian oil production would soon fall dramatically.

    The impact of the sanctions threatens the transfer of cutting-edge technology and expertise to Russia

    Now, with western companies in retreat, the development of those resources will be at best delayed, if not scrapped altogether, according to numerous government officials, executives and analysts.

    The US and
    Europe have imposed a string of sanctions on the Russian oil industry in response to Moscow’s actions in Ukraine, restricting access to western financial markets and limiting exports of equipment. The consequences for Russia are stark: next year, many believe, its oil production will fall – a first drop, excluding a dip in 2008, since 1998 and the start of what many expect will be a long-term decline.

    “In the last few years production growth has stabilised,” says Leonid Fedun, vice-president of Lukoil, Russia’s largest private sector oil group. “But there will not be any more growth.”

    IHS CERA, a leading oil consultancy, has slashed its outlook for Russian oil production, predicting in a recent research report that if western sanctions are maintained, the country’s oil production could fall from 10.5m barrels a day to about 7.6m b/d in 2025.

    A fall in Russian production could reshape the country’s political future as well as world energy markets. Moscow relies on the energy industry for more than half of its revenues – Rbs7.3tn ($171bn) according to the state accounts chamber – and a fall in production, combined with the recent drop in oil prices, could threaten the Kremlin’s ability to maintain stability at home and project its power abroad.

    On a global scale, a 3m b/d drop in Russian production could offset some of the growth in supply from the US shale boom, helping to reverse the current market surplus and keep oil prices high in the medium term.

    Russia’s shale revolution

    Two and a half years after his speech in New York, Igor Sechin stood aboard a drilling rig in the icy waters of the Arctic and declared victory. After months of suspense, Rosneft revealed it had struck oil in the Kara Sea, one of the last great untapped oil reservoirs that may contain as much crude as the Gulf of Mexico. The new field, he said, would be called Pobeda – victory.

    Mr Sechin made a point of naming all the western companies that had worked on the project, down to the service companies and equipment manufacturers that usually remain behind the scenes. “This is our united victory,” he said.

    But the victory was hollow. After the US and EU in September imposed sanctions blocking the export of a wide range of goods, services and technology to three types of Russian oil project – Arctic, deepwater and shale – western participation in such projects is all but impossible, lawyers and executives say.

    Exxon has wound down its participation in the Kara Sea project, and will not be able to return until US sanctions are lifted. And it is not alone. Artur Chilingarov, a Russian senator who sits on Rosneft’s board, says that “under the circumstances of sanctions, further co-operation with international companies [in the Arctic] will be difficult”.

    Rosneft – which yesterday revealed that its third-quarter profit was all but wiped out by the fall in the rouble and lower oil prices – insists it will continue exploring in the Kara Sea, with or without Exxon. But most in the industry are sceptical. “Offshore Arctic is closed for the foreseeable future,” says Duncan Milligan, a Russian oil specialist at consultancy Wood Mackenzie.

    Exxon’s Arctic venture may be the highest profile casualty of western sanctions against Russia, but it is unlikely to be the most significant. “For all the attention given to Exxon and Rosneft, that’s the oil of a decade from now,” says Thane Gustafson, author of Wheel of Fortune, a history of the Russian oil industry. “The point of the spear, I think, is what people are now calling tight oil.”

    Tight or shale oil, known in Russian by the looser term “hard-to-recover” oil, has been the target of a major push by Moscow as the Kremlin hopes to replicate the US shale revolution in Russia.

    In theory, at least, that is not far-fetched: Russia is estimated by the US Department of Energy to have the largest reserves of shale oil on the planet at 75bn barrels, with the Bazhenov field, several times the size of the Bakken, the driver of the US shale revolution.

    But western co-operation in Russian shale oil is also foundering. Exxon’s projects with Rosneft to explore the Bazhenov have been frozen; so has a Shell joint venture with Gazprom Neft, the oil division of gas giant Gazprom; so has a tie-up between Total and Lukoil.

    Out of service

    Executives and lawyers say the sanctions effectively prohibit western oil companies from any involvement in Russian shale projects – in particular by inhibiting the service companies whose expertise is essential to carrying out the complex drilling operations that characterise shale production. “You can’t touch Bazhenov any more. That’s dead,” says a western oil executive in Moscow.

    Moscow’s hopes of 440,000 b/d of Russian shale oil production by 2020 now seem unlikely, analysts say.

    Some Russian companies believe they will be able to develop shale resources without western assistance. But Russia lacks the nimble and entrepreneurial small oil companies that have driven the US boom, says Mr Gustafson.

    “There was a very interesting experiment under way,” he says. “If the Russians don’t have small companies of the kind that did the magic in North Dakota, the bet was that big companies could come in and partner with even bigger companies and realise the same magic.”

    But the impact of the sanctions goes further still, executives say, challenging the transfer of cutting-edge technology and expertise to Russia altogether.

    Just as financial sanctions against certain companies have triggered a wider freeze in lending to Russia as a whole, so the energy sector sanctions have caused a ripple effect of “sympathy sanctions”, as western companies step back from the Russian market as a whole, regardless of the letter of the sanctions.

    “It’s not just what the sanctions say, it’s the whole atmosphere it creates around the industry,” says Mr Milligan.

    The move has the greatest potential impact in the services sector – the companies that actually drill the wells, manufacture specialist parts, and provide the expertise to analyse the result.

    These functions are overwhelmingly provided by western companies – the likes of Schlumberger, Halliburton and Baker Hughes – at Russia’s most technically challenging projects. Western companies account for about half of the technology used in hard-to-recover oil projects and more than 80 per cent of the technology used offshore, according to Russia’s energy ministry.

    While techniques such as fracking and horizontal drilling are associated with shale, they are also widely used to maximise production from more conventional oilfields, with pockets of oil held in harder-to-access rock formations. It makes a broader retreat by western service companies deeply concerning for Russia’s oil executives.

    Fragile sector

    Vagit Alekperov, chief executive of Lukoil, recently told Prime Minister Dmitry Medvedev that 25 per cent of Russian oil production involved fracking and relied on western service companies. “This is the most fragile part, that could be the first to cause damage to the oil industry,” he said.

    Even though most western service companies have publicly affirmed their commitment to Russia, competitors and clients say there are clear signs that they are stepping back.

    Some specialised pieces of equipment used for horizontal drilling and fracking, and offshore production, are now harder to come by in Russia, executives say. Among them are liner hanger systems, used to prepare wells for drilling; bottom-hole assemblies, the collection of parts around the drill bit; and high-pressure engines designed specifically for fracking.

    That has raised concerns that even oilfields already in production might run into difficulties when equipment needs to be replaced.

    “If you lose a big bottom-hole assembly then it’s hard to replace,” says a senior executive at a small Russian oil company. “So far the effect is subtle, but it’s going to get worse.”

    Vladimir Shmatovich, head of strategy at Russian pipe manufacturer TMK, says western competitors have been dropping out of the market even in areas not directly targeted by sanctions, such as the Caspian Sea. “Western pipe manufacturers’ share of the Russian market has declined significantly and they are now almost completely out,” he says.

    One western executive says his company was forced to freeze a project after the service companies withdrew.

    Mr Gustafson says: “If the service companies are not able to work their magic then that really does do
    damage to the capacity of Russian oil companies to move from conventional to unconventional.”

    In Moscow, the sense of urgency is palpable. “To maintain the current level of production, we will need to drill not 20 metres as we do now, but 30 metres,” says Mr Fedun of Lukoil. “Such a level requires an increase in the quantity of drilling teams by 60 per cent. But given the fact that western contractors are curtailing their work in Russia, such an increase is highly doubtful.”

    The Kremlin is responding: the $83bn National Wealth Fund – designed to finance the country’s state pensions – is likely to be tapped by oil companies suffering from sanctions. Rosneft alone has asked for a 2 trillion ($48bn) rouble loan, although government officials indicate it is likely to receive substantially less than that.

    Inevitably perhaps, some are beginning to look back to the Soviet oil industry with nostalgia. Mr Alekperov recalls that when he was deputy oil and minister of the Soviet Union in the late 1980s “100 per cent of the equipment was Soviet-manufactured”. Now, he warns, replacing western equipment and services will require “colossal funds”.

    Just as in Soviet times, Russia is likely to throw resources at the problem, says Valery Nesterov, senior oil analyst at Sberbank. Among the options being considered is the creation of a giant state-owned oil services company to replace western companies.

    “Russia has a tradition of focusing on priority projects and succeeding,” says Mr Nesterov, recalling the Soviet space programme. “Given the importance of the oil sector to the country, if production falls sharply all necessary measures will be taken to improve the situation.”

    Oil services: How Stalin opened the door to western groups

    It was Josef Stalin who first brought a western oil service company to Russia. In 1929, under pressure to meet the targets set out in the Soviet leader’s first five-year plan, oil managers hired Conrad and Marcel Schlumberger to use their pioneering technology to map oilfields in Chechnya and Baku.

    Seven decades later it was a Schlumberger executive who was instrumental in bringing western technology to the Russian oil industry after the Soviet Union’s collapse. Joe Mach, with a mantra of “frack every well”, joined Yukos in 1999, helping to double its production in five years.

    Today, Schlumberger accounts for a 10th of drilling and other services in the Russian oil industry, according to Dmitry Lebedev, head of Russia-focused consultancy REnergyCo. Other western peers, such as Weatherford, Baker Hughes and Halliburton, account for another 10 per cent, though that understates their importance in the most technically challenging projects.

    The companies have responded to sanctions by stepping back from Russia. Schlumberger, for example, has withdrawn a significant number of its US and European executives from Russia, according to industry executives. The company declined to comment, saying only that it “continues to take all steps necessary to ensure compliance with applicable laws”.

    Vladimir Salamatov, director of Moscow’s World Trade Centre, which
    promotes business, says the value of Russia’s imports of the oil equipment on the sanctions list has risen nearly sixfold since 2001. Countries that have imposed sanctions on Russia account for $1.2bn – 57 per cent – of those imports.

    Some of that is easily replaceable. But other equipment and technology will be slower – if not impossible – to replace, Mr Salamatov says. He singles out rotary steerable systems, used to guide horizontal drills.

    And even where Russian suppliers can replace western equipment, the quality is likely to be lower. “The Russian oil services industry is in a bad shape, it always was,” says Mr Lebedev. “It’s like having an old Russian Lada instead of a Mercedes.”