What will Russia oppose to the sanctions pressure from unfriendly countries?

Perhaps one of the most burning issues against the background of sanctions passions is what awaits the Russian oil industry at least in the near and medium term. The new reality forces us to look at oil from a "gas" angle: now we need to think not only about how to extract it, but also – most importantly – how to sell and transport it. 

What does the current crisis mean for the economy?

By the beginning of 2022, the economies of most regions of the world had not yet overcome the slowdown caused by the covid crisis. Almost no region (except the USA) has achieved a pre-nominal level of GDP growth (see Table 1).

Then, quite serious consequences of the special military operation in Ukraine were superimposed on this: although it is often said that Russia's share in the global economy is only 2%, it must be understood that in reality it is certainly much higher. Here we are talking about both the hydrocarbon and food markets, as well as many commodity markets that are strategic for both traditional and low-carbon energy (see Figure 1).

As a result, we are seeing a very significant jump in prices for almost all commodity groups in all regions of the world. Now there are quite serious concerns that already in 2022 the economy of many regions (including Europe) may enter a recession zone, which will negatively affect manufacturers and all customer markets.

The rise in prices on commodity markets indicates the likelihood of a subsequent recession. So, on June 21, Goldman Sachs doubled the probability of a recession by the end of the year, bringing it to 30%, and during 2022-2023 this probability is estimated at 48%. The risks of a reduction in commodity trading have increased. At the same time, commercial reserves of oil and petroleum products in OECD countries are below normal levels (outside the OECD they are at a higher level).

Overall forecasts for global markets range from moderately bad to fairly bad. Most of the concerns are related to both a significant increase in prices for traditional energy sources and high inflation rates. According to forecasts of the International Energy Agency (IEA), from April to August 2022, the growth in oil demand in the world may amount to 3.6 million barrels per day. Most of this growth will be in the summer period.

The level of execution of the OPEC+ deal in May, according to IEA estimates, amounted to 261%, the alliance's production lagged behind targets by 2.8 million barrels per day. The cartel plans to increase production quotas by 648 thousand barrels per day in July and August, but only Saudi Arabia and the UAE will be able to really take advantage of this in light of sanctions against Russia and underinvestment in production. According to the IEA, by the beginning of September, Saudi Arabia's spare capacity will amount to 1.2 million barrels per day and almost 1 million barrels per day from the UAE. In general, OPEC+ capacities (excluding Iran and Russia) are estimated by the IEA at 2.6 million barrels per day by the fourth quarter of 2022, which will increase market volatility.

Goldman Sachs does not expect a drastic decline in oil prices until the end of 2022. Citibank analysts are more pessimistic, who in the event of a recession and its negative consequences (in the form of an increase in unemployment and bankruptcy of companies) fear a drop in the price of Brent to $ 65/bbl. This is slightly higher than the desired "price ceiling" for Russian oil, announced at the end of June at the G7 summit in Germany – $40-60/bbl (however, it will not be easy for interested parties to maintain this ceiling). JP Morgan Chase, on the contrary, expects Brent prices to rise to $380/bbl if Russia reduces oil production by 5 million barrels per day in 2023.

Sanctions and self-sanctions

A significant risk factor for the Russian oil industry is that about 55% of oil exports go to "unfriendly" markets (out of 4.5 million barrels per day, 52% go to Europe, 1% to the United States and 2% to the United Kingdom). Another 32% is accounted for by China. As for the export of petroleum products, unfriendly countries account for about 65% (of 2.75 million barrels per day, 50% – to Europe, 21% – to the United States, which imposed a ban on the import of Russian petroleum products, 4% – to the United Kingdom) (see Fig. 2).

So far, the United States, Great Britain and the EU do not have a complete ban on interaction with Russian oil companies (they are not blacklisted – SDN), but this process is negatively affected by sanctions against Russian banks. At the same time, the United States and Great Britain have imposed a ban on the export of technologies and equipment for oil and gas production, and the EU – on the export of dual-use technologies, LNG technologies and oil refining technologies. Russian oil supplies to the United States have been banned since April 22, 2022, and the United Kingdom is preparing to ban Russian oil and petroleum products by the end of 2022. The EU will impose an embargo on maritime supplies from the end of 2022 to the beginning of 2023. In addition, Germany and Poland will voluntarily refuse any kind of supplies from Russia.

However, in the third quarter of this year, on the eve of the entry into force of sanctions, many analysts expect a surge in demand for Russian raw materials. As a result, it turns out that the sanctions have a limited or reverse short-term effect on the revenues of the Russian oil and gas segment.

Additional operational and strategic risks for the industry are created by so-called "self-sanctions" on the part of Western companies. Companies such as BP, ENEOS, Eni, Equinor, Galp, Glencore, Neste, OMV Petrom, Preem, Repsol, Shell, Trafigura, TotalEnergies refused to conclude new contracts (the volume of refusals is 1 million barrels/day for oil and 1 million barrels/day for petroleum products). Logistics companies and tanker owners are beginning to restrict work in Russian ports and with Russian companies. Marine insurance companies and banks are also starting to avoid transactions with Russian oil and other cargoes. Under the influence of these factors, the selling price of Russian oil has fallen significantly.

At the same time, there has been no reduction in oil production in the Russian Federation so far. Offshore oil exports have been redirected to new regions, and petroleum products have decreased, but not significantly so far. Refining margins have increased sharply due to the redirection of flows and the shortage of diesel in Europe.

At the same time, the European Union is quite actively claiming to abandon traditional hydrocarbon supplies from Russia, and in fact, the energy transition agenda for this region has been combined with the energy security agenda. But there are no real alternatives to supplies from Russia on the market for up to five years, and in this sense, abandoning them and redirecting flows will be difficult not only for local producers, but also for consumers.

Possible scenarios for the development of events

The key question for understanding future market development scenarios is what is the share of Russian oil that can be fully embargoed. Taking into account current estimates, three scenarios can be assumed here (see Figure 3).

1. The optimistic scenario is 2.4 million barrels per day (implies a ban on exports to the United States and Great Britain, as well as a decrease in exports through ports focused on exports to Europe: Ust–Luga, Primorsk and partly Novorossiysk).

2. The average scenario is 3.7 million barrels per day (a ban on the supply of oil and petroleum products to Europe by tankers, supplies via the Druzhba oil pipeline remain).

3. The scenario of a complete embargo is 5.1 million barrels per day (Europe stops importing oil and petroleum products from the Russian Federation, and the countries of the Asia–Pacific region partially abandon them).

The world will be able to adapt to the lack of Russian oil, but in the next decade this will be an extremely fragile and expensive balance.

At the same time, the Russian segment of oil refining is more vulnerable due to factors such as a high proportion of "dark" residues that have traditionally been processed in the EU and the USA (it is now difficult to find a comparable foothold), as well as dependence on imported catalysts, which in some cases reaches 100% (but the Omsk plant under construction should cover by 2023 up to 90% of demand). It is also worth taking into account the unclear prospects for the domestic market, the increase in refining capacity in the Middle East and the fact that as the pandemic ends, China is reloading its own refining capacities.

The diesel fuel segment seems to be the most difficult to balance: its exports from Russia in 2021 amounted to 2.1 million barrels per day, while 1.1 million barrels per day were supplied to Europe. The volume under the embargo now stands at 1.6 million barrels per day. At the same time, 70% of European diesel fuel imports come from Russia, and the loss of this volume will be critical, since it will require a sharp increase in global refining in a short time. Long-haul imports from the United States, the Middle East, India (we are talking about petroleum products produced from Russian oil) and other Asian countries are considered as a substitute. At the same time, Russian diesel is refocusing on Latin American markets and on countries east of the Suez Canal. As a result, there will be logistical problems, high freight rates, and rising prices for consumers.

New logistical constraints will arise due to sanctions, self-sanctions and the economic consequences of the geopolitical crisis. But there will also be more attractive projects with access to the Asia-Pacific and Indian markets, including logistics facilities. In general, the approach to oil projects is becoming closer to the gas one – an integrated assessment of the commercial potential of the extracted product is needed.

Challenges and opportunities of import substitution

Considering the issues of import substitution, it is impossible not to take into account the fact that in Russia foreign companies were present in all segments of the "oil industry". The share of foreign participation in oil and gas production here was approximately 2.5 million barrels per day, which is equivalent to 11% of the total volume of 23.5 million barrels per day in 2021. It is necessary to separate oil production and the purchase of assets, the production of which is not put on the balance sheet of a foreign company. For example, BP's entire production accounts for 19.75% of Rosneft's shares, and more than 50% of Total's production accounts for 19.4% of Novatek's shares.

23 foreign companies participated in Russian oil and gas assets, including pipeline transport. Most often they cooperate with Rosneft and Gazprom. The sanctions affected offshore projects, as well as projects for the extraction of hard-to-recover reserves in the Bazhenov and Achimov formations, and the development of domanic deposits in the Orenburg region.

In addition, international oilfield service companies play key roles in the supply of software for oil and gas production, equipment for the LNG industry and mainline transportation, as well as in multi-stage hydraulic fracturing.

Foreign service companies have practically monopolized the most critical segments of the Russian market. At the end of 2020, 38% of hydraulic fracturing operations were carried out by foreign companies such as Weatherford, Schlumberger and Halliburton (USA), as well as Austrian PeWeTe and Canadian Calfrac. At the same time, in the whole hydraulic fracturing market, more than 95% of the equipment components used are American, European and Chinese–made (see Fig. 4).

It should also be noted that there are about 90 hydraulic fracturing fleets in Russia, more than 80% of which were launched 10 or more years ago. Up to 90% of the domestic MWD/LWD equipment market (for telemetry and logging during drilling) is occupied by foreign manufacturers. The market leaders are Schlumberger, Halliburton, and Baker Hughes, which together occupy about 50%.

Among the key technological challenges are drilling (a fleet of modern installations), equipment for large–capacity LNG, chemical reagents for hydraulic fracturing fluids and drilling fluids, catalysts, lubricants, cryogenic steels, high-tech plastics, instrumentation, as well as integrated turnkey project management (the entire system from exploration to production management).

Most of the oil production in the Russian Federation is accounted for by deposits of conventional oil and gas condensate. It will not be difficult for companies to maintain the operation of these fields even with the departure of the majority of foreign participants (the share of foreign equipment in the development of traditional fields was estimated at 20%). But the fields are being depleted, and new modern technologies for increasing oil recovery are required to maintain them, where the role of foreign companies is still high (over 50%). The share of TRIZ in the structure of proven reserves, according to the Ministry of Energy, is 65%, and the need to enter such reserves will grow every year. It was on TRIZ and MOON that the main bets were placed in the field of increasing oil production in Russia and maintaining it at the level of 550 million tons per year.

In case of unavailability of technologies in the long term, Russian oil production may decrease significantly by 2030 – up to 350-450 million tons per year. Such a large spread is explained by the high degree of uncertainty in the plans of foreign oilfield service companies regarding future projects: will equipment be supplied for them? There is also a question of the availability of project financing in the context of sanctions.

Thus, the departure of international oil and gas companies will have a strong impact on the LNG sector and offshore projects, but in general it will not be critical. The departure of oilfield service companies may have a more serious impact, since they provided supplies of high-tech equipment and software.

In the medium term (until 2025, taking into account the reduction in production under the OPEC+ deal), Russia will be able to ensure stable oil production at the expense of its own reserves and the participation of Asian partners. However, the risks of worsening the situation are increasing, as the availability of complex software will be limited. In the long term, Russian oil production will depend on the effectiveness of the import substitution program and the development of TRIZ and MOON technologies.