The economic landscape for the Russian energy sector changed dramatically over the past 12 months, primarily due to a steep fall in oil prices to their lowest level since 2008.
2014 has been very difficult for Russia's energy sector. Photo: Getty Images / Fotobank
For the Russian energy sector, the year 2014 started off cautiously, with the release of the draft Energy Strategy in January. Already, there was some thinking in policymaking circles that strategic planning for the Russian energy sector would have to become proactive rather than reactive.
This applied as well to Russia’s presence in the international energy markets. By the end of the year, it had become clear that Russian strategic planning in the energy sector would have to be fundamentally revamped in response to external economic shocks.
Can we be optimistic heading into 2015? The answer on the surface is simple: Things look worse today for the Russian energy sector than they did a year ago. The reason for that assessment can be found in these six key events in 2014.
#1: The fall of oil prices to their lowest level since 2008
The price of oil fell from around $110/barrel to below $60/barrel and stabilized at that level. It is still a subject of extensive debate as to what caused that steep decline in oil prices in such a short period of time. The problem in relation to the price of oil is that all economic development in Russia in the first decade of the 21st century has been driven by an increase in global oil prices, and one of the key concerns even a year ago was that the momentum toward higher oil prices seemed to be slowing.
A market price for oil at a level much lower than the level predicted by basic principles of supply and demand primarily has an impact on the margin producers (i.e. producers with the highest costs). Unfortunately, Russia belongs to this group. The drop in prices will have an effect on both production and demand - downward pressure on investment into new production, combined with upward pressure on demand. For Russia as a higher-cost producer, this means lower production and a loss in market share.
#2: The economic crisis in Russia accompanied by the fall of the ruble
The Russian ruble has depreciated by more than half since the beginning of the year. In turn, the falling ruble causes a higher inflation rate and a lowering of the overall purchasing power of Russian citizens. In December, we also witnessed a liquidity crisis of the dollar in Russian banks.
For companies in the energy sector, the falling ruble means that those Russian companies that have debts denominated in foreign currencies will have trouble repaying them. The prices of ruble-denominated assets have decreased accordingly. Added to the problem of attracting external financing, this creates a much more challenging business climate for the energy sector heavily dependent on its ties with the international energy markets.
Overall, there has already been a noticeable decline in capital inflows into the Russian economy, as well as the loss of trust toward the Russian economy as an investment market.
All of this necessitates a new approach to energy and economic policy. Already by the end of 2013, it was crystal clear that the growth model of the Russian economy was unsustainable, so it seemed essential to diversify the quantity and quality of energy exports, diversify the direction of these exports and push other sectors of the economy to develop.
#3: The Ukraine crisis
In 2014, following public protests at Kiev’s Maidan, Ukraine entered a period of political turbulence with an inability of the internal political forces to find consensus concerning the way the country should be governed. What seemed to be a fight about getting into the European orbit transformed into a civil war-like struggle within the country and a Cold War-like standoff in world politics.
The sides actively involved in the development of the situation in Ukraine are the European Union (remember, it was the accession agreement with the EU that caused Russia to worry back in 2013) and, obviously, Russia. What has followed is the referendum in Crimea and its controversial decision to become a part of Russia, de facto civil war in Eastern Ukraine, and an overall divide between Russia and the West on the perspectives of the settlement.
In spring 2014, it became clear that the situation was not so much about Ukraine but rather, about Russia and its relations with the EU (in the context of energy supplies) and the U.S. (in a general geopolitical context).
The impact of Russia’s troubles with Ukraine resulted in the rapidly decreasing role of Ukraine as a market and as a transit route for its energy resources. There are a lot of unanswered questions. For example: Who is responsible for shooting down the airplane of the Malaysian airliner that flew over the territory of Ukraine and crashed during the summer of 2014? Another question is the actual involvement of Russian military forces in Ukraine. The largest concern is caused by what is called the “annexation of Crimea” by Russia.
The response has demonstrated the nature of the conflict - not bilateral, but rather, reflecting a wider context. A set of sanctions, which were gradually becoming more comprehensive throughout 2014, is a clear outcome, and its impact on the Russian energy sector is quite dramatic.
Valve control wheels are seen on pipework near gas well site at Bovanenkovo gas field, Yamalo-Nenetsky region, Russia. Photo: Getty Images / Fotobank
#4: Western sanctions
Since March 17, 2014 there have been nine packages of sanctions introduced by the EU. EU sanctions include restrictions on financing and supplies of equipment and technology. U.S. sanctions in general follow the lines set by the EU but go further (for example, they include a wider list of companies; specify what projects can be considered deep-water; and include software for deep water, Arctic and shale oil projects).
Firstly, there are additional long-term costs for Russia’s energy businesses.
Secondly, a moderate impact is expected from the sanctions dealing with exploration and production, particularly in relation to complex projects in the Arctic and shale developments, which were to be realized in partnerships with Western firms. Techniques such as fracking and horizontal drilling (which can be acquired through such partnerships) are associated with shale, but they are also used to maximize production from conventional fields.
Thirdly, a large negative impact is coming from the software transfer restrictions. Finding the replacement options for software solutions will be lot more difficult than finding partners for upstream development (Asian companies can serve as partners in the latter case).
Overall, Russia risks being unable to implement its plans on sustaining production levels that are necessary to keep it as one of the key players in the international energy markets. The most critical impact is that the problems inherent to the Russian economy became more evident and acute.
There had been a threat of underinvestment already before the introduction of the sanctions regime. Sanctions have created additional constraints on the Russian energy sector. The energy sector produces 60 percent of gross income, thus measures targeting the energy sector will have a spillover effect on the whole economy, and we could already witness this effect in 2014.
#5: Slumping demand in the European gas market
Falling demand in Europe has caused falling Russian exports in the European direction starting in the second half of 2014. The South Stream project was cancelled and replaced by a new supply project to Turkey. There is also a problem of oversupply in the liquefied natural gas (LNG) market.
In 2013, there was already talk of increased opportunities for energy exports. Falling demand in Europe – the key market for Russian energy resources – was already creating some troubles, but there was hope that the situation would improve in 2014.
The first outcome of slumping energy demand in Europe is a definite reshaping of the European gas market and the decline of the long-term contract. Overall, the outlook for Russia-EU gas trade looks rather grim. It is both an outcome of the demand fundamentals in the European region, and the troubles in political relations.
The cancellation of the South Stream project signals that Russia does not view the European direction as preferable any more and is not ready to proceed with high-cost projects in the light of uncertainties of its position in the European gas market. This is a logical development in the light of European problems with Russian gas that lie in the dimension of political perceptions and political priorities.
#6: Russia’s pivot to Asia
A major implication of the sanctions regime as well as Russia-EU trade rebalancing, both of which became a reality in 2014, is Russia’s explicit turn toward Asia. This pivot to Asia is both in terms of actual supplies and in terms of cooperation in equipment purchases, investment and financing.
In this regard, the Gazprom-CNPC contract of May 2014, which called for the export of 38 billion cubic meters (bcm) of natural gas to China annually over the period of 30 years through the Eastern route, is critical. There is also a Gazprom-CNPC framework agreement calling for the export of 30 bcm of natural gas through the Western route of the Altai pipeline.
These two deals are enhanced by the event that occurred in 2013: the granting of LNG export licenses to Rosneft and Novatek, which effectively means the lifting of Gazprom export monopoly through an expanded number of LNG exporters. LNG exports have their clear geographical target: Asian market. The contract between Gazprom and CNPC marks the beginning of a new era. This deal marks a strategic turn to the East, and in the situation of changing geography of world energy trade the presence in the fastest-growing market is essential for a producer that wishes to remain an important player in the international energy markets.
The long-term contract secures demand for the development of the pipeline. The perspective of gas exports to China gives Russia the opportunity to win a position in the Asian gas market, which currently is the largest in terms of gas demand.
The deal is further strengthened by the possible additional contract for supplies via the Western route, which theoretically could use the same resource base as used for current European exports, thus creating de facto competition for gas supplies between two regional gas markets – Asian and European. This effect is slightly diminished by the fact of declining European demand.
Finally, the LNG developments are targeted at the Asian market, which are predominantly trading LNG and are characterized by the highest gas prices as of 2014. The downside is the fact that Asian LNG prices are tied to oil prices through long-term supply contract provisions, which provides for a decline in the second half of 2015 as a result of oil price developments we have seen in 2014.
All of these events are indicative of a vastly different landscape for the Russian energy sector for 2015. The different landscape explains the necessity of new approaches to energy policy. What will Russian energy strategy look like in this new landscape? For now, the draft energy strategy document still has not been finalized, with key scenario calculations complete but in a need of serious reconsideration given the events of October-December 2014.
The key challenges – such as the new conditions in external markets and the slowing pace of domestic economic growth – remain the same. Some measures, like changes to the Russian tax code, are underway and will likely materialize in 2015.
What to expect from 2015? Oil prices will likely remain low during the first half of 2015. This will lead to continuing troubles for the Russian energy sector caused by Western sanctions. It could also lead to financing issues for companies within the energy sector, as well as problems with replacing imports in the sanctions-hit domestic energy sector. Certainly, a challenging yet interesting year looms ahead for the Russian energy sector.