Sanctions Put the Russian Energy Market at a Crossroads
In response to the tightening of EU and US sanctions, and the German insistence on the maintenance of sanctions until a withdrawal from Ukraine, Russian Foreign Minister Sergey Lavrov was defiant. He said that “Russia is not going to negotiate the conditions for lifting sanctions.” Does this defiance suggest that Russia can take any amount of damage and maintain its energy market or is this is pure defiance in face of very significant economic damage but which still keeps the government in place (the Iran scenario)? Or in fact is the real lever the falling oil price and not sanctions at all?
Professor Andrei Belyi, Associate Professor at University of Tartu, tends toward the Iranian scenario “Western sanctions on Russian oil and gas industries have started to take a significant although indirect effect. It would be still too much to expect that sanctions would have their immediate political effect on Russia’s position towards Ukraine. Nevertheless, important difficulties have emerged for the world's largest hydrocarbon producer. In fact, the history of sanctions demonstrates that economic pressure only rarely leads to a political effect. It could be that cases of sanctions against South Africa are amongst the rarest examples of political change followed by an economic isolation, whereas a number of unsuccessful stories (Cuba, Iran and Iraq are being the most notorious examples) demonstrate the limited effect of economic instruments in international affairs. In most of the cases, sanctions become an excuse for economic failures and rather reinforce a hardliner geopolitical choice of the states in question. For now, Russian political elites, and first of all Russian President, are not planning to give up their position on Ukraine even under a context of an economic hardship. Therefore, many in Russia claim that sanctions don’t have an effect. However, the industry experiences difficulties, especially in attracting credits and capital. And the situation is worsened by the oil price decline.”
Indeed, falling oil prices make the position of Russia even more complex. Nevertheless, even if the oil price was stabilized, it would not get any better for Russia as the real problems lay much deeper. First of all, the world in on the verge of a major global energy development caused mainly caused by two factors: 1)shale revolution that is going to change the supply logistics from east to west scheme as the Americas become the centre of global hydrocarbon production and 2) the growing demand in Asia.
Russia has to adjust to the new rules of competition in the way it develops its energy industry. And that is where the internal problems begin. Conventional oil and gas fields provide 90% of the current oil production in Russia. The sector is now seeing existing fields going into their decline phase. In Soviet period, especially1960-1980s, oil fields were overused under the slogan “catch up and overtake”. With immense reserves and oil extraction low cost price let Russia did not have to think about technological improvements. The result is oil and gas engineering weakness and depleting brownfields. Despite many warnings the country did not invest enough in technological upgrade and new fields. As a consequence the late 1980s saw a production collapse.
In the more favorable 2000s with high oil prices a flood of foreign experts and service companies entered the sector to raise production. Most of the oil-production enterprises in Russia enlisted the co-operation of foreign services companies. It is the combination of foreign technology, experts and service companies that makes the Russia quite vulnerable to the Western sanctions, which are clearly targeted at potential growth sectors of the Russian energy economy where new energy technology and expertise will be required.
On 5th of December the EU Council published amendments to sanctions against Russia. It clarified some dispositions in energy sphere, including restrictions on the sale, supply and export of oil exploration and production projects in Russia’s Continental Shelf and Exclusive Economic Zone. The EU appear to take sanctions seriously and appear to be committed for the long haul. In the mid-term and long-term sanctions can cause serious problems: suffice to say , some branches of the Russian economy are dependent on Western import by 70-90% (engineering tools by more than 90%, including related to oil and gas industry , electronic industry by more than 80%). At the same time export volumes have slowly started to decline: according to the Federal Customs Service of Russia, since August the scope of delivery of natural gas to non-CIS countries was reduced by 20%.
However, despite all attempts of the EU to reduce dependence on Russian gas and the fall of demand , countries will need at least 100bcm of gas up to 2030. In mid-term Europe has contractual obligations to import around 75% of current export (115bcm/year), according to Gazprom Export statistics. Even though some countries work actively on diversification of supply , the price of substitution is rather high. For instance, Klaipeda LNG Terminal in Lithuania costs $128 million and the price of imported Norwegian LNG is no better than the Gazprom offer.
Ironically, Western sanctions are helpful for Russia in some way. As the oil price falls the country will have to find solutions for the old problems. Energy producer enterprises will have to take over some of the service activities themselves and replace foreign with local expertise. Another issue is the increase of energy efficiency that requires innovative technologies instead of the equipment of late 1990s. From this point of view economic crisis can become a catalyst for Russia’s energy sector renovation.
Mutual dependence between the European Union and Russia has been forming during decades. Established logistics of energy supply cannot be changed with a wave of a wand: Even if the wand is waved by the occupant of the oval office. For instance, President Obama cannot simply order US LNG producers to supply American shale gas to Europe as soon as possible. As long as Russia and Europe are interdependent, they have to find ways to get along. Primarily it means that Russia needs to rethink its foreign policy which led only to a retreat in influence in all spheres. Dmitry Medvedev, Russian Prime Minister, recently said that Russia must “eventually get off the oil needle”. Currently Russian budget is dependent on the oil and gas revenues for 52%. With falling oil prices the revenue side of the budget falls with every $1 of Brent price by $2 billion. Andrei Belyi summarizes: “Time will show if Russian political and economic elite will follow either “South African” or “Iran” scenario of reaction towards the economic difficulties. Due to the importance of interdependence, investment and market risks related to sanctions, the impact of international sanctions will increasingly lay heavily on Russia”.
Marina Zvonareva
Marina Zvonareva is a Natural Gas Europe analyst focused on Russia’s international energy relations. Follow her on Twitter: @ZvonarevaMar1na