Q2 2022 Research Theme: The Impact Of Western Sanctions On The Russian Oil Industry



When once confronted with a report that he had died, Mark Twain responded, "The rumors of my demise have been greatly exaggerated." The same might now be said of Russia’s upstream oil industry. Some six months after its invasion of Ukraine and despite a growing array of Western sanctions, the resilience of Russia’s upstream oil output and exports has confounded and surprised many observers.


Indeed, the IEA now estimates Russian July oil output is just 3% below pre-war levels with Russian oil and product exports down by just 580,000 bopd – hardly the collapse originally predicted by the IEA!


We believe the West is now well and truly caught in a cleft stick – soaring inflation threatens a global recession while Saudi Arabia and the UAE – the only OPEC members with any material spare production capacity – have proved unwilling, or perhaps unable, to step in and swiftly replace Russian oil exports. OPEC+’s recent 100,000 bopd quota uplift was a setback for the West and a slap in the face for Biden.


With no additional OPEC output in the offing, any further Western sanctions that seriously threaten Russian exports are already being ‘defanged’ for fear of causing global oil prices to skyrocket once more.


For example, as described later, a joint UK/EU proposal to withdraw protection and indemnity (P&I) insurance cover for Russian oil cargoes – an obvious Achilles heel given UK/EU dominance of the maritime insurance market – has been greatly eased following successful lobbying by Washington.


Near-term, Russia will likely be able to continue exporting sufficient oil & product volumes, albeit predominantly to Asian markets, to avoid a global supply crunch. Western economies will continue to tacitly ‘tolerate’ such exports, fearful of further inflaming inflation and interest rates and the risk of their own economies tipping over into full-blown recession.


As such, we do not foresee any immediate pressures for Russia to shut-in significant levels of oil production – unless the UK does decide to adopt the EU ban on global P&I cover for Russian oil cargoes.


Unless and until the threat of global recession recedes, so commercial realpolitik will rule the day.


Of course, the political situation between Russia and the West remains volatile to say the least, so newly reconfigured oil trade flows, market equilibrium and thus pricing can turn on a dime.


Medium-term, despite the conspicuous exit of Western oil majors and oilfield service companies, Russia possesses sufficient domestic oilfield service capacity to maintain Russia’s ‘core’ production base of low cost, conventional onshore oilfields, and thus largely offset expected natural production declines. Additional infield drilling and workovers will likely substitute for enhanced reservoir modelling and recovery techniques, albeit sacrificing long-term field performance and ultimate reserve recovery.


Long-term, sustained Western sanctions will inevitably hasten the long-term decline of Russia’s oil and gas industry. Exploration, appraisal and development of new, complex oil & gas reservoirs and offshore facilities will be severely constrained without long-term access to Western oilfield service technologies.


The entire Russian oil and gas industry, operators and service companies alike, has modernized over the last three decades but, likewise, Russia’s largest ‘core’ onshore oilfields are now long in the tooth.


Without sustained access to critical Western OFS technologies, the risk of Russia’s oil industry repeating its post-Soviet collapse cannot be understated.


The Demise Of Russia’s Oil Exports Has Been Greatly Exaggerated


Prior to its invasion of Ukraine, Russia was producing ca. 10 mmbopd of crude oil while exporting close to 5 mmbopd of crude oil and 2.5 mmbopd of products, with half of such exports destined for the EU.


Post-invasion, global oil prices swiftly surged beyond US$100/bbl, with Brent peaking at US$133/bbl. Hardly surprising – the oil market, already struggling to meet burgeoning post-Covid demand, was now spooked by fears of substantial cuts in Russian oil and product exports either due to Western sanctions and boycotts or indeed imposed by Moscow as punishment for Western support of Ukraine.


In early March, amid the fog of early sanctions and reports that over half of Russia’s March oil loadings remained unsold – witness the unparalleled US$30+/bbl Urals-Brent differential, Goldman Sachs concluded that, were such market behavior sustained, “this would represent a 3 mmbopd decline in Russian crude and product seaborne exports, the fifth largest one-month disruption since WWII.”


By way of context, Russia has no SPR, just buffer storage at refineries and marine terminals – in all representing less than ten days of output. Furthermore, both the main ESPO export pipeline to Russia’s Kozmino port that serves Asian markets as well as the ESPO spur pipeline to mainland China were already operating close to capacity prior to the invasion, offering little export upside. Hence swingeing cuts in Western oil exports were widely believed to require matching cuts in Russia’s upstream output.


Indeed, by mid-March, the IEA announced that “from April, 3 mmbopd of Russian oil output could be shut in as sanctions take hold and buyers shun exports’, prompting ‘the biggest supply crisis in decades.”


Fueling such fears, Moscow has also long argued that any shut-in of this scale would significantly impair future Russian output due to the irreparable impact of Siberian weather and permafrost on dormant well infrastructure. However, as we discuss later, the near-complete recovery of Russia’s oil output since the historic OPEC+ quota cuts of mid-2020 has demonstrated such propaganda to be largely untrue.


Of course, the United States, Canadian and Australian bans on Russian oil imports were swift but merely symbolic, while EU members took until June to finally agree a full embargo on all Russian crude and product imports (bar those to central Europe via the Druzhba pipeline). This embargo will impact some 2.5 mmbopd of Russian oil and product exports – but only from December 2022 and February 2023 respectively.


By April, Russian oil output did indeed plunge but by just 930,000 bopd or 9% from prewar levels, as its largest export market, the EU, shrank swiftly due to initial boycotts. Since then, voluntary boycotts have caused Russia to lose two-thirds of its seaborne oil exports to Northern Europe. However, since that April nadir, Russia has proved surprisingly adept at redirecting marine cargoes to enthusiastic Asian buyers, principally China and India – no doubt aided in large part by the compelling market discount.


By way of example, according to S&P Global data, EU imports of Russian crude fell by 780 kbopd between January and May 2022. However, over the same period, Russian crude exports to India increased by almost the same amount, 760 kbopd – almost exactly offsetting those lost EU volumes.


Some six months later, the resilience of Russia’s upstream oil output and exports has confounded early forecasts and surprised many observers – including the IEA, which now estimates that Russia’s July crude oil output was only 310,000 bopd or 3% below pre-war levels and just 5% below the IEA’s estimate of Russia’s sustainable1 productive capacity, with exports down just 580 kbopd since the war.


It’s All About The Tankers


Direct Russian crude exports to China via the ESPO/CNPC pipelines are more or less maxed out, the Kazakhstan-China pipeline may offer up to 200,000 bopd of additional crude export capacity while additional railcar capacity and surfactant use within the ESPO pipeline could lift oil loadings at Kozmino from 2021 levels of ca. 720,000 bopd to some 900,000 bopd by year-end – potentially a 400,000 bopd contribution to maintaining Russia’s overall oil exports in the face of a full EU boycott of Russian oil.


Russia’s conspicuous success in sustaining overall oil output and exports to date is all down to tankers.


Russia swiftly adopted many of the sanction-busting tactics used by Iran and Venezuela to access export markets, the result being that global seaborne trade in Russian crude and products is going ‘dark’ to avoid the impact of US and EU sanctions. As Western trading houses and oil majors have scaled back their trade in Russian oil, so a ‘grey market’ led by Russian and Asian traders has evolved.


Russian oil shipments are increasingly marked as ‘destination unknown’, up from almost none prior to the invasion. Subsequent ship-to-ship (STS) transfers in international waters, often with satellite transponders switched off to avoid detection, disguise the Russian origin of the final oil cargoes.


Continued access to shipping, capital and insurance is of course vital to sustaining Russian oil exports.


Russia’s state-owned shipping company, Sovcomflot, has reflagged much of its fleet by transferring or selling a variety of oil tankers to Greek, Middle-Eastern and Asian entities. Likewise, as of early August, Vortexa reports that China has assembled a sizeable tanker fleet – 14 VLCC and 3 Suezmax tankers – for STS transfers of Russian crude back to China. New oil traders based in Dubai and Asia have emerged as intermediaries while Asian banks are providing capital, displacing the United States and European peers. Increasingly, non-US dollar denominated contracts are used to prevent Western scrutiny of cargoes and thus outmaneuver sanctions: renminbi-ruble trading volumes are up 10-fold since the invasion.


However, beyond shipping and finance, the true ‘Achilles heel’ for global Russian oil cargoes is continued access to internationally recognized maritime insurance, a market dominated by UK and EU insurers.


In early June, alongside its future embargo on Russian oil imports, the EU banned the provision of marine insurance for tankers conveying Russian crude and products to any global market from year-end.


Crucially, the UK was widely anticipated to follow suit. With Lloyd’s of London providing protection and indemnity (P&I) cover for 95% of worldwide cargo shipments by tonnage, a coordinated UK/EU maritime insurance ban would actually provide a far more potent and comprehensive constraint on Russian oil exports than the forthcoming UK/EU embargoes on physical Russian oil imports.


With shipowners unwilling to lift Russian cargoes without P&I cover, and vessels potentially barred from some ports, Russia’s ability to export crude oil and products anywhere in the world would be crippled, the inevitable result being that Moscow would be forced to shut-in the majority of its oil production.


Potent UK/EU Marine Insurance Ban Promptly Neutered By US


However, having been bluntly rebuffed by both Saudi Arabia and the UAE despite recent overtures for increased oil production, Washington has successfully lobbied the UK and EU to ease their prospective insurance bans, arguing that the impact on Russian oil exports would cause global oil prices to skyrocket.


Record gasoline prices, soaring inflation and upcoming midterms no doubt explain such US intervention.


As a result, the UK has dodged the much-anticipated global insurance ban on Russian oil cargoes, merely banning the provision of P&I cover for UK-bound Russian oil cargoes from year-end.


Likewise, in a surprise move, the EU also back-pedaled and amended its sanctions to permit the lifting of Russian crude oil by European companies for export to countries outside the EU, “to avoid any potential negative consequences for food and energy security around the world”.

In summary, the proposed UK/EU ban on global maritime insurance for Russian oil cargoes has been largely neutered amid fears of further oil price hikes tipping Western economies into recession.


Furthermore, Western P&I cover is already being supplanted by sovereign guarantees issued by the Russian government. State-controlled Russian National Reinsurance Company has reportedly become the main reinsurer of Russian cargo vessels, including Sovcomflot’s entire tanker fleet.


In a parallel move designed to help Russian state shipping company Sovcomflot maintain an operational tanker fleet and thus continue to export Russian crude oil, India also recently provided internationally recognized safety certification for more than 80 tankers owned by a Dubai-based Sovcomflot subsidiary.


With EU shippers and UK P&I cover available for Russian oil shipments outside Europe, the US EIA estimates that about 80% of the crude and products subject to the EU import ban will find alternate buyers, predominantly in Asia – leaving a potential market shortfall of less than 1 mmbopd.


The IEA maintains that Russia may shut-in up to 2 mmbopd by February 2023, when the EU embargo comes into full force. We would contend that the continued availability of EU shipping and UK P&I cover largely undermines this argument, but we acknowledge much room for uncertainty in all forecasts.


Furthermore, we cannot rule out future malign moves by Moscow to deliberately manipulate global markets and punish the West for its continued funding and arming of Ukraine.


As sanctions displace most Russian oil cargoes to distant Asian markets so Europe’s ‘missing’ imports must also travel further, from markets such as the United States, West Africa, Middle East and Latin America.


With greater oil volumes in long-term transit, there will be a commensurate tightening of the tanker market. Available tanker fleet capacity by size (i.e. VLCC, Aframax, Suezmax et al) and port logistics will play a large part in determining whether the global oil market can readily match supply with demand.


Global Oil Pricing Has Retrenched Close To Pre-War Levels


However, the recent retrenchment of global oil prices back to levels close to pre-invasion levels does suggest that the oil market is, for the moment, discounting the risk of any significant near-term shortage of Russian oil exports or, at the very least, largely matching that risk with the potential of weaker recession-led demand or increased output from other markets.


For example, Washington’s decision to release 180 mmbbls of SPR crude, reduced refining capacity and a relatively weak driving season have flooded the United States domestic market with excess crude, driving WTI to a substantial US$12+/bbl discount to Brent. No doubt the SPR release was intended to address runaway domestic gasoline prices; Europe also benefits by now importing record levels of cheap US crude.


Brent & WTI Pricing, 2022 to date

Source: Macrotrends

In summary, until there is conspicuous growth in alternate crude supply (e.g. United States crude exports, relaxed OPEC+ quotas, renewed Iranian exports if nuclear talks progress well), Russia will likely be able to export sufficient oil & product volumes, albeit predominantly to Asian markets, to avoid a global supply crunch.


Western economies, particularly those of Europe, will effectively ‘tolerate’ such exports to avoid further inflaming inflation and interest rates and the risk of tipping their economies into full-blown recession.


Russian Oil Output Is More Flexible Than Moscow Would Have Us Believe


Moscow has long cited Siberia’s extreme weather conditions and permafrost as the obvious reason why curtailing and restoring Russian oil production is no simple matter: once a typical Russian well is shut-in, the intensely cold weather and permafrost causes all entrained water and wax to freeze and solidify – requiring a costly well workover or a newly drilled well to restore full oil production thereafter.


This ‘cold weather’ defence has been used by Russia repeatedly in its negotiations with OPEC – after the oil price collapse of 1998, during the global recession of 2008 and as recently as 2014 and 2016 – principally so that it could ‘freeride’ on the back of OPEC cuts, reaping the benefits without any costs.


Saudi Arabia along with many other market participants have thus long grown sceptical of such claims.


Certainly, there is no doubt that such intense cold does pose a particular set of issues for cycling well production up and down without compromising well productivity or causing lasting reservoir damage.


However, experienced oilfield contractors can largely eliminate such issues with meticulous planning and prior interventions such as the clearing of lines, lifting of downhole pumps and glycol injection.


It took a pandemic and the historic OPEC+ cuts of mid-2020 to finally put paid to Moscow’s defence.


Faced with collapsing global oil demand and little if any crude storage available, Russia finally agreed in May 2020, as part of OPEC+, to cut oil output by 2 mmbopd or 20%. However, this decision followed two months of stalling as Moscow refused to cooperate with the initial OPEC+ cuts proposed in early March.


Putting aside OPEC politics, the most obvious argument put forward for this two-month delay is two-fold: as above, the need to identify and prepare those fields and wells best suited for shut-in, but also to await better summer weather to allow easier well shut-ins without damaging long-term consequences.


Russian Crude Oil & Condensate Production, 2018 to date


Source: ycharts.com

Two years later, Russia has proved able to not only swiftly shut-in a substantial fraction of its oil output, albeit after two months’ prevarication, but also almost fully restore overall oil output thereafter.


Russia’s July crude output lies some 450,000 bopd below the IEA’s current assessment of Russia’s sustainable productive capacity of 10.2 mmbopd, this assessment in turn some 600,000 bopd below its July OPEC+ production quota of 10.8 mmbopd.


In all, such comparisons suggest that the deep production cuts enacted mid-2020 may have degraded overall productive capacity by as much as 1 mmbopd, or 10%, far less than Moscow has long guided.


Of course, until March 2022, Russia’s upstream oil industry also benefited from a full complement of Western oilfield services companies and technologies which no doubt aided this restoration of output.


What Can We Expect For Russia’s Future Level Of Oil Output?


With the withdrawal of oil majors BP, Shell and ExxonMobil and all Western oilfield service companies from Russia, there is a risk that schadenfreude may blind us to recognising Russia’s domestic capacity and ability can likely sustain much of its conventional oil production over the next several years or, at the very least, largely mitigate expected natural field declines over the near to medium-term.


Russia’s oil and gas majors, Rosneft, Gazprom and Lukoil, operate vast portfolios of oil and gas fields in western Siberia and the Urals which enjoy low operating costs and require little foreign OFS support.


European and United States sanctions first targeted the Russian oil industry back in 2014 following Moscow’s annexation of Crimea. As a result of these international sanctions, Moscow introduced an Industry Support Fund to support domestic manufacturing and technological development. Although Western OFS companies continued to operate within Russia thereafter, the Russian upstream oil industry has had plenty of time to increase its self-reliance and address many prior shortcomings.


Rosneft, Gazprom and other Russian oil and gas majors have vertically integrated, investing heavily in the development of Russia’s domestic OFS sector. Rosneft’s and Gazprom’s drilling subsidiaries operated over 340 and 120 drilling rigs at year-end 2020 respectively. Gazprom Drilling also provides cementing and mud services. Other independent domestic OFS providers include drillers Eurasia Drilling, Naftagaz, Eriell and IGC, tubular and top drive manufacturers TMK and SLC Group (a Russia-China JV) and Burintekh which produces an array of drilling and coring hardware and mud/cement additives.


Over the short to medium term, Russia’s dependence on Western OFS companies is likely overstated. Basic OFS hardware and equipment is already locally manufactured and available. Sufficient Russian (and Chinese) OFS capacity exists to maintain infield drilling and workover programs across Russia’s ‘core’ base of conventional onshore oilfields for the next few years. Indeed, according to Rystad Energy, Russian companies provided some 80% by value of the oilfield services provided to such fields in 2021.


Over time, however, Russia’s upstream sector will inevitably face major issues: more than half the domestic drilling fleet is over ten years old. With no access to Western service parts let alone leading-edge technology, well servicing and drilling will no doubt continue but with greatly reduced efficiencies.


But the long-term problem for Russia’s upstream sector is not hardware. The key gap in Russia’s domestic OFS capabilities lies with software – sophisticated cloud-based interpretation and reservoir modelling tools that enable efficient recovery from Russia’s ageing fields or the development of complex new oil and gas reservoirs in remote offshore locations such as the Barents Sea.


Such software is the preserve of the Western OFS sector and no longer accessible nor easily replicated.


With ageing onshore fields, Russia’s long-term strategy is focussed on the need to find and develop new Arctic resources, such as Rosneft’s Vostok Oil, Novatek’s Arctic LNG 2 and Gazprom’s Baltic LNG projects.


Indeed, Russia aims to secure at least 20% of the global LNG market by expanding its annual output four-fold, from 30 million tonnes to at least 120 million tonnes by 2035.

However, Western sanctions prevent access to vital leading-edge European LNG technologies that underpin the development of the Arctic LNG 2 and Baltic LNG projects. With local LNG expertise and technology many years away, Russia’s long-term LNG strategy is now under serious threat.


It is perhaps worth reflecting on the history of Russian oil production. Upon the disintegration of the Soviet Union, it took just seven years for Russian oil output to collapse from over 11 mmbopd to a post-Soviet Union nadir of 6 mmbopd in 1996. However, it took twenty years, considerable investment and open access to Western OFS technology to finally restore oil output back to 11.3 mmbopd in 2016.


The entire Russian oil and gas industry, operators and service companies alike, has modernized over the last three decades but, likewise, many of Russia’s largest ‘core’ onshore oilfields have also aged.


Without sustained access to critical OFS technologies – in particular software as detailed above – the risk of Russia repeating history cannot be understated.


In summary, sustained Western sanctions will inevitably hasten the long-term decline of Russia’s oil and gas industry. Exploration, appraisal and development of new, complex oil & gas reservoirs and offshore facilities will be severely constrained without long-term access to Western oilfield service technologies.


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