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Low prices will hurt the Russian economy, but they are far from being Russia’s only problem

The World Bank last month released its growth projections for Russia in 2015 and 2016, offering a glimpse into a potentially bleak future for the country. The report included three separate projections for the Russian economy for the next two years based off the average price of a barrel of oil over the same period of time. In 2012, Russia’s energy sector accounted for approximately two-thirds of the country’s exports, around 30% of GDP and almost half of the Federal Budget revenues, according to Jack Sharples of the University of Glasgow.

The World Bank’s baseline projections were set with $78.00 a barrel in 2015 and $80.00 a barrel in 2016. The bank’s “lower-case” scenario assumes $70.00 a barrel in 2015 and $72.00 in 2016. With analysts like KLR Group setting their 2015 Brent price forecast to $62.50 and 2016 Brent price forecast to $85.00, the World Bank’s “lower-case” scenario is already starting to seem a bit optimistic.

Assuming $70.00 per barrel in 2015 and $72.00 per barrel in 2016, the Russian economy is projected to contract by 1.5% in 2015 before expanding by 0.3% in 2016. “The key driver of the additional contraction in the lower-case scenario is a more pronounced decline in consumption.  A shrinking economy and declining real wages could result in a vicious circle for consumption,” said Birgit Hansl, World Bank Lead Economist for the Russian Federation.


Source: World Bank

Low oil prices are partially responsible for the crippled Russian economy, bringing on a recession for the first time since 2009, but prices are far from the only concern for the politicians in the Kremlin. Vladimir Milov, the former Russian Deputy Minister of Energy and president of the Institute of Energy Policy, said at a Columbia University presentation that Russia’s declining production, structural challenges within the industry and, possibly more than anything else, sanctions from the West would contribute to the country’s decline.

In this Oil & Gas 360® weekly edition, we will look at the major factors lending to the decline of Russia’s heavily oil and gas dependent economy.

Old Soviet fields are reaching the end of their production lives

Russia’s oil and gas industry has been steadily increasing output since the end of the Soviet era, reaching a post-Soviet record in 2014. The country’s oil output reached a new high average of 10.58 MMBOPD, rising by 0.7%, reports Reuters. The Russian Ministry of Energy reported crude oil production, including natural gas condensate, for December at 45,114 thousand tons, or approximately 322.9 MMBO.

While these numbers are impressive, they mask a serious problem that is bearing down on Russia: without developing new fields, the record-setting production reported most recently by the Ministry of Energy is completely unsustainable. The old Soviet “brownfields” are starting to run dry, according to Milov. “[The brownfields] are very low cost, but they are expiring. You need to go to new greenfields that are extremely expensive in order to keep production at current levels,” to say nothing of increasing production volumes.

Russian oil and gas producers are able to produce from these old Soviet fields for US$3.00 from the wellhead, and approximately US$10.00 to get a barrel of oil to market, not inclusive of administrative costs, according to Milov, but they have not reinvested in developing new fields, an even more pressing problem now that prices are plummeting. As Russian producers are seeing thinner profit margins, it will become increasingly difficult for them to raise the capital necessary to develop new assets, especially as the West’s growing sanction regime cuts off more of the Russian economy from outside investment.

This is a problem for more than just Russian oil and gas producers though. As Milov points out, “The taxation system [in Russia] is designed so that any revenue that is above $40 per barrel, most of the revenue, goes to the Federal Budget.” This means that while companies like Rosneft (ticker: RNFTF) and Gazprom (ticker: OGZPY) are feeling the effects of low oil prices, it is the federal government of the Russian Federation that really stands to lose the most.

Even though Rosneft plans to develop new fields, both in Eastern Siberia and in the Artic, Igor Sechin, CEO of Rosneft, said that production is not expected to start in East Siberia until 2021, doing little to alleviate declining production for the rest of this decade.

Inertia is the key when thinking about the Russian economy

“The keyword to remember when talking about Russian economics is ‘inertia,’” says Milov. While economist predict the beginning of a recession in 2015, the problem could get worse if the situation is not addressed.

State-owned giants like Gazprom and Rosneft have become too inefficient to compete, says Milov. The companies’ debt to annual revenue ratios are in the 35% to 55% range, he says, greatly constraining their ability to develop new production. Milov said that while he was in the government, they tried to put forward a plan to unbundle Gazprom, allowing for a more competitive market, but that the plan was rejected. “[Those in power] set up this system … they will not dismantle it. They built it this way, so why would they consider efficiency?”

Even if Russia does have the resources to survive the current downturn, the serious mismanagement of those assets seems to be putting the Russian economy at even greater risk. “The situation is still manageable, but the people in power [in Russia] make one systemic mistake after another,” says Milov. “Russia could have passed through the brownfield challenge much easier if it had not been burdened by the extreme inefficiencies of state monopolies.”

As serious a problem as declining production is to the Russian oil and gas industry, it is still only one facet of a much larger issue facing the oil and gas industry in Russia, and the country’s economy as a whole. The mismanagement of Russia’s resources, along with a cumbersome, inefficient industry and sanctions from the West could create too much inertia for Russia to avoid going over the proverbial edge.

Watch for Part Two: Oil & Gas 360® Looks at Russian Oil and Gas – Next Week

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