Amid the oil price crash, Rosneft is running to stand still

Across the global oil patch, from Texas to the North Sea, drilling rigs are standing idle as energy companies respond to the slump in crude prices by cutting investments.

Not so in the swampy Siberian marshes that are Rosneft’s heartland. At Yuganskneftegaz, the production subsidiary that accounts for more than one-tenth of the country’s oil output, the state-controlled Russian oil company doubled its drilling rate during 2015.

This counterintuitive move highlights a paradox driving the Russian oil industry — thanks to the weakness of the rouble and the nature of the country’s tax system, energy companies are coping with the collapse in crude prices better than their peers almost anywhere in the world. Russia, the world’s third-largest oil producer, lifted output to a post-Soviet record of 10.91m barrels a day in January, partly due to a 12 per cent increase in drilling last year.

But that may not be enough. With the enormous west Siberian fields developed in Soviet times in decline, Russia needs to invest ever more just to keep oil production steady. Rosneft’s sharp increase in drilling at Yuganskneftegaz came as output at the unit fell 3.2 per cent last year. Rosneft said in December it could increase capital expenditure by one-third this year in rouble terms compared with 2015, just to keep production stable.

Russian companies “are on a treadmill”, says Ronald Smith, analyst at Citi. “The bigger you are the faster you have to run just to keep production flat.”

With the double blow of western sanctions and low oil prices, it is increasingly uncertain whether Russia will be able to maintain output at current levels in the medium to long term — a priority for President Vladimir Putin’s government, which until the plunge in crude prices relied on oil and gas for about half its revenue.

That means that January’s post-Soviet record output level could be a high watermark for Russian oil production over the next few decades, some analysts believe — and the country’s provisional agreement reached last month with Saudi Arabia to freeze output at January levels may therefore simply be a formalisation of the status quo.

Nonetheless, few analysts expect Russian production to fall dramatically in the near future.

The first reason is the fall in the rouble, which has cushioned much of the blow of lower oil prices for companies that sell oil in dollars but set workers’ pay in roubles. For example, at Lukoil, the privately owned company that is Russia’s second-largest oil producer, the cost of pumping crude fell 35 per cent year-on-year in dollar terms during the first nine months of 2015.

Equally important is Russia’s tax regime, under which the government’s budget enjoys the vast majority of any windfall when oil prices rise, and also takes the brunt of the pain when values fall.

Another factor supporting the short-term outlook for Russian oil production is more than 1m barrels a day of new production scheduled to come on stream over the next five years through the launch of greenfield projects.

But investments in new Russian production are increasingly in doubt should oil prices stay low.

A large part of the problem is financial — the combined impact of western sanctions related to the Ukraine conflict and low oil prices has forced Russian oil companies to prioritise their investments. The position of Rosneft is further complicated by its hefty debts.

“They’ve been able to use their cash to focus on short-gestation, high-impact projects,” says Matthew Sagers, analyst at IHS. “That’s allowed them to maintain production with the cash they’ve got.”

But long-term projects are being pushed back. A presentation by Alexander Novak, energy minister, last November said that Russia’s oil companies have delayed 29 projects whose combined peak production would be about 500,000 barrels a day, according to one person familiar with the document.

In January, Transneft, the state owned energy infrastructure company, said it would delay the expansion of an east Siberian pipeline due to project deferrals by Rosneft and Gazprom Neft, the oil subsidiary of Gazprom, the state-controlled gas giant.

The main challenge for the Russian oil industry is in the more distant future.

For two decades, oil companies have largely relied on discoveries made in Soviet times. But after the current crop of greenfield projects has been sucked dry, there will be little conventional oil left to develop.

The government had hoped the gap would be filled by shale oil — Russia is estimated to hold the largest reserves of this type in the world — and the Arctic, one of the last great untapped sources of crude.

But sanctions have blocked western oil majors from participating in projects in the Russian Arctic, as well as initiatives to develop the country’s shale. For example, in 2014 ExxonMobil halted a joint venture with Rosneft in the Arctic while Royal Dutch Shell suspended work with Gazprom Neft on shale.

Some analysts argue that Russia could maintain production at current levels without the Arctic or shale if the country’s tax regime is adjusted to incentivise further investments in depleted fields — something the government is currently studying.

“By 2018 you either have to change the tax system or see a production decline,” says Karen Kostanian, analyst at Bank of America Merrill Lynch.

Tax may be the greatest risk to Russia’s ability to maintain production. With oil revenue due to fall sharply this year, thus increasing the Russian budget deficit to an estimated 4.4 per cent of gross domestic product, according to Standard & Poor’s, some Russian officials are calling for tax increases on the energy sector.

Sergei Shatalov, deputy finance minister, said in January the oil industry could survive “the removal of some belly fat”. This comes after taxes on the sector were revised last year to raise an additional 200bn roubles.

“This country has the potential to produce for 20-plus years at this level,” says Vladimir Drebentsov, chief Russia and CIS economist at BP. “It’s all a function of the fiscal regime. If they try to squeeze too much, oil production will collapse.”

This is the second part of a Financial Times series entitled Oil: Lower for longer, examining the consequences of the prolonged slump in oil prices.