Western Sanctions on Russian Oil and Gas: The Turn of the Screw?

The latest round of US and EU sanctions are unlikely to bring the Russian energy sector to an immediate grinding halt. However, the range of sanctions focusing on energy technology potentially threatens two of the growth areas of the Russian energy sector, Arctic resources and shale oil development. From a Russian perspective, although the sanctions are potentially threatening there is time to adjust and take measures to offset their impact.

The latest package of Western sanctions focused on the energy technology towards Russia that was announced at the end of July. Sanctions are clearly targeted at potential growth sectors of the Russian energy economy where new energy technology will be required. These are principally in the Arctic in the Kara and Barents Sea, working ironically with western companies such as Exxon, BP and Statoil to extract huge oil and resources in extremely difficult climate conditions. The other area where Western energy technology will be required is the enormous Bazhenov shale oil play in Western Siberia, which appears to be around 80 times larger than the key US shale oil play, the Bakken in North Dakota.

The initial Russian response to these sanctions has been dismissive. “The sanctions don’t have a great impact on our current activities. We are not planning to change our investment plans, too” – said Alexei Yankevich, Deputy CEO for Economics and Finance, Gazprom Neft, in a typical and robust response which has been repeated across the official Russian energy sector. This is also not an entirely unreasonable response as energy technology sanctions will not have an immediate impact on current production from traditional conventional oil and gas fields.

However, while Russia is not planning to back down, the situation in the energy sector might be dramatically changed over the years. The goal of Western sanctions appears to be not to inhibit present oil production but to complicate Russia’s energy future. According to Merrill Lynch analysts, Russia stands to lose $500 billion in direct investment, the multiplier effect of $300 billion, and the budget revenue loss of $27-65 billion.

Conventional oil and gas fields provide 90% of the current oil production in Russia and the country is seeing existing fields going into their decline phase. Furthermore, there are current fields which will be hit by lack of access to energy technology. For instance, the maintenance of the rate of production West Siberian brownfields requires technologies that are now being sanctioned.  Depleting West Siberian and other brownfields force Russian oil companies to move intro more difficult parts of the existing formations.  Based on Fitch Ratings, Gazprom Neft is relying on wells with horizontal drilling, which accounted for 42% of all wells drilled in 2013 compared to 4% in 2011, and multi-stage fracking, which changed from 3% in 2011 to 57% of high-tech wells completed in 2013. Sanctions therefore harm both the ability to successfully develop harder-to-reach deposits and maintain current brownfields.

In the long run, measures will affect Russia’s projects in the Arctic that have huge potential. Russian companies have a lack of experience and depend on joint ventures with western companies, such as Exxon Mobil, Royal Dutch Shell and BP to provide technology and equipment. In this case, if Russia doesn’t find alternatives, sanctions can put the feasibility of these projects into question.

As a response to the Western cool-down, Russia's energy sector started to reorient itself to Asia. According to the Wall Street Journal, 30% of Russia’s oil export (1.2 millions barrels a day) went to the East, mainly China. Moreover, China is likely to provide a substitution for the energy sector equipment.  Analysts say China’s Honghua Group, one of the largest construction companies of onshore drilling rings, could become a main Asian benefactor. "Honghua can provide similar quality rigs as Western companies with a 20% price discount, plus cheaper and more efficient delivery thanks to access by rail instead of ship," - commented Gordon Kwan, head of oil and gas research at Nomura.

However, supply change will take some time.  Rosneft’s Chairman Igor Sechin already announced that the execution time of some projects may be rescheduled because of the sanctions. In addition to Chinese technology and capital, Russia has two other reponses two technology sanctions. First, to squeeze more efficiency out of existing levels of technology, repair pipelines, improve maintenance levels and increase competition in the oil and gas sector. Second, it can look at developing second tier fields in Western Siberia which do not need as much advanced technology to be developed. One of the ironies of sanctions is that they may in fact encourage Russian energy reform the West would approve of, but would never have been undertaken without Western said sanctions.

Nevertheless, the sanctions do pose a threat to Russia and further, to global financial stability. Marcel Fratzscher, a former head of International Policy Analysis at the European Central Bank, said that the problem with sanctions is that they can become more efficient than it was intended. Russia’s economy is too large and nobody knows how the sanctions will unfold. Hit by sanctions, Russia may refuse to return to the negotiation table as well and continue to increase its commercial relationship with Asia.

Undeniably - sanctions will have costs for both sides. Russia and the West are likely over the next few months to rethink their approach to sanctions.  Even now, Vygaudas Usackas, the EU ambassador in Moscow, told Russian media that the sanctions could be set aside earlier within a year should the situation in eastern Ukraine be resolved.

 Marina Zvonareva is a Natural Gas Europe analyst focused on Russia’s international energy relations