The Fuse

Russia’s Oil Industry Not Designed for Swing Production

by Leslie Hayward | January 27, 2016

New rumors have surfaced regarding the potential for OPEC collaboration with other major producers—namely Russia—as oil prices continue to languish around $30 per barrel. This afternoon, fresh reports said that the head of Russia’s Transneft was in discussions with Saudi Arabia, and that both producers had sent signals of greater interest in cooperating. As Reuters reported earlier this week, “OPEC Secretary General Abdullah al-Badri said other producers should work together with the group to tackle swollen global stockpiles so prices can recover, essentially reiterating OPEC’s longstanding position that it would only consider cutting output if others pitch in.”

Oman and Azerbaijan have reportedly expressed willingness to cooperate with OPEC in a coordinated output cut, but with a combined production of less than 2 million barrels per day (mbd), they hold little market power. Russia, with production well over 10 mbd and growing, is the lynchpin to any potential deal.

Russia and OPEC together represent 45 percent of global oil production, which would create a formidable force in global markets.

The chances of a coordinated cut between OPEC and non-OPEC members are extremely slim, but the rumors have nonetheless resulted in a minor market rally. After all, Russia and OPEC together represent 45 percent of global oil production, which would create a formidable force in global markets. But despite Russia’s rhetoric, the fact remains that the country is not designed to accommodate any kind of swing producer role, or dramatic cuts in oil output, for a range of technical, logistical, and financial reasons.

Physical obstacles

Both Russia and Saudi Arabia are currently producing at near-record levels above 10 million barrels per day, but their oil industries are not comparable. Saudi Arabia’s oil industry is essentially designed to accommodate swing production. In 2005, Saudi Aramco began managing all of its oil and gas production, refining, and transportation through an extremely technologically advanced system, which enables remote control of production volumes. Accordingly, the country can adjust its production levels at negligible costs.

Saudi Arabia’s oil industry is essentially designed to accommodate swing production.

The same cannot be said for Russia, whose rigs are located in remote areas with harsh conditions. ­­­­­Over 60 percent of Russia’s oil production comes from Arctic regions of Western Siberia, and an additional 20 percent comes from the Ural Mountains, which also has a severe winter climate. Much of recent drilling in Russia has focused on enhanced oil recovery, rejuvenating aging brownfields, Arctic offshore, and directional or horizontal drilling.

It’s difficult to determine well productivity in both countries, given the number of uncertainties and lack of transparent data, but given Saudi Arabia’s uniquely favorable geography, it is likely that Russia would have to shutter a significantly larger number of wells in order to remove any meaningful volumes from their production totals. According to Baker Hughes, Saudi Arabia has less than 100 active oil and gas drilling rigs. The data on Russia’s active rig count is not reported by Baker Hughes, but it’s understood that the country has over 1,200 active rigs, augmenting 146,279 producing wells as of 2014.

Additionally, Russia’s breakeven oil production cost is estimated to be above $40 per barrel, while Saudi Arabia’s is closer to $7. The higher cost of the production, combined with the lower well productivity, suggests that Russia has more to lose by shuttering wells. Ramping production up or down tends to be a labor and time intensive process—which the Russian oil industry isn’t designed for.

Russia’s oil sector: It’s complicated

OPEC member states typically operate through a single national oil company, which takes orders from the country’s central government. For example, all of Saudi Arabia’s oil is produced by Saudi Aramco, which operates in lock step with the interests of the Saudi Royal Family.

Russia’s oil industry is not as straightforward, and officials have spoken to this challenge. In September, at yet another point when rumors of Russian-OPEC collaboration were swirling, Rosneft CEO Igor Sechin explained that Russia’s system of private oil companies would struggle to execute coordinated output cuts. According to The Moscow Times, Sechin argued that “Russia would face difficulties joining OPEC because its crude oil is produced by oil companies with private investors that cannot simply be told to stop work.”

“Russia would face difficulties joining OPEC because its crude oil is produced by oil companies with private investors that cannot simply be told to stop work.”

Rosneft is 70 percent owned by the Russian Government, 20 percent owned by BP, and publicly traded. Meanwhile, Lukoil, Surgutneftegaz, and Gazprom Neft are also publicly traded, but many are partially owned by the oil majors, or have other international stakeholders. If the Kremlin were to agree to a significant production cut, there’s no clear path to how such an action would be executed among the various players.

“The Russian government, understanding the differences in the conditions of production and property, agrees to observer status in OPEC,” Sechin said in September. Meanwhile, Russian energy minister Alexander Novak said on Friday that a coordinated cut between Russia and OPEC would “not be efficient,” and added, “From our point of view, it is unlikely that all the countries within OPEC can agree on production cuts, let alone those countries which are not in the OPEC coalition.” Novak also pointed out that Saudi Arabia has increased oil production over the course of the past year.

To Novak’s point, Saudi Arabia—despite the financial hardship it has faced in the low price environment—has continued investing in its upstream sector, while reporting gains in production efficiency. Saudi officials have consistently stated that they are unwilling to shoulder the burden of rebalancing the market on their own, but would participate in a coordinated cut which included both OPEC and non-OPEC producers. However, as the Kingdom continues its upstream investment, it’s unclear if the country’s stated willingness to cut is disingenuous, or the Kingdom simply doesn’t think there’s a credible expectation that the world’s other major producers will join them.

Last December’s OPEC meeting was so fraught with internal disagreement that the members couldn’t agree on an official production target, and the group has been pumping above its longstanding target of 30 mbd for some time.

No love lost between Saudi and Russia

In 2001, Russia pledged to join OPEC in a modest supply cut to boost prices, but later reneged.

Rumors that Russia and OPEC would cooperate on managing oil prices have surfaced before. In 2001, Russia pledged to join OPEC in a modest supply cut to boost prices, but later reneged. More recently, in August 2013, leaked transcripts from a closed-door meeting between Russian President Vladmir Putin and Saudi Prince Bandar bin Sultan revealed a conversation in which Saudi Arabia offered to collaborate tightly on managing oil production and prices in exchange for a deal in Syria, where the countries remain geopolitical adversaries in the country’s civil war. The failure of previous talks will no doubt contribute to uncertainty and mistrust in today’s conversations.