Energy Security Intelligence Research

ESIR

RUSSIA

Russia Outlook in Oil and Gas Sectors in the Era of Sanctions: Strategies for Foreign Investors

Russia Outlook in Oil and Gas Sectors in the Era of Sanctions: Strategies for Foreign Investors

Executive Summary

This update was generated based on an expert consulting and advisory knowledge supported by primary data for foreign investors and IOCs who wishes to operate in Russia. The aim of this report is to help industry investors in various countries and context conditions, to be aware of policies, security risks, regulatory frameworks and industrial strategies to maximize the benefits of their operations in oil and gas development that could promise while reducing the associated risks.

In this report, ESIR analyses Russia’s institutional dynamics in the hydrocarbon sectors; the political economy of oil and gas in the era of Western sanctions and it reserves strength. This report is based in part on ESIR’s integrated approach to the survival of Russian crude export. Both the oil and gas sectors have experienced a certain degree of decentralization, which has been accompanied by a weakening role of the State. This comparison aims to demonstrate that Russia’s oil and gas industries are significantly different despite their post-command economy similarities. The opposing institutional trends are related to different centralization—decentralization dynamics, which reflect an ever-changing interrelation between a State and market forces. At the beginning of transition to a market economy, the oil sector was almost entirely privatized and restructured, unlike the gas sector. Since 2003 a market concentration of the oil sector has taken place, with the creation of a national oil company, Rosneft. At the same time, since 2009, the gas monopoly has been under pressure from both domestic and international (mostly European) markets. Likewise, Gazprom has been able to diversify its exports to Asia-Pacific has a gas deal with China. Consequently, Rosneft is gaining importance, whereas Gazprom is softening its position in the gas sector, which also creates grounds for (at least a partial) DE monopolization of gas export from Russia.

Therefore, far-reaching inter-linked trend place the oil and gas sector at the centre of the global political and economic stage. It’s hope that analysing how business models in these sectors are changing to meet rising demand amid oil glut with price decline and national interest/geo-politics is a vital element in how foreign investors should positioned themselves on strategies in doing business in Russia in the era of Western sanctions.

We hope that this report—and the perspectives it offers—will add to the business insight. Further information on the report, and additional analysis, can be obtained from our website commodity section on: https://www.esirgroup.com/Russia.html#Russia

Contents

Executive Summary…………………………………………………………………………………………..2

Introduction………………………………………………………………………………………………………4

Methodology…………………………………………………………………………………………………….6

Overview of Russia Oil and Gas Sector……………………………………………………………..11

Russia’s Hydrocarbon Regulations and Management………………………………………14

Investors Awareness of the Eurasian Custom Union………………………………………..28

Russia’s LNG Exports: New Paradigm and Investment Opportunities………………34

Can Russia be considered a Reliable Partner for Foreign Investors.………………37

Key issues for investors when bidding for hydrocarbon in a new frontier like Russia………………………………………..........................................................................41

Seventeen Key issues to watch-out for in investing in Russia…………………………..47

Political Risk in Upstream………………………………………………………………………………..57

Indirect Expropriation and Political Risk Insurance for Energy Projects in Russia…………………………………………………………………………….………………………………..63

Russia’s Oil and Gas Squeezed at both Ends……………………………….……………………85

Chinese-Russia growing oil trade……………..……………………………………………………..93

Kremlin Energy Security Policy in the Era of Sanctions…………………………………….95

Conclusion……………………………………………………………………………………………………..101

References……………………………………………………………………………………………………..103


POLITICS AND ECONOMIC OF RUSSIA ENERGY SECTOR

  1. Russia resilience oil output 2013-18
  2. Playing the game and determined output
  3. Pushing and strategizing energy industry headwinds
  4. Dealing with tax avoiders and strong market plans
  5. Oil and Gas diplomacy in central Asia

Despite having the world's largest gas reserves, Russia is held back in its ambitions with western sanctions. Russia energy potentials is so huge but its geographical location presents its own obstacles. However, eight hundred miles northeast of St. Petersburg are gas-fields that could one day support shipments of up to 20 million tonnes a year (t/y) of gas to Asia. But the Russia summers are short and winter temperatures can fall to -40c. Therefore, getting the gas out of the ground, through ice up to three metres thick, liquefying it; and shipping it across the world is difficult and costly.

Kremlin's strategy and proposal is building both an extensive gas pipeline network as well as liquefied natural gas (LNG) export infrastructure to link the East Siberian fields with the Chinese, South Korean and Japanese markets. But there are hurdles at every stage of the plan.

Eurasia: Concerns over Bashneft’s minority shareholders’ rights following Rosneft purchase
Sectors: oil & gas
Key Risks: shareholders’ rights

Following Rosneft's purchase of the Bashkortostan region's 50.07 per cent stake in Bashneft on 12 October 2016, concerns have arisen regarding how the company will treat its existing minority shareholders. Under Russian law, Rosneft has until 17 November 2016 to buy out minority shareholders and the offer must be of an equal premium to that paid to the state, which would be roughly 218.3bln rubles (US$3.5bln). Yet there are concerns shareholders will be forced to accept a lower price as the legislature is scheduled to consider a bill in early November 2016 that would exempt price requirements if a company purchases another on the orders of the government. Rosneft was formally ordered to do so by the state and the law, if passed, would apply retroactively. Should the law be passed, it would raise major concerns over shareholders’ rights in Russia going forward.
 

Russia: First domestic oil IPO in ten years highlights political risks
Sectors: energy
Key Risks: sanctions; state interference; rule of law

Russneft launched the first domestic oil company IPO in 10 years. 20 per cent of the firm was sold at 550 rubles per share. The IPO valued the company at 162bln rubles (US$2.49bln). Russneft was wholly-owned by businessman Mikhail Gutseriev, who has previously quarreled with the Kremlin but has witnessed a strong revival of fortunes in recent years. 90 per cent reportedly went to domestic investors. Local media claimed interested foreign investors were largely Asia-based. US President-elect Donald Trump has not laid out a policy on Russian sanctions, although foreign demand for Russian investments could increase in the event he does. EU sanctions are also seen as increasingly likely to easen. Nevertheless, even in the event of a major uptick in relations, Russian energy assets are likely to continue to trade at a discount compared to foreign competitors as foreign investors retain concerns over political interference.

Tensions with economic liberals rise in Moscow
Sectors: all
Key Risks: currency inconvertibility
 
Eurasian currency markets could be in for significant volatility this week as Russian state-run oil giant is expected to issue more than 1 trillion worth of ruble-denominated bonds, worth some US$16-17bln. The last time Rosneft undertook a large domestic debt placement was in 2014 and the Central Bank allowed the notes to be used as collateral in its currency auctions, which allowed Rosneft to quickly turn them into dollars. The move caused the largest one-day collapse in the ruble’s value since the 1998 Russian financial crisis and subsequent default. However, Rosneft CEO Igor Sechin has recently demonstrated his influence through the arrest of Economy Minister Alexei Ulyukayev, reportedly on his orders, and it is unclear if Central Bank governor Elvira Nabiullina would be able to resist a demand from Sechin to again exchange the notes. Conversely, in Uzbekistan, President Shavkat Mirziyoyev has signalled he will begin a series of steps aimed at economic liberalisation following his election - effectively a coronation in the tightly controlled-state - on 4 December. The moves could see foreign investors look to return to the country.

Rosneft deal portends likelihood sanctions will be lifted but business risks remain
Sectors: all
Key Risks: sanctions; political uncertainty
 
The shock 7 October announcement that Rosneft would sell a 19.5 per cent stake in Russian state-owned energy giant Rosneft to Glencore and Qatar demonstrates the likelihood that sanctions on Russia will be loosened once US President-elect Donald Trump formally takes office. This has been further evidenced by Senator Bob Corker, head of the Senate Foreign Police Community, refusing to schedule a vote on extending Crimea sanctions, viewed as the least controversial, before Trump takes office. The Glencore-Qatar deal also foreshadowed the 12 December announcement that JPMorgan, SMBC and Mizuho would lend EUR800m over four years to Gazprom, further evidence Western financial institutions will extend activity in Russia. Nevertheless, the Glencore-Qatar deal’s structure has raised questions and could eventually see Russia take back part of the stake through the associated call options, demonstrating the continuing complications of doing business in Russia. Moscow also still maintains a majority stake in Rosneft.

Global oil pact underscores Saudi-Russian energy alliance  

The first global crude supply pact in 15 years has underlined the growing energy alliance between Saudi Arabia and Russia, as the depth of the two-year oil slump forces co-operation between once unlikely partners. Russia led the main oil producers from outside the OPEC cartel, including Mexico and Kazakhstan, in a deal signed this weekend to reduce supply by 568,000 barrels a day — with Moscow, the largest non-OPEC exporter, agreeing to shoulder just over half the cut. Brent crude was up as much as 6.5 per cent within minutes of markets opening in Asia on Monday 12 December 2016, to a year-high above $57.89 a barrel, following the non-OPEC deal. The agreement follows almost a year of petro-diplomacy that led Russian president Vladimir Putin and Saudi Arabian leaders to put aside differences over the war in Syria as their economies struggle to adapt to the halving in oil prices since mid-2014. The direct co-operation between the world’s top two crude exporters comes after Saudi Arabia on November 30, 2016 led the 13-member OPEC cartel in a deal to cut supply by more than 1m b/d, pushing prices up 15 per cent to above $54 a barrel. “It is very significant to have an agreement by the two powerhouses that are Russia and Saudi Arabia,” said Olivier Jakob, analyst at the Petromatrix consultancy. “A new geopolitical dynamic is being created which could be transformative for oil markets. Saudi Arabia and Russia together account for more than a fifth of global oil supplies, but mistrust between the two nations has not easily been overcome. Russia reneged on a previous joint deal to reduce output during the last prolonged oil slump at the turn of the century, and its offer to reduce supply by 300,000 b/d this time is seen as partly including natural declines from older fields. But the involvement of Mr Putin, who has held talks this year with Saudi’s powerful Deputy Crown Prince Mohammed bin Salman, adds weight to Moscow’s commitment. “With Putin directly involved in brokering this deal and Saudi Arabia and Russia co-operating on various fronts, not just the oil market, Putin is likely to put substantial political pressure on the companies to ensure substantial, if not full, compliance,” said Amrita Sen, co-founder at Energy Aspects. Saudi Arabia has traditionally acted as the oil market’s so-called swing producer, raising production when supplies were tight and lowering them when necessary to bolster the market and support the price. But in 2014 the rapid growth of US shale and other high-cost output, after almost four years of $100 oil, led Riyadh to abandon its role due to fear of losing market share. The subsequent crash in prices has stalled non-OPEC supply growth and led to as much as a trillion dollars in investment cuts, but also hammered the budgets of major oil producers. Riyadh has embarked on an ambitious project to end its economy’s over reliance on oil revenues but needs a higher price in the short term to achieve its goals, including listing part of Saudi Aramco, its state oil company, to raise funds. It feared giving up more market share to Russia, one of the few non-OPEC countries to successfully keep raising output during the slump. Russian output this year reached a record above 11m b/d, but a painful oil-price triggered recession — compounded by sanctions over Russia’s involvement in Ukraine — led Moscow to talks. “Negotiations from technical to leadership went on for a year with meetings in Russia and elsewhere,” said one OPEC delegate. “This wasn’t a game and it didn’t come easily but it is impossible to see [Mr Putin] changing his mind. Saudi too will fulfil its promise. This   deal will help ease supply glut but comes at a price for some cartel members Khalid al Falih, Saudi Arabia’s energy minister, said over the weekend that he could now potentially cut supply further than what was agreed with OPEC at the start of the year, in what has been seen as a warning shot to traders that might want to test their resolve. Riyadh and Moscow are thought to be targeting pushing prices above $60 a barrel next year, though analysts cautioned that they are unlikely to have the market entirely their own way. US oil output has fallen by about 10 per cent since early 2015, but US shale drillers have cut costs dramatically and could respond to any price recovery. Some market watchers also still harbour doubts whether enough of their pledged cuts will be enacted to start drawing down the huge overhang of inventories that built up during the glut. “Occasionally these loose, ad hoc producer agreements enjoyed temporary success, but all eventually failed due to cheating from without and within,” said Bob McNally, a former White House energy adviser who runs Rapidan Group, a US-based consulting group. “Time will tell whether [November 30, 2016] agreement breaks the historical mould.”

Russia Federation: conflict in Ukraine threatens to escalate again
Sectors: all
Key Risks: political violence; instability; war; terrorism
 
The Ukrainian military press centre reported 5 Ukrainian soldiers were killed and 14 wounded as a result of heavy clashes on 29 January, primarily in Avdiivka, a Ukrainian-held suburb northwest of Donetsk on 29 January. Mortars and small artillery attacks were also reported north-east of Mariupol, although such instances have remained common ever since the conflict reached its current lull two years ago. Ukraine alleged that 15 separatist militants were also killed in the fight around Avdiivka, alleging that they attempted to storm the down, but the separatists contradicted this. Fighting is ongoing and there is a significant risk of further escalation. Russia may seek to test Western resolve on Ukraine after US President Donald Trump and Russian President Vladimir Putin held their first phone conversation, although Trump mentioned neither Ukraine nor sanctions and US presidential officials indicated sanctions could be lifted based solely on an agreement to fight terrorism in Syria.

Eurasia: US expected to expand sanctions on Russia, Nord Stream 2 may be affected
Sectors: energy; defence
Key Risks: sanctions

The US Congress is expected to pass new sanctions on Russia as early as 25 July 2017. The bill was held up over the Trump administration’s concerns it erodes executive authority given requirements Congress approve loosening Russian sanctions. However, given significant public pressure, Trump is expected to sign the bill. The measures target actors in Russia's cyber and military activities and restrict the ability to work with Russian energy firms, which has raised concerns it could impact the Nord Stream 2 project. A vote is expected on 25 July 2017. The European Union has warned it will retaliate against any implications the bill could have for European energy companies involved in the Nord Stream 2 pipeline project. The original Senate bill, passed last month, read that the US shall continue to oppose the Nord Stream 2 pipeline given its detrimental impacts on the European Union’s energy security, gas market development in Central and Eastern Europe, and energy reforms in Ukraine.

Europe:  EU - Russia tensions over Moldova, Romania
Sectors: all
Key Risks: external conflict

On 28 July 2017, Russian Deputy Prime Minister Dmitry Rogozin’s flight was refused access to Romanian and Ukrainian airspace and thereby prohibited from landing in Moldova. Rogozin, who is on EU sanctions lists, threatened Romania on Twitter, but he has long been known for his bluster. Further tensions should be expected. Russia is likely to step up its criticism of the Romanian government, which also announced this month that it would buy a US$3.9bln Patriot missile defence system from the US, a move Russian President Vladimir Putin explicitly warned against. Meanwhile the expected passage of additional US sanctions on Russia has raised the EU’s ire over fears it could result in European firms being affected. ESIRGROUP views this as unlikely but the situation results in a Sword of Damocles hanging over sanctions compliance for such projects, which will strongly disincentive relevant financial institutions.

Eurasia: Putin may be setting up showdown with Trump; Uzbekistan prepares currency reforms
Sectors: all
Key Risks: sanctions, political interference, foreign exchange 
 

On 28 July 2017, Russia ordered the US to cut its diplomatic staff in Russia to 435 people. The move would result in a major degradation of US diplomatic and intelligence capabilities in Russia but would only come into effect on 1 September 2017. Putin may be seeking a showdown with US President Donald Trump, who also announced that he would sign into law new sanctions against Russia, with Putin potentially seeking to negotiate an agreement to withdraw both. Meanwhile on 26 July 2017, Uzbekistan’s Deputy Finance Minister Mubin Mirzayev stated Tashkent’s foreign currency reserves were ‘about US$20bln’, far in excess of what was previously assumed. The statements came after the IMF reported Uzbekistan had 'ample' foreign currency reserves for plans to liberalise its currency, the som. While a timeline for undertaking currency reforms has not been announced, one can be expected by year's end.
 

                    ONES TO WATCH 2018

Eurasia: Power struggle in Luhansk, Kadyrov may be out as head of Chechnya
Sectors: energy (North Caucasus); coal, mining and metals (eastern Ukraine / western Russia)
Key Risks:  political instability, government infighting
 
Igor Plotnitsky resigned as 'president' of the Luhansk People's Republic (LNR), a Russian-backed Ukrainian breakaway state. The move came after a four-day standoff between Plotnitsky and those loyal to Igor Kornet, who Plotnitsky sacked as 'interior minister' on 20 November. Leonid Pasechnik, who is seen as a proxy of Russia’s Federal Security Service (FSB), was named the LNR’s acting head. There remains a risk of further intra-separatist squabbles. The LNR could be ‘united’ with Russia’s other Ukrainian proxy, the Donetsk People’s Republic (DNR). The move will likely set off a new competition for control of resources in separatist-Russian-held areas of Luhansk Oblast. Meanwhile, controversial but powerful Chechen regional head Ramzan KAdyrov said on 26 November that he was prepared to resign, although Kremlin sources downplayed this in local media the next day. Kadyrov has previously made similar comments but the tone and nationally-televised prime time nature of the statement will continue to prompt speculation.

US measures targeting Russia under CAATSA to be announced 29 January 2018
Sectors:
all
Key Risks:  sanctions

Under the Countering America’s Adversaries through Sanctions Act (CAATSA) - adopted over US President Donald Trump’s protests in August 2017 - new sanctions targeting Russia are due to be announced on 29 January. The law also mandates the release of a list of oligarchs tied to the Kremlin, which will effectively serve as a ‘sanctions list in waiting’. Although they will not be subject to OFAC sanctions, it will make it far more difficult for Western financial institutions to do business with those named. However, large portions of the list may be classified so as to temper this impact. CAATSA requires the Trump administration implement at least five of 12 measures against Russia listed in the bill, and the lightest potential outcome could effectively change little to the current environment. The measures will also have a major impact on the Nord Stream 2 export pipeline, which is largely being funded by European energy companies and is complicated by separate political tensions over the project in the EU. The White House is authorised to sanction such companies under the bill as well. Although such a step is unlikely, the tenor of the moves announced could heavily disincentivize the project.