Russia’s role in the OPEC supply cut agreement

May 2017 | Anna Nikitina

The November OPEC deal to cut production was unique due to the involvement of several major non-OPEC players—including Russia. The country has pledged to cut 300,000 b/d in H1 2017 with 12 main companies participating. It has ramped up production in the preceding months to a historic maximum to cut from a higher base. Therefore, Russia will feel the economic and political benefits of the deal without making a major market share sacrifice. We believe both the November deal and its extension in May 2017 will have limited impact on Russia’s long-term production outlook. Instead, its key limiting factors are exploration investments at currently depressed oil prices, as well as restrictions imposed by the EU/US sanctions on foreign company participation in Russian projects.

In November 2016, OPEC announced its landmark decision to remove 1.8 MMb/d from the market in H1 2017 in order to achieve rebalancing. The agreement is particularly important due to 600,000 b/d reduction coming from outside of the cartel. Notably, Russia, the largest oil producer globally, agreed to cut 300,000 b/d.

In the Russian case, although contribution to the cut is voluntary, 12 major companies that control 90% of output agreed to partake. The producers were supposed to decrease output in accordance with their share of Russia’s total mix, after the initial idea of trading quotas between companies was rejected. More than a half of Russia’s oil output is controlled directly by the state, which helped ensure high compliance levels (Exhibit 1). In April, Russia’s compliance stood at 95.2%. Upon reaching the agreed reduction of 300,000 b/d, current output levels will be maintained during H1 2017 until the deal expires.

Exhibit 1: Companies participating in the cut accounted for 87% of Russia’s production in 2016 with most of it controlled directly by the state

1 Includes Bashneft
2 JV of Gazprom Neft and Rosneft
3 Includes PSA operators

Since the deal was announced, although impacted by US shale revival, Urals oil prices still rose from less than USD45/bbl to around USD50/bbl. The Urals-Brent differential has also been gradually narrowing down, further increasing oil revenues for Russia. Finally, the oil price increase has positively affected prices of other commodities, such as natural gas, refined products, and coal. This is especially important for Russia, which is the largest global exporter of natural gas.

Backing key energy players should also elevate Russia’s image in the world arena. In particular, negotiating a compromise between Saudi Arabia and Iran aided in further strengthening the Moscow-Tehran relationship. A 100,000 b/d oil swap contract is just the latest in a row of high-profile energy deals between the two countries. Cooperation with Saudi Arabia on possible deal extension has also been mirrored by closer ties in arms trade.

Compliance with the agreement is more attractive than it seems for Russia. Its production costs are almost entirely based on the local currency, the rouble. Since the announcement of OPEC agreement, the rouble has gained around 10% of its value, increasing production costs accordingly. A temporary decrease in activity could therefore be appealing to operators, who can ramp up output again once currency fluctuations improve project economics.

Prior to the agreement, Russia had also reached a new post-Soviet oil peak, surpassing expectations from abroad. The ramp-up has been partly driven by development of condensate-rich gas fields in the Urengoi area. Brownfields have also experienced better decline rate management and more investment (Exhibit 2). By bringing drilling services in-house, oil giant Rosneft has managed to optimize costs and grow development drilling by 35% in 2016. At Rosneft’s largest 1.2 MMb/d Yuganskneftegaz project, development drilling increased by 59% last year and hydraulic fracturing by 40%. While this means Russia was cutting from a higher base, it is also ambiguous whether operators would have been able to maintain such volumes in the longer term, even if the output cut agreement was not in place.

Exhibit 2: Intensive summer 2016 drilling campaign in Russia helped to ramp-up production volumes prior to the cut

1 April 2017 driling data not yet available
SOURCE: CDU TEK, Ministry of Energy of Russian Federation

Will the OPEC agreement impact Russia’s near-term outlook? We estimate less than 1% of Russian production will be affected in the short-term. The supply deal's prolongation to March 2018 at already agreed-upon volumes would compromise another 1.5% of output. Until now, Russian companies were responding primarily by decreasing development drilling volumes, rather than shutting in existing wells. When it came to shut-ins, the companies concentrated on marginal wells that are easy to bring back onstream and that do not disrupt field operations. Should the deal be prolonged, near-term production will depend on whether operators will instead focus on large-scale well conservation, as recent data shows signs of drilling activity rebound (Exhibit 2).

In the longer term, political sanctions represent a more substantial threat to Russian output. US/EU companies are forbidden from participating in technology-intensive Arctic deepwater, shale, and heavy oil projects. Russian companies, however, are used to relying on foreign partners and do not yet have the capabilities for solo exploration and development in deepwater. As West Siberia—the bedrock of the Russian oil industry—continues to mature, venturing into frontier projects will be essential for maintaining stable output.

Markets situation will also affect Russia’s long-term outlook, as the country is gradually moving towards more costly, hard-to-recover reserves. Under our low case scenario, reduction of long-term oil prices to USD40-50/bbl could take out up to 680,000 b/d from Russia’s output by 2030 and erase prospects of diversifying into LTO production in the near future. On the other hand, prices rising to USD80-90/bbl as a result of geopolitical shock could see Russia add an additional 640,000 b/d by 2030. This would happen mainly through accelerated development of conventional onshore projects, as activity in frontier regions will continue to be stagnated.

Another threat to Russian production is the decrease in exploration expenditure after the oil price collapse. Even though a minor growth in exploration spend is expected this year, we do not expect it to return to pre-2014 levels any time soon. In addition, unconventional hydrocarbons will continue to play a marginal role, as we do not envision large-scale exploration investment in LTO until 2028 at the earliest.

So what happens next? Russia has now officially backed deal prolongation until March 2018 and will negotiate with key players at the OPEC summit on May 25th. While the government previously admitted that it had higher hopes for the agreement, expecting oil prices to stabilize at around USD55-60/bbl, it has no regrets in backing OPEC and believes the market situation has improved. If the deal is extended, it will be hard for participating companies in Russia to withdraw. This gives them the opportunity to focus on exploration efforts and grow their resource base while the market rebalances.


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About the author

Anna Nikitina is a Senior Analyst with Energy Insights in McKinsey's Wroclaw office.

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