With global oil prices showing no signs of strengthening anytime soon, the Kremlin needs to come up with a new plan for the Russian energy sector that takes into account both sanctions and a new era of cheaper energy.

An oil worker walks by an oil pump during a sandstorm that blew in on Thursday, Jan. 8, 2015, in the desert oil fields of Sakhir, Bahrain. Photo: AP

The China-led slowdown in global economic growth and a decline in manufacturing appear to be the biggest factors behind falling oil prices in the U.S. and Europe. As Reuters points out, “U.S. oil prices headed for their eighth consecutive week of falls on August 21, the longest losing streak since 1986.”

However, the drop in oil prices actually started in mid-2014, when the Organization of the Petroleum Exporting Countries (OPEC) decided not to cut oil production. As a result, 2015 has witnessed a continuing decline in oil prices. One barrel of Brent crude traded below $60 in January 2015, and, stumbling around the $60-65 price level, fell again below $50 in August.

This is not a good sign for the world’s energy markets or for developing economies reliant on oil exports, including Russia.  

“The price collapse is neither unexpected nor unprecedented,” the International Energy Agency, the energy think tank of the OECD, argues in its latest medium-term oil market report. In fact, it warns against over-production of oil by OPEC countries and their reluctance to cut oil production.

Indeed, the oil price has fallen in several periods after the 1970s oil supply shocks (namely, in 1986, 1998 and 2008). However, unlike these historical drops, the current one is both supply- and demand-driven. One of the factors driving the price down is the record growth of non-OPEC supply in 2014.

Another factor is unexpectedly weak demand growth. The International Energy Agency in the aforementioned report expects that there will be a slight uptick in the oil price, “The prices are likely to stabilize at levels higher than recent, but below the highs of the last three years.”

In August 2015, Brent and WTI futures were at $47 and $42, respectively. One of the key factors in falling oil prices is oversupply. There is spare capacity of OPEC producers (plus a decision to not introduce production quotas by OPEC in late November 2014) as well as a sharp increase of production of light tight oil (LTO) by the U.S.

The advancement of extraction technologies has unlocked vast resources and shifted the balance between OPEC and non-OPEC production. Oversupply leads to further oil price decreases, and in the situation of increased U.S. production, there is more competition between other oil producers.

But oil price is not the only problem when it comes to the changes in international energy markets. Natural gas prices have also seen a decline post-2008, which resulted from the shale gas breakthrough in North America, which made shale resources much more attractive from a commercial point of view.

The availability of gas volumes has created a situation where North American gas prices were lowest among regional markets (compared to Europe and Asia-Pacific). Additionally, through the mechanism of inter-fuel competition, certain volumes of coal were pushed into the European market, thus affecting demand levels in Europe.

What are the implications for Russia?

Obviously Russia, whose budget is 50 percent formed by energy export revenues, is affected by the changes in world energy markets, and not just by the fuel mix, but also by the price levels and external factors in the oil markets.

Firstly, from the point of view of market organization, there is a changing lead player. In 2014, when there were worrying signs about decreasing oil prices, OPEC met in Vienna to conclude that they would not introduce quotas on oil production. OPEC embraced market forces in late 2014 in a bid to keep their market share.

Therefore, all eyes are now focused on the manufacturers of light tight oil as the primary market movers. U.S. oil production kept rising in the first quarter of 2015 despite the decline in the number of active rigs. The potential to efficiently produce oil from unconventional sources is greater than previously thought, as evidenced by the development of shale oil production in China

Secondly, the record high volumes of the U.S. production have led to a decrease in oil supplies to the U.S. and enhanced competition among suppliers in other markets. Moreover, as was noted above, there is a tendency of moving from crude oil trade toward oil products trade in the oil markets.

Thirdly, most oil (more than 4 billion tons) can be obtained even at prices below $90 per barrel. This includes conventional oil and liquefied natural gas (LNG), U.S. shale, tight oil and oil from the Canadian tar sands.

Russia seems indeed to be “the biggest casualty of the oil price fall,” in the words of the IEA. The low price, however, is not the only problem. Russia’s perspectives have to be viewed in the context of three parallel developments: low oil prices, Western sanctions and a weak ruble.Oil price and RUB/USD exchange rate. Source: Bloomberg, Central Bank of Russia

The issue of price is central to Russia’s production profile: If the price remains at a low level, Russia has to revise development plans for offshore and unconventional projects. Thus far, Russia has managed to keep its share in the oil market through signing long-term contracts and pursuing export projects, including in the Eastern direction.

However, in order to adjust to the changing market and maintain market share, Russia has to either aggressively push for developments in the Arctic and East Siberia, or completely change the structure of its oil sector.

Both options are problematic in the wake of sanctions: the functioning of the energy sector is impeded by lack of access to technology and funding. The companies hit by the sanctions include Gazprom, Lukoil, Rosneft and others. The sanctions regime hit deepwater, Arctic and shale projects. Both Total and ExxonMobil have postponed or suspended their participation in joint ventures with Russian partners.

The ruble fell dramatically at the end of 2014. The Central Bank has increased interest rates, while companies experienced difficulties with access to foreign financing (as a result of sanctions). Russian companies now lack the ability to refinance their debt. Lack of funds will inevitably lead to lower capital expenditures, which in turn makes both above-mentioned options (developments in new areas or changing the structure of the sector) less likely.

Even higher production decline rates can be expected in the future. Moreover, a weak ruble is resulting in the inability of the Russian domestic market to benefit from lower international energy prices. All of which leads to greater urgency for Russian policy planners to make hard choices sooner rather than later.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.