Oil Market Report February, 2014

With neighboring Ukraine literally erupting into flames, February marked Russia’s hosting of the 2014 Winter Olympic Games, in a place that was, quite frankly, absurdly ill-suited to winter sports. Average February temperature in the seaside resort of Sochi is 12 deg C, whilst the “mountain” resort of Krasnaya Polyana (where the skiing events were held) has average winter temperatures of 5 deg C. This makes it about 1 degree warmer than York, so perhaps an Olympic bid for the Howardian Hills should be considered come 2022…

Having said that, in Russia, all things come back to oil and both the staging and extravagance of the Sochi Games was only possible because of Russia’s huge mineral wealth (at $50bn, the cost of the games exceeded the expenditure at all previous Winter Olympics put together). Depending on which statistics you believe, Russia is the 1st, 2nd or 3rd biggest producer of oil and gas in the world and, since the break-up of the Soviet Union, this mineral bounty has transformed the country. As the free market opened up and commodity prices soared, the old-communist guard suddenly found themselves bathing in previously unheard of riches, that are currently worth $1bn per day(!). In political terms, Russia’s oil hegemony has helped re-establish its influence over countries near and far and this influence continues unabated to this day. Just look at the recent protest / revolution in Ukraine, where energy dependence on Russia is ultimately at the heart of the uprising. And why would it not be? After all, the Ukraine is a country where average winter temperatures are minus 6 deg C and 70% of heat comes from Russia…

But scratch below the surface and the state of Russian oil and gas is not quite so bright. Firstly oil reserves may be staggering in size but production capacity lags way behind – not surprising in a country where historical corruption, soviet era-technology and state bullying of Western companies has been the order of the day. In this sense the Russian oil industry is rather like a giant ATM cash machine, where thousands of pounds sit in the vault but a £200 daily withdrawal limit means that getting money out is a slow process. Such inefficiency shows no sign of diminishing wherever you look in the sector; overall production is down from 13m barrels per day (bpd) in 2010 to 10m bpd in 2013, refineries are so basic and under-invested that they continue to produce inordinate amounts of worthless fuel oil (flooding the market and helping no-one) and at the same time Russia’s gas industry flares (ie, wastes) 40bn cubic meters of gas into the atmosphere each year.

Compounding these problems, we have an increasingly truculent EU – Russia’s biggest “customer”. First came anti-competition raids on Russian oil & gas offices throughout Europe, and then came the unprecedented climb-down from Gazprom (Russia’s state gas company) in accepting that European gas prices must be decoupled from (high) oil prices. Furthermore, it was then agreed that Gazprom would pay $5bn to European customers in price refunds – approximately doubling the refunds of the previous year ($2.7bn in 2012-13).

However, if EU leaders are smelling blood, they should probably get their olfactory senses double-checked for the Russian Bear has a horrible habit of proving rather resilient. The recent announcement that JP Morgan is to sell its oil business to Russian trading giant Mercuria only goes to show that where Western companies fear to tread, Russian businesses continue to tread fearlessly. Furthermore, such is the decline in North Sea oil production that it now seems inevitable that Russian crude (from the Urals) will soon form part of the Brent Crude price – effectively the world’s oil price outside of the USA. And probably most significant of all was the reaching of full capacity last year on the Eastern Siberia Pacific Ocean (ESPO) pipeline, whereby 100% of Russian oil can now be exported via Russia’s Eastern Seaboard (Kozmino, nr Vladivostok) to the USA, China, Japan, South Korea and all of South-East Asia. In fact with export options to the North (via Arctic Sea shipping channels), the East (through ESPO) and the South (the Black Sea), Russian producers now have the ability to bypass Europe and their meddling Brussels bureaucrats all-together. So imagine that folks. Not only are we to have the prospect of Russian oil becoming (over time) the main player in the benchmark Brent crude price, but the logistical options available to Russia, now mean that their oil can flow east rather than west – glutting or starving markets – subject to price and political desire.

That Russia has deep internal economic and political problems cannot be in doubt. Political opposition to the ruling party is no more tolerated now than it was in the days of the Soviet Union. Power and favour is funneled down from the top and cronyism is endemic*. The economy is so badly skewed to the oil and gas industry (75% of exports / 30% of GDP) that all other industries are in a perpetual state of decay, with no incentive to reform. But these are problems for the Russian people and are arguably of little interest to the outside world. What does matter to the rest of world and particularly Europe is our continued reliance on Russian energy and the prospect of this reliance becoming ever more costly as each year goes by.

* Pure coincidence no doubt that Sochi Games Organiser Arkady Rotenberg was one of Vladimir Putin’s boyhood Judo partners…!