Russia’s energy wealth has long been the main pillar of the country’s economy, but what’s the long-term future of that financial security in a world that is gradually moving toward decarbonization? Thane Gustafson, whose Wheel of Fortune: The Battle for Oil and Power in Russia we recently released in a paperback edition, addressed that question earlier this fall when he delivered the Chatham House’s Annual Russia Lecture. The text of his address is below.
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The last time I had the honor of giving a speech here at Chatham House was thirteen years ago, in 2004. The talk was entitled “The Russian Oil Miracle.” Five years before, after sinking to a low point equal to about half of the Soviet-era record of 1988, Russian oil production had abruptly turned around, and between 1999 and 2004, it had regained much of the lost ground. During those years, Russia accounted for all of the net addition of crude to world oil supply.
What we could not see at the time, however, was that 2004 was the last of the miracle years, which were essentially based on capturing the “Soviet dividend.” By 2004 much of the Soviet dividend had been extracted, and while Russian oil production has continued to grow steadily since then, progress has been very gradual, and every year the net increase in production is far outstripped by the volume of drilling required to produce it, as each year’s production must overcome the built-in decline rate of existing fields as well as the diminishing returns from new ones. The Russian oil industry is very much in the position of an athlete that is running uphill against a slope that is steadily growing steeper.
But it is not my purpose today to deliver an update of the Russian Oil Miracle, but rather, to ask a very different sort of question, reflecting the revolutionary changes that have taken place in the world of energy, and especially in our perceptions of it, in just a decade-and-a-half, and to reflect with you on the implications of these changes for Russia as an energy producer and as—I think we can fairly use the term—a “petro-state.” Namely—what happens to Russia as an energy superpower as global demand for oil approaches a peak?
Cycles within Cycles: How to Think about the Energy Future of Russia
Trying to predict the future of Russian energy, and indeed of Russia itself, is like predicting climate change. And here I’m not talking about Mark Twain’s famous wisecrack that “everybody talks about the weather, but nobody does anything about it.” Rather, what I mean is the classic difficulty in any conversation about climate change—namely, that of distinguishing between long-term cycles and near-term ones, or, to put it another way, between signal and noise. Rising ocean levels are signal, whereas last year’s winter temperatures in Washington are noise.
Let me take as one example the cycles of global crude oil prices and their impact on the Russian economy. Russia has gone through four economic crashes since the mid-1980s, all four of them connected to the rise and fall of commodity prices and specifically oil. The precise causes and course of each of these cycles has been different from case to case. Yet the following would have seemed like a safe prediction just a few years ago:
- The cycle of peak and trough in global commodity prices will continue—that is what commodities do—and since oil markets are increasingly globalized and commoditized, the same cyclical pattern will govern oil prices as well—and gas too, by the way, as liquefied natural gas (LNG) increasingly turns gas into a globally traded commodity.
- And with each downturn—possibly at more frequent intervals in the future than in the past, but roughly once every decade—Russia will be thrown into recession, although with improved macroeconomic management (as in the last downturn) the extent of the decline may be cushioned. Conversely, as Alexei Kudrin has been warning for a decade, the stimulative effect of each upswing in oil prices will also be smaller each time, as the dependence of the Russian state budget on oil revenues increases.
As I say, this would have seemed like a safe prediction, at least a few years ago. But now three important things are changing. Of course, we are always being told, “This time it’s different.” But if you add together the three long-term changes I’m about to describe, things really are about to become different. In comparison to them, the ten-year cycle of oil prices—jarring as it is for Russia each time—can be set aside as noise. But these are long-term signals, and all three signal bad news for Russia:
- The first is the unconventional oil revolution in North America, but not in Russia.
- The second is the narrowing of margins as Russian oil becomes increasingly high-cost.
- The third—and potentially by far the most serious—is the displacement of oil from its one remaining niche in the world economy, namely, transportation.
The Consequences and Challenges of Unconventional Oil
The unconventional oil revolution, briefly described, is the result of the simultaneous application of three basic technologies to previously uneconomic tight oil formations. The three are: horizontal drilling; multi-stage fracturing; and seismic imaging. None of these is new; what is new is what happens when the three are applied in combination. The result has been extraordinary. Since 2004, when I was last here, tight oil production, as the term has come to be used—or shale oil, as the term is more commonly misused—has turned the US oil industry upside down. At present, out of a total of about 9.2 million barrels per day (mbd) of U.S. oil production, so-called “shale oil” accounts for over half, or 5.6 mbd.
That’s no longer news. But what is news is the revolution in productivity that has followed the latest collapse in oil prices. It used to be said that the break-even price for most tight oil was about $90 a barrel. Now, in the wake of the oil-price fall, it is closer to $40. Moreover, the more tight oil companies refine their techniques, they are increasingly confident that they can keep the revolution going at these low prices or even lower indefinitely. Projections for U.S. tight oil production in 2040 range as high as 11 to 17 million barrels a day. The U.S. has become the oil world’s swing producer, and in the process makes such things as this year’s OPEC’s output-reduction agreement largely irrelevant—essentially noise.
The Growing Battle for Margins between the Industry and the State in Russia
Until recently, Russia was comfortably in the middle of the global cost curve—higher than the Middle East, but lower than most other producers, including the United States. Now that has changed—Russia is moving up the cost curve, and as time passes, it will continue to do so.
In Wheel of Fortune, I made a crude distinction among three colors of oil—blue, green, and brown. “Blue” is essentially prospective arctic deepwater; “green” is new oil in virgin onshore regions, chiefly in East Siberia and the Russian Far East; “brown” is conventional oil located in fields mostly under development—in many instances since Soviet times—mainly concentrated in West Siberia and in the Volga-Urals basin.
I won’t go into detail on the differences among these three categories, except to say that over the coming decades, Russian oil is going to change color—from predominantly brown (as it was ten years ago), to a mixture of brown and green (as it is today), and finally—if all goes well—to a progressively deeper shade of blue.
But as it does so, Russian oil will gradually become more and more costly to find, produce, and transport. This will lead the state and the oil companies into an increasingly tough battle for shrinking margins. Unless technology offers a way out by opening up a new source of low-cost brown oil, as I’ll discuss in a moment. But at the moment that is not happening. And the result is going to be an increasingly bitter fight. The oil industry needs the shrinking margins for investment—remember that even drilling infill wells in existing fields is considered investment—but the state needs the margins to balance its budget. It’s the classic zero-sum competition for the proverbial shrinking pie.
The Ultimate Threat: Oil Is Being Squeezed out of Its Last Remaining Market—Transportation
But the greatest long-term threat to the Russian oil industry is the prospect of “peak demand” for oil. The progress of electric cars and battery technology is exceeding all expectations. At the moment, the two greatest obstacles facing the electric car are insufficient battery power and lack of recharging infrastructure. It is surely a reasonable expectation that there will be a breakthrough in the first and steady progress in the second. The predictable result is that oil will gradually be squeezed out of its main remaining niche—transportation. For Russia, the implication is both lower oil prices and lower volumes, especially if Russia remains at the high end of the cost curve.
Now, recall what I said earlier, about the cycles within cycles. The ten-year cycle of global oil prices will continue. And every time the price goes up there will be those who will say, “See—business as usual.” It will be difficult to distinguish the long-term signal from the short-term noise.
But the shape of things to come can be seen in items such as a recent report in the Financial Times that China is actively considering joining France and the UK in banning combustion engine cars by 2040. China accounted for 30 percent of the 94 million cars produced in the world last year. By 2040, it is likely to account for a far larger share of a far larger number—but how many of them will be combustion engine vehicles? It need not be zero to have a dramatic impact on the long-term price of oil—and Russia’s long-term fortunes.
It’s important to put this in perspective. We’re not talking about the global oil industry becoming a case of “stranded oil.” Oil will still be produced a generation from now, perhaps above today’s level of 98 mbd. But the point is that there will be heightened competition for the remaining oil market, and only the lowest-cost producers will win. At this point that has several implications:
- The Russian “blue oil” is likely to remain at the bottom of the ocean. This is the highest-cost resource in the Russian oil portfolio.
- The future of Russian “green oil” will depend on whether a definitive geological model for East Siberia is developed in coming years. At this moment, it seems clear at the very least that East Siberia is not West Siberia, and never will be. Unless something alters that picture, Russian “green oil” will mostly remain at the high end of the Russian cost portfolio as well.
- That leaves “brown oil,” and that boils down to a question that seems at first to be purely one of technology: Can there be a brown-oil renaissance in Russia? Could there be a tight oil revolution in Russia on the scale of what has occurred in the United States?
Can the Russian Oil Industry Do Tight Oil?
Russian oil companies are already adopting the “magic three” technologies underlying tight oil, and Russian contractors are mastering them. A growing percentage of Russian wells are horizontal, and are being fracked. With the help of foreign service companies, high-resolution seismic imaging is increasingly in use. In other words, the basic “below-ground” elements of tight oil production are already in place.
But that is to miss an essential difference. The tight oil revolution in the United States is an above-ground phenomenon. It is the product of literally thousands of small and medium-sized companies, competing with one another in an environment that rewards flexibility and trial-and-error. This supportive environment does not exist in Russia; to take just one example: in the United States a production plan filed with local authorities can be changed within a day; in Russia it takes several months. Indeed the small companies that drive the revolution in the United States hardly exist either.
Thus the crucial question is whether a “tight oil revolution” can break out in Russia. So far the evidence suggests that it will be a long time coming.
If not Oil, then What about Gas?
This is the golden age of gas, but not the golden age of gas profits. Why is that, and what are the implications for Russia? If Russia can no longer be an oil superpower, can it become a gas superpower, whether in the form of pipeline gas or LNG? You may be relieved when I say I’m not going to double down with a discussion of the future of gas. Let me just make a couple of brief points:
- First, gas is not nearly as profitable as oil. The capital costs are far higher, and the rents are lower.
- At this moment, oil accounts for only one-fifth of Russia’s hydrocarbon export revenues. Gas can simply not substitute for oil as a source of export income, and that is likely to remain true in the future as well.
- The key to expanding into global gas markets will be LNG, and here the Russians have some real advantages in the Yamal Peninsula. But their chief liability will be ferocious competition from places like Qatar, that have even cheaper gas and are more favorably situated.
- Consequently, there will be an important gas niche for Russia, but not on the same scale as oil.
Last Thoughts: the Future of Russian Oil in the Mirror of the Past
To sum up, three trends underscore the challenges faced by Russia as an energy superpower. One of these—the prospect of a demand peak for oil—is out of Russia’s hands. But the other two—Russia’s long-term rising cost trend and the above-ground obstacles facing tight oil production—lie within Russia’s grasp. The answer is technology—but technology rightly understood as a complex of below-ground techniques and above-ground environment. It is the latter that needs fixing in Russia today.
