Why Russia will stick to its pledge to cut oil
The Russian oil industry has the motivation and the ability to meet its pledge to lower production
Russia and other unaligned producers agreed earlier this month to join OPEC in cutting oil output, saying they would reduce supplies by 558,000 barrels per day. On top of Opec’s pledge to cut 1.2m b/d the path to a rebalanced oil market much is now clearer.
Oil prices have climbed from $48 per barrel in late November to $55 this week. At this point, commodity and equity markets are, however, beginning to ponder whether these pledged cuts will be realised.
This is not surprising given OPEC’s patchy record adhering to quotas and the participation of Russia and other non member countries. Some question how serious Russia might be about following through on its own 300,000 b/d commitment, while others wonder if Moscow even has the legal or technical ability to deliver those pledged cuts.
For our part, we think Russia is highly motivated to follow through with its proffered cut for two reasons.
First, Russia reportedly played a key role in both deals, with President Putin personally acting as a deal-maker between Iran and Saudi Arabia to bring the original OPEC deal and then committing Russia to a 300,000 b/d reduction to catalyse non-OPEC participation.
As such, the Russian government, including President Putin himself, have made a substantial reputational commitment to making the deal work. In that light, it is not surprising that the Kremlin has already begun detailing specific country-wide targets of 200,000 b/d of reductions for the first quarter of next year and an additional 100,000 by mid-year, signalling to oil markets its seriousness.
Second, the maths of higher prices versus lower production provides significant stimulus for the Russian government. This is based on the fact that oil taxation has traditionally provided almost half of the country’s tax revenue and because the Russian oil tax regime is highly geared to the price of oil.
For example, extraction taxes and export duties combined go up $8.3 per barrel for every $10 rise in oil prices. The net effect of a 300,000 b/d output cut and a $10 oil price increase would be a 28 per cent increase in oil tax revenues in US dollar terms, and 15 per cent in local currency terms, giving a material boost to the government’s efforts to balance its budget.
As for Russia’s ability to cut output and questions about the Kremlin’s legal authority to dictate production levels, while the government may lack formal control over output, it has substantial informal influence over the industry. We think Russia’s oil producers will be willing to work with the government to meet the production cuts.
Indeed, we think the first step in reducing output will likely involve the government asking producers for voluntary cuts.
Why would producers voluntarily reduce output? We think most Russian oil companies have at least some older fields that are at best marginally profitable, with economic rents predominantly going to the government as taxation: One large Russian oil company estimated in March that ‘over 30 per cent’ of its producing fields were uneconomic. While this could partly be due to the low oil prices at the time, it also lends credence to our suspicion that there may be a material amount of Russian production that remains on-line to generate tax revenues for the government than profit for the producing company.
Additional cuts could come from slowing brownfield drilling, a delayed but potentially powerful method of adjusting production. To illustrate, consider that a 15 per cent decline rate on 11.2m b/d of production implies Russian oil companies have to bring on 140,000 b/d of new production each and every month just to maintain current output levels. This calculation roughly fits the observed numbers in Lukoil’s West Siberian fields, where the company cut drilling by 40 per cent in early 2015 and quickly saw 8-9 per cent year-on-year production declines emerge, which didn’t stop until drilling was ramped back up this past summer.
Applying that 8 per cent decline rate to total Russian production would imply about 5 months needed to meet the entire 300,000 b/d production cut target. However, we would expect Russia to be a bit wary about encouraging that large of a drilling cut, as there would be undesirable knock-on effects on employment and economic activity until the production target was hit and the rigs put back in the field to stabilise production.