“My problem is that my imagination won’t turn off. I wake up so excited I can’t eat breakfast. I’ve never run out of energy. It’s not like OPEC oil; I don’t worry about a premium going on my energy. It’s just always been there. I got it from my mom.” — Steven Spielberg
“Russia is tough. The history, the land, the people — brutal.” — Henry Rollins
We recently met with the management team at Rosneft — the third largest company in Russia and one of the top 25 oil & gas exploration companies in the world by revenue — for a wide ranging discussion on oil & gas, Russian macro, the deal with Saudi Arabia and OPEC, shale oil and geopolitics. In this week’s piece we share our notes from the meeting.
On Russian macro:
- Russian budget balances at an oil price of around US dollar 47 per barrel.
- Government and corporate external debt has declined from around US dollars 730 billion in 2014 to approximately US dollars 450 billion by the end of 2018.
- 50 per cent of crude oil production is exported unrefined, 50 per cent of production is utilised for refined products of which 50 per cent are exported. Directly and indirectly, approximately 75 per cent of oil produced is exported.
- The government is actively running a weak ruble policy, which is benefiting exporters at the cost of lower domestic economic growth and lower purchasing power for the Russian consumer. This is translating into Russian economic growth being investment-led as opposed to consumption-led.
- Moreover, the policy is resulting in weaker than potential economic growth. Real GDP growth is around 2 per cent while the economy has the potential to grow between 3 to 5 per cent annually.
- To counter the below potential growth, the government is trying to attract foreign direct investment into the economy — Russia moved up to 31st in the World’ Bank’s ‘Doing Business’ rankings in 2018, up from 120th in 2011. The spectre of further economic sanctions, however, has thus far deterred foreign capital.
- To implement the weak ruble policy, the Central Bank of Russia sterilises all oil revenues above US dollars 40 per barrel. At current oil prices, the central bank purchases between US dollars 200 to 300 million from the open market on a daily basis
- Russia is able to implement its weak ruble policy as the majority of costs, even for oil & gas exploration companies, are priced in rubles. For example, Schlumberger and Haliburton price onshore oil rigs lease rates in rubles, not US dollars. Oil & gas companies are only impacted if they are engaged in offshore drilling as offshore drills are not available in Russia. At present none of the Russian oil & gas majors are engaged in offshore drilling.
- Pension reforms implemented in 2018 raised the retirement age from 60 to 65 years for men and 55 to 60 years for women. The reforms were deeply unpopular amongst the populace and instigated protests across the former Soviet Union. Eventually only a watered down version of the originally proposed reforms were implemented.
On the deal with OPEC / Saudi Arabia:
- The production quotas / deal between Russia and OPEC holds far greater significance for Saudi Arabia than for Russia given Russia’s lower budget break even price, free floating currency and ruble based cost structure.
- Russian oil production peaked in October 2018 at 11.4 million barrels per day. It has been cutting daily production levels by 65,000 barrels each month starting January 2019 and will reach the agreed upon production level in May 2019, which should be between 220,000 to 230,000 barrels per day lower than levels recorded in October.
- Saudi Arabia has already cut production by more than the levels they had committed to as part of the deal with Russia and they expect the Kingdom to enact further cuts in the coming months.
- Subsequent to our meeting, Bloomberg reported that “Saudi Arabia will supply its clients with significantly less oil than they requested in April, extending deeper-than-agreed production cuts into a second month”.
- Although Rosneft is opposed to the production quotas, they expect the deal between Russia and OPEC to be extended beyond June 2019.
- Rosneft, which accounts for 41 per cent of Russian oil production, could have increased its output by 5 per cent in 2019 but will limit growth to 2 per cent. In return, they have submitted a request for tax breaks to the Russian Ministry of Finance to compensate for the lost revenue.
- One of the unintended consequences of the production cuts has been heavy, high-sulphur (or “sour”) crude trading at a premium to Brent crude in parts of North West Europe and the United States despite its lower grade. This has occurred as the majority of OPEC producers, predominantly Saudi Arabia, have focused their production cuts on high-sulphur crude and at the same time sanctions have been enacted on Venezuela, a major producer of high-sulphur crude. Demand from US refiners, which are configured to operate only with high-sulphur crude, and China’s preference for it as well — a byproduct of refining heavy crude is bitumen, which is used in the construction of roads — has caused the squeeze.
On demand:
- Demand erosion from electric vehicles has not been evident and it will take a much higher adoption rate for it to have a meaningful impact. Whatever adoption that is taking place is being more than compensated for by first time automobile buyers in emerging markets, particularly India and China.
- Global demand is robust and should remain so as long as the US can avoid a recession in 2019.
On shale oil:
- Full cycle, operating and capital expenditures cash break even for the Permian basin is between US dollar 40 to 50 per barrel versus the widely touted US dollars 35 to 40 dollars. This excludes the cost of land, which can push break even levels to as high as US dollars 55 to 60 per barrel.
- There are signs of high cost inflation in the shale patch, particularly in the Permian, which may push up break even levels.
- Listed shale oil companies returning capital to shareholders are being rewarded and those increasing capital expenditures have been punished. This suggests that the capital expenditure cycle for US shale may have peaked and that an increasing number of companies will choose to return capital as opposed to increasing production. If this happens, US production growth is likely to disappoint to the downside.
On natural gas and geopolitics:
- Nord Stream is an offshore natural gas pipeline between Russia and Germany that is owned and operated by Nord Stream AG, whose majority shareholder is the Russian state company Gazprom. It has an annual capacity of 55 billion cubic metres.
- Gazprom has a monopoly on all Russian natural gas exports.
- Nord Stream 2 is a project to lay two additional lines and double annual capacity to 110 billion cubic metres and due for completion in 2019 . The project was backed by Chancellor Angela Merkel and the German government despite objections from some EU and NATO member states and from the European Commission
- Since November 25, 2015, Ukraine has no longer imported Russian gas; instead, all supplies that enter Ukraine’s gas network from Russia are transferred to Europe. The gas transit agreement with Ukraine expires in December 2019. Nord Stream 2 is incidentally due for completion in December 2019. The completion of the project would allow all Russian gas to flow directly into Germany without transiting through Ukraine.
- The cost of liquefaction, transportation and gasification of natural gas from alternate sources means that Russian gas remains the most economically viable source for Europe. Given Germany’s reliance on natural gas, especially after Chancellor Merkel outlawed nuclear power in Germany, it is difficult to see Europe turning away from Russian gas. German dependence on Russian gas has, however, caused a rift between France and Germany in the recent past.
- Russia is confident that it can find alternative buyers for its supplies should Europe decide to stop buying from them.
- In 2017, Rosneft sold a 20 per cent stake in Verkhnechonskneftegaz — one of the largest-producing fields in eastern Siberia that connects Russia with China, Japan and South Korea — to Beijing Gas. This is a sign of growing collaboration between the two states and a possible step towards de-dollarization. With the added benefit for Rosneft and Beijing Gas of undermining the domestic monopolies of Gazprom and China National Petroleum Corporation.
Some data points:
- Organic reserve replacement costs in Russia are approximately US dollar 0.20 per barrel of oil equivalent vs. US dollars 1.10 for BP, 1.00 for Chevron, 2.90 for Royal Dutch Shell and 5.70 for PetroChina
- Lifting costs (the cost of producing oil and gas after drilling is complete) is US dollar 2.50 in Saudi Arabia and US dollars 3.10 in Russia vs. US dollars 5.60 for Total, 7.30 for BP, 10.60 for Royal Dutch Shell, 11.40 for Chevron, 11.50 for PetroChina and 12.30 for ExxonMobil.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.