Economist's Corner

Russian Oil Export : Projection Fraught With Risk

With the onset of the global economic decline, last year brought rather unpleasant news to the Russian oil sector. According to Rosstat data, Russia’s oil and natural gas liquids production in all of 2008 was lower than the total for only the first 9 months of 2007—notwithstanding the increase of prices to record levels during the first 7 months of last year. In all, 2008 marked the first year since 1998 that Russian oil production has declined. The situation, if anything, was more acute for natural gas. Russian Finance Minister Aleksey Kudrin told journalists in November that gas production had peaked, and the statistics soon seemed to bear him out. While oil production in the first half of 2009 stagnated at 100.1% of the comparable year-on-year (yoy) level, gas production simply collapsed to 79.2% on a yoy-comparison basis.

Understandably, the dramatic fall of oil and gas prices in the second half of 2008 only exacerbated the problems of declining production. Both Russia and the West for some years have become used to the constant growth of Russian production, and the sudden declines have a large impact on world hydrocarbon markets. Russia is an extremely important player in those markets, ranking as the world’s second-largest producer (9.8 million B/D) and exporter (7 million B/D) of oil—after Saudi Arabia—and largest exporter of natural gas. Russia’s hydrocarbon exports generate roughly 20% of its gross domestic product and account for 64% of all Russian exports.

The needed investment in the hydrocarbon sector is huge. Leonid Fedun, vice president of Russian oil giant Lukoil, said in an interview with the Financial Times that USD 1 trillion of investment in the country’s oil-extraction industry will be required in the next 20 years just to maintain the existing production level. However, the price for export-benchmark Urals crude not long ago fell to levels too low to support even the investment needed to compensate for production declines, let alone generate any growth in output. Furthermore, the decline in the export market prompted Russian oil companies to shift focus to the domestic market, where price declines in gasoline (which averages 1.5 to 2 times the level of US prices) were not as steep.

Taking a longer-term view, even should a price recovery lead to a temporary reversal of current trends, Russia inevitably will face the issue of permanent production decline sooner or later. To consider how this situation might play out, it is instructive to look at Indonesia and the United Kingdom—major oil producers that have seen production decline from peak levels and have shifted from net-exporter to net-importer status.

Indonesia in 1996 exported 780,000 B/D of oil, but within 8 years, falling production levels led to the country becoming a net importer of crude. The UK was a net exporter of 1.2 million B/D of crude in 1999 but evolved into a net importer in only 7 years. A characteristic feature of these transitions was that exports declined much more rapidly than production. For oil producers, a shift away from net-exporter status generally is driven by two concurrent factors: declining production and increasing domestic consumption. This was true in the case of both Indonesia and the UK.

Geologists Jeffrey Brown and Samuel Foucher have created a simple mathematical model, the export land model (ELM), that describes the usual dynamics of countries’ oil-export declines (Brown and Foucher 2008). The two geologists assume a hypothetical country that produces 2 million B/D of oil, consuming 1 million B/D and exporting 1 million B/D. Once peak production is passed, production falls by 5% per year while internal consumption increases by 2.5% per year. While neither the production decline nor consumption increase appears to be extreme, the net exporter becomes a net importer in only 9 years! Certainly, ELM is a simplification of reality, as is any economic model. Nevertheless, it comprises two important insights: that exports decline faster than production and that export-decline rates accelerate.

Notably, Indonesia and the UK are very different in a number of key economic factors. Indonesia has low per-capita income and government-subsidized fuel prices, while it experienced a high 4.1% average yearly growth in fuel consumption during the transition from net exporter (peak oil production) to net importer. The UK has high per-capita income and high fuel taxes, as opposed to subsidies, while it experienced a minimal 0.2% average yearly growth in fuel consumption during the comparable transition. These national disparities help to give credence to the ELM.

How do these examples, both of which conform to the general pattern predicted by the ELM, relate to Russia? Internal oil consumption has been on a growth trend in Russia and, despite the global economic downturn, could reach an annual rate of 4%, close to that of Indonesia and not far below the 5–7% growth rates seen among most Middle Eastern oil producers recently. There is no realistic economic projection of a major long-term slowdown of domestic oil consumption in Russia.

Indeed, domestic oil consumption by the world’s net exporters—boosted, in part, by fuel subsidies in some countries—has been on a major growth trend. This would seem to accentuate the importance of the ELM. Viewed as a whole, oil’s net-exporting countries are now the world’s second-largest oil consumer next to the United States. By themselves, the OPEC countries, Mexico, and Russia consumed more than 12 million B/D in 2006, which was slightly larger than total consumption in all of Western Europe and exceeded China’s consumption by approximately 60%.

On the production side, is the example of the UK relevant to Russia? Yes. The sharp production-decline rates characteristic of the UK’s major offshore-shelf deposits are also a significant factor for Russia. In a prominent example, ExxonMobil forecast a 17.9% decline in 2008 from peak 2007 production at the Russian offshore Sakhalin 1 project.

The effect of such trends matters a great deal to the rest of the world. Russian hydrocarbon exports over the past 10 years have compensated for stagnation and declines in production and exports by other producers, including a number of OPEC countries. The cumulative export growth of OPEC, taken as a whole; Mexico; and Russia during the 2000–07 period, was 70% attributable to Russia.

 With growing internal demand and falling production, Russia seems to be in full conformity with the ELM pattern. It appears practically certain that Russian exports will decline sharply in 2009 and continue to fall in subsequent years. So, assuming the preconditions of the ELM (production peaking and then declining at average rates, while internal consumption grows), Russian oil production will fall to the level of domestic consumption between 2019 and 2028. For natural gas, the process will be even speedier, with production falling to internal-consumption levels between 2016 and 2022. Therefore, projecting Russian hydrocarbon-export levels, based upon assumptions prevailing until 2008, is becoming very risky for consumers in importing countries. TWA

Reference

Brown J. and Foucher S. 2008. A Quantitative Assessment of Future Net Oil Exports by the Top Five Net Oil Exporters. Oilography/Energy Bulletin, www.energybulletin.net/node/38948. Last accessed. 26 August 2009.


Alexander Zotin is professor of political economy at the Russian State University of Humanities (RSUH), Moscow. His articles on political and economic issues have appeared in RBC and other business magazines. Zotin graduated from RSUH in 2004 and received a PhD in political science from RSUH in 2005.


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