Having suffered massive oil revenue shortages and budget deficits since the oil price collapse in 2014, Russia and Saudi Arabia have now agreed to cooperate on stabilizing the oil market. What this “cooperation” will actually mean - freezing production levels, cutting them, ramping them up or keeping the status quo, remains to be seen. The result of cooperation may, to some degree, depend on Saudi Arabia’s and Russia’s assessment of each other’s intentions and credence that the other party will stick to an agreement.
The signing of a Saudi-Russian memorandum on cooperation to stabilize oil markets on the sidelines of the G-20 Summit in China on September 5th induced a wide array of forecasts and speculations about the implications of this agreement and its impact on oil prices. Some industry officials and experts put a fair share of hopes on it and believe that the agreement will revive oil prices, whereas others have been quite skeptical that any agreement reached between Russia and Saudi Arabia can be kept at all. Many have expressed doubts that a temporary production freeze between OPEC and Russia leads to a sustainable recovery of crude prices, given the glut of oil inventories in the world market and cooling economic growth in certain Asian nations.
Despite the skeptic apprehensions, one thing is very clear: Russia’s expansion in Chinese energy markets and its greater role in Syrian conflict reconciliation process; Saudi-Arabia’s fear to lose oil market share to Iran and Russia, and its faltering dominance in the Middle Eastern politics; let alone the detrimental blow the oil price slump has struck to the oil-exporting countries’ budgets and economies makes it important enough for the two leaders, Russia and Saudi Arabia to come to the table.
Falling oil prices and sanctions imposed by the U.S. and Europe severely impacted Russia’s economy in the past few years.
According to Federal Treasury, Russia’s federal budget deficit amounted to 1.5 trillion rubles ($23.2 billion) in January - July this year, which is up 35.4% year-on-year, TASS reported.
This year the Russian Finance Ministry made three transfers from the Reserve Fund for a cumulative of 1.17 trillion rubles (US$18.05 billion) to cover the Russian budget deficit. According to the Ministry, in August the Reserve Fund was down to $32.22 bln.
Earlier in July, Deputy Finance Minister Sergey Storchak stated that he did not rule out a possibility that Russia’s Reserve Fund may be depleted in 2017,adding that “political decisions are made at various levels" and "at the moment this level is higher than mine.", he was quoted as saying.
As for Saudi Arabia, its budget slashed by the plummeting oil prices, reached a record deficit of $98 billion last year. The kingdom’s revenues were estimated at $162 billion for 2015, while spending was reported to be $260 billion. The country’s GDP fell by 13 percent and its net foreign assets plunged $115 billion, as the government sought to cover a $100 billion budget deficit.
According to Fitch Ratings estimates, the KSA’s budget deficit will remain high until at least 2018. The government debt is projected to go up to 14.7 percent of GDP by end-2016, from just 1.6 percent in 2014.
However, despite the crippled budgets and strains on domestic economies, Saudi Arabia and Russia are seeking ways to improve the situation and diversify its assets base and sources of income.
Although battered by low oil revenues, Saudi Arabia still possesses significant assets abroad. In March this year, international bankers estimated Saudi Arabia’s net foreign assets at nearly $600 billion, as reported by Reuters.
Both Russia and Saudi Arabia are currently pondering the sale of billions of energy and resource assets. Two of the most prominent examples here the partial privatization of Rosneft and the Aramco IPO.
Even though making plans and gaining access to generating more capital through investment and sale of stakes in some of the biggest revenue cash cows are important steps, they still do not provide a solution on how to maximize oil revenues and not lose a country’s share on the world oil market amidst low oil prices. What would be the right strategy to follow: ramp up, curtail, freeze production or simply leave everything the way it is?
Most of the Saudi oil reserves are in large conventional formations that lie close to the surface, and are easy to extract. Saudi Aramco – the Saudi Kingdom owned national oil company, does not have to pay any royalties for exploration, the costs of exploration are low, and all its costs from exploration, processing, transportation and refining are applied over the whole company; there are no separate cost centers in the chain.
For Russia, the situation is quite different. Most of the country's large oil reserves lie under the vast Siberian plains, and the harsh Russian climate and challenging geology make the reserves harder to get to and extraction process is more complex. Russia simply cannot stop wells from pumping oil. If the pumping is stopped, the wells will freeze. Russia also cannot afford shifting production levels up and down as rapidly and as much as it pleases, the way Saudi Arabia can. In the past Russian fields typically took 30-40 years to reach peak production, although with the technological advancement this industrial cycle has been reduced.
For Russia, given the complex and quite rigid taxation applied on the oil industry, lower production levels and higher oil prices would not necessarily mean higher profits for Russian oil companies. The oil industry taxation system has long been in need of a reform. The Russian Ministry of Energy and Ministry of Finance announced the taxation revision plan in the beginning of this year, but its final approval is still pending.
As the Russian media source Vedomosti reported, this new concept is to eliminate duties and production levies and replace them with a profit-based taxation scheme for energy producers. Under the new rules, the tax on the added income (TAI) will be 50% and will be applied only once a company has had a chance to recover its capital expenditures and start making profit. This is meant to boost production of new oil fields and speed up the cost recovery period for some older ones.
However, it looks like the Ministry of Finance will not compromise on the mineral extraction tax (MET). This tax application has been much argued against by the Russian oil producers and the Russian Energy Ministry before, but their lobbying has not yielded a desirable result so far. According to Vedomosti, the sources from Ministry of Finance told media that “MET will be increased, it is only a matter of time before this news gets announced”.
Forbes also reported a Finance Ministry official saying “in order to make up for the 40 billion ruble shortfall, it will increase the severance tax on oil deposits”.
Ultimately, Putin will have to decide whom he is going to support in this tie: the Ministry of Finance insisting on budget austerity, or oil companies and Ministry of Energy pushing for easing MET tax burden, particularly in an application to the old oilfields.
Given these circumstances, it seems as if significant curtailment of oil output over any lengthy period may not be a viable option for Russia. Establishing a stronger presence on the Asian markets and increasing Russian oil and gas deliveries to China and India, thus squeezing the Saudis out of the market, is another essential factor against backing an output cut strategy.
According to the Russian authorities, Russia has already reached a 25-year record of 11 million barrels a day this past August.
It appears that a temporary freeze of output, is a more feasible negotiating strategy with the Saudis and other OPEC members.
The Russian Energy Minister Aleksandr Novak after meeting with Saudi officials at Hangzhou G20 Summit specifically emphasized that Russia saw freezing production as the most efficient tool for stabilizing the market, and that a freezing period from three to six or more months at the levels of July, August or September was point of discussion. He also made a point that the UAE expressed a great deal of support for a freeze.
On the Saudi part, the response was quite obscure and appeared devoid of the intention to do anything, as Saudi Oil Minister Al Falih commented: "there was no need now to freeze production now and it is just one of the preferred possibilities” and “that it did not have to happen today, there was time to take that kind of decision”. He also was reported saying that the market was improving day by day.
What other preferred possibilities did the Oil Minister have in mind? How much time was set aside for making a decision? These and other points were not disclosed. This, of course, does not mean that Saudis have not thought about it. They may have a plan in mind but may be too wary to share their intentions publicly at this point.
This could be a sort of the “Prisoner’s Dilemma wait and see game”. Every oil exporter would benefit from a higher price, but everyone would benefit even more from maintaining or even expanding production while someone else cuts to raise the price. Saudi Arabia is very well aware of it: repeated betrayals by fellow cartel members was primarily the reason why it quit the role of the oil price fixer and tried to squeeze high cost US shale producers out of the market. Saudi Arabia does not seem in a rush to cut a deal with Russia or any other OPEC members for that matter, particularly after having seen Russia’s recent increased oil production output, and its strong advocacy for allowing Iran’s production to get back to pre-sanctions levels.
Russia may be betting on the Saudis to come to the Russians and say something to the effect of "okay, we'll get serious on production freeze" If they did, Russia could always adjust and ratify the plan to raise taxes accordingly.
As of today though, it appears that the Russian Ministry of Finance does not have much faith in oil revenues growth. Last Wednesday, September 14, Russia’s Deputy Finance Minister Maksim Oreshkin announced that Russian Finance Ministry’s budget stress scenario is based on the oil price of $30 per barrel, Tass reported.
How the implementation of The Vision 2030 will play out in reality, and what the actual net worth of Saudi Aramco shall be at the time of IPO in 2017, remains yet to be seen.
Can Russia ramp up oil production to 12 million barrels a day, and thus lower the potential market value of Aramco’s shares as a bargaining tool with Saudi Arabia in order to facilitate a desired output freeze? It may be a possibility, the future will tell. For the time being, the wise thing to do is hope for the best but prepare for the worst.
By Ekaterina Pokrovskaya for Oilprice.com
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