Russia hopes that OPEC blinks first

Feb 12, 2002 01:00 AM

The Russian government has yet to decide whether to extend its agreement with OPEC beyond the current quarter. Russia thinks that it is better placed to survive an oil-price war than the Middle Eastern producers and may thus expect OPEC to blink first. However, a collapse in oil prices would also have serious repercussions for the Russian economy.
With exports of almost 3.9 mm bpd in 2001 (2.7 mm in crude plus oil products), Russia is now the world's second biggest oil exporter after Saudi Arabia. Not surprisingly, when oil prices tumbled in late 2001 OPEC tried to get Russia on board for further production cutbacks.
Although Russia has no history of complying with OPEC measures, it grudgingly agreed to cut crude oil exports by 150,000 bpd in the first quarter of 2002 (using relatively high Q3/01 exports of 2.61 mm bpd as a base). Although this was less than OPEC had hoped for, it allowed the cartel to announce 1.5 mm bpd cuts for the first quarter, with other non-OPEC producers also promising cuts.

There were doubts about Russia's ability and willingness to comply with the agreement from the start. For one, Russia's offer referred to exports rather than production, potentially allowing producers to divert crude to local refineries and step up fuel exports instead. Second, the offer applied to non-CIS exports via Transneft, the state-controlled pipeline operator, only.
This makes sense in practical terms, as Russia's largest oil companies are privately owned and the government can vouch only for exports via the pipeline network it controls. But it implies that Russian oil producers can exceed the agreed quota, for example by shipping crude via the railways or tankers. Last but not least, the cut in exports meant no real harm since Russian oil exports tend to fall over the winter months anyway, mainly because of adverse weather conditions.

Evidence of Russia's compliance with the OPEC deal is by no means clear-cut. According to Russian industry sources, crude oil exports in January were roughly in line with what was agreed (2.59 mm bpd, compared with the 2.54 mm bpd enshrined in the deal). But data from the International Energy Agency (IEA) show a considerable increase in exports compared with the third quarter of 2001 (3.74 mm bpd compared with 3.52 mm bpd). However, the IEA data do not distinguish between Russian and other (much smaller) former Soviet producers.
Furthermore, some of the January increase in oil exports reflected delayed shipments from December when weather conditions were very harsh. The same applies to exports of oil products, which rose by 30 % in January at the main Baltic and Black Sea ports.
However, while some of this may be delayed December shipments, the government opened the door to more fuel oil exports by scrapping export quotas in January and slashing export tariffs in February. These moves were probably designed to alleviate oversupply on the domestic oil market.

The IEA says that Russian crude oil production in January was up by 60,000 bpd compared with December, thus resulting in an oil glut at a time when exports were constrained. This has depressed domestic oil price to below $ 4/bbl in February, compared with $ 20/bbl for Urals blend on the international market. This huge gap gives an indication of Russia's incentive to increase exports again once the current agreement runs out at the end of March.
OPEC is worried because the end of the agreement roughly coincides with the end of the heating season in the Western hemisphere, which implies that oil supplies could get a boost exactly when global demand contracts, thus putting downward pressure on prices.
The Russian government is dragging its feet on whether it will strike another deal with OPEC. On the one hand, the president, Vladimir Putin, has indicated that Russia would like to see international oil prices stabilise at $ 20-25/bbl. On the other hand, he and other high officials insist that Russia should continue to expand its global market share, which is still below what it was during Soviet times.

Most analysts expect Russia to walk away from the agreement in March but Russia will have to contemplate a number of factors before making a decision:
-- Oil demand
Current uncertainties about economic trends worldwide have made forecasting global energy demand more difficult than usual. Much will depend on when and how fast the US economy emerges from recession. If the news coming from the US remain good, Russia may resolve support for OPEC is no longer needed. Alternatively, indications that the US recession could be W- rather than V-shaped may prompt Russia to start talking to OPEC again.

-- Political consideration
Mr Putin appears determined to cement his rapprochement with the US, despite the re-appearance of strain in bilateral relations. One way in which to please the US would be to ignore OPEC since lower oil prices could deliver a much-needed boost to the US economy. Also, security considerations in the aftermath of September 11th have led the US to dust offplans to diversify oil supplies away from the Gulf region.
Russia could be a major alternative supplier, provided political ties remain solid. However, US President George W. Bush has recently taken a more confrontational line on a number of issues close to Russia's heart, including missile defence and anti-terrorist measures against countries that Russia considers allies. Mr Putin may yet decide that business is business and gamble on a higher oil price.

-- OPEC credibility
Russian analysts say that one month of figures is not enough to establish whether Russia is cheating or not. The same may apply to OPEC, but the cartel members will certainly have to improve their compliance if they want to have any credibility in forthcoming negotiations with non-OPEC members.
OPEC was already falling behind on its output cut targets last year. And in January, OPEC members cut production by only 640,000 bpd -- less than half the 1.5 mm bpd they had agreed on. The IEA estimates that the cartel is now pumping 1.3 mm bpd above its agreed ceiling of 21.7 mm bpd.

-- Business considerations
Although the Russian government controls the pipelines, it still needs the co-operation of the country's oil majors to credibly promise export or production curbs. But the oil companies themselves cannot agree on what is best for them. Those with high production costs, such as LUKoil (the country's largest producer), will want to avoid a price war, which would considerably harm their earnings.
Low-cost producers, on the other hand, such as Yukos (the country's number two) and Sibneft (number six), are more sanguine about plunging prices. They have ambitious expansion plans for this year (Yukos, for example, is planning to boost production by 25 %) and they may even hope that financial stress may force their competitors to sell valuable production assets on the cheap.

-- Economic risks
Clearly the best outcome for Russia would be to free-ride on OPEC production cuts, thus enjoying both stable oil prices andthe opportunity to expand market share at the expense of OPEC producers. Russia has successfully employed this strategy in the past, but its growing importance as a global oil player makes free riding more difficult.
Renaissance Capital, a Moscow brokerage, estimates that if Russia's oil majors carry out their 2002 expansion plans, they would cater for a full 90 % of global oil demand growth this year (as forecast by the IEA), leaving OPEC producers to pick up the crumbs.
Russia's strategy will therefore largely depend on whether it thinks that OPEC will blink first. The top OPEC members are assumed to have more to lose from a price war than Russia, since oil accounts for a larger share of their export earnings and fiscal revenue. But this does not mean that Russia is immune to falling oil prices. According to Russia's energy minister, Igor Yusufov, energy accounted for 50 % of Russia's exports last year and for more than one-third of total federal budget revenue. Investment spending is also heavily concentrated in the oil sector, which implies that growth would be harmed if oil prices tumble.
Nevertheless, on balance Russia looks unlikely to agree to another export cut in the second quarter. Russia's oil companies are already being hurt by very low domestic prices and they will throw their full lobbying weight behind increased crude export quotas for the rest of the year.

OPEC has much to lose from a price war and is therefore likely to continue with its half-hearted implementation of pre-agreed production cuts. However, as long as Russia's oil majors pursue their aggressive expansion plans the potential for tensions with OPEC will only continue to rise.

Source: The Economist Intelligence Unit Ltd.
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