The Effects of Lower Oil Prices on Russia

Economic Impact

The impact of falling global oil prices on the Russian economy cannot be seen apart from the impact of a worsening geopolitical situation and the introduction of economic sanctions on Russia in 2014. Altogether these factors have led to increasing uncertainty, a rapid economic decline, and a deterioration of the conditions for further economic growth.

According to the estimates by the Russian Ministry of Economic Development, in 2015 annual GDP could contract by 4%–5% if oil prices remain low at around $45–$55 per barrel. [1] In 2016–17, according to the Energy Research Institute of the Russian Academy of Sciences, economic growth will remain negative at around -0.5%–1.5%, even if oil prices recover to $80 per barrel. According to our estimates, the Russian economy could only achieve positive growth if the oil price were to rise above $90 per barrel. [1]

This situation yields high risks for the 2015 national budget, which the government initially set given an oil price of $96 per barrel. According to the head of the Accounts Chamber of the Russian Federation, by the end of 2015 the state budget deficit could reach 17% of budget incomes ($45 billion). [3] In response to this situation, the government plans to make significant cuts to the budget, primarily to salaries in the public sector. This policy could create social tension, given the potential reduction in household income and the rate of employment.

The government had to provide state support to the companies affected by falling oil prices by taking assets out of the National Welfare Fund (NWF), which has created additional risks for the Russian budget. In July 2014 the total allocation of funds to reduce the impact of the economic crisis increased to 60% of the overall reserves within the NWF. Energy companies are among the major recipients of this state aid: as of April 2015, the Yamal LNG project run by Novatek has received 150 billion rubles from the NWF. Rosatom, which is implementing its Hanhikivi-1 nuclear power plant project in Finland, received similar state support (5% of NWF reserves). [4] The largest application for state support comes from Rosneft, which requested 1.5 trillion rubles (or 30% of NWF reserves). [5]

Policy Implications

First of all, low oil prices challenge implementation of large upstream projects, which has changed the attitude of the government toward Russian oil companies. For the first time in many years, the government is seriously considering the possibility of directly subsidizing state companies and strategically important projects out of NWF reserves.

The second most important consequence is linked to the accelerated reorientation of Russian export policy. Low oil prices, coupled with falling demand in the European market and growing competition for European consumers between Russian, Middle Eastern, and African suppliers of oil and petroleum products, make reorienting exports eastward and cooperating with Asian partners on a large scale the main strategic priority for Russia.

Cooperation with Asian partners concerns not just export supplies but also the problem of insufficient investments (given low prices). Russia is planning to partially resolve the latter problem by involving Asian companies in Russian upstream projects. According to Russia’s current law on strategic reserves, foreign investors cannot acquire stakes over 10% in companies developing large fields (with reserves over 70 million tonnes of oil). As of March 2014, the government started to consider allowing Chinese companies the opportunity to freely own a 25%–49% stake in production companies and potentially even a controlling stake in companies developing strategic fields. [6] This would be implemented within the framework of economic integration between Russia and China. Such measures would be approved by a special committee and would be aimed at increasing capital investment in the oil industry. However, they require significant adjustments to the existing Russian legislation.

Lower oil prices have also raised the issue of changing the taxation system for oil production. In 2014, Russian president Vladimir Putin did not support a proposed move toward a profit-based tax for oil companies. Despite this, widespread discussion continues on this subject, fueled by low prices, which the supporters of such a move use as a key argument. This new taxation system would be effective for the oil companies but rather risky for the Russian budget. Oil companies are actively lobbying for a move away from the current “tax plus royalty” system and a shift toward a profit-based tax. [7] The main argument used by the supporters of a profit-based tax is the fact that the current system is aimed at taking away super-profits, which no longer exist given the current oil price. Proponents argue that maintaining the current regime could lead to a reduction in investment, which would negatively affect production. Those arguing against the profit-based tax point to large losses in budget revenue and the difficulty of tax administration. For example, the director of the Department for Tax and Customs Policy of the Ministry of Finance, Ilya Trunin, stated that, according to initial estimates, if a profit-based tax were introduced, federal budget losses could reach $44.4 million. [8] No final decision has yet been made, but in any scenario, this implementation would have major consequences for the Russian oil industry.

Energy Security Impact

Low oil prices are not expected to have any serious impact on the energy security of Russian consumers. A large proportion of investment in refineries was made prior to the oil price decline, and these plants will enable Russia to provide an uninterrupted supply of oil to its domestic market.

However, the issue of ensuring demand security for external supplies prompts serious concerns. Given stagnating demand in the European market, Russia faces a serious issue of organizing construction of large export infrastructure projects in the eastern direction, while there is an increasing lack of investment due to the Russian energy companies and governmental revenue decline. For example, by 2022 Russia plans to extend the Eastern Siberia–Pacific Ocean (ESPO) pipeline capacity from the current level of 50 million tonnes annually to 80 million tonnes annually. [9] To provide financing for these projects, the top management of Rosneft uses long-term contracts to hedge large risks. As of 2015, around 30 million tonnes of oil (60% of the total volume supplied via ESPO) have been contracted to China.

Prospects for Regional Cooperation on Oil Market Stability

The Russian government places high hopes on integration within the framework of the Eurasian Economic Union (EEU), which was created on January 1, 2015. Russia, Kazakhstan, Belarus, and Armenia became members, and Kyrgyzstan is expected to join in May 2015. Countries outside Russia’s immediate neighborhood have also shown interest in this single economic union, including Vietnam, Iran, India, and Egypt. One of the main goals of the EEU in the oil market is to create by 2025 a single trade zone for the export and import of petroleum products. The agreement envisions a single petroleum price for all members of the EEU and common export routes.

Creating a single market for petroleum products carries with it both positive and negative consequences for Russia. An increase in the export of petroleum products to EEU member countries is one of the positive effects, as it would partially offset declining Russian exports to Europe. However, a potential oversupply of petroleum products could drive down prices. This in turn would negatively affect the profits of oil companies and budget revenues from exports.

The effect of low oil prices on Russia cannot be separated from the sanctions imposed in 2014 and increased competition in oil export markets, particularly in Europe. Together, these developments in the short term will have a negative impact on budget revenues and economic growth. Facing these challenges, the Russian oil industry has undertaken an active reorientation to the East. This reorientation consists not only in increasing export volumes but also in establishing business relations with Asian partners.

Endnotes

[1] Ministry of Economic Development (Russia), “Alexey Ulyukaev—Bloomberg TV: Economic Growth of Russia Will Resume in 2016–2017,” January 15, 2015, http://economy.gov.ru/wps/wcm/connect/economylib4/en/home/press/news/201501154.

[2] “Global and Russian Energy Outlook to 2040,” Energy Research Institute of the Russian Academy of Sciences and Analytical Center for the Government of the Russian Federation, 2014, http://www.eriras.ru/files/Global_and_Russian_energy_outlook_up_to_2040.pdf.

[3]Andrey Ostroukh, “Russia’s Budget Deficit More Than Doubles in a Month,” Wall Street Journal, March 12, 2015, http://www.wsj.com/articles/russias-budget-deficit-more-than-doubles-in-a-month-1426176589.

[4] “New Requests for NWF Funding Have Worse Chance than Old Ones—Dvorkovich (Part 2),” Interfax, April 3, 2015, http://www.interfax.com/newsinf.asp?id=583416.

[5] The Russian government is still reviewing this application.

[6]Gazprombank, Oil and Gas Weekly, March, 14, 2014, http://www.gazprombank.ru/upload/iblock/868/gpb_og_weekly_20140314.pdf.

[7]These taxation regimes are used in Norway and Australia.

[8] “Minfin: Poteri byudzheta ot perehoda neftyanki na NFR mogut dostich 2,8 trln rub” [Ministry of Finance: Budget Losses from the Oil Industry in the Transition PBT Can Reach 2.8 Trillion Rubles], Neft Rossii, March, 17, 2014.

[9] Transneft, “Eastern Siberia–Pacific Ocean Pipeline System,” http://www.en.transneft.ru/about/projects/current/1204.

Ekaterina Grushevenko is a Senior Researcher at the Center for International Energy Markets Studies in the Energy Research Institute of the Russian Academy of Sciences.