How do Western sanctions affect Russia’s oil and gas sector? Industry observers are sharply divided. One group of experts argues that the sanctions have no effect and, moreover, are finally stimulating import substitution and technological development in Russia. The second group believes the sanctions will soon have catastrophic consequences due to the sector’s extreme dependence on foreign financing and technology.
Unsurprisingly, the truth is somewhere in the middle and, to a significant degree, stems from the very logic of imposing sanctions.
Technological and financial sanctions targeting economic sectors are a common practice globally. However, only in the most egregious cases are they imposed on basic technologies. Generally, sanctions are oriented not on undermining the offending country’s actions, but on closing off avenues for its future growth and development. The sanctions are designed so that their asphyxiating effect is not immediately noticeable. For a while, it seems everything is fine. But then the situation gradually deteriorates and the country falls into unremitting stagnation, losing all impulses for intensive growth.
At the Skolkovo Moscow School of Management’s Energy Center, my colleagues and I carried out a detailed analysis and modeling of Western sanctions’ ramifications for Russian oil production. Unfortunately, our research indicates a high likelihood that Russia will face the consequences described above.
In this sense, the sanctions were formulated effectively. Currently, they barely affect the global hydrocarbon market and have caused neither catastrophic destabilization nor price shocks (which would happen were a hydrocarbon embargo imposed on a large exporter like Russia). Nonetheless, they are capable of jeopardizing Russia’s production of gas and, particularly, oil in the future.
The sanctions can also seriously slow the development of export pipeline infrastructure by gradually squeezing Russia out of external markets, narrowing its channels for receiving export profits, and undermining the stability of its national economy.
An important feature of the sanctions passed in 2014–2017 is their exceedingly vague wording. This allows for significant flexibility in their interpretation and application, depending on the individual situation and the level of geopolitical tension. Under the current sanctions, it is possible to simply preserve the status quo. But it is also possible to intensify the restrictions, including through their stricter interpretation or active application to specific projects. In both cases, the impact depends on the time frame.
A more consistent application of the current sanctions regime’s financial constraints and a broader interpretation of their technology restrictions could have noticeable negative consequences for Russian oil. For example, transactions involving hydraulic fracturing equipment, which currently provides roughly 10 percent of total oil extraction (around 50–55 million tons), are subject to control by regulators. Under the current measures, if the regulators believe the technology can theoretically be used to extract shale oil, the transaction is forbidden. Russia produces its own equipment for fracking, but in the last three years it has not created a single fracking fleet. And the existing fleet is old and requires replacement.
The sanctions also create room for imposing restrictive measures on the gas sector. Much depends on interpretation. For example, in summer 2015, the U.S. Treasury Department identified the Yuzhno-Kirinskoye gas deposit on Sakhalin Island as an oil deposit in the Arctic. As a result, it ended up on the sanctions list, and the launch of operations there had to be delayed.
But perhaps the greatest problems for the Russian gas sector may come from the expanded application of the sanctions to export pipelines under the Countering America’s Adversaries Through Sanctions Act, which was signed by President Donald Trump in August 2017. The act potentially allows the U.S. president to impose sanctions blocking any operation worth more than $5 million a year (a very small sum for gas projects) that provides equipment and services for the construction of new gas pipelines and the maintenance of old ones if 1) the pipelines threaten U.S. national interests and 2) the sanctions are imposed after preliminary consultations with Washington’s European partners.
Until recently, these European partners were the main defenders of Russia’s state-controlled Gazprom gas corporation. The German authorities even said that the United States promised not to impose sanctions on export pipeline construction. But the United States’ 2018 imposition of personal sanctions on Gazprom head Alexei Miller was a bad sign. For the first time since 2014, Europeans were unable to block such a detrimental measure to Russia.
So far, no radical initiatives—an embargo, for example—are being discussed. Moreover, Russian oil and gas companies have adapted to the sanctions regime, and production has grown in the last few years. Previous large investments, numerous tax privileges, and the devaluation of the ruble allowed Russia to not only avoid a production decrease, but to also experience record growth.
Our analysis and modeling indicate that, despite the restrictions, Russia has the potential to further increase extraction volumes until 2020 due to already prepared fields. Thus, in the short term, the sanctions’ effect on production will be practically zero.
However, Russia’s future prospects are less clear. According to our calculations, even if restrictions on access to technology are strengthened, extraction volumes will not suffer catastrophically in the mid-term perspective. The difference between the “default scenario” and the “strengthened sanctions scenario” is 30 million tons by 2025 (around 5 percent of current production). And the main reason for this decrease might not be the inaccessibility of Western technologies needed for new projects, but a lack of technological capabilities needed to intensify production at already existing oil and gas fields.
Given Russia’s conflictual relationship with Ukraine, we are already seeing a bottleneck in gas transit through export pipelines to Europe. In order to further increase export volumes and fulfill its official plans, Russia must either urgently launch Nord Stream 2 or rachet up gas transit through Ukraine to levels higher than in the early 2000s. The latter option is unacceptable to the Russian leadership for political reasons, and the situation with Nord Stream 2 is exceedingly difficult.
Rumors that the United States will impose sanctions on European companies involved in Nord Stream are spreading quickly. In the U.S. Congress, “punishing” Russia is perhaps the only subject that unites Republicans and Democrats. And the scandalous consequences of the Stockholm arbitration case between Russia and Ukraine are only adding to tensions. Hopes for and against this pipeline are already so high that building Nord Stream 2 is growing more difficult.
In the longer term, up until 2030, it will be difficult for Russia to maintain its gas production volume. First off, the country’s oil and gas deposits are objectively deteriorating. An increasing share of reserves is difficult to recover. Russia could maintain current production levels by more deeply developing existing traditional oil wells using methods for intensifying production (for example, hydraulic fracturing) and by developing non-traditional oil reserves on land (the Bazhenov formation in Western Siberia) or offshore (including the Arctic shelf).
However, Russian companies currently lack native technology and equipment to develop unconventional and offshore reserves. And sanctions limit access to foreign technology.
So far, these restrictions are not ironclad, and the companies themselves are seriously investing in developing their own technologies. Over ten years, a country can theoretically launch its own production system and establish relations with new foreign partners. And even without import substitution measures, the worst-case scenario will be deeply unpleasant, but not catastrophic. We calculate that by 2030, the reduction in production could reach 55 million tons (10 percent of current levels).
The gas export situation could also be worse. It is unlikely that Russia will be able to increase gas transit to Europe after 2025: there is no visible growth in demand there. But there is also China and the post-Soviet market. And Russia can substitute inaccessible technologies with its own versions.
But while struggling not to lose production, Russia also won’t grow. And the country is unlikely to preserve the ruble devaluation’s beneficial effects for a decade. Furthermore, without international financing, it is difficult to imagine Russia will maintain its competitive edge.
Moreover, there has never before been such a variety of hydrocarbon supplies on the world market. And the sanctions have a delayed effect: they give other players time to prepare to gradually replace Russian oil and gas in international trade.
The danger here isn’t an embargo or insidious plans to completely drive Russia from external markets. At a minimum, this is difficult to imagine in Asia. Yet the current sanctions, combined with excessive supply from competitors, makes it theoretically possible to severely restrict export to Europe. That wouldn’t require a conspiracy.