The Myth of Russia's Energy Strength

A truck carries wood and Gazprom Neft branded oil barrels along the M54 federal highway south of Siberian city of Krasnoyarsk, February 21, 2015. Ilya Naymushin/Reuters

The idea that Russia could achieve a strategic advantage over its neighbors through its energy resources is well known. After the start of the conflict in Ukraine last year, Western media and energy experts suggested that Russia could use its energy power as part of its "hybrid war." It is therefore worth looking closely at what is real and what is false in the Kremlin's capabilities in the oil and gas sector.

In the early 2000s, when global oil and gas prices began to rise, Vladimir Putin's government formulated the idea that Russia should become an energy superpower. His doctoral thesis from late 1990s at the St. Petersburg Mining Institute focuses on the advantages of state management of natural resources in Russia at a time of transition from a planned economy to capitalism.

Since that time, the Kremlin's strategy to regain superpower status and uphold internal stability has been to consolidate most production of oil and gas and their cash flows into state entities—Rosneft for oil, Gazprom for gas, and their affiliated companies—or into the hands of nominally independent companies that are controlled by regime insiders.

Until the financial crash of 2008-2009, Russian officials liked to emphasize to Western audiences the security of Russian supply, which would match demand from Europe, Japan, South Korea and the United States.

Russian officials envisaged high-level joint ventures, where international oil companies with national government backing would get a stake in Russia's hydrocarbon reserves, or the chance to operate them, in exchange for Russia receiving a stake in lucrative assets in the West such as refineries or distribution networks. This was accompanied by suggestions that Russian supply could be guaranteed only if the European Union helped with bypass routes to avoid not only Ukraine but Belarus, Poland and the Baltic States.

As for Asian countries, especially China, the perception was that rising demand would inevitably bring these buyers to Russia, which could then more or less dictate a price.

Since 2000, the Russian federal budget alone has earned roughly $2 trillion from the energy sector, yet Gazprom and Rosneft have failed to invest adequately in exploration. More importantly, they have tended to rely on fields developed in the Soviet period or they have exploited and taken over other companies' upstream developments.

Characteristically, it was BP that managed to save and maintain output at the flooded Samotlor field, the pearl of Soviet industry, and it was international oil companies headed by Shell that launched Sakhalin-2, the first and only working liquefied natural gas project in Russia.

Gazprom was originally seen as the leader in inefficient and opaque mergers and acquisitions, but in 2013 Rosneft paid $55 billion in cash and shares, or according to its own and mainstream industry accounts, a 30 to 50 percent premium to the market price, for its acquisition of TNK-BP. In order to service the loans to carry out this deal, Rosneft has sold future crude output to China to the value of over $70 billion. The company's capitalization has now fallen below $35 billion.

In 2008, Gazprom was planning to become a trillion dollar company by now, but it has seen its latest capitalization figure drop to $53 billion, one of the lowest in the industry considering its vast commercial recoverable reserves.

The myth in the 1990s that a state monopoly of gas supply would hold the country together has ended up with domestic consumers paying higher prices. Gas price rises have contributed at least 1 or 2 percent to the national inflation rate, even by conservative estimates, while Gazprom enjoys one of the lowest tax burdens among mineral extraction industries.

President Putin is known for his fondness for micromanaging Gazprom and Novatek, an independent gas producer, giving them preferential access to resources and markets, tax holidays and personally brokering foreign investments.

It was only four years ago that he allowed a gradual increase in mineral extraction tax for the gas industry, while the monopoly for gas transit and export has been largely left intact, with the exception of some liquefied natural gas projects for Novatek and Rosneft.

Western financial and technology sanctions instituted last year against Russian state energy companies, coupled with the oil price drop, have continued the trend. Uniquely in Europe, Russia has seen rising petrol prices (even in U.S. dollar terms) at the time when the crude oil price is falling, thanks to the predominance of Rosneft and a few well-connected oil companies in sales of petrol and diesel at local level, which prevents competition.

Rosneft and Novatek are now asking the government for loans to replace foreign finance that has been cut off by sanctions. They have already reportedly secured the promise to use the 60 percent share of National Welfare Fund that is allocated to investment.

The state takeover of the previously privatized oil company Bashneft in October shows that simply being loyal to the Kremlin is no longer enough for private owners to keep their exploration and production assets.

Sanctions and the falling oil price are pushing the government further to consolidate cash flow into the hands of the fully controlled entities and Kremlin insiders. In that respect, the outlook for LUKoil and other small and medium sized producers inside Russia looks gloomy.

The inefficiency and poor planning of the Russian oil and gas sector does not only affect the domestic market. It reduces the capacity of the Kremlin to exert pressure on its neighbors. The South Stream project, designed to bring more gas to Central Europe and Italy via a Black Sea pipeline while exploiting Central Asia supplies and bypassing Ukraine, was repudiated by Putin in December. Market realities delivered two blows—European customers do not need so much new gas, while Central Asia has reoriented itself to China.

Bypassing Ukraine remains a priority for the Kremlin, but this has been effectively blocked by the European Union. The South Stream pipeline is now to be redirected southward to Turkey and then to Greece. But this replacement project should be seen more as bluff than reality. There is no need for 63 billion cubic meters a year of South Stream gas in that regional market. Gazprom would still need to meet EU regulations if it is to sell in Greece.

Russian oil and gas output is already falling, given sanctions and declining demand abroad. Boasts that imported technology would rapidly be replaced by domestic or non-Western substitutes should be viewed with scepticism. Most cutting-edge projects in the Russian oil and gas industry used technology from companies such as Schlumberger that have now essentially departed.

Rosneft has already frozen its Arctic and Bazhenov shale developments, with the Yamal LNG project, on Russia's Arctic coast, and the Caspian offshore development struggling to survive. The trend projected by most market analysts suggests that Russia will see its oil and gas market share drop in Europe, while increasing in China as far as Beijing allows but not as much as Russia wants.

With energy prices falling and the West increasingly relying on unconventional sources while adopting energy efficiency measures, Russia is not an energy superpower. Rather, it faces a buyer's market.

Ilya Zaslavskiy is a Robert Bosch fellow with the Russia and Eurasia Programme at Chatham House, the Royal Institute of International Affairs. This article first appeared on the Chatham House website.