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Teneo

Vision 2020

Balancing Act: Russia and OPEC



Operating under Western economic sanctions for over five years, Russia finds itself in a unique position heading into 2020. Through a combination of careful fiscal management and coordinated energy policies, Russia has leveraged its status as one of the world’s leading oil and gas producers to achieve a number of geostrategic objectives. Among other efforts, Russia has had considerable success in participating in the OPEC+ negotiation process, gaining influence at a time when OPEC’s future is more uncertain than ever before.

However, can this success turn into long-term gains, or has Russian foreign policy become overstretched in the face of domestic economic constraints? The divergence between the interests of the state and the main players at state-owned energy enterprises may strain President Vladimir Putin’s careful balancing act in the coming 12-18 months.

Geopolitical Maneuvering

Since the enactment of sanctions targeting Russian government officials in a number of areas by the U.S. Department of Treasury’s Office of Foreign Assets Control since early 2014, Russia’s geostrategic objective has been to develop regional counterweights to the US and its allies. This endeavor became most obvious in the fall of 2015 when Russia began its military intervention in Syria in an effort to stabilize its last remaining regional ally, Syrian President Bashar al-Assad, and to enhance its own role in the Middle East. However, other examples of Russian entrenchment or realignment abound. These include a shift toward a strategic partnership with China, as well as continued support for President Nicholas Maduro’s regime in Venezuela, even at the risk of further retaliatory sanctions.

But there is also an energy dimension to Russia’s geostrategic maneuvering. Long accused of wielding its oil and gas resources as an instrument to advance foreign policy objectives, Russia has now confirmed these suspicions via the so-called OPEC+ process. Namely, the Declaration of Cooperation of OPEC members and non-members signed in December 2016 and its subsequent extensions have served as a vehicle for Russia, along with Saudi Arabia, to compete head-to-head with surging U.S. oil supplies in the world market. The OPEC process has served other purposes beyond this, including allowing Putin to take direct control in guiding Russian oil output, as evidenced by the postponement of the OPEC June 2019 Joint Ministerial Monitoring  Committee meeting until Putin announced a continuation of the OPEC+ agreement at the G20 summit in Osaka.

The OPEC process also has the potential to give Russia a permanent seat at the OPEC table, particularly at a time when the organization itself is undergoing changes, as evidenced by the departure of Qatar in 2018. Finally, Russia nowhas the leverage to explore other potentially mutually beneficial avenues, such as proposed investments from Saudi Arabia in support of Russia’s import substitution strategy, as well as potential collaboration with Iran in a number of sectors.

Using energy policy in the pursuit of this geostrategic aim – to develop a counterbalance to Western economic sanctions – is fraught with domestic fiscal and political constraints that restrict the Kremlin. Not least of these is the fact that the stated objective of OPEC+ is to reduce global oil supply in the interest of higher prices, a move that directly benefits U.S. producers. Russia’s own oil output has seen robust growth in recent years on the back of a number of heavyweights, ranging from Rosneft to Lukoil to Gazprom Neft.

All of these Russian industry actors have close ties to the Kremlin but divergent interests in terms of potential output cuts. In addition, depending on the structure of the Russian tax code, any cut in Russian production could directly lead to losses in federal revenue, even in a high-commodity-price environment. A similar impact would be felt by the National Welfare Fund, a rainy-day reserve that serves to cover social spending needs ahead of major elections.

With these constraints in mind, Russia’s approach to OPEC+ negotiations have been characterized by a push for flexible, reversible cuts, stopping short of full non-compliance. The hallmark of this strategy is extended periods of non-compliance with agreed-upon OPEC+ output cuts, ostensibly due to difficulties managing Russian oilfields during the cold winter months. The effect of this balancing act has been to guarantee Russia a seat at the OPEC table while shifting the majority of output cuts onto other countries such as Saudi Arabia. Moreover, it serves a vital function for Putin of placating dissenting voices within the Kremlin representing the oil industry. For example, through May 2019, Russia was fully non-compliant with its agreed-upon cuts, but last-minute compliance in June 2019 ensured that Russia would continue to be an influential voice in the OPEC+ process going forward.

Tied Hands? Domestic Fiscal Constraints

With its economy heavily dependent on the export of primary commodities, Russia has seen several economic shocks in the Putin-era. The 2008-2009 financial crisis was accompanied by a 35% decline in the price of Urals oil, and this, in turn, led to an all-time high in deficit spending under Putin to shore up the federal budget. Softening the blow was the fact that leading up to 2008, Russia had built a much-needed cushion of well-over USD 150bn in its sovereign wealth fund, which depends on oil and gas export revenue.

When commodity prices again collapsed beginning in late 2014, Russia was not as prepared for the fiscal impact; social spending spiked in the run-up to the March 2018 presidential election, and the federal budget at that time required an Urals benchmark price of USD 72/bbl just to break-even. With no presidential election scheduled again until 2024, Putin has pushed through a series of unpopular tax and pension reforms to ease pressure on the budget. Having learned its lesson, the latest three-year budget features a much lower break-even oil price for 2019-2021.

There is a cap on federal revenue attributable to oil and gas royalties of USD 42/bbl (full-year average). Any royalty revenue above this threshold will be allocated to the National Welfare Fund. The base case forecast put forward by the Ministry of Economic Development recognizes that oil prices are expected to continue to trend below USD 60/bbl through 2021. This correlates with relatively modest official forecasts of Russia’s GDP growth, at only +2% in 2020 and +3.1% in 2021.

With such conservative budgeting, Russia has had a free hand to engage with OPEC, agreeing to cut output without necessarily feeling the pain of severe cuts. And, as in 2008-2009, the National Welfare Fund has been used liberally to avoid borrowing (perhaps a moot point in the face of sanctions) and to justify tax breaks demanded by Rosneft as compensation for even limited compliance with the OPEC Declaration of Cooperation. This begs the question: in the absence of a strong fiscal imperative, how does Russia benefit from participating in the OPEC+ process?

There are two direct benefits. First, it widens the scope of potential joint investments into Russia, hoping to avoid the reach of sanctions. Second, it allows Russia a free hand to influence OPEC states beyond the energy sector.

The former is evidenced by the active work of the Russian Direct Investment Fund (RDIF) in attracting a flow of funds from sovereigns (mostly in the Gulf) to new infrastructure projects. These include, but are not limited to, direct investments in support of the Kremlin’s import substitution strategy such as fertilizers, the Ust-Luga transshipment terminal, petrochemicals, and agriculture. As an example, RDIF has a partnership with Saudi Arabia’s Public Investment Fund that has earmarked up to USD 10bn for joint investments. Russian participation and leadership in OPEC+ is yet another lever to develop economic ties with sovereigns against the backdrop of sanctions.

Dissent Within the Kremlin?

Prior to the G20 meeting in Osaka in summer 2019, all Russian negotiations in OPEC+ had been handled by Minister of Energy Alexander Novak. With comparatively low exposure to sanctions and recognizing the fiscal cushion in place, Novak and Minister of Finance, Anton Siluanov, have been very willing to toe the Kremlin’s line on the benefits of cooperation with OPEC+. In general, however, Kremlin officials or close Putin confidantes are more likely to be opposed to OPEC cooperation if they are subject to sanctions and primarily motivated by commercial, rather than geostrategic objectives. For example, the most vocal critic of the OPEC agreement has been the CEO of sovereign-owned Rosneft, Igor Sechin. For one, any Russian output cuts fall disproportionately on the shoulders of Rosneft, which is simultaneously the largest single contributor to the federal budget.

But another reason for Sechin’s opposition is that Rosneft has already made commercial compromises in the interests of advancing the Kremlin’s foreign policy goals. In support of the beleaguered Maduro regime in Venezuela, Rosneft is currently the only active supplier of crude oil to the country, for which it does not receive market value. A similar dynamic is at play in Iran; the Kremlin has offered Tehran a discounted oil transit agreement (shipping Iranian oil to the Black Sea for export) on non-commercial terms, and Rosneft in 2017 signed a joint investment protocol with the National Iranian Oil Company. The result of these non-commercial transactions is that the cost of cuts are borne by the Russian taxpayer (vis-à-vis the federal budget) or by flagship stateowned enterprises such as Rosneft.

This balancing act came to a head in summer 2019. Rosneft took a further commercial hit on account of the contamination of one of Russia’s major oil export pipelines, resulting in mutually incriminating accusations between Rosneft and Transneft. Seeking to placate personal allies such as Sechin, while also maintaining a freehand to deal directly with OPEC member countries, Putin postponed a formal extension of the OPEC+ Declaration of Cooperation from the June 2019 Ministerial in Baku to the G20 Heads of State summit in Osaka. He followed this up by granting Sechin the tax breaks he desired, much to the dismay of the Ministry of Finance.

In short, pressure on the Kremlin is building, and to date, the release valve for this pressure has been fiscal policy. Should fiscal constraints tighten, the Kremlin’s balancing act will become ever more difficult.

What to Expect in 2020

Heading into 2020, the Kremlin has already agreed to a nine-month extension of mandated OPEC+ output cuts. But with global oil prices weakening, it is likely that Russia’s balancing act will become strained. Russia cannot comply with the OPEC+ mandate without directly pressuring Rosneft to cut output. And having already maintained this fragile balance for a year, the fiscal cushion is not as deep as it was in years past. Indeed, the National Welfare Fund stands at just under USD 60bn, having lost value since the start of the year. This is a far cry from the Ministry of Finance’s USD 150bn target for the end of 2020.

Most importantly, the economic sanctions regime remains firmly in place. As a result, Russia will continue to operate within a framework of import substitution, with direct investment from sovereigns sought in lieu of private sector investment. At a large scale, the most prominent investment will be sought in energy export projects, such as NOVATEK’s Arctic LNG and Gazprom’s Baltic LNG (which has already seen one multinational pull out – Royal Dutch Shell). Moreover, Russia has already made overtures to sell Russian helicopters to Saudi Arabia and the S-400 missile defense system to OPEC members. This follows a year in which Russia succeeded somewhat in driving a wedge between NATO members with the sale of the S-400 to Turkey.

Using energy policy to advance these goals will likely lead Russia to a push for a more permanent cooperation framework with the remaining OPEC members. One option, put forward by Gazprom Neft CEO Alexander Dyukov and supported by the Kremlin, would be for OPEC to shift from a hard price target to a softer price corridor in line with the commercial break-evens of major oil producers. At any rate, the Russian tactic in negotiations with OPEC will be characterized either by a series of phased cuts (possibly including last-minute compliance), or by an agreement that would allow larger producers such as Russia to overproduce in response to the ongoing loss of oil supply in Iran and Venezuela, both subject to punitive sanctions.

Going forward, so long as economic sanctions are in place, Russia will seek to deepen its strategic ties away from the West. In addition to building a strategic alliance with China, Russia will continue to leverage its vast energy resources to formalize its foreign relations with OPEC member states, in particular, Saudi Arabia, Iran, and Venezuela. The degree to which Russia can manage this balancing act will depend largely on Putin’s ability to convince his allies in the domestic oil and gas sector to reprioritize their commercial interests to meet Russia’s geostrategic objectives. All of this is happening against the backdrop of a changing domestic political dynamic within Russia, making Putin’s balancing act even more delicate.


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The views and opinions in this book are solely of the authors and do not necessarily reflect those of Teneo. They are offered to stimulate thought and discussion and not as legal, financial, accounting, tax or other professional advice or counsel.