US sanctions impact Russian Arctic offshore oil and gas projects

Article by Michael Bradshaw, Professor of Global Energy, Warwick Business School

It is now more than three years since the West imposed sanctions on Russia, due to its activities in Ukraine. Most recently, the Trump administration has taken additional steps to punish Russia for its alleged interference in the US presidential election in 2016.

The sanctions have not impeded Russia’s ability to supply the international oil market. In fact, the country’s oil production has reached record post-Soviet levels. Rather, the intent has been to limit Russia’s ability to develop new production in the 2020s by targeting equipment and technologies and services which would be necessary for deepwater oil exploration and production, Arctic oil exploration, and shale oil projects. Another goal has been to exclude Russian oil companies from capital markets.

This Sakhalin Oil and Gas Conference in Yuzhno-Sakhalinsk in September afforded the opportunity to reflect on the impact of the sanctions on Russia’s offshore programmes. Given the maturity of the existing Sakhalin projects and their focus on expanding LNG exports, these were not an initial target of the sanctions. However, in the summer of 2015 the US State Department added the undeveloped Yuzhno-Kirinskoye field (part of the Sakhalin-3 licence block) to the list in the belief that it contained significant oil reserves. And this is one instance where the sanctions are having an impact.

Sakhalin-3 operator Gazprom has identified a subsea development of Yuzhno-Kirinskoye as providing the feed gas for expansion of the Sakhalin Energy-operated Sakhalin-2 onshore LNG plant. It is probably not coincidental that the field was added to US sanctions soon after Gazprom announced a strategic alliance with Shell at the St Petersburg Economic Forum. It leaves Gazprom and its partners in Sakhalin Energy with a problem: the construction of a third LNG train is clearly needed, but they currently lack access to the necessary gas resources.

However, the ExxonMobil/Rosneft Sakhalin-1 project has significant gas that it is seeking to monetise, potentially through building its own single-train LNG plant on the site of its oil export terminal at De Kastri on the Russian mainland. But the Sakhalin-1 partners have also discussed selling Sakhalin-2 the gas it needs. This would solve the immediate problem and would limit the impact of sanctions on Yuzhno-Kiriniskoye. It also appears to be the best outcome for the Russian state because the cost of the Sakhalin-1 LNG plant would have been covered by the production-sharing agreement and the investors would first have had to recoup their costs.

The sanctions against Russia need to be considered in light of two other significant developments. First, the fall in the price of oil post-2014, and second, the decision by the Russian government to allow the rouble to devalue. These two factors are clearly inter-related and have served to isolate the Russian oil and gas industry, and to some extent, the Russian government, from the impact of the falling oil price. Each dollar earned now equates to a lot more roubles to be spent domestically, and by international standards Russian production costs are low. Even if the sanctions were not in place, the partners in all Russia’s oil and gas projects—both foreign and domestically operated—would be obliged to maximise their reliance on domestic suppliers, some of which would be joint ventures or foreign-owned subsidiaries with a cost base in roubles.

Of course, this also assumes there are sufficient technically competent domestic companies to service the needs of the various projects. On Sakhalin, this process was embedded in the island’s economy through the ‘Russian Content’ requirements of the various Sakhalin licence block production-sharing agreements, and this did much to raise the competence of the domestic supply chain to the offshore industry. However, the sanctions have halted access to the supply of equipment and services that are not currently available from Russian companies. The intent is to inhibit exploration and development.

One response, where possible, has been to source these needs from countries and companies not under sanctions, such as Chinese oilfield service contractors. But, the deepwater offshore, Arctic, and shale oil are specifically areas of Western competence.

Another response has been for the Russian state to encourage ‘import substitution’ by promoting and subsidising the development of Russian competencies. But this is a costly and long-term process and it remains to be seen how much progress is being made.

So, on the face of it sanctions have stopped Russia from exploring and developing its deepwater offshore, Arctic and shale oil potential. This is a problem because Russia’s traditional fields are well past their peak and new production needs to be developed, while at the same time, the cost base of Russian oil and gas is increasing.

However, the sanctions are proving to be positive for Russia in that they are forcing a greater cost-consciousness – because capital is hard to come by – and they are stimulating localisation and import-substitution which will increase the amount of value added captured by Russian industry. Over the longer term, they may reduce Russia’s reliance on Western equipment, technologies, and services.