Mar 3, 2016 | 01:00 GMT

7 mins read

In Russia, an Energy Freeze Comes With Strings Attached

It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

Russian President Vladimir Putin announced on March 2 that his country's major oil producers had reached an agreement to freeze production at January's levels. This confirms that Russia will cooperate with a general production freeze agreement made in February by major producers both in and outside OPEC. Although Putin's announcement is significant, global oil markets didn't react. This is an acknowledgment of the reality that Russia's production in January was already at a post-Soviet record 10.9 million barrels per day, according to CDU-TEK

A production freeze from Russia is a prerequisite for any broader deal between OPEC and non-OPEC members. While Russia now appears to be on board, Iran and Iraq won't commit to a freeze. Ultimately, the strategy to enact a freeze depends on Saudi Arabia, which has remained open to the strategy. Yet, Riyadh prefers letting market forces dictate production levels and prices globally.

Despite the high-profile announcement, Russia's national production in 2016 had already been predicted to stay relatively flat — if not decline outright — regardless of any formal agreement to freeze production levels. Unlike most other major oil-producing countries attempting to negotiate a production freeze or even a cut, Russia's domestic petroleum industry remains fragmented. This makes the country's overall energy strategy difficult to control. As a result, Putin needed a high-profile show of support for the action from bigger oil firms to give the appearance of a grand deal. To achieve this, Putin had to adopt a conciliatory tone during a meeting with the heads of the Russian firms. He asked them for their input not only on the global problem but also on the other issues that they face.

This opened the door for the energy firms to demand political concessions in exchange for supporting the production freeze. With low oil prices, regulatory changes in Europe, and Russia's evolving Asian energy strategy, the time is ripe for firms to extract concessions — even though it would mean the restructuring of Russia's energy sector.

Perhaps the biggest demand was the breakdown of the monopolies and near-monopolies of the country's natural gas giants. Gazprom not only has a legal monopoly over all exports of piped natural gas, but it also controls most of the domestic pipeline infrastructure. This forces other domestic producers to sell natural gas cheap domestically while paying Gazprom steep transit fees — alternatively, they could flare their associated gas production. Rivals Rosneft and Novatek, as well as Gazprom's customers in Europe, have long pushed for ending Gazprom's monopoly on piped exports. As the company's elevated political status wanes, the loss of its monopoly is becoming an increasingly plausible scenario.

Unlike Rosneft, Gazprom's base of political power has not been tied to key oligarchs, silovarchs or any other firm power base. It instead stems from Gazprom's efficacy and potency as a foreign policy tool. Through Gazprom's control over natural gas, the Kremlin had wielded powerful influence over Eastern European leaders. However, the European Union effectively countered Gazprom's monopoly through legislation and infrastructure that make it difficult for the company to single out a customer. For instance, Ukraine — a country that Moscow once held considerable sway over through control of its gas supplies — has bypassed Russia almost entirely as a direct gas supplier for most of 2015.

Gazprom's dwindling political importance has allowed the idea of breaking up its monopolies to gain popularity within the Kremlin. It is no longer a matter of if Gazprom's monopoly on exports will end, but when. Even now, Novatek is taking that demand further by asking for direct access to the domestic gas distribution system — a move that could eventually lead to the reallocation of Gazprom's pipeline ownership to an independent firm or firms.

Beyond Gazprom's status, Moscow remains under considerable financial stress and hopes to raise revenue either through higher taxes on oil companies or by privatizing shares of state-owned companies. Russian Economic Minister Alexei Ulyukaev stated Tuesday that he would like to see timelines for all of the privatization proposals. Rosneft — of which the Kremlin owns 69.5 percent — has been fighting against a privatization of a further 19.5 percent of its ownership. Rosneft CEO Igor Sechin is open to selling part of Rosneft to a giant partner such as China's CNPC or Sinopec but would only be willing to do so if the company's shares are valued at the same level as in previous privatizations (for comparison, in a 2010 auction, the share price was $8.33; currently, it is $3.92).

Another company central to the Kremlin's privatization efforts is Bashneft, which was renationalized in October 2014. The company's 400,000 bpd of production is centered in the Muslim autonomous region of Bashkortostan, making it politically difficult to sell to a foreign firm. Both Rosneft and LUKoil have expressed interest in taking over the company, pitting Russia's two largest oil producers — one with close ties to Russia's security services and the other with the most commercial and financial strength — against one another. The decision of whether to privatize Bashneft or sell some of Rosneft's shares, and to whom, will fall to Putin. But much like Gazprom's energy monopoly, pressures to do so are growing, making Rosneft more likely to extract concessions in exchange for supporting privatization.

Despite the looming possibility of privatization, one thing that will ultimately remain true is the importance of oil to the Russian economy and budget. This makes Rosneft and Lukoil particularly powerful firms that the Kremlin must consult with before making any change in energy policy — either internally or externally. Rosneft and LUKoil will bear the brunt of an energy production freeze or cut. Until recently, both have pushed against a production cut. LUKoil — which remains focused on bringing domestic production levels higher — will still demand the power to make investments based on market conditions, rather than a political agreement. Rosneft, however, appears to be more open to more than just a freeze.

For Rosneft, this is likely more about a natural decline in production rather than actively sidelining production. Most of Rosneft's production remains in the aging, mature West Siberia Basin, where production is falling by 5 to 10 percent annually. Rosneft's mid-term and long-term replacements — in Eastern Siberia and the Arctic — remain capital intensive to develop. And not only are they expensive, in the latter case, any development is subject to sanctions. To help support more expensive production, the Russian government had originally pledged in 2014 to lower taxes on energy exports starting in 2016, going from 42 percent to 36 percent. But the Kremlin froze the proposal in 2015 while drafting the new federal budget. That, combined with low oil prices, means Rosneft is likely facing a slight decline in production — or at least level production — regardless of any agreements. What Rosneft does not want, however, is to be tied into a decision where it must unilaterally enact cuts, giving an advantage to internal or external competitors.

Russia's lack of a cohesive energy policy is a reflection of the varied, and often conflicting, interests of its companies, all of which are trying to spin a difficult financial environment to their advantage. Quite often — as Gazprom has found out — one company's gain is another's loss. Ultimately this means that the Kremlin will continue to directly negotiate on production levels, but there will be disunity from oil producers and energy ministries, all of which have differing positions. As a result, a sustained production freeze or production cut in Russia remains difficult to achieve politically — and instead will be dictated by market forces.

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