December 17, 2016 by AK
Ronald Smith, also known as Ron Smith, Citigroup’s oil and gas analyst covering Russia and the CIS, argues in the Financial Times (if you cannot access it, try googling the title and reading Google’s cache) that Russia is likely to stick to its pledge to cut 300,000 bpd next year:
First, Russia reportedly played a key role in both deals, with President Vladimir Putin personally acting as a dealmaker between Iran and Saudi Arabia…
Second, the maths of higher prices versus lower production provides significant stimulus for the Russian government… oil taxation has traditionally provided almost half of the country’s tax revenue and because the Russian oil tax regime is highly geared to the price of oil.
“Progressive taxation” as I called it here. I’ve got no argument with Smith on these two theses of his. But then he asks another question: how does the government compel oil companies to comply?
Smith thinks Russian oil companies don’t actually mind reducing output. Again, he provides two reason. The second one I fullly agree with:
Additional cuts could come from slowing brownfield drilling, a delayed but potentially powerful method of adjusting production…
Applying that 8 per cent decline rate to total Russian production would imply about 5 months needed to meet the entire 300,000 b/d production cut target.
Except that I would apply, say, a 12% rate to about half the Russian production (roughly speaking, Western Siberia south of Yamal), leading to a slightly longer adjustment period.
The most interesting and controversial part of Smith’s piece is his number one reason why Russian companies would be happy to cut – because they are overproducing:
We think most Russian oil companies have at least some older fields that are at best marginally profitable, with economic rents predominantly going to the government as taxation: One large Russian oil company estimated in March that “over 30 per cent’”of its producing fields were uneconomic. While this could partly be due to the low oil prices at the time, it also lends credence to our suspicion that there may be a material amount of Russian production that remains on-line to generate tax revenues for the government than profit for the producing company.
I have the same suspicion but I think that “uneconomic,” in this context, should refer to the combined cost of producing, transporting and selling crude and of keeping up output, or at least preventing it from declining too fast. In other words, few if any wells or well clusters or fields are producing at an operating loss – but it’s possible that all the cash they generate goes on drilling new wells (plus fracs, sidetracks and various workovers) to neuter the natural production decline.
If some companies’ investment decisions are motivated by fear of the authorities’ reconciliation against those who cut down on capex too aggressively – blatantly reducing the tax base in the eyes of the taxman – overinvestment and overproduction follow. Once the taxman changes his mind, the producer will cut down on drilling but won’t shut in many producing wells. What Smith sees as “[a]dditional cuts… from slowing brownfield drilling” might very well turn out the primary transmission mechanism for the agreed-upon cuts.
In his October 3 FT comment, Smith was skeptical about any production cap or cut by Russia. So was I (September 21), although I pointed out what I thought would be a realistic path to lower output (October 11). Arguing his point, Ron Smith noted:
…First, contrary to common misconception, Russia’s oil production is not a high-cost venture. Instead, the typical Russian barrel of oil resides far down the cost curve, generating economic value even at oil prices below $20 per barrel, although the bulk of that economic value goes to the Russian government via taxes, rather than to producers in the form of profit.
How does it square with Smith’s suspicion that “there may be a material amount of Russian production that remains on-line to generate tax revenues… than profit for the producing company?” Once you make the distinction between opex and output-maintenance capex, between production today and production six months down the road, the apparent contradiction should melt away.