How the Ukrainian Crisis Impacts Russia’s Energy Companies

by Koen van Delft

The Ukrainian Revolution has thus far seen the ousting of President Yanukovych and the rise of new parties fighting to gain control of Ukraine. Since then, the residents of Crimea have seen the arrival of unmarked Russian military troops supposedly protecting the Russian inhabitants of the region. The most recent development has led to a referendum in which the people of Crimea voted to join Russia; 95% of the votes casted show that the Crimean people are in favor of joining Russia. Some people in Crimea and Russia see this as a positive development since it increases Russian influence in the region. Crimea is home to a large Russian naval base in Sevastopol, it is an important energy hub/route to Europe and it has significant oil and gas reserves in the Black Sea. In addition to the fact that there are ethnic Russians living in Crimea, these characteristics increase the attractiveness of the region to Russia.

“From the Russian point of view, if the EU would implement economic sanctions, the annual loss in Russian revenues would be in the order of $70 billion or three percent of GDP due to the average sale price of $350 per thousand cubic meters for Russian gas”.

On March 17th 2014, the United States announced that sanctions would be put in place against a number of high-ranking Russian and Ukrainian officials. According to NBC and the Guardian, the result of these sanctions is that their foreign bank accounts will be frozen and their visas will be banned. On March 18th, the European Union and Japan have announced that they will join the sanctions placed on Russia. Japan’s reaction has been slightly more moderate compared to the US and the EU, Japan will pause investment talks, “space exploration and military cooperation according to statement by Japanese Foreign Minister Fumio.”

Russian – EU Exports and Imports

So far the imposed sanctions have only targeted Russian and Ukrainian officials and their foreign assets. The EU and US could impose economic sanctions such as import/export restrictions/bans, higher import tariffs and taxes, as well as quotas. According to Danny Vinik of New Republic, this would lead to increased prices for Russian products entering the European Union and the United States. The consequences would influence several parties including the sanctioning parties. The US engages in relatively little trade with Russia. In 2013 the US traded only $40 billion worth of goods according to the US Bureau of Census. The European Union depends on Russia for energy supplies, international trade and foreign direct investment opportunities. According to the European Union official statistics the total import from Russia amounted to 228,2 billion and total export to Russia totaled 151,2 billion. Since the European Union has a significantly larger trade balance with Russia than the US, economic sanctions would affect the EU more than the US. The EU imports from Russia are dominated by raw materials, in particular, oil and gas. Since the European Union is dependent on Russian energy, it is unlikely that the EU will enforce economic sanctions since it would lead to energy shortages in the EU. Georg Zachmann from Bruegel.org pointed out the possible effect on Russia of such sanctions. “From the Russian point of view, if the EU would implement economic sanctions, the annual loss in Russian revenues would be in the order of $70 billion or three percent of GDP due to the average sale price of $350 per thousand cubic meters for Russian gas”.

The partnership [between ExxonMobil and Rosneft] involves transferring the technically advanced skills from ExxonMobil to develop the difficult Russian Far East fields. This process requires international trade to transport machinery and parts from the Western facilities and/or factories to Russia.

Data from the European Commission estimated that up to 75% of Foreign Direct Investment stocks in Russia come from European Member States. Since the level of economic interconnection is not limited to international trade, Western (including EU and US) companies that have partnerships and investments in Russia’s energy sector might face difficulties continuing their operations if economic sanctions are put in place. According to RBS, the Austrian Bank Raiffeisen lost nearly 8% per share due to its 18 billion loans outstanding to Russia and Ukraine. Similarly, the investments made by foreign car companies in Russia accumulated more than $6 billion since 2011 (Ernst and Young). The example of the Raiffeisen Bank shows how investments of Western companies in Russia are seen as riskier now that sanctions are imposed on Russian and Ukrainian officials. It seems likely that investments would be seen as even riskier if economic sanctions were forced upon Russia. Such sanctions would make it more difficult for these companies to manage their operations and send their non-Russian employees to these locations. Additionally, they could not export machinery and funds to these Russian locations, which would further complicate and delay business. These economic sanctions would therefore not only hurt the Russian economy, it would also create significant losses for these foreign companies that have invested in Russia.

Russian Western Cooperation: ExxonMobil and Rosneft Partnership

The US based company ExxonMobil and Russian Rosneft have been cooperating for a number of years. Last year on June 21st, new agreements were signed by Mr. Sechin, the Rosneft president and Mr. Tillerson, the CEO of ExxonMobil, to explore the Arctic region and develop a LNG plant in the Russian Far East. Reuters reported that the partners seek to transfer the knowhow gained in North America to western Siberia. According to Exxon’s Russian chief, the companies have a unique partnership “They have the world’s biggest reserves and we have the largest market capitalization”. This cooperation could experience serious difficulty if economic sanctions were to be put in place since it requires technology sharing, economic cooperation and cooperation between employees of the two companies. Sanctions that have been put in place in the past against Iran included bans on supply of heavy weaponry, nuclear technology, arms exports, and freezing of assets. The EU additionally imposed restrictions on trade of equipment. At this point in time, the question can be asked whether we will see a repetition of the 1970s actions taken by the US to limit Moscow’s source of hard currency revenues by imposing US and EU sanctions to control Russian oil and gas exports. In the 70s the European Allies of the US were not at all content with these sanctions and preferred the trade revenues that resulted from cooperation with the Russian government.

Graph 1: Net direct investment for the Russian Federation. Federal Reserve Economic Data (FRED)

According to RIA Novosti, the upper house of Russia’s parliament is mulling measures allowing property and assets of European and US companies to be confiscated in the event of sanctions being adopted against Russia over its military intervention in Ukraine.

According to Andy Rowell of Oil Change International, if we see a repetition of such economic sanctions, it could make it impossible for ExxonMobil to continue its project with Rosneft; however, this would also create a serious burden for Exxon. The partnership involves transferring the technically advanced skills from ExxonMobil to develop the difficult Russian Far East fields. This process requires international trade to transport machinery and parts from the Western facilities and/or factories to Russia. Also, they use non-Russian employees to take on tasks that cannot be performed by Russians. Economic sanctions against Western companies cooperating with Russian companies could jeopardize partnerships between Russian and Western companies such as ExxonMobil and Rosneft. Trade restrictions could severely limit the technology transfer from the US to Russia. According to Deaux and Dicker of The Street online publication, not only would this create a significant financial burden for the Russian companies, but it would also negatively affect the US companies operating in Russia.

EU money flow to Russia. Eurostat.

If such sanctions are put in place and result in cancellation or suspension of cooperation between Russian and Western companies, the Russian government might see an opportunity to increase its control over Western assets in Russia. According to RIA Novosti, the upper house of Russia’s parliament is mulling measures allowing property and assets of European and US companies to be confiscated in the event of sanctions being adopted against Russia over its military intervention in Ukraine. However, it is highly questionable whether Russia would be able to continue the technologically advanced projects in Sakhalin, for instance, where Western companies have been specifically introduced to take on these difficult tasks. If they take out these foreign companies, it is likely that Rosneft will not be able to continue the project in the same manner as it is now. Therefore the chances are small that the Russian government will nationalize or try to increase its share in projects such as between ExxonMobil and Rosneft.

How the Russian Budget Fits In

Additionally Russia needs European countries to purchase its oil and gas output. The Russian government financial balance depends to a large extent on revenues from oil and gas sales to Europe. Since Europe has not been able to completely diversify its energy supplies away from Russia and the US has not approved its LNG and/or shale gas exports to Europe, Europe will continue to depend on Russian energy supplies in the short term. Therefore, it seems very likely that Europe will not support US led economic sanctions against Russia as it did similarly in the ‘80s.

The decrease of the ruble would be beneficial for state revenues, causing them to increase by 1% of GDP for every 10% decrease of the ruble against the dollar. The downside of the ruble value decrease would be that inflation would also rise to approximately 7% per year.

Europe and Russia will lose significant economic growth if economic sanctions are installed, according to Dutch Planning Bureau (CPB) a 10% increase in oil price due to the Crimea developments can result in a lower economic growth of 0,25% instead of 0,75% in the Netherlands alone. Since many European countries are in comparable economic situations, it can be expected that they will not be too excited to reduce economic growth only to punish Russia.

As explained earlier, Russia is unlikely to seize European or Western energy assets and projects since the country needs the knowledge and experience that is brought in by these companies. These assets remain a point of leverage for Russia vis a vis Europe and Western companies and countries in general. Graph 1 displays how Russian FDI abroad was significantly negative in the period from 2008 to 2010; non-Russian companies and countries on average invest more in Russia than Russian companies do in non-Russian regions. According to data from 2007 (graph 2), Russia’s FDI has always been smaller than non-Russian FDI into Russia. EU Direct Investment into Russia (2007) was 16% whereas Russia’s FDI to the EU was only 2,3% in that same year. This results in a situation in which Russia can seize more assets and investments from non-Russians in Russia than the EU or the US can.

Another important issue for Russia is its credit rating, both S&P and Fitch ratings agencies downgraded their longterm outlooks on Russia’s debt from stable to negative. In addition to this downgrading, the Russian Finance Ministry said on March 21, 2014 that it may be forced to cancel plans to borrow abroad this year. This is due to the fact that the cost of borrowing can rise. According to Neil Shearing, chief emerging market economist at Capital Economics, the decrease of the ruble would be beneficial for state revenues, causing them to increase by 1% of GDP for every 10% decrease of the ruble against the dollar. The downside of the ruble value decrease would be that inflation would also rise to approximately 7% per year.

Crimea: New Russian Energy Frontier?

Apart from the sanctions and the outcomes and consequences that these sanctions might have in political and economical terms for Russia, there are positive aspects for the Russian economy and companies. Since the Crimean region has significant oil and gas reserves, Russia is able to increase its domestic reserves by allowing Crimea to become a part of the Russian Federation. The reserves in Crimea are estimated to possibly have an annual production from the Skifska and Foroska fields of 3-4 billion cubic meters and 2-3 billion cubic meters, reported the Kyiv Post. These reserves in Ukrainian hands would reduce Gazprom’s and thereby Russia’s influence over Ukraine, as Ukraine could potentially develop some of these fields. If these reserves were to fall into Russian hands, its influence over Ukraine would increase due to higher dependency of Ukraine on Russian gas imports since it domestic reserves would be significantly reduced.

The reserves in Crimea are estimated to possibly have an annual production from the Skifska and Foroska fields of 3-4 billion cubic meters and 2-3 billion cu-bic meters, reported the Kyiv Post.

Production Sharing Agreements between Ukraine and possible partners have not been signed for the Skifska and Foroska fields, and until now there has been no exploration of these fields (Macadam). According to Crimean officials, Crimea may sell the Ukrainian energy firm Chornomornaftogaz to a Russian company “like Gazprom” once the regional authorities take control of it. “After nationalization of the company we would openly take a decision – if a large investor, like Gazprom or others emerges – to carry out (privatization),” Rustam Temirgaliev, Crimea’s first deputy prime minister, stated.

Conclusion

The sanctions imposed by the US, EU and Japan have so far been limited to the freezing of Russian assets located abroad and bans have been put on visas of Russian Officials traveling to regions supporting the sanctions. Currently, the sanctions do not include economic measures against Russia, therefore it does not yet affect the cooperation between Western and Russian companies directly. Based on the dependency of European countries on Russian energy supplies, it seems unlikely that European countries will support significant economic sanctions. This would create a situation in which Russia is likely to counteract and freeze Western assets and projects in Russia. The fact is that the Western countries and companies have far more FDI in Russia compared to Russian FDI in Western countries. That means that if both regions nationalize or freeze assets, Russia comes out winning in terms of seized assets.

Due to the economic assets and interests of the EU in Russia, it is unlikely that Europe will press for economic sanctions, however the US might see legitimate reasons to create sanctions. This would hurt all parties and companies involved in trade, and at this point in time world economies are recovering from the previous economic crisis and need all the economic growth possible. Sanctions would seriously hurt the US, EU and Russian economies. Therefore it seems more logical that the EU will press for political sanctions instead of economic measures against Russia.

Koen van Delft is an MA student in the ENERPO program at European University at St. Petersburg.

Sources

Bloomberg.com Retrieved from http://www.bloomberg.com/news/2014-01-02/exxon-s-russia-ambitions-show-drilling-trumps-obama-putin-spats.html

BusinessInsider Retrieved from http://www.businessinsider.com/obama-statement-ukraine-crimea-referendum-vote-putin-sanctions-2014-3#ixzz2wESbCLgT

Bruegel.org Retrieved from http://www.bruegel.org/1279-the-cost-of-escalating-sanctions-on-russia-over-ukraine-and-crimea.html

Joe Deaux and Daniel Dicker Retrieved from http://www.thestreet.com/video/12534121/us-sanctions-against-russia-may-target-exxon-mobil-next.html

Ernst and Young via FT.com Retrieved from http://www.ft.com/intl/cms/s/0/1c947e3a-a2b9-11e3-9685-00144feab7de.html#axzz2wVc9bBAx

European Commission Retrieved from http://ec.europa.eu/trade/policy/countries-and-regions/countries/russia/

Guardian Retrieved from http://www.theguardian.com/world/2014/mar/06/ukraine-crisis-russia-crimea-eu-un-live

Japanese Foreign Minister Fumio Retrieved from http://www.edmontonjournal.com/news/Ja-pan+imposes+sanctions+against+Russia+over+Crimea/9628847/story.html

Kyiv Post. Retrieved from http://www.kyivpost.com/content/business/ukraine-seeks-energy-majors-for-black-sea-explorat-129039.html

Macadam D., Retrieved from http://theoligarchkings.wordpress.com/2014/03/12/rothschild-russia-and-why-everyone-is-getting-upset-about-crimea/

NBCnews Retrieved from http://www.nbcnews.com/storyline/ukraine-crisis/whats-putins-next-move-its-anyones-guess-experts-say-n53886

Newrepublic Retrieved from http://www.newrepublic.com/article/116908/definition-and-explanation-us-economic-sanctions-against-russia

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RBS via FT.com Retrieved from http://www.ft.com/intl/cms/s/0/1c947e3a-a2b9-11e3-9685-00144feab7de.html#axzz2wVc9bBAx

Reuters.com Retrieved from http://www.reuters.com/article/2012/04/18/us-exxon-rosneft-idUSBRE83H0UE20120418

US Bureau of census Retrieved from http://www.census.gov/foreign-trade/balance/c4621.html

Wall Street Journal http://online.wsj.com/news/articles/SB10001424052702304747404579446641418330738?mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702304747404579446641418330738.html

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