Energy production and exports play an outsize role in the Russian economy. By the same token, Russia is a big player in world energy markets—not just in oil, but also natural gas and coal—with Europe being particularly vulnerable to changes in Russian energy supplies. For this reason, even though the West could cause great harm to Russia with sanctions on Russian energy exports, so far the United States and Europe have been reluctant to impose the harshest controls on energy.
Despite the relatively few direct sanctions on Russian energy products however, the markets for oil and gas have been roiled since the Russian invasion of Ukraine, contributing to rising prices and inflation around the world. As the West finds ways to move away from Russian energy supplies and Russia becomes more isolated from the world economy there will be massive long-term effects for Russia’s energy production.
Russian energy exports were initially largely exempted from sanctions. But Russia’s energy production is likely to see large negative effects over the long term.
The Facts:
Hydrocarbon exports dominate the foreign earnings received by the Russian state. Revenues from oil and natural gas made up Four. Five% of Russia’s federal budget in 2021, according to the International Energy Agency. Oil dominates the earnings that the Russian state receives in the form of royalties and is Russia’s most important export by far, accounting for around half of export earnings.
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When you add in Russia’s natural gas and coal exports to its oil exports, energy exports together accounted for roughly two-thirds of the country’s export earnings before the pandemic (see chart above).
The European Union proposed a ban on Russian crude within six months; Moscow and Kyiv accused each other of breaking a cease-fire in Mariupol. Photo: Julien Warnand/Shutterstock
Russia is the second-most important exporter in world energy markets and Europe is especially dependent upon energy exports from Russia. Russia is responsible for about one eighth of the world’s oil exports. Europe, the largest importer of oil from Russiais particularly vulnerable.
While they import some of that oil by tanker—and thus can replace Russian sources with others, in principle—an important share comes in by pipeline in various forms. For example, refineries, landlocked in Central Europe located along a pipeline specifically designed for Russian oil, do not have very many other sources of oil and are likely to face distress as they try to find alternatives (see here). Europe also depends heavily on Russian exports of diesel fuel.
In gas European dependence is even more acute. Russia is second to the United States in natural-gas production and is the world’s largest gas exporter. Russian natural gas accounts for about 40% of the supply in Europe and is used for home heating, power generation, and industry.
How are sanctions impacting Russia’s oil sector? Russia is already exporting less oil thanks to sanctions that have made it harder to clear payments, charter ships and obtain insurance.
While it is difficult to obtain exact estimates due to the opacity surrounding Russian oil exports, the total volume of oil in play may be about half a million barrels per day in April or possibly as much as three million barrels per day—and grow in the future. That doesn’t sound like much, but in a tight 100 million barrel per day oil market it has big effects on CL00 prices,
Because most oil exports are by tanker and fungible in the global market, you’re starting to see it flowing to other countries that are more willing to accept those imports—like China and India. (The situation with coal is similar and there has been an uptick in the price for coal and an increase in exports of Russian coal to China and declines in Western imports of coal from Russia.)
However, the fact that Russia has become a pariah is also having a powerful effect: it has become very difficult for Western banks, Western insurance companies, and shipping owners to do business with Russia. This has introduced all kinds of friction into the oil market.
Russia, as one of the lower-cost oil producers in the world, tends to profit greatly when there’s a big rise in oil prices. However, some of the windfall gains from higher oil prices have been whittled away from Russia by these frictions in the form of discounts to big buyers like China and India; extra fees that are being paid to insurance companies; higher fees to charterers; and so on.
Europeans are moving to reduce their near-term dependence on Russian gas exports and to reduce their dependence on natural gas altogether in the longer term. Natural gas is less fungible than oil and coal with most being delivered through pipelines.
Related stories: ‘Energy is being increasingly weaponized.’ Analysts weigh up risks after Russia cuts gas to two EU countries
Sanctions on Russian gas thus far have included the cancellation of the Nord Stream 2 pipeline, which was ready to start operations and would have doubled the supply of gas that could be moved by pipeline directly from Russia to the lucrative German market.
The Europeans have announced aggressive plans to cut dependence on Russia. My estimate is that this year alone we could see perhaps a shift of about 20% of European gas to non-Russian sources, mostly through purchases of liquefied natural gas (LNG). But this means redirecting gas that would otherwise likely go to East Asia, leading to much higher prices NG00,
on the global gas market.
Gas prices in Europe in April were about five times the level they should be this time of the year. In the longer term, the Russian invasion of Ukraine has provided Europe with additional incentives to accelerate efforts to transition toward clean and efficient alternatives to natural gas.
Sanctions that limit Russian access to Western technology limit its potential for future productive capacity in energy exports, especially with respect to gas. When Russia annexed Crimea and invaded the Donbas region of Ukraine in 2014, Western sanctions prohibited, among other things, the transfer of advanced oil drilling technology to Russia.
Since those sanctions, Russia has already started to try to make itself less dependent on Western technology. In many respects that onshoring strategy worked: its onshore oil production, notably, has become more independent of Western technology and capital. But they are highly dependent on Western technology and markets for the big, most lucrative, long-term gas export projects—such as those involving LNG technology that would allow them a broader global market for their output.
An area to watch, which has received very little attention so far, is nuclear power. Russians are currently the dominant exporters of nuclear reactors and the fuel cycle that goes with those nuclear reactors, which is all Russified technology. It is possible that Russia would try to expand international customers willing to buy their products, and having all-Russian supply chains for nuclear power.
So far, several countries have shown they are willing to do business with Russia on nuclear power, and now they don’t have much choice but to keep those relationships in place.
What this means:
At the outset of the war, energy exports were largely exempted from sanctions because hefty sanctions would cause huge economic and political harm in the Western sanctioning countries. But as the war in Ukraine drags on, the West is finding ways to lower its dependence on Russian energy—with European policy makers in the lead.
Russia may find this important source of funding diminished—essentially permanently. Because energy revenues are vital to the Russian economy, this is likely to spell very severe macroeconomic harm to the Russian government over the long term.
David Victor is a professor of innovation and public policy at the University of California, San Diego. His research focuses on regulated industries, and how regulation affects the operation of major energy markets.
This commentary was originally published by Econofact.org—The Role of Energy Markets in the War in Ukraine
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