The Russian oil miracle - how production has soared despite low oil prices

Russia's offer to OPEC to freeze production as part of a concerted effort aimed at stabilising oil markets comes, conveniently, as output soars to record highs. As other countries suffer production declines under the pressure of low oil prices, Russia is bucking the trend. What's different about Russia? Can it last? What's the longer term outlook?

Global liquids production is dominated by the big 3 – USA (12.3 million b/d in 2016), Saudi Arabia (12.1 million b/d) and Russia (11.6 million b/d), which together comprise a third of world supply. The rise of tight oil this decade has lifted the US to top dog, touching 12.9 million b/d at peak in April 2015. But low oil prices are taking their toll on the L48, and production will fall back to 12.0 million b/d by Q1 2017. Even so, the US should still be the world's biggest producer next year.

Russia's rise has been as impressive, doubling since 2000 to a post-Soviet high of 11.9 million b/d in October 2016.

In contrast to the US, Russian output has risen progressively since 2014, despite sanctions which have restricted inward investment and the transfer of the latest technological advances. There are three main factors behind the achievement.

First, buoyant upstream margins. The correlation of the rouble with the oil price has protected Russian producers from the worst. Brent falling from US$99 in 2014 to US$44 in 2016 destroyed the margins of US producers. This necessitated the brutal cost cutting and efficiency drive of 2015/16 that has helped keep tight oil production at respectable levels.

Russian producers in contrast have luxuriated in relatively high margins. Oil prices fell by just 22% in rouble terms from 2014 to 2016; and upstream costs are almost entirely denominated in roubles.

This means that Russian producers sold oil at an effective price of US$77/bbl in 2016. Other producing nations have benefited from a similar currency effect on revenues, but few have such a high proportion of costs in local currency.

The Russian Government reacted to a loss of tax revenues by increasing the tax rate. But as a major upstream stakeholder itself, the Government is as incentivised as the operators to maximise production and cash flow; as well as being keen to bring economic support to the oil producing regions. High margins have had a rejuvenating effect on investment.

Rosneft, the biggest operator in the mature West Siberia fields which produce 6 million b/d, has not only arrested a long-term decline but has managed to increase output since 2014.

Second, technology. Sanctions have severely restricted Russia's ability to import new technology to tap frontier projects, but technology is playing a part. Rosneft has kicked off a phase of intense drilling in the last three years with 1,600 wells targeted at deeper, low permeability plays in West Siberia as the shallow, older producing zones water out. Around 1 in 8 of these is a horizontal well extending to 3,000 ft and with 3-5 stage fracking. These are baby steps – leading-edge US tight oil operators are drilling 7,000 ft laterals with 50 stage fracking. But it's still progress for Russia.

Third, greenfield start-ups. Tax breaks have incentivised new developments and in October President Putin inaugurated the start up of Vladimir Filanovski, LUKOIL's flagship project in the North Caspian Sea. Production is already 68,000 b/d from just three wells, and should double by 2020. LUKOIL will bring onstream its Pyakyakhinskoye gas field next year, which will produce 31,000 b/d of oil and condensate.

The outlook for Russian production near term is positive. These three drivers are the main factors behind our forecast of a steady climb towards an annual average of just under 12 million b/d through 2020.

Further out there are question marks. There is a lack of greenfield projects in the pipeline. Mature fields in West Siberia and the Volga Urals might deliver more with EOR and technology to stem declines, but it won't be easy. Modest recovery factors of 28% from the conventional reservoirs in these giant basins points to the potential – Russia's Energy Strategy is aiming for 40%.

Fresh opportunities need to be opened if production is to be maintained at current levels or grow into next decade.

But the potentially giant new resources in deep water, Arctic and Bazhenov shale oil are high cost and challenging. Fiscal incentives, new technology and in all likelihood higher oil prices will all be needed to make these commercial.