Oil and Gas After Sanctions

In the long term there’s no question about it: what Putin has done is totally disastrous. But it ceased to be a an energy story, or even a technology story. What’s scary is that now the drums of war are beating and the hounds of war are loose and we’re way beyond energy and way beyond sanctions now. It’s scary as hell.

An interview with Thane Gustafson

Last Friday I spoke via Zoom with Thane Gustafson, a professor of Government at Georgetown University. Gustafson is an expert on the politics of oil and gas in Russia and the former Soviet Union. He has written a number of books on the topic, including The Bridge: Natural Gas in a Redivided Europe (2020) and the magisterial Wheel of Fortune: The Battle for Oil and Power in Russia (2012). The world oil market, Gustafson said during our call, “is one big bathtub with lots and lots of faucets pouring in and lots and lots of drains draining out. And what happens in between is pretty opaque.” I wanted some clarity about this bathtub, and I was curious about what had changed in the oil and natural gas industries in Russia over the past few years—and what the prospects are in the wake of the invasion of Ukraine. At one point Gustafson paused our conversation to show me the painting hanging behind his head, which he used on the cover of Capitalism Russian-Style (1999). The painting, by Viktor Krotov (no relation), is a Daliesque depiction of Russia as a blindfolded avenging angel that holds a dagger in one hand and the tipping scales of justice in the other. The fires of hell are open at the bottom, hundred-dollar bills float in the wind, and on the bottom right is the iconic former headquarters of Gazprom, in Moscow. Our conversation was calm and friendly, but the turmoil in the painting seemed apposite. This interview has been condensed and edited. —Mark Krotov

Mark Krotov: In a perfect world I would spend this interview talking about the Russian oil industry’s tumultuous transition after the fall of the Soviet Union, a very interesting story you depict brilliantly in Wheel of Fortune. But I suspect our readers want to know what’s happening now. Maybe we can sneak some history in. To begin with, though: Vladimir Putin. What do you think some of the media accounts are missing?

Thane Gustafson: Putin is a policy wonk. He follows the details of oil and gas very closely and always has done, going back to his days in St. Petersburg. When he was de facto mayor of St. Petersburg, he was getting a postdoc at an energy institute along with Igor Sechin [the CEO of Rosneft, Russia’s state oil company, appointed to the role by Putin in 2004]. One of his very first business trips after he was elected president was to sit down with [Ukraine’s then-president] Leonid Kuchma and talk about gas. When something happens in the European gas market, Putin is on it right away.

He keeps a close eye on Gazprom [Russia’s natural gas company]. He has, of course, put one of his previous associates, Alexey Miller, in command and kept him there because Miller is loyal. A Gazprom friend of mine jokes that Putin keeps a safe in his office and every so often he opens the safe to make sure that Miller has deposited there what he’s supposed to. Putin nods and closes the safe again and keeps Miller on the job. Putin is also the man who authorized the partial demonopolization of gas exports by allowing Novatek to export LNG [liquefied natural gas] outside the Gazprom monopoly. Putin has followed the Novatek odyssey in detail.

Igor Sechin, as we know, has been Putin’s right-hand man for over twenty years—his closest associate, the guardian of access to his office. The Sechin story is as intimate a partnership as exists in politics anywhere. You add one thing and another and Putin is Mr. Energy, in so many ways. And that is what puts energy at the center of this tragedy, because Putin puts it there by some strange quirk of personality. He’s been obsessed by Ukrainian gas. He has tried again and again to gain control of the Ukrainian pipeline system. Time and again he thought he had won. Time and again he’s been thwarted by the turn of events, at the center of which, among other things, is gas. So his behavior, even though in so many ways it’s self-defeating, becomes a little more—what’s the right word—clinically understandable.

MK: OK, now for a little history. What role did the state play in the oil industry after the fall of the Soviet Union?

TG: The early post-Soviet Russian government did not intend to create a state-owned oil company. They backed into it by absorbing what was left after the oligarchs had seized the juicy bits. The result was Rosneft, which was a collection of the leftovers. But then that became the core, particularly for Putin. The people Putin put in place at Rosneft—especially Sechin—began acquiring this bit and that bit. It was the acquisition of TNK-BP that really put Rosneft on the map. So the story is broadly one of increasing state takeover and increasing state takeover of the revenues, as well as the development of various tax systems that have been effective at capturing the rents, the dividends, the export revenues, and so on—so that the Russian government manages to capture most of the upside. But at the same time it has itself become very dependent on oil revenues.

MK: Have the foreign oil companies and the independent Russian oil companies come to play ever smaller roles in recent years?

TG: Yes, I think so. But at the same time the industry moves on. You might say that geography moves on. West Siberia has peaked, pretty clearly. The Khanty-Mansi Okrug—by the way, Mark, do you speak Russian? Were you raised speaking Russian?

MK: I was, yeah.

TG: That’s marvelous. Any other languages?

MK: Well, my French is deteriorating as fast as Soviet oil infrastructure was in the early ’90s. It’s slowly rusting away, but unfortunately in my case there aren’t any good Western technicians to come and repair it for me.

TG: I can very much relate to that. I largely grew up in France and I try to keep my French going with podcasts. There are a lot of good ones. I particularly recommend one called L’Esprit public, which was the creation of Philippe Meyer.

MK: Thank you, that’s a good recommendation!

TG: At any rate, back to business. As I started to say, the landscape moves on, and as West Siberia declines, the big issue for the Russian oil industry has been: well, where do we go from here? And so there’s been this running debate. Do we go deep or do we go out? Do we go to the Arctic offshore? The problem there is that the Russians never did develop the right technology for offshore work. They didn’t because they didn’t have to, to begin with—because they had that tremendous resource. But the bottom line is now that they would like to go offshore, they can’t. They just don’t have the technology and that’s where the Western companies really could—and were about to—make a difference. And then along came sanctions, and that put an end to that.

MK: What were the plans for Western involvement in offshore development until the sanctions hit?

TG: The big one was Exxon. The Western companies would have had to provide pretty much the whole thing: the heavy engineering, the platforms. Gazprom actually attempted to build an offshore platform in the Arctic, and they relied on the Russian shipyards in the Murmansk area, which are direct descendants of the military-industrial complex. Well, that proved to be a disaster—those guys couldn’t build to save their souls, and Gazprom ended up with this very defective platform. The Russians were just unprepared for this kind of activity. So Exxon came in, as the principal player, and then pulled back out again.

MK: So what is the future of the Russian oil industry? Are people freaking out because of the sanctions?

TG: The sanctions will have no effect whatsoever on production. Where the impact will be felt is downstream at the level of the refineries. If the refineries can’t move their products to Europe—which is their main outlet—they’re going to be forced to stop operations. Basically you’ll have an indigestion, so to speak, if you can’t sell the products. Then, also downstream, you have the challenge of actually finding a tanker. I think it’s much more difficult to run an embargo than to declare one, as we learned in the case of Iran. All kinds of tankers were coming out of Iran and moving on to places like China, and there wasn’t much we could do about that if the buyer wouldn’t cooperate.

The sanctions that are being applied will probably affect the oil service companies: Schlumberger, Halliburton, Baker Hughes, et cetera. Take fracking, for example. You see a horizontal well that goes on for ten or fifteen miles, unbelievably. That’s called a long-reach well, and the service companies are the ones who will provide those extra-long-reach wells. And then you frack and you have what’s called a multiple fracture. You go down that horizontal well board and you go frack, frack, frack, frack at intervals. So you get this tremendous multiplication effect. The Russians have now learned to do fracking and horizontal drilling, and they are somewhat constrained because you have to have seismic visualization, which the Western companies still provide most of. But the Russians learn fast and they’re picking up these techniques, and now lately they’ve been buying up the Russian subsidiaries of these Western oil service companies and that movement will accelerate. They’re mostly staffed by Russians anyway, and those guys stay on presumably. So the transfer of technology has continued.

The big question now is new field development, with Vostok Oil being the place to watch, and also some new developments in East Siberia in Yakutia. But in general the oil and gas resources of the East are far less plentiful than the resources in the West.

MK: Have any of the sanctions thus far been truly terrifying for Russia with respect to either oil production or export?

TG: One has to distinguish between the near term and the longer range. Before I got involved in energy, I spent a lot of time looking at Russian science and technology policy. That was during the ’70s and ’80s. The problems that the Russians continue to have are very much the same ones as those that they typically had in those days. There’s sort of a signature Russian way of doing technology—or, more precisely, not doing technology—that is remarkably unchanged. Now what makes a difference, of course, is the Russian dependence on microelectronics, on IT, on computers. The whole 21st century is imported, practically speaking. Despite all these policies about import substitution and so on, it doesn’t actually happen except for a handful of items that are under the direct control of military-industrial companies that have procurement quotas. There are a handful of technologies that these companies produce and develop willy-nilly. But private operators don’t want to touch that stuff, and they keep telling the government: just let us buy what we need to buy overseas, so we can get on with the business. In that respect the situation was poor before and it’s going to be worse now. So in the long term there’s no question about it: what Putin has done is totally disastrous. But it ceased to be a an energy story, or even a technology story. What’s scary is that now the drums of war are beating and the hounds of war are loose and we’re way beyond energy and way beyond sanctions now. It’s scary as hell.

MK: Yeah, I feel a little sheepish just devoting a conversation about the war to oil and gas.

TG: The Russians face two challenges. One is that internally, their oil at the margin is growing more costly, and that process will continue, because as they move out of their comfort zone in Khanty-Mansiysk and into the Taymyr and so on, that is probably more costly oil, so they’ll move up the global cost curve.

And that brings us to the second challenge, which is that if peak-oil demand becomes reality—which it may well do roughly by 2030—if you have a decline in oil demand after that, that means there’s going to be heightened competition for the remaining sale of barrels among increasingly desperate producers. First and foremost, Saudi Arabia, UAE, et cetera—these countries’ state budgets depend acutely on oil exports even more than Russia’s does. So come hell or high water, those guys are going to be producing oil, even if it’s selling for a penny a barrel. The Russians are going to be caught in that trap between higher cost and lower demand. Their margins are going to go down, and correspondingly that means that the export revenues will go down and the revenues of the Russian government will go down. So beginning in the 2030s, those two trends will start to be the governing trends. And sanctions don’t really affect that picture in any fundamental way except that they block the Russians from going offshore.

MK: What have the technological and political challenges been in Europe to Russian natural gas export in recent years?

TG: When I started writing what ultimately became The Bridge, I thought I was going to write a companion volume to Wheel of Fortune. I was simply going to do the gas story. But I realized very quickly that, in fact, the Russian gas story is only half of the full story. The other half is what was going on in Europe. What happened in Europe is the revolution of liberalism, liberalization, privatization, and so on. And also digitalization, computerization. The bottom line is that the European gas industry has gone through a complete revolution. The power and gas industry together.

In the process some of the familiar names of the European gas industry of the 1980s, the early players, have disappeared and have been absorbed very largely by power companies, which have emerged as the big winners. And the business model has changed. The Dutch created the industry and the business model, which was hinged to oil prices. Gas was sold on the basis of long-term contracts. This is the so-called Groningen model: long-term contracts keyed to oil prices. That’s what the Russians grew up with, because that was the way the game was played in Europe at the time the Russians first came into Europe in the 1980s and into the 1990s. But the Groningen system has now been completely replaced by a system based on computerized trading hubs and spot prices, short-term spot contracts. Long-term contracts do still exist, but they’re no longer keyed to oil prices and in addition to that there’s been a whole host of regulatory changes. So, for example, something called unbundling, which states that you cannot be both the owner of the pipeline and the gas inside the pipeline: you have to break those up and create two separate companies.

Well, the Russians were fit to be tied. They liked the Groningen system, they liked the oil-linked prices, they liked the control that single ownership gave them, and so on. And so did their German partners when they came into Germany. But all of that got completely turned upside down. Now the question is: who has emerged a winner? To hear the yowling and yammering and screaming by the Russians, you would think that they’ve been the losers, but in actual fact they’re starting to realize that at this moment, at any rate, they’ve come out the winners. And we have Putin’s word for it. A few months ago he smirked and said, in effect, you Europeans, you think you’re so smart now, you’ve been hoisted by your own liberal petard, because what you’ve got is an unstable market in which the marginal producer—that’s us—has all the leverage. I don’t think Biden knows enough about the gas business to smirk about any part of this, but Putin was perfectly aware of the irony of the fact that the Europeans were undermined by the spot market regime they had created.

MK: So what’s going to happen with sanctions on natural gas? Will the gas keep flowing no matter what?

TG: By no means. It can be cut off by the Russians. It can be cut off by the Europeans. Germany is ground zero, in a matter of speaking—I hope not literally. The Germans are really between a rock and a hard place, as a result of the very innovations that they started putting into place thirty years ago—the so-called Energiewende, which consisted very largely of building renewables, and then swearing off nuclear and increasingly swearing off coal. So there they are at the end of this year with no nuclear. Coal will be completely phased out by 2030. They’ve gone very far down the road toward solar and wind, but now they face NIMBYism and regulatory resistance and consequently the progress of renewables has been considerably slowed. So what’s left? What’s left is natural gas, particularly for heating and for industry. So the Germans are, as I say, between a rock and a hard place. Nevertheless, they’ve really got their backs up, and they’ve now put this Nord Stream pipeline on ice. Not canceled, by the way. Nice turn of turn of phrase: on ice. But they could well say to the Russians, look, we will take no more gas. That would be a hardship for the Germans, but perfectly viable even in the short term. Then, of course, the big question behind that is what is the long-term impact for German climate policy? I think it’s probably given it a new life. We’ll have an Energiewende 2.0.

MK: Are the Russians operating in a world where that’s a possibility?

TG: I think there’s very little doubt about it considering the trends, which I think if anything could accelerate. The Russian gas business in Europe—pipeline gas as we’ve known it for the past half-century—is dead. It’s doomed. Not in Turkey, which is a different story, and even in Eastern Europe, but the core clients—Germany, Italy—will swear off Russian gas as they move to renewables and take up the ideology of decarbonization, which is backed increasingly by the technology and the economics. So Putin has really screwed Gazexport.

MK: And did this begin before the invasion? Did Putin set European consumption of natural gas on this course with the increasing hostilities of the past decade?

TG: I think the invasion of Ukraine has put in focus some things that have been brewing for a long time, if I could mix my metaphors. Take Ukraine, for example. In The Bridge there’s a whole chapter on the Ukrainian story, but it’s summed up in the opening sentence: “This is the story of a prolonged and difficult divorce.” That was true, of course, even before the invasion. The problem can be very simply summed up. The Soviet gas industry was founded on the basis of gas reserves in Ukraine. The initial pipelines were built out of Ukraine, and the Soviet centrally planned system basically exhausted the reserves in Ukraine—not entirely but largely—and then came the very fortuitous discovery of gas and oil in Tyumen province in West Siberia. So the gas industry moved on and created a new production center there. The gas came out of West Siberia, but it continued to be shipped through networks of pipelines that passed through Ukraine. So when the Soviet Union broke up, the Russians were left with the gas, but the Ukrainians were left with the pipelines—and that’s what created the basis for the bad marriage. The Ukrainians kept stealing gas from the system, passing it on to various oligarchs who would pass some of the rents back under the table to various well-placed people in Russia, but never mind.

So that sets the stage for the next act in the play, which is that the Russians decide, OK, that’s enough of that, we’re not going to be played for fools anymore. And they started building a whole new system of export pipelines to bypass Ukraine. They began that policy about fifteen years ago with the construction of Blue Stream. Then Yamal–Europe. Then Nord Stream 1. Then TurkStream. And then finally Nord Stream 2.

It was only then, when they finally started building Nord Stream 2, that Washington woke up and realized: Whoa! Wait a minute! That horse is leaving the barn! Well, sorry Washington, that’s the fifth and last horse leaving the barn. Where were you when this whole thing began? So Nord Stream 2 is indeed the last horse out of the barn, and in effect, the point of the messy divorce is that now, at the end of this messy proceeding, Ukraine has been virtually cut out of the transit business. So the game is almost over.

MK: But Ukraine has had more time to adjust to that reality than the Americans who weren’t paying attention, right?

TG: Indeed. And part of is just the force of events: declining living standards, and all the rest of it. So Ukrainian domestic consumption went way down. Then with the liberalization of the gas trade in Europe, there are smaller operators who are perfectly happy to move gas from the West into Ukraine—never mind that it’s Russian molecules, which is pretty entertaining. So the molecules do the long, long trip around. They arrive from Russia into Western Europe. They’re sold to Western traders who then turn the gas around and move it into Ukraine from the West. The Ukrainians no longer take direct imports of gas from Russia. So, adding one thing and another, the Ukrainians are far less dependent, except, of course, on those transit revenues. The number you keep hearing is about $1 billion a year. That’s probably about right, but that’s it. That would have been gone if Nord Stream 2 had been put into operation on schedule.

MK: What about China? How important is Chinese oil and gas consumption for Russia, and how much more important could it become?

TG: There’s a lot of talk in the media and from the Russians to the effect that, well, if we can’t sell our oil in Europe, and our products and our coal and our gas, too bad for them—we’ll turn around and sell it to China. But if you actually go down the list of fuels that you can sell to China, there are problems with that proposition for each one.

Oil is probably the one thing that could be expanded if there’s tanker capacity available. And that’s where the sanctions could bite. So there’s no magic pivot to the east. Ten years out, yes. But not now.

In terms of natural gas, the Russians have built a pipeline called Power of Siberia. It took over twenty years to negotiate. It was actually a BP project, a field called Kovykta, near Lake Baikal. The idea that the Brits had was to build a pipeline through Mongolia. Now we’ve come back to that idea, but in the meantime, after many adventures, the Kovytka field ended up being taken over by Gazprom, and after another decade of negotiations with the Chinese Gazprom was able to seal the deal for Power of Siberia. But the in the process it’s widely believed that the Russians really took a bath on the deal and had to agree to a low price, a very low price. So now there’s discussion of Power of Siberia 2, and what the Russians have been pushing for a decade now is a pipeline that would be sourced from West Siberia that would pass through—you guessed it, Mongolia.

Well, the Chinese are not buying any of that, because they know that if Gazprom sources the gas from West Siberia, then Gazprom can swing back and forth between the European market and the Chinese market and play those two buyers against one another. The Chinese are not going to go along with that game. So this agreement, in principle, for Power of Siberia 2, which was just signed when Putin went to Beijing—Gazprom has hailed it as a great breakthrough. But I haven’t seen any press releases from the Chinese side on that. I’ve been asking Chinese friends: is this a done deal, from the Chinese perspective? I don’t think so. In any case that’ll take a long time because we’re still at very early stages and China doesn’t move quickly. So that’s pipeline gas—that’s not going to expand rapidly.

With LNG, the governing constraint for Novatek is transportation, the availability of tankers, and there again you get into import substation policy. Novatek has been buying its tankers from South Korea. But first of all, the South Koreans are probably not going to sell any more tankers to Novatek, and second, Novatek has to buy the tankers and then load those up and move those to the east. Well, the ice still isn’t gone, so the window of ice-free transportation is still fairly narrow. You need icebreakers—those are provided by Rosatom, which buys them from military-industrial shipyards. Well, as Gazprom discovered, that’s a problem. So one by one by one, eyedrop after another, Rosatom is taking delivery of this new generation of nuclear-powered icebreakers. Well that’s not happening fast enough. So you see what I mean. There are constraints all over the place.

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