COVID-19 has birthed an oil shock the likes of which the world has never seen. A mix of oversupply and lockdown-induced demand destruction have slammed oil exporters. Despite Russia’s reputation as a “Kalashnikov economy” – low-tech, cheap, and nearly indestructible – this shock is different than previous ones Moscow has weathered.
The coronavirus has yet to run its course, and most focus is now drawn to the immediate damage to the Russian economy. Moscow is party to a renewed OPEC+ agreement to collectively cut roughly 10 million barrels of production. The latest deal has helped, but the overall story is clear. Demand will have fallen by an unprecedented amount for the year, and there’s growing unease among traders and international oil companies that it may never fully recover.
Russia’s fortunes track heavily with the oil market. Lacking a reform plan, oil prices have to recover for the Kremlin’s economic policy plans. But COVID-19 has fundamentally disrupted the market, deepening Russia’s economic reliance on China without much prospect for growth.
Double, Double Oil in Trouble
At the end of April, Argus estimated that the combined effects of agreed OPEC+ cuts and low prices will lower Russian oil firms’ earnings by $18-20 billion and starve the budget of as much as $50 billion in tax receipts. The one-two punch of low oil prices and losses from lockdowns have GDP on course to contract 4-6 percent or more for the year, dragging down revenues.
Financing deficits is theoretically not much of a problem thanks to a disciplined Central Bank and macroeconomic policy. With about $562 billion in foreign reserves in hand as of May 8, and a plan to raise $55-62 billion in debt issuances – twice the usual figure – the budget is safe for now.
That’s where the good news ends. Russia’s dependence on oil and gas exports to generate orders and cash for other sectors has changed relatively little since 2014. Its petrodollar (and petro-euro) earnings remain a crucial stabilizing factor for the ruble, the budget, and the broader economy.
Unfortunately, Russia has to be careful in how it spends its dollars.
The National Wealth Fund (NWF) and its antecedents were created to reduce ruble volatility and improve sovereign and corporate credit ratings while lowering borrowing costs. This source of reserves as well as the Central Bank’s accumulation and management of foreign currency reserves ease the flow of credit and stabilize exchange rates. Moscow is therefore cautious in drawing down the NWF to cover budget deficits.
Considering its constraints and obsession with tight fiscal policy, Russia’s first two stimulus packages were equivalent to 2.8 percent of GDP. The third announced last week is worth 800 billion rubles – about $10.8 billion – and focuses on things like tax breaks for companies retaining workers and direct cash payments for the self-employed and those with young children. It’s a lifeline, not a stimulus.
Russian policy appears to now be looking at prematurely reopening to avoid mass bankruptcies and permanent economic losses rather than spending more. A recovery on oil and gas markets is the only stimulus available without spending, but requires a global recovery.
Oil, Austerity, and Single Life
Russia’s long-running pivot to Asia has reduced the country’s reliance on European consumption, but not ended it. Europe consumed about two-thirds of the roughly 5.4 million barrels per day Russia exported in 2019. Of the approximately 219 bcm of piped natural gas Russia exported in 2019, around 80 percent went to Europe.
If you apply those ratios to Russia’s oil and gas export earnings for last year, you’re looking at about $160 billion. That nearly matches the entirety of Russia’s trade surplus – its principal source of reserves accumulation – at $164 billion for 2019. European energy demand is central to Russia’s macroeconomic policy.
EU oil demand peaked in 2006 at just under 15.2 million barrels per day (bpd), and was down 10 percent off its 2008 figures as of 2018 at 13.3 million bpd. Natural gas consumption hit 516.6 bcm in 2008, and was down 11.35 percent off that peak in 2018. That’s due to climate-friendly energy policies and Europe’s biggest structural problem: economic growth.
Eurozone GDP grew an average of 1.4 percent annually between 2010 and 2019. The post-crisis decision by European governments to impose austerity – cutting spending in order to reduce debt levels – proved disastrous. Pursuing monetary stimulus by cutting interest rates and printing more money while starving economies of investment precisely when it was needed most increased inequality, suppressed investment and wage growth, and weakened the bloc’s long-term growth potential at the worst time.
COVID-19 has made debt an issue. The absence of mutual debt within the Eurozone means that member countries face differentiated default risks depending on national policies and budgets despite having a shared monetary policy. This has led to political crisis, one all the riskier because of the amount of sovereign debt held by European banks.
Worst of all, stimulus meant to generate growth hasn’t taken shape. Everything thus far has been life support. There’s no coherent vision for how anything like an investment-heavy Green Deal would ameliorate the bloc’s structural problems undercutting wage growth and increased consumption.
Europe’s a terrible bet for energy demand. But China’s not looking great either.
Bring Out Your Debt
Like Europe, China is constrained by the aftermath of the financial crisis and its policy response. Debt was the main cost of spending out of the financial crisis, cumulatively topping 300 percent of GDP last year – 15 percent of all debt globally, with the world’s highest corporate debt to GDP ratio at 156.7 percent. That’s a drag on demand.
High debt levels have created huge risks. S&P estimated in April that the sectors hardest hit account for roughly one-third of China’s domestic bank loans, with non-performing loans skyrocketing year-on-year. Current economic indicators suggest a long period of recovery and after a stingy start, Beijing is turning to more stimulus.
Pressure to pull supply chains from China creates long-term employment concerns. Exports now only account for roughly 20 percent of GDP, but exporting industries still matter a great deal. China’s slowdown has been broadly shared across emerging markets since 2010, increasing pressure to transition away from export-dependence to consumption. Consumption, however, relies on employment and wages. Unemployment rates are likely higher than the official figures, and retail sales fell more than projected for April.
Beijing’s next rounds of stimulus are better served targeting industries and projects dependent on domestic demand and less reliant on energy inputs than heavy industry and energy-intensive infrastructure. Oil consumption may have grown dramatically after the last stimulus plan, but a heightened focus on public transit, lower-carbon investments, and services will lower long-run demand growth for oil.
Then Comes the Stall
China has driven oil demand growth since 2008 and overtook the EU by 2018, consuming just under 14 million bpd. Since 2012, China has picked up the slack from Europe for Russia’s oil sector. Imports have steadily risen and exceeded 10 million bpd last year – Russia’s exports to China have risen in tandem and it’s become China’s largest supplier. But China’s ability to replace demand losses in Europe waned as a slowing economy, emissions standards, and the U.S. trade war began to weigh on oil demand growth.
China soaked up almost the entirety of the other third of Russia’s oil exports and a growing chunk of its natural gas exports in 2019, around $45-50 billion total. Earnings are expected to rise as the Power of Siberia pipeline reaches full capacity and Russia builds new LNG trains to serve demand in Asia, but gas earns much less than oil and an LNG market supply glut has driven prices down.
The trouble is that while China has helped offset losses from exports to Europe over the last decade, European demand is set to fall while China’s slows down.
Pre-COVID demand growth was already set to halve in 2020 compared to 2019. China increased exploration investment for its core oil fields last year by an estimated 20 percent to reduce import dependency. April figures showed a continued 0.8 percent production increase year-on-year, a figure that would have been higher if prices hadn’t cratered after January and production held around 4.2 million bpd.
China’s firms are also pushing ahead to increase natural gas output by over 5 percent this year despite spending cuts. Growing domestic unconventional gas production and declining gas consumption in Japan and South Korea will push piped gas and LNG prices further downward.
These trends will pressure Russia’s exports earnings. Brent crude prices averaged about $64 a barrel last year, yielding about $188 billion in earnings for crude and refined products. That collapses to around $125 billion if oil sticks at $40 for the year, and less than $100 billion closer at $30 a barrel. Lower oil prices drag down natural gas prices with them. Export earnings losses will have to be accompanied by declines in imports to preserve the trade surplus unless policymakers are comfortable running down reserves over time to maintain the ruble’s value. That points to lower consumption – and lower growth.
Margin Call
A failure of reform has forced Russia’s hand to privilege closer energy ties with China over the last decade. As demand has declined and stagnated in Europe, China has been the critical market to plug the gap as Russian firms have sought to maintain and increase exports. As goes China, so goes the oil market.
This dynamic has sharpened Russia’s dependency on China as bilateral trade has grown, all the more intensely as European growth founders. That’s now hurting Russia’s long-term growth as China’s economy pivots away from energy-intensive industries.
COVID-19 has accelerated the timeframe for “peak oil” based on demand destruction, weaker growth, changing investor calculi, and policy. Oil demand might recover, but seems unlikely to ever grow much again. Prices will remain lower from the as yet incalculable effects of lost incomes, supply chain shifts, and job dislocation across the globe.
The last decade, China’s been the key demand-side energy market driver underpinning Russia’s flow of dollars. Unfortunately for Russian policymakers, it’s likely to be a buyer’s market from here on out. As peak oil demand nears, Russia’s macroeconomic policy faces a reckoning. Reliance on external demand is a loss of economic sovereignty by another name when exiting this crisis. Whether the Kremlin realizes that is an open question.
Nicholas Trickett is an analyst covering oil and gas markets, trade and political economy, with a focus on Russia and the post-Soviet space. He holds an MA in Russia/Eurasia studies from the European University on St. Petersburg and an MSc in international political economy from LSE. He previously worked as a consultant in the energy industry.