Service during sanctions

For Western-based service companies whose products or personnel were at work in the waters off the Russia, projects that were already complex by virtue of the location became substantially more so with the recent Western sanctions against the Russian Federation.

“When you have the US Treasury Department or the federal government lowering the boom on a country that’s a strategic competitor of America, that’s a complicating factor,” says Dr. Jim Krane, a fellow in energy geopolitics at Rice University’s Baker Institute for Public Policy.

The balancing act

Image of Rosneft operating in the Kara Sea, which is where the Universitetskaya-1 exploration well in the East-Prinovozemelskiy-1 license is located. Rosneft’s joint venture partner on the license is the Irving-based ExxonMobil. Image from Rosneft.

These sanctions differ from previous programs the energy industry has dealt with, explains Matthew West, a partner with the international law firm Baker Botts LLP.

“An important element of the sanctions regarding the situation in Ukraine is that these sanctions are more narrowly tailored than if you look at a program like what the US has imposed on Iran,” says West, who focuses on international transactions, US regulation of international trade and investment, and global trade policy and assists clients in navigating sanctions.

West notes that companies, including oilfield service companies, can likely still find opportunities in commercial activities outside of those areas currently under sanction. However, the difference would be in the working environment’s regulatory landscape, he says.

“Prior to the sanctions, Western companies could go in to Russia and could work without having to be overly concerned that their operations were going to run afoul of US trade laws, because there weren’t economic sanctions on Russia and there, largely, were not highly restrictive export controls on technologies used in the energy industries in Russia,” he says.

If they are still able to operate in Russia in its post-sanction environment, service companies must now take the proper steps to make sure that restricted US or European technology is not used for operations in sanctioned areas, and that the operations in Russia are compliant with the applicable sanctions.

If the service companies are involved in a sector of the oil and gas industry unaffected by the sanctions, they must be sure to keep in strict compliance with applicable US and EU rules.

If the service companies are currently unable to operate in Russia, Krane warns that it might become a diplomatic dance in order to maintain and protect business interests there.

“It’s a fine balance for these companies,” Krane says. “You want to show that you have some commitment to the country and your business there. You have to be cognizant of the threat that sanctions pose to your relationships in Russia, but if you have investments sunk in Russia you can’t just walk away from those.”

However, for now, Krane says Russian companies will have to move on to the next project on their list without a Western partner while being mindful of the diplomacy necessary on their end.

“Right now, markets are over-supplied, so there’s no great urgency to move ahead with increased production, but you don’t want to alienate people either,” he says. “When this ‘poisoned atmosphere’ clears and ties become workable again, you want to re-open these projects if the situations warrants it.”

Direct effects

The first casualty of Western sanctions against Russia was the ExxonMobil-Rosneft partnership’s Universitetskaya-1 exploration well in the East-Prinovozemelskiy-1 license in the Kara Sea. The well was spudded despite sanctions on 31 July and encountered 338Bcm of gas and more than 100 million tons of oil in late September. Several Western companies had a hand in the operation, including:

Nord Atlantic Drilling, Schlumberger, Halliburton, Weatherford, Baker Hughes, Trendsetter, and FMC Technologies.

Already, the joint venture in charge of the Kara Sea prospect, Karmorneftegaz SARL (Rosneft 66.67%, ExxonMobil 33.33%)has ended associated contract work. Siem Offshore reported its contract for the 2015 season in the Kara Sea was cancelled in early December. The original contract involves the charter of two AHTS vessels, Siem Topaz and Siem Amethyst, and one PSV, Siem Pilot. Siem Offshore said the original charter was work approximately US$60 million net.

Days after the discovery announcement, on 30 September, Bloomberg reported that Schlumberger was withdrawing expat employees from the country.

“I see the news on withdrawal of key technical and management personnel from Russia by service companies as a very unwelcome effect of sanctions,” says Dr. Anna Belova, GlobalData’s Lead Upstream Analyst covering the former Soviet Union. “While the sanctions were designed to target the future strategic reserves in the offshore Arctic and in the low-permeability plays, limited availability of service providers will affect a lot of conventional oil and gas production in Russia.

“Many Russian operators came to rely on the expertise of global service companies to produce from both greenfield and depleted fields – thus, this latest development would affect the entire industry, not just offshore or unconventional segments.”

Belova says that Western-based service companies had found a great deal of success in the country.

Image from Rosneft.

“Where the exploration and production companies themselves might not have been able to penetrate the market, the Schlumbergers of the world and the Halliburtons of the world have been doing a lot of business in Russia,” she says. “However, I am somewhat optimistic as to US company relationships in Russia.

“I think Russia needs the US, but the US needs the market for its services.”

She continues, saying that more industries, such as the European food industries, stand to feel the sanctions’ squeeze.

“The oil and gas industry is so well integrated in international geography – you cannot just take away one-third of the business and expect everyone else to do well,” she said.

The bottom line: Short-term, the outlook is not good for US-based services companies, according to Alexei Kokin, senior oil and gas analyst for Moscow-based URALSIB Capital.

“As far as I know, Schlumberger received 5-7% of its revenue from Russia and Halliburton, Baker Hughes, and Weatherford, 4-5%,” he says. “Schlumberger warned in Q3 2014 that the sanctions could hurt its earnings per share (EPS) by $0.03 of EPS, which later turned out to be 2% of Q3 2014 EPS.

“That gives an idea of the short-term damage to earnings from the sanctions. If the sanctions remain and are extended to cover all tight oil reserves, the oil field services majors may lose over half their Russian revenues,” Kokin says.

Rosneft was already moving to decrease its dependency on international service companies. In a 13 July US$500 million cash transaction, it purchased Weatherford’s land drilling and workover operations in Russia and Venezuela. Weatherford said in a statement that the Russian company landed 61 Russian land drilling crews and a fleet of workover rigs, and six land drilling rigs from the Venezuelan operations.

“Even though the sanctions do not directly affect the day-to-day operations of the conventional oil and gas field, we’re still going to see some fall-out from sanctions and I think the result is going to be more Russian drilling service companies coming into play,” Belova says. Also, the oil companies themselves will develop drilling services in-house.”

Unintended consequences

As a result, Russian oil and gas companies are turning to other sources, most notably Asia, for the financing and technology critical for deepwater exploration and production - particularly in the Arctic.

Image from Rosneft.

On 10 July, Offshore Oil Engineering Co., a subsidiary of China National Offshore Oil Corp., signed a $1.6 billion contract with Russia’s Novatek to construct the core modules for the Yamal LNG plant’s liquefaction facilities. Belova identifies this transaction as one of the main examples of Russia strengthening ties with China as a result of the sanctions.

Located in the estuary of the Ob River and locked in ice nine months a year, Yamal LNG is one of Russia’s most extensive projects in the Arctic. Partner Total says it will eventually involve the drilling of more than 200 wells, the construction of three 5.5MTPA trains, a gas terminal, and the commissioning of 16 icebreaker tankers, each able to transport 170,000cu m.

Most recently, on 25 November, Gazprom Neft and state-owned PetroVietnam began exclusive talks to potentially cooperate in the development of the Dolginskoye field, located about 75km off the Russian coast in the Pechora Sea.

Russia is scrambling to attract Asian investment to make up for the funding, technology and support yanked by the Western companies, and it is offering an array of diverse investment deals to do so. In the event that sanctions stay in place long-term, Belova believes that Russian companies will turn to less-costly onshore developments where they already have existing expertise. In a move that could be indicative of this gradual shift, and of Russia’s desire to offer attractive investments to China, Rosneft signed a framework agreement on 10 November to extend China National Petroleum Corp. (CNPC) a 10% stake in Vankorneft, its subsidiary that operates the onshore Vankor project.

"We see 10% ownership being offered to CNPC as means of raising financing. Rosneft doesn't need Chinese expertise.  The asset is online and producing. The lifting cost at Vankor  is below $3/bbl. It's a very profitable project," Belova says. "But Russia is offering 10% equity to CNPC as a means of establishing a relationship."

At the time of the signing, Rosneft Chairman Igor Sechin said: "Today's reached agreement show the systematic development of the large-scale cooperation with our Chinese partners, including the upstream area in the Russian Federation.”

Of course, China would have its own reasons to strengthen its relationship with its Eastern neighbor - Russia’s massive oil and gas reserves, which are 80 billion bo and 1688Tcf, respectively, according to the US Energy Information Administration’s (EIA) January 2013 estimates.

“China seems to be using this opportunity to secure future imports of Russian oil and gas on favorable terms,” Kokin says.

On 24 March 2014, the US Energy Information Administration said that China’s rising oil consumption coupled with steady economic growth, propelled the country past the US to become the world’s largest net importer of petroleum and other liquids.

Although Russia and China are working to strengthen their business and lending relationship, it might not be as mutually beneficial to the Eastern giants as they anticipated, says Michael Wachtel, partner and head of the oil & gas practice at Clyde & Co.

“Russian companies will perhaps look to Chinese banks for funding, but this may not assist them, as Chinese funding to foreign companies tends to focus on bolstering Chinese exports,” says Watchel, who specializes in cross-border merger and acquisitions, and regulatory advisory work in regions including the Commonwealth of the Independent States.

Financing

Beyond the sting felt by the service companies and exploration and production companies with long-term Russian projects in place, the sanctions rigidified Russia’s lending situation. The effects of this, too, could be felt outside of Russia.

Image from Rosneft.

Wachtel said that the difficulty Russian companies now have in securing financing contributes to the precarious situation.

Overall, European companies are reluctant to lend to even those Russian companies currently not sanctioned in case that situation finds itself changing.

“For the time being this is resulting in delays, but over the longer term Russian companies may not be able to pay cash calls from the joint venture partner,” he said. “Clearly delay in payment is a big issue for service companies, which rely on a steady income stream, and some of the smaller players could find themselves in trouble.”

While companies await getting back to work on their Russian deepwater projects, Krane warned of the sanctions’ inherent “stickiness.”

“Sanctions are easier to impose than they are to retract,” he explains. “Especially, if Congress gets involved. It’s easier to find reasons to leave them in place than to take the effort to roll them back.”