Russian Energy Sanctions have Backfired

Western sanctions on the Russian energy sector have so far not had the intended devastating impact on Russian energy companies. Sanctions certainly did restrict the flow of Western investment, equipment and technology necessary toward the development of oil and natural gas fields in Russia, and the overall impact on Russia’s energy sector was indeed significant.

However, by forcing Russia to shift its focus from Europe to Asia, sanctions may have actually strengthened – not weakened – the Russian energy sector’s long-term prospects, while simultaneously derailing progress on a number of important international issues.

Russian Minister of Finance Anton Siluanov has estimated the annual loss for Russia due to sanctions at approximately $40 billion, in addition to the $100 billion in revenue lost as a result of last year’s fall in global oil prices (which would have happened anyway). Unlike the sanctions against Iran, the main intention of sanctions against Russia was not to stop its oil and gas from getting to the world market, but to significantly diminish prospects for the sector’s development in the long run.

Reserve depletion levels are the more pressing issue for Russia. According to studies on Russia’s oil industry, the depletion level of recoverable reserves exceeds an average of 50 percent of the developed oil fields, while the degree of depletion is critical in the Urals and Volga region (in excess of 60 percent) and in the North Caucasus (nearly 80 percent).

To improve long-term production capabilities, Russia needs to develop new fields (including deep-water, Arctic offshore or shale projects), but the country lacks both the technology and investment necessary to do so.

Western sanctions targeted exactly these types of ventures, prohibiting the provision, export or re-export of goods, services, or technology in support of exploration or production. In that regard, the sanctions have hit Russia hard indeed.

Russia offset the impact of sanctions by turning to Asia

Russia has been able to seek other sources of support for its energy sector, primarily from China and other Asian countries. After ten years of negotiation, Russia and China signed a major pipeline gas deal in 2014 that is expected to transfer Russian gas to China through the new pipeline “Power of Siberia,” starting in 2019. The presidents of both countries also signed a memorandum of understanding for the second Siberian gas pipeline on the Western-Siberia route through the Altai Mountains.

The 30-year agreement enabling the creation of the Power of Siberia will likely withstand any short or medium-term economic or political pressures that may appear in either Russia or China. There is a question about whether the fundamental assumptions and projections behind the agreement will endure for the coming three decades, however. For example, will China’s demand for oil continue to grow at the pace that it has over the previous three decades and continue to be an incentive to purchase as much oil from Russia?

Also, given the history between China and Russia, there is no guarantee that bilateral relations will remain conflict-free, particularly as there remain some unresolved border disputes between the two nations. It is important to bear in mind that both powers seek to enhance their ability to achieve their economic and military objectives in overlapping parts of the world, such as Central Asia, the Middle East, Southeast Asia and Japan. They are not natural political allies.

Russian-Asian cooperation is also evident from gas pipeline consultations with South Korea, Japanese law makers’ support for a pipeline from the Sakhalin fields to Japan, and interest on the part of the Indian government for building a pipeline from Russia. Russia’s oil and gas continues to be imperative for Europe — as Europe remains dependent on Russian gas — and will grow in importance to Asia.

The development of shale gas fields in Europe has almost completely stopped due to high production costs and environmental concerns. When U.S. shale starts to be exported, it is likely to be sold mainly to Asia, where prices are higher and the infrastructure to import the product already exists. Other plans to supply Europe with natural gas — including pipelines from the Caspian region —remain at the inception stage, despite nearly two decades of European interest and support from the U.S.

Russia has no choice but to diversify its energy exports, and its ability to do so beyond its current initiatives appears to be good, which will give Russia the necessary flexibility to hedge against future risks. Russian political and business leaders have recently stated that despite the sanctions and other issues with Europe (such as the EU’s third energy package) Russian energy companies will continue to work there, which means that it will be harder for Western sanctions to stand the test of time.

The European Union must renew sanctions annually (which it has just done for the coming six months), whereas the U.S. must specifically stop them. Many European nations are under pressure from their respective business communities to stop the sanctions, whereas the U.S. is likely to keep them in place for many years to come, unless there is some fundamental change in the state of Russia-U.S. relations.

Western nations’ decision not to impose sanctions blocking the export of Russia’s oil and gas to the world market was deliberate, as the world needs Russia’s natural resources. If Russia had been restricted in this way, the result would have been significantly higher global oil and gas prices, so they were crafted so as not to have global repercussions. If the West were to try to impose broader sanctions, such as to restrict Russia’s banking sector, it could easily blow back in the form of an alternative currency union between Russia, China and its trading partners that excludes the use of the U.S. dollar.

For some time now, Western critics of European-Russian cooperation in the energy sector have been questioning Russia’s ability to support the required level of energy production, yet Russia continues to fulfill all contracts. Understanding the long-term importance of Russia’s energy resources, some European (and American) energy companies are looking for ways around the Western sanctions.

The entire situation has essentially evolved into a game of chicken, where Russia’s energy sector and economy are pressured while the West risks creating an even more tenuous global energy security environment. It is one thing to impose sanctions on the 29th largest economy in the world (Iran), and another to do the same on the world’s 10th largest economy by GDP (Russia), which has extensive trading relationships around the world.

In truth, the negative impact on the Russia economy and oil industry has much more to do with the decline in the price of oil than the imposition of sanctions. The more important issue is the evolving landscape among the oil producing nations regarding oil production levels.

How energy sanctions have backfired

While the West was doing what it knows best — imposing sanctions on Russia in retaliation for behavior it disagreed with (the re-incorporation of Crimea and support for rebels in Eastern Ukraine), it appears not to have thought out the potential consequences for Europe, or the changing dynamics of the global trade in oil and gas.

Having only partially succeeded in its original objective, and in turn having resulted in closer relations between Russia, China, and other Asian nations, lawmakers on both sides of the pond may now be regretting having imposed sanctions in the first place, particularly as the new sanctions regime has served to emphasize how very different the relative costs and benefits of sanctions have been for Europe versus the U.S., based on their levels of trade with Russia. Europe has been significantly negatively impacted, while the U.S. has not.

As a result of the sanctions, arms control between Russia and the U.S. is virtually dead, as is important potential cooperation between Russia and the U.S. on a host of other issues, ranging from Syria and Iran to the global fight against terror.

A generally heightened state of tension has emerged, prompting military chest thumping from both sides, alleged cyber-attacks, and the death knell of any thought of another attempted “reset” in bilateral relations. When faced with an external threat, Russian nationalism goes into hyper-drive, and the average Russian circles the wagons in response. Mr. Putin’s rankings remain above 80 percent in national polls. Which Western leader can say that?

Did Western policy makers consider all this before they pushed for the imposition of sanctions? Apparently not, for if they had, they would not have pursued them quite as vigorously in the first place. Surely, by now, they should know that Mr. Putin does not blink, and that he is a worthy adversary.

The truth remains that the U.S. needs Russia for its own foreign policy objectives a lot more than the reverse. That will continue to be true for the foreseeable future. U.S. lawmakers should perform a hard cost-benefit analysis before considering next steps. In agreeing to continue sanctions only for another six months, the EU appears already to have taken a step in that direction.