vk.com/id446425943

International crude oil pricing

Overview

The discount of Russia’s main seaborne benchmarks, Urals Mediterranean, to dated Brent (quoted on a CIF, or delivered, basis), has narrowed to below $1.0/bl in recent years. The differential for these quotes has averaged $1.4/bl since January 1992, as shown in Figure 112. The early 1990s saw spreads of this magnitude, as domestic demand plummeted and producers sought export markets. Urals spent much of the mid- to-late 1990s trading at a narrower absolute discount; however, the differential widened markedly in 2000 as Russia’s output bounce began in earnest. The differential tended to narrow in 2001, 2002, 2009, 2012 and 2017 as the effects of OPEC production restraints were felt; the opposite effect of OPEC’s increasing output was seen during 2004-2008, and in 2010. The differential narrowed substantially during 2012-2013, and then again in 2019, and there were months during 2013 and 2019 when Urals averaged at a premium to dated Brent. There were several reasons explaining this phenomenon at the time, including growing crude production in the US (which has Brent-like qualities), declining exports from Iran, Iraq and Venezuela (these are heavier crudes and are more akin to Urals), OPEC supply cuts, and growing Russian exports to East Asia following the expansion of the ESPO route in 2012, and, as a result, reduced availability of Urals in the European market. Russia’s continuing upward trend in crude production and export growth have contributed to a widening discount in 2014-2016.

Despite significant volatility in the spread over the years, the bottom line is that Urals is generally priced at a discount to Brent. This is explained by both structural and cyclical factors: freight costs, the influence of OPEC, and specific supply/demand considerations affecting Russian crude, which is medium and sour (i.e. the commonest variety available on the market).

Renaissance Capital

20 June 2019

Russian oil & gas

Urals discounts have narrowed

Structural and cyclical factors explain spreads

Freight

Figure 112 also shows the gap between CIF (what the customer pays at the delivery point) and FOB prices (what the exporter receives at the point of loading) for Urals. This is over and above the recently narrowed Urals (CIF) to dated Brent differential, and reflects the significance of freight costs. Insurance costs have an influence too, but this is beyond the scope of this report.

Figure 112: Urals vs dated Brent, $/bl

	Urals (cif) differential to Dated Brent		Urals (fob) differential to Dated Brent

7.0

6.0

5.0

4.0

3.0

2.0

1.0

-

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

Note: 2019 data are YtD.

Source: Thomson Reuters

Figure 113 shows the freight cost derived from a world-scale route rate for shipping crude in a 140,000 dwt dirty tanker – a typical Black Sea (Novorossiysk) loading, on a Black

Freight costs have subsided, to below the historical average

110

vk.com/id446425943

Renaissance Capital 20 June 2019

Russian oil & gas

Sea-to-Mediterranean voyage. This is not a perfect example of what a Russian producer pays, but we believe it is close enough, and its dynamics are consistent with Figure 113.

This freight rate has averaged $1.27/bl since the start of the series (December 2003) and $1.09/bl in 2018. However, the average and peak rates over the past five years have been much higher, as portrayed in Figure 114. Specifically, a recent monthly peak of $2.16/bl was achieved in January 2014. So far in 2019, tanker rates have remained stable, with a YtD average of $1.10/bl, some of the lowest levels in more than a decade.

Figure 113: Black Sea-to-Med freight, $/bl

3.50

3.00

2.50

2.00

1.50

1.00

0.50

-

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18

Note: 2019 data are YtD.

Source: Bloomberg

OPEC output

Russian crude competes against other crude grades in world markets. The commissioning of the ESPO pipeline from 2011 and related start of crude deliveries to China and East Asia has resulted in a premium pricing for a better-quality ESPO blend vs Urals. However, eastwards shipments are currently maxed out, as the ESPO pipeline is working at full capacity, meaning that most of the volatility in Russian crude volumes and pricing is still coming from the West. Ignoring, for a second, the volumes shipped via pipeline to Central and Eastern Europe, the Mediterranean is the hardest turf, with plentiful supplies of other grades. Therefore, demand for Russian crude is influenced by output swings from OPEC, particularly because the cartel tends to cut cheaper (heavyor medium-sour) grades (similar in nature to Urals) when it trims output, and vice versa. This influence is explored in Figure 114.

Figure 114: OPEC output vs Brent/Urals differential (rhs), mnb/d and $/bl

OPEC output (LHS)		Urals (fob) differential to Dated Brent (RHS)

36															8
34									Russian crude exports to China	pipeline have lowered Urals/Brent	between 2011-2013, in our view				7
															6
32															5
30															4
															3
28															2
															1
26									Growth of	via ESPO	differentail
															-
24															(1)
	Jul-99		Jul-02		Jul-05		Jul-08		Jul-11			Jul-14		Jul-17
Jan-98		Jan-01		Jan-04		Jan-07		Jan-10			Jan-13		Jan-16		Jan-19

Source: Bloomberg, Thomson Reuters

Urals competes head on with widely available medium-sour grades when OPEC increases output

111

vk.com/id446425943

Renaissance Capital 20 June 2019

Russian oil & gas

Figure 114 illustrates that OPEC’s curtailment of supplies in 2001, 2009, 2012, 2016 and 2018 helped the differential between Urals and Brent to narrow. The process reversed from mid-2002 and in 2008-2012, when OPEC began to supply more crude to international markets. This latter period was also associated with robust growth in Russian output, which led to a wider discount in 2011, although the discount narrowed to just $1.49/bl in 2012 as OPEC started to cut its output in September 2012, but this was also influenced by other factors, as explained earlier. The increase in OPEC production in 2014-2016 again coincided with an increase in the Urals differential, while OPEC’s supply cuts agreed in November 2018 have led to a narrower discount in 2019.

Specific supply/demand considerations

Other specific issues also have a bearing on the differential.

First, there is only a finite level of demand for Russian crude. Along the northern Druzhba pipeline, Gdansk (Poland) and Rostock (Germany) have emerged as re-export points for Russian crude, competing with deliveries from the Baltic state outlets and the Primorsk terminal. In the southern branch, there is no outlet apart from customers en route – refineries in Slovakia, the Czech Republic, Hungary and the former Yugoslavia. These countries certainly have a finite level of demand, which explains the under-utilisation of this branch, and the search for a Mediterranean outlet (such as through the recent expansion of Novorossiysk Sea Port capacity). An increase in Russian crude exports to East Asia through the ESPO pipeline helped to reduce the oversupplies in Europe and likely contributed to the reduction of the Urals discount, we think, although there are quality issues to consider, as explained below.

Second, there is a certain structural aspect to the existing differential. In large part, this just reflects that Urals blend happens to have properties (API 31-32º, 1.3-1.8% sulphur content, i.e. medium and sour) that are widely available and represent 40% of global oil output (see Figure 115, taken from ENI’s 2018 World Oil & Gas Review). This means Urals needs to displace other similar blends, while lighter Russian types of crude (ESPO blend, Siberian Light, Sokol, Sakhalin blend, Varandey blend, Novy Port, ARCO, Vityaz, CPC blend) fall into less competitive categories.

Figure 115: Share in global oil production
Heavy and medium-sour	Unassigned		Ultra light
	1%		4%
2%
	Heavy and
Heavy and sweet		sour
3%		9%
			Light and sweet
			19%
				Light and medium-
				sour
	Medium and sour			5%
	40%		Medium and	Light and sour
			sweet	3%
			10%

Medium and medium-sour

4%

Degrees API gravity = (141.5/specific gravity at 60º F) – 131.5. Heavy crude has API < 28º. Light crude has an API > 33º.

Crude oil naturally contains sulphur. If crude has less than 0.5% sulphur, it is considered to be sweet. If it has more than 2.5% sulphur, it is sour crude.

Source: ENI (World Oil & Gas Review 2018)

Finally, the nature of the Urals blend is changing. The start of the ESPO pipeline in 2011 resulted in the Urals blend becoming heavier, as some West Siberian crude is shipped to

There is finite demand for Russian crude via the Druzhba pipeline

Urals blend is changing

112

vk.com/id446425943

Renaissance Capital 20 June 2019

Russian oil & gas

the East. Exporters increasingly use proprietary export means to avoid blending (see Figure 98), which further reduces the quality of Urals. Offsetting this trend area structurally exgrowth inputs from Volga-Urals. In addition, the new 7mn tpa TANECO refinery in Tatarstan, launched in 2014, was expected to take some of the locally produced heavy crude out of the Urals pool, but this has not happened, as Tatneft uses sweeter West Siberian crude for refining purposes, while its sour crude remains blended into Urals. The net effect of these changes is that there is an incremental annual inflow of 1.5-2.0mnt of high sulphur crude into the Transneft system, which leads to the gradual worsening of the Urals blend. Transneft has proposed separating the flow of high sulphur crude and dedicate its 30mn tpa Primorsk port exclusively to high sulphur oil exports, but this is not an easy decision to make for the Russian government, and there is none in sight.

113