Oil, gas and war: Effect of sanctions on Russian energy industry

In the two-plus years since Russia’s full-scale invasion of Ukraine, the United States and its allies have imposed approximately two thousand sanctions on Russian corporations, financial institutions and individuals.

But while the sanctions have been broad, sweeping, and in some cases unprecedented, the discussion about their level of efficacy is still ongoing. This is particularly true for the industries that comprise the lifeblood of the Russian economy—the oil and gas sectors.

 While Russia’s hydrocarbon revenues have been significantly affected by Western sanctions, this impact has varied significantly across sectors.

 Assessing the real impact of sanctions on these vital industries, and calibrating them to have the maximum impact on Vladimir Putin’s ability to continue financing and waging his war of aggression, will require policymakers to understand these nuances—to understand what has worked, what has not, and why.

Primarily, this requires an understanding of how the effect of sanctions has varied between the oil and gas industries.

 It also requires an examination of other relevant factors, most notably the role of China, other Asian markets and the Global South in mitigating the negative impact of sanctions. It also requires an understanding of the role liquefied natural gas (LNG) has played in Putin’s efforts to evade sanctions.

Impact of sanctions

The impact of Western sanctions differs not only between the oil and gas industries, but also between natural gas and LNG. There is also a significant divergence between the negative impact of sanctions on the Russian oil and gas industries on one hand, and the impact on state budget revenues on the other.

It should be stressed that the decoupling of Gazprom from the European gas market was mostly caused not by the Western sanctions—the European Union (EU) did not introduce an embargo against Russian natural gas as such—but, rather, by Gazprom’s self-imposed cut-off of piped-gas supplies to most EU member states.

The Russian natural-gas industry, primarily Gazprom, has struggled with the consequences of decoupling from the EU market, as it lacks a viable business model to compensate for the loss.

The oil industry, on the other hand, has managed to weather the sanctions better, albeit with significant loss of revenue due to heavy price discounts in Asian gas markets and sharp increases in the cost of shipping oil to Asia.

The party that has suffered the most from Western sanctions, however, is Russia’s state budget, which saw its revenues from oil and gas decline 24 per cent in 2023 compared to 2022.

This has forced the authorities to consider serious tax hikes on the oil and gas industry to compensate for the losses and enable Putin to finance the war in Ukraine. Such a move would hurt investment and could result in subsequent output decline.

While piped-gas exports to Europe have decreased dramatically, Russia continues to export significant amounts of LNG to the EU unabated, resulting in significant revenue.

Unlike Gazprom’s piped-gas exports, however, LNG exports are largely untaxed, meaning the government does not receive direct revenues from them. 

But for reasons that will be discussed in greater detail below, the Russian state has other means to extract rents from LNG exports to finance the war—notably through windfall taxes.

Sanctions and decoupling from European oil and gas markets have also significantly reduced Russia’s ability to use energy as a tool of political pressure against Western democratic countries.

No substitutes for lost European market

Russia’s natural-gas giant Gazprom has suffered enormously from cutting ties with Europe, formerly its largest market. As noted earlier, the termination of gas supplies to Europe happened not because of sanctions, but due to voluntary actions by Russia.

In mid-2022, Gazprom cut off gas supplies to Europe through most of the export-pipeline routes, clearly aiming at creating political and economic problems for EU countries ahead of the 2022–2023 winter season.

The Kremlin’s hopes didn’t materialise. Despite rising gas prices, the EU managed to successfully navigate the winter and, in the process, find alternative long-term sources of gas imports.

This allowed Europe to free itself from most Russian piped-gas imports, without even imposing sanctions on Gazprom.

Gazprom’s lost revenue

According to the company’s own reporting, Gazprom’s revenue fell by 41 per cent year-over-year in the first half of 2023, while sales profits fell by 71 per cent and gas production by 25 per cent.

In the first quarter 2024, Gazprom reported a net loss of almost $7 billion in 2023, marking its first annual loss in more than 20 years. Moreover, Gazprom’s upstream gas-production base is now isolated because infrastructure connecting its main western Siberian fields with alternative Asian markets is lacking.

Gazprom also failed to build any LNG plants in western Siberia, which, before the imposition of sanctions, would have enabled the company to reroute natural gas to alternative markets.

Gazprom does not disclose the estimated construction costs of new pipeline infrastructure to China, but it would probably require at least $100 billion given the company’s experience constructing the existing Power of Siberia pipeline.

That pipeline, which connects western and eastern Siberia and also delivers gas supplies to China, is considerably shorter than a proposed new pipeline, known as Power of Siberia-2, which would pipe gas from western Siberia to China. That raises the fundamental question of whether Russian gas supplies to China will ever be profitable.

Power of Siberia

Gazprom refuses to publish any data on gas-supply prices to China via Power of Siberia, but data published by Reuters, citing obtained internal materials of the Russian government, suggests that the average annual price of piped gas supplied to China was $297.30 per thousand cubic meters (tcm) in 2023 and will be $271.60 in 2024.

Prices for 2023 were also not published, but the officially disclosed volume of supply was 22.7 billion cubic meters (bcm), and the cost of Chinese imports of piped gas from Russia was $6.4 billion.

Thus, the average 2023 gas-supply price from Russia to China was $282/tcm (in 2020–2022, the price was well below $300/tcm). This means that Russia is, in fact, most likely selling gas to China at a significant loss. When the contract to deliver gas to China via the Power of Siberia pipeline was signed in 2014, the average gas-supply price was set in the range of $350–380 per tcm.

That suggests that Russian gas supplies to China may not become profitable for the foreseeable future. China is clearly not expected to need additional gas supply until after 2030, and that appears to explain why Beijing is not interested in granting Gazprom any kind of price premium for new gas-supply contracts.

Moreover, China has alternatives: domestic Chinese gas production, LNG, and imports of piped gas from Central Asia.