Whither Oil for a Russian Bear?

Whither Oil for a Russian Bear?

Russia exports over 6 million barrels of crude oil a day. Rosneft lifts over 40% of the oil in Russia. The global rig count is down, oil and freight futures are trending lower. Oil demand has signs of having already begun to weaken.

So how will the planet's largest listed oil company fare?

3 things about oil demand
Oil demand pushes supply almost universally. When any weakness in demand occurs oil companies cap wellheads, slow down exploration, and traders close speculative positions. The oil demand curve begins to shift back, thus weakening price as supply conditions balance to demand. Oil demand becomes even more price sensitive.

Three forces are responsible for the oil demand curve shift: regional tension, emerging country currency devaluation, and developed country debt and employment.

First, the "almost" military intervention in Syria seems momentarily resolved. However, traders will continue to have a wait and see aversion to propping up supply. Reduction in tension in the Middle East may cut the risk premium a bit in the oil price.

China, India, Japan, and South Korea had cut their oil imports from Iran by almost 20% through August. With tension reduced in Iran as nuclear verifications begin, we can expect volumes to rise over the next 2-3 months if U.S. talks with allies Israel and Saudi Arabia are successful. Exports to China should resume where a lower than normal temperature winter will spur heating oil production and reserves.

The same goes for Libyan export production. Only if conflicts between businesses, workers, tribes, and the government can be resolved will production resume putting downward pressure on prices.

Second, emerging country debt, natural disasters, and slowly growing economies currencies are depreciating. Oil is quoted in U.S. dollars. This means that the Philippines, India, Indonesia, Malaysia, Peru, and Thailand, all depreciating through the last two quarters of 2013, could slow oil demand as it becomes too costly in local currency to buy oil in dollars. Depreciation may soon be followed by official devaluation.

Third, the U.S. Federal Reserve will probably continue quantitative easing, or QE, though the end of the year as it continues to buy Treasury bonds. Chairman Yellen would seem to favor improvement of unemployment over inflation targets as she tackles an over $3 trillion debt. This translates into the one possibly positive note for demand growth and disinflation of oil and other energy prices.

The Russia-China connection
The bottom line is that Rosneft has a China hedge for potentially lower oil demand in emerging and developed countries. Russia exports more than 6 million barrels per day of crude oil. China needs to import over 6 million barrels per day.

Over the past few years, Russia has struck an oil-for-yuan loan with China which could total over $500 billion. At the center of the swap is Rosneft and Sinopec. The beauty of the swap for both Sinopec and Rosneft is that oil is not denominated in U.S. dollars.

Rosneft borrowed money to acquire nationalized oil producer YUKOS while agreeing to build a pipeline to supply China with 300,000 barrels per day for 15 years. Rosneft borrowed more yuan to complete its $55 billion acquisition of rival TNK-BP from from BP to become the world's largest listed oil producer. Rosneft just agreed to a $5 billion prepayment loan with BP to manage certain of the TNK-BP repayments. Deutsche Bank and HSBC are arranging the deal.

The pipeline is operational now. By agreeing to build a pipeline, Rosneft expanded its scope into midstream services and away from a pure oil commodity play.

Recently Rosneft dealt with export-import duty issues with Kazakhstan to sign a 20 year oil pipeline agreement with KazTransOil. This will allow Rosneft to directly transport oil through Kazakhstan to Sinopec. Sinopec gets the benefits of Rosneft's low lift cost of $5/bbl, a relatively inexpensive transport cost through Kazakhstan, and secure supply.

China net imports over 4 million barrels per day of crude oil. China is fast becoming Russia's largest oil trading partner, of course, after the E.U. With China easing imports from Iran, and another cold winter is about to hit China, Rosneft stands to gain from China's projected need to buy reserve capacity.

Petroyuan replacing the Petrodollar?
The Sino-Russo oil-for-yuan loan agreement is effectively setting up a ruble-yuan currency union. The yuan will be backed by Russian crude and China's burgeoning demand, increased influence in all things East Asian, all tied to a growing fleet of national oil companies in the southern hemisphere.

China is internationalizing the Renminbi (yuan) mainly through its many deals with national oil companies. On top of this, the Shanghai Futures Exchange recently unveiled a yuan denominated oil contract.

The era of the Petroyuan is about to unfold.

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