Russia’s new drink of choice

These days Russians are filling up on something other than vodka. Oil is the flavor of the day, or rather, revenues generated by oil and gas. According to Thomson Datastream, Russia’s gross domestic product has nearly doubled since 2003, and this is due largely to the spike in energy prices. Riding this wave, Russia suddenly finds itself in the catbird seat after a decade of playing Europe’s sick old man, but in tying its fortunes so closely to the oil and gas sector, and becoming for all intents and purposes a “petrostate,” Russia is also ignoring the experience of other countries that have attempted to follow the same route to prosperity.

Historically, the price of any commodity waxes and wanes, and national economies tied too closely to one commodity often collapse along with price of that commodity. There have been spectacular examples of this throughout recent history. Think of the crisis following the collapse of tin prices in the 1980s, or the price of coffee in the late 1990s, or the price of jute over several stages of the past century. So commonplace is this phenomenon, much study has gone into the effect commodity prices have on national economies, especially those in the third world. In general, the cycle plays itself out much the same regardless of the commodity or the economy involved – high demand leads to ever-increasing investments in production until a tipping point is reached and prices begin to plummet due to oversupply. Then you’re stuck with a bunch of operating assets churning out products for low prices, assuming there are still customers. After all, what good is a tin mine if the cost of extracting it is greater than the cost of the stuff on the market?

Oil – and more broadly, energy – is different, or at least, that is what Moscow is banking on. President Vladimir Putin has very deliberately followed a course that would tie Russia’s fortunes to the price (and by extension, the supply) of oil and gas. In one shady deal after another, the Russian state has essentially re-nationalized the lion’s share of the country’s oil and gas industry, the masterstroke of this strategy being the jailing of former Yukos Oil CEO Mikhail Khodorkovsky in the fall of 2003 and the eventual acquisition of Yukos by state-owned Rosneft via an (shall we say, supralegal?) acquisition vehicle named Baikal Finance Group (BFG) the following year. BFG was essentially a shell company, unheard of by anybody in Western financial circles until the days immediately preceding the Yukos auction; BFG was then purchased by Rosneft for a song.

By itself, this transaction restored to the Kremlin virtual control over the oil and gas industry in Russia, but there have been equally shady follow-on deals and transactions that have further strengthened the Kremlin’s hand, albeit none as breathtakingly audacious as the Yukos affair. For example, in February, while The New York Times was busy nattering on about the high time Russian Olympians were having in Turin, a little-noticed shakedown was occurring concerning the fate of the Sakhalin-2 project off the coast of Sakhalin Island. Through a series of state-sponsored extortions and coercions, ongoing since January 2004, Gazprom, the state-owned Russian oil and gas major, has insinuated itself into the project, forcing the project’s main stakeholder, Royal Dutch/Shell, to lower its stake.

Further, as Strategic Forecasting, Inc. reported in July, the Russian State Audit Chamber has indicated that Royal Dutch/Shell should reimburse the state $2.5 billion for its poor “choice of consultant, equipment and contractors” which “had cost the state $2.5 billion in lost profits.” As if all of this isn’t quite shady enough, the projected cost of Sakhalin-2 recently leapt to $20 billion, an overrun of 67% percent, most of which Royal Dutch/Shell is on the hook for.

To anyone with half a brain (which, apparently, is half more than anyone has at Royal Dutch/Shell), it should be abundantly clear that the Russian government is not about to allow foreign concerns to enter the Russian oil and gas industry without paying an exorbitant price, and even then, they won’t be calling the shots, and in so doing – at least, for the short term – the Kremlin has re-established Russia as something more than a byword for demographic decline and civilizational dysfunction. While the US press has focused on Russia’s haplessly backward politics, Putin has craftily transformed Russia into the main energy supplier to Europe, of which it starkly reminded the world when it rang in the new year by turning off the tap to Ukraine. The Ukrainians (it being winter and awfully cold) then began siphoning off gas bound for central Europe, and when Germans awoke the next morning without gas, the shit hit the proverbial fan.

The incident left central and western Europe with a new insecurity to ponder – and Russia holding all the cards. Western Europe now imports 25% of its supply of natural gas from the Russians. More to the point, however, is how the Kremlin is using energy policy as a political tool. What prompted Russia’s abrupt closing of the spigot to Ukraine was Ukraine’s refusal to renegotiate the contract stipulating the rate it pays Russia for gas. Formerly, it was $50 per thousand cubic meters. Russia demanded a price nearer the European average of $240. You might say that the Russian government was well within its rights to ask for a hike in prices, but consider that Russia continues to charge Belarus, its loyal ally, but $47. Even the wealthier Baltic countries pay only $110. Seen from this context, it becomes clear that Russia is leaning on Ukraine, attempting to control it via its energy policies, especially so since Ukraine’s so-called Orange Revolution of 2004 ousted a Moscow-friendly regime and replaced it with one seeking to move the country closer to the West.

While today’s high energy prices have given Russians a new card to play in the short term, relying so heavily on oil comes with its own risks. As mentioned at the outset, the turbulence inherent in commodity prices can wreck a national economy too dependent upon one source of income (oil and gas account for just over half of Russia’s GDP). Obviously, the Russians have surmised that we are entering a long period of high energy costs, resulting from (a) skyrocketing demand for fuel from China and the developing world, and (b) years of underinvestment in the energy industry (remember, as late as 2002, oil prices were hovering around $20 a barrel). Perhaps the Russians are correct in their assessment, and perhaps not. But is it so hard to imagine a global recession, led by a Chinese financial crisis, that cuts into demand virtually overnight? Not really, and some experts fully expect it before 2010. Also, in the US, we are now seeing a convergence of sorts between environmentalists concerned about global warming and conservatives who desire energy independence and are tired of never-ending Middle Eastern conflicts. If this odd pairing gets its way, the US is about to spend an unprecedented amount of cash researching alternative fuel sources. So maybe the Kremlin’s calculations aren’t as rock solid as it thinks.

In any event, Russia’s growing reliance on oil and gas exports has in turn set off another dynamic, often referred to as “Dutch disease.” Originally coined by The Economist in 1977 to explain the collapse of Dutch manufacturing after The Netherlands discovered natural gas fields in the 1960s, the basic theory argues that a boom in natural resources can, in effect, make a country’s manufacturing sector less competitive by shifting investment away from these industries, and once these industries go belly up, they are hard to rebuild. No big deal if the price and supply of natural resources remain consistently high, but that is historically rare, even for oil.

The current high energy prices and some shady business dealings have catapulted energy-rich Russia back into international prominence, but history suggests it won’t last, and without any real diversification of the national economy, Russia will find that oil giveth, and oil taketh away.