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Putin’s Petro State Approaching Empty

Wednesday, June 5, 2013

Russia faces two challenges that will affect its preeminence as an energy supplier and its ability to wield oil and gas as geostrategic tools. At stake are the stability of the regime — and perhaps even its survival.

The centrality of hydrocarbons to Russia’s economy is hardly a new issue, but it is one well worth revisiting today. One of the two largest oil producers in the world, Russia accounts for 12 percent of global output. Russia is also the top producer of natural gas, accounting for about 20 percent of the world’s total.

Russia faces two challenges that will affect not only its preeminence as an energy supplier but also its ability to wield oil and gas as geostrategic tools. New technologies are helping other countries develop their own natural resources more easily and inexpensively, threatening billions of dollars of Russian state revenue. At the same time, to maintain the current level of production, not to mention increase it, Russia must make huge investments in exploring and recovering oil from virgin deposits (“greenfields”) of the east Siberian region and the Arctic shelf. The likely result is a significant thinning of oil and gas rents — jeopardizing the stability of the regime and perhaps even its survival.

President Vladimir Putin’s commitment to oil and gas as the mainstay of Russia’s progress stems from a deep and abiding conviction about its importance to the nation’s economy. Long before he came to power, he had believed that “the restructuring of the national [Russian] economy on the basis of mineral and raw material resources” was “a strategic factor of economic growth in the near term.”

In an article published a year before he became president, he reiterated that Russian mineral resources would be central to the country’s economic development, security, and modernization. For Putin, oil and gas were also paramount politically as guarantors of the security and stability of the Russian state. As he put it, “The country’s natural resource endowment is the most important economic and political factor in the development of social production.” Furthermore, he believed the mineral extraction sector of the economy “diminishes social tensions” by raising the “level of well-being” of the Russian population.

State control or outright ownership of the oil and gas industry became a central element in the “Putin Doctrine,” which postulated the recovery of the state’s political, economic, and geostrategic assets following the antitotalitarian revolution of late 1987–91. The state was to again become the only sovereign political and economic actor in Russia, with the private sector, civil society, and its institutions mere objects.

The Rise of the Russian Petro-Gas State

Oil and gas rents are a vital component in elite management under Putin’s neopatrimonial regime.

From less than 50 percent in the mid-1990s, the share of commodities in Russian exports has grown to 70 percent today, with oil accounting for more than half of export income. Representing up to 30 percent of the country’s GDP and half of its GDP growth since 2000, hydrocarbons provided at least half of the state’s budget revenues last year. Five years ago, Russia needed oil prices of $50 to $55 a barrel to balance its budget, but Alexei Kudrin, former first deputy prime minister and finance minister, estimated the breakeven price at $117 per barrel last year. Russia’s dependence on energy exports was highlighted by the 2009 world financial crisis. As oil plunged from $147 to $34 per barrel, the resource-based economy contracted by almost 8 percent — the largest drop among the G20 top industrial nations.

As in virtually every other petro-gas state, the rise of the Russian one has been attended by corruption likely unprecedented even in the country’s far-from-pristine history. In Transparency International’s 2012 Corruption Perception Index, Russia was 133rd among 176 countries, worse than Belarus, Vietnam, and Sierra Leone and on par with Honduras, Iran, and Kazakhstan.

Yet the most dangerous political legacy of the Russian petro-gas state is the centrality of oil and gas revenues, which amounted to $215 billion last year, to the loyalty of two groups that are essential for the regime’s survival: the lower-income and elite segments. Trillion-ruble transfers help to maintain social peace in what is known as “Russia-2” — poorer regions, especially the volatile and increasingly violent Muslim North Caucasus, small towns and rural areas, and the rusting “monotowns” (one-company towns) of Stalinist industrialization.

The sporadic raising of meager pensions and salaries for the millions of Russians on the government payroll is part of the same strategy. At the same time, oil and gas rents are a vital component in elite management under Putin’s neopatrimonial regime: a tacit but ironclad agreement between the Kremlin and the bureaucracies from top to bottom that permits the latter to enrich themselves at the treasury’s expense in exchange for their loyalty.

Challenges to the Status Quo: Oil

Russian oil companies are effectively taxed at a 70 percent rate.

But this status quo may not be sustainable indefinitely. After two decades of essentially living off the Soviet Union’s “legacy fields,” the “brownfields” (exploited deposits, as opposed to newly discovered ones, or “greenfields”) of western Siberia are “entering a long-term decline.” Although Russia is not running out of oil, a leading expert believes it may be running out of cheap oil. Instead, oil will have to be pumped from places that are “colder, deeper and more remote,” such as the continental shelf in the Arctic, the ever more remote regions of eastern Siberia, the “deeper horizons” of western Siberia, or the Black Sea.

Yet the enormous upfront investments that such an effort would require are hard to come by when taxes on oil companies’ profits have greatly reduced the incentive to invest in new technology and greenfield exploration. After they pay the profit tax, value-added tax, mineral extraction tax, asset tax, charges for the use of subsoil resources, mandatory contribution to social funds, and export duties, Russian oil companies are effectively taxed at a 70 percent rate. (By comparison, in 2011, Chevron and ExxonMobil were taxed at an effective rate of 42–43 percent in the United States.) This policy leaves massive capital and technology transfers from Western multinational corporations as the key to sustaining the present levels of oil production. Among the more notable of such ventures was ExxonMobil’s agreement last year to invest, in a joint venture with Rosneft, $3.2 billion into the exploration and development of the Black Sea and the Kara Sea in the Arctic.

Yet such deals fall far short of what is needed to ensure Russia’s continued status as an “energy superpower,” and the barriers to large-scale Western investments are formidable, if not prohibitive. Shale oil and environmentally “cleaner” liquefied natural gas (LNG) will likely push down oil prices, making greenfield investments less profitable. Then there is the 2008 law that restricts foreign control over companies operating in Russia’s “strategic industries” (certainly including oil and gas), in effect banning non-Russian energy firms from a majority ownership of any significant venture. (In the ExxonMobil-Rosneft deal, ExxonMobil owns only one-third of the venture.)

Challenges to the Status Quo: Gas

Although Russia is not running out of oil, a leading expert believes it may be running out of cheap oil.

Even more than Russian oil, natural gas rents are likely to shrink significantly in the coming years. Gazprom’s modernization and greenfield investments are also hampered by enormously expensive projects that seem motivated more by the Kremlin’s geostrategic ambitions than by a search for profitability. Thus, in an effort to bypass Ukraine, Gazprom completed the Nord Stream twin pipeline system under the Baltic Sea in October 2012 and launched the South Stream project, which includes a stretch under the Black Sea, in December 2012. The price tag for both projects is around $40 billion. In April of this year, Putin ordered Gazprom to revive the Yamal-Europe-2 project, which would construct yet another gas pipeline bypassing Ukraine, from the Belarusian border via Poland to Slovakia.

The immediate challenge to natural gas rents, however, is a sharp loss of profit because of the competition from alternative modes of production made possible by new technologies. The latter includes “horizontal drilling” to tap shallow but broad deposits and hydraulic fracturing (or “fracking”). As a result, over the last decade U.S. gas imports have shrunk by 45 percent. By contrast, Gazprom has yet to start tapping these resources. Instead, the company’s president, Alexei Miller, has repeatedly decried shale gas as a “myth” and a “well planned propaganda campaign.”

The Shrinking European Market and Uncertain Alternatives

To make up for domestic corruption and inefficiency, Gazprom needs large profit margins in Europe, where it used to sell gas at a 66 percent profit. Just to break even, the firm needs to earn $12 per thousand cubic feet. By comparison, natural gas is sold at below $3 per thousand cubic feet in the United States today.

With an effectively bankrupt state pension fund and a rapidly aging population, the Kremlin’s ability to prevent a full-blown pension crisis will require a huge influx of gold and hard currency reserves.

Meanwhile, the lower prices have forced Gazprom, which last year supplied a quarter of European gas, to renegotiate delivery prices to levels closer to those in the spot markets, where commodities are traded for cash for immediate delivery and where prices have dipped as low as half of those in Gazprom’s long-term contracts. In addition, the Russian natural gas behemoth has begun to grant as much as a 10 percent discount on existing contracts. Still, Gazprom saw its exports to Europe go down by 8 percent in 2012, to the lowest level in a decade.

Gazprom has been attempting to make up for the decreasing prices and shrinking demand in Europe by increasing sales to the East, most of all China, but the prospects are uncertain at best. China already imports far cheaper gas from Turkmenistan via a recently constructed pipeline. Furthermore, with the estimated largest deposits of shale gas in the world, China could well be close to self-sufficiency by the time the currently planned pipeline from Eastern Siberia materializes. As a result, Russia and China have repeatedly failed to agree on the price for the putative imports.

Similarly, shale gas appears to obviate any prospects for increasing Gazprom sales to Ukraine, the second-largest European consumer of Russian gas after Germany. By the time Ukraine’s current contract with Russia runs out in 2019, Russia’s southwestern neighbor, which last year bought 33 billion cubic meters of gas from Gazprom, may see its needs for Russian gas significantly, if not dramatically, reduced. Ukraine has Europe’s third-largest shale gas reserves, and this past January Kiev signed a $10 billion deal with Royal Dutch Shell to extract shale gas from a field in Eastern Ukraine. Although, as with other European shale gas prospects as a whole, the Ukrainian deposits are not likely to be developed as quickly as those in the United States, the project is an important step toward reducing Ukraine’s energy dependence on Russia.

The Urgency of a ‘New Model of Economic Growth’

Russia’s dependence on energy exports was highlighted by the 2009 world financial crisis.

To Putin’s Kremlin, which like all restoration regimes is preoccupied almost exclusively with the here and now rather than a long-term strategy, the political implications of diminished oil and gas revenue may seem distant and avoidable. Yet, even apart from the all-but-inevitable and significant diminution in energy export revenues, the dangers of the Russian economy’s continuing and growing reliance on gas and oil have been increasingly obvious both to government and independent experts. Six weeks ago in Moscow, I was struck by a wide consensus that an average 3 percent growth since 2009 (and projected for this year as well) is totally inadequate to address the country’s social, economic, political, and demographic problems.

Another element of the consensus I found was the need for “a new model of economic growth” to replace the current energy-based structure. Within the current economic model, the centrality of commodity exports means a dangerous dependence on commodity prices, as the GDP plunge during the 2008–09 world financial crisis demonstrated. The country must modernize and diversify. Even Putin and Prime Minister Dmitry Medvedev have paid lip service to the urgency of transforming the country’s economy from one that is extraction-based to one founded on technological innovation.

Yet, such a transformation is at least as much a political problem as an economic one. Oil and gas dependence renders political and social institutions all but impervious to modernization. Modernization and diversification, watchwords in Moscow, are impossible without enormous and potentially short-term destabilizing institutional change.

At least in the short run, reducing dependence on oil and gas revenue will mean sweeping and politically fraught reforms in welfare and pension systems and cutting back on subsidies to Russia’s poorer regions, the monotowns, and unprofitable industries. It would also mean a sharp reduction in military expenditures, instead of embarking on the $770 billion, 10-year “rearmament” program announced by Putin last year. Moving away from gas and oil must also entail overhauling the taxation system, filled with ad hoc tax breaks for the state’s “pet projects,” and replacing it with a predictable “profit-based” system, which will assure potential foreign and, most importantly, domestic investors, who last year took over $56 billion out of the country. If fully implemented, such reforms will erode the Kremlin’s control over the economy, courts, and, inevitably, politics.

No Good Options for the Kremlin?

Five years ago, Russia needed oil prices of $50 to $55 a barrel to balance its budget; the estimated breakeven price was $117 per barrel last year.

The alternative is to maintain the present economic and political arrangements in the hope of another spike in oil prices, perhaps as a result of a Middle East war caused by Iran’s pursuit of nuclear weapons. Yet doing nothing in the face of lower oil and gas revenues also carries enormous social and political risks. These include diminution, in real terms, of the already very modest expenditures on health care and education. With an effectively bankrupt state pension fund and a rapidly aging population, the Kremlin’s ability to prevent a full-blown pension crisis will require a huge influx of gold and hard currency reserves. At a time when soaring household utility prices (tariffs) are a leading source of dissatisfaction with the regime, the diminishing energy revenues will endanger the regime’s ability to subsidize the costs.

Finally, among the most destabilizing consequences of the continuing dependence on oil and gas will be the Kremlin’s declining ability to secure the elites’ loyalty. Fiercely protective of their share of the politically apportioned riches of Russia’s state capitalism, powerful clans will squabble to secure the same share of a diminishing pie, in the process threatening the stability of the regime. “Putin’s unchallenged power” rests on a tripartite foundation: “oil and gas money, the Federal Security Service, and television,” a Russian observer noted last December. Today, one leg of this tripod is beginning to look wobbly.

These may not be the challenges of tomorrow or the day after. Yet in the medium and longer term, trends in technology and the global economy, as well as the country’s own economic, social, political, and demographic dynamics, seem to have conspired to leave the Kremlin no good, risk-free choices.

This essay is adapted from an AEI Russian Outlook "The Political Economy of Russian Oil and Gas."

Leon Aron is a resident scholar and director of Russian Studies at the American Enterprise Institute.

FURTHER READING: Aron also writes “Putin’s War on Russian Civil Society Continues,” “Understanding Chechnya, Jihad, and the Region’s Deep Ties with al Qaeda,” “A Russian 'Frenemy,'” and “The Putin Doctrine.” Ambassador Richard S. Williamson says it’s “Time to Reset Obama’s Reset Policy.”

Image by Diana Ingram / Bergman Group

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