Russia 2020 – Game over Putin?

Since 1990 Russia has experienced something of an escalator ride in the nation’s fortunes. From near bankruptcy the Russian economy has bounced back since the beginning of the Putin years, largely on the back of a vast overhaul of its oil and gas industry which has fuelled the increasing spending demands of Putin’s various administrations. Yet are we about to see the Russian state experiencing another rollercoaster drop in the next decade? Here are a few humble suggestions why Russia is facing a perfect storm in 2020:

“It’s the Economy Stupid” – or more accurately it’s the Oil Price.

For most of Russia’s history its economy has been primarily driven by its primary industries which have exported the vast resources at the states disposal. But in recent years the dependency of the current Russian economy on oil and gas exports has become truly staggering. Not only does Russia’s oil and gas industry now account for 49% of the state’s revenues, but Russia also requires over 2/3rds of its gas production simply to service its own economies internal requirements.

The situation when we start to examine Russia’s much discussed export of oil and gas products gets far worse (if you are Russian). Of Russia’s 600BcM of gas produced every year, around 140BcM is exported to Europe but of that 140 BcM exported to Europe, Germany and Ukraine account for 70BcM of exports combined (at 30BcM and 40BcM respectively. To re-phrase this, Russia relies on Germany and Ukraine for around 34% of its gas sales, whilst Ukraine accounts for nearly 19% of all Russia’s gas exports. Compounding even this terrifying over-reliance, the pipelines that provide Russia’s gas to the rest of its EU markets all currently use Ukraine as a transit nation. Thus for anyone who remembers the 2009 gas crisis in Europe, this is why Russian planners are so concerned about their gas position.

Even if Russia is able to construct its South Stream project to reduce its reliance on Ukraine as a transit hub it is not only competing against the EU machine, which has aggressively tried to challenge Russian gas hegemony, but also the alternative gas pipeline, Nabucco West.

Taking aside the above issues however the baseline concern for the Russian economy is to do with the price of oil. With the US explosion of Shale gas, estimated to increases the US gas production by 25% by 2020, there will be an inevitable decline in demand for oil related products on the international market, especially as other BRIC nations seek their own domestic means of energy production. In addition, the climate change agenda and the effects of air pollution in major cities is leading developing nations like China to increasingly seek gas as an alternative to oil. The problem for Russia however is that, simply put, it gets such a good price from Europe that it won’t accept the terms China and others are offering.

The implication of this fall in the oil price is an inevitable decline in the Russian state revenues. If the price of oil and gas declines then Russia will face a choice: to reduce its current output of oil and gas to maintain the price level (assuming the rest of OPEC will do likewise) or to maintain its output but at a reduced profit (and in some cases certain projects will become close to loss making). All of which is disastrous for the Russian government’s spending pledges, including its $800 billion armed forces modernisation programme….

The energy crisis however is not just linked to the state revenues from oil and gas however. The World Bank’s latest report on the ECA and FSU states has indicated that they will need to invest $1.5 trillion into maintain and modernising its energy infrastructure within the next 20 years, yet to do this will require a large increase in the price of electricity. This then leads to the next problem of the Russian economy: a large proportion of high energy intensity industries whose main advantage is price competitiveness, in no small part due to low energy prices. So the question here is: if faced with a decline in global oil and gas prices will Russia reduce its supply of oil and gas and sell its products purely on the basis of the highest bidder in Europe and at home, or will it maintain its output levels and use its oil and gas industry to subsidize its domestic manufacturing industries?

The net result of any of these variables above will mean less revenue for the Russian state and hence the problems below:

Increasing domestic instability and declining state security resources:

The re-election of Vladimir Putin was considered by many competitors to be an academic exercise. He was too strong, too popular or too well connected to lose so commentators said. And sure enough they were right, except this time Russia’s voters didn’t lie down and play dead. The scale of protests was unprecedented under Putin’s rule and provides a glimmer of the hostility ordinary people feel towards the current government.

It is true that for many Putin is still deeply popular but the same is certainly not true of his lieutenants and it is their increasingly public misdemeanours that are starting to significantly chip-away at the regimes support base. The sense of insecurity felt by Putin was perhaps best displayed by the obscene levels of attention and media coverage that was generated by the Russian punk rock band “Pussy Riot” whose 30 seconds of fame generated world-wide news coverage.

Now whilst Russia has often suppressed riots and domestic violence, it is the impact of declining state revenues that will suddenly start to lead to difficult strategic decisions on where Russia spends its resources. If the state continues to focus its funding on internal suppression then it will inevitably have to reduce its spending on its planned military modernisation programme, something which will surely reduce the global reach of the Russian military and certainly the extent it can intimidate its neighbours.

Furthermore, if Russia does retrench domestically, will this lead to more aggressive actions by those states that have territorial disputes with Russia currently? Any increased belligerence by states like Georgia and Azerbaijan would be increasingly embarrassing for Moscow, whose people would demand a response. Will the Russian state be able to in the future? Even the latest Russian fighter jet project, a symbol of its super-power aspirations, could be threatened if it fails to find suitable export partners and its numbers drop below its already low order number, (expected to be initially 100 or less).

Demographic issues:

Inherently linked in Russia with domestic security concerns is population issues and immigration. The Russian state has always incorporated a large number of ethnic minorities and different faiths, but notice the word minorities. The modern Russia today is facing a marked decline in the birth rate of European, orthodox Russians, whilst its minority populations, notably those who follow Islam, continue to grow, as does the number of immigrants from central Asian states.

This again will start to stir domestic tensions where the state has historically under invested in the East and often concentrated its investments into a few key cities like Moscow. Furthermore, regional hot-spots like Chechnya may become emboldened to push for further regional autonomy if the region’s population continues to grow whilst the typically more Slavic and European population of western Russia declines.

Linking this all back in again. Under-investment in regions with high birth rates which will require greater state resources for health care and education as well as state and/or private investment to create job opportunities for a rapidly increasing young workforce will create a policy headache for a state with limited alternatives than state spending or careers in the oil and gas sector. Both of which seem certain to decline.

Squaring the Circle – concluding remarks:

So what does all this mean? In effect Russia is facing a perfect storm by the end of this decade and the only possible solutions to its problems still look as distant as ever.

The Russian state cannot generate internal investment without an end to the rampant corruption that eats away at public confidence in the state bureaucracy and decimates the ability of financial institutions to invest sensibly into growth prospects. But more fundamentally what Russia really lacks is a functioning rule of law.

No company today can invest in Russia without the concern of expropriation or state interference and those that have tried have often been burnt badly in the process, whether BNP-TNK or Shell and its development of Sakhalin island. This hampers any serious private sector investment and again places the onus of investment squarely on the Russian state.

With declining state revenues and increasing demands on its budget, does Russia have many options left open? Can it cut spending and if so what? Can it increase its level of government debt and if so for how long and at what cost? All of these questions leave Russian policy planners feeling uneasy and with Putin’s grand ambitions so publically stated what would be the political damage if the policies failed or perhaps even worse, they were cancelled?

So while for now Russia may be having its moment in the spotlight as a super-power in Syria, it’s worth waiting to see what happens next. My suspicion? Russia may just start getting that bit quieter and quieter as this decade progresses.

So keep an eye on Russia and 2020. The Russian roller coaster may just be about to drop.

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The Southern Gas Corridor

The end of Russian Hegemony or an expensive distraction?

In 1990 the Cold War ended, the Iron Curtain fell and former Soviet satellites dashed towards Europe and the US to learn from them and emulate their apparent success. Nearing the end of 2012 and things look slightly different. Russia is re-emerging as an economic and political power, bolstered by its vast energy reserves and the high global price of oil and gas, whilst the EU remains in the doldrums of economic stagnation and the US recovery teeters on the edge of its self-created “Fiscal cliff”.

But despite this current state of affairs, many former Soviet Satellites have boomed since the end of the cold war and with their ascension into the EU, particular states like Poland whose growth rates have remained high and its political clout has grown have boomed. Romania, Hungary, Bulgaria are also former Russian satellites that are on the ascendance too, with an increasingly educated populace, strong national work ethics and cost competitive environments for manufacturing. Yet despite weaknesses in governance and the power of organised crimes in many of these states, it is Energy security, or perhaps more appropriately, independence from Russian gas that garners the greatest concern in these states about their future prospects.

For the last decade Russia has utilised its gas hegemony in Europe to economically pressure and cajole its former satellites and when that has failed, such as the deployment of US missile defence systems in Romania, Russia has punished these states with crippling energy prices. Little wonder therefore why the dream of the “Southern Gas Corridor”, to break Russia’s seeming stranglehold over the regions gas supplies, has such a strong appeal.

The Shah Deniz Stage II Consortium

The Southern Gas corridor plan that exists today began life as a plan by a consortium of Eastern European nations, with EU and US endorsement, to bring gas from Azerbaijan’s largest gas field, Shah Deniz Stage II, to Europe via Turkey. This idea, originally conceptualised in the planned “Nabucco Project” has subsequently faced several alterations and has now broken up into 3 pipeline projects.

The main pipeline route from Shah Deniz to Europe will be provided by the Trans-Anatolian-Pipeline or TANAP that will bring the gas from Turkey’s border with Georgia through to Turkey’s European border. From there the Shah Deniz consortium, led by BP, will decide in spring 2013 whether to award the next stage to Nabucco West or its rival the Trans-Adriatic-Pipeline (TAP).

 Nabucco West

Nabucco West planned route.

 TAP

 

 

 

 

 

Trans-Adriatic-Pipeline planned route.

South Stream and regional politicking:

Of course Russia has not exactly been blind to these plans and has been developing its own pipeline route called “South Stream” which aims to undermine those states that currently provide the transit point for Russian gas into Europe, most notably Ukraine. For Russia the southern gas route provides an opportunity for diversifying its supplies into Europe, thus weakening the transit states it has been traditionally forced to negotiate with whilst also increasing Russia’s hegemony of gas supplies into the region.

The existence therefore of two fundamentally competing visions for the Southern Gas Corridor, one Russian, one European, has inevitably stimulated intense political manoeuvring by the transit states, perhaps most notably Bulgaria. For those states within Eastern Europe both projects represent inherent risks and potential pitfalls which has required careful consideration. To ignore or refuse to cooperate with Gaprom on the Russian South Stream project may leave states in Eastern Europe facing potential price hikes in their gas imports, which for many states may be as much as 80% of their total gas which is sourced from Russia. Yet to endorse South Stream at the expense of Nabucco West (and to a significantly smaller extent TAP), will continue to leave Russia in control of Eastern Europe’s energy supplies.

Thus the planned transit states of Eastern Europe are all seemingly playing a double game. They have mostly endorsed both South Steam and its rival Nabucco West and have made public statements in support of both projects.

What happens next and why is the Southern Gas Corridor a “Distraction”?

The title of this post alluded to the author’s personal belief that the Southern Gas Corridor is a distraction and indeed this author does believe that the Southern Gas Corridor is a distraction from the more effective options available to provide Eastern Europe with the Energy security it craves.

The flaws of Shah Deniz:

Most significantly in the mythology that surrounds TANAP, TAP and Nabucco West is the unspoken acceptance that Shah Deniz Stage II can supply meaningful levels of gas to Europe at a cost efficient level for the medium to long term. This would seem not only an absurd assumption when we consider that the Nabucco West pipeline combined with TANAP would require in excess of 3,500km’s of pipeline to be laid (which appears the most logical choice by the Shah Deniz Consortium), which in turn requires this vast pipeline to be secure from attacks over 2,000km’s of mountainous Turkish hinterland as well as the security of the pipelines within Georgia and Azerbajan.

Furthermore, the real gas providers in the region, namely northern Iraq and Turkmenistan (and realistically Iran), are all unfeasible in the current geo-political environment, yet offer the only real long term gas reserves at a price competitive level to make the European Southern Gas corridor viable.

The Russian bluff – sourcing South Stream:

Whilst I have criticized the viability of the EU endorsed TANAP –TAP-Nabucco West vision, the Russian South Stream project is even more questionable. Whilst the old adage of beware a Greek bearing gifts is an old cliché, the idea that Russia is able to source 63 billion cubic meters of gas to Europe via South Stream by 2018, after completing the pipeline (4 pipes together) under the Black sea and across over 3,000km’s of territory by 2015 seems very much like an empty present.

Not only has Gazprom not yet identified where it will source this vast quantity of gas that it intends to supply, it also has stated that it will personally cover the cost of creating the vast majority of the pipeline. Again it seems questionable that Gazprom would invest such a vast sum into a project with so many as yet unresolved variables.

The fundamental issue – the myth of $100 a barrel:

Perhaps the single greatest flaw that underpins the Southern Gas Corridor is the belief that the oil price will remain above $100 per barrel and with it, the price of natural gas will remain high too. To maintain oil at $100 a barrel or greater will require some very intense discussions and negotiations between OPEC and other oil and gas hubs in the future as Europe increases its usage of Renewable energy, the US moves towards Shale gas.

At its heart the dilemma is that many oil sources are only viable at $100 per barrel to develop at a profitable level, yet if demand falls then either the price must decline or the supply must decline, both factors which will reduce the state revenues that OPEC members have traditionally relied above in order to suppress internal dissent and exert political power on the international stage.

With the global shipping industry moving towards eco-ship designs, “cold ironing” and gas driven designs, the airline industry actively pursuing reduced fuel sources and the increasing use of alternative fuel sources in automobiles, cane sugar in Brazil, a core market for oil products has a clearly declining demand trajectory.

Thus it seems unlikely in the medium to long term that either pipeline project, whether Russian or EU backed will live up it its much hyped expectations. Rather, the Southern gas corridor will become just another small part of the European energy supply network. Not insignificant, but perhaps not the anticipated game changer.

If the Southern Gas Corridor is a distraction, then what?

The key issue that the EU seems consistently unable to address is that of a European wide energy grid. For Europe, a totally integrated Energy grid would be able to deliver multiple immediate benefits with relatively few drawbacks:

  1. The construction of the infrastructure needed for a European energy grid would help to stimulate economic growth.
  2. A Europe wide grid would reduce wastage within national grid systems by allowing surplus energy from one state to be moved to another.
  3. Greater regional integration and cooperation as all states become more closely intertwined.
  4. A more consistent energy prize for all European citizens and states.
  5. A significant reduction in the dependency of any European energy state on one energy source.
  6. Greater political independence from Russia.

Whether people like the idea of greater European integration or not, it is inevitable that the future energy security of Europe will not be secured by grand visions like the Southern Gas Corridor but rather by integrating those networks that are already in place. That is the true answer and path to Europe’s energy security.