Petrostate:Putin, Power, and the New Russia

by Marshall I. Goldman

  RUSSIAN PETROLEUM AS DIPLOMATIC WEAPON

  The CIA rightly concerned itself with the Soviet Union’s ability to export petroleum. The earlier surge in Soviet petroleum output and the corresponding increase in exports in the 1960s and 1970s provided Soviet leaders with a particularly effective economic and foreign policy weapon. It opened doors in the third world for Soviet ideology and diplomatic initiatives that otherwise might have remained closed or just half open. Countries in the struggling regions of Asia, Africa, and Latin America in that era generally welcomed the radical rhetoric propagated by the USSR but often hesitated to turn their backs completely on their former colonial masters for fear of economic reprisals and export embargoes. In particular, radical leaders in the third world feared that if they became too tied to the Soviet Union or went so far as to nationalize the Western oil companies’ distribution network as did Cuba and Ceylon (renamed Sri Lanka in 1972), the United States would arrange with the so-called Seven Sisters capitalist oil companies to embargo the delivery of the petroleum essential to running their economies.26

  First organized in 1928, the original Seven Sisters consisted of Royal Dutch Shell, Standard Oil of New Jersey (today’s Exxon), and the Anglo Persian Oil Company (today’s BP). After the breakup of Standard Oil, the original three members were expanded to include Standard Oil of California (today’s Chevron), Standard Oil of New York (Socony Vaccum and later Mobil Oil, now part of Exxon), the Texas Company (what became Texaco and then Chevron), and what was once Gulf Oil (now also Chevron). In contrast to today’s world where we worry about energy shortages, the reason the Seven Sisters joined together was to deal with an overabundance of petroleum on the market and the price cutting that resulted. Their purpose was to form a cartel and limit production and price cutting, and in the 1950s one of their main concerns was how to deal with the Soviet practice of price cutting. They also used their control of petroleum exports to punish third world countries that nationalized properties owned by Western investors or otherwise impinged on Western prerogatives.27

  Man does not live by bread or oil alone, but the leaders in the third world quickly discovered that it helps to have a little of both. Once the USSR began offering to underwrite the growing ranks of rebellious colonies with Soviet petroleum, this reduced the retaliatory powers of the mother countries and the Western oil cartels, which often as not did their bidding. Even when there was no formal embargo on petroleum sales, such offers from Soviet officials were very much appreciated because most of these former colonies lacked sufficient hard (convertible) currency for their needed purchases in the traditional energy markets. The Soviets in almost all cases were happy to sell oil at a lower price (sometimes less than a dollar a barrel) or lend or barter their oil without insisting on hard currency payments as a way to gain influence. This was an important form of economic support for the East European Communist and other Council of Mutual Economic Assistance countries (CMEA but more commonly referred to as COMECON) as well as Cuba and most of the former African and Asian colonies including India, Ceylon, Pakistan, Guinea, and Ghana.28

  Since the Soviet Ministry of Petroleum was an instrument of the state, there was little resistance within the Soviet Union to using the country’s petroleum this way. The first priority was to provide for domestic needs. The next was to use petroleum exports to generate the money needed to pay for the Soviet Union’s and Eastern Europe’s hard currency imports from the capitalist world. Anything extra available for export could then be used to promote the state’s political goals. Unlike a private petroleum company, the Ministry of Petroleum did not feel constrained by normal corporate profit and loss considerations. To say the least, profit maximization was not an overriding objective. In fact, it usually played no role at all. Moreover, just as in the Czarist era, the richer countries in the outside world, and especially the Seven Sisters, were not particularly welcoming to exports of Soviet petroleum. Both Western governments and businesses remained unforgiving about the nationalization of the Baku oil fields. For example, until 1971 the British went so far as to prohibit oil dealers, including a network of as many as 400 Soviet-owned service stations located in the United Kingdom, from importing Soviet crude oil.29 The Soviet response was to arrange for their English subsidiary to import crude oil instead from Finland, which was strange, since Finland is not often thought of as a petroleum powerhouse. In fact, Finland imported more than three-quarters of its petroleum from the USSR. Admittedly this was a pain in the neck and added an extra step for the Soviet Ministry of Foreign Trade officials in charge of their British subsidiary. But it also shows how difficult it was to exclude Soviet petroleum exports from world markets.

  Such efforts to keep Soviet petroleum out of world markets was largely a result of the Seven Sisters’ neither needing nor desiring to buy any petroleum from the Soviet Union. These companies regarded the Soviet Union as a spoiler and a disruptive influence—often accusing Soiuznefteexport, the Soviet Foreign Trade Organization responsible for exporting the country’s petroleum, of dumping its products to force down the Sisters’ petroleum prices and profits. Because there was pressure to keep them out of world markets, for some time Soviet petroleum export officials were relegated to dealing with impecunious and marginal consumers or working out under-the-table transactions.

  As world energy demand grew, however, attempts to exclude the Soviet Union from the capitalist world’s petroleum markets became harder. Even more important, by the mid-1970s it made increasingly less sense. The first serious Soviet challenge to important Seven Sisters markets occurred in 1960. ENI, an Italian energy company headed by Enrico Mattei, had been attempting to break into the Sisters’ club. In 1957, he signed a contract with Iran to buy petroleum from that country at concessionary prices that were higher than those that had been offered Iran by the Seven Sisters.30 At the same time he offered to sell potential customers that Iranian petroleum at a cut-rate price. Increasing the pressure, Mattei broke ranks again in 1960 by arranging for yet another out-of-order petroleum purchase, this time a cut-rate purchase from Soiuznefeexport. As he did with Iranian petroleum, he sought to sell this petroleum to Seven Sisters customers in Europe by undercutting the prevailing Seven Sisters price. This was considered a direct challenge to the ability of the Seven Sisters to control prices and a serious destabilizing threat. In some quarters, the inability of the Seven Sisters to prevent low-priced Soviet petroleum from breeching their monopoly control was viewed as the end of the Seven Sisters monopoly.

  But Soviet petroleum exports served as an equal opportunity spoiler. They not only undermined the Seven Sisters and their price control efforts but they also undercut the efforts of the Organization of Petroleum Exporting Countries (OPEC) member countries that were trying to do the same thing. Created in September 1960, OPEC was set up to prevent private oil companies from cutting the price of the petroleum they purchased from Saudi Arabia, Kuwait, Iraq, Iran, and Venezuela. These original members of OPEC attempted to do this by regulating how much petroleum each of these countries could produce and by doing so reduce worldwide supplies.

  But while most of the world’s major petroleum exporters were curbing their production and exports, the Soviets were expanding theirs. By 1975, they had become the world’s largest producer of petroleum, overtaking the United States, which had maintained that distinction continuously since 1902 when it outproduced the largest producer at that time, Czarist Russia.

  By refusing to go along with OPEC, the Soviets increased their political leverage as well as their earning power. For that reason, the 1973 OPEC oil embargo imposed on the United States and several European countries provided the Soviet Union with a golden opportunity. The tightening of petroleum markets that resulted from that OPEC embargo more or less brought an end to the USSR’s bad boy image. The Soviet Union may have been a rogue, but OPEC members were no better, and in 1973, at least, were much worse. Thus after 1973, energy consumers around the world came face to face with the realization that reliance
on energy supplies from the Middle East involved enormous risks. How much more risky could reliance on the USSR be?

  As their industrial output continued to grow, Soviet leaders also sought to export some of their growing output of natural gas. At the same time, after 1973, whatever resistance potential customers may have had to buying petroleum and gas from the Soviet Union all but disappeared. Chastened by the 1973 Arab embargo, customers in Western Europe in particular began to search for ways to reduce their dependence on the now uncertain imports from the Middle East. The Germans were especially eager to gain access to other sources, and the Soviets could ship them natural gas—a cleaner fuel than oil—via an overland pipeline. Most of all, it was reassuring that petroleum and gas from the USSR would be unaffected by OPEC embargoes or sea blockades. To top it off, because of their outsider status, the Soviets were usually willing to undercut market prices.

  In time, major net importers of energy such as the United States, Western Europe, China, and India came to realize that it was in their interest to encourage as much energy production in the world from as many different producers as possible. This obviously included Russia— the more supplies there were the better. This was particularly important for consumers of petroleum. If one supplier decided to withhold deliveries of its petroleum, importers could readily substitute with petroleum from another supplier. That reduced—but did not eliminate—the chance of a political embargo by an OPEC-type organization against a single consumer or group of consumers. But those who initiated such an embargo had to win support from like-minded exporters and even then there were bound to be some exporters such as Russia that would refuse to join in. There is always the danger that those exporters would use the opportunity to poach on others’ customers and sign up new sales.

  But while buying petroleum and natural gas from Russia has its advantages, there can also be serious risks, especially for consumers of Russia’s natural gas. Because pipelines needed to supply natural gas are very expensive to construct, no one can afford to build a second standby pipeline from some other supplier as a reserve for emergencies. Thus even though the European pipeline network links up three major sources of supply—Russia, the North Sea, and Algeria—consumers of natural gas tend to become dependent on a single dominant supply source. This makes them vulnerable to the whims of that supplier. While LNG (liquefied natural gas), which can be delivered by seagoing tankers, could serve as a backup, it too requires billions of dollars in investment, not only for the special tankers that transport it but also for the expensive processing plants at the export site that freeze it and the plants at the import destination that return it to gaseous form. As a result, no one is willing or able to sell or buy LNG without an expensive infrastructure already in place, which explains why it is so hard to create a spot market for LNG, a market where buyers and sellers can agree to a sale at the last minute on the spot. As a result, unlike petroleum imports, which can be sent by tanker from any number of petroleum producers, if something happens to that natural gas pipeline, there are rarely any alternative natural gas supplies available to pipe in as a substitute.

  President Ronald Reagan understood the political implications of all this and decided to do what he could to prevent the USSR from building a gas pipeline to Western Europe. He worried that if the Europeans became increasingly dependent on such supplies, as strong economically as Western Europe might be, they would soon find themselves vulnerable to Soviet political pressure. Reagan worried that as West European households and industries began to rely on Soviet natural gas, they would likely begin to think twice about countering Soviet political demands.

  In an effort to deny the USSR such a weapon, Reagan launched an intense effort to prevent the pipeline’s construction. In 1984, he asked his friend, British Prime Minister Margaret Thatcher, to prevent the English firm, John Brown Engineering, from selling the Soviets the compressors they needed to move the gas through the pipeline from the super giant Urengoi natural gas field in West Siberia to Germany. Similar pressure was put on General Electric, another manufacturer of turbines and compressors. These efforts failed, however, and the pipeline was eventually completed.

  Once the pipeline was completed in 1985, consumers in Western Europe became quite comfortable importing Russian natural gas and using it in their homes and factories. While cold weather caused occasional delivery problems, the Cold War never did. As a good salesman, Viktor Chernomyrdin, when he was Minister of the Soviet Gas Industry, always insisted that he would never think of cutting off the flow of gas for political reasons. He continued to issue such assurances when the Ministry, in August 1989, was transformed into a hybrid state corporate entity which he called Gazprom. He abandoned the title of minister and called himself the CEO of the now newly created joint stock corporation. The promise that the ministry and then Gazprom would honor its contracts has been echoed by numerous other senior government officials including Chernomyrdin’s immediate successor, Rem Vyakhirev, who as CEO, sold much of the company’s stock to nonstate entities in November 1992. Others frequently made the same claim. For example, in 2006, Igor Shuvalov, President Vladimir Putin’s economic adviser insisted that “Europe will never have a more reliable supplier than Russia.”31 Or listen to Putin himself. At the Balkan Energy Cooperative Summit in Zagreb in June 2007, he insisted that “for four decades now, despite the serious and truly global changes in the world, Russia has never broken a single one of its contractual commitments.”

  Such assertions, however, overlook the fact that the Soviet Union in its day and Russia after 1991 have frequently terminated the shipment of energy supplies when a customer chose to oppose Soviet or Russian political or economic objectives. Yugoslavia under Tito, Israel in 1956, Finland in 1958, China in 1959, Latvia in 1990, Lithuania in 1990 and 2006, and Estonia in 2007 had their petroleum deliveries cut off. Later, Putin’s regime halted or reduced the flow of natural gas supplies to Ukraine, Belarus, Georgia, Moldova, and even Bosnia. What passes as “the rule of law” in other societies became “the law of the rulers” under Putin. A contract commitment with state-controlled enterprises in Russia has never been a guarantee of performance nor a deterrent to arbitrary behavior by Russian entities. That was true in the Soviet era and it again became common under Putin. Concessions made at a time when Russia is weak and prices are low are invariably invalidated once prices rise again and Russia regains its strength. Put simply, higher prices increase Russia’s bargaining power. Precedent is no guarantee that the Russians will not some day mend their ways, but it does suggest that President Reagan had legitimate concerns.

  WILLIAM CASEY: DID HE PRECIPITATE THE COLLAPSE OF THE USSR?

  Recognizing how important petroleum and natural gas production and delivery were to the Soviet Union’s domestic and foreign well-being and influence, William Casey, appointed by President Reagan in 1981 to head the CIA, decided that the best way to undermine the USSR was to undertake an effort to cripple its energy sector. Given that four years earlier the CIA had predicted there would be a sharp drop in production, which would turn Russia from an oil exporter to an oil importer, it should be relatively easy to expedite that drop in oil production.

  Fortunately for the USSR, neither it nor Russia became net importers—far from it. So was the CIA wrong? Production did peak in 1987 at 625 million tons and it did fall to 571 million tons in 1990 (see Table 2.1). Yet according to the CIA, the USSR and Eastern Europe should have been importing 175 to 225 million tons by then. But that did not happen. The USSR remained a major petroleum exporter until it disintegrated. After that, production in Russia itself did indeed fall sharply in the mid-1990s, but as we shall see in Chapter 4, this was because petroleum prices were low and taxes were high so the new private owners concluded they could make more money by stripping assets than by producing petroleum. These were not the reasons anticipated by the CIA.

  The CIA prediction was far off the mark. In fact, in 2006 Russia again became the world’s largest producer of petroleum.
Nonetheless, the production and central planning problems on which the CIA based its 1977 analysis were real. The Soviets continued to inject too much water into the oil fields and the bureaucratic and central planning practices that characterized the Soviet economic system resulted in enormous waste and lost opportunities.

  While the CIA devoted considerable effort to research and analysis of the problems that confronted the Soviet petroleum industry and its exports, once William Casey took over as the head of the CIA, he began to tackle the issue more aggressively. Some, including Peter Schweizer of the Hoover Institute and Yegor Gaidar, former Acting Prime Minister of Russia in the early years of Boris Yeltsin’s presidency, have advanced the view that Casey sought to cripple the Soviet petroleum industry’s export-earning capabilities to prevent it from generating the hard currency Russia so desperately needed to pay for its food and technology imports.32

  Schweizer goes so far as to argue that the CIA under William Casey launched a complicated scheme that ultimately led to the collapse of the Soviet Union. As Schweizer tells the story, CIA chief Casey received authorization from his boss, President Reagan, to work with Saudi Arabia to weaken the Soviet petroleum industry. This was typical of Casey’s out-of-the-box thinking. As he saw it, Casey reasoned that the Saudis would cooperate because they were angered by the Soviet invasion of Afghanistan, a brother Islamic country. Saudi Arabia at the time actively supported the Afghan guerillas fighting the Soviet occupiers. Before long the Soviet Union found itself bogged down there. Casey also sought to weaken the USSR at home.