Petrostate:Putin, Power, and the New Russia

by Marshall I. Goldman

  Russian industrial output and the stock market also took direct hits. The gross domestic product was 5 percent lower in 1998 than 1997. The impact on the Russian stock market was much more far-reaching. By October 1998, just a year after the October 1997 record RTS high of 571, the index fell to a mere 39. For all intents and purposes, the Russian stock market had disappeared.

  The impact was not restricted only to those who had invested in the Russian stock market or to Russians. Western banks that had been lending so eagerly to Russian borrowers found themselves with worthless bonds. Some had to write off several hundred million dollars’ worth of loans. Credit Suisse First Boston, for example, lost $1.3 billion and Barclay’s Bank in England lost $400 million.4 In the United States, Bankers Trust wrote off a comparable amount to that lost by Barclay’s Bank.5 More than that, there were fears that the whole U.S. financial world would be similarly affected when the monster hedge fund, Long Term Capital Management (LTCM), in Greenwich, Connecticut, acknowledged that it had lost $1.86 billion of its capital and was insolvent. It was not that the Fund itself had invested in Russia. Rather, it had lent money to other investors who were affected by the moratorium on Russian debt and the collapse of the ruble, none of whom could now repay their loans. Were it not for the timely intervention of the U.S. Federal Reserve Bank, it was likely that the LTCM collapse would have triggered a cascade of other defaults throughout the financial system. Out of concern over the impact of LTCM, the Dow Jones Index dropped by over 20 percent.

  Banks and the Dow Jones Index were not the only ones affected. In the panic that followed, many foreign investors who had already set up operations in Russia—not the least of which was Pizza Hut—and imported what they sold were forced to close down. Many decided it was best simply to walk away from investments worth tens of millions of dollars. Others who were thinking of investing simply went elsewhere. Simultaneously, the price of petroleum, Russia’s most important export product, fell from $26 a barrel in 1996 to almost $15 a barrel (see Table 2.1). With its banks closed, its credit worthless, and its main export product earning only 60 percent of what it had two years earlier, Russia saw many of its businesses close or come to the verge of closing, and the prospects for the Russian economy were bleak.

  The drop in oil prices in the early and mid-1990s had a devastating impact on oil production. With oil prices so low, by the time the petroleum producers allowed for production costs, taxes, and transportation expenses, there was little and often nothing left over for profit. So the new owners (many of whom were now private entities) not only halted exploration for new fields, they also cut back production in existing fields.6 As a result, Russian crude oil output fell nearly 40 percent from 1990 to 1998.

  A QUICK RECOVERY

  But sooner than might have been expected, the world economy began to recover. Led by an increase in commodity prices in southeastern Asia, where the recession began a year earlier, energy prices also began a quick recovery. By 2000, oil prices hit $33 a barrel, double what they had been only two years earlier (see Table 2.1). What had been a glutted market almost overnight turned into a tight market.

  Much of the impetus for this change was due not only to a recovery in Europe and the United States but an ever larger increase in demand for oil and gas in India and China. Whereas China was actually a net exporter of petroleum in 1993, by 2005 it had become a major importer, forced to import 40 percent of its petroleum.7 In 2006, it imported 138 million tons of crude oil and 24 million tons of refined petroleum.8 Only the United States imports more. As the Chinese economy grew, this new wealth brought with it an even higher demand for petroleum. Chinese consumers’ increasing use of cars and air conditioners, machines that are particularly heavy users of energy, was especially important in driving up demand. Simultaneously, China continued making massive investments in heavy industries such as steel, aluminum, and cement plants, all of which require very intense input of energy.9 So in 2004, while China’s GDP rose about 9 percent, oil consumption rose 16 percent. Overall, from 2001 to 2006 China’s energy consumption rose an average of 11.4 percent annually, which was greater than the 10 percent annual growth of its GDP during similar years.10 Oil consumption did not increase as much in the years immediately following, but still by 2006 China consumed about 7.5 million barrels of petroleum per day (350 million tons), 6–8 percent of the world’s total and second only to the United States, which consumed about 20 million barrels per day (940 million tons).11 Some Chinese economists project that energy consumption in China will more than double between 2006 and 2020 and triple by 2030.12 This would mean China will be importing 500 million tons of petroleum a year, which approximates Saudi Arabia’s entire production. (Some of this would come from countries that no longer need to consume as much because they have become more efficient in using what they have. But that would not free up enough to satisfy China’s need. Who the suppliers will be for the additional coal, oil, and gas needed to feed China’s voracious energy consumption is not clear.)

  Recognizing their problem, the Chinese government, for example, seeks to reduce energy consumption per unit of GDP by 20 percent from 2006 to 2010. That would help, but since China grows by 10 percent a year, much of that saving would be absorbed by the higher rate of growth. Moreover, so far the Chinese have been able to reduce energy consumption per unit of GDP by only 3 percent a year.13

  The story is much the same in India. It now imports two-thirds of the energy it consumes. The expectation is that it will have to import even more to fuel its future growth, especially if it continues to grow annually at 8 percent as it did in 2006. What makes China’s and India’s appetite for energy particularly important for Russia is that these newly enriched super-size populations have created an unprecedented new market situation. Their incremental demands in the early twenty-first century have sopped up most of the world’s available excess oil-production capacity and more than offset whatever energy conservation may have been achieved in countries like Japan or Europe and in 2006, even the United States.14 From 2001 to 2005, China was responsible for 30–40 percent of the increase in oil consumption. Emerging market countries as a group in 2005 generated 90 percent of the incremental growth in demand.15 No wonder prices rose to what seemed to be new highs.

  If allowance is made for inflation, 2007 oil prices were not, in fact, at record levels. April 1980 oil prices, for example, if adjusted for inflation in mid-2007 would have amounted to $101, about equal to what seemed to be the record $100-a-barrel price of January 2008. Nonetheless, in mid-2007, the International Energy Authority predicted that because of growing market pressures, real energy prices would continue to increase through 2012. As they saw it, world demand for petroleum would grow at an average of 2.2 percent a year while oil supply in non-OPEC countries would expand at only 1.1 percent. This would reduce OPEC’s spare capacity and lead to continuing high energy prices.

  The tightening of the market for energy products and the increase in prices that followed, even if not at a record level, had a direct and immediate impact on Russia. After a half dozen or more years of asset stripping and a corresponding reluctance to invest in new exploration and development, the oligarchs and managers of energy-producing entities came to realize that with higher energy prices they could make more money by putting their funds into exploration and production at home rather than by stripping such assets and investing the proceeds from their sale abroad. Their decision to increase production was also affected by the state’s decision in 1998 to begin liberalizing taxation by instituting a flat 13 percent tax on income. It also helped that after the devaluation of the ruble in August 1998, the cheaper ruble meant that foreigners could buy more Russian products with their dollars and euros, which helped to increase Russian exports.16

  So the oligarchs began to invest in geological exploration and better equipment. This included using more advanced Western technology. In September 2006, I had a chance to see how important Western technology has become for the Russian oil
industry when I visited the Yuganskneftegaz Priobskaia oil field in West Siberia. This was the oil division that had been taken over by the state-owned Rosneft company from Mikhail Khodorkovsky’s Yukos. Almost all the drilling there was being done by the American-French company, Schlumberger. Halliburton, Vice President Dick Cheney’s former company, is doing much the same thing elsewhere in Russia. They both are using technology denied to the USSR during the Cold War. When the Cold War ended, the Russians still were unable to use this technology because with oil prices so low, they could not afford it. Once oil prices rose, however, Russian companies were able to hire such service companies and in doing so, they gained access to deposits that would otherwise be beyond the reach of their indigenous technology. Almost immediately there was a sharp jump in production, the first time there had been a meaningful increase since 1987. Contrary to the earlier prediction by the CIA that Russian oil production would fall off sharply, in 2000 Russian oil production rose 6 percent and by 2003, 11 percent. While the rate of growth fell to 2 percent in 2005, by 2006 Russia was even out-pumping Saudi Arabia. Just as in the periods from 1898 to 1901 and 1975 to 1992, Russia once again became the world’s largest producer of petroleum (see Table 2.1).

  Since Russian GDP turns out to be almost entirely dependent on changes in oil production, after years of decline Russia’s GDP also increased significantly. As Table 4.1 indicates, there is an almost perfect correlation between oil production increase and decrease and changes in GDP. Moreover, with more output, there was more to export. By 2006, Russia’s foreign trade surplus hit $140 billion, much of which went into Russia’s currency reserves. In 2006 alone, Russia’s reserves increased by more than $100 billion to a total of $300 billion by year’s end. This meant that as of mid-2007, with more than $420 billion in the state treasury, Russia had the world’s third largest holdings of foreign currency reserves and gold, behind only China, with more than $1.4 trillion, and Japan, with $900 billion.17

  TABLE 4.1 Russian Oil Production and GDP (% change) Oil GDP

  With so much cash in hand, the Russian government moved quickly to pay off its loans. As of September 2006, its foreign sovereign debt amounted to about $73 billion, less than half of the $150 billion it owed in the aftermath of the August 1998 financial collapse.18 Much of this debt was prepaid in advance of when it was due. In August 2006, for example, Russia paid $23.7 billion to the Paris Club (creditor countries that join together to try to collect money they are owed by other debtor countries), some of it in advance of the due date.19 Along with the buoyant yearly growth of its GDP, this prepayment helped to improve Russia’s credit rating. By contrast, while the government was paying down its debt, the private corporations and banks moved in to take advantage of the more favorable credit ratings and as of October 2006 had increased their borrowings to more than $210 billion. Much of this went to corporations like Gazprom, Rosneft, and UES to finance their purchase of other properties.20 There were fears that with private corporations seduced by so much cheap money, too much of their borrowing was being used for peripheral projects that might some day prove to be a problem. Despite the pay-down of government debt, the ratio of overall joint private and government debt to GDP increased from 19 percent at the end of 2004 to 23 percent in 2005. Nonetheless, the overall financial ratings for Russia and its corporations increased markedly from their 1998 low point.21 In July 2006, for example, the financial rating company Fitch Ratings lifted Russia from a risky to a reasonable investment rating.22

  Those fortunate enough to have ignored Layard and Parker’s book and its advice to invest just before the 1998 financial crash but who did invest after 2000 in Russian stocks (except, of course, for Yukos) probably did quite well. By then the boom had indeed come to Russia. When Putin took over as prime minister in August 1999, the capitalized value of the country’s publicly traded stocks amounted to $74 billion. By 2006, the capitalized value exceeded $1 trillion.23

  EUROPE DIVERSIFIES

  At the same time that Russia’s energy sector brought prosperity to most of those who invested in it, energy imported from Russia had also become attractive to those seeking to reduce their dependence on energy from the Middle East. Given the political and military turbulence in the Persian Gulf, Europe was eager to avail itself of a supplemental source of energy. Since Russia was part of the European continent, petroleum and gas could be delivered by an on-land pipeline as well as by ship, railroad, and highway. This meant not only a shorter journey but also one no longer vulnerable to terrorism in the Persian Gulf or Suez Canal, not to mention OPEC hijinks and 1973-type political embargoes.

  The land link between producers in Russia and consumers in Europe is particularly important for natural gas customers. As we just noted, unlike petroleum, which is a liquid and thus can be delivered easily by railroad tank car, truck, and pipeline, most gas can be delivered only by pipeline. The only other alternative to pipeline-delivered natural gas is LNG, carried by expensive, specially designed ships. Railroads and tank trucks are unsuited for transporting commercial quantities of natural gas.

  Given all the advantages of a natural gas pipeline, it was no wonder that despite Ronald Reagan’s best efforts, the pipeline from the USSR to Europe was built. As German Chancellor Gerhard Schroeder later also noted, from an environmental point of view, natural gas would be more environmentally friendly than coal or nuclear energy. More than that, the Russian Republic had the world’s largest reserves of natural gas. Initially, Germany received most of its gas from the North Sea. But since the North Sea fields were more modest in size, before long, Russia became the largest supplier of natural gas to most of Europe. As the North Sea fields, especially the gas provided by Norway, begin to decline, Russia will undoubtedly provide an ever-larger share.

  Of course, there was always the danger, much as President Reagan had warned, that like some OPEC petroleum suppliers, Russia might threaten to cut off the flow of its gas for one reason or another. After all, the USSR and then Russia did just that to several of its petroleum customers. Yet except for an occasional weather-related problem, Russia has behaved honorably with most of its West European customers. This was the case even during occasional tense Cold War confrontations. More than that, when OPEC cut back petroleum production and imposed an embargo on the United States and the Netherlands in 1973, the USSR refused to participate. Instead, as petroleum prices rose, it not only continued to honor its contracts but it expanded its exports of both petroleum and gas, and by doing so, it took advantage of the high world prices resulting from OPEC’s heroics. As its reputation for reliability grew, whatever hesitancy some may have had about becoming dependent on Soviet natural gas dissipated, and Soviet supplies came to be accepted throughout Europe as an integral and dependable part of the region’s supply network.

  WHO OWNS GAZPROM?

  With the collapse of the Soviet Union and its communist system, for the first time foreign and private individuals and companies could invest and buy shares of stock in these newly privatized Russian entities, including most of those producing energy. In December 1998, for example, Ruhrgas of Germany acquired 2.5 percent of Gazprom stock for $660 million and another 1 percent in May 1999 for $210 million more. Combined with another 1.5 percent of stock it controls indirectly, Ruhrgas at one point owned or controlled over 5 percent of Gazprom stock. For a time, nonstate investors, mostly Russian entities, owned 61.63 percent of the company’s stock. However, the state owned more than any other single holder and so, at least in theory, it has the right to determine management control.

  Yet without 50 percent plus one share state ownership, there was always the possibility that a foreign group could accumulate enough stock to take control. When Putin became president, one of his priorities was to prevent such a possibility. Accordingly, in mid-2005, he arranged for state-run Rosneft to buy up another 10.74 percent of Gazprom shares. With these extra shares, the state or state-owned entities then held 50.002 percent of the company’s shares. Another 29.482 percent
was controlled by other Russian businesses and institutions. Of the remainder, 13.068 percent was held by Russian individuals, and 7.448 percent by nonresident individuals, companies, and groups.24

  Gazprom has worked to keep tight monopoly control not only over the country’s natural gas pipeline network but also over its natural gas output. Occasionally, when the Russians feel unable to master the technology required to work particularly difficult sites such as Sakhalin and the Barents Sea Shtokman field, they have agreed reluctantly to allow foreign companies to work a few such fields on their own, without Russian or Gazprom involvement. But as in the past, once their national treasury begins to overflow and new confidence builds, the Russians quickly move to circumscribe foreign involvement and invariably they take development back into their own hands.

  AN OPENING FOR FOREIGN FIRMS

  Because the petroleum ministry, unlike the gas ministry, was not held together during privatization as a unified whole in an entity comparable to a Gazprom, privatization provided more of an opportunity for foreign companies to set up their own petroleum-producing subsidiaries and enter into joint ventures. Philbro Energy Products created a company with the romantic name “White Nights.” It was one of the first joint ventures in the post-Communist era. Its concept was a laudable one. Drilling practices in the Soviet era were notorious for their poor conservation efforts and sloppy operating methods. Against this background, White Nights proposed forming a joint venture with a Russian company to take over some of the already worked and even abandoned oil wells. They were convinced they could restore them or increase their yield by utilizing advanced Western technology. So they created a joint venture consisting of a group from Anglo-Suisse and Philbro Energy Products, a subsidy of the American company Solomon Brothers. They joined with Varyeganneftegaz Oil and Gas Production Association, whose oil wells they would be reworking. The joint venture was predicated on the assumption that without foreign assistance, output from the Varyeganneftegaz field would decline at a rate of about 25 percent a year. Anything the joint venture produced above and beyond that trend line would be considered profit for the joint venture and would be shared equally by the Russian and Western partners.