Streetwise Professor

Remember back in November and December when Russia was playing footsie with OPEC? All the sweet nothings about coordinating output cuts to stabilize prices? Well, sweet nothings they were. From Reuters:

Russian oil output fell to 9.66 million barrels per day (40.87 million tonnes) in December 2008, down 1.6  percent from 9.82 million bpd in November, while exports via pipeline monopoly  Transneft <TRNF_p.RTS> rose 17.9 percent to 4.36 million bpd (18.4 million  tonnes).

Another Reuters article reports that Russian seaborne exports rose 20 percent as well.   Although Russian output declined, exports rose: and it’s exports that have an effect on world prices.  

Yesterday Russia also announced that February’s oil export duty would likely fall to $100/ton (from $119/ton):

Russia may cut its oil export duty to around $100 per tonne from Feb. 1 to account for lower oil prices, a senior Finance Ministry official told Reuters on Monday.

Alexander Sakovich, deputy head of the ministry’s customs monitoring department, told Reuters the February export duty was calculated based on the average price for Russia’s benchmark Urals crude blend URL-E URL-NWE-E of $39.8 per barrel since the monitoring started on Dec. 15.

“If the oil price will not rise above $67.5 per barrel in the next three days, the duty will most likely be cut. It will be close to $100,” he said.

The oil export duty was set at $119.1 per barrel in January.  

If Russia were serious about cutting exports in order to raise prices it would raise export duties.

As low as prices are, Russia has little independent incentive to cut output.  It is much more profitable to let OPEC chumps bear the brunt of output cuts, and sell as much as possible.  

Maybe OPEC will remember this next time Putin or Sechin pledges solidarity.

The Eurasian Daily Monitor’s Pavel Korduban presents an analysis that echoes that of new commenter Elmer:

Interestingly, Yushchenko looks like a natural ally for Yanukovych in a campaign to undermine the government of his former Orange Revolution allies. Yanukovych probably meant Yushchenko when he suggested that “a certain portion of my opponents should join us to build our Ukraine together” (Channel 5, January 6). Both Yanukovych and Yushchenko deny the legitimacy of the new coalition, arguing that it controls less than half of parliament. They also agree that the main aim of the coalition is to keep Tymoshenko’s “populist” government afloat. Both hold Tymoshenko, rather than the global crisis, responsible for the current economic hardships and want her resignation.

Yushchenko and Yanukovych have also been on the same side in the recent banking scandals and possibly in the continuing Russia-Ukraine gas row. Tymoshenko accused the central bank, Yushchenko, and the Nadra bank of conducting illegal currency operations. She wants to oust the head of the central bank Volodymyr Stelmakh (Ukrainski Novyny, December 12; Ukrainska Pravda, December 20). Yushchenko defended the Nadra bank and refused to dismiss Stelmakh (Ukrainska Pravda, December 22, 27). Nadra is linked to businessman Dmytro Firtash, who is believed to be among the main financiers of the PRU. Firtash also co-owns RosUkrEnergo, which has been the intermediary, with Yushchenko’s consent, in gas trade between Russia and Ukraine since 2006. Tymoshenko has pledged to expel RosUkrEnergo from the market.

There are so many cross-currents in the Russo-Ukrainian gas standoff that anyone who predicts a quick or lasting resolution is, in my view, completely unrealistic.   Bilateral monopoly situation creates immense rents.   Numerous parties with both economic and non-economic agendas are contending for these rents.   The economic agendas are relatively easy to comprehend, but the political agendas are much more amorphous.   They include geopolitics (Russia wanting to undo the Orange revolution, and reassert control over Ukraine), grubby domestic infighting (obviously on the Ukrainian side, but likely occurring under the carpet on the Russian side), and the pettily personal (with Putin being famous for his hatreds, and pursuing them ruthlessly).   All of this taking place in two nations with weak, not to say non-existent, institutional constraints (e.g., policy transparency, electoral accountability) on corrupt rent seeking.

But it gets better!:

Gossip that the mafia has its hands in the export and transit of Russian gas via Ukraine became even louder after the gas crisis in Europe began.

Allegedly, Semyon Mogilevich, considered to be one of the bosses, or even the chief mafia boss in Russia, is at the helm of the mysterious company RosUkrEnego, which sells gas to Europe and Ukraine, the Slobodna Dalmacija daily reported.

He is a Russian citizen of Ukrainian descent whom the FBI considers the key person of international crime. What is interesting is the fact that, due to special services for Zagreb, he was granted Croatian citizenship. During his arrest for tax evasion last year, allegedly, police found a Croatian passport on him.

Mogilevich was arrested using a false name of Sergei Schneider, which is one of the 17 false names he used. Claims that Mogilevich is the head of the RosUkrEnego company began back in 2005 when the then Ukrainian counterintelligence service chief, Olexandr Turchinov, said he had proof that the Russian mafia boss was the director of the mysterious company. Soon after, Moscow’s daily Komersan wrote about Migolevich taking part in negotiations about the prices of gas supply for 2006.

Since Mogilevich was arrested a year ago, it is unclear whether he is pulling any of the strings now.   (Though notorious criminals, ranging from Pablo Escobar to Chicago homey Jeff Fort of El Rukn infamy have been known to run criminal operations while in “custody.”) Even if Mogilevich is not currently involved in RosUkrEnergo, and is not playing a role in the resolution–or not–of the current situation, his purported involvement gives a flavor of the kind of bottom dwellers associated with that “company” which has a throttlehold on Europe’s gas.

In any event, it is pretty clear that Tymoshenko’s year old assertion was wildly optimistic:

The arrest of suspected crime boss Semion Mogilevich should signal the end for shadowy middlemen in Ukraine’s $6.5 billion gas trade with former Soviet states, Ukraine’s Prime Minister Yulia Tymoshenko said Monday.

Tymoshenko has previously said Ukrainian-born Mogilevich, arrested last week in Moscow, is behind RosUkrEnergo, a mysterious joint venture which has a monopoly on the sale of Russian and Central Asian gas to Ukraine.

Mogilevich and the Ukrainian businessmen who own 50 percent of RosUkrEnergo have denied any links with each other. Russia’s gas monopoly Gazprom, which owns the other half, declined comment. “As far as gas transit from Uzbekistan, Tajikistan and other countries is concerned, we don’t need any shadowy intermediaries,” Tymoshenko told reporters after talks with European Commission President Jose Manuel Barroso in Brussels.

“There will be transparency in our government and society. It also concerns energy policy,” she said, responding to a question about the detention by Russian police of Mogilevich.

Since regaining the premiership last month, Tymoshenko has resumed a campaign against RosUkrEnergo, which won its monopoly in January 2006 after the price dispute that led Russia to shut off gas to Ukraine in mid-winter.

That jeopardised supplies to Europe, which counts on Russia for 25 percent of its gas needs.

Industry analysts have repeatedly questioned why Ukraine and Russian state gas monopoly Gazprom need RosUkrEnergo at all, since they could deal directly with each other.

Tymoshenko told the BBC’s Panorama programe in 2006 that she had “no doubts whatsoever” that Mogilevich was behind RosUkrEnergo, according to a transcript on the BBC website.

A Ukrainian security service investigation found “many indications” that Mogilevich indirectly controls the firm.

Mogilevich is wanted by the U.S. Federal Bureau of Investigation for alleged fraud, money laundering and racketeering. The Ukrainian security service SBU says it has no ongoing investigation regarding him at present.

Analysts said Mogilevich’s detention could mark the end of the firm’s grip on the gas mains of Ukraine.

“Mogilevich does not have any real political support and RosUkrEnergo is going through rough times due to these attacks from Tymoshenko. So this looks like some cautionary house-cleaning from the Russian side,” said Yevgeny Volk, analyst at the U.S.-based Heritage Foundation.

Stanislav Belkovsky, head of the National Strategy Institute in Moscow, said that a “critical mass of people in Ukraine has emerged against the existence of this middleman structure and at the same time, there is a group of people on the Russian side whose interests are in alignment with”.

Still waiting on that transparency thing, girl.   And I repeat the suspicions I voiced in my reply to Elmer’s comment–Tymoshenko’s aversion is not middlemen in general, just to those who help fund her political opponents.   Do you agree, Elmer?

That’s all, Folks! 😉

One of the arguments commonly raised in Russia’s favor in the periodic gas wars with Ukraine is that Russia has every right to get the “market price” for its gas.  That is, it can charge what it wants, and can refuse to sell to anyone that won’t pay what Gazprom demands.

Fair enough.  But a couple of things to keep in mind.

First, as I wrote a couple of years ago in “Yes, But What Kind of Market“, the “market price” is not the same as an (even approximately) competitive price.  Gazprom exercises market power.  Moreover, Gazprom price discriminates.  For instance, it charges Belarus a lower price than Germany, or Ukraine, for that matter.  So, Gazprom/Russia is not really arguing that Ukraine is demanding to pay a subcompetitive price; it is asserting that it has a right to receive a supercompetitive price. . . because it can.   Hardly the moral high ground.

Second, this logic cuts both ways.  If Gazprom has the right to demand what it wants for gas, why doesn’t Ukraine have the right to demand what it wants for transporting gas?  And remember, although the differential has narrowed somewhat, Gazprom has historically exercised the power inherent in its control of the only route by which Turkmenistan can export gas by charging an extremely high transit fee, paying the Turkmen far less for gas than it receives when it sells it to the Europeans. (This was documented in Yes, But What Kind of Market.)  In essence, Ukraine is using the market power inherent in its control of the pipeline between Russia and Europe in exactly the same way Russia/Gazprom has used the market power inherent in its (government granted) monopoly over the pipeline between Turkmenistan and Europe.  And which it also uses, by the way, to stifle competition from other Russian producers of gas.  (As one prominent example, it used its ability to deprive BP-TNK access to a pipeline to force the consortium to sell the Kovykta field to Gazprom–a commitment the Russian giant is now trying to escape given its financial straits.  And even domestic Russian gas producers have been unable to get stranded gas to market.)  So, when Gazprom and Putin scream “No Fair!”, there’s more than a little hypocrisy involved.  My heart bleeds.

Bottom line–there are no saints involved in this episode.  There is a classic bilateral monopoly situation.  Each side is using its leverage to try to extract as much from the other as possible.  There is a substantial rent to be had, and Ukraine and Russia/Gazprom are using every lever they can to get the lion’s share of that rent.

Both sides play the victim, but there’s little to choose between them.  Well, there is.  Gazprom’s protestations of commercial morality ring very, very hollow given that it treats other sellers of gas in exactly the same way that it accuses Ukraine of treating it.

What do they say about payback?  Hmmm.  Trying to remember.  Starts with a “B”, I think.

This conflict is inherent in the dysfunctional market structure upstream and midstream.  State mandated monopolies over transportation in Russia and Ukraine, with no system of open access and common carriage, distort markets.  When these monopolies are back to back, rent seeking battles are inevitable.

Absent some regime of open access, or common carriage at regulated rates, the distortions in the Eurasian gas market will persist.  The second best alternative is to create additional pipeline routes connecting other sources of gas (Turkmenistan, Kazakhstan) with consumers downstream.  Importantly, these additional routes must not be in control of the incumbents–notably Gazprom–so Nord Stream and Blue Stream South Stream don’t help.  An additional, non-Gazprom pipeline would create additional competition (though far from anything resembling perfect competition) both for the gas, and for the transport of gas.

This is not likely to happen anytime soon, given the difficult economics of Nabucco, the dynamics of the new Great Game in Central Asia (and Russia’s strong strategic hand in that game, and its ruthlessness in playing it), and the pathetic dithering of the Europeans.  Which means that the gas wars will remain as regular a New Years event as the Rose Bowl and hangovers.

Oil has been up smartly since the last trading day of 2009, up around 25 percent (from around $40/bbl to $50/bbl).   But today, a record stocks build in beautiful, windswept Cushing Oklahoma (I’ve been there–don’t make a special trip) caused prices to drop precipitously:

The latest US stock data has just been released and it’s a whopper of a build at Cushing, Oklahoma- the delivery point for West Texas Intermediate physical barrels which set the WTI Nymex benchmark. The number is currently the most closely watched inventory figure because of the contango in the forward curve and the associated incentive to store crude.

Few analysts would have expected Wednesday’s build of 4.1m to 32.2 mn barrels. The total build documented by the US Energy Information Administration figures was 6.7m to 325.4m barrels. Crude has unsurprisingly come off sharply on the news – WTI down to some $44 per barrel at the last look, off some 7.6 per cent over the session. According to Dow Jones Newswires, total capacity at Cushing is some 45 mn barrels.

All in all it’s a very bearish indicator for crude with inventories across the oil complex building much more than expected:

As a result, as of mid-day Central Time, Brent is down around 7 percent, and WTI (which is settled by Cushing delivery) is down over 10 percent.

Looking at the charts from ICE , there was a huge drop in prices exactly at the time the storage number was released, then a little dead cat bounce, then a continued decline.

This is another indication of persistent bearish fundamentals.   Another is that traders are continuing to hire VLCCs to store oil:

Frontline Ltd., the world’s biggest owner of supertankers, said oil traders want to charter as many as 10 vessels to stockpile crude to take advantage of higher prices later in the year.

About 25 supertankers were already hired for storage and there are enquiries for 5 to 10 more, Jens Martin Jensen, Singapore-based interim chief executive officer of the company’s management unit, said by phone today.

What’s going on in the oil market reminds me of the sorcerer’s apprentice in Disney’s Fantasia.   Traders are running about willy-nilly looking for any pot and pan available to hold the oil that producers are pumping but consumers ain’t buying.   Supply is very hard to adjust in the short run (operating a well being essentially an “on-off” decision, and turning off a well by capping it is an expensive, and expensive to reverse, decision that producers are loath to make.   Especially in places like Russia due to the lovely climate.)

The recent rally reflects two forces.   One is some limited optimism about economic prospects; the stock market has steadied, and indeed rallied a bit, and there has been a pretty decent rally in the credit market.   The other is geopolitical uncertainty, driven by the Gaza war and the Russian-Ukrainian gas stand off.

The whopping storage build should considerably dent this tentative optimism regarding firming fundamentals.   The geopolitical uncertainty is harder to gauge.

LaRussophobe beat me to the punch in hypothesizing (with accustomed hyperbole 😉 ) that one (of many) motives behind Russia’s hard line with Ukraine is that it benefits from political tensions that raise fears about energy–and hence raise energy prices:

Why, it was almost as if Russia wanted to disturb the gas market and drive up prices artificially due to a panic.   Why would it want to do an outrageous thing like that, bordering on terrorism?

. . . .

This makes it clear that Russia is not above destabilizing financial markets in order to turn a quick profit, belying any Russian contention that it is a “stable partner” in the energy field and therefore deserving of, for instance, a seat at the G-8 table.

What LR says about Russia goes exponentially for Iran, which is also sucking wind as oil prices plummet.   Indeed, Iran’s economic situation is far more dire than Russia’s.

Now, take into consideration the fact that Hamas is an Iranian sock puppet.   Oil prices spiked during the Israel-Hezbollah war in 2006, and are experiencing a mini-spike now as the Israelis pound the snot out of Hamas.   Although the Iran/Hamas-Israel hostilities have a long history, and the current conflict is overdetermined, the timing is indeed interesting.   Just as oil prices come down hard, Hamas declares the end of a cease fire, conflict erupts, and oil prices rebound, thereby helping patron Iran.   How very convenient.   Can’t say definitively that Iran turned Hamas loose in order to stem a rapidly deteriorating economic situation, but it is a reasonable hypothesis, and consistent with the observed time line.

The lessons from all this?   I draw several.   First, economic (as opposed to fear factor) fundamentals remain very weak.   Second, the recent rally (which was still to small to provide more than modest relief to Russia, Iran, Venezuela, etc.)   is primarily driven by geopolitical uncertainty.   Third, given the fact that myriad bad actors in the world sell oil, and benefit from ratcheting up fear and chaos, said actors have an incentive to sow said fear/chaos.   Meaning that we may be in for a spell of conflicts and standoffs in the former Warsaw Pact region, the Middle East, and perhaps, the Carribbean.

Thus, the oil market will be pushed and pulled by contrary forces–weak economic fundamentals in the industrial/developed world, and disorder in energy producing regions.   This is a recipe for high volatility, but I think that it is likely that the weak fundamentals will dominate, and that as a result, $50/bbl or thereabouts will probably represent the upside for oil for a while.

Russia’s cutoff of gas to Ukraine is now into its sixth day, with no immediate resolution in sight. Many analysts had expected that this episode would have ended by now with some sort of deal because Gazprom could not afford damaging its reputation as a reliable supplier. Those forecasts are evidently wide of the mark.

The wider world first became aware of the contentious relationship between Russia and Ukraine over natural gas three years ago, when Russia/Gazprom cut off shipments to Ukraine. Gazprom indeed suffered a major black eye in Europe, and soon cut a deal through murky intermediaries with highly disreputable connections, even by the region’s notoriously low standards.

But just because 2006 was the first time that world attention focused on the gas wars doesn’t mean that was the year of the first battle of that war. In fact, it had been raging since the collapse of the USSR. This ongoing struggle is driven by economics, the historical legacy of the USSR, geopolitics, and domestic politics in the two countries.

So what is going on now? The situation is complex, and extremely opaque, which makes it difficult to proceed with any confidence–but hey, that’s never stopped me before. So, here are a few thoughts.

First, if any economics student wants a great example of Williamsonian holdups in action–here it is. Russia has the gas. Ukraine has the pipelines needed to get that gas to those willing to pay the highest price for it. There is a bilateral monopoly. There are large economic rents at stake, and the contenting parties have a tremendous incentive to use whatever means at their disposal, fair or foul, to get the biggest share of these rents. In these situations, brinksmanship and holdup s(Russia denying gas to Ukraine, Ukraine siphoning gas from Russia destined for Europe) are inevitable.

In normal, commercial relationships, vertical integration is one way of solving the problem. Uniting the ownership of the gas with the ownership of the pipes eliminates the potential to battle over rents. Indeed, that’s what the USSR was–a vertically integrated energy supplier. 1991 dis-integrated the industry, with the consequences we observe today.

This is, in fact, an acute problem throughout the CIS, and even within Russia. The USSR set up many large scale, and in some cases monopoly, enterprises. Central command authority mitigated holdup problems between these enterprises. With privatization, and the breakup of the USSR, these once integrated enterprises became separate business, creating incentives for both ex ante and ex post opportunism. Monopoly markups and higher transactions costs were the result. Where complementary activities found themselves located in different nations, these transactions costs became especially acute. The gas wars are only the most public, and most spectacular, manifestation of this.

Second, matters are complicated tremendously by the cross currents of private and government interests, and conflicting factions within each country. The gas intermediaries–notably RusUkrEnergo in the present instance–reflect these conflicts.

To the best I am able to piece things together, these intermediaries first developed as a result of the opening of the gas wars in the early-1990s. Ukrainian industrial firms paid Naftohaz Ukrainy (the Ukrainian national gas utility) for gas. NU got the gas from Gazprom–but didn’t pay for it. The intermediaries formed, and offered Ukrainian buyers a price lower than NU. But where could the intermediaries get the gas? It couldn’t come from Gazprom directly–so enter deals with Turkmenistan. But this gas had to travel through Gazprom pipes. So, directly or indirectly, high level people from Gazprom were involved in the intermediaries, and lined their own pockets in the bargain. The Ukrainian government still had considerable leverage due to its control over the pipelines, so those with connections were able to get a piece of the action; that is, partial ownership of these intermediaries. (RusUrkEnergo is 50 pct Russian owned, 50 pct Ukrainian.) In essence, these intermediaries facilitate the privatization of monopoly rents in the Russia-Ukrainian gas trade.

This means that in some sense viewing the current standoff as the Russian government (or Gazprom) vs. the Ukrainian government is misleading. There are very powerful private interests in each country–some of whom are also in the government, or who work for government enterprises–that privately profit from the trade, and who want to ensure that the gravy train continues, and that they continue to ride it.

Interestingly, it is very curious that Gazprom and the Russian government are front and center in the dispute. Formally, NU doesn’t owe Gazprom or Russia anything–it owes RusUrkEnergo. It claims it has paid RUE. The intense interest of Gazprom and Russia in these matters suggests that RUE is nothing but a stalking horse for interested parties in Gazprom and the Russian government.

A third aspect of the conflict is that it is playing out against the backdrop of the financial crisis, and Gazprom’s acute economic difficulties. Gazprom has been the Russian government’s cash cow–but the cow is running dry. Its revenues on sales to Europe are contractually tied to the lagged oil price. That lagged price is high now, but will drop in coming quarters due to the recent fall in the oil price. Gazprom is already deep in debt, makes little on its domestic sales, and is facing a sharp decline on its revenues from sales to Europe. Squeezing Ukraine for a higher price would help that situation some. Gazprom CEO Alexi Miller is demanding the Ukrainians pay a “European” price of above $400/mcm for gas in 2009–but that’s a European price that was based on 2008 oil prices. The European price for most of 2009 will be well below that due to the sharply lower 2009 oil price. Moreover, Ukraine is already an economic basket case, and has been hit even harder by the world economic crisis than Russia. Its heavy industries cannot afford a $400+ price.

A smart monopolist would price discriminate, and charge Ukraine a lower price than it charged Europe. At $400/mcm, Ukrainian consumption would plunge. Charging an extremely high price and selling low volume is not profit maximizing. Miller’s extreme demands are economically irrational–they are based on obsolete economic circumstances, and would not maximize Gazprom’s profit. Thus, Miller seems to be posturing. But his demands are so unrealistic, and his negotiating position is so weak due to the Ukrainian stranglehold on the pipelines, it is highly unlikely that he will get anything close to that price–nor should he want to if profit maximization is his true goal.

But that’s where things get really complicated. Maximizing Gazprom profit may not be the only, or even primary motivation on the Russian side. Outrageous Gazprom demands create a pretext for another face saving deal where an intermediary provides gas at a lower price–and where the profits can conveniently flow into private pockets (or the private pockets of public officials.) Moreover, there is a geopolitical angle here. Putin and Russia want to undermine the sovereignty of Ukraine, and torpedo the Orange forces in that country. That is a sufficiently large prize that Putin et al may be more than willing to sacrifice some profit. That is, the payoff from stiffing the Ukraine is not economic, but geopolitical.

The crazed Ukrainian domestic situation adds yet another layer of complexity. I’ve analogized Ukrainian politics to the three way gunfight at the climax of the spaghetti western “The Good, the Bad, and the Ugly”, and that tragicomic standoff continues. Each of the three major antagonists in Ukrainian politics wouldn’t consider a prolonged standoff and economic pain a bad thing–as long as the one (or both) of the other two takes the blame. The private economic interests of these individuals, their parties, and their associates, also affect their motives and behavior.

In a word: A mess.

It does seem that Gazprom and Russia have the most to lose, and has the weakest hand. Gazprom’s already dodgy reputation in Europe will suffer from another extended cutoff. It has no other way to reach Europe except via Ukraine. Ukraine is already an economic basket case, and although it would suffer somewhat reputationally from a protracted standoff, it doesn’t have the same ambitions and value as Gazprom. It has enough supply stored to get through the winter.

My prediction–albeit offered far more tentatively than my usual fearless forecasts;-)? If economics is the driver, there will be a deal, probably executed through an intermediary, if not RusUkrEnergo, then through some made to order substitute. The price will be lower–far lower–than Miller is demanding. Such a deal will maximize the profits of those who matter–in both Russia and Ukraine.

But I am less than confident that economics will be the driver. The geopolitical stakes have risen dramatically since the Russo-Georgian War, and Putin badly wants to bring Ukraine to heel for both political and personal reasons (the Orange Revolution being a stinging personal defeat.) Moreover, humbling a nation many Russians perceive as an American lackey would be quite welcome given the discontent arising from the economic crisis. Furthermore, it takes more than one to tango, and the vicious political riptides in Ukraine undermine the potential for a deal.

As a result, I place high odds on a protracted standoff. If and when a deal gets done, it will likely be through an intermediary that funnels cash to connected parties in both countries, and at a price that is far below what Gazprom’s Miller is demanding.

The island of stability theme is now longer operative.   According to Interfax,

Russia more vulnerable to world crisis because of integration – Putin

MOSCOW. Dec 29 (Interfax) – The global financial crisis’ effect on the Russian economy is rather substantial because Russia has become an integral part of the world economy, Prime Minister Vladimir Putin said at the Monday meeting of the federal government.

“Since the late 1990s we had been seeking integration with the world economy. Our integration wish came true. As people say, we slit our own throat,” he said.

Is this a self-reproach?   Hard to tell.   But since (a) Putin has been in charge of the integration policy since its initiation in the late-1990s, and (b) he blames integration for his country’s current difficulties, that seems a reasonable conclusion.

I must say, however, that his diagnosis is largely misguided.   Even in the days of its alleged autarky, the USSR was integrated with the world economy–through the commodity markets, most notably the oil market (as a seller) and the grain market (as a buyer).   In its later days, the USSR also borrowed extensively on the international credit markets.   Indeed, the collapse of the USSR was hastened–and arguably caused–by a collapse in the price of oil that deprived it of the export revenues necessary service its debts and to buy grain to feed the populace.

Current events are not all that different.   A collapse in raw material prices (led by oil) knocked the props from under the Russian economy.   Government debt is not large, but private debt is, and the decline in resource export values is making it very difficult for the borrowers to service that debt.   Moreover, the line between public and private debt in Russia is somewhat blurred, given the Russian government’s adamant refusal to let control of “strategic” firms fall from Russian hands.

Some things are somewhat changed.   Today, international investors and currency traders make very public evaluations of Russian economic conditions, as revealed in stock prices and the exchange rate.   These signs of economic distress were lacking in the 1980s.   These public expressions of gloom no doubt infuriate Putin, who desires total control over information and publicity.   But, in my view, these markets are of secondary importance compared to commodities and debt.   In these areas, Russia’s integration with the world economy is nothing new.

I will say, however, that Putin is right about “slit[ting] our own throat.”   He’s just right in the wrong way.   Yukos; backsliding on various economic reforms; Sakhalin II, etc., Mechel, BP-TNK, the Russo-Georgian War, continuing legal nihilism and hostility to property rights, a misguided ruble policy and other ham-handed economic policies in the midst of crisis, and a revanchist foreign policy have all conspired to dramatically increase the difficulties that Russia will face in recovering from its current difficulties.   And all–all–of these elements are Made in Moscow, and Produced by Putin.

In brief, Vlad’s laments, and dreams of some imaginary autarkic paradise, reflect a sadly distorted view of history, and the way the world works.   Russia (and its Soviet predecessor) have long been integrated in the world economy.   It has been connected through the commodity/oil price channel, and its booms and busts have followed closely the waves of world commodity booms and busts.

Ironically, Russian policy under Putin has not ameliorated, and arguably has aggravated, this integration.   The focus on energy-led development, the disregard of the development of other sectors (silly things like the creation of state nanotechnology corporations don’t count), and the erosion of property rights have increased Russia’s reliance on industries that are highly sensitive to world economic conditions.   So, again, he is in a way correct about slitting his own throat–just not in the way he thinks.

Putin’s remarks suggest a desire to turn inwards, to cut Russia off from the broader world economy, probably through protectionist measures (already seen in automobiles and timber).   That would be just another self-inflicted wound.   Protectionism would only exacerbate the economic malaise (cf., Smoot-Hawley), cement the retrograde practices so common in the Russian economy, and delay its economic evolution.   It’s a really dumb idea, but given Putin’s economic illiteracy, I fully expect it to be implemented.

* The Deguello was a tune dating from the wars of the Reconquista in Spain.   Literally, it means “The Throat Slitting,” and was played before battle to signal “no quarter.”   Santa Anna’s army played it before storming the Alamo.

The price of oil continues to drop.   Earlier today, February Brent fell below $40/bbl.   It is now at $40.23.   WTI is also down.   This follows a rather steep drop yesterday.   Inventories continue to build in the US Midcontinent, and reports that oil companies are leasing supertankers to store crude are common.   In the Midcontinent, Cushing storage is almost full up.   (This is why WTI delivered in Cushing is selling at a discount to Brent, in contrast to the typical relationship where WTI sells at a premium.)

This accumulation of inventory will have a lasting effect on the price of oil.   Even when demand turns up (and who knows when when is?), much of that demand increase can be met by drawing stocks down to more normal levels, thereby dampening any price recovery.     Inventories may well continue to build, moreover, due to the fact that supply is very inelastic in the short run, and shutting down wells is a costly proposition.

Update: Urals Med (per WSJ) was quoted at $33.87/bbl this PM in Europe.   Ouch!   Or, should I say —ой!

The Russian Central Bank is increasing the pace of its devaluation of the ruble:

The ruble fell to a record against the euro as Russia devalued the currency for a second time this week amid tumbling oil prices and shrinking reserves.

The ruble weakened to an all-time low of 40.1096 per euro, and was 0.8 percent lower as of 2:39 p.m. in Moscow. Bank Rossii allowed the ruble to decline as much as 1.4 percent against its target basket of dollars and euros, the eighth depreciation since Nov. 11, according to a bank official who declined to be identified. The currency fell 15 percent versus the dollar since August.

This slow motion devaluation is widely recognized to be a major policy error:

“It’s better that they do this quicker rather than slower because everything is looking particularly weak in Russia with the oil price where it is,” said Eugene Belin, head of fixed income, currencies and commodities in Moscow at Citigroup Inc. “The sooner they’re finished with this devaluation process the better for the economy.”

Maintaining the ruble at a level higher than justified by fundamentals bleeds reserves, and weakens the country’s ability to deal with macroeconomic and terms of trade shocks in the future.   Moreover, it damages Russian domestic manufacturing.   Russian industry faces competitiveness problems even absent an inflated currency–propping up the currency only exacerbates that problem. Note that Russia’s recovery from the 1998 disaster was greatly helped by the adjustment of the currency to reflect fundamentals.

So why is Russia boiling the frog by slowly turning up the temperature gradually, rather than allowing the currency float to a level that reflects the dismal fundamentals now facing the country?   The answer is almost certainly domestic politics.   Although several commentors have pooh-poohed my arguments that pronounced and protracted economic difficulties could spark domestic unrest, especially given the fundamentally dishonest way Putin and Medvedev are dealing with the situation, it seems that some people in Russia agree with me about the potential for civil disorder.   People like Putin, Medvedev, and the security forces:

In expectation of uprisingsThe powers have rethought reducing interior troops

Yesterday, the MVD [Ministry of Internal Affairs] decided not to reduce the interior troops (VV), called upon, in part, to disperse demonstrators. The command of the troops justifies this by «tasks that have been set », without specifying them. In the opinion of experts, the siloviki seriously fear unrest among the unemployed, automobilists, discharged military, those dissatisfied with the growth of housing-and-public-utilities tariffs and other victims of the crisis and of the decisions of government officials.

«Reduction of the internal troops of the MVD of Russia will be suspended », — reported, citing a decision of the leadership of the country, commander in chief of the VV general of the army Nikolai Rogozhkin. He in no way connects the decision to maintain the numbers of the VV with the financial crisis, citing the «necessity of fulfilling all tasks that have been set », but which ones specifically, Mr. Rogozhkin does not specify.

«Our troops are designated for the protection of state and industrial facilities, convoying of special cargoes, defense of service lines, suppressing internal unrests and resolving inter-nationality conflicts on the territory of the country, — clarified an RBK daily source in the VV. — Probably, the leadership of the country is assessing the domestic political situation as not very stable, which is why it rethought reducing us ».

The consequences of the crisis and unpopular decisions of the powers have already brought people out on the streets. In Vladivostok a march of protest of several thousand automobilists against the increase in customs duties for used foreign makes went outside the thematic bounds: people started talking about the costliness of fuel, food products and housing-and-public-utilities services, about unemployment, the crisis and property stratification. A protest rally against the growth of housing-and-public-utilities tariffs on 15 December took place in Izhevsk, while on 21 December in the Far east and in Khabarovsk Kray are expected new protests of automobilists. The slogans of the protestors have remained unnoticed by the central telechannels, but have attracted the attention of the siloviki: in the regions are being created anticrisis special groups of the MVD, the heads of the territorial administrations of the FSB are likewise expecting protest actions. MVD analysts are attributing to the risk group reduced military and rotation workers come back from Moscow. Also pouring oil on the fire are growing wage arrears. Thus, according to the data of Rosstat, overdue indebtedness on wages in November increased in Russia by 93% and comprised 7.765 bln rub.

«As much as I know, the power elites are seriously concerned by people’s unrest associated with the financial crisis, — clarified to RBK daily the political scientist Stanislav Belkovsky. — In the situation that has evolved the Kremlin has two ways out: pinpoint financial injections and cracking down on demonstrators with the help of internal troops ». In the opinion of Mr. Belkovsky, the peak of people’s dissatisfaction is going to come in the first quarter of the year 2009: «The ranks of the demonstrators will be augmented as well by people deprived of mortgaged apartments, because for this period is planned their mass repossession ».

The most recent–and most serious–protests occurred in Vladivostok in response to the government’s attempt to protect the imploding domestic car industry (misery loves company) by restricting imports of used cars.

As Russia has experienced numerous times in its history–think 1905, 1917, 1991–protests of this sort can snowball.   Protesters must overcome collective action problems, and isolated protests can be crushed.   When the level of discontent becomes sufficiently great, and a critical mass of protests occurs, it is easier for protestors to coalesce as the security forces become spread more thinly.

The car tariff decision reeks of desperation in the Kremlin–and the White House (on the Moskva).   An ad hoc response taken in haste to defuse one problem creates another.   Putin has few good options.   With the entire economy imploding, everybody is hurting, and moves to help one sector will only aggravate the suffering in others.   Such clumsy moves will quickly undermine the aura of competence surrounding Putin–an aura created by luck (skyrocketing prices for raw materials and a predictable recovery from an inherited economic disaster) rather than by any real economic policy acumen.   Once this aura disappears, the potential for protests and disenchantment grows.   He has only made the ultimate reckoning worse by his failure to level with the Russian people about the seriousness of the situation.   How will Putin likely respond?   I think we all know (and dread) the answer–the answer implicit in the strengthening of the MVD.

Russia’s ruble problem has been eased somewhat by the precipitous drop of the dollar against the Euro and the Yen.   The Fed’s dramatic easing is, in my view, highly unwise.   It appears to be doing little to spark the economy (high powered money is increasing, but velocity is decreasing, meaning that the injection of cash is largely being hoarded.)   Moreover, the huge dollar overhang that is building up will threaten a sharp increase in the price level when the banking crisis eases and financial institutions start lending, rather than holding, this cash hoard.   This will likely lead the Fed to dramatically reverse direction, raise interest rates sharply, and throttle any recovery in the crib.

The continuing fall in the price of oil–January NYMEX WTI closing at $36.25–is particularly remarkable in light of the substantial drop in the dollar in recent days.   Ordinarily, the sharp drop in the dollar would cause an increase in the price of oil.   Not this time.

Doubly remarkable, in fact, in light of OPEC’s record cut.   Or should I say, intended cut.   As I’ve said ad nauseum, these are pie crust promises (to quote Mary Poppins), easily made, easily broken.   The market’s sell-off in the aftermath of the OPEC meeting reflects (a) widespread skepticism about the willingness of OPEC members to adhere to the cuts, especially in the face of pressing budgetary needs and excess capacity, (b) continuing economic weakness and plummeting demand, as indicated by ballooning inventories, and (c) (drum roll please) Russia’s Lucy-and-the-football move of promising cooperation with OPEC, and even intimating joining the organization, and then refusing to cut output:

Russia is not in talks over joining OPEC and has not pledged any oil output cuts in its memo to the oil producers’ group this week, deputy energy minister Anatoliy Yanovsky said on Wednesday.

“There is no talk of Russia joining OPEC,” Yanovsky told reporters, adding that Russia has given a memorandum of cooperation to the Organization of the Petroleum Exporting Countries.

Asked if the document contained any output cut pledges on Russia’s part, he said: “Of course not.”

“Of course not.”   How sweet.   Especially mere days after this:

President Dmitry Medvedev said Russia may join the Organization of Petroleum Exporting Countries and reduce production to support the oil price.

“We have to defend ourselves,” Medvedev said in the Ural Mountains city of Kurgan today. “This is our revenue base, both from oil and from gas,” he said. “I believe that we mustn’t rule out any options.”

Defensive measures may include “cutting the volume of oil production and participating in existing organizations of suppliers, and in new organizations, if we can reach such an agreement,” Medvedev said in comments broadcast on state television.

So, the options are: (a) Medvedev was lying, and Russia had no intention of cooperating with OPEC let alone joining it, or (b) Medvedev gave his honest opinion, and was sandbagged by the real powers in Russia.   Regardless of the truth–and neither is especially flattering to Medvedev or the Russian government generally–there is no doubt that OPEC feels betrayed.   Not that I’m crying or anything, mind you.   As I’ve said before, there’s no honor among colluders.

Although some in the Russian government may feel that they’ve played OPEC like a fiddle, the fact of the matter is that Russia is in a world of hurt.   (Again, much company in this department, but Russia’s economic straits are more acute than Europe’s or the US’s.   Far more acute.)   With Urals blend well below $40/bbl again, domestic manufacturing cratering (with the slo-mo devaluation exacerbating the damage), and reserves ebbing, a hard but brittle political system faces an existential challenge.   The risks of a cataclysm increase by the day.   The probability is not yet 1, but it is rising.   And remember that these processes tend to be “jumpy” and exhibit positive feedback–meaning that once the dynamic of protest and repression begins, it often feeds on itself and spins out of control, and does so discontinuously and rapidly.

Exactly 11 months ago I wrote a post about Russia’s use of “vaporware” and threats to seize control of Serbia’s national oil company NIS at a bargain basement price:

To make the deal look a little less like an abject surrender, Gazprom has also dangled the prospect of giving Serbia a stake in a future gas venture. Word of advice, guys-DON’T BELIEVE IT, and DON’T TAKE IT. Gazprom is the master of what Bob Amsterdam calls “premature contractualization.” That is, announcing deals just in time to forestall projects that are adverse to Gazprom’s interest, and then fading the deal when the threatening competing projects are shelved in response to the Gazprom announcement. Gazprom will whisper sweet promises in anybody’s ear to get what they want, and then renege when it suits them. (Nigeria-you should take note of this, as Gazprom has been wooing you too.)

Gazprom’s stratagem is analogous to a common ploy in the software business. In the 80s and 90s “vaporware” was a commonly employed competitive strategy. A software company would announce a new, improved software product in order to forestall entry by a competitor. Once the potential entrant was scared away, the new software would just fade away into the mists, never to be seen. Gazprom is essentially following this playbook-constantly announcing vaporpipelines, vaporwells, vaporinvestments, vaporstorage, vapor-you-name-it whenever a threatening project is mooted.

So, what Gazprom is offering Serbia is: a pittance in cash plus a pig in a poke in exchange for hard assets right now. Given Gazprom’s record of delivering on its big talk, the Serbs would be well advised to take cash on the barrelhead and take the promises for what they are worth-a little more than nothing.

“A little more than nothing” seems to be a gross overvaluation, based on this piece from Eurasia Daily Monitor:

Serbia’s coalition government has removed Economics Minister Mladan Dinkic from his concurrent assignment as head of the negotiating team on energy agreements with Russia. The impending oil and gas deals involve essentially a Russian takeover of Serbia’s energy sector. Dinkic and his colleagues who were also ousted from the team—State Secretary Nebojsa Ciric and Privatization Agency Chief Branislav Zec—stand accused of holding “unconstructive positions in the negotiations” (Radio B-92 cited by Interfax, December 11; RTS Radio Belgrade, December 12). The government’s Russophile elements have prevailed without apparent difficulty on their pro-European colleagues to precipitate the energy deals on Russian-imposed terms.

One major contentious issue is Gazprom’s promise to build a section of the South Stream pipeline through Serbia. The Russian side is avoiding a clear commitment to a construction schedule and gas supply volumes and is even stalling for time on submission of a feasibility study. This evasive attitude can only reinforce the growing international doubts about South Stream’s plausibility.

Nevertheless, the agreements on oil and gas are now expected to be signed in Belgrade before Christmas by a high-level Russian delegation. Moscow is throwing in some sweeteners outside the energy sector. These would, however, only lead to greater Russian economic penetration of Serbia, correspondingly influencing its political system, and raising questions about Serbia’s European integration, the goal of President Boris Tadic and parts of the body politic.

. . . .

Now, however, Moscow suddenly insists that NIS be separated from the package. It wants to sign the NIS purchase contract immediately and postpone the signing for South Stream for a few years. Officially, Moscow claims that the oil deal and the gas deal remain packaged together, but that this does not preclude separating the time-frames for implementation of each. For Serbia, however, this means no guarantee and indeed no leverage to ensure that the South Stream pipeline and storage site would be built in Serbia. Thus, the disadvantageous handover of NIS to Russia as an incentive for South Stream would have been in vain and a total net economic loss to Serbia (BETA, December 11; RTS Radio Belgrade, December 12).

Vaporware, indeed.   Serbia originally–and grudgingly–acquiesced to the sale of NIJ in return for promises regarding South Stream.   Now, Gazprom/Russia is telling Serbia those promises are no longer operative.   Beware any deal that involves asynchronous performance.   Especially if the party promising to perform later is Gazprom.   You can take their promises to the bank–and be met with stares of disbelief for having been such a sucker.

This discarding of even the pretense of proceeding with part of the South Stream project also speaks to its viability, and the effect of the ongoing financial crisis on that viability.   And if there’s not the money for South Stream–what about Nord Stream?   And if neither is an immediate prospect, what does that say about European gas supplies, and the prospects for Nabucco?   (There’s also an interesting article in EDM about Hungary’s MOL and Nabucco, but that will have to wait for another post.)

Today’s WSJ ran an extensive article on BP’s misadventures in Russia over BP-TNK.   It is titled “Misreading the Kremlin.”   Yes, truly an understatement.

This quote stands out:

“The mistake was believing that there was consensus among all the guys that make these decisions,” said one person close to BP.

Repeat that quote to yourself a few times.   Then ask yourself: who in their right mind could possibly think that there was consensus “among all the guys that make these decisions”?   Anyone who follows this at all knows–knows–that there are battling clans in Russia, and that the most prominent and the most powerful and the most adversarial center on Rosneft and Gazprom.   There is never consensus among these guys.   At best there is a truce, like that between the Five Families of the New York mafia.   Putin’s main job is to balance these factions and keep things from breaking into outright warfare.     There is an uneasy peace, and one faction is not going to do anything to help the other.   Indeed, each will try to torpedo the other whenever possible.

Anyone following Russian energy also knows that Igor Sechin is the godfather of the Rosneft clan.   So what does BP do?   It goes to Sechin–the engine of Yukos’s destruction–to talk about its plans to cooperate with Gazprom:

In April, Mr. Hayward visited Igor Sechin, a powerful Putin confidant. According to people familiar with the meeting, Mr. Hayward laid out BP’s efforts to reach a deal with Gazprom.

Un-freaking-believable.

This is a runner-up in the understatement derby:

Mr. Sechin was in an interesting position: He also serves as chairman of state oil company Rosneft, and is generally opposed to further expansion of Gazprom, especially into the oil business, say several people who’ve discussed these issues with him.

“Generally opposed to further expansion of Gazprom.”   You don’t say.

I can only imagine the derisive laughter echoing off the walls of Sechin’s office after Hayward left the room.

In other words, if this article is to be believed, BP was unaware of the most basic contours of the Russian political landscape.   It assumed that “the Kremlin” was a monolithic body at odds with the AAR oligarchs.   Certainly the oligarchs were in a tenuous position, but their very survival was–and is–almost certainly attributable to the fact that the “Kremlin” is anything but monolithic.   The balance of power between the Rosneft-Sechin and Gazprom factions would have been disrupted by ousting the oligarchs, and putting one of the factions in control of BP-TNK.   Hence, these oligarchs survived.

Given the history of Yukos, it should have been readily apparent if the powers that be wanted to destroy these oligarchs, they would have already been destroyed–and BP would not have been the beneficiary.   Their very existence should have raised questions in the mind of BP CEO Tony Hayward.   No doubt Gazprom was feeding Hayward and other BP people a line that “the Kremlin” was looking to boot the oligarchs.   But one must take any representation from Gazprom with all the grains of salt from all the mines in Siberia.   And one must also base all strategies on an understanding of the fundamental Gazprom-Rosneft rift, and an analysis of how one’s proposed moves would play into that battle.

Any strategy involving the Russian energy business must start from a recognition that   there is bitter division and intense rivalry within the Russian hierarchy, especially in anything involving energy.   Basing a strategy on an assumption of “consensus” was a blunder of the first order.   Dealing with Sechin to advance a transaction that would benefit Gazprom is an even worse blunder.

In short, this article makes Tony Hayward and the rest of BP’s upper management look like complete incompetents.   This quote pretty much sums it up:

“There’s a group of people who know what’s going on and know what to expect,” said one person close to BP. “And then there’s the London office.”

Well put.

This is not to say that there is any right way to navigate the Russian energy labyrinth.   Or, to mix classical metaphors, in attempting to do business in Russian energy one must steer between Scylla and Charybdis–a virtually impossible task.   But blundering along as if these dangers do not exist is inexcusable.