Streetwise Professor

Over the weekend I blogged about the renewed legal hostilities over Vimpelcom, Ltd, which, among other consequences, prevents the company from paying dividends.  Mikhail Fridman’s Alpha Group holds a large stake in Vimpelcom, along with Norway’s Telenor, and the Russian Anti-Monopoly Service which has moved against Vimpelcom is presumably acting as Fridman’s stalking horse. Another Alpha joint venture with a big western company-TNK-BP-is also unable to pay dividends because its board “inquorate” (a new word for me) due to the resignation of Gerhard Schroeder in December, and the to-the-knife conflict between the Russian AAR partners and BP that has precluded the naming of a replacement.  (BP claims that it can force the firm to pay dividends through an arbitration process.)

The war between the Russian owners and BP is now on the verge of going nuclear with Fridman’s resignation as CEO.

This means something big, obviously.  Just what? I have no clue.  Neither does anyone else, though numerous theories are being hawked.

Pretty much everyone agrees that this has something to do with Putin’s return to the presidency; Igor Sechin; the fallout from the failed BP-Rosneft deal; Russian energy politics; and the operations of the Russian natural state, with its balancing among oligarchical, state, and clan interests.   Just exactly how these pieces fit together is what no one quite gets.  This is Riddle, Mystery, Enigma: The Energy Edition.

A big part of this is due to the fact that no one understands what cratered the BP-Rosneft deal.  Yes, we all know that AAR’s demand that BP adhere to the TNK-BP shareholder agreement that required the British company to work exclusively through TNK-BP in Russia was the proximate cause of the termination of the Rosneft-BP transaction.  But no one knows exactly what went on.  Were Fridman and the other AAR partners defying Putin and Sechin, or acting with their tacit or explicit consent?  Or did Putin side with AAR against Sechin then, but is changing sides now?

What is certain is that this bodes ill for Russian efforts to attract investment.  What I find amusing is that much of the commentary presumes that Putin’s first priority is to implement reforms that improve the investment climate in order to build a stronger Russian economy, and wean it from its dependence on energy and raw materials generally.   He certainly pays lip service to this, but that is not his first priority.  Or even his second.  His overriding concern is maintaining control and the equilibrium between the grasping factions within the elite, and his main means of doing so is managing the distribution of rents, especially those thrown off by energy assets.

Given the virtual lack of any real formal legislative or judicial checks on his discretion, and the obvious glee with which he issues blizzards of ukases ordering this and that in the economy, I see no way for him to credibly commit to reforms that limit his discretion to intervene.  Indeed, the transition from the current state of affairs to such a rule-based would be so fraught with risk for him and the elite, that I cannot see it happening.

Putin decreed that five energy companies are “strategic” and therefore will not be privatized (h/t R).  The most important of these companies is Rosneft, to which Igor Sechin is returning as Chairman.  Putin argues that the companies are undervalued:

“We can argue that at this particular moment and in the current conditions they are undervalued,” he said in televised remarks. “We would hate to see them privatized for pennies and then sold off for big money.”

Of course, the primary reasons that Russian companies-and especially Russian energy companies-appear “undervalued” relative to comparable non-Russian firms are, inter alia, the huge political risk of operating in Russia, the lack of protection for minority shareholders, the lack of transparency, and extreme deficiencies in corporate governance.  That, and the fear if they are indeed sold off for big money later, there is the risk that the Russian government will claw them back, claiming that the poor government has been taken advantage of (especially if foreigners are the ones who profit.)

The Russia discount is, in other words, made in Russia.  And Putin’s meddling in the decisions of Russian companies contributes to that, in a big way.  It is clear that Russian companies operate subject to the whims of the power structures, and are more vulnerable to these whims than companies elsewhere-including in other emerging markets.

Putin’s remarks are therefore a sort of self-fulfilling prophecy. As illustrated by the fact that the companies became more undervalued immediately after he made them:

The moves helped push Russia’s benchmark MICEX down 3.4 percent on Wednesday, though those losses were also due to fears of the impact of Europe’s financial turmoil. RusHydro tumbled 9.4 percent on the news, FSK and MRSK also posted substantial losses on Wednesday.

On Thursday, the MICEX recovered some 1.3 percent, though shares in FSK were still 6.2 percent lower, RusHydro 4.9 percent, and MRSK 3.8 percent.

Putin wants to get first world prices but live by third world rules.  He can’t have it both ways.  If he wants to live by third world rules, in which everyone’s property is held at the sufferance of those in political power, the price will never be right.

Apropos my Russia-as-a-high-beta-economy theme, consider this Russophobic jeremiad:

Vladimir Putin faces the risk of Russia’s political stability being shaken if Greece leaves the euro area, triggering a global crisis and sinking the price of oil, according to the Center for Strategic Studies in Moscow.

There’s a more than 50 percent chance of a Greek exit, which would lead to more countries pulling out of the currency union, Mikhail Dmitriev [what a clever disguise!], the research institute’s head, said in an interview yesterday. Russia’s main risks are a worsening economy, which would swell anti-Putin sentiment, and increased political repression, according to a study published today by the institute, which advises the government.

“If these trends continue, we will see the escalation of political violence and repression on one hand, and the worst economic crisis on the other,” said Dmitriev, a deputy economy minister from 2000 to 2004. “This may lead to Putin losing control and a chaotic political transformation.”

The article goes on in a familiar vein, linking Russia’s economic fortunes to the price of oil, and the price of oil to the impending train wreck in Europe.  Nothing you haven’t read here, if you’ve been reading here.

Moreover, Dmitriev echoes another long-standing SWP theme.  Namely, that in the present political environment, a sufficiently severed adverse economic shock could threaten Putin’s brittle political system:

“The political crisis could quickly become acute if it’s aggravated by a fresh economic crisis,” it said. “This is highly likely to provoke a rapid loss of political control and an accelerated change in the political system.”

Dmitriev predicts that in the event, Putin will respond with repressive measures.   Indeed, one can see the new law imposing huge fines on demonstrators as a preparation for such an eventuality.

No, pointing out that  (a) Russia is hostage to international economic conditions, and (b) Russia’s brittle polity is in turn vulnerable to economic shocks is not Russophobic.  It is a very reasonable appraisal of reality, and many Russians viewing the situation objectively, like Mikhail Dmitriev and the Center for Strategic Studies, arrive at the same conclusion.

Russia is continuing its Fear, Uncertainty, and Doubt campaign aimed at arresting the decline in oil prices (h/t R):

Some countries favor more than ever using a military strike to stem Iran’s nuclear ambitions, Russian Deputy Foreign Minister Sergei Ryabkov said.

Talks this month in Baghdad must show progress on reaching an agreement over the Persian nation’s nuclear program to placate the international community, he said today on a flight as he returned from the Group of Eight meeting in the U.S.

“Russia is concerned that an attempt to resolve this problem with military methods is still a possibility,” Ryabkov told reporters. “We periodically get signals publicly and via private channels that certain capitals favor this option much more than they did up to this point.”

How constructive.  When interpreting any Russian statement on these issues, never forget that Russia benefits directly from turmoil in the Persian Gulf.  Anything it can do to raise concerns about the risk of conflict there also raises the price of oil-which redounds directly to Russia’s benefit.

Russia has been notably obstreperous on two foreign policy issues: American missile defense plans and Syria. In each instance, members of the leadership have threatened direct military confrontation if Russia’s will is thwarted.  Ironically, the more veiled of these threats-Medvedev’s with respect to Syria-led to a bigger blowback on Russia.

A little over two weeks ago, Chief of the General Staff of the Armed Forces of Russia and First Deputy Minister of Defense Nikolai Makarov stated that Russia might launch a preemptive attack against US antimissile systems based in Europe if “the situation worsened.” Makarov would not make such a statement unless it was approved at the highest levels-meaning Putin.

Makarov’s warning was paired with a presentation of a computer simulation in which a diabolical US system shot down a barrage of Soviet I mean Russian ICBMs headed for the US.

It is flattering, I guess, that the Russians believe that US ABM systems are so capable, or will be in less than a decade’s time.  But if they actually believe this, they are delusional.  The particular installations in Europe against which Makarov vented, and threatened to attack, are of no use whatsoever against a Russian ICBM launch against the US.  They are not on the path of outgoing land based Russian missiles (which would take a polar trajectory), of no use whatsoever against SLBMs, and are laughably few in number.  US systems based in North America are also very limited in number and coverage.

Indeed, even the Russians themselves can’t tell a consistent story. They tout the evasive capabilities of their new ICBMs and the difficulty of ABM systems in dealing with large numbers of decoys.  Rogozin the Ridiculous tweeted:

If someone tried 2 build MD system right under our noses, it’d only give’m illusion of defense. We’ll pierce that fence

The mixed messages, and the underlying unreality of the characterization of the threat, make it rather difficult to interpret exactly what Putin et al are thinking.  Any reasonable interpretation does not give comfort.  Paranoid and panicky vs. using missile defense as a pretext to attempt to cow the Europeans and split them from the US.  Or both.  Oh joy.

An even higher authority-at least de jure-uttered the other apocalyptic threat.  Dmitri Medvedev obliquely raised the threat of nuclear war in remarks on Syria:

In his comments at a conference for lawyers in St. Petersburg, Mr. Medvedev started out by ruminating on the unintended outcomes of military campaigns. That is a theme often taken up by Russian officials as a line of criticism for what they see as America’s interventionist policies in the Middle East.

“The recent, hasty military operations inside foreign states usually end with the arrival of radicals in power,” Mr. Medvedev said shortly before 1 p.m. on Thursday.

He went on to add that: “At some moment, such actions, which undermine sovereignty, can end with a full-fledged regional war, or even, and I don’t want to scare anybody, the use of nuclear weapons.”

Russia has been shrill in its defense of its client and big arms buyer, the murderous Assad regime, and was outraged at the demise of another client (and big arms customer), the Khaddafy regime.  It has made it clear that it will not abide a repeat of what transpired in Tripoli and Benghazi in Damascus and Homs.  In this context, raising the possibility of the use of nuclear weapons can only be interpreted as a threat by Medvedev (which again would not be made without Putin’s approval) to employ nuclear weapons in response to NATO/US efforts to overthrow Assad.

Is the threat credible? Unlikely, but who is taking chances? Certainly not the markets:

An unusually candid reference to nuclear war by Russia’s prime minister prompted a sell-off in the nation’s stock market this week, underscoring how nervous traders here have become about worsening relations with the West, a street protest movement in Moscow and an overall slump in emerging markets.

. . . .

The Russian Micex index, a gauge of large blue chips traded on the domestic market, fell sharply. By the market closing, the index had lost 3.5 percent and ended the day at its lowest level in seven months. Some large Russian companies tumbled even further. Sberbank, the country’s largest lender, dropped 7 percent.

Yes, there were other bearish developments, notably a drop in oil prices, but the market drop appears to large to be explained by these other developments alone.

Why the reaction? One explanation is that they highlight the political risk of investing in Russia. They emphasize the importance of geopolitical objectives to the Russian leadership, and that they are not all that interested about comity with the west.  Such a confrontational posture will almost certainly create risks for foreign investments in Russia, and the Russian economy generally.

Here is another interpretation.  Yes, the remarks did coincide with a selloff in oil.  And that may be exactly why Medvedev uttered them.  The Russian economy and the Russian fisc are highly dependent on the price of oil.  Oil prices are currently below the level necessary to balance the Russian budget, which is not a good thing given the tumult in European capital markets. Brent is now trading at about $107/bbl.  Given current spending, Russia needs a price in the $115-$120/bbl range to balance the budget, and around $150/bbl to fund Putin’s elaborate election promises.

As my friend Sergei Guriev notes, Russia’s vulnerability is acute:

“It’s very hard to overestimate how vulnerable the Russian economy is to external pressures” from the oil price, Sergei Guriev, the rector of the New Economic School in Moscow, said in a telephone interview. “That vulnerability is huge, which is why Russia must be very vigilant. The spending is a risk.”

That vulnerability is huge.  No lie. That Sergei must be another one of those damned Russophobes.

Given this huge vulnerability, perhaps it is not surprising that Medvedev rattled the nuclear saber in the midst of a sharp selloff of oil: what better way to goose the price of oil than a threat of nuclear Armageddon in the Middle East?  Under that interpretation, his remarks would betray a certain, shall we say, anxiety about the current economic situation.  Which would help explain the sharp selloff in Russian stocks, or perhaps even suggest that the selloff was underdone.

I have often noted that Russia is a high beta economy.  This reflects, primarily, its extreme dependence on raw materials generally, and energy particularly.  Economic contraction reduces the demand for, and prices of, these commodities, and this hits Russia hard.

Witness the events of recent days.  Europe is re-entering crisis mode, with Greece teetering again, and Spain-a much bigger problem-also in extremis.  China is exhibiting serious signs of weakness.  As a result, commodity prices are down, about 7 percent this month (as measured by the DJ commodity index).

And Russia is down along with commodity prices:

While most countries’ stock markets have been hammered amid Greece’s sovereign-debt woes and its possible exit from the euro, the plunge in Russian stocks—which have dropped from their 2012 highs by nearly twice as much in percentage terms as the MSCI Emerging Markets Index—has been particularly fierce.

“Such is the level of risk-phobia in the world right now, and Russia, despite the generally positive domestic backdrop and very cheap asset base, is viewed as being the most at-risk economy in the world,” said Chris Weafer, chief strategist at Troika Dialog, an investment bank in Moscow.

Moreover, capital outflows are continuing:

Activists who clashed with police before Putin’s May 7 inauguration are protesting non-stop in Moscow, using the Occupy Wall Street movement’s tactics. As the benchmark RTS equity index entered a bear market, Russia-focused equity funds recorded $251 million of outflows in the seven days to May 9, the most this year, while China lost $127 million, India $148 million and Brazil $167 million, EPFR Global data show.

Further:

Russia’s top central banker warned on Wednesday that capital flight is a “serious problem,” as newly released figures showed $42 billion has left the country in the first four months of the year.

“Capital outflow continues to be a serious problem for the Russian economy,” the central bank’s chairman, Sergei Ignatyev, told Russia’s lower house of Parliament.

The ruble is weakening too, down about 5 percent this month.

This follows a first quarter in which Russian growth exceeded expectations.  But that was also a quarter in which oil and commodity prices spiked.

One thing that complicates interpretation of these figures is that multiple things are going on. The first is the economic problems in Europe and Asia.  The second is the ongoing political uncertainty in Russia.  Both are pushing money in the same direction-out of Russia.  The difficulty is trying to determine how much of the outflow is attributable to each of these factors.  It is quite remarkable, however, that the election and the ebbing of the protest movement has quite evidently not staunched the outflow.

With respect to the outflows, Russian officialdom is whistling past the graveyard-and blowing smoke up everybody’s collective rear. Yeah, they say, we’ve had problems-but Happy Days Are Around the Corner!  The flows will reverse manana.

I howled when I read this:

Russian financial officials have assured that Russia would start seeing capital inflows in the second half of the year after the new government is formed. Prime Minister Dmitry Medvedev has submitted candidates for the cabinet to President Vladimir Putin for him to sign on the list of new ministers by the end of the month.

Yeah.  It’s all that uncertainty about the cabinet that is driving money away.

To the extent that the outflows are politically driven, rather than a manifestation of the high beta effect, the exact opposite is true.  It is the realization that the Putin Purgatory, with all its legal nihilism, is here to stay that is the problem.  Investors-including, it should be noted, many rich Russians-have seen the future, and know it won’t work.

When a strong world economy or supply shocks keep commodity and energy prices high, the high beta effect covers a multitude of sins in Russia.  When these factors reverse, things get double ugly.  There is the ugliness of the natural state, Putin’s Purgatory. That is, sadly, arguably a constant.  Then there is the ugliness that comes with a commodity price-crushing world economic contraction.

The thing to watch going forward is how these things interact.  Economic weakness resulting from the high beta effect will impact politics in Russia-and Putin will react to that in ways that will likely exacerbate Russia’s politically-grounded economic difficulties. The populism and promises of government largesse that Putin used to campaign for re-election will not be sustainable.  What will the popular backlash? How will Putin hit back?

Meaning that if the world economic situation continues to deteriorate, the brittleness of the Russian natural state will be tested.

An interesting contrast in a couple of disparate articles I came across in my morning news trawl.

Item One: Sechin opposes privatization of Transneft because “public trading of shares would complicate the firm’s debt financing.”

Item Two: NY Fed research paper shows that firms with publicly traded equity can borrow at lower rates than otherwise comparable private firms:

In a 2012 New York Fed study, Chenyang Wei and [Anna Kovner] find that interest rate spreads on publicly traded bonds issued by companies with privately traded equity are about 31 basis points higher on average than spreads on bonds issued by companies with publicly traded equity, even after controlling for risk and other factors. These differences are economically and statistically significant and they persist in the secondary market. We control for many factors associated with bond pricing, including risk, liquidity, and covenants. Although these controls account for some of the absolute pricing difference, the price wedge between public and private companies remains. Despite these pricing differences, private companies with public bonds are no more likely to go bankrupt or to be downgraded than are similar public companies.

One plausible explanation of the Kovner-Wei result is that private firms can more readily divert cash flows and/or are more difficult to monitor than public ones.

And monitoring the diversion of cash flows is almost certainly the “complication” that Sechin wants to avoid.  The NY Fed paper’s results suggest that Transneft would be able to borrow more cheaply if it also floated common equity.  But doing so would reduce the private control benefits that Sechin and his ilk reap from Transneft.  In the end, not surprisingly, the private control benefits win out.

Much has been written about Putin’s resumption of the Russian presidency. Much of it relates to economics. Much of it is silly.

This article from the FT’s Beyond Brics blog summarizes a lot of the silliness that is spun by those making the “bullish” case for a Putin return:

The bulls can put together a persuasive story: Putin 2.0 cannot run the economy as he did in his first two presidential terms in 2000-8 or as prime minister in 2008-12 because he can no longer rely on rapidly rising oil prices.

. . . .

Therefore, so the bull argument goes, Putin must pursue economic reform, including market liberalisation, privatisation, reducing red tape and fighting corruption. Otherwise Russia cannot generate the economic growth needed to transform itself into a fully-functioning modern society. Finance minister Anton Siluanov said on Monday Russia required growth of 5.6 per cent annually, (not the 3.4 per cent forecast by the government for 2012).

. . . .

So, say the bulls, Putin will change because he must. At the age of 59, he will be thinking of his legacy, and he won’t want to be remembered as the man who created a historic opportunity to modernise his country – only to waste it.

Most of that is nonsense on stilts.  Or, more accurately it is projection on stilts: it accurately summarizes what Putin should do if his objective was to create a modern Russian economy with self-sustaining growth, which is what the bulls think a “normal” country and a “normal” leader would do.

But that totally misses the way the Russian system works, and what Putinism is about.  It misses that Russia is a natural state, and that the system is structured to benefit the elites and uses control of resources to keep a balance among the elites in order to maintain political stability.  Creating a dynamic system, a modern system, would fatally undermine this equilibrium.  Moreover, in this system, corruption is a feature, not a bug.

As I noted yesterday, Putin is already signaling clearly that he will brook no opposition, and will bring down the batons on anyone with the audacity to raise his head.  This is one aspect of maintaining political control.  Maintaining control of the economic levers is another.   Putin may talk modernism, but he walks traditionalism, meaning a traditional, natural, authoritarian state where economic policy is all about distributing rents and maintaining control of economic resources in order to protect the elite and their property.

And although Putin may talk about moving beyond oil and gas, he’s not walking away from it.  To the contrary.  He is avidly pursuing energy deals with western companies (h/t R), and touting these deals to anyone who will listen.  Steve LeVine argues Putin is “good for business” but the businesses LeVine mentions are notably the big western energy companies.

Some (including LeVine, it appears) rationalize this as a means of funding and pivoting to a more modern economy.  Such beliefs are truly a triumph of hope over experience.  Sergei Guriev has written often and powerfully about this.

Further note that although Putin announced privatizations, energy was clearly off the table:

In the decrees, Putin said he wanted the government to sell its stakes in firms which do not belong to natural resources or defence sectors and are not natural monopolies. That would require a change to the state’s privatisation programme when he wanted in place by Nov. 1, he added.

This strongly suggests that Sechin has prevailed, and that what is old is new again.

Other aspects of Putin’s newly announced programs are purely aspirational, decrees to achieve wonderful economic outcomes, but with no concrete policies that could actually achieve them:

Putin ordered the government to take measures to raise capital investment to no less than 25 percent of GDP in 2015, from the current level of 20 percent, and to create 25 million high productivity jobs by 2020.

He also called for a 50 percent increase in labour productivity by 2018 and a 30 percent increase in the share of high tech products in GDP in order to lessen Russia’s dependency on natural resources.

Uhm, just how, exactly?  This is redolent of Soviet planning, with the center setting ambitious targets.  The difference being that it’s easier to do that with something like steel production, especially when you can shoot people who don’t perform, and dragoon peasants from the farms to the factories and dragoon the peasants who stay behind into feeding those who left.  Not so easy to do in a modern economy.

Putin seems to recognize this (h/t R again):

In characteristically colorful language, Putin struck back by blaming the economic difficulties on the Communists who ruled the Soviet Union until 1991. The Soviet economy was based on heavy industry and produced shoddy consumer goods.

“Yes, my dears, there’s no need to discuss this,” Putin said. “The point is that what we produced — and no need to wave your arms — no one needed. No one bought our galoshes except for Africans who had to walk on hot sand.”

That’s great that he recognizes the obvious, but it’s a long way from that to understanding how to create a system that generates 25 million high productivity jobs and increases the role of high tech in the country.  It’s further still from such an understanding to a willingness to take the measures necessary-measures that would undermine his power, his wealth, the wealth of the elite, and the stability of the political system.

And he’s all about stability.  When analyzing the actual policies he pursues, rather than the pie-in-the-sky rhetoric, you have to start from that fact, rather than projecting western political “it’s the economy stupid” attitudes onto him.  Putin understands Soviet failures, and will not repeat them.  But he also understands the mortal dangers that a rule based, competitive system would pose to him and the elites.  He will steer a middle course, a natural state course.  He will continue on, pretty much as before.

Another “bull” point (with “bull” being accurate in more ways than one) in the Beyond Brics article is that Putin will change to ensure his legacy.   I think that’s farcical for the reasons just discussed, but it is completely unrealistic for other reasons as well.  First, although it is not historically unprecedented, it is extremely rare for aging leaders to change dramatically.  Hell, it’s extremely rare for aging people period to change dramatically.  Indeed, habits and tendencies tend to become progressively more defined and rigid as one ages.   For someone as arrogant as Putin, in particular, it is delusional to think he will conclude that he has to change dramatically.  Second, change requires receiving realistic feedback.  Authoritarian systems generally, and Putin’s in particular, have disconnected most of the feedback mechanisms: elections, a free media.  The crackdown on the opposition (including today’s lovely threats to smear their livers on the sidewalk) may succeed in its object, but in so doing will short circuit another source of feedback.  The natural authoritarian tendency for leaders to surround themselves with sycophants, and for sycophants to rise to the top because sycophancy is the primary fitness trait in such regimes, further isolates the leader from reality.

Some of Putin’s other decrees are particularly idiotic:

Putin bound the government to reduce mortgage loan rates to 2.2 percent by 2018.

He also pushed for state measures to increase real wages 1.4-1.5-fold by 2018. The average lifespan in Russia must reach at least 74 year Putin said in a decree.

2.2 percent? Really? What’s he doing? Trying to create a real estate bubble? That always ends so well!

And just what state measures can increase wages 50 percent in 6 years?  Why hasn’t any other state figured out how to do that?  And how is lifespan to be increased by decree? He might as well order the tides to stop: Canute knew better than this, but pace the sycophancy point, who in Russia is going to tell him so?  And would Putin play Canute to chide the sycophants around him? Please.

No.  There will be no modernization to speak of.  Putin’s Purgatory will continue, and become more stagnant and corrupt.  The hamster wheel from hell will keep on spinning, until it falls apart or is knocked over by some shock that turns off the tap of resource rents that is essential to its operation.

Very interesting of juxtaposition of stories involving Norway and Russia (h/t R).

Story one-Norway’s Statoil and Russia’s Rosneft agree to exploration joint ventures in the Russian Arctic:

Statoil (OSE:STL, NYSE:STO) and Rosneft today signed a cooperation agreement. The companies have agreed to jointly explore offshore frontier areas of Russia and Norway and to conduct joint technical studies on two onshore Russian assets.

The agreement also envisages Rosneft’s acquisition of participating interests in selected Statoil projects.

. . . .

Under the agreement, Statoil and Rosneft will set up joint ventures, with Statoil holding 33,33% in each. The partners will jointly explore the Perseevsky licence in in the Russian part of the Central Barents Sea and three licences – the Kashevarovsky, Lisyansky and Magadan-1 – north of Sakhalin island in the Sea of Okhotsk. The four offshore licences cover an area of more than 100,000 square kilometres, equalling approximately 200 blocks on the Norwegian continental shelf.

Are the Norwegians setting themselves up to be the next victims of expropriation? A couple of things to note.

First, this an exploration deal.  Although this involves irreversible investments, the real risk of expropriation spikes when production begins.  This is particularly true inasmuch as even if the exploration identifies commercially attractive opportunities.  Rosneft would be in no position to try to freeze out Statoil after it had paid to discover the prospects because the Russian company seriously lacks the expertise to develop these resources itself: this is why it is so assiduously pursuing agreements with all the major western majors.

Second, it appears that Statoil is following the hostage model pioneered by ExxonMobil:

The cooperation agreement also provides Rosneft with an opportunity to acquire interests in selected Statoil exploration licences and assets in the North Sea as well as in the Norwegian sector of the Barents Sea.

This article, and all the others I’ve tracked down about the deal, are maddeningly short of details on this crucial aspect of the transaction.  But it is evident that the deal is structured so that Rosneft has a valuable asset at risk if it (or the Russian government) tries its old tricks.

Note to reporters: please get a clue and get more detail on this aspect of the agreement.  This is the crucial term in the agreement.

The hostage mechanism is an oft-used way of enforcing good behavior in transactions involving long-lived investments in specific assets.  Williamson wrote about this mechanism in detail in The Economic Institutions of  Capitalism and elsewhere.

The devil is truly in the details, though.  XOM is apparently confident that it can provide incentives for good behavior from the Russians, and apparently Statoil has taken XOM’s confidence to heart.  But how it works in practice remains to be seen.  Don’t underestimate the ability of the Russians to behave opportunistically.

A particular risk is that the values of the investment opportunities in Russia and in Norway (or in the US Gulf, in the XOM deal) diverge.  Let’s say that the Russian resource turns out to be extremely valuable, but the Norwegian (or Gulf) resource comes a cropper.  Then the hostage has no value, and the risk of expropriation rises dramatically.

That risk seems to be particularly acute in this context, given the extreme uncertainty about the commercial value of the different projects.  Much information will be developed over time about the value of the various resources.  Moreover, technologies will change, affecting the commercial prospects of each.  There is an appreciable risk of a divergence in hostage values.  Given the asymmetric risk of opportunism, that divergence is particularly hazardous for Statoil and Exxon.

This probably explains why all of the deals involve bundles of several exploration prospects.  This diversification reduces the risk of the loss of hostage value.  Only if all of the Norwegian prospects turn out badly do the hostages die, leaving Rosneft free to screw the Norwegians out of any attractive opportunities in Russia.  Note in this regard that the Norwegian prospects are in two different regions-the North Sea and the Barents Sea.  This increases the diversification.

Clever.  I hope it works out for them.

Hey, Tim Newman-your insights would be greatly appreciated.

To emphasize why such measures are particularly important in dealing with Russia, consider the second story, about Russia banning Norwegian salmon imports:

Russia temporarily halted chilled salmon imports from 13 Norwegian firms, the animal and plant health watchdog in Moscow said.

The ban followed repeated instances of microbe pollution, a spokesman for the regulator said on Saturday.

Norway’s food Safety Authority said on April 30 it had received advance notice of the ban, which does not include frozen salmon, and was working with the firms to resolve the “very serious” issue.

Russia is Norway’s biggest salmon market.

Shares in fish and seafood products company Russian Sea . rose 7 percent in Moscow on Saturday.

. . . .

The global salmon market is experiencing a glut, and many firms are struggling to shift their stocks.

There are no “microbes” in salmon caught in Russian nets?  Sure there aren’t.

No.  The last two sentences tell the real story.  A supply glut is weighing on prices, hurting Russian fishers.  So the Russians gin up (or would that be vodka up?) the “health and safety” issue to justify an import ban.  Lo and behold, Russian fishing companies (or at least one, anyways, but there is no reason to believe it is exceptional) realize a windfall.

I’ve written in the past about how Russia routinely manipulates health and safety concerns as a protectionist instrument. (Search the site for “swine flu” and a couple of posts will come up.) (And yes, I recognize and condemn the fact that Russia is not the only sinner in this regard.  The US also engages in various forms of legerdemain to protect US firms.)  That this continues even as Russia joins the WTO indicates that it is still not too keen on rules and agreements that constrain its ability to take from foreigners to benefit domestic interests.

So, this fish story should focus Norwegian minds on the risks that they assume when trawling for other riches in cold waters.  Maybe the hostages will keep the Russians in line.  But the point is that you need hostages in dealing with them, for reputation and contracts alone aren’t enough.  You just need to hope that your hostages don’t die before you need them.

For years Russia and Gazprom have pooh-poohed the shale gas revolution.  No longer.  Putin has raised the alarm:

Russian President-elect Vladimir Putin urged energy producers from the world’s biggest natural- gas exporter to “rise to the challenge” of a changing market as the U.S. increases output of shale gas.

U.S. shale gas production may “seriously” restructure supply and demand in the global hydrocarbons market, Putin said today in an address to the Russian lower house of parliament.

The impact of shale is being felt immediately in pricing, with customers demanding concessions on Gazprom’s oil-linked pricing mechanism.  The divergence between oil and gas prices has exploded, and now tops 52 (WTI to Henry Hub) and 60 (Brent to Henry Hub): historically, the ratio has been around 10.  Although the disparity is not nearly so large in Europe, oil-linked gas prices have diverged substantially from spot prices there as well.

In defense of the oil peg, Gazprom’s Alexander Medvedev keeps blowing the same gas:

Mr Medvedev insists that the oil link is here to stay. “[Because] the liquidity of the gas market is so low, spot pricing can’t give the right price signals, to suppliers or customers,” he says. “We want predictable prices for the consumer.”

To repeat: liquidity is endogenous, and liquidity feeds to liquidity.  A move to a market-based pricing mechanism would lead to a spiral of liquidity, just as occurred in the US following deregulation in the early-1990s.

And please, oil prices that diverge radically from gas prices are giving better price signals? Really?

Finally, since when are oil prices predictable?  Yes, historically they are less volatile than gas prices, but that’s irrelevant.  Volatility per se is neither good nor bad. Prices that don’t adjust to reflect supply and demand conditions for the particular commodity are sending bad signals. If supply and demand are volatile, or there are rigidities and bottlenecks that make it difficult to adjust output in respond to shocks, then prices have to be volatile to send the right signals.  A price that is perfectly predictable is likely sending the wrong signal at all times but on a set of measure zero.

No, if prices are volatile, than customers who don’t like the risk should have the opportunity to hedge that risk via derivatives markets.  That’s exactly what happened in the US markets.  But that would involve speculators who take on that risk, and we can’t have THAT now, can we?

The pricing mechanism is really just a means to an end, from Gazprom’s perspective, the end being high prices.  You can bet the company would jettison the link in a second if the divergence was working the other way.  But the availability of low cost supplies will undermine that end, as Putin publicly recognizes.  The biggest potential obstacle to those supplies hitting the market is environmental restrictions on tracking.  Hence the widespread suspicions that Gazprom bankrolls anti-fracking campaigns and organizations, particularly in Europe.  (Good luck with that in China!)

Gazprom is one of the world’s least efficient companies. It can survive due to a relative lack of competition.  Vigorous competition from new supplies will dramatically erode its profitability-and with that comes damage to the budget of the Russian state, not to mention the personal budgets of all those myriad officials who feed at the Gazprom trough.

The day can’t come soon enough.