Streetwise Professor

In potentially ominous news, Gazprom has entered an agreement with Azeri national energy company SOCAR to purchase Azeri gas at a price of $350/thousand cubic meters.  Initial volumes of 500 mcm for 2010 are modest, but Gazprom is allegedly to be a preferential buyer (whatever that means) for gas from the second stage of the immense Shan Deniz field.  

The price in the deal is very interesting, given that Gazprom is balking at paying the same price from Turkmenistan (admittedly the Azeri gas is closer to market, and should receive something of a premium).  Indeed, recent reports tend to confirm my initial conclusion that the gas pipeline “explosion” in Turkemenistan was just a consequence of the Russian reneging on its contract to buy gas at $345 from the Turkmen, a price that seemed like a good deal at the time, but which looks very rich given the current market:  

Gazprom wants Ashgabat to reduce either the price or the volume of Turkmen gas delivered to Russia; or some combination of the two reductions. In either case, Turkmenistan’s national income (based almost entirely on gas exports) would be severely hit.

Russia’s prolonged stoppage puts Ashgabat under growing pressure to re-negotiate the existing agreements. High-level Russian delegations have been descending on Ashgabat almost on a weekly basis recently. During June, for example, Russian First Deputy Prime Minister and concurrently Gazprom Chairman Viktor Zubkov, Gazprom CEO Aleksei Miller, and the company’s vice-president and Gazexport Director-General Aleksandr Medvedev, held talks one after the other in Ashgabat with President Gurbanguly Berdimuhamedov and other Turkmen officials (Interfax, June 3, 14, 19, 21, 24).

Moscow apparently feels that it has the upper hand and can continue the import stoppage as long as necessary. On the occasion of Gazprom shareholders’ annual meeting, just held in Moscow, Medvedev simply recommended to “wait and see how the talks proceed” with Turkmenistan. More to the point, Miller indicated to the press that Ashgabat has no alternative option for export or swap operations until the Turkmenistan-China pipeline comes on stream (Interfax, June 26).

Ashgabat is intensifying its contacts with the European Union, European companies, and the United States in search of export diversification options for the future. Meanwhile, China provides the first alternative option at hand.

It must be particularly irksome to Turkmenistan that at the same time Gazprom is stiffing it by saying that $345 is too high a price, and that it doesn’t need all the gas it contracted for, it is running off to Azerbaijan to enter into a deal to buy additional volumes at $350.  Square that circle, dudes.  

Presumably the wily Azeri president  Ilham Aliyev is well aware of Gazprom’s practices, and is watching Gazprom’s heavy-handedness with Turkmenistan carefully.  So why would he deal with this devil?  Perhaps this is wishful thinking on my part, but what would make sense is that Aliyev is losing patience with European dithering over Nabucco.  By showing a willingness to deal with Gazprom, he is sending a shot across the bow of the EUnuchs, letting them know with actions rather than words that they need to move sooner rather than later or Nabucco is going to turn into a, well, pipe dream.  

Will the Europeans get it through their thick skulls?  I highly doubt it.  They are so divided–with Russia and Gazprom merrily promoting and exploiting those divisions–that they will be mightily pressed to get their act together soon.  If they don’t Azerbaijan may figure that it has no real alternative but Gazprom.  And what a pity that would be.  

In other gas news, as I wrote in a sarcastic piece earlier, Gazprom and Nigeria have entered a joint venture. Responding to the inflammatory choice of a name for the venture, one Nigerian said:  “White people are making too much of this. As long as the Russians pay us, they can call it what they like.”  

But that’s the rub.  “As long as the Russians pay us.”  That’s a big if, especially considering Gazprom’s cash flow problems (requiring an 85 percent dividend cut and a 50 percent cut in capex), and its hugely expensive commitments on core strategic projects North Stream and South Stream, plus its need to develop new reserves in Russia to replace its declining fields.  Where’s the money going to come from?  

Now, it seems nigh on to impossible that Gazprom can finance its commitment in the Nigaz venture along with all its other needs in these straitened times.  So “pay us” is unlikely to mean “pay us over the table to invest in the joint venture.”  But, given that it is Russia and Nigeria that we are talking about here, “pay us” could mean payments under the table–payments European and American companies would have a difficult time matching (and would certainly incur more risk to match).  These payments would be intended to keep the Nigerian gas from going to Europe.  Under the table payoffs to stymie development of gas could be much more profitable to the powers that be in Nigeria than legitimate investments to spur their development.  

Regardless of whether one takes the JV at face value–a sincere Russian effort to develop additional gas supplies–or treats it more cynically–as just another in a long line of Gazprom efforts to keep potentially competitive sources of gas offline–it should be another red flag to the Europeans.  Yet another warning that Russia is aggressively pursuing a strategy to restrict the competition it faces in the European market.  (Which is why nobody in their right mind should expect Russian help in Iran–the possessor of the 2d largest gas reserves in the world, now largely unavailable due to Iran’s oh-so-convenient pariah status.)  

Do the Europeans get it?  Do they understand the significance of the Azeri-Russian deal?  I wish I could say yes.  But although Europe yammers on about diversifying its gas sources, its actions belie its words.  Pretty soon, it won’t have any actions available to it, except to go hat in hand to Moscow.  They will have no one to blame but themselves.

Nigeria’s NNPC and Gazprom have entered into a joint venture in refining, transportation, and power in Nigeria.   The venture is to be called Nigaz.   Words fail me.   I strongly suggest a name change in the event that the venture contemplates expansion into North America.  Or in the event it doesn’t.

A couple of interesting stories about investment and Russia: one about investment in Russia, the other about Russia as an investor.

The investment in Russia story involves Putin’s invitation to Shell to participate in the Sakhalin III and IV projects.  Shell, if you recall, was browbeaten into giving up a stake in the Sakhalin II project at a bargain basement price to Gazprom.  The new offer (along with deals with German Eon and French Total) is widely considered a symptom of Russian desperation for cash as a result of the financial crisis, and its technological backwardness, combined with the desperation of the supermajors to replenish reserves.  

To me, reserves or no, it is the height of folly for Shell to rush back in.  Russia has proven time and again that it has myriad ways to separate oil majors foreign and domestic from their oil investments.  Environmental regulations, taxes, labor law, you name it.  Although some have suggested that Shell will only invest if it receives “international bank guarantees”  I don’t find this credible.  What bank would take this risk?  How could you write a contract that would specify the relevant contingencies, given the imagination of the Russians in finding ways of exerting pressure to extort wealth?

Russia may be desperate.  Today.  They were desperate in the late-90s when they entered the PSAs with Exxon and Shell and others.  They took the terms offered, then undid some of the deals when prices turned around and they felt that they didn’t need the supermajors’ money.  

Indeed, Russia used the fact that it agreed to the PSAs due to its economic exigencies to justify its subsequent attacks on Shell and others; it had been taken advantage of, Russia whined, and was taking back what had been taken from it due to its weakness.  

It is eminently predictable that it will do the same again when the market turns around at some future date. Indeed, if Shell and others rush back in now, it will reassure Putin and future Russian leaders that they pay no price for expropriation.  Steal from them today, and they’ll be back tomorrow.  

So, it appears that Shell is ready to play Charlie Brown yet again.  Good luck with that.

The other story relates to GM’s second thoughts about selling Opel to Magna, Sberbank, and Russian automaker GAZ.  GM is seeking other potential buyers, and demanding Sberbank pay 14 times more than it originally offered (perhaps reflecting a perception that the economy has firmed and the value of Opel is higher as a result).  

Another sticking point is concern about technology:

However, the Magna talks have run into difficulty over access to the Detroit group’s global technology, which Magna wants to secure on behalf of Russian partners. If the sale proceeds, Magna and Sberbank plan to build Opel-based cars in Russia with Gaz, billionaire Oleg Deripaska’s car company.

This is wise.  Property rights in Russia are weak, and this is especially the case with respect to intellectual property.  It will be very difficult for Opel and GM from keeping GAZ from circumventing any contractual protections on its IP.  

In short, whether you are thinking of investing in Russia, or having Russians invest in you . . . be VERY careful.

I’m back!  And glad to be here.  Italy was great, but it nothing beats the US in my book.  Going away for awhile helps make that very clear.

And now, back to our regularly scheduled blogging . . .  

Earlier in the year I argued (mainly with BFC) that Russia was a high beta economy, meaning that the fluctuations in Russian economic performance, and the performance of its financial markets, would be more extreme than those in the rest of the world. This original diagnosis was predicated on Russia’s extreme dependence on hydrocarbon exports, and the dependence of hydrocarbon prices on worldwide economic conditions.   One corollary of this is that Russia’s economic fate is tied to that of the broader world economy: As goes the world economy, goes the price of oil, goes Russia.

Recent news provides some confirmation of this analysis, but also suggests quite strongly that other aspects of Russia’s economic fate are unique to it—and that those don’t, don’t bode well for Russia’s near and medium term future.   (It’s long term future is pretty bleak, given its demographic difficulties.)   That said, Russia is not hopeless; its prospects depend on foreign investors failing to learn their lessons about the dangers of putting capital in Putinist Russia, and past experience suggests that these investors are capable of just that.  

The confirmation of the high beta hypothesis: the fact that Russian stock prices fell far more than world prices during the height of the crisis 4Q 2008; the recent boom in Russian stock prices, up around 140 percent off their lows, coincident with a strong but substantially smaller (around 33 percent) increase in stock prices in the US and Europe, and the rally in oil—up around 120 percent off its lows; the more recent drop in Russian equities—around 20 percent—coincident with a 5 percent or so drop in developed market prices, and a 10 percent or so drop in emerging markets, and a modest drop in oil prices; and increased pessimism about the prospects for recovery in Russia, coincident with a diminution of hopes for an imminent, and robust, world economic recovery.  

Virtually all of the economic news emanating from Russia is quite bleak.    To wit:

A stunning drop in investment spending:  

Russia’s biggest contraction in capital investment since December 1998 shows that the government’s stimulus package is “not working,” Alfa Bank said.

Last month’s 23.1 percent annual drop means “the fiscal stimulus funds are not finding their way into the real economy,” Natalia Orlova, Moscow-based chief economist at Alfa, Russia’s largest privately owned bank, wrote in a note e-mailed today.

“The general conclusion is that the state’s fiscal policy is focused on the social sphere rather than investment and that the Finance Ministry is trying to offset the decline in budget revenues with lower spending,” Orlova wrote.

The economy of the world’s biggest energy producer shrank an annual 9.8 percent in the first quarter, the most in 15 years, and may contract 8 percent this year, the government estimates. The stimulus package earmarks 2.51 billion rubles ($80 million) to battle the slump, including funding designated for the auto industry, agriculture and construction.

The budget deficit widening to 511 billion rubles through the end of May was the result of increasing transfers to regional budgets, rather than funneling money to the economy, the report said.

The source of the widening budget deficit—transfers to regional budgets—is of particular interest.   It suggests that the center feels compelled to prop up the regional governments, likely out of fear of social discontent and popular unrest.  

EDM provides further detail on the desperate straits of the regional governments, and the central government’s pulling out all the stops to keep them afloat while demanding that they in turn support employment in their regions:

Kudrin’s main headache, however, is the need to bail out an increasing number of regions that face insolvency while the income from the state budget has fallen by more than one third (Vedomosti, June 19). Putin is inspecting the regions demanding from the governors not to close the plants that cannot find any demand for their products and to pay salaries to idle workers, but that requires more transfer of funds from the federal coffers – a policy that goes directly against Kudrin’s course on reducing inflation (Kommersant, June 19).

Moreover, the decline in investment reflects a very bearish view on the economic future.   Given that Russia’s recent investment levels are quite modest compared to other emerging markets, and to the past example of the Asian Tigers, this drop in investment bodes ill for future growth.

A widespread recognition that government policy is ineffectual at best, and more likely extremely counterproductive:

Russia’s “anti-crisis” program, signed by Prime Minister Vladimir Putin on June 19, probably won’t return the country to sustained growth before 2012 and risks increasing state intervention, Capital Economics said.

“At its core there remains a fixation with micro-managing the economy, characterized by a plethora of targets, an over- reliance on state intervention and a hint of economic nationalism,” Capital’s London-based emerging-Europe economist analyst Neil Shearing wrote in a note e-mailed late yesterday.

The economy of the world’s biggest oil producer shrank an annual 9.8 percent in the first quarter, the most in 15 years, and may contract 8 percent this year, the government estimates. The stimulus package earmarks 2.51 billion rubles ($80 billion to battle the slump, including funding designated for the auto industry, agriculture and construction.

The government’s intent to “pick winners” among industries and check the growth of food prices may distort market and curb the supply of products, the Shearing said.

Carmakers are set to receive 90 billion rubles, farmers 63.1 billion rubles for agriculture and construction companies 247.2 billion rubles, according to calculations by Trust Investment Bank.

The total amount in the final draft is less than the 2.98 trillion rubles pledged by the government earlier after it reduced support for the banking industry by 500 billion rubles.  

Declining retail sales:

Russia’s economy is shrinking more than expected, sending “damaging waves” throughout the former Soviet Union, the World Bank said.

Collapsing industrial production, rising unemployment and capital flight will reduce Russia’s gross domestic product by 7.5 percent this year and restrain “intraregional trade flows and transfers,” the World Bank said in a report posted on its Web site today.

. . . .

Retail sales fell the most in almost a decade in May, sliding an annual 5.6 percent, the fourth consecutive decline and the biggest since September 1999. The average monthly wage decreased an annual 3.3 percent in May, while real disposable incomes dropped 1.3 percent.

And perhaps most ominously, the prospect that rising energy prices—themselves dependent on the extremely uncertain prospects for a global recovery, and the policy of the Fed—will not be Russia’s (or should I say Putin’s?) salvation when (or should I say if?) they come to stay:

Russia’s economic slump may deepen in the second quarter to an annual contraction of 10.9 percent because rising oil prices won’t spur growth without a recovery in lending, according to Goldman Sachs Group Inc.

“Russia’s deep output decline, in our view, is less the direct impact of lower commodity prices and more the effect of the sudden stop in capital inflows that the country suffered beginning in the third quarter of 2008,” Rory MacFarquhar, Moscow-based economist at Goldman, said in a report today.

The world’s biggest energy supplier is falling into its first recession in a decade after the global decline sapped demand for commodities while capital flows to riskier markets dried up. A stimulus package has failed to spur lending even as the central bank cut interest rates three times since April.

Capital investment in May fell an annual 23.1 percent, the biggest drop since December 1998, as industrial output declined a record 17.1 percent last month. Russian retail sales slid an annual 5.6 percent in May, the fourth consecutive decline and the biggest since September 1999.

. . . .

Lending to households and companies declined in the fourth quarter of last year by the equivalent of 5 percent of gross domestic product and fell 6 percent of GDP during the first three months of 2009 from a year earlier, according to Goldman.

Urals crude oil, Russia’s chief export earner, traded at more than $71 a barrel this month after falling to a low of $32.34 in December. The higher oil prices won’t spur growth because the profits are largely collected by the government in taxes, MacFarquhar wrote.

In previous years, the non-financial sector expanded borrowing by over 20 percent of GDP annually and Russia’s external debt grew by 30 percent every year, the report said.

The rise in oil prices will result in a stronger ruble and increase nominal GDP, leading to a budget shortfall of 6.2 percent this year, compared with an official forecast for a deficit of more than 10 percent, according to Goldman.

The collapse in capital inflows is another manifestation of the widespread pessimism about Russian economic prospects, and parallels the decline in investment.   The disparity between the dizzying growth rate in household and business lending in recent years, and the decline in 4Q 2008-1Q 2009 is particularly illuminating.

Investment is not robust anywhere, but the Russian fall is precipitous and nearly unique: notably the BIC countries have not experienced the collapse observed in Russia.   (Although lumping these countries together has never made much sense given their great differences on virtually every economically and politically relevant dimension—and including the Russian “R” to make BIC into BRIC was especially non-sensical).   This is the factor that seems on the one hand to confirm the high beta hypothesis, but which instead more likely reflects something distinctive to Russia other than its dependence on raw material exports.   Instead, it plausibly reflects the fundamental defects of the country’s natural state political and economic system.  

This is a natural implication of Putinism, as Shearing puts it: “At its core there remains a fixation with micro-managing the economy, characterized by a plethora of targets, an over- reliance on state intervention and a hint of economic nationalism.”   Add to this the Telenor fiasco, coming as it did on the top of numerous expropriations of investors both foreign and domestic; the ongoing farce of the Khodorkovsky trial, with its chilling implications for any Russian who falls afoul of the system, and its demonstration of the complete absence of an independent legal system and protection of individual rights; the trial of a different sort of being a foreign investor in Russia (cf. Ikea’s decision to suspend expansion in the country in large part due to the abuses it has suffered at the hands of Russian officialdom, petty and elevated); the WTO decision; the rows with everyone from Belarus to the US over food imports; the lack of credible commitment by the government to protect property or to adhere to contracts; the political risks epitomized by the Georgian War and its lawless, rogue aftermath (with the recent veto of the UN mission in South Ossetia and Abkhazia just the most recent example); and on and on.   Given this litany, it is no surprise that foreign investment has deserted Russia, and is unlikely to come back any time soon.

Here’s a way of summarizing this: high raw material prices are a necessary, but not sufficient condition, for Russian economic growth.   Booming resource prices in the earlier years of this decade created the possibility that Russia could be a lucrative investment market—if those investments were secure from predation.     And that proved to be a big if.   The capital outflows started before the world economic crisis—with the Georgian War, in fact, which put an exclamation point on the political risks in Russia.   The crisis, and the resulting collapse in materials prices, accelerated that decline.   The question is whether a reversal of the decline will lure foreign investors back.

There is room for doubt because there is no doubt that the government’s behavior both during the boom and the collapse made it abundantly clear that a fool is soon separated from his money in Russia—and that anyone who invests in Russia is very likely a fool.   If the high beta nature of the Russian economy doesn’t get you, the government is likely to.   Even companies and countries that assiduously courted the Putinite elite—BP and Norway come to mind—found themselves the victims of a predatory system.   (Is it a coincidence that Victor Fridman is deeply involved in both situations a coincidence?   Methinks not.)

Once burned, twice shy?   One would think so, and in the event, Russia’s future prospects would certainly be quite bleak.   For world economic prospects remain troubled, with pronouncements of the “green shoots” (gag) of an economic spring appearing decidedly premature, and Russia ill positioned to benefit from any world rebound due to its sinister reputation as a very dangerous place to invest.   For a country that experienced growth largely due to foreign investment attracted in large part by a boom in commodity prices, this is a very dangerous position to occupy.

But not all is lost for Putinism.   World economic recovery; a wildly expansive and inflationary US monetary policy; and the slashing of investment programs in oil and metals during the crisis; could lay the groundwork for another spike in commodity prices.   And past experience suggests that investors sometimes have short memories, and tend to let their wishes override the lessons of experience, and an understanding of the nature of Putinism.   Another commodity boom may induce foreign investors to throw caution—and common sense—to the wind, and invest in Russia again.  

So, in a nutshell, the positive case for Russian economic prospects: (a) another spike in commodity prices, and (b) foreign investors continuing to play Charlie Brown to Putin’s Lucy (tempting them with the financial football).   I put the probability of (a) in the 30-40 percent range in the 2010-2011 period, especially given the difficulties that the Fed will face when attempting to extricate itself from the extraordinary measures it has taken in recent years, difficulties exacerbated by the fiscal pressures emanating from Obamaism.   I put the probability of (b) somewhat lower than that—but not at zero, which is where it should be.   So, Russia should have no economic future due to the deformities of its politico-economic system, but it just might in spite of itself due to the prospects for policy errors in the US (and the West more generally), and (most importantly) to the cognitive and mnemonic deficiencies of Western investors.

Russia has decided not to enter the WTO, announcing its intentions to join the organization as part of a customs union with Kazakhstan and Belarus.   According to Stephen Blank, there is room to doubt whether the announcement was coordinated or not with the other two CIS members.   As Blank also notes, Russia was no doubt unwilling to agree to conditions—such as opening its meat and dairy sectors—and realistic in recognizing that Georgia‘s veto would make joining the organization an unlikely prospect in any event.   But Blank‘s most important conclusion echoes my reply to commentor Howard Roarke in response to the latter’s query regarding my opinion on the subject:

Naturally, such economic policies are also connected with the growing efforts of Putin’s entourage to rely exclusively on energy prices going up to extricate Russia from the current crisis, and their efforts to extend ever more state (i.e., their personal) control over ever more sectors of their own and other states’ economies. Closed markets and trade blocs generally accompany closed political systems and neo-imperial policies that can only end in conflict. Georgia may have been the first as we saw last year, but as Belarus shows, it probably will not be the last such example

Blank‘s diagnosis could have been written by the theorists of the Natural State, North, Wallis, and Weingast.   NWW emphasize the connection between closed economic systems that do not permit free entry and open competition even when they possess the simulacra of a capitalist system (e.g., corporations and some freedom to contract) on the one hand, and closed political systems that do not permit free entry and open competition in political life even though they possess the simulacra of a democratic system (e.g., elections and parties).  

The entire trajectory of Russian politics and economics post-crisis is further illustration of the Natural State character of Russia.   Some within Russia, including some elements associated with Medvedev, have expressed hopes that the crisis would spark a transformation in the economy, leading to a decreasing reliance on energy and resource rents.   These hopes have proved chimerical—as the Natural State theory would suggest.     The natural state is highly vulnerable to the destabilizing effects of economic and political competition, especially Schumpeterian “destructive competition.”   Economic competition upsets the distribution of rents—economic goodies—that holds together the coalition of factions in the Russian state.       As a result, when the state is weakened and threatened, the immediate response is to move even more aggressively to limit competition.   Sure, the crisis provides strong evidence that to benefit Russia, it needs to diversify.   But “benefitting Russia“ and “benefitting the factions in a rentier state“ are two very, very different things.  

And, truth be told, it is quite possible that an attempt to move beyond the natural state would be so destabilizing that the result would be chaos.   That‘s why I‘ve called Putinism purgatory economics.   It‘s not hell, and it’s sure not heaven.   But, attempting to leave purgatory is more likely to result in taking up residence in hell than in heaven—as centuries of Russian history, most notably the last, demonstrate.  

The WTO announcement, along with numerous other recent developments, is a manifestation of this fundamental tendency to respond to crisis by suppressing competitive forces, rather than strengthening them.   International trade erodes rents, reducing the power of some and increasing the power of others.   Upsetting the balance of rents—and hence the balance of power—is a dangerous thing in the natural state.   Moreover, WTO is rule based.   Natural states also rely heavily on the ability of a relatively unconstrained state, often embodied in a highly personalized style of rule (Blank also mentions the highly personalized Putin style) to adjudicate between rival factions in order to maintain balance.   Rules impede the ability to do this.  

The other developments include: Medvedev‘s announcements that attempts to spur innovation in the Russian economy would be focused in state corporations, rather than left to market processes; Putin‘s statement that he would create a “vertically integrated“ state-controlled body to oversee oil and gas exploration in Russia; and Putin‘s personal intervention in Pikalevo.  

And, if further illustration were needed that Russia lacks the institutional infrastructure to support a transition, today the Bailiffs’  Service announced its intention to sell Telenor‘s stake in Vimpelcom.   Add that to the Khodorkovsky trial, and the new legal travesty involving Heritage and HSBC, and you will understand that there is no check on the discretion of the state, least of all from the court system.  

The logic of the Russian state is that the prospect of negotiating a transformation from a competition-suppressing rent-based natural state to a competitive economic and political system is so daunting that it is unlikely to be attempted.   Anything that limits the flexibility of the center to shuffle around money and power is not to be tolerated.    The response will be to double down on the existing system, not to move away from it.  Indeed, all forces tend to work against the movement to an impersonal, competitive system: and will continue to do so until the pressure of crisis abates, or the system collapses.    As Wellington said of Waterloo, which alternative is realized in Russia will be a close run thing.   It could go either way.

Treasury Secretary Timothy Geithner’s trip to China drew guffaws—yes, laughter—when he tried to say with a straight face that the US was committed to a strong dollar policy.      (The Wall Street Journal tried to put a more favorable gloss on it, saying that the audience at Beijing University “tittered” at Geithner’s statement.   FT Alphaville (linked above) called it “loud laughter.”)     Guffaws are warranted.   The credibility of this statement is indeed risible, even though it is no laughing matter.   Every major policy initiative points in the exact opposite direction.  

Angela Merkel isn’t laughing.   She’s spitting mad, apparently sharing the same concern as Geithner’s China audience.   She delivered a broadside against the aggressive quantitative easing by the US Fed, the Bank of England, and (to a lesser degree) the European Central Bank.  

Even one of the authors of that policy, Ben Bernanke has suggested (in testimony before Congress) that American deficits are too large and could threaten price stability.

Commodity prices could well be the harbinger of an incipient inflation, and provide a money-where-your-mouth-is verdict on the credibility of Geithner’s pronouncement.   Fundamentals in the developed economies—the US, Europe, and Japan—remain horrid.   Yet copper has breached $5000 for the first time in months and oil neared $70 before selling off on 3 June on additional signs of fundamental weakness, a building of crude stocks of about 2 million barrels when a bigger than 1 million draw was widely forecast.  

So where is the demand coming from?   China is widely identified as the source.   Moreover, the rally in world equity markets in past weeks has been driven in part by a belief that the Chinese economy is strong and will experience decent growth for the remainder of the year.        Forecasts of 8 percent growth are widespread.

I am very skeptical about the realism of such forecasts, and similarly skeptical about the official statistics on the purported growth in Chinese manufacturing.   Here’s the reason for my skepticism.   Every major export-oriented economy is in deep trouble: Japan has experienced a double-digit decline in GDP; South Korea is sputtering; Germany is one of Europe’s weakest economies.   China is an export driven economy.   Domestic consumption accounts for only about 35 percent of Chinese GDP.   As the FT Alphaville post (by Izabella Kaminska) states: “trade has been a key engine for China’s rapid economic growth in the past few years, but a slump in global demand has caused a fall in Chinese exports since November of last year.             Exports in April fell 22.6 percent from a year earlier, compared with a fall of 17.1 percent in March and 25.7 percent in February.”   So, (a) China is a trade dominated economy, and its remarkable growth in recent years has been driven by exports; (b) its exports have declined dramatically; (c) other trade-oriented economies have experienced declines in GDP bigger than those experienced by less-export dependent economies; but (d) China is growing, or going to grow, far more than virtually any other economy in the world.   Huh?   How is that possible?   (Not to mention the other anecdotal evidence, such as the layoff of 20 million migrant workers, and the closure of numerous factories in the (former?) boom areas of coastal China.)   It all doesn’t add up.

What does make sense is that China is indeed buying commodities, but as an inflation/dollar hedge, rather than to feed a resurgent manufacturing sector.   Given its massive investments in dollar-denominated securities, dollar inflation is in fact no laughing matter to China, and it makes perfect sense to substitute out of such assets into commodities.   This makes sense not just for Chinese, but for others holding dollar-denominated assets, and the assets denominated in currencies of other countries/regions with central banks which are engaged in aggressive quantitative easing.  

I find it very hard, therefore, to credit the commodity rally to strengthening real fundamentals.   Other data support this.   The differential between nominal yields on Treasuries and yields on inflation protected Treasuries (TIPS) are widening, indicating increased inflation expectations.   But, importantly, TIPS yields themselves are not rising.   That is, real interest rates are not rising, as would be expected as the real economy strengthens.    This is important, and has gone largely unremarked.  Indeed, some advocates of quantitative easing and expansionary fiscal policies, such as Martin Wolf, actually view the decline in TIPS yields as a favorable sign.  Wolf says this means that government spending and borrowing is not crowding out private investment.  Another way of putting this is that there is little demand for private investment.  Hardly the sign of an impending recovery, that.  

Like James Hamilton, I believe that the main puzzle is why nominal yields haven’t risen  more relative to TIPS; the monetary expansion and the spurt in commodity prices both would suggest a bigger increase in inflationary expectations than the nominal-TIPS yield differential reflects.   Moribund commodity consumption (as indicated by continued high and at times rising stocks), flat-to-declining real interest rates, rising nominal rates, and spurting prices commodity prices say stagflation to me—not recovery.     And that’s not funny.  

Vlad Socor has two  pieces  on the South Stream pipeline project.  Here’s the nub of the analysis:

Despite facing gas production shortfalls (relative to internal and external supply commitments) post-2010, Russia is multiplying its supply offers to European consumer countries through South Stream and other pipeline projects. Gazprom signed bilateral agreements on building South Stream with state-controlled Italian, Bulgarian, Greek, and Serbian companies on May 15 in Sochi, with Prime Minister Vladimir Putin attending, and it is negotiating similar agreements with more countries (Interfax, May 15, 16; EDM, May 27).

As enticements, Moscow is declaring ever-larger design capacities for the putative South Stream pipeline system, rival to the European Union and the United States’ backed Nabucco and Southern Corridor projects. South Stream’s other goal is to threaten Ukraine with diverting gas transit volumes, from the Ukrainian transit system into the South Stream pipeline on the seabed of the Black Sea. The Kremlin will most likely roll back its South Stream project, if Moscow achieves its earlier goal of gaining control over the Ukrainian gas transit system.

Gazprom’s strategy reminds me of the movie The Producers; the company is promising the moon to everybody with little chance that it can deliver. The promised capacity is growing by leaps and bounds, from 30 bcm/year in 2008, to 47 bcm/year in February, to 60 bcm/year this month.    It is offering every country in the region a piece of South Stream, with new pipelines wending through southern and eastern Europe, and storage facilities here, there and everywhere.  But with nothing really to back it up.  There are no sources of gas committed to the project (unlike with Nord Stream, as dubious as those sources are).  Cost projections are ballooning along with capacity plans.  In the midst of an existential financial crisis, just where is Gazprom–which has seen its market cap plummet, its cash flows decline dramatically, and which has just slashed its dividend by 83 percent–going to get the $24 billion plus to pay for this project?  Not to mention the money required to develop the gas fields required to fill it and Nord Stream and meet anticipated growth in domestic demand.  

I’ve written before on the vaporware aspect of many Gazprom plans.  Just like software companies that announce brand new software initiatives (that never appear) in order to dissuade entry by competitors, Gazprom announces these grandiose expansion plans to deter entry, in this case, entry by Nabucco.  (Robert Amsterdam calls this “premature contractualization” but the idea is the same.)  The plans and capacities and the like are sort of Monopoly money that Gazprom throws around in an attempt to peel off enough countries to prevent Nabucco from getting the scale and traction it needs.  (Nabucco has its own problems, of course, not the least of which being where the gas for it is going to come from, and the indecisiveness of the Europeans.)  

The frantic increase in the amount of vapor being pumped out seems to suggest a certain amount of desperation on Gazprom’s part.  Nabucco has made some tentative strides of late, particularly getting Turkey more or less onside (even though it still hasn’t resolved the supply issue).  In response, Gazprom seems to be making more extravagant promises.

In other gas news which may be closely related to the South Stream saga, is this piece relating to a story I wrote a couple of posts about a few months back.  Turkmenistan is threatening to sue Russia over the gas pipeline explosion:

Turkmenistan threatened to take Russia to court over last month’s gas pipeline explosion, RIA news agency reported, escalating a dispute that has severed a vital energy link through Russia to Europe.

Turkmenistan blames Russia for blowing up the pipeline, which carries more than half of its most valuable export, by cutting the gas flows without enough warning.

“When you shut off the flows, you get what is called a vacuum-bomb effect,” Odek Odekov, head of Turkmen state geological institute Turkmengeologia, told reporters during an energy conference in Paris, RIA reported.

“The system has to be prepared for a shut-off three days in advance, and Russia did it in the course of one day,” he said.

Russia’s gas export monopoly Gazprom denies any wrongdoing and it has said it hopes to resolve the issue through talks. The company has avoided making detailed public statements on the matter.

Silence is probably advisable, under the circumstances.

As I originally opined, there is a strong case to be made that the cutoff of gas from Turkmenistan (which led to the explosion) was economically driven.  Russia had gotten what it asked for, but came to regret it.  In 2008 it agreed to buy all of Turkmenistan’s gas at what seemed to be a bargain price, but what which in the aftermath of the financial crisis turned out to be too much gas at too high a price:

Every month, Turkmenistan is therefore losing between $800 million and $1 billion per month in export revenues, said Mikhail Korchemkin, director of East European Gas Analysis. “Turkmenistan has every right to demand this money,” he said.

U.S. PUSHES FOR BYPASSING RUSSIA

Due a sharp drop in demand for gas in Europe, Russia no longer needs to buy Turkmen gas, because it can meet European demand more profitably by selling its own.

For the short term, therefore, analysts said the explosion played into Russia’s hands by halting imports from Turkmenistan.

Korchemkin estimated that Gazprom is getting an additional $330-450 million per month in net profits out of this situation, while the Russian budget is getting an extra $300-400 million in customs duties.

So there’s another  Producers parallel: when their scam failed, the hapless producers blew up the theater to avoid paying off their debts.  When its Turkmenistan scheme backfires, Gazprom blows up the pipeline to avoid paying off  its debts.  LOL.  

The cutoff of purchases from Turkmenistan helps Russia out of a short term difficulty, but creates serious longer term ones.  First, Turkmenistan has take-or-pay contracts with Russia.  Though Russia is likely to claim force majeure due to the pipeline explosion, if this matter gets to a reliable arbitrator, Gazprom may end up on the hook to pay for the gas it didn’t take.  

Second, it has made the wily Turkmen president  Kurbanguly Berdymukhamedov look for other options:

After the row with Russia, Berdymukhamedov has spoken out about the need to diversify gas exports.

Russia, keen to maintain control over the region’s gas flows, is plowing ahead with its own pipeline project in the region, South Stream

“But South Stream does not open any new markets for Turkmenistan, because Russia would remain its only consumer. Nabucco, however, opens up all of Europe,” Korchemkin said.

And Turkmen cooperation could be just what Nabucco needs to be viable.  And that, in turn, could well explain why The Producers at Gazprom have gone into high gear, promising more to every country in Eastern Europe than they can possible deliver.

This Reuters article provides confirmation that Russia’s opportunistic attempts to use OPEC to advance its own interests (opportunism analyzed in detail in several SWP points) have left the oil cartel spitting mad:

Russia is no longer a welcome guest of OPEC after boosting its production to levels far above those pumped by the group’s biggest exporter, Saudi Arabia, and snatching away market share.

After flirting with OPEC when a barrel of oil cost less than $40, Moscow has once more set its course on raising production to support an economy entering its first recession in a decade, leaving OPEC to shoulder the burden of record output cuts.

“OPEC members have cut almost 4 million barrels per day in order to subsidize the Russian oil industry and economy to the tune of about $150 million per day,” said Chris Weafer, chief strategist at UralSib investment bank.

“This is unlikely to sit well with OPEC member countries.”

. . . .  

Senior Russian government officials have attended the last few gatherings, while producers, including the largest independent oil firm LUKOIL (LKOH.MM), had signaled they might be willing to cut output.

Yet Russian oil production rose in April to 9.85 million bpd — 1.3 percent more than the 9.72 million bpd produced in February.

Saudi Arabia, the world’s top exporter, has been pumping less than 8.05 million bpd since February as it accounts for the bulk of OPEC’s cuts.

“Russia, rather than cutting exports, has now increased exports of oil products at a time when OPEC supplies are at their lowest in five years,” said Valery Nesterov, oil and gas analyst at Russian investment bank Troika Dialog.

While OPEC has cut output by about 5 million barrels per day since last July, Russia has increased the supply of oil and oil products by 6.4 percent, or 0.45 million bpd, Nesterov said.

“In other words, Russia has compensated for about 10 percent of the cuts made by OPEC.”

The Russian response?  A real howler:

Russian officials said they were not invited to this week’s OPEC meeting, but say their absence is not political.

“It has nothing to do with the rising oil prices. There are some organizational issues,” Anatoly Yankovsky, Russia’s deputy energy minister, told Reuters. Another ministry official said OPEC called Russia to its meetings as an observer during crises in global oil markets. “OPEC now considers that the situation is stable,” he said.

Yeah.  There are some organizational issues.  Like, the organization in question has had enough of Russia’s BS, and is not going to be played for chumps again by Igor Sechin.  

Now, I detest OPEC, and attempts to cut output collusively to prop up prices above the competitive level.  So, in that sense, it is a good thing that Russia cranked up output in response to OPEC cuts.  Though I know that Russia’s actions had nothing to do with any commitment to competition or any aversion to anti-competitive tactics.  

That said, I still find this dispute among thieves to be quite illuminating.  In particular, it casts a glaring light on the duplicity and opportunism that characterizes the actions of the siloviki that dominate the Russian energy business, and hence, by extension, the Russian government.  OPEC has found to its dismay (but to the joy of energy consumers) that Russian declarations of solidarity and cooperation are intended primarily to gull the credulous, and that such whispered sweet nothings are completely incredible.  Chumming for chumps.  This has implications that extend far beyond Russia’s dealings with OPEC.  In particular, it seriously undermines the case for a “realist” “reset” with Russia; what’s the point of negotiating grand bargains with such bald faced opportunists and liars?

Russia has announced that it probably won’t send a delegation to OPEC’s May 28th meeting.  Think it might have something to do with Russia’s/Sechin’s repeated Lucy-and-the-football antics in late-08 early-09?  You know, the oh-yes-we’ll cooperate with you OPEC; we support output cuts OPEC; we’re with you 100 percent OPEC BS, followed by no output cuts, and indeed by actions that resulted in Russia increasing output and exports slightly, while OPEC was making hefty cuts?  Think that maybe OPEC sent via backchannels a “If you know what’s good for you don’t show your lying faces (plural) around Vienna again” message?  It couldn’t be that, could it?  

Fool me once, shame on you.  Fool me twice shame on me.  OPEC seems to have taken that aphorism to heart.

The Telegraph has an interesting interview with Medvedev advisor Igor Yurgens.  Here are the bits that caught my eye:

“The present system shows signs of overextension,” Mr Yurgens said. “It shows signs of over centralisation and fragility  [where have I heard that before?] because it is based not on institutions  [ditto] but on the mythological vertical of power.

“The reform process stumbled halfway. We have to push very hard to restart those reforms otherwise we will not be ready to catch up with the G8. We will remain on the level of leading emerging nations.”

Yes, institutional weakness, and personalized, centralized rule create fragility that will make it lucky for Russia to “remain on the level of leading emerging nations.”  

Also an interesting article in the Moscow Times:

“April data suggests there is no reason for optimism on the state of our economy,” said economist Yevsei Gurvich, head of EEG think tank. “It creates a risk that a second phase of the downturn cannot be ruled out.”  

The Central Bank, which is under pressure to ease credit conditions, cut official interest rates twice in recent weeks and signaled more cuts despite inflation remaining in double digits. Officials have said the economic situation was stabilizing.  

“Today’s data signals very weak labor market data,” said Rasmussen. Many analysts will also be watching the next jobless data as a measure of domestic political risks, although public discontent with the anti-crisis policy remains subdued.  

The State Statistical Service did not release its monthly jobless numbers for March, publishing quarterly data instead, a move seen by some analysts as an attempt to gloss over unpleasant information.  

The service did not explain the move, and an absence of the monthly data for April will further undermine analysts’ view on stabilization of the Russian economy.  

Monday’s record fall in industrial production compared to a 13.7 percent year on year decline in March. The previous contraction record in the series’ seven-year history was set in January, when output fell by 16 percent.  

“The search for the bottom is still on. In May, we may see an even lower number,” said Trust Bank chief economist Yevgeny Nadorshin. “Problems in heavy industries, cuts in investment plans remain.”  

This article illustrates the policy dilemma facing Russia.  Attempts to spur economic activity by cutting interest rates risks fueling inflation and weakening the ruble.  No wonder Kudrin is “stressed.”