Streetwise Professor

This piece by Andrei Tsygankov presents a persuasive appraisal of Russia’s long term “strategy,” such as it is:

The global economic crisis has prompted some observers to speculate that  Russia  has little choice but to abandon its international assertiveness in favor of re-engaging the West and diversifying its energy-dependent economy.  

The Russian leadership, however, has shown little inclination to principally revise its international strategy and its petro component. The Kremlin assumes that the alternative to its energy-based strategy is a decline relative to existing and rising powers, which will lead to the degeneration of Russia into a geographically truncated, under-populated and resource-depleted  nation that accepts political demands from others.  

. . . .

The government understands that the only way out of its progressive power differential situation is to fully exploit the comparative advantage of Russia’s energy reserves. Already in 1997, while working for the governor of St Petersburg, Vladimir Putin wrote in his doctoral thesis about the critical importance ofoil  and  gas  to preserve Russia’s great power status within the next 50 years. The Kremlin believes that building up the capacity to shape global energy markets is not a luxury, but a necessity.  

. . . .

The idea is to develop a capacity to shape world markets first and only then to become serious about diversifying its economy. Russia needs to attract sufficient investments for its energy projects. Then it wants to develop energy fields and build the northern and southern pipelines that are scheduled to become operational in 2011 and 2014, respectively. Only after generating sufficient resources for a great power recovery will the government diversify the economy. The intention has been to diversify by 2020 – perhaps too optimistic, even by pre-crisis standards.  

This strategy is about as realistic as planning to win at poker by filling inside straights–repeatedly.  It relies on things breaking just right.  It puts Russia’s fate in the hands of the most volatile, fickle, and tempestuous markets–the markets for energy.  It (as the article notes) depends upon assistance from nations and companies that Russia has stiffed or expropriated.  It is hostage to technological change–innovations that reduce the demand for energy undercut the strategy.  It is vulnerable to policy and regulatory changes, most notably climate change legislation designed to reduce dramatically energy consumption.  

In other words: Good luck with that.

Several thoughts come to mind.

First, such a strategy represents a damning–no, an extremely damning–assessment of Russia’s prospects by its own political leadership.  Anytime anybody out there wants to accuse me of Russophobia–hey, I’ve got nothing on Putin et al.  They are evidently so despairing of Russia’s ability to compete demographically, technologically, militarily, or economically in any area other than energy that they are essentially giving up in these areas without a fight, and wagering everything on everything breaking their way in energy.  

Second, this strategy has one, and only one, objective in mind–derzhavnost.  It is aimed solely at restoring the Glory Days, at making Russia a “great power” yet again.  It reminds me of nothing so much as Terry Malloy (Marlon Brado) in On the Waterfront: “You don’t understand! I coulda had class. I coulda been a contender. I coulda been somebody instead of a bum, which is what I am.”  There is evidently no thought of using Russia’s energy bounty to fund a modern economy or a civil society; of addressing its pressing demographic and health problems; of restoring its once formidable but now decrepit education system; or even of building some decent roads.  In other words: Russians don’t matter, but Russia does–as a state.  This attitude has a long legacy in Russia; sadly, it is a legacy of pain and poverty, and an attitude that is a failure even on its own terms, because Russia has never been an enduring great power.  The episodes of Russian importance on the world stage have been short lived, and ended  each and every time in chaos and destruction.  

Third, the centrality of energy to Russian geopolitical strategy means that attempts to make distinctions between “commercial” and “political” motivations behind the actions of state firms such as Gazprom are futile.  Commercial and geostrategic motivations are so intertwined that dichotomies between them are fallacious and misleading.  So, when anybody tries to argue that the dispute between Ukraine and Gazprom is purely commercial in nature, just a hard nosed confrontation over price, don’t believe them.  Sure, money matters, but in large part because money can be used to fund dreams of empire.  Moreover, when the geopolitical prize is large enough, Russia/Gazprom are willing to leave money on the table to advance its political objectives.  

In brief, this is a strategy of desperation of a clique of megalomaniacs.  They have 18th century ambitions, and intend to achieve them using mid-20th century (at best) economic tools.  It’s like watching a train wreck.  Worse–the latest in a long line of train wrecks.

I’ve said it before, and I’ll say it again.  Putin and the siloviki are the 21st century equivalents of the Bourbons.  They have learned nothing, and they have forgotten nothing.  If (pace Marx) history repeats itself first as tragedy, and then as farce–how does it repeat itself the fifth time?

“When their lips are moving,” I can hear you say.   But really, that’s not what I was going to say.

What I was going to say is–“When they blame their troubles on nefarious Amerikanski plots.”

The “they”, of course, being the Russian powers that be.   Aleksandr Medvedev of Gazprom has ominously   suggested that the Ukrainians are acting under American orders in the ongoing gas standoff.   For “evidence” he pointed to an anodyne US-Ukraine Charter on Strategic Partnership in which the parties stated:

Recognizing the importance of a well functioning energy sector, the parties intend to work closely together on rehabilitating and modernizing the capacity of Ukraine’s gas transit infrastructure and diversify and secure Ukraine’s sources of nuclear fuel making Ukraine less dependent on foreign sources of nuclear fuel and nuclear fuel storage.

Following the Roadmap of Priorities for U.S.-Ukraine Cooperation, the United States and Ukraine intend to launch the work of the Bilateral Energy Security Working Group. Consistent with the U.S.-EU Summit Declaration of June 10, 2008, the United States and Ukraine intend to enhance a trilateral dialogue with the European Union on enhanced energy security.

Wow.   You can really see how suspicious this is.

Medvedev also said something about how (I’m quoting from memory) “we don’t know all that’s in the agreement.”   Now, on the matter of secret protocols, of course I defer to the expertise of the political descendents of the signatories to the Molotov-Ribbentrop pact, but I mean, really.   This is just typical State Department fluff, sound and no fury signifying less than nothing.

But the fact that Russia/Gazprom are apparently so desperate to feel compelled to play the VAC (“Vast American Conspiracy”) card says a whole helluva lot.

It also undermines, in my mind anyways, any credibility that Gazprom has in this dispute.   The facts in this affair are extremely difficult to get, let alone interpret, and it is clear that the Ukrainians and their crazed domestic politics bear more than a little blame for what has transpired, and which is still transpiring.   But Gazprom/Russia is hardly an angel here.   Both sides have been ruthlessly opportunistic.   But Gazprom has tried hard to convince the world that it is being reasonable.   When it says silly things like the blame lies on the Potomoc rather than the Dneiper or the Moskva, though, it makes it pretty clear that all the reasonableness is just an act.

So, in a way, Medvedev has done the world a favor by letting the mask slip to reveal the sovok face underneath.

* Or should that be “eminentoes”?   Paging Dan Quayle!

The Russo-Ukrainian Winter War continues apace.   Professional and personal time demands preclude an extended original response at this time, so I’ll resort to the gambit employed by baseball broadcasters during rain delays–reruns of past games;-)

Here’s a warning about Gazprom I penned (or would that be “pixeled”) in June, 2006.   This was originally published in World Energy Magazine:

Just Say No–To Gazprom

Churchill famously said that Russia “is a riddle, wrapped in a mystery, inside an enigma.” There is nothing mysterious, however, about recent Russian policy to leverage its primary strategic asset—energy—to regain its status as a world power even as it faces an existential demographic crisis.

The Russian state’s vehicle in this endeavor is the monopoly gas provider Gazprom. Like ripples from a stone thrown in a pond, Gazprom’s influence is spreading from Russia, first to the “near abroad”—Ukraine, Armenia, Georgia, Belarus—next to the old Warsaw Pact countries, now to western Europe, and eventually, perhaps, to the US. Through murky deals and the specter of economic blackmail, the company has obtained control of pipelines in Belarus and Armenia. Georgia is under intense pressure to sell its gas trunkline. With German assistance, Gazprom is in the process of increasing Polish energy vulnerability by building a Baltic pipeline that will allow Russia to sell gas to Western Europe while cutting off Poland, thereby resurrecting unpleasant memories of past Russo-German collaboration at Polish expense.

Gazprom is now obtaining positions in gas distribution networks in Western Europe. It mooted the possibility of buying the British gas distributor Centrica, which set off a controversy in the UK over the wisdom of such a transaction. Recently other Europeans have echoed these concerns. Gazprom and the Russian government have responded acidly to European criticism, calling the Europeans hypocritical in insisting that Russia open its upstream energy market to foreign investment while considering limitations on Gazprom investment in the European midstream.

Europe would be well advised to evaluate Gazprom moves with intense skepticism, and to dismiss charges of hypocrisy. Appreciable control over the midstream would enhance Gazprom’s market power in the European market which it could use to impede or foreclose development of alternative supply sources, thereby allowing Gazprom to charge supracompetitive prices, especially as North Sea gas reserves decline. Insofar as hypocrisy is concerned, not all investment is created equal. Upstream investment in Russia does not raise the same serious competitive concerns as Gazprom ownership of significant slices of the European distribution network and control of most major pipeline routes from producing regions in Russia and Central Asia to consuming markets in Europe.

This advice goes double given the geopolitical ramifications of Gazprom. No less an authority than Russian President Vladimir Putin laid out in his (perhaps partially plagiarized) PhD thesis a strategy to utilize vertically integrated state owned energy companies to restore Russia to its former power and influence. In this regard, it is useful to remember the oft-omitted second part of Churchill’s aphorism, namely that the key to understanding Russia is “Russian national [read state] interest.”

Europe should therefore resist encroachment of Gazprom into the intra-European gas transportation network, encourage and finance development of pipelines from gas producing regions that are outside of Gazprom control, and proceed full speed with development of LNG infrastructure.

Lest this be considered a jeremiad against Russians, nothing could be further from the truth. The interests of the Russian state and the Russian people have been antithetical for centuries, virtually without pause. Although Gazprom’s meteoric rise has enriched a few in Russia, and empowered and emboldened the state, this does not bode well for Russians at large. Petrostates are largely immune from pressures to liberalize their economies and facilitate the development of private property rights and civil society. Pace GM, what is good for Gazprom is not good for Russia.

And the Russian strategy of putting all their strategic eggs in the energy basket is very risky too. Energy prices are high now, and the Russian economy is riding high with them. But energy prices go down too, and a poorly diversified Russia just recovering from a virtual economic collapse in the 1990s (exacerbated by low oil prices) is in no position to thrive given even a moderate correction in energy prices.

So as the G8 Summit in St. Petersburg approaches, Europe, Japan, and the US would be well advised to push their host hard on liberalizing the Russian energy market and to resist pressures to extend Gazprom’s reach to the Atlantic.

I think this stands up pretty well, even if I do say so myself;-)

Of course, the Europeans have done nothing that I (and many others) recommended.   They fiddled while Rome froze, as it were.   As in most things that are important, they demonstrated that EU solidarity is a farce, as each nation cut its own self-serving deal with Gazprom, and eminentos* such as Schroeder and Berlusconi played monkey to Putin’s organ grinder.   (Whenever I see photos of the ludicrously grinning Schroeder next to Putin I can’t get the organ grinder image out of my mind.) If “Europe” (as an entity) wants to be taken seriously, perhaps Europeans should take vital things seriously, rather than merely being supercilious posers.

My warnings of the dangers of Russia’s dependence on energy, its vulnerability to energy price declines, and the corrosive effect of energy dependence on its civil society have also been borne out.

Just call me Cassandra;-)

In today’s WSJ, Gary Kasparov opines that Russia as an incentive to sow chaos in the Middle East in order to pump up oil prices.   He emphasizes that relying on Russia to take a constructive role in constraining Iran’s nuclear program is particularly foolish.  I advanced the same hypotheses about a year ago here:

Moreover, it should be noted that uncertainty and the potential for supply disruption can drive energy prices higher. This undermines Russia’s interest in promoting stability in major energy producing regions, such as the Gulf, Nigeria, or South America. Indeed, it may provide an incentive to sow instability in these regions. As a result, there is a reasonable basis for suspicion over the motives behind its policies regarding Iran, as well as other energy producing nations.

To say the least, Russia’s acute dependence on energy, and its desperate need for higher energy prices makes it very tempting for Putin to stir the pot in the Middle East, rather than try to help resolve problems there.

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.