Streetwise Professor

Russia Weakens Ruble Defense After Record Drop in Crude to $39.

Dec. 5 (Bloomberg) — Russia weakened its defense of the ruble for a fourth time in a month, pushing the currency near a three-year low against the dollar, as the price of the nation’s crude oil fell by a record this week to less than $40 a barrel.

The currency slid as much as 1.2 percent to 28.1344 per dollar and dropped 1 percent to 31.5971 against the central bank’s target basket of euros and dollars. “The corridor has been widened,” a Bank Rossii official who declined to be identified said in a phone interview from Moscow today.

As for those of you (ahem) who took solace in the $5 billion rise in reserves last week, this was largely a technical seasonal development driven by tax payment considerations.   The article continues:

“Given oil is already below $40 a barrel we can’t rule out more depreciation,” said Evgeny Gavrilenkov, chief economist at Troika Dialog in Moscow, Russia’s oldest investment bank. “Any further devaluation depends on oil.”

Russia is facing its worst financial crisis since the government defaulted on $40 billion of debt a decade ago, prompting a 71 percent ruble devaluation against the dollar that eroded bank deposits.

Concern about the currency’s decline spurred Russians in October to withdraw 355 billion rubles ($13 billion) from their deposits, the most in two years, according to central bank data. Foreign-currency deposits rose 11 percent.

Putin’s Pledge

“The gradual approach feeds expectations of further devaluation and prompts the population and companies to convert all extra rubles into foreign exchange,” said Tatiana Orlova, an economist in Moscow for ING Groep NV. “This policy will likely lead to further depletion of foreign exchange and gold reserves.”

Those quoted in the article predict a ruble decline of between 15 and 30 percent.

The ruble has actually declined less against the dollar than other commodity currencies, even though Russia’s main export has declined in price more than, say, Brazilian soybeans.   This suggests that a big decline is coming.   And the consensus is increasingly that Russia is throwing good money after bad by attempting to slow this process:

Russia is wasting its cash reserves by propping up the ruble as lower oil prices drive away investors from commodity-led economies, according to Brown Brothers Harriman & Co.

“The pressure on the ruble will remain and Russia shouldn’t try to resist it by depleting its reserves,” said Win Thin, a currency strategist at Brown Brothers Harriman in New York. “Oil producers are really struggling in terms of trade shock.”

The CHART OF THE DAY shows that the 16 percent slide in the ruble is yet to match the decline in the currencies of commodity exporters including Australia and Mexico, which have fallen 33 percent and 24 percent versus the dollar since July.

Urals crude, Russia’s main export blend of oil, has slumped 68 percent since July to $43 a barrel, below the $70 average needed to balance the country’s budget next year. Russia has spent $148 billion or a quarter of its international reserves since August to defend the ruble.

Of the other “commodity currencies”, the Brazilian real slid 33 percent against the dollar, the New Zealand dollar dropped 30 percent, the Chilean peso 21 percent and the South African rand fell 23 percent.

Deferring the day of reckoning will only make the ultimate consequences all the worse.

A few posts ago I suggested that the Bruce Springsteen song “Glory Days” was quite apropos to Russia.   Today, another Springsteen song seems appropriate: “I’m Goin’ Down.”     What’s goin’ down, again, is the price of oil.

As I write, Brent on ICE is down $3.30–or 7.8 percent.   Cash settled WTI on ICE is down $3.33, or 7.6 percent.

A couple of weeks back, Michel asked when the price of Urals Med would fall below $40/bbl.   Since it was selling at $41.75 yesterday, I imagine that today is the day.

So . . . any guesses as to when we hit $30?

I have been adamant in my opinion that OPEC is a weak reed for non-OPEC producers like Russia to lean on, because cartel members face a prisoners’ dilemma that can make cheating a dominant strategy.   The market’s decidedly bearish reaction to various OPEC pronouncements suggests that most people who are putting their money where their mouths are share similar views.   Reuters reports that OPEC compliance–or lack thereof–has indeed been weighing on prices:

Members of the Organization of Petroleum Exporting Countries had pledged to lower output by 1.5 million barrels per day for November in order to prop up prices, but were only 66 percent compliant with the target last month, a Reuters survey showed on Tuesday.

OPEC’s decision to wait until later this month to take more supply off the market, combined with a steep sell-off in U.S. stocks, led to a drop of more than 9 percent in U.S. crude oil futures on Monday.

Benchmark U.S. stock indexes were up more than 3 percent on Tuesday as investors hunted for bargains amid optimism that the government will bail out the U.S. auto industry.

OPEC CUTS

OPEC members remained concerned about oversupply in the world oil market and may decide to cut output further at their next meeting in Algeria on December 17.

“We are concerned about the glut … I think there is an indication that we will have another cut,” Qatar Oil Minister Abdullah al-Attiya said.

Top oil exporter Saudi Arabia has highlighted $75 a barrel as a “fair price” for oil.

Meanwhile, sources said two OPEC members, the United Arab Emirates and Kuwait, will increase oil sales to many major Asian customers, sending mixed signals about OPEC output cuts.

This is especially ominous for oil sellers because (a) compliance usually is at its peak immediately following new agreements, and (b) even in a competitive market, some producers would cut output anyways in the face of sharply lower prices, so the two-thirds compliance overstates the extent to which anybody is taking one for the team.

There were recently reports that Russia would cooperate with OPEC in an attempt to stabilize prices, although Medvedev’s comments on the subject during his love-in with that looker Hugo Chavez were decidedly mealy-mouthed:

Major price swings aren’t in the interest of either oil- producing or consuming countries, Medvedev said yesterday in a Caracas ceremony where he and Venezuela President Hugo Chavez signed energy accords. He said Russia would “coordinate fundamentally with Venezuela” and other OPEC nations, without specifying how.

“We will be coordinating, but it doesn’t mean that we’ll be colluding.”

And just what does that mean, exactly?

Ironically, through its tax policy, Russia has already effectively cut world supplies:

November oil exports fell to their lowest level since 2004 as firms cut supplies because of high export duties while output headed for its first decline in a decade.

Falling shipments have become a major concern for the government since the budget depends heavily on oil-export revenues.

Energy Ministry data showed Tuesday that Russian oil exports via pipeline monopoly Transneft stood at 3.70 million barrels per day in November, down by 12 percent from 4.21 million bpd in October. Oil companies had threatened to cut November deliveries by as much as a quarter because they said exports were loss-making with an export duty at $287 per ton ($39 per barrel). The average price for Urals blend crude was about $55 per barrel.

The decrease in exports made the government change the scheme of calculating the oil export duty, which, starting from December, will be set monthly instead of once every two months.

The December oil-export duty calculated under the new scheme was set at $192.1 per ton, almost a $100-per-ton decrease from the November level, but oil firms have said it was still too high to make exports attractive.

Viktor Vekselberg, one of the major shareholders at BP’s Russian venture, TNK-BP, said last week that the new export duty would help oil firms survive but was not enough to encourage investment.

The Energy Ministry data also showed that Russia’s oil production fell by 0.4 percent to 9.82 million bpd in November from 9.86 million bpd in the previous month.

Oil output fell throughout the first half of the year, and analysts had expected that it would recover in the second half after a number of oil companies started new fields.

That cut of 500m bbl/day is about one-third of the promised OPEC cut, and (per the Reuters numbers) about one-half of the actual cut.   So, if unwittingly, Russia has done proportionally much more than OPEC to support prices.   (OPEC output is about 34 mm bbl/day, Russian output is about 10mm bbl/day, so the Russian reduction is about 5 percent, OPEC’s 3 percent.)

But–and here’s where the irony gets even thicker–due to the shrieks of the domestic oil producers, Russia is considering a cut   in export duties, which would result in higher exports, lower world prices, higher domestic (after-duty) prices, and likely lower government revenues.   Thus, Medvedev, Putin, and others are talking out of both sides of their mouths, simultaneously promising Chavez, OPEC, that they will “coordinate” to keep world prices high, and telling domestic producers that they will ease export duties.

Ummm, sorry to break it to you guys, but it’s one or the other–either keep the export duty high to reduce exports and help prop up the world price while screwing domestic producers, or cut it to help domestic producers and undercut fast friends like Chavez and Ahmadinejad (who are the most hawkish OPEC members) while putting further downward pressure on world prices.   “Both” is not an option.

Ain’t choices grand?   Let us know when you make up your minds.

Like a spoiled child who has lost a game at his birthday party, Vladimir Putin cries: “It’s NOT FAIR!“:

Prime Minister Vladimir Putin described the effect foreign markets have on domestic share prices as “unfair” during a government meeting Monday, saying the values of the securities do not accurately reflect those of the companies themselves.

Putin also spoke out against insider trading and again blamed the West for the country’s economic difficulties, adding that those trading on domestic exchanges would be compensated for financial losses, Interfax reported.

“Decisions concerning which securities to buy or sell on Russian markets are, for the most part, made abroad,” Putin said, the news agency reported. “Moreover, the criteria by which these decisions are made have very little connection to the actual state of our economy or Russian companies.”

At the same time, he was careful to point out that the country did not want to exclude foreign investors.

“No one is preparing to limit the activities of foreign capital in the Russian stock market — we welcome foreign investors,” Putin said. “But at the same time, the task lies in properly building a large class of domestic investors as a powerful and capable financial institution of its own.”

While the lack of domestic investors is clearly a problem and shares in Russian companies trade at levels below what might be expected given their fundamentals, said James Beadle, director of Pilgrim Asset Management, the blame for their performance should be shared around.

“On the face of it, Putin is completely correct — I think a lot of the market’s reaction has had nothing to do with the Russian economy,” Beadle said. “But Russia’s situation has been, as we know, worse than most emerging markets. I put that down to the weak economic environment, the political risk and a lack of domestic investors.”

While lashing out at the West, Putin said the government remained committed to turning Moscow into an international financial center.

“In the very near future, the government will examine a comprehensive plan regarding the financial center’s creation,” he said, adding that the financial crisis would perhaps change the global economic pecking order, affording Russia greater opportunity to achieve its goal.

Vladimir Milovidov, head of the Federal Financial Markets Service, followed Putin’s comments at the meeting by elaborating on the state’s plans for compensating investors for market losses, Interfax reported.

Milovidov explained that this would be achieved through a mechanism based on the Deposit Insurance Agency, which is designed to insure individual bank deposits.

“I don’t see any clear obstacles to the creation of such a system of compensation based on the idea of the Deposit Insurance Agency,” Milovidov said, although he added that the question would require further consultation with various ministries and departments.

There was skepticism over whether such a plan could work.

“It seems a little unrealistic to me,” said Tom Mundy, an analyst at Renaissance Capital. “Maybe it would be better to think about how Russia can restructure its financial institutions.”

While saying there was some truth to the charges Putin made, Mundy also said not all of the blame for weak domestic markets should be placed elsewhere.

“Russia’s financial institution did break down. The banks didn’t lend,” he said. “[The crisis] is an inherited problem, and I can understand why the market is frustrated. But it does not mean that Russia is completely blameless.

“There is a little bit of blame to be passed overseas, and there is some internal blame as well with these oligarchs who had [overleveraged their companies],” said Ronald Smith, chief strategist at Alfa Bank. “There’s blame all the way around.”

In line with Putin’s comments, the Presidium approved a strategic development project for Russia’s financial markets through 2020, Milovidov reported. He added that the Presidium also approved a draft law designed to combat insider trading.

Mundy said the Kremlin’s focus on a global financial center pointed to a healthy desire for economic integration and that, in the end, the crisis might actually help push along Russia’s economic development.

“‘The next stage in Russia’s development is probably creating more transparency,” he said.

I especially like the part about insider trading.   I’m sure no silovik ever does that.

The prattle about Russia as a financial center is simply delusional.   No secure property rights, no credible policy commitments, no rule of law, corporate raiding, expropriation of foreign investors–yeah, that’s the foundation for a world financial center.   You betcha!

And what’s the deal about compensating those trading on domestic exchanges for their losses?   That’s the ticket, give investors a put paid for with government money.   No better way to encourage wild risk taking–private gains, socialized losses.   The proposal also smacks of a scheme to tunnel state assets and direct them to the pockets of political favorites.   We are repeatedly told that individual investors don’t play the Russian stock market–that it is the playground of a limited set of connected players, the oligarchs prominent among them.   So this seems like just another bailout.

Tom Mundy gets a nomination for the Understatement of the Year Award:

“It seems a little unrealistic to me,” said Tom Mundy, an analyst at Renaissance Capital. “Maybe it would be better to think about how Russia can restructure its financial institutions.”

Ya think?

Last week I linked to a Reuters story (one of many from a variety of news sources) that stated that Russia was backing away from liberalization of the power market.   (That’s the market for electricity, not the market for political power, which will remain illiberal for the foreseeable future;-)

Not so fast, says Vladimir Putin:

Prime Minister Vladimir Putin pledged Friday not to slow the development of the power industry, responding to concerns from Germany’s E.On, Russian news agencies reported Friday.

“All the plans that we set out for this sector, we will fulfill. We will not cut them back,” Putin said, RIA-Novosti reported.

On Friday, Putin received E.On’s chief executive, Wulf Bernotat, at the presidential residence in Novo-Ogaryovo. Bernotat was reported as saying the planned liberalization of the power market was a key factor in E.On’s $6 billion acquisition of power producer OGK-4 this year.

Since the acquisition, the global financial crisis has knocked Russian share price indexes down by some 70 percent, and many industries have begun to lobby against the full liberalization of electricity prices by 2011, which power firms like OGK-4 are counting on to make a profit.

“As far as we are being assured, nothing has changed,” Bernotat said, Interfax reported. “It is important to us to know that all obligations will be fulfilled. … It is important for us to have political support,” he was quoted as saying.

“We are conducting fruitful negotiations with [Deputy Prime Minster] Igor Sechin and [Energy Minister] Sergei Shmatko on this issue, but it is important for us to have political support,” Bernotat said.

This echoes Shmatko’s statement from last week:

The pace of the move toward market rates for electricity will not be slowed, Energy Minister Sergei Shmatko said Friday, dispelling fears that the liberalization might be delayed.

The Market Council, a state-controlled watchdog for the electricity sector, said Wednesday that the idea of slowing deregulation of power prices was being discussed.

“We have been getting a great number of requests from various sectors asking to freeze the tariff,” Shmatko said on the sidelines of a meeting with power industry executives devoted to preparations for the winter heating season. “But we suggest sticking to the decisions that have already been made.”

Under the liberalization plan, half of Russia’s electricity production is to be traded at market rates from July 1, 2009, while prices for the other half are to be set by the Federal Tariffs Service. Only 25 percent of the electricity trade is currently deregulated.

A delay “would affect the investment climate and investors’ activity in the sector,” Shmatko said, calling it “a very bad signal to the market.”

He also said for the first time that Russian power consumption had slowed and that there was a special team at the ministry to “react swiftly” to problems in the power sector.

“We know there will be problems between the wholesale and retail companies, between Gazprom and the generators … problems with payment delays,” Shmatko said. He added that companies shouldn’t bother asking the ministry for the help, including the financial support.

So what’s going on?   Who knows?   And that’s exactly the problem.   The fact that E.On felt compelled to genuflect to Putin personally tells you all you need to know about Russia’s politico-economic system.   Namely, that it is a personalized system of rule in which crucial decisions are the result of negotiations (and who knows what else) centering on Putin, the Godfather.

Investment and growth are crucially dependent on the existence of credible policy commitments.     Investors who have no confidence that the returns to their capital are secure from expropriation or radical policy shifts will not sink their wealth into immobile, specific assets–like power plants.   A stable political system that has mechanisms to make policy commitments credible is essential to providing investors with such assurances.   It is virtually impossible to make credible commitments in a highly personalized political system like Russia’s.   Especially since that system is extremely corrupt, lacking in a rule of law, and suffused with violence and the potential for violence.

So, perhaps Putin made the right decision–today.   And regardless of the correctness of the decision, the process is far more problematic.   With such a process, in which CEOs of major companies must seek personal assurances from the nation’s prime minister, there is no assurance that today’s decision will survive until tomorrow.   And given the uncertainty which is inherent in a personalized system lacking the institutional mechanisms to make policy commitments credible, investors will be very wary about investing in Russia.

Today’s oil market, that is.   January Brent on ICE down 11.4 percent to $47.53/bbl.   January WTI on NYMEX down a mere 9.5 percent to $48.28/bbl.   And our favorite, Urals Med, down to $43.79/bbl in European trading.

The oil market continues its death ride strapped to the equity market.   This is historically unusual.   From 1985-2008, on average a 1 percent move in the SP500 was associated with a 0–yes zero–percent move in WTI.   That is, there is historically zero correlation between WTI and the SP.     In the summer of 2008, the correlation was negative–when the oil market went up, the stock market went down.   During this period, a 1 percent increase in the price of WTI was associated with about a .8 percent decline in the S&P.   This is consistent with supply shocks being the main driver of oil prices during that period.   An adverse supply shock raises oil prices and constrains economic activity, leading to lower stock prices.

What a difference a few months makes.   During October and November, oil and stock prices have been moving in the same direction, in a virtually unprecedented way.   A one percent change in the price of oil during these months is associated with a .85 percent change in the S&P   in the same direction, i.e., a one percent drop in the price of oil is associated with a .85 percent decline in the S&P.

In the past 20 years, the largest value of this coefficient is .4.   So, in the past two decades oil and stocks have never been even close to as highly correlated as they are now.

This all means that demand is now in the driver’s seat.   A decline in the S&P reflects bearish prospects for the economy.   Bad economy–low demand for oil–low oil price.

Today’s oil price bloodbath sure speaks volumes about the market’s assessment of the credibility of OPEC General Secretary al-Badri, who said today:

OPEC is ready to cut production by a significant amount when it meets later this month in Algeria, prompted by high oil inventories, the group’s secretary-general said on Monday.

“We are all geared toward a cut in Algeria,” Abdullah al-Badri told a news conference in Tehran, two days after the Organization of the Petroleum Exporting Countries decided at a meeting in Cairo to delay a decision on a new supply reduction.

Tell us another one, Abdullah!

Today’s plunge also speaks to those in Russia, and those bullish on Russia, who are counting on OPEC to ride to Russia’s rescue.   Don’t count on it, in other words.   To believe such is to grasp at straws in the tempest.

The market’s scoffing at al-Badri’s whistling-past-the-graveyard bravado reflects a clear-eyed appraisal of the realities facing OPEC.   As I’ve noted on SWP before, cartels in general, and OPEC in particular, face serious problems from cheating.   It is collectively rational to cut output to raise prices, but individually rational for each individual member country to produce more than its quota. This prisoner’s dilemma undermines cartel discipline, and means that cross-my-heart-hope-to-die promises to cut output are worthless.

Due to the sharp contraction in oil demand (as manifest in the decline in prices and the rapid growth of inventories), most OPEC countries are operating well below capacity.   This cushion would only increase were they to cut output in response to OPEC agreement.   They therefore have the ability and incentive to increase output beyond their quotas.   And believe me, they will.

This bodes ill indeed for Russia’s recovery.   The only somewhat gloomy World Bank report on the Russian economy, which predicted a slowdown in growth to 3 percent was predicated on an oil price of $74.45/bbl for 2009.   That is looking increasingly unlikely, meaning that the 3 percent growth number is similarly unlikely.

The first reliable indicators of damage to Russia’s real economy are also becoming available.   Manufacturing activity has declined more than in–wait for it–1998:

Russian manufacturing shrank more in November than during the 1998 financial collapse as the global economic crisis drove output and new orders to record lows and companies cut jobs, VTB Bank Europe said.

VTB’s Purchasing Managers’ Index fell for a fourth month to 39.8, its lowest level, from 46.4 in October, the bank said in an e-mailed statement today. The previous low was 43.2 in September 1998, a month after the government’s ruble devaluation and default on $40 billion of debt. A figure above 50 means growth, below 50 a contraction. The bank surveyed 300 purchasing executives.

“The sense of doom and gloom was only deepening,” in November, Tatiana Orlova an economist in Moscow at ING Group NV said by telephone. “The mood isn’t getting any better.”

Industrial production has slumped and unemployment is rising as declining commodities prices and the seizure of credit markets prompt an outflow of capital. Investors withdrew $190 billion from the country since August, BNP Paribas SA estimates, as oil fell below the $70-a-barrel average needed to balance the 2009 budget.

“Driving the rapid contraction of the manufacturing sector in November was a record fall in incoming new work,” the bank said in the statement. New export contracts tumbled because of “fallout from the global financial crisis.”

(Not that things are rosy in the US.   Here manufacturing dropped by the largest amount in 26 years–that is, since the Reagan-Volker recession.)

But nonetheless, the Russia Central Bank continues its insane policy of supporting the ruble, thereby accelerating the erosion in its currency reserves:

Dec. 2 (Bloomberg) — Russia’s central bank probably doubled spending of foreign reserves to defend the ruble from its biggest weekly plunge against the euro in more than four years, according to the median of 10 analyst estimates.

Bank Rossii may have sold $5.75 billion of foreign currency last week, based on the average of predictions ranging between $2 billion and $6.5 billion. That’s likely to contribute to a decline of about $6.25 billion in Russia’s overall cash pool, compared with $3.6 billion in the previous week, the survey by Bloomberg shows.

Russia lifted interest rates twice last month and drained $148 billion from the world’s third-largest reserves since August to stem a 16 percent currency slide against the dollar. BNP Paribas SA estimates that investors withdrew $190 billion since August as oil prices below the $70-a-barrel average needed to balance the 2009 budget triggered Russia’s worst financial crisis since the government’s default a decade ago.

“The central bank is willing to use reserves daily to make sure the ruble falls at their pace,” said Elina Ribakova, chief economist in Moscow at Citigroup Inc., which forecasts a 15 percent fall in the ruble next year. “I expect continued declines in reserves until the end of the year and into the next.”

Bank Rossii buys and sells foreign currency to keep the ruble within a trading band against a basket comprised 55 percent of dollars and rest in euros. Policy makers widened the band three times last month as the ruble lost 3 percent versus the basket.

The Russian currency weakened 2.3 percent against the euro last week, its biggest plunge since August 2004. It traded near the weakest in 2 1/2 years against the dollar yesterday.

Currency Gains

The government may have deepened the reduction of its reserves from $449.9 billion last week by transferring cash to state lender Vnesheconombank, said Tatiana Orlova, an economist in Moscow at ING Groep NV.

A $1.8 billion loan to Evraz Group SA, Russia’s second- largest steelmaker, may also appear in the reserves data for last week, said Katya Malofeeva, an analyst in Moscow at Renaissance Capital.

An acceleration of purchases of rubles from the reserve combined with the fact that the ruble continued to fall last week suggests that a speculative attack against the currency is gaining speed.   And Russia is getting what for this, exactly?   Letting the ruble go to find an equilibrium level consistent with the dramatically weakening fundamentals (i.e., a plummeting oil price) would ease the drain on the reserves, and would also help the country’s increasingly desperate manufacturing sector.   But it would represent a very public repudiation of the Putin’s main economic argument.   So, expect speculators to make money at Russian expense, and for most Russians to see exactly bupkus from the summer’s oil windfall.   Easy come, easy go.

So, to tie everything together.   The price of oil is a hostage of the financial crisis in the West, with the linkage between the oil price and stock prices tighter than ever.   Russia’s economy is hostage to the price of oil, with the linkage again arguably tighter than ever.   With no end in sight to the West’s economic travails, this means that economic growth in Russia in 2009–even 1 percent–is likely a pipe dream, and that an economic contraction is far more likely.

The only question is what will be the broader fallout of a sharp decline in the ruble (inevitable, sooner or later) and a recession in Russia, against the background of unrealistic expectations stoked by a government controlled media.   Will Russians behave in the stereotypical, fatalistic fashion, and accept yet another disappointment with resignation?   Or will this spark another of Russia’s paroxysms of political chaos?   The latter is not a certainty, but it cannot be ruled out.   And the more severe the contraction becomes, the more likely that outcome.

I haven’t written anything on Russia lately, being absorbed (obsessed?) with all things clearing, so I need to do something to stir up the natives in SWP-land;-)

There has been little concrete news to write about.   The odd constitutional amendment Kabuki dance continues, but there’s little more to say about it.     The Russian central bank has loosened the ruble band a bit further, but is evidently still defending the ruble–effectively giving speculators a free put that will pay off when the bank cries uncle, as it inevitably must.   This is a foolish economic policy dictated by political considerations; if rapidly deteriorating fundamentals justify a drop in the ruble, let it drop rather than throw away (I cleaned that up) hard won reserves in an ultimately futile defense of an overvalued currency.   The only conceivable reason for engaging in this policy is that Putin has staked his reputation on the ruble and avoiding another 1998-esque collapse, and that relatedly, a rapid drop would give the lie to Putin’s and Medvedev’s public expressions of confidence.   Timothy Post and Da Russophile are sanguine that the Russian people will not turn on the government out of anger over the economic situation, but its actions suggest that Putin and Medvedev are not quite so confident.

Speaking of deteriorating fundamentals, oil sold off sharply today after a nice rally yesterday.   Urals Med was quoted at $45.86 in European trading today.   Brent has sold off some since that price was quoted, so the current price of Urals is probably south of that number.   $45.86 ain’t $40, but it’s a long way from where the price needs to be to stabilize the Russian economy.

The most interesting news is this Reuters report that the government has decided to “delay” electricity pricing reform.   A long article in the Moscow Times last week suggested that such a move was in the offing.   Russia had spun off its electricity generators from state monopoly UES, but prices are still regulated at very low levels that make it completely uneconomical to make desperately needed investments.   The next step of the restructuring plan would have raised these prices to allow grid operators to earn a rate of return sufficient to attract new capital.   Allowing generators to sell at higher prices was essential to attracting desperately needed investment in new capacity.

The suspension of the pricing reform will likely be viewed as the government reneging on a commitment.   This will make it even more difficult to attact the massive amounts of capital necessary to improve Russia’s decrepit power grid.   (Though it should be noted that the financial crisis itself, and the problems in the real economy that will result from it, would undermine the investment case without the government’s piling on.   But the reputational effect of changing the rules will exacerbate the difficulties in attracting capital, and will have effects well after the financial crisis abates.)

The decision making process was typically opaque, but it appears that major industrial interests, especially the big energy and mining companies pressured the government to keep prices low in order to support their suddenly struggling operations.     This will further discourage investors, not just in electricity, but in all sectors, as it provides additional evidence (as if any was needed) that political calculations, rather than economics, drive key policy decisions.   (And, in a pre-emptive exercise of “whataboutism,”   I concur completely that this is going on the US and Europe too.   Any bailout of the auto companies would be similarly egregious.)

The whole affair also shines a light on Russia’s vast investment needs.   Electricity, roads, rails, health care, to name just the largest, are all in need of massive investments.   The politicized capital allocation mechanism was not directing the oil windfall to where it was needed when energy prices were high, and now tens, and perhaps hundreds, of billions prudently accumulated when oil prices were high are being frittered away bailing out oligarchs to keep the stock they have pledged in collateral out of the hands of western banks, and propping up an overvalued ruble.   This will have deleterious effects on Russia’s long term growth prospects.

Due to the closed nature of Russian governance, the silovikis‘ hands are invisible, but that’s not what Adam Smith had in mind.   The hidden hand of the siloviki distorts the allocation of capital and discourages badly needed investment.   Russia will not make the transition beyond Nigeria with snow and missiles until their malign influence is eliminated.

An interesting article in the Moscow Times states that ConocoPhillips and ExxonMobil are negotiating with Gazprom to help the latter in the Yamal LNG project.   I know what you are thinking–Time to short CP and Exxon!   Are they out of their minds?   Investing in Russia with Gazprom?   Don’t they remember Sakhalin II?   BP-TNK?   Yukos?

But read a little bit deeper, and take a look at an accompanying article,   and it makes a little more sense.   Gazprom chairman Alexander Medvedev said: “Recently, we had a meeting with top managers of Conoco and outlined potential areas of cooperation. One of these areas [involves] the Arctic, both in the United States and Russia. … They are very similar.”   The accompanying article states:

Gazprom said it might explore offshore Alaska with ConocoPhillips as the gas exporter seeks to expand its global reach.

CEO Alexei Miller and his counterpart from ConocoPhillips, Jim Mulva, held talks Monday in Moscow, Gazprom said in a statement.

Gazprom, which supplies one-quarter of Europe’s gas, is seeking access to new markets in North America, and a delegation visited Alaska last month. Miller and Mulva on Monday discussed joint projects on international markets, focusing on liquefied natural gas supplies, the statement said.

“The experience of Gazprom could be beneficial in developing gas projects in the U.S.,” Miller said in the statement.

Miller said in June that Gazprom had approached ConocoPhillips and BP on joining their Denali pipeline project, aimed at delivering Alaskan gas to the continental United States. Gazprom sent eight executives, including Miller, to Anchorage in October, where they met with ConocoPhillips representatives.

My interpretation of all this is that it involves a Williamsonian exchange of hostages.   Yes, maybe US majors will invest in Russia, but at the same time Gazprom will invest in the US.   If Russia expropriates the western firms, they will have a hostage that they can seize in return.

The critical thing will be to craft the agreement and contracts so that Gazprom’s investment can truly be seized if Russia/Gazprom attempts to steal the western firms’ investment in Russia.   Russia has already shown great creativity in finding ways to expropriate assets–even from its own.   Yukos–taxes.   Uralkali (perhaps)–safety investigation.   Mechel (perhaps)–antitrust.   Sakhalin II–environmental violations.   BP-TNK–immigration issues, license revocations.   It will be a challenge to write an agreement that defines expropriation sufficiently broadly so as to encompass all the various schemes that the Russian government–and the country’s pliant courts–could use   to effectively expropriate western investments in Yamal, or make the transaction so unpalatable that the western majors are forced into selling their stake at a distressed price.   (Perhaps one clever thing to do would be to preclude any Russian firm from buying the stake in the future.)   Even then, there is the challenge of dealing with the asymmetry between Russian and western courts.   Gazprom would almost certainly get a fairer hearing in any western jurisdiction than any western firm would get in Russia.

Perhaps no deal will get done.   But the I’ll-invest-in-yours-if-you-invest-in-mine approach is quite revealing.   It indicates that Putin’s and Gazprom’s past actions have affected the thinking of western firms.     They understand the nature of the expropriation risk, and are dealing with it by going medeival: that is, by exchanging hostages the way knights and dukes and kings did in the days of yore.

The discussions are revealing in another way.   They represent a dramatic turn away from Gazprom’s go it alone bravado of 2007 and earlier in 2008.   Their tune then: Western investors?   We don’t need no stinkin’ western investors.     Their tune now: come on over!   We could use the help.   This is indicative of (a) the effects of the financial crisis on Gazprom’s ability to finance these huge projects, and likely (b) Gazprom’s recognition of its technical capability to complete these challenging projects and its desperate need for new gas supplies to offset its declining production and large delivery commitments.

It’s amazing how rapidly things can change.   But CP and XOM and BP should recognize that things can change right backagain.   Therefore, I suggest that they craft their hostage agreements very, very, carefully.

A couple of blogs have posts that make points familiar to SWP readers.   One is at Cicero’s Songs.   He also argues that the economic crisis raises the specter of internecine warfare and civil unrest in Russia. (Since Cicero describes himself as “an economic liberal”–as am I, in the British/European, rather than American sense of the word–this confluence of opinions on Russia probably reflects a similarity in worldviews.   A worldview that differs notably from DR, for instance–hence our almost perfectly negatively correlated opinions on virtually every issue;-)   Except for ethanol, perhaps.)

Although I agree with Cicero’s bigger points, I have a few quibbles.   Putin didn’t consciously elect for Russia to suffer the resource curse–it was endowed with it.   That said, Putin et al have done everything to exacerbate, and nothing to palliate, all of the pernicious effects of this curse.   They revel in it.     Also, the “85% of GDP relies on the extraction of raw materials” figure is clearly wrong.   I think Cicero means that 85 percent of export earnings are derived from natural resources.

Another SWP-approved post is this one from Political Betting.   Author Balakirev argues that economic reality is slowly dawning on the folks in power.   That is likely, although there are still behaviors that suggest that denial has not been banished altogether.   Now the question (implicit in the previous post) is: when will everybody else in Russia figure this out?

A very nice and spirited interchange going on in the comments.     This article in the Telegraph speaks to many of the issues under discussion.

Regarding the apparent nonchalance of the Russian populace to the ongoing crisis, the Telegraphs says:

Subjected to more than a century of propaganda masquerading as news, Russians often seem to live in a different reality from the rest of us.

And sure enough, at a time when their country is locked in its worst financial crisis in a decade, they are more optimistic about the economy than they have ever been. According to opinion polls, 57 per cent reckon it is flourishing, up from 53 per cent in July.

The survey’s findings are a triumph for the state, proving that the Kremlin has not lost its touch when it comes to manipulating fact. Obeying orders from the top, Russian television has banned the use of words such as “crisis”, “decline” and “devaluation”. Coverage of the mayhem in the country’s stock market, where shares have fallen by 75 per cent since August, is scant.

Instead, just as in Soviet times, Russians are told how bad everything is in the West. The US, Russians are told, is in irreversible decline, while desperate Britons are throwing themselves into the Thames. The Queen, facing imminent penury, has been forced to pawn her diamonds and, according to one tabloid front page, we can no longer afford to bury our dead.

It has fallen to Russia, one television commentator gravely intoned, to come to the rescue of Europe. Russia, another newspaper declared, was set to become the continent’s lender of last resort.

Objectively, there is no possible basis for increased economic optimism, either here in the US, or in Europe, or in Russia.   One may not think that things (and the future) are as bad as I or others have postulated, but it is utterly delusional to think that the Russian economy is doing better now than in July.   Utterly.     As the article says (echoing things I’ve written before–eliciting Timothy’s dissent), this is a testament to the government’s information/propaganda strategy.   It also says something about Russians.   But it is consistent with Timothy’s assertion that most Russians are blithely unconcerned with the financial situation.

That’s where we part company.   I can believe that lulled by a steady drumbeat of nationalist crowing and economic propaganda, they are unconcerned now, but this is not sustainable indefinitely, as propaganda can hide economic reality for only so long.   If things do not improve, or especially if they worsen, (the most likely outcomes in the coming months), the government’s “who you gonna believe, Vlad or your lyin’ eyes?” strategy will fail.   Cognitive dissonance can only be pushed so far.     That’s why (contra Timothy) I consider this to be a very high risk strategy.   If it doesn’t work, the backlash will be intense.

Russians have often been described as possessing two natures–usually inert and passive and supportive of authority, but capable of wild, violent, and anarchic outbursts when disillusioned with that authority.   They are in the inert/passive/supportive phase now.   But will they stay there when the realization dawns that however battered the US is, Russia has suffered far more damage?   I doubt it.

The article also discusses the machinations over the Constitution and the presidency.   In WWMD (“What Would   Machiavelli Do”) (hundreds of posts ago!   whoda thunk?)   I postulated that Putin would find some way to hang onto the formal powers of the presidency.   I was wrong–then.   My post-mortem was that Putin figured that he could maintain sufficient control from the White House that he did not need to take the draconian step of changing the Constitution.   This would have, among other things, cost Putin and Russia diplomatically.

But that decision was made when things were breaking Putin’s–and Russia’s–way.   Commodity prices were high and going higher.   The government was swimming in money, and the perceived leverage derived from its energy resources at a time when the world was panicking about energy supplies.     Those conditions reduced the strains on the country’s political equilibrium.   There were a lot of rents to distribute to keep everybody happy.   This reduced the necessity of taking the potentially controversial step of modifying the supposedly sacrosanct Constitution.

The worm, as they say, has turned.   The energy rents are a thing of the past–and only a hope for the future.   As the article notes (echoing SWP):

The Kremlin has always been heavily factionalised, with rival groups competing for control of Russia’s lucrative energy and metals companies. As Russia’s economy boomed after 1999, Mr Putin was able to maintain a veneer of unity between these factions, many of which acquired their fortunes during the carve-up of state assets in the 1990s, and protected them ruthlessly. But with oil and commodity prices plunging, there are no longer enough spoils to go round.

Russia’s biggest businessmen owe Western banks more than $500 billion, borrowed using stock as collateral. The fall in share prices has triggered a wave of margin calls, prompting many banks to call in their loans. The state has promised $50 billion to rescue the oligarchs as part of a $200 billion bail-out – but not all will be saved.

For Mr Putin, the crisis provides plenty of opportunities that he could take advantage of. Assets that were privatised in the 1990s will again come under the control of the Kremlin and can be palmed out to his closest allies. The oligarchs who are allowed to survive will be bound to him even more closely.

At the same time, the risk of internecine warfare among these powerful individuals is high and could destabilise Russia. There was a whiff of the potential danger last year, when contract killings rose dramatically amid uncertainty over Mr Putin’s future.

Dmitry Oreshkin makes similar points in Monday’s Moscow Times.

Under these circumstances, the diumvirate is a far chancier proposition than it was before.   What’s more, Putin and Mededev pretty much shot their international   image and cred with their excellent Georgian/Ossetian adventure, and Western governments are distracted by other issues, so the diplomatic cost of Constitutional legendermain that magically returns Putin to the presidency is far lower than it would have been in late-2007 or early-2008.

Of course, maybe I’m wrong, and this isn’t a maneuver to return Putin to the presidency sooner rather than later.   If I am, I will have a good deal of company–as virtually nobody other than Kremlin puppets believes otherwise.     At the very least, it is giving Putin an option.   If things continue to go pear shaped, he can swoop in and “save the country.”   If problems ease–well, Medvedev can keep the chair warm for a little while longer.

One thing in the article that caught my eye, and which I found not completely credible, is this:

There is compelling evidence that the crisis has started affecting ordinary people. The middle class has shrunk from 25 per cent of the population to 18 per cent in the past few months alone.

This is a dramatic figure (a greater than 25 percent decline in the “middle class”).   So dramatic that I take it with a grain of salt.   It would be interesting to know the basis for this figure.

In sum, I agree with this article’s assessment (and Oreshkin’s and others’) that there is a substantial risk (not a certainty) of serious political and civil turmoil in Russia as the full effects of the financial crisis set in.   Political machinations and propaganda can buy time, but they can’t change economic realities.   The higher the expectations–and the polling evidence from the article suggests that the expectations have actually become rosier–the greater the disillusionment and anger that will result when those expectations and hopes are dashed.   The delicate political balance in the country, and the prominence of those comfortable with the use of violence, and expert in its use make it vulnerable to large shocks.   And the ongoing world financial crisis, and its dire implications for the prices of natural resources and the economic health of a country acutely dependent on such resources is a very large shock indeed.

For these reasons, the poll evidence cited in the article actually leads me to increase my estimate of the probability of a political crisis and civil unrest.