Streetwise Professor

A few quickies on Russia.

It appears that BP-TNK will soon lose its license to the Kovykta gas project. No surprise. It also goes to show that, as I wrote on April Fool’s Day, dancing to Vlad’s tune won’t save you if you have something he really wants. Hopefully, other western energy companies will finally answer the clue phone and realize that playing go along to get along in Russia is futile. Lord Browne bent over backwards to appease Russia, and it did him and his company no good whatsoever. Going forward, these companies will have to develop a new legal structure to protect their investments in Russia. This will require an exchange of hostages, and a mechanism for adjudicating disputes that is not dependent on Russian courts. But most importantly, they have to learn to Just Say No and walk away if Russia doesn’t want to play by these rules.

I know the arguments–you gotta go where the resources are. But what’s the point of making investments in those resources unless you can protect them against expropriation once you’ve sunk billions into the ground (literally)?

Speaking of BP, one of my sources tells me that in years past, the company worked against the Transcaspian pipeline to protect other gas deals in the region from competition from lower priced gas from Turkmenistan. Turkmenbashi wanted to proceed, but BP (and Turkey) worked against him. When they had a change of heart, Turkmenbashi told them to pound sand. Further evidence of how the divided (and time varying) interests and agendas of western energy companies advance Russian interests and ultimately undercut their own.

And speaking of the Transcaspian, commenter James notes that Iran is likely to veto this project. Yes, James, the Transcaspian is a geopolitical minefield, and there are many obstacles and pitfalls. I didn’t mean to suggest in my original post that getting a deal done would be a diplomatic cakewalk–to the contrary. The very complexity means that getting a deal will be an arduous and complex task–and that the US and Europe don’t seem to be doing the heavy lifting required to get it done.

Money does make the world go round, though. The spread between the price that Gazprom pays Turkmenistan and the price they charge the Europeans represents a valuable rent that can be distributed to attract the necessary support for the venture.

Two major obstacles the US and Europe face in getting things to go their way are moral scruples and legal constraints on how–and to whom–that rent is distributed. According to this article in This is London, Gazprom has employed massive bribes to advance its interests:

Key to this triumph has been Alisher Usmanov and his Gazprominvest Holdings. This [Gazprom] subsidiary is the channel for massive slush funds. In November 2004, for example, a payment of £44million to Gulnara, the daughter of President Karimov of Uzbekistan, secured that country’s gas contracts for Gazprom from under the noses of the US.

In return for the cash, Putin instructed Karimov to kick out a US military base that dominated Central Asia, and Gazprom secured the strategic kingpin to dominate the Central Asian and Caucasus gas reserves.

To reiterate, the struggle will not be an easy one, but it is vital, and requires more assiduous–and creative–efforts than the US and Europe have undertaken heretofore. And the short-sighted actions of some companies–as in the BP example discussed above–don’t help one bit.

In this vein, James also points out that Chevron will benefit from the deal to ship Kazakh oil via Russia. Given the state of play, this is no doubt the rational thing for Chevron to do, but this is just another example of the negative contracting externalities that undermine American and European interests in the region. Friday I wrote about Whinston’s Lectures on Antitrust, and noted that I can think of few practical examples of his models of vertical restrictions (which are driven by contracting externalities) in a commercial context. However, some of these models describe Russian actions in energy to a “T.” Specifically, Whinston discusses models that show that bilateral contracts can have externalities, and can be used as part of a “divide and conquer” strategy. That is exactly what Russia is doing in the energy field; by offering relatively attractive deals to selected parties early on, they reduce the bargaining power of other customers later in the game.

Contracting externalities can best be eliminated by a coordinated, cooperative strategy among customers. It is just this coordinated approach that is lacking in energy. German, French, and Italian firms (often with the enthusiastic support of their governments) have been the worst offenders so far.

These companies and nations would do well to remember what Ben Franklin said at the signing of the Declaration of Independence: “We must, indeed, all hang together or, most assuredly, we shall all hang separately. ” Europe is going to the gallows one at a time; hopefully they will come to their senses soon before they all swing on Gazprom’s rope. After all, isn’t it things like this for which a European Union is truly useful? But no, Brussels bureaucrats seem to be too involved in enforcing politically correct speech and standardizing sausage ingredients to be bothered with such trivialities.

Oh, and one last thing. Make sure you read these two Edward Lucas posts.

While reading Vladimir Socor’s dispiriting account of Putin’s successes in Turkmenistan and Kazakhstan, I came across this:

During the summit, Putin underscored with satisfaction that Russian companies will receive production-sharing agreements (PSAs) in Turkmenistan. This seems ironic as the Kremlin is now refusing to sign PSAs with Western energy companies in Russia and is tearing up existing PSAs.

Ironic, indeed. Ironic doesn’t quite do justice to this. Chutzpah doesn’t even do it justice. In their attempts to justify expropriations (e.g., Sakhalin II), the Russians whine that production sharing agreements were foisted upon a desperate and helpless Russia; that they were an example of western economic imperialism; that they are fundamentally unfair and unjust.

But when the shoe is on the other foot, the Russians do their best Emily Litella imitation. “Never Mind.” Or maybe they just agree with Emerson that a foolish consistency is the hobgoblin of little minds. Or maybe they are truly consistent in their belief that PSAs are an unfair, imperialistic instrument that the strong use to exploit the weak, but it just so happens in this case that the Russians are strong, and are not in the least bit troubled by moral qualms in exploiting that strength.

Apropos my remarks last night, this is the kind of thing that should give the US and an EU some leverage in the region. If the Russia-Turkmenistan PSAs are truly tilted in favor of the Russians, there should be an opportunity to trump their offer with a more favorable arrangement. How ’bout it, folks?

Not long ago (April Fool’s Day, in fact) I wrote that “the most important thing” that could be done vis-a-vis Russian energy imperialism is to court aggressively the Transcaspian states, especially Turkmenistan and Kazakhstan. These states could be the Russian Achilles Heel, as Gazprom is acutely dependent on cheap gas from these countries. A Transcaspian pipeline would provide a competitive alternative for gas from east of the Caspian, resulting in an increase in prices for the producers, lower prices for consumers–and much slimmer margins for Gazprom.

Apparently the US and the EU don’t take this seriously enough. Last week Putin waltzed into Kazakhstan and Turkmenistan, and secured deals to move gas out of these countries via Russia on a to-be-built pipeline on the east side of the Caspian. Kazakhstan and Russia also approached a deal on transporting Kazakh oil via Russia, although Kazakh president Nazarbayev is apparently driving a hard bargain.

While Putin spent a week in the area, the US and EU apparently can’t be bothered to send high-powered delegations to Kazakhstan and Turkmenistan. My sources in the region tell me that US and EU diplomacy has been ineffectual, not to say incompetent. Specifically, the US and EU have merely announced their support for a Transcaspian pipeline without adequately consulting the Turkmen and Kazakh governments, and without a serious effort to woo them to support the endeavor. This has given the Russians an opening that Putin has exploited brilliantly. While the Americans and Europeans engage in long distance happy talk, they are not doing the face-to-face horse trading (almost literally–Putin left Kazakhstan with a beautiful stallion) needed to do business in that part of the world.

Not to say that it is easy. The governments in the region are authoritarian and corrupt. Moreover, Russia is next door, while the US and Europe are far, far way; like I said many months ago, Turkmenistan is so close to Russia, so far from God. These governments fear color (color revolutions, that is)–as does Russia; Turkmenistan and Kazakhstan fear that US/EU support will be tied to demands for reform, demands that the Russians will never make. Moreover, Kazakhstan has a large Russian population. It is surely paying close attention to how Russian nationalists are making trouble in Estonia. Indeed, I would not be surprised to learn that the FSB is stirring up the Nashiniks in Estonia in part to send a message to other countries with a large Russian population.

It is one thing to lose when the odds are against you. It is something else altogether not to get in the game at all. The Russians have some strategic advantages in this region, but we certainly have some arrows in our quiver as well, but we are not even forcing Putin to break a sweat. The matter should be particularly pressing for the Europeans, but they can’t seem to get their energy act together.

The Transcaspian is still the most important theater of energy geopolitics. Putin has recently gained some major victories in that theater, but the game is not over–if we decide to play. So jock it up, folks. If you can’t, one has to wonder why we have a State Department in the first place.

Back in January I was reading North, Wallis and Weingast’s “The Natural State: The Political Economy of Non-Development” and came across a passage that captured modern Russia to a T:

A natural state is a specific way of structuring political and economic systems so that the economic rents created by limited entry are available to secure credible commitments among politically powerful groups. Potential rivals in a natural state stop fighting (or fight less when the economic rents they enjoy depend on continued existence of the sate and of social order. Natural states limit economic entry to create rents and then use those rents to credibly commit powerful groups to support the state. In other words, natural states use the economic system as a tool to solidify the stability of the ruling coalition.

Natural states create property rights to the exclusive use of land, labor and other valuable resources, as well as rights to perform valuable economic functions, such as trade. These rights are only available to members of the dominant coalition. Limiting access to rights increases economic rents . . . . The rents bind particular constituent groups to the ruler because they have something to lose if the ruler is replaced. Creating a wide range of rents allows the ruler to create a support constituency potentially capable of both maintaining power and supporting the wealth associated with specialization and exchange. . . .

The natural state is natural because it is based on personal exchange: privileges are granted to specific gbroups and differ across groups. These exchanges are enforced by the same type of mechanisms used in the primitive order, namely, face to face repeat play mechanisms. Moreover, economic exchange is also based on personal exchange mechanisms: the natural state cannot sustain impersonal exchange associated with open access orders. . . .

[T]he state is self-limiting in that it cannot honor rights to individuals outside of the narrow set of constituents. . . .

[T]he natural state is self-limiting with respect to the economy. . . . The natrual state’s systematic “market intervention:” is not the result of mis-guided policymaking, but fundamental to how [it creates] political order and stability. Natural states therefore cannot support competitive markets based on open entry. This logic also implies that natural states view markets as instruments of political control, not sources of citizen welfare.

North, Wallis and Weingast do not discuss post-Soviet Russia in particular, but their natural state is an apt characterization of it. A recent article by Celeste Wallander in the Spring 2007 Washington Quarterly does not mention North et al, but presents an analysis of post-Soviet Russia that mirrors their argument almost exactly:

Patrimonial authoritarianism is a political system based on holding power in order to create, access, and distribute rents. It is well known that Russia is deeply corrupt, but corruption in the Russian system of patrimonial authoritarianism is not merely a feature of the system; it is essential to the very functioning of political power. The political system is based on the political control of economic resources in order to enrich those within patron-client clans. The patron remains in power by rewarding clients, and the clients are rewarded by supporting their patron. The patron requires support from his clients, and he must access and distribute rents for that support. Without the creation and control of rents, political power disappears. At the top of the political system, Putin manages relations among competing patron-client clans headed by top government and business figures, such as Development and Trade Minister German Gref, Deputy Prime Minister and Gazprom chairman Dmitry Medvedev, Gazprom president Alexei Miller, and Igor Sechin, deputy head of the presidential administration and chairman of Rosneft. Each of these individuals in turn has his own set of clients, who are in turn patrons of their own clans, and so on, creating a complex web of relationships that sustain political power and distribute patronage rents.

Obviously, patrimonial authoritarianism is wholly inconsistent with transparency, rule of law, and political competition. The true purpose of the political system is not to mediate among citizens, businesses, or interest groups but to manage and control them so that they do not impinge on the ability of the patron-client clans to use their political power to generate, access, and distribute rents. Patrimonial authoritarianism requires a nontransparent, nonaccountable, nonpermeable, vertical, and centralized political system.

Wallander calls this system Patrimonialism, and asserts that it is “Transimperial,” in contrast to “neoimperial” and “postimperial” alternatives. Interestingly, Wallander does not cite Pipes’s analysis of Patrimonial Russia, although there are some strong similarities between the historical Russian patrimonial state Pipes analyzes in his Russia Under the Old Regime and Property and Freedom and the new patrimonial state that Wallender describes.

One source of concern: natural/patrimonial states are extremely brittle. They rely on a balance between contenting forces in a rent seeking battle. When a shock upsets the balance of forces, or when one faction deems that it has a preponderance of power and therefore should get a greater share of the rents, a battle can break out–and it can become very brutal. Indeed, since natural/patrimonial states have underdeveloped institutional means for settling and mitigating conflict, breakdowns in cooperation can lead to open warfare. The threat of violence in the event of a breakdown in the system is what sustains the cooperation. It is a political system sustained by MAD. But (analogous to mutually destructive price wars in a cartel) cooperation can break down, and when it does–look out.

If you need a mental model of what can happen in this kind of system, think of Chicago, Capone, Moran, and the St. Valentine’s Massacre. One shudders at the prospect of that happening in Russia, but it is not an idle fear. This fear is the driving force behind attempts to find a way to keep Putin in command, de facto if not de jure. But this course holds its own perils. There are no doubt those who think that it should be their turn post-2008, and may resort to resistance (carried out mafia style, no doubt) if the Putin regime is extended by hook or by crook.

The current uncertainty over the post-Putin transition will put incredible strain on the Russian natural/patrimonial state. This uncertainty will only increase in the coming weeks. And with it comes the prospect for an explosion. Not that it will happen, but it is a serious possibility.

The singlemost important thing the west can do to liberate itself from its increasing dependence on Russian energy is to support the development of alternative transportation routes that circumvent the current Russian stranglehold on the shipment of gas from Central Asia to Europe. The singlemost important component of that strategy is a Transcaspian gas pipeline. This will free gas from Turkmenistan, Kazakhstan, and Uzbekistan to flow to Europe without transiting Russia.

This will provide direct competition for Gazprom. Recall that Gazprom essentially uses Turkmenistan as its gas piggy bank. It pays the Turkmens peanuts and sells the gas to the western Europeans at far higher prices. Gazprom (and the Russian state) pocket the difference. Moreover, access to Central Asian gas makes it easier for Gazprom to meet its contractual commitments without making additional investments in new reserves in Russia. It is now widely recognized that Russia’s domestic production is stagnating, and with growing domestic demand it would have difficulty meeting its commitments unless it could exploit Central Asian reserves at bargain prices–bargain prices because Gazprom provides the only way for this gas to reach the market. Create an alternative route, and the cheap gas would disappear. Without its piggybank, Gazprom is in a world of hurt.

Fortunately, it seems that the US, some states in the Caucasus, and some Europeans recognize this and are looking for ways to achieve this objective. Unfortunately, this article also argues that some Europeans–round up the usual suspects, that is, the French and the Germans–want to deal bilaterally with Russia and don’t support these multilateral efforts. Talk about selling the rope, sheesh. This is the one strategy that poses a serious threat to Russian hopes to retain massive energy market power. Get with the program boys and girls. You can grasp the nettle now, or suffer much greater pain later.

The very fact that this strategy strikes at their vitals will ensure that the Russians will do everything to thwart it. Their pressure on Georgia is part of these efforts. The sweet-talking of the Hungarians and Bulgarians to create a pipeline that would undercut the Nabucco pipeline (a key link in the chain from Central Asia to the Caucasus to Europe) is another. One can expect that the intensity–and dirtiness–of Russian efforts will only increase if these efforts to circumvent them appear to have a prospect for success.

However, Russian squealing and dirty play should only spur the Turkmens, the Azeris, the Georgians, the Europeans, and the Americans to even greater efforts, because squealing and retaliation would indicate that the circumvention strategy is having the desired effect. I am skeptical, however, that the Europeans have the stones to do what is necessary. (One need only to observe its pusillanimous response to Iran’s hostage taking provocation to understand that Old Europe is very old, tired, impotent and cowardly indeed.) Hence, perhaps again the US–this time in conjunction with former Soviet Republics–will have to save the Europeans from themselves. Not that we can expect any thanks (and indeed expect the opposite), but hey, we’re used to that by now.

BP (via its joint venture TNK-BP) has become the latest big oil company to play the monkey to Vladimir Putin’s organ grinder. The license of TNK-BP in Kovykta hangs by a thread; under the license, it is obligated to produce a volume of gas that Gazprom refuses to transport, so the company cannot produce what is required. This gives the Russian government the pretext to revoke the license.

But Vlad the Organgrinder needs a performance. In particular, he needs somebody to pretend to bid on Yukos assets (specifically, a stake in Rosneft) so that a sham auction for these assets meets the formal requirements of Russian law. Not bid with the intent or slightest expectation of winning, mind you. Indeed, to bid with the understanding that the outcome is pre-ordained, and that Rosneft would walk away with the stake at a bargain price.

So Vlad cranks the organ, and TNK-BP obligingly does a little dance, doffing its cap in mimicry of someone bidding at a real auction, and then scurries away when Rosneft shows up.

TNK-BP abases itself so in the hope that Vlad will let it keep a piece of Kovykta. Perhaps he will—for today. But don’t count on tomorrow—unless perhaps Vlad needs another performance.

Despite this latest episode in an ongoing saga of state expropriation of energy assets, western oil companies desperate to find new reserves are still anxious to do business in Russia. Samuel Johnson described second marriages as a triumph of hope over experience; the willingness of BP, and Chevron, and Conoco Phillips, etc. to continue to pursue Russian projects takes that to an entirely new level. The triumph of insanity over experience, perhaps.

This raises the question of whether there is any mechanism that can secure the property rights of foreign investors in Russia (or other resource rich/governance weak polities), especially investors in “strategic” sectors such as energy. History provides a potential model, but I am extremely skeptical that it can be implemented today.

Specifically, Avner Greif’s analysis of medieval merchant guilds (contained in his Institutions and the Path to the Modern Economy) shows that guilds were able to protect the property of merchants from the depredations of foreign rulers. They did so by coordinating and enforcing embargoes on rulers that abused the property rights of any of their members. Greif shows that the threat of an individual merchant (or small group of merchants) to withhold future trade in the aftermath of an expropriation could not impose a sufficient cost to deter expropriation, but that a coordinated embargo by all guild members in response to any expropriation could do so. This required the guild to impose costs on any member who attempted to circumvent the guild’s embargo. Moreover, the guild had to be sufficiently large for its threat to be a credible deterrent.

A modern guild of oil companies, for instance, could serve this role. Expropriate one, and the others withhold investment.

Could it work? I am very skeptical. Even absent legal obstacles, the difficulties of coordination are immense, especially inasmuch as Russia is past master at divide and conquer. Moreover, antitrust laws would likely severely impede any such effort. Furthermore, it would be a challenge, to say the least, to craft credible punishments to enforce defections from the “guild’s” embargoes.

There is another issue. The formal models in Greif show that the guild mechanism works best when time horizons are long and discount rates are short. These factors make the cost of expropriation—a foregone stream of future gains from trade—large. However, as I have noted in earlier posts, time horizons are short and discount rates are likely high in Russia’s unsettled (and brutal, and arguably murderous) political environment. Hence, reputational penalties like those that support trade in Greif’s models are unlikely to be big enough to work in this instance—or in other garden spots where expropriation risks are high (e.g, Venezuela).

Thus, it is likely that some other mechanism—such as the taking of hostages a la Williamson—is required to deter expropriation. In any event, in a world thirsty for new energy supplies, and where these supplies are located primarily in states with predatory governments that show little respect for property rights, meeting the demand for energy will require a new approach to protect energy investors against expropriation. Until such a mechanism is created, however, expect periodic reprises of Organgrinder Vlad’s Monkey Show, with oil company executives starring as the monkeys.

One article about the ICE initiative suggests the possibility of a three way–CME+CBT+ICE. This is an intriguing possibility. As I noted in the previous post, the benefits of an ICE-CBT combination are underwhelming, but adding ICE to the CME-CBT combo would add additional savings to the already large benefits of the latter combination.

If this does happen, NYMEX would be in a very tenuous situation. I have been somewhat skeptical of NYMEX’s strategic situation. In particular, NYMEX does not own its technology. Pushed by ICE, it ran into the arms of the CME. The move to Globex turned out to be a win-win for the two Mercs. But if the CME combines with ICE, NYMEX is in a world of hurt. I doubt it would be feasible (especially given its technology track record) to build a credible electronic platform on the fly, and would have to partner up with another exchange (e.g., Eurex or EuroNext), and right quick too. Its negotiating position would be pretty weak, although it could potentially play Eurex off against EuroNext/NYSE.

It’s hard to figure out what the market thinks of this possibility. Even before this all hit, I thought NYMEX was overvalued, but its stock went up 8 percent on the ICE announcement, and has held onto most of that gain. In contrast, ICE stock jumped up on the news, and then went down by almost the same amount by the end of the day. Indeed, it is now trading below the pre-announcement price. (CBT stock is above the pre-announcement level, but off its high.) I conclude that the market’s collective judgment is either that an ICE-CME tie up is unlikely, or that if successful this would make NYMEX a takeover candidate. Expanding on the first alternative, NYMEX’s strong stock price performance could suggest a market view that however things work out, the ICE endeavor divert its management’s attention and resources away from energy, thereby taking some of the heat off NYMEX. It is ironic, however, that the stock of a seeming bystander has done so well as a result of ICE’s move.

Vladimir Socor of the Jamestown Foundation’s Eurasia Daily Monitor writes of a new deal between Gazprom and Uzbekistan that increases the amount of gas the Uzbeks will supply, and raises the price from $65/mcm to $100/mcm. Socor also claims that “Gazprom delivers the gas [to Europe] at prices in the range of $300 per 1,000 cubic meters in 2007.” I have not seen reports of these prices for European gas, so I am inquiring about the source of this data. Even at a delivered price of $230 in Germany and a $100 price in Uzbekistan, the calculations in my earlier “Yes, But What Kind of Market?” post demonstrate that the margin is very fat; a $300 price in Europe pushes the margin beyond fat.

Articles last week also reported that Gazprom was squeezing not just furriners, but Russian electricity suppliers as well. Russian electrical utilities have to meet their gas needs in excess of their long term contractual purchases at an auction. Gazprom, as the only transporter, extracts a very healthy margin on these purchases.

The Uzbek story also claims that the Russia-Uzbekistan deal is part of the Kremlin’s long term plan to lock up gas supplies in order to increase their leverage over the Europeans. Hello, anybody home? Anybody paying attention? Wakeup call number . . . well, to tell you the truth I’ve lost count. Using Uzbekistan, Kazakhstan, and Turkmenistan to supply gas also helps address Gazprom’s own production problems.

A trans-Caspian pipeline would redound to the great benefit of the ‘Stans, Azerbaijan, Georgia, and the Europeans. It would outflank Russia, and allow direct European customer access to the ‘Stans, thereby raising prices there and lowering them in Europe. It is technologically feasible (and certainly far more economically and environmentally sensible than Nordstream). Moreover, it would deprive Gazprom of the gas piggybank that it draws on to offset its own declining production. European, American, and Turkish diplomatic efforts should be focused on making this a reality. It is Russia/Gazprom’s biggest vulnerability. There would be a major brawl over this, as it strikes at the heart of Russia’s long term strategy to exploit energy for economic and political purposes, but it is a battle well worth fighting.

Commentor (and former student) Samir makes several excellent points, but I’ll focus on one. Specifically, the uncoordinated European response to Gazprom.

One of the points that Gazprom and its acolytes attempt to use to gull the lazy minded is that there is a symmetry between Europe and Russia/Gazprom. Europe has one major supplier–Russia–but Russia has only one consumer–Europe. I have even seen the term “bilateral monopoly” used in this context. Relatedly, Gazprom constantly retorts “security of demand” whenever Europeans have the temerity to question the security of their Russian supplies, suggesting that Gazprom is as vulnerable to opportunistic behavior by its customers as are its customers to a gas shutoff by Gazprom.

Strike up another chorus of “I don’t wanna hear it!” Europe is not a monolithic entity in the same way Gazprom is. Not only are there several handfuls of European countries, each of whom pursue their own interests (EU rhetoric to the contrary), but even within most European countries there are multiple consumers of gas, including utilities and industrial consumers. That is, the demand side is relatively fragmented and competitive compared to the supply side. Moreover, Gazprom is a past master at playing off one European government against the other, and European companies against one another. Divide and conquer is an old game, and Gazprom/Russia play it well. Sad to say, they are aided in this by short sighted, cynical European governments. As Samir notes, the French just cut their own deal with Gazprom. Germany has been a major enabler, although Angela Merkel is pulling back somewhat. The question remains, however, as to whether she can overcome the influence of the German banking and industrial establishment, which has a long history of cynical dealings with Russia (as during the early Bolshevik period immediately following Brest-Litovsk). The Italians have also been major collaborators.

Thus, there is no symmetry between the monolithic Russian supply side and the fragmented European demand side, and Putin’s/Gazprom’s repeated attempts to assert such balance where none exists is further evidence of their disingenuousness. Actually, I can tolerate that; I don’t blame the wolf for its nature. What I cannot tolerate is the failure to think by those in the west who parrot such nonsense.

The most common defense of Russia’s/Gazprom’s increasing the price of gas to Ukraine, Belarus, Azerbaijan and others is to deny that the motive is political, and to claim instead that these consumers are now being charged the same market price as the Western Europeans. There is a kernel of truth to this, but it obscures the crucial question: just what kind of market is this?

Some markets are competitive. Some markets are not. The market for Russian and most Central Asian gas falls squarely under “not.” Gazprom has a state enforced monopoly on the transit of gas across Russian territory. Moreover, the Russian government is aggressively playing the “Great Game” in Central Asia and the Caucasus to stymie development of any alternative transport routes. For instance, Russia used its overwhelming leverage against Armenia to get that impoverished nation to limit the size of a gas pipeline from Iran, thereby ensuring that the pipe could not be used to transport Iranian gas into Europe.

Russia’s central geographic position, and its heretofore successful efforts to impede development of alternative transportation routes gives the transit monopoly Gazprom great market power. It is effectively a monopsonist upstream, and can exploit this monopsony power to depress the purchase price of gas from Turkmenistan and other “independent” suppliers. Moreover, because the supply of gas into Europe from non-Russian sources is constrained (and will continue to be so unless and until Europe invests in substantial LNG capacity), Russia faces a downward sloping demand for its gas in Europe, which gives it some monopoly power. Indeed, Eastern and Central Europe have even fewer alternatives to Russian gas, and are even more vulnerable to the exercise of market power.

This combination of monopoly and monopsony power is reflected in the chasm between the purchase price of gas from Turkmenistan and Kazakhstan–about $45-$65 per mcm for years, lately raised to $100 per mcm–and the price in Europe–upwards of $230 per mcm. Based on a price of $230 to Germany, and a price in Turkmenistan of $65, this translates to a price difference between consumer and producer of about 3.5 cents per mcm per kilometer. This represents a markup over the Turkmenistan price of about 63 percent per 1000 kilometers. (Even at the now higher Turkmenistan price of $100, the shadow price of transportation is about 2.8 cents per mcm per kilometer, and the markup is 42 percent per 1000 kilometers.)

To put things in perspective, the basis (i.e., the price difference) between the price of gas in Chicago, and the price of gas at the AECO hub in Alberta, a distant Canadian gas supply location, averaged a little over 1 cent per mcm per kilometer from November 2003-January 2007. The markup is about 5.5 percent per 1000 kilometers. Examining the AECO-Iroquois route (Iroquois is a gas hub in New York state), the average basis worked out to about 1.5 cents per mcm per kilometer in 2003-2007, and the markup was about 7.5 percent of the AECO price per 1000 clicks. Iroquois is often quite congested, especially during the winter, so it tends to exhibit a wide basis compared to other locations in North America. Nonetheless, the Europe-Turkmenistan basis dwarfs the Iroquois-AECO basis, and dwarfs the Chicago City Gate-AECO basis even more.

Now, some of the disparity arises because of Gazprom’s inefficiency. (If the exercise of market power doesn’t bother them, global warming worriers should fret about the massive amounts of methane–a greenhouse gas much more potent than CO2–that leaks from Gazprom’s pipes.) But a healthy chunk reflects a market power rent that exists in the no-entry Russian market but does not exist in the much more competitive North American gas transportation market.

The Europeans have importuned Russia to open its gas transportation system. Sorry, not going to happen. This arrangement is too lucrative for the Russian government and the various hogs that feed at the Gazprom trough. This market is not competitive, and is unlikely to become so any time soon.

So let’s call a spade a spade. Let’s not pretend that the price of gas in Europe is a competitive market price. It’s not. It’s a monopoly market price, supported by a state-enforced entry barrier. It deserves no deference from supporters of free markets. The subsidized prices that once prevailed in Ukraine and Belarus don’t deserve deference either; nor does the highly subsidized domestic Russian price.

But two wrongs don’t add up to a right. This has long been a dysfunctional market supported by the dysfunctional exercise of government power. The old dysfunction was to subsidize the consumption of energy by inefficient manufacturing enterprises. The new dysfunction is to extract monopoly and monopsony rents. Prices were too low before. They are too high now (for consumers–still too low for producers).

So, the next time I hear someone repeat the mantra that Gazprom is just charging “the market price,” I will be tempted to sing a few bars from the Minor Threat song “I don’t wanna hear it”:

I don’t want to hear it
‘Cause I know that none of it’s true
I don’t want to hear it
Sick and tired of all your lies
I don’t want to hear it
When are you gonna realize…

That I don’t want to hear it
Know you’re full of ****

Except, I’ll probably fill in the ellipses. ‘Cuz I am–The Streetwise Professor.

Big hat tip to former students Monika and Samir for bird-dogging the data for me. Mucho obligo.