Streetwise Professor

February 23, 2006


Filed under: Commodities — The Professor @ 10:02 am

The New Year saw an ugly scene play out between The Russian Federation and Ukraine. Gazprom, the Russian gas monopoly, reduced flows of natural gas to Ukraine in a pricing dispute. Ukraine apparently continued to take gas, so the lower injections of gas reduced the flow to western Europe. The Europeans reacted with alarm, and questioned Gazprom’s/Russia’s reliability as a supplier. Soon thereafter a deal was done, involving the usual mysterious intermediaries.

The upshot of the deal is that prices to gas to Ukraine will rise, but not to the level charged western Europe. Gazprom will sell gas to Ukraine at the $260/mm cubic meter price the Europeans pay, but this gas will be “rolled in” with cheap gas from Turkmenistan, so that the average price paid by the Ukrainians will be slightly higher than the old price, but well below the price Gazprom charges for other exported gas. Since Turkmenistan has no viable markets for its gas other than Gazprom, they have to go along with this deal that allows Gazprom and Ukraine to save face. Gazprom can claim that it sold “its” gas for the full market price; Ukraine can claim that it is buying gas for less than the full market price. Turkmenistan: so close to Russia, so far from God.

Reading about this episode brings to mind Churchill’s pithy characterization of Russia seen through Western eyes–“It is a riddle wrapped in a mystery inside an enigma.” Both sides (Ukraine and Russia) have been fighting a PR war as well as a gas war. Sorting out the facts in this situation is all but impossible, especially at the remove of thousands of miles, and more especially because so much that happens is hidden from view, cloaked by political wheeler-dealing and the machinations of opaque “trading companies.” Gazprom wraps itself in the mantle of the free market. The Ukranians claim political intimidation at the same time that credible reports suggest that well-connected Ukranians are reaping large profits from this deal. Russian Blog has a reasoned summary of the situation that is largely sympathetic to Russia but the US government has criticized the deal in a similarly reasoned fashion. So what are we to conclude?

To me the fundamental underlying conclusion is that this is a huge rent seeking contest, and few participants in such contests are as pure as the driven snow. It is laughable to think of Gazprom as an avatar of the free market. It is a largely state owned company that controls all the gas pipelines in Russia and which has a monopoly over export of gas. Most importantly, its control of pipelines means that Gazprom is effectively a monopsonist. It can extract huge rents from the upstream producers. These include Turkmenistan, but also independent Russian producers such as OAO Novatek and OAO Lukoil. It arguably has some market power downstream in the European market too. Gazprom does have a vulnerability, however; Ukraine controls the pipelines between Russia and European markets. This puts Ukraine in a position to holdup Gazprom. (At least for now. Gazprom is building a pipeline under the Baltic that will reduce its reliance on Ukrainian pipes. Also, Russia/Gazprom are building pipelines to Asia.) Rent seeking contests are typically ugly, and often result in threats, ultimatums, and the withholding of specific assets (such as gas pipelines). Those upstream and downstream from the specific assets usually end up paying the price when those in the middle battle over the quasi-rents inherent in these assets. With whom should we sympathize? The monopolist/monopsonist? The party trying to expropriate the monopolist/monopsonist? Is death an option?

It is also naive to view this as merely an economic dispute with no political dimension. There is clearly a history–both distant and recent–between Russia and Ukraine, and it is by no means a happy history. Moreover, Putin has made it clear that he views energy as a key element of Russian state power, and that Russia will use energy to restore Russia to its former position of geopolitical importance. Nor is this a new thought to Putin. It is the theme of his PhD thesis at the St. Petersburg Mining Institute. I was unaware of this until I read the linked Radio Free Europe/Radio Liberty article, which states that in his thesis “[Putin] argued that the most effective way to exploit this resource was through state regulation of the fuel sector, and by creating large and vertically integrated companies that would work in partnership with the state.”

This continues a long Russian tradition of using control of natural resources to finance the state and exert political leverage. In this regard, it is interesting to contrast the history of the Russian and American fur trades. The Russian fur trade was from the beginning an adjunct to the state, and a major source of revenues for the Tsars. In contrast, the American fur trade was not a creature of the US government, but a much more individualistic and corporate enterprise. Energy has been pretty much the same story.

Given that there is little likelihood of a Russian equivalent of FERC Rule 636 (which made US gas pipelines open access facilities, thereby facilitating competition upstream, downstream, and midstream, thereby squeezing out rents), the rent seeking will continue. Those upstream and downstream of Gazprom’s pipes would be well advised to seek alternatives to the company’s (or should I say state’s?) transportation assets. For the Europeans, this probably means increased reliance on LNG–which in turn has implications for the US and which probably will result in higher US gas prices over the short and medium term. Russia’s dominating central geographic position creates tremendous difficulties for central Asian gas producers (such as Turkmenistan) and obviously for Russian independent producers (who may well not be independent for too long–integration of the upstream firms with the midstream monopsonist would mitigate some of the monopsonistic production distortion). Alternative transport routes will be difficult and costly to develop, and cannot come on line for some years. It is likely, therefore, that Putin will be able to implement his game plan for years to come.

Although this may be good news for the Russian state, and those individuals and companies who can siphon off some the Gazprom rents, it is not a blessing to Russia and its people as a whole–or for Russia’s neighbors and the world. A state that can finance itself with a stream of rents from natural resource assets need not fear being checked by a vigorous citizenry and private sector. Such a state need not bargain over the terms of its support with the citizenry (or through its elected representatives.) As a consequence, the people have little leverage over the state and hence little power to control domestic depredations or foreign adventurism.

The ambitions of Charles I and James I in England were frustrated by their dependence on Parliament for financial support. In control of a stream of oil and gas revenues, Putin and his successors are not similarly dependent on the legislature, the people, or private enterprise. Given Putin’s avowedly imperial ambitions (he openly lamented the fall of the USSR as the “greatest geopolitical tragedy of the century”–a remarkable statement when one remembers that WWI, WWII, the Holocaust, etc., occurred in the same century) this is not a happy prospect. Although Russia still remains relatively weak (especially compared to the heyday of the USSR) and faces daunting demographic challenges, its oil and gas resources are more than adequate to support mischief in the “near abroad” and further afield. Moreover, the energy rents dissipate the incentive of the government to relax controls over the broader economy or to encourage the development of a robust private sector. Furthermore, rent seeking diverts valuable resources away from productive uses towards politicking, extortion, and fraud. None if this is good news for most ordinary Russians.

Nor is this a problem unique to Russia. Indeed, perhaps the most troubling consequence of the current high energy price environment is that it is enriching the most repressive and retrogressive political and economic forces on the planet, from the mullahs in Iran to the Saudi princes to the vulgar, thuggish, erratic, and adventuring Chavez regime in Venezuela. Here in the US it is fashionable to demonize the high profits earned by the ExxonMobils and Shells and BPs, but what a far, far better world it would be if all oil and gas riches flowed through private corporations to private shareholders, rather than through government entities to prop up repressive states.

But that is not this world. It is too tempting–and too easy–for governments to expropriate the rents from energy production. As long as fossil fuel based energy is dearly priced, as it is today, it will fuel more than cars and power plants–it will also fuel government repression and adventurism.

Postscript. This post is likely to strike the reader as very harsh towards Putin. In many ways, it echoes the argument that Andrei Illiarionov made in a 2/4/2006 NY Times editorial; Illiaronov resigned in protest against what he views as Putin’s arbitrary policy of state corporate imperialism. Illiaronov also puts Russia in the same category as Venzuela, Saudi Arabia and Iran.

Further the riddle/mystery/enigma point, I am aware that (a) Putin is very popular in Russia, and (b) has many articulate defenders both in Russia and the West. Like many historic figures, he sparks strong and varied reactions–think of the continuing debates over Napoleon or Alexander. In the future, I hope to post more on other developments in Russia that may put Putin in a different light. It is perhaps better, however, to get away from the issue of personalities altogether. As a former student of George Stigler, who was outspoken in his view that political personality is irrelevant (I think someone referred to him as the last Marxist because of his belief in the dominance of economic and historical forces over the “great man”), I am sympathetic to the view that the thrust of Russian policy would be the same regardless of the name of the person at the top. The main idea I am trying to convey in this post is that large economic rents derived from natural resources (energy in this case) are not conducive to the development of a vibrant private sector, and indeed they often encourage the worst tendencies of states/governments. On balance, natural riches are more of a curse than a blessing.

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