Streetwise Professor

Konstantin Sonin is an excellent economist at the New Economics School in Moscow.  (Obama spoke there during his visit to Moscow.  My friend Sergei Guriev is Rector of the school.)  Konstantin and Sergei wrote an excellent paper using media freedom as a measure of property rights.

Unfortunately, Konstantin’s article in today’s Moscow Times lays a couple of eggs.  First, he argues that (a) production sharing agreements (“PSAs”) in energy markets are a means of protecting investors against political/expropriation, and (b) Russia has no need for PSAs because it presents no such risks:

An economist would normally criticize Deputy Prime Minister Igor Sechin. He rarely says anything meaningful in terms of economics. But twice in the past two weeks, it was necessary to come to Sechin’s defense. First, he was right in saying that Russia does not need a production sharing agreement, or PSA. Second, claims that Russia’s agreement to provide China with oil is unprofitable for Russia might really turn out to be groundless. But the lack of understanding on the subject and the controversy surrounding it attests to the lack of transparency in the agreement. This is an unacceptable situation, particularly when it involves such an important strategic interest.

Russia currently has three PSAs that are intended to protect foreign investors from political risks. Such agreements were specially created to allow major international corporations to sign long-term contracts with unpredictable, authoritarian regimes. In many countries, these PSAs have proven at least partially successful at protecting foreign investors from changes in leadership. But there is a certain stigma attached to them since they are only needed in unstable countries. In stable states with a safe investment climate, foreign investors do not require special protection because all investors are protected equally.

Although Russia does not need insure foreigners against risks connected with its own behavior, it might need to insure itself against the risks involved in deals with other countries.

First, PSAs are not in the first, second, third . . . instance a means of protecting investors against political risk.  Instead, they are a mechanism for sharing development cost risks.  Or, better put, they essentially put the development cost risk on the resource owner: the resource owner gets paid after the E&P company recoups its costs.  Second, even if they were intended to protect investors against political risk, how can Konstantin state seriously, in the aftermath of all that’s transpired in Russia (and the oil sector in particular) in recent years, that Russia poses no political or expropriation risks?  The risks there are huge.  Indeed, they are so large that I look in amazement when companies like Shell act like victims of the battered spouse syndrome and return to their abuser.  Third, if PSAs are intended to protect investors against expropriation and political risk, they do a lousy job of it.  Just ask Shell: it had a PSA for the Sakhalin II project, and a fat lot of good that did.  Indeed, PSAs have been used by the Russians to justify expropriation.

Konstantin’s second error in his defense of Sechin relates to the murky China-Russia oil deal consummated earlier in the year.  He argues that the deal was good for Russia, even though it was at below market prices, because it locked in prices, and therefore provided insurance (a hedge) against price fluctuations:

Although Russia does not need insure foreigners against risks connected with its own behavior, it might need to insure itself against the risks involved in deals with other countries.

Thus, there might be good reason to consider Russia’s agreement to sell oil to China at $55 to $60 per barrel as some form of insurance, considering that the deal only becomes profitable at a price of $80 per barrel. The idea of any insurance policy is that it chews up a certain percent of the profit when everything is going well but saves the insured party from major losses if things go badly.

Now here, Konstantin is somewhat unclear on what he intends by the word “insurance” and the phrase “things go badly.”  If by “insurance” he means price insurance, and “things go[ing] badly” he means a price collapse, the deal still is priced extremely unfavorably for Russia.  The price involved was well below the forward curve for oil for the foreseeable future, and the forward curve gives the price a seller can lock in.

As I noted in earlier posts on the subject, the seemingly unfavorable pricing makes sense, because it reflects a big credit spread.  That is, at the time the deal was done, Russia’s credit was in the dumper, and since the stated interest rate on the loan used to finance the pipeline was at a premium to LIBOR well under the premium on Russian debt prevailing in the market at the time, the Chinese were only willing to make the loan if there was an offsetting benefit–a below market price of oil.  That is, although Sechin touted the low interest rate in the deal, this was in effect a “teaser” rate–the oil price discount represented a hidden interest charge.

That is, the pricing of the deal doesn’t reflect insurance–it reflects Russia’s credit risk at the time the deal was done.

Russia’s credit has rebounded since the deal was inked.  Note Gazprom sold Eurobonds at a pretty good rate last week.  This raises a possibility that I raised in my original posts, and reiterated in a presentation on Russian energy strategy to a group of Foreign Service people (including some folks based in Moscow working on energy issues) today: namely, that Russia will try to find a way to back out of the deal, or force renegotiation, when the market turns.  Both the oil market and the credit market are much more favorable to Russia today than when the deal is done–which means the the deal done then is much LESS favorable to Russia today (and hence more favorable to China today) than when it was signed.  I see the potential for a dispute arising very soon.  That would be VERY interesting to watch.

Konstantin does make one very good point in his article:

Thus, criticism rained down on Sechin from all sides for having orchestrated an unprofitable agreement with China. But its profitability can only be gauged once all the terms of the agreement are finally made public.

That disclosure process should happen as soon as possible. The rules are very simple: If an economic agreement is signed in the best interests of the country, there is no reason to hide anything. If the agreement is sound, it will naturally withstand criticism from political opponents, analysts and the press. The fact that leaders are afraid to reveal the terms is probably a sign that the agreement has problems. If the agreement with China is flawless, why keep it secret?

Russia already has enough corruption without adding speculation about whether the agreement with China was on the up and up. If, however, anything underhanded is involved here and the agreement is not sound, Sechin’s contract with China might go down in history like the notorious privatization auctions of the early 1990s.

Hear, hear.  There is considerable room for skepticism about the benefits of the deal to Russia, because of the dishonest way that it was spun publicly; notably, Sechin’s crowing about the interest rate, and obfuscating about the oil price.  Both pieces of information are needed to determine the REAL interest rate in the loan, and therefore to determine whether it was on-market or not, and how far away it is from the current market (probably a lot, given the changes in the credit and oil markets).

Given that the deal’s economics probably look far worse for Russia today than they entered into the contract with China earlier this year, I wouldn’t hold my breath waiting for the Full Monty from Igor.  The most likely way that information will come out is that if the unfavorable economics are used to justify abrogating the transaction.  That is, the only way that the details of the transaction are likely to be made public is if Russia decides to claim that the Chinese screwed them as a justification for walking on the deal, or insisting on renegotiation.

Which just may happen.