Streetwise Professor

December 2, 2006

Russian Roundup

Filed under: Commodities,Politics,Russia — The Professor @ 10:50 am

So much Russia-related news, so little time. At the top of the list, of course, is the Litvinenko story. I can do no better than Russian commentator Leonid Radzikhovskiy:

In the case of Litvinenko, there are so many things that are absolutely incomprehensible – especially from the sidelines – that to try and play the role of a self-styled Dr Watson would be absurd. And I wouldn’t dare to try my hand at Sherlock Holmes.

There are many theories, but few facts. [NB. The morning after I posted this, Edward Lucas said that the Russian phrase “Nyet faktov, tolko versii”–no facts, only theories–fits the situation perfectly. Here, here–great minds!] To extend the Holmes analogy, these are akin to the story of Holmes, Dr. Moriarty and the London-Dover-Canterbury train. Putin had him killed. No, somebody had him killed to make Putin look bad. No, Putin had him killed to make it look like somebody was trying to make Putin look bad. And on and on. I think people should chill until more facts are in evidence.

Regardless of which of these theories–or some even wilder possibility that no one has yet thought of–is correct, one thing is certain: Russia is not a normal country where powerful people play by even slightly civilized rules. Pick your poison: murder by the security forces at the Kremlin’s behest; murder by a rogue element in the security forces; murder by an oligarch; some dangerous plot that backfired on its perpetrator. Every alternative is depressing, and makes one despair for Russia and for everyone who intersects Russian interests in any way.

And much news about Gazprom. The excellent Edward Lucas notes that Gazprom is terribly inefficient, and that as a result Russia faces a gas shortage–which would make it highly unreliable as a supplier to Europe and Asia. Leon Aron of AEI similarly notes the stagnation (at best) of Russian energy output in the aftermath of the Kremlin’s de-privatization of the energy sector. The combination of subsidized domestic gas prices, a Kremlin push to encourage substitution of gas for other fuels (both of which encourage domestic consumption), a decaying infrastructure, and niggardly investment in new capacity all threaten to constrain sharply the amount of gas available for export. There was some talk of raising domestic prices, but that plan has supposedly gone by the board.

Moreover, Russia is supposedly attempting to form a cartel of gas exporting nations. Although Kremlin spokesmen deny this, their denials are risible. They prattle about the “interdependence” of producers and consumers, and say that only a “madman” would do anything to harm its customers. Err, monopolists and cartels exist to harm customers by forcing them to pay excessively high prices. Interdependence my eye. Gazprom’s strategy is to increase European dependence on Russian gas by constraining output of alternative suppliers, or denying the access of these suppliers to the European market (by buying up strategic pieces of the European gas infrastructure).

The Russians repeatedly present the image of symmetry between demanders and suppliers (“mutual interdependence,” “security of demand and security of supply are equally important”) but there is no symmetry here. A fragmented consumer and industrial side with myriad relatively small demanders is in no way symmetric to a highly concentrated supply side. The Orwellian phrase “security of demand” so often repeated by Putin and the Gazpromniks really means: we want no competition; we want to ensure that there are no substitutes for what we sell; we want to make sure that you have to deal with us on our terms.

There are certainly circumstances where a buyer and a seller are locked into a bilateral relationship due to their investment in specific assets, and where there is a symmetric threat of opportunistic holdup. This is not the case here. There are many competing buyers of gas who cannot individually holdup Gazprom. There is one Gazprom that can holdup its customers.

The lack of Gazprom investment in upstream production noted by Lucas, Aron, and this Washington Post article likely arises from a variety of factors. First, a firm with market power restricts output. Not investing in capacity is a credible way of constraining production. Second, as a majority state owned company Gazprom is largely free from capital market discipline. Third, and relatedly, it faces the free cash flow problem from hell. The company throws off huge amounts of cash, which permits its managers to do pretty much what they damn well please without having to satisfy investors. Hence, according to the WaPo article, the company spent $18 billion on non-gas acquisitions, or about 6 times what it spent on investments in gas.

Moreover, I surmise that management’s discount rate is very high. In an environment as volatile–and deadly–as Russia is today for both the ordinary man or the very powerful, planning for the distant future is probably not a high priority. Get what you can today, and let the very tenuous tomorrows take care of themselves. Such circumstances are not exactly conducive to taking the long investment view–and there are few industries where the long view is more relevant than energy given the size of the projects, and the length of the exploration and development process.

The WaPo article also mentions that Gazprom’s pipeline construction costs are two to three times industry norms. To me this suggests a Credit Mobilier-Union Pacific type situation, where inflated prices for materials and equipment flow into the pockets of companies owned by Gazprom managers. Just thinkin’.

Before leaving this Gazprom rant, I have to mention the hilarious statement of Gazprom Vice Chairman Alexander Medvedev: “We are not an instrument of policy because it cannot comply with our commercial structure.” Stop it, Alex, you’re killing me! (That’s a figure of speech there, Alex old buddy. Don’t get any ideas. Can’t be too careful.)

I guess I have time for one more Russia story–there are many more that will just have to wait for another day. Peter Hambro Mining’s (subscription required) share price fell 14 percent after the Russian government threatened to revoke some of its licenses to mine and produce gold. The head of the natural resource ministry’s environmental regulator, Rosprirodnadzor, cited two (somewhat contradictory) explanations for this action: environmental law violations, and a failure to develop projects rapidly enough. As if revoking the licenses is going to expedite the development of these properties.

Another day, another holdup. Rent seeking run amok. Another short sighted decision that will further erode confidence in the security of investments in Russia–another manifestation of the truncation of time horizons in a land where life is too often brutish and short.

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