The last several weeks have delivered a harsh reality check for Russian policymakers: the hundreds of billions of dollars’ worth of reserves and earnings they provided the regime ‘for stability’ are conduits of American, European, and foreign financial power. Energy exports may be explicitly excluded from direct sanction, but self-sanctioning, logistical disruptions, and fears of financial sanctions risks alongside COVID-19 have created a level of chaos in global energy markets not seen since the oil shocks of the 1970s. But whereas the oil shocks of the 1970s provided windfalls that prolonged the stagnation wracking the Soviet economy until its unraveling, the current shock threatens to trigger a systemic crisis for the political economy of energy exports and rents key to the regime’s notional ‘stability’. The Central Bank has explicitly communicated that the economy “has entered a phase of massive structural rebuilding,” invoking the dreaded term perestroika to describe the scale and nature of the current explosion of inflation and shortfalls of inputs. Autarky in Russia has always depended on commodity exports in some form, but sanctions and self-sanctions threaten that relationship. Before synthesizing what these destabilizing changes entail, one needs a view of the sheer breadth of the pressure facing the Russian energy sector.
Oil and the Damage Done
The announcements from BP, Shell, and Exxon were a shock to the system, but the exit of western oil majors from the Russian oil sector is a comparatively small problem compared to demand-side effects from sanctions. According to Russian energy expert Mikhail Krutikhin, half of the 6 million barrels a day of oil and refined products Russia normally exports are already off the market. The IEA similarly forecasts a shortfall of 3 million barrels per day of production from Russia may in April as buyers continue to shun Russian crude cargoes. Halliburton, the world’s second largest oilfield service providers, has decided to pull out of the Russian market completely and Schlumberger, the world’s largest oilfield services firm, has ceased all new investments and technology deployment in observance of existing sanctions. Production costs are rising and access to technology and expertise is being constrained. Though foreign service providers only accounted for 18% of the market as of 2020, they generally provide the highest end technological and technical support.
Add to this that Russia lacks significant crude oil storage capacity. All production must be sold, not stored. If buyers shun purchases, Russian exporters can store crude at sea in a tanker – an increasingly difficult proposition as insurers and banks also don’t want to be exposed to reputational or direct sanctions risks – or throttle production at existing oil fields. Self-sanctioning is a far greater problem than the otherwise limited effects of US, Canadian, and UK import bans that reshuffle trade flows.
The longer an oil well is not producing nor is permanently ‘plugged,’ the greater the likelihood that the cement casing lining the well fails, risking the integrity of the well for production. Back in 2015, a survey of Russian oil companiesfound well casing failure rates ranging from 1.7-4.1%, a figure that has likely climbed at the oldest, most depleted fields. If firms can’t find buyers for even 1 million barrels a day for long enough, the rates of well casing failure and the costs of maintaining wells otherwise not producing will begin to rise as wells have to be idled. Inactivity will take thousands of barrels of production offline permanently in relatively short order only to see that figure balloon as the problem drags on. Since Russian oil exports are being priced at discounts of $20-30 a barrel relative to the Brent crude benchmark, the state and oil firms are also benefiting less financially from what they are capable of selling on the market.
Finally, the near total cessation of international air travel and incoming strains on domestic carriers’ capacity to fly routes due to lost access to components and repair parts will crush domestic demand for jet fuel. Refineries have to vary what capacity they utilize to yield the mix of refined products necessary to meet demand from wholesalers and retailers, a constant balancing act between different units using different processes and temperatures to yield the right products. Jet fuel is a middle distillate that is quite volatile, so most production is consumed within about three months. If you can’t store it for long, your only options are to repurpose it for other products or reduce your runs of jet fuel and try to reconfigure your operations accordingly, risking losses and imbalances of refined products. A common approach is to blend jet fuel into diesel, but collapsing incomes, consumer spending, and investment plans will undoubtedly drag down diesel demand as well. Reports are now emerging that Russian refiners are cutting production from lack of storage capacity while fuel prices for drivers remain elevated with production for the first half of March down 6% vs. February, a figure sure to rise into April. These factors can contribute to inflation and create future bottlenecks for consumers and industries without state support.
A Messy Divorce
Gas exports to Europe remain steady, but have come under pressure from new initiatives led by the European Commission to slash Russian gas imports by two-thirds this year, diversify supply away from Russian pipeline gas, and reduce fossil gas consumption 30% by 2030. The Commission’s announcement included expected plans to require national gas storage to be at least 90% full by October 1 of every year, undercutting potential leverage from supply disruptions or Gazprom’s insistence that long-term contracts rather than spot trading supplies be used to meet import needs. Europe is broadly abandoning assumptions that Russia is a reliable energy security partner.
EU governments have agreed to jointly buy LNG and gas supplies this years to coordinate supply. After officially halting certification of Nord Stream 2, several projects now being fast-tracked by the German government are expected to provide over 10% of Germany’s natural gas needs if fully utilized. Germany vice chancellor Robert Habeck has followed up with visits to Norway and Qatar, signing an agreement for a long-term energy partnership with Qatari counterpart Emir Sheikh Tamim bin Hamad al-Thani to snap up LNG cargoes. Bulgarian Deputy Prime Minister Assen Vassilev announced that the state would not seek to renew its contract with Gazprom at the end of the year, instead betting on other suppliers and the Bulgaria-Greece interconnector to manage in the near-term. Italian energy firm Snam is in talks with Spanish counterparts to build a new offshore pipeline to build better links between the Spanish market – supplied dominantly by LNG and North African pipeline imports – with the rest of the EU. Eni is also fast-tracking a new upstream project with Algerian Sonatrach to launch new oil & gas production by Q3 2022 and expand Algerian exports to Italy. The Dutch government is also trying to increase the import capacity of the Gate terminal at Rotterdam for LNG and contracting floating terminal capacity. These are being announced alongside Belgium’s decision to extend the use of nuclear power to 2035, countless renewables projects being permitted, Poland’s recent announcement of a $1 billion commitment from US partners to invest in a nuclear plant with mining firm KGHM, and the Czech Republic’s exclusion of Rosatom from tenders to build a new nuclear plant at Dukovany.
European energy politics and markets are in rapid flux. We are seeing what an energy ‘divorce’ looks like, even if the goal to reduce imports for 2022 faces considerable uncertainty and may not be feasible. Gazprom cannot redirect the scores of unused bcm of export capacity it has to European markets to China or LNG terminals. That means thousands of kilometers of pipeline, compressor stations, and gas fields not utilized to their capacity pose an increasingly heavy drag on Gazprom’s balance sheets as European imports decline. New routes can and will probably have to be built, including the Power of Siberia 2 via Mongolia. However, export prices and profit margins realized for production from Yamal and Europe-facing fields would be considerably lower due to the sheer distances involved for delivery. Gazprom suffered numerous problems with labor, inefficient investment, and cost overruns at Chayanda – the main field supplying the current Power of Siberia pipeline – which doesn’t speak to a flexible response in the event that European purchases of natural gas decline precipitously. Rosatom may not be an important source of export earnings – its export portfolio probably only generates a few billion dollars in profit a year – but these changes are similarly affecting its capacity to profit off of decarbonization efforts since deals in developing countries typically require state-backed concessionary loans, minimal returns on investment, and increasing pushback on the “Build, Own, Operate” model that Rosatom prefers.
Coal and Russia’s ‘Rust Belt’
Coal markets are now suffering the same turmoil as oil & gas. Immediately after the announcement of western financial sanctions, China’s state banks began refusing to extend letters of credit to finance imports of Russian commodities and coal shipments started falling. President Biden’s March 19 phone call with President Xi reiterated American intentions to apply secondary sanctions to Chinese firms and banks breaking with the existing regime against the backdrop of a scramble for coal. The National Development and Reform Commission has called for China’s regions and miners to increase coal production capacity by 300 million tons annually, a volume equivalent to the entirety of China’s import needs. Beijing’s policy pivot seems intent on maintaining the country’s Australian import ban while displacing Russian imports. Whatever hopes Russian policymakers had of increasing coal exports to China by 2024 to offset expected losses in Europe are being crushed.
Coal mining forms an important link in the regional chain of hydrocarbon dependencies and industrial relations underpinning the regime’s political economy. Coal mining provides comparatively cheap inputs for domestic steelmakers and industry, jobs for relatively unpopulous regions dependent on resource exports, and demand for Russia’s heavier industrial base. Bulk cargo gondola cars are a particularly prominent example since coal in Russia is transported primarily by rail to domestic depots and ports. Prior to the invasion of Ukraine, miners in the Kuzbas were complaining to MinTrans that they could not move 17,000 railwagons full of coal due to inadequate rail capacity from Russian Railways’ oft-delayed, underinvested expansions of the Trans-Siberian and Baikal-Amur Mainline. At the same time, the rail network struggled in 2021 with a cumulative deficit of over 36,700 gondola cars and expectations of gondola car demand in the range of 20,000 per annum for 2022-2026. Exporters in general, and coal exporters in particular given the sheer physical volume they require, underpin the profitability of the factory base spread across the Volga-Urals region and Western Siberia manufacturing rolling stock and similar heavy kit and equipment used for freight and railway construction and maintenance.
Russia’s ‘Rust Belt’ has been propped up through the direct and indirect demand generated by commodity exporting industries for most of the last 25 years and now faces novel risks. Underinvestment in rail capacity created bottlenecks that prevented Russian coal miners from fully reaping the benefits of last fall’s coal demand surge in China and achieving their export aims. That’s now collided with the very real possibility that the exporters sustaining industrial demand for older Soviet plants that frequently rely on procurement orders via state monopolies or parastatal firms underwritten through commodity exports won’t be able to provide enough demand to maintain existing productive capacity that’s been mired in stagnation for the last decade. Annual seasonal cycles of railwagon surpluses and deficits that filter into the transport costs and capacity for basic goods including wheat shipments in dry bulk cars may turn to a large, persistent deficit into next year that will increase food prices as well. Higher transport costs then affect orders further across supply chains given the dominant role of railfreight for deliveries at 1,000 km or more, which accounts for a very large proportion of deliveries on the domestic market. Railfreight also becomes more attractive economically against long-haul truck deliveries as diesel and benzine prices have risen since 2020 in real terms and were forecast to rise this year above the Bank of Russia’s now completely irrelevant inflation target of 4%. The main offset for higher fuel prices proposed has been the nullification of all tolls paid to the Platon system on federal highways, itself a rentier goldmine for clan Rotenberg introduced amid recession in 2015-2016.
The oil shock of 2014-2015 and sanctions targeting Arctic projects put a large damper on a bevy of offshore oil & gas projects that it was hoped would help the Russian economy to break out of its 1-2.5% annual GDP growth ceiling without a structural adjustment towards consumption-led growth. Prior to the invasion of Ukraine, Gazprom was aiming to become the world’s largest exporter of carbon-neutral ‘blue’ hydrogen with an explicit aim to account for 20% of global supply through 2050. The thinking was three-fold: prevent the depreciation of natural gas assets – namely pipelines – that require significant capex and opex, capture a new market expected to raise tens of billions of dollars, and work in an area where cooperation with European partners could bridge the sanctions regime and broader chill on foreign investment into the Russian economy since 2014.
For a global snapshot, the Hydrogen Council estimated that as of July 2021, approximately $500 billion in investment into hydrogen projects through 2030 had been announced. $150 billion of that was considered ‘mature’ meaning that projects were in the planning stages, nearing, or else taking final investment decisions. The world’s largest hydrogen project was announced by US startup Green Hydrogen International in South Texas called Hydrogen City, a massive hydrogen project with considerable salt cavern storage capacity using solar and wind power to produce 2.4 mtpa of green hydrogen. The project is backed by Australian businesses. In mid-February, the Australian Hydrogen Energy Supply Chain (HESC) pilot project – a pilot project that cost about $500 million – sent its first cargo of liquefied hydrogen to Japan. German vice chancellor Robert Habeck also signed a blue hydrogen supply agreement with the UAE while visiting the Gulf and Saudi Arabia just announced the construction of a $5 billion hydrogen plant in Neom.
The Hydrogen Council’s figures are surely over-optimistic and a great deal of uncertainty remains over how hydrogen markets develop, not least because hydrogen is not nearly as energy dense as natural gas. But a huge wave of investment and deal-making is taking place without any substantive hope of Russian participation. Australian Miner Fortescue set a very stretch target of 15 mtpa of green hydrogen production by 2030 a year ago and is now confident that’s no longer a ‘stretch’ because of the degree of investor and market interest. Smaller pilot projects using hydrogen as feedstock for operations or else laying the foundation for hubs in Queensland are afoot as well. Prior plans from Gazprom to refurbish and repurpose existing natural gas infrastructure for hydrogen exports grow now seem highly unlikely in the absence of foreign partners and interested foreign buyers. These initiatives could have generated trillions of rubles in construction and procurement contracts and support new manufacturing investment as well exploiting localization and import substitution subsidy and policy schemes. That’s now gone and, in its wake, the global market for hydrogen is moving on quickly.
The New Oil Diplomacy
Moscow also can’t dismiss the direction of travel for efforts by the Biden administration to push a deal with Iran over the finish line and to begin speaking with Maduro in Venezuela once more. For now, any prospective Iran deal is hostage to the idiocy of the US Congress and Biden’s hunt for a larger deal. De-listing the IRGC signals a desire and belief that something beyond a technical agreement over nuclear weapons capabilities is possible. Were the IRGC to be de-listed, presumably Biden is opening the door to complete the withdrawal from Iraq he has likely wanted since coming into office as well as securing a potential exit from Syria. An agreement with Iran and any sanctions relief for Veneuzela would return several hundreds of thousands of barrels of crude to market relatively quickly, but take a much longer time to lead to durable supply increases, though any Iran deal now seems dead thanks to the efforts of US hawks and diplomacy in the Gulf. All the same, the administration has little choice so long as US shale drillers are restrained by the interests of investors and bankers in New York and considerable squeezes for supply chains, namely piping, drilling equipment and parts, rolled steel, and even labor. The recent decision to relaunch leasing for oil & gas projects on federal lands is another useful move, even if quite limited in effect, to deflate the persistent industry myth that the White House was standing in the way of drilling.
Saudi Arabia has reacted with toothless talk of launching “petroyuan” in its oil export trade with its real strategy: increasing its output ceiling by 1 million barrels per day in the next 5 years to 13 million bpd and, most importantly, substituting as much oil-fueled domestic power generation with natural gas as fast as possible to retain export capacity. Though MbS may wish to communicate that Saudi Arabia isn’t responsible for stabilizing the market so long as rocket attacks continue on oil facilities with comparatively limited effect, the real thrust of Saudi policy is to kick Russia while its down. The United Arab Emirates are now fast-tracking project plans intended to increase oil output by 1 million barrels per day by 2030, lifting production from 4 to 5 million bpd.
The shutdown of the Caspian Pipeline Consortium’s pipeline throughput capacity at Novorossiysk is another body blow to short-run supply, taking 1 million barrels per day of Kazakh crude exports off the market for what looks like 2-3 weeks. In truth, there is no short-term solution aside from cutting demand or the misery that is demand destruction. Diesel prices have shot up on shortages also influenced by the uneven ramp up of refined products throughput from last year into this year due to the loss of jet fuel and gasoline demand. There is no clear solution there without some planning mechanism and capacity to rapidly stand up production that, as yet, is lacking at the international level and in many cases at the national level.
Presidents lack any ready instruments aside from jawboning and backroom deals, whether that be through the delivery of Patriot missile systems, an offer of sanctions relief in exchange for something, or else a round of grip, grin, and grandstand appealing to domestic energy industry players who love to howl about energy independence when Democrats are in power. Whether or not the press team at the White House and the inner sanctum of the Biden administration have any clue how to sell these policies and security partners in the Middle East attempt to ally with hawks in Congress to block progress, it’s significant that this crisis has given rise to a degree of creativity and rapid reaction we would not have expected prior to February 24. Prior releases from the Strategic Petroleum Reserve were of limited use, but in diplomatic terms, also signaled a willingness to cooperate with China as well as partners to bring barrels to market in an attempt to reduce bargaining power of OPEC+. No matter how prices come down to earth – right now, there is clear statistical evidence that retail fuel demand is beginning to flag vs. December 2019 from high prices – the geopolitical balance of power between consumers and producers will have once more changed in unexpected ways ultimately to the detriment of Russian foreign and domestic policy.
The Energy Doom Loop
One of the greatest disservices ever done to the analysis and understanding of the political economy of Russia was the meme proffered by countless voices echoing the late Senator John McCain: Russia is nothing but a gas station. This is, in plain terms, completely false. Russia is not a classic petrostate. It did not come into its geopolitical power or aspirations on the basis of its petroleum exports, nor is the economy as concentrated in the energy sector as one would presume assuming the categorical implications of ‘petrostates.’ Instead, it’s best to think of the Soviet Union’s dependence on oil & gas as a long-running process that began in the mid-50s with the development of deposits surveyed during the Great and Patriotic War, first oil export deals undercutting OPEC’s pricing power, and desire to significantly expand the national petrochemical industrial base in support of agriculture. By the 1960s, they were a crucial source of export earnings to cover food imports and fertilizer and chemical feedstock and inputs for other industries. By the 1970s, the cumulative windfalls from the first and second oil shocks allowed the state to lean on oil & gas as supports for what would prove to be the festering decay of the nation’s economic base, over-built heavy industry, and massively under-developed light goods and consumer durables sectors constrained by the absence of strong demand. The absence of price signals guiding capital expenditures and operational expenditures domestically, presence of price signals affecting the attractiveness of exports and budget planning, mismanagement of existing oil & gas fields, and rising costs of newer oil & gas finds and provinces all collided. The cost of supporting the sector otherwise underpinning a significant part of the budget and domestic industries skyrocketed and then prices crashed in 1986. Whenever anyone tries to sell you a bridge talking up Russia’s petrostate problems, remember it was a highly urbanized, educated, and industrialized economy when the political system became ‘addicted.’
Russia’s Soviet inheritance was therefore an extractives and energy sector that could sustain a wide range of industries, provide export-driven demand, and churn out fiscal resources. First, pre-war claims that Russia could simply trudge through a structural decline in demand for its hydrocarbon exports were terribly flawed. Since the triple shock of sanctions, oil price collapse, and banking sector crisis in 2014-2015, austerity policies intended to reduce Russia’s comparative dependence on oil & gas revenues meant capping social spending, continuing elevated levels of defense expenditure until 2017 when they leveled off, and most importantly increasing the comparative tax burden on households, businesses, and consumption through changes in rates and improvements for tax collection. From the perspective of the state budget, resource dependence fell. In reality, the opposite happened due to Russian macroeconomic policy. By 2019, extractive industries saw investments approximately 20% higher in real terms per Rosstat relative to 2013. They were even higher – 26% above 2013 levels – in 2018 when the Trump administration reimposed sanctions on Iran, targeting oil exports. In 2020, they were still roughly 16% higher than 2013. Manufacturing investment levels hung between 17% and 7% down in real terms from 2013, generally trending at about 8% lower than pre-Crimea levels headed into COVID. Retail only saw one year of investment elevated above 2013 levels – 2018 – in a short-lived blip of an 8% increase. Transport and storage investments trailed terribly with an average falloff of 25-33% relative to 2013 in real terms. Cumulative investment levels in real terms were 99.6% what they were in 2013 as of 2019, yet with significantly elevated shares for natural resource extraction and growing sectors like IT with comparatively worse performance for almost any sector dependent on domestic consumption and demand.
These are just snapshots but they make an important point clear: the economy’s relative level of investment into natural resources continued to grow while sectors focused on domestic demand fell. Demand for Russian exports was sustaining investment, but failed completely to sustain real incomes because austerity policies prevented a more expansive redistribution from being used post-Crimea. The implications are quite worrisome. Even marginal declines in oil production, coal exports and production, or natural gas exports create knock-on effects across Russia’s regions that the regime can only offset through a combination of command economics and fiscal expansion. Fewer wells to drill means less cement, less steel, less labor, and less services needed. That then means fuel retailers sell less locally, manufacturers see fewer domestic orders and imports would have once filled that gap, fewer jobs available in regions often struggling with depopulation or else so remote as to have few settlements outside of industrial city clusters. Tax receipts decline since regional governments take the lion’s share of regionally domiciled corporate tax revenues levied by federal law in the fiscal system, fewer VAT revenues, lower income tax revenues, and worse.
The regime’s “oil-proofing” policies were also linked to the decision to float the ruble, with the value of the ruble managed through fiscal rules dictating that all revenues realized per barrel above the cutoff of $42/bbl of Urals blend (+ an inflation adjustment from its adoption) would be parked aside in the National Welfare Fund or otherwise sterilized through the treasury. The idea was to decouple the ruble from the oil price, but what it actually did was expose the ruble to far greater geopolitical risk and simply decouple the two when oil prices rose and link them once more when they fell. As we’ve seen, the role of energy in the real economy actually expanded in investment terms after 2014. Price declines tended to worsen the effect. Instead of a fiscal or financial fortress, the regime built a hydrocarbon prison through its own orthodoxy.
As each of these structural dependencies, relationships, and flaws interact, there emerges the risk of an energy “doom loop.” The notional “doom loop” in banking refers to the over concentration of European banks’ portfolios in European sovereign debt, creating a vicious cycle of contraction when the solvency of sovereigns in the Eurozone was at issue. Any hit to a sovereign credit rating or the pricing of default risks via the bond market would encourage a contraction in lending activity, worsening the already significant damage of the Global Financial Crisis. In the Russian case, that doom loop is more akin to the over-concentration of private sector consumption, fiscal revenues, state procurements, and various rents in the energy sector. The continued increase in oil drilling activity, deployment of horizontal drilling, and company-level benefits from the devaluation of the ruble at the end of 2014 allowed oil & gas firms to offset the depth of the stagnation visited upon by the Russian economy by policy choice more than by sanctions. There are countless possible scenarios that could now play out, but it’s safe to assume a significant decline in oil exports – and therefore production – this year, gas export constraints because of Gazprom’s own refusal to supply via spot trades in Europe and now idiotic attempts by Putin to suggest they break their contracts and only take payment in rubles, and a slow but accelerating fall off in investment for the extractive sector in 2022 and in the years ahead relative to the pre-war ‘ceiling’ or potential they had. Russia’s economic potential and the capacity of the regime to transfer rents from the sector elsewhere decline precipitously the greater the share of oil production affected.
The expected decline in demand for domestic industries serving exporters also runs up against the novel nature of the current economic shock. With so many key technological inputs now sanctioned or self-sanctioned and numerous foreign industrial firms and consumer and retail brands ending services in Russia, fiscal attempts to subsidize domestic substitutes and offset the degree of pain felt by consumers will be inflationary because of the disconnect between what’s available domestically and what’s reliant on imported components or entirely imported. As of 2021, the average Russian household spent roughly 37-38% of their income on food and basic goods and the supposed hydrocarbon windfall so many bang on about regarding Russia’s current account doesn’t exist in a vacuum. Surging natural gas prices abroad coupled with surging fertilizer prices abroad, forcing domestic producers to demand more on the domestic market or else opt to export. Export bans may increase domestic supply by force, but fertilizer prices are very high domestically and subsidized loan programs and soft price control measures to keep them lower in the sector are either running out or not working. Households are going to see even more of their now declining incomes going towards food. Disruptions for exports by ban or, in the case of agriculture, loss of Black Sea export capacity ends up reducing what exporters plant and harvest down the road as well as the productive capacity fertilizer producers maintain. The effects pile on emanating outwards from the energy sector.
We have already seen evidence of movements back towards sectoral planning. The Central Bank is being tasked with direct FX liquidity management for imports, there’s now movement to reinstitute some degree of nationalized control and planning capacity for rail logistics, and an otherwise paltry support package of 1 trillion rubles. The regime depended on the energy sector to maintain the coalition of stagnation it pivoted to in 2012 after Bolotnaya. Past iterations of autarky necessitated Russia export commodities to raise capital to pay for technological imports or food. The former has been disrupted by sanctions, the latter now irrelevant but feeding into domestic food prices through the integration of Russian fertilizer and food production onto global markets with prices set regionally and globally. Russia’s integration into global commodities markets is now its biggest weakness, not its greatest strength. The Russian economy today is more isolated than the Soviet Union was in economic terms. Whatever the return to soft or harder forms of planning and command look like, we can be certain that Russian economic policy has no intention of shifting to a demand-led view of how it can achieve growth. The rents, as they say, are too damned high.