Top of the Pops
The OPEC+ standoff with the UAE over its plans to increase output in the face of soon-to-decline demand drags on. The White House made clear through spokesperson Jen Psaki that it’s worried about high gasoline prices, but there isn’t yet much evidence Biden and his team are expending much political capital to fight them. That’s probably because of the structure of consumer spending in the US amid evidence that low-end wages for service jobs are rising again. As Zach Carter notes, housing accounts for 37% on average of household spending followed by transportation at 16%. 10% for married parents goes to childcare vs. 34% for single parents. It comes down to political priorities. More expensive gas makes a difference, but far less of one when wages are improving for those most exposed to increases in costs and you need buy-in for Iran deal negotiations. That’s also why the bipartisan and reconciliation infrastructure are so important — they’ll include some funding to improve public transit, rail transit, and support the purchase of charging stations and the purchase of electric vehicles while also trying to build in more child tax credits and social spending to ease the burden of childcare. Russia’s in a fairly weak negotiating position now since investments are affected on a 1-2 year lag when prices crash. The following is OPEC upstream investment excluding supporting infrastructure:
The fact is that output has to rise in the near future to make upstream investments more sustainable and avoid instability. But OPEC members, namely Saudi Arabia, the UAE, and Kuwait, are in much better position than Russia on that front. They can more easily idle capacity and generally get more bang for their buck investing into newer production, though this is somewhat dependent on the project and company operator in Russia for comparison. That the UAE has been able to jam everything up goes to show that it can afford to gamble recklessly. If current cuts hold through April, it benefits far more in relative terms than Moscow and, conversely, benefits far more from decoupling output increases starting in August from the April 2022 deadline for current cut levels too since Russia’s only major greenfield project in the pipeline is Vostok Oil, and it has to be subsidized. The UAE wants to revise the baseline for output calculations from the 3-year old levels to April 2020 — only Saudi Arabia, the UAE, and Kuwait would benefit within the deal framework. Russia would theoretically gain too, but is also aware it may cede market share in the near future due to domestic output declines and doesn’t want to lose market share in China to Saudi Arabia.
What’s going on?
The government is now discussing tax reforms intended to raise about 400 billion rubles ($5.46 billion) between 2022-2024. About 100 billion rubles ($1.37 billion) will come from an increase of the mineral extraction tax rate for precious metals, 90 billion rubles ($1.23 billion) from taxes on oil firms’ “additional income” above a target level, and 100 billion rubles ($1.37 billion) from improvements to the collection of excise taxes or else upwards adjustments on some goods. The other 110 billion rubles ($1.5 billion) will come from raising taxes on individuals and other measures. On that last front, the government’s commission for tax policy came out against a tax on luxury goods, including high-end real estate, cars, yachts, and private planes. For now, it seems they’re burying the negotiations into MinFin’s budget process for the next 3-year budget proposal to keep talk of any politically sensitive taxes ‘inside the family’ while the Duma’s on vacation. What was more interesting to see from the Vedomosti writeup is that MinEkon sees no need to tighten budget policy — they aren’t linking the budget to inflation problems — while MinFin has set out its view that last year’s expanded deficit and state spending contributed to rising price levels. Minister Maxim Reshetnikov is now trying to pull off an equivalent oil tax maneuver for the metallurgical sector so the state can properly reap the windfall profits from the new commodity price cycle while retaining enough space for firms to invest into output. There’s more to ponder — an increase in alcohol excise taxes would increase illegal consumption, for example — but my overall impression is that budget policy is likelier to be tightened by increases in taxation rather more than any decreases in spending at the moment.
As the government’s share of consumption of GDP has fallen with the snapback to budget consolidation, a burst in sales and the circulation of goods (and to a lesser extent services) picked up the slack in 1Q. Practically, that means the best of the COVID recovery is already behind us because the inventory that manufacturers and retailers had available to sell cleared in 1Q. Making more means absorbing higher input costs, which eventually have to be passed onto households. The following is the % structure of GDP:
Seafoam = household consumption Black = non-commercial org consumption Yellow = change in material inventories Salmon = State consumption Light Blue = gross capital formation Darker Blue = Net Exports
These are year-on-year comparisons for 1Q so they don’t capture the extent of changes perfectly well, but we can see the obvious problem. Any increase in household consumption since 1Q 2019 has been debt-financed. What’s even crazier is that capital investment as a % of GDP fell further this year in 1Q from 15.4% in 1Q 2020 to 14.9% while overall investment data has shown a slight increase (2%) as of June. What gives? By the look of it to me, companies are spending less on fixed assets — land, machinery, buildings — and more on things like intellectual property or else financial assets in response to business conditions and rising inflation. In short, they don’t believe the demand will be there to justify an expansion of capacity because the state refused to more proactively manage the recovery, instead trying now to manage cost increases from higher commodity prices or supply chain bottlenecks for imported gear like semiconductors. The increase in investment activity seen more recently is happening because businesses are trying to get ahead of the Central Bank’s rate hikes that’ll make credit more expensive. The recovery may well flame out this summer, especially with the terrible toll the Delta variant is now taking on lives, health, confidence, and certainty.
The withdrawal of US forces from Afghanistan is having its intended strategic effect. There’s a resurgence of concern in Moscow that the Taliban represent a serious threat to Russia. Foreign Minister Sergei Lavrov noted last week that IS was also a resurgent problem since it could ostensibly launch attacks from Afghanistan as a base — he of course did not note that the Taliban fight any IS presence regularly since, unlike Al Qaeda, they intend to setup an actual presence to govern rather than just act as a network aiming at far away targets. The Uzbek government has setup a tent city near Termez anticipating refugees and Afghan soldiers fleeing the Taliban will come in large numbers — Tashkent expressly takes the line that soldiers crossing the border without permission are in violation of international law whereas Tajikistan has done less to discourage them. Moscow’s made clear it’ll provide assistance to Dushanbe to police the border properly. At the current rate, we may begin to see the Ministry of Defense, Ministry of Foreign Affairs, and public-facing security officials lay more groundwork to justify military action into Afghanistan in response to threats from IS. At that point, something akin to targeted airstrikes supported by small incursions from ground units and/or groups of Taliban fighters against IS would be closer to reality. Once that happens, the reality of the US decision to withdraw will finally hit home — US competitors will have to shoulder at least some of the burden of managing Afghanistan, tying up precious resources while the US has more room to pivot its own to the Levant or East Asia. Officials in Kabul are currently in talks with Moscow to establish an intelligence exchange to potentially coordinate future efforts. The CIA has deep ties with Afghan intelligence. It’d be a golden opportunity to those in D.C. looking to make the most of a politically contentious but proper decision to reduce the American footprint to keeping Kabul safe, providing financial assistance, and targeted air support. The Kremlin’s announced a beefed up presence to monitor the situation from the Tajik border, but has yet to talk to Kabul about placing troops inside Afghanistan. How long that lasts is an open question.
The Federal Anti-Monopoly Service (FAS) and MinEnergo have worked out a joint order to set new guidelines for sales of coal on exchanges. The aim is to require the largest coal producers to trade 10% of their monthly sales via exchanges where buyers bid and trade contracts rather than through direct producer-buyer agreements outside SPIMEX in Moscow. New guidelines for exchange trading will then aid price discovery and help stabilize prices. Market participants will be able to assess their contracts for coal supplies in light of broader market movements, improving transparency and market efficiency by circumventing the incentives to inflate costs in local and regional corruption schemes or else use insider trading between a coal miner and a subsidiary to pass money around between asset owners. Instituting exchange contracts as a normative requirement will undercut the use of privately negotiated contracts traded over-the-counter (OTC) to this effect. There’s little doubt that corruption schemes jack up costs, however it’s unclear how this latest stab at speculation really fixes the problem. Cost increases should turn up in higher profits for producers who could be cajoled into producing more and reinvesting said profits into productivity gains. There might also be a bigger problem of firms misquoting actual production costs since wages tend to be politically suppressed and managed in the sector to limit labor bargaining power (within limits). Oil firms regularly inflate production costs to lower their tax burden and then announce lower production costs to foreign investors to make them happy. It’s a decent idea that may help around the margins. Fighting speculation as if it’s the proximate cause of all price instability doesn’t make sense, though.
COVID Status Report
24,535 cases — the 3rd day in a row with over 24,000 cases — and 654 deaths were recorded in the last day. Rospotrednadzor estimates COVID has cost the Russian economy 1 trillion rubles ($13.65 billion), an estimate that almost certainly understates the damage when you factor in Long COVID and losses associated with inefficient and sometimes half-baked economic measures on top of limited state support. The week-on-week rate of increase is coming down — hard to say it’s close to being ‘enough’ yet given gaps in testing and the continued upward trend seen for cases across the regions though the reintroduction of some restrictions is helping:
Russia set its official mortality record over the weekend — 697 deaths in one day — and the last 5 days have broken previous highs. Much of that is probably explained by terrible data from the 1st wave and mediocre data from the 2nd wave, as much as it deserves note. United Russia is following up on Putin’s Direct Line by consulting with experts on how to approach long-term recovery from COVID symptoms and after-effects. I’m relieved it’s on the policy agenda. Daily vaccination demand has hit 500,000 doses — a 5-fold increase over March levels. Hopefully production can keep pace. Levada found that 54% of Russians still aren’t ready to get vaccinated…
Iraq and Roll
According to Iraqi oil minister Ihsan Abdul Jabbar, BP and Lukoil — two of the biggest foreign partners for Iraq’s upstream oil sector — are looking to sell their assets tied up in the West Qurna fields and invest elsewhere. In BP’s case, it seems likely connected to pressures to meet climate targets and divest from dirtier projects where practices such as flaring are more commonplace. For Lukoil, it’s probably more to do with a change in portfolio preferences — it just acquired a 50% operator interest in a shallow offshore project in Mexico for $435 million after having closed a Sales and Purchase Agreement for 49.99% of a Caspian offshore bloc owned by Kazakhstan’s KazMunayGas. Both companies are looking to sell to Chinese firms. ExxonMobil has tried to sell its 32.7% stake in West Qurna 1 to 2 Chinese firms for $400 million, but had the deal held up by authorities in Baghdad concerned about the political significance of the transfer of assets given Washington’s role providing security for the state. Iraq’s oil ministry has made clear that the country has become unattractive for major oil companies because of failures to stick to contracts, frequently poor economics for projects based on payments per barrel extracted, and now the issue of carbon emissions affecting firm rationales. That Chinese firms — the big one so far is CNPC — are considering buying speaks to an acceleration of underlying pre-COVID trends. China’s the world’s largest importer, it’s domestic output has plateaued, and the COVID crash gave Chinese firms an opportunity to eye up investment opportunities other firms might otherwise pass on in order to advance national energy security priorities and deepen ties with regional governments.
At the beginning of January, China’s Zhenhua Oil co. reached a tentative deal with Baghdad that would have provided $2 billion upfront to secure 5-years’ worth of oil at a time when the national budget was straining from the 2020 price crash. The Iraqi dinar was devalued by 20% in December in a desperate bid to restore order to the nation’s balance of payments and budget by increasing the cost of imports and increasing relative earnings off of oil extraction and exports. As the OPEC+ cuts and then US recovery did their work and oil prices recovered, Baghdad reneged on the prepayment deal realizing it’d be foolish to lock in too low a price. But now its spotty record has caught up to it as western and Russian oil majors have to reconsider how to maximize profits and please investors in a world where the extraction of oil must become cleaner and faces rising scrutiny. The panic of The Terminally Online over an offshore spill and fire via leak in the Gulf of Mexico, though brought under control swiftly, raised a lot of uninformed takery regarding the viability of oil operations — capitalism was blamed, though naturally the company Pemex is state-owned. Yet the same people wringing their hands over the Pemex fire were silent when video surfaced that quite clearly shows a massive natural gas leakage and fire off the Azeri coast from gas fields managed by SOCAR. SOCAR has denied any trouble as a matter of course, but it has to — like Iraq, its western partners led by BP have reconsidered its role in their portfolios particularly as Baku renegotiated its production sharing agreements to increase its relative stakes and revenue take from projects. Pemex has to get help if it can’t sort out these problems effectively on its own as well.
A few weeks ago, a consortium led by China’s Silk Road Fund acquired a 49.9% stake in Aramco’s oil pipelines for $12.9 billion. It was a bit of paper pushing to raise cash for Riyadh, but underscores a crucial inflection point for both US and Russian foreign policy in the Middle East. US imports from the region have fallen. In January, the US imported no oil from Saudi Arabia for the first time in 35 years. The Biden administration has been pursuing a further withdrawal of US personnel out of Iraq while negotiating a timeline with the government in Baghdad in the interest of reducing its presence to focus on training and support and, crucially, allowing to shift more resources to focus on Syria and Libya based outside of Iraq at the variety of bases that have been expanded since 2016 across the region or else the Asia-Pacific. The omnipresence of American air capabilities in the Middle East is intended to act as a backstop easing the way. Having Russian and Chinese firms in Iraq isn’t new — they first won contracts for tenders back in 2008-2009 when they were first issued (which kind of dents the obnoxious war for oil narrative). What is new is that China has positioned itself as a lender and investor of last resort for Iraq. Moscow’s biggest economic gains all came in Iraqi Kurdistan led by Rosneft’s acquisition of pipeline infrastructure and some upstream awards, with similar awards to a few other Russian majors. Moscow provided a supply prepayment for $1 billion in 2017 to the government in Erbil to buy trust. As time goes on, China’s corporate presence across the region will probably keep growing. Its nationally-owned or backed companies don’t face the same political pressures from investors to go green, it has fewer issues buying into lower-return projects since it can comfortably finance activities and make use of its massive foreign currency reserves, and its import dependency keeps rising.
Evan Feigenbaum likes to joke that the United States should not simply become the Hessians of Asia, guns for hire in a pinch, but rather develop a complete approach that incorporates economic diplomacy and other factors to build a self-sustaining web of mutual interests across the continent. That’s what’s happened to US strategy in the Middle East — American soldiers and contractors are Hessians for governments dependent on external rents to sustain their internal political organization or else security. Oddly enough, it’s the approach that Moscow mirrored when it decided it had to take on a more proactive role starting with the intervention in Syria. There have been commercial contracts linked to these activities. We shouldn’t discount mercenary groups or contractors, for instance, securing exploration and extraction rights for oil in Syria (and attempt to replicate the model of security for assets further afield from Libya to Sub-Saharan Africa). Overall, however, these contracts are small potatoes. China’s not just stepped in to try and find bargains post-COVID, but also directing more of its investments towards green projects across the region. China’s a leading player for solar developments given its industrial heft for supply chains and interest in reducing Saudi, Emirati, and Middle Eastern oil consumption for power to reduce emissions and ensure the availability of cheap oil for export.
Whereas US strategies have become increasingly militarized ever since the Clinton administration adopted a policy of democratic enlargement followed by the Iraq Liberation Act of 1998 that formally established US policy would support efforts to remove the regime in Iraq, Russia’s presence across Eurasia from Central Asia to the Levant militarized as a result of its economic deficiencies and domestic institutional structures. This analysis can apply to the US — look only to the creation of the Department of Homeland Security and rise of the security contractor as an example — but is a much larger challenge for Russian policymakers. China overtook Russia as the economic prime mover of Central Asia by the time the Global Financial Crisis hit, the South Caucasus has since similarly felt the pull of China’s demand and search for assets to buy, and the Middle East has been reorienting its economic priorities eastwards ever since Chinese demand rose explosively. At each juncture, Russia’s best response has been to double down on its competitive advantages — existing elite ties, security relationships, and a willingness to get involved with narrowly defined missions. Since 2013, the exhaustion of domestic rents provided by oil-led growth gave rise to a resurgence of rent-seeking via foreign policy initiatives. A Saturday piece by Giorgii Kunadze for Novaya Gazeta. talks about the “mania of greatness” that has consumed Russian foreign policymaking. That certainly explains the psychology of many decisions. It does not, however, capture how incentives changed for so many constituent parts of the nation’s political economy. Economic sectors leapt for ever more trade protections, SOEs began to demand more and more bans on imports to lock in demand, private political entrepreneurs began to more actively chase glory raising havoc in far flung conflict zones, and the Ministry of Defense has had to eye roll at the appearance of mercenaries in Syria operating outside of its control and without respect to established rules of engagement to avoid direct conflict with the US and its NATO partners.
It’s impossible to untangle Russia’s sudden appetite for action from the underlying failure of its political establishment to create economic growth, as much as the psychological explanations of how figures like Putin or Patrushev make decisions can explain Russian policy outwardly. At the end of the day, however, it’s China and other large external investors willing to take gambles owning and operating the key infrastructure and extractive industries of the Middle East that benefit. Firms unencumbered by US sanctions or the same reputational risks, investors able to manage relationships with local militias, hire security contractors, and trust that their political counterparts on the ground have a decent enough relationship and understanding of the Iraqi security forces and role of American personnel and military formations to protect their investments. In the same way one can argue the US is footing the bill for conflicts China ought to be helping to pay for, so is Russia even if it’s doing so in opposition to erstwhile European powers and the United States. Geopolitical machinations have an underlying logic not entirely dissimilar from financial balance sheets. Every ‘asset’ gained carries with it a corresponding liability. Some liabilities are very easy to manage, some not. Some assets offer fantastic returns, others become sinkholes. On balance, Russian foreign policy has done relatively little to advance material gains aside from the performative component of playing the part of a major power. Moscow is underwriting an evolving, anarchic security system that local and regional actors exploit to secure their own ends, including the corruption and money flows tied to owning and holding oil assets. Iraq is a sign of the complexities of ‘green’ geopolitics to come as oil power takes on new meanings and forms in a world of rising non-fossil fuel commodity prices and demand paired with macroeconomic innovation foisted onto developing markets and countries like Russia from the US and EU.
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