6 min read

The Commanding Blights

COVID Metamorphoses
The Commanding Blights

It’s quite fitting that Russia's weaknesses sometimes spare it a worse fate. COVID-19 has not decimated Russian economic output largely because of the lower share of GDP taken up its services sector and continued reliance on commodity exports to maintain its current account surplus. Debt issuances have also helped manage some of the ruble’s ongoing volatility - just 3 weeks ago, MinFin set a record placing 215 billion rubles’ worth of OFZ in one day and earlier in the summer, capital inflows helped around the edges as the ruble took a dive on bear market news for oil and global growth. With the federal budget deficit now breaking 1.7 trillion rubles, the 2021-2024 budget proposal will be wheeled out tomorrow and while deficits will persist through 2024, it’s clear that FM Anton Siluanov wants to get back to consolidation to maintain the sanctity of the nation’s balance sheets. Defining fiscal priorities is all the more important now that Moscow seems to have finally lost an audience in Berlin, Belarus is still teetering, and conflict in Nagorno-Karabakh could have a host of knock-on effects if the fighting escalates.

But Russia’s obsession with austerity and its fiscal fortress is now misplaced. The CBR rightly worries about price inflation because of regionality - transport costs, infrastructure, and more beyond the money supply have large distortionary effects on price and the median expected inflation for. the next 12 months from CBR surveys hit 8.9% for September. The trouble is threefold:

  1. Oil prices are likely to struggle to lift past $55 a barrel ever again which entails cuts to spending and shifting the tax burden onto the population
  2. Inflationary expectations don’t align with the fact that 6.1% of middle class are now estimated to be considered poor and nearly 19.9 million now qualify as living in poverty
  3. The forecast from MinEkonomRazvitiye literally ignores any structural impacts from a global second wave of infections in its base cases, which seems rather odd for a country for whom trade accounts for about half of GDP

Any attempt to return to a fiscal surplus is done at the cost of growth and, in practice, the population. Forex and gold reserves stood at $594 billion at the end of August and the National Welfare Fund has actually grown in value this year. Setting aside arguments over industrial policy or this and that sector, in a macroeconomic sense, Russia has opted to preserve its own status quo focus on moving towards fiscal surplus. In so doing, it intends to take that money out of the pockets of people who, by some estimates, lost as much as 12% of their real incomes during the pandemic and were only compensated with 2%, presumably further offset by taking on more debt juiced by the CBR’s cutting the key rate steadily down to 4.25%. The mistake is to assume that Russian reform efforts hinge on sectoral initiatives. They matter. But the real crisis is the poverty of current macroeconomic policy and thinking to adapt to the new world post-COVID. Public surpluses are private deficits and austerity always seems to be the order on the menu.

Shell-shocked

The oil price naturally holds much of that fiscal balance together. Following BP’s aggressive moves to pitch itself as a green energy company-in-waiting and raising the alarm for future oil demand, Shell has pushed out its own “Project Reshape” to reportedly cut its operating costs for oil and gas projects by 40%. It’s in line with what most industries do in a recession: rip up anything that isn’t bolted to the floor and cut the deadweight. Equinor has done so much to cut costs and improve recovery rates at North Sea fields, it feels confident in launching a $2 billion joint project at the Breidablikk field which reportedly as 200 million barrels of recoverable oil. The point is that the early doom and gloom about NOCs dominating the oil sector as international, privately-held companies wither away due to the price effects of COVID and negligible demand growth prospects isn’t quite accurate. Cost savings are effectively permanent once they’re realized and NOCs are simply not that good at moving fast on these things, especially when it comes to cutting costs given institutional incentives to wring out as much as possible for contractors, find ways to justify claiming higher expenses to avoid more onerous tax liabilities and so on.

Betting on a massive price rally ignores that the last 6 years have forced a lot of companies to get leaner internally and more disciplined. While many cut a lot of fat after 2014, there’s always more slack to go as technology improves and, crucially, labor markets are no longer tight thanks to COVID. Though US output may never recover fully because investors have finally learned that cash flow matters, supply shortfalls on the market will be cushioned by a concerted effort to lower break-evens yet again using automation, software, foreign labor, anything these companies can think of. In the end, the oil price rally many are praying for hinges on demand. There isn’t a flood of money coming into the Russian budget next year thanks to the current budget rule, I’m afraid.

The IEA’s relatively bullish forecast on demand captures the basic problem for oil demand, and by extension, Russia, Azerbaijan, and Kazakhstan. The trend line for declining growth YoY corresponds to a bunch underlying trends:

  1. The growth of trade relative to GDP declined
  2. The global growth rate has declined
  3. The monetary regime after the Global Financial Crisis helped finance shale oil and maintain consumption levels, but now may have the inverse impact due to policy intervention
  4. Key economies may be reaching a critical “breaking point” for the impacts of economic inequality on policy and consumption
  5. Trade imbalances undermine future growth, especially in China

The IEA trend line suggests we hit peak oil demand somewhere past 2030. BP has put out a scenario saying the peak is actually sometime in the next few years. The truth is no one has any clue. A great deal depends on policy choices made in the next 24 months. One thing is certain: we’re nowhere near beating the virus, have no coherent idea of how vaccines will be distributed or even how effective they’ll be, and how much changes to behavior and preferences will stick. On the net, uncertainty is terrible for oil demand prospects in the short to medium-term, which makes BP’s “oil doomer” outlook much likelier and what I subscribe to based on macroeconomic fundamentals,  the market’s current reaction to the latest price shock, and the fact that models are notoriously bad at capturing the rate of adoption for new technologies, especially when there might be major policy changes in places like the US soon.

Neft for Dead

With all that in mind, the trouble with Russian macroeconomic policy is that its framers maintain an economic orthodoxy that congealed for them after Russia defaulted on its domestic debts in 1998. The major players in Moscow worship deficit reduction, the avoidance of external debt - the Soviet and Russian governments always prioritized external debt repayment over internal debts - and observe their own type of aversion to ‘crowding out’ private investment with public investment (which really is convenient cover for starving the country of investment and ensuring that only the right hands get a cut of the action). The rise of the public-private partnership obsession - great for ensuring the public bears the risk and takes none of the reward - has not fostered an investment boom. Energy Minister Alexander Novak can call for big global economic players to coordinate in response to the global oil demand crisis, but it just goes to show the limits of the prevailing orthodoxy and Russia’s economic weakness. The demand side calls the tune. Too bad Moscow banked on Trump’s candidacy and the international incoherence it accelerated.

The tax burden for other companies, including the metallurgical sector, and the population is being raised by a combined 504 billion rubles to feed the budget. In the current environment, fiscal discipline isn’t doing much to keep the ruble stable or attracting foreign investment. The reality is that the tax shift that will have to take place from the oil sector can be managed, and managed effectively, but oil prices are still driving budgetary politics and the business cycle. Oil is most likely going to stay cheaper than not till the end of time. The Kremlin can throw money at Vostok Oil to expand its international market share, aid the Arctic economy, undermine OPEC+ cuts, and maybe score a little GDP growth quickly. Putinomics was once about controlling the Commanding Heights. Alas it turned out that so far as growth was concerned, they were commanding blights.