15 min read

Trap Lords

Another Inozemtsev piece on the oil problem caught my eye
Trap Lords

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OPEC+ surprised again. The UAE held up what was otherwise an acceptable compromise to start raising output by 400,000 barrels per day each month starting in August. It wanted larger exemptions so it can begin to expand upstream investments to raise oil production by 1 million barrels per day in the next decade — up to 5 million bpd. Back to the drawing board today as the bloc figures out what can be agreed. If no pathway to an increase is agreed, we’re in dangerous territory for market stability. The problem isn’t necessarily how short the market currently is for supply, but rather that the default framework in place calls for no change in output till April 2022 if there’s no deal. Suddenly defections become a huge concern and global price inflation would be worsened for many emerging markets and import-dependent economies if prices kept rising past $80-85 a barrel, including Russia. Then there’s the issue of US output. Ignore Pantheon here — it’s the latest attempt to up Alaskan production, still a bit tentative for costs, and not particularly important for the point though could matter:

The core of US shale plays managed to get their breakevens down to the $45-60 dollar a barrel range with a far bit of offshore capacity in that range as well. If prices rise enough without any output increase from OPEC+ and the expectation they do nothing till April 2022, even relatively restrained shale drillers will have a reason to increase output to meet demand. Those investments operate on a 6-8 week timeline, not the years and years that conventional onshore and offshore projects are designed around. You can kill wasteful spending in shale, but you can’t kill its effect on oil price ranges structurally. Only modify it. Moscow is undoubtedly cognizant of this dynamic when pushing for more output sooner.


What’s going on?

  1. Rosatom’s AEM-Tekhnologiya, a core part of its manufacturing division, is sinking 9.7 billion rubles ($131.82 million) into the modernization of plant between 2021-2023. The infusion represents a 60% increase on capex into production for 2018-2020 and a six-fold increase over 2015-2017 — the progression of spending makes sense when you recall that back in 2017-2018, Rosatom’s expenditure levels were slated to match or exceed those of Rosatom and Gazprom by 2021-2022 (if I recall correctly). Investments into the firm’s fixed capital hit 12.8 billion rubles ($173.87 million) for 2021 against just 4 billion rubles in 2018. Naturally nothing has been revealed as to whether it’s company money or debt paying for these upgrades and investments. Shockingly, AEM-Tekhnologiya is the only company in Russia that produces the full complement of parts and equipment for the nuclear steam generating installations that power nuclear reactors. Given that, these spending levels for capacity and productivity enhancement seem quite small comparatively. Vedomosti’s writeup uses the company and government line by playing up the fact that the IEA has called for a 4-fold increase in nuclear power plant construction through to 2030 to meet net zero goals. The intention per director Igor Kotov is to time the completion of these upgrades with the peak of the investment cycle in 2023-2025 when a bunch of Rosatom’s export catalog should, in theory, be moving into more active project phases past initial planning, duals over contractual terms, and various agreements to agree. The pressure’s on. Poland’s announcement last year it’d look to spend up t $40 billion on nuclear capacity to ease the replacement of its coal fleet came with a 2023 launch date for the first plant. Rosatom isn’t winning that tender, but it’s an important leading indicator for what might soon become broader willingness to (re)commit to nuclear, particularly if natural gas prices remain higher for longer.

  2. The June release for IHS Markit’s industrial PMI ticked back under 50 again, signaling a fall in demand for Russian firms. It fell to 49.2 from 51.9 for May. Cost increases linked to inflation are the leading culprit as firms now have to pass on more costs to wholesalers and, by extension, consumers. The Gaidar Institute’s own measure of demand based on the ability of consumers to pay also indicated a downward trend compared to expectations for June, though still showing growth month-on-month:

    Balance = % Growth - % Decline — Blue = expected Red = actual

    Inflation is now eating the economic recovery alive with the added blows of political pressures to restrain spending and difficulty finding buyers for Russia’s sovereign debt at the moment. As inputs get more expensive, intermediate goods and inputs rise in price. Before you know it, manufacturing is struggling. Any of the positive momentum Reshetnikov and MinEkon were talking up from May is largely gone now with everyone well aware there’s no ‘breakthrough’ for growth on the way. What will Moscow policymakers do? So far, we’ve seen no evidence that any stimulus will be provided and instead efforts are centered on capping further price rises. The short answer is they’ll do nothing. I’m increasingly interested in the implications of Russia’s push for a much faster hike in oil output with OPEC+. There’s probably a (small) component of it hoping to get inflation under control more globally alongside the boost to domestic demand. But that would also require Gazprom increasing deliveries to Europe and a surge of capacity investment into other forms of extraction that’s now at risk thanks to the expanded use of export duties.

  3. Yesterday, president Putin signaled that Moscow will expand its economic support to Belarus as needed in the face of mounting sanctions pressures from the West. Last August, that came out to a $1.5 billion infusion, $1 billion of which came from state funds and the rest from the Eurasian Stabilization Fund for which 90% of its capitalization is provided by Russian budget funds. The newer EU sanctions have limited Belarusian banks’ ability to raise funds abroad by capping maturities at 90 days for any loans made to the Belarusian state, its agents, and corporations or else any sovereign debt purchases. Over 90% of Belarus’ sovereign debt is denominated in foreign currencies — Minsk has about $3.3 billion in eurobonds outstanding at the moment and I’ll have to ask Max Hess for more details, but apparently the market’s pricing them at just slightly. better than Ethiopian issuances. All of this is to say that in the midst of an escalating return to economic crisis conditions in Russia, Moscow is closing ranks and not ceding an inch on Belarus. But there’s a brewing liquidity problem across the Belarusian economy. The National Bank suspended liquidity provisions to banks on a continuous basis at the end of last August and has extended said suspension indefinitely after initially suggesting it’d be lifted by mid-September last year. As inflation shot up and macroeconomic pressures have worsened since the COVID crisis began, the National Bank has had to limit the liquidity flowing into the banks to head off a collapse in the foreign exchange market since both households and firms, expecting a massive drop in the value of the Belarusian ruble, have every reason to buy foreign currency and wait for the devaluation to take place. At the same time, consumer debts have fallen 9 months in a row — people are paying down debts more than borrowing — and the more that trend continues, the worse off incomes and demand will be whenever the economy normalizes more. Things aren’t looking good and only Moscow can offer significant external help.

  4. Ukrainian president Zelensky has made a huge splash today that deserves recognition: he’s managed to pass systemic land reform allowing private ownership of agricultural land in Ukraine that has now taken effect. This is a hugely positive sign for the country’s agricultural sector and exports, though its institutional consequences aren’t as clear yet. The reform is proceeding in two phases. Until 2023, only individuals can buy, sell, or lease up to 100 hectares of land at a time. Starting Jan. 1, 2024, legal entities can buy, sell, or lease up to 10,000 hectares at a time so long as they meet crucial conditions. The founders and/or members of the legal entity have to be Ukrainian citizens, foreign citizens can’t buy land (though this will be put to a referendum), foreigners will never be allowed to own land within 50 kilometers of Ukraine’s borders, companies without a readily identifiable beneficial owner will be barred from ownership, and individuals from “aggressor states” (read: Russia) will also be banned regardless of the referendum. There are tons of hurdles to clear, but it’s a huge deal given how deeply entrenched the problem of who controls what has been since Ukraine’s independence. The reform will, imperfectly, bring more money into state coffers as well as provide more transparency — shadow leasing schemes are commonplace and smallholders have historically struggled against larger agroholdings. This won’t fix that, but can provide more opportunity to consolidate plots or else actually receive some form of compensation instead of facing displacement without any property rights. There’s going to be a flood of legal queries and fights over whether owners and tracts of land are properly registered in the cadastre. If someone claims ownership illegally or else no one steps forward to claim said land as they privatize what was public property, that land will become communal property after 2025. One can imagine plenty of shenanigans with any transition. It’ll take some time, but land reform in Russia was integral to its eventual rise as a leading wheat exporter. The quality of land in Ukraine tends to be higher thanks to the black earth it possesses, giving it higher yields. Russia’s wheat exporters will hardly be ecstatic since they can’t buy into the gold rush ahead.


COVID Status Report

23,218 new cases and yet another record 679 deaths were recorded in the last day. Hospitals are so slammed with new patients that MinPromTorg is asking the metallurgical sector to reduce its consumption of oxygen for production in order to redirect more oxygen supplies to healthcare facilities in order to head off shortages. Authorities in St. Petersburg are now working how to vaccinate 400,000 migrant laborers as the scramble to dole out doses has become a prime concern for an already tight labor market still suffering from lower migration levels. Duma deputy Vitaliy Milonov has proposed to Labor Minister Anton Kotyakov that Russians getting vaccinated receive an extra paid day off to recuperate and encourage more people to get their vaccines. All hands on deck coming up with whatever sticks at this point. It’s also worth acknowledging the latest variant to worry about — the ‘lambda’ variant found in Latin America where case levels remain high and risks of contagion via travel remain (lambda has already been found in the UK):

Per the FT’s writeup, we don’t yet know if this new variant is more transmissible. It’s raised concerns because apparently its mutations are unusual. I flagged this cause it’s a healthy reminder that there really is no solution except to vaccinate everyone as fast as possible and then adjust accordingly, whether that be booster shots or, eventually, reconfiguring existing vaccines. And while Russia may have made decisions about opening or closing flight access on the basis of other country’s infection levels, it could end up a longer-term pariah for tourism unless it can sort out this situation effectively. At the same time, that won’t matter too much so long as incomes continue to fall.


It’s a Trap!

Oil dependency is a harsh mistress. For all of the clangorous thrumming about Russia’s successful efforts to wean itself off of oil, it’s still the thread that holds the budget and economic system that has sustained the regime together. That’s why I found Vladislav Inozemtsev’s latest for Riddle a great read — he well understands that a return to high oil prices would actually be terrible for the Russian economy’s prospects. I think he could take his argument a fair bit further than he does, and I also have a few significant points of disagreement worth working out as to why. Overall, the idea that commodity price cycles can convince a political leadership an aging, ineffective, and increasingly toxic economic model is sustainable has huge explanatory power for the course of Russian economic and security policymaking since the late 90s. You may be able to teach some old dogs new tricks, but you can’t retune entire fiscal, monetary, commercial, and financial structures built upon the premise that the state can soak the oil & gas sector to lighten the load for everyone else.

It never ceases to surprise me how much even the liberal critics of Russian economic policy and the Russian state seem to believe that changes in monetary policy, in this case the massive easing and provision of liquidity on the part of the Federal Reserve since this crisis began, magically inflate commodity prices by speculation. Inozemtsev indulges this narrative when explaining why oil prices have been rising since the start of the year:

“On the one hand, it is important to realise that the main reason for the current price rises is not a fundamental increase in demand but, rather, a speculative game triggered by a huge influx of money supply during the pandemic. The US ­alone has increased its public debt by USD 4.9 trillion since the beginning of 2020, while governments around the world have injected USD 12–17 trillion into the economy. Much of this money went to the stock and commodities markets, driving prices across almost the entire spectrum of positions. Not ­only oil and gas, but also metals, foodstuffs and fertilisers went up in price by 60 to 200% during the last year.”

This is bad logic that ignores longer commodity price and investment cycles and really needs to be explicated to capture where his argument falls short and could be all the more impactful hammering home an important thesis. The speculative trading of commodities is about betting on future prices and buying or selling physical volumes of commodities that only exist on paper. Financial speculators are, with the exception of those who use physical commodities as collateral or else also act as physical traders, buying and selling assets that are linked to commodities but not the commodities themselves on the premise that the value of those assets will rise or fall in the future. While net positions of capital on futures markets can be heavily weighted towards going long or short per price increases or decreases depending on the maturity of the futures contract traded, the reality is that someone’s taking an opposite position for any given speculator’s bet so it’s also not a one-way street. It’s easy to blame speculators because no one likes bankers, greed is easy to identify as sinful rather than structural, and they certainly don’t cover themselves in glory. But futures work differently than physical trading and there isn’t a clear pricing connection between investment from true speculators like hedge funds or more passive investors linked to the massive index fund industry (that also sours a bit on commodities whenever prices fall). Futures’ effect on prices is generally quite short-run when it’s found.

It’s really difficult to short a commodity in physical trading because shorting requires an absence of the good whereas betting on a future price increase is easy cause you can sit on the good as long as it doesn’t spoil but you don’t earn till you sell. On a futures market, shorting a commodity costs the same as going long. You’d think it’d increase price volatility but not significantly impact price discovery for physical goods since the paper market isn’t competing with the physical market for supply broadly and supply and demand fundamentals still matter a great deal to how speculators position themselves. That Inozemtsev opens with this point about oil prices, to my mind, reflects a sort of comfort zone for Russian economists and analysts. Speculation on physical goods prices happened on physical markets in the Soviet system because of the gap between the formal and informal pricing of goods that were often in short supply. ‘Speculation’ wasn’t trading paper futures, it would have been withholding goods to force prices up. But if any individual or enterprise did that, then they’d risk others stepping in and realizing price gains without taking that bet to begin with. By placing the focus on monetary policy and politics, it becomes an excuse to blame the Federal Reserve for its competence. Further, commodity production costs are heavily influenced by the cost of credit. The massive provision of liquidity and low rate environment make it easier for commodities producers to borrow and invest into production, admittedly more of a challenge for Russian firms limited in their ability to access credit abroad in US dollars. The very policies he’s blaming are deflationary in the long run and, indirectly and probably unintentionally, fit into a broader elite discourse that likes to blame Anglo-American capitalism for a host of global problems.

Once we account for this gap in the argument, the rest of it still makes decent points. The notional ‘industrial revolution’ Inozemtsev talks about is certainly a macro trend globally. Martin Sandbu’s counter in a column yesterday to the Russian position on the multiplication of discriminatory measures for trade in a net zero world — a trend that ultimately goes back to 2008-2009 — is, I think, a compelling way to reframe the problem. Assumptions about competition in the traditional free trade framework from which the WTO evolved aren’t designed to incorporate externalities and social costs that undercut domestic institutional arrangements. The result is that trade openness treats international and domestic trade as somehow equivalent when we well know the distributional consequences aren’t. Inozemtsev’s contention is that these pressures coincide with the risk that Russia runs into the problem facing Latin American resource exporters in the 70s and 80s — the explosion of US dollar denominated debt fueled by oil price increases (and other factors) in the 70s led to economic crises from which many countries struggled to recover. Russia’s debt levels aren’t that high in GDP terms and it’s borrowing in its own currency. The dynamics are different. What’s far more concerning is not that a renewed spike in oil prices suddenly “solves” the debt problem for the regime, but rather that it worsens the inflation problem:

Price expectations for businesses in the next 3 monthsGrey = Consumer price expectations Red = value-added production Blue = Retailers Black = Everything

Businesses are looking to markup prices at levels they haven’t in 18 years. A lot of these price increases are ultimately about high commodity price levels and many goods dependent on imported components are facing the same bottlenecks everyone is thanks to reopenings and the strength of American consumer demand. Oddly, though, Inozemtsev’s argument sidesteps the problem that the energy transition and the industrial revolution he alludes to are going to require cheap credit to be able to scale the types of investments needed as quickly as possible. In a world like that, commodities will always be expensive if we accept the idea that speculators are to blame. But that’s not really why expensive oil is so bad for the regime in my view despite the cogent and valuable political point he raises in the article. Since Russian output has likely already peaked, a view that’s become more commonplace in the last few months, a large price increase is unlikely to bring a net increase to output since producers are relatively price insensitive for investment plans above $35 a barrel. A higher price with lower aggregate domestic output means a much stronger negative effect via inflation — fewer people will be employed or consuming related goods and services via intermediate demand from the oil sector while the state budget has to compensate refiners more to subsidize prices and industrial manufacturers feel the effects on their supply chains, including petrochemical products used for fertilizer.

Inozemtsev ends with a note about the West undermining the Bretton Woods agreement in an oddly ahistorical manner. Bretton Woods only ‘functioned’ for about a decade of its existence and it swiftly fell apart under the weight of its internal contradictions, worsened considerably by the effect of the Vietnam War on the US labor market and deficit, French intransigence, and the export-oriented political economy of West Germany. It’s not just that countries have been left out at the margins, it’s that the “non-system” since 1971 allows for a far greater degree of action on matters like climate than an otherwise ‘anchored’ monetary system tied to gold. His article is a great read to get a sense of what more liberal-minded economists in Russia may be reflecting on as we see the state finally react to the threat of decarbonization. None seem to be drawing links to the long-run risk of higher inflation as a result of the paradigm shifts taking place. Expensive oil is a problem for the Russian economy precisely because the regime has tried to escape oil dependence and failed. That leaves the economy in its own transitional Hotel California, able to take the initial macroeconomic measures to do so (even at the cost of greater geopolitical risk) but unable to leave that transitory stage where oil has ceased to provide any growth but still undergirds the macroeconomic settlement and system governing politics. Iika Korhonen perfectly captures the visual of this trap as laid out by Inozemtsev:

High oil prices sustained Russian growth from 2000-2011. Then they didn’t. 0.9% isn’t just anemic, it’s made the economy far more susceptible to commodity price swings. The piece is spot on about the lack of rents to finance modernization and the direction of the regime. It just stops short of really challenging the underlying assumptions about how Russia’s economy is governed that have left it in such a bind.


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