Petrostate: Putin, Power, and the New Russia

THE AUTHOR AS JAMES BOND

At first I was puzzled. Where were they taking us? For such a big, sleek, glass Moscow high rise, Gazprom’s elevator in its headquarters building was tiny (five people could barely squeeze in) and its hall corridors narrow. This was, after all, the world’s largest producer of natural gas, not to mention Russia’s largest company. Following a short walk we were ushered into a darkened, silent room where nothing seemed to be happening. Strange.

It was only when all the members of our group had made their way up on the elevators that the room suddenly came alive. Then for a time I felt as if I had wandered into the NASA Space Center, or was it a James Bond movie set? All that was missing was that out of body voice intoning, “Welcome, Mr. Goldman. We were expecting you.”

In front of me, covering the whole 100-foot wall of the room, was a map with a spiderweb-like maze of natural gas pipelines reaching from East Siberia west to the Atlantic Ocean and from the Arctic ocean south to the Caspian and Black Seas. Manipulating this display were Gazprom dispatchers, three men controlling the flow of Gazprom’s gas to East and West European consumers of this Russian natural gas monopoly. No wonder there was tight security. There was also a sense of self-assurance. As measured by the value of its corporate stock, by summer 2006, Gazprom, this state-dominated joint stock corporation (until 1992 it was actually the Soviet Ministry of the Gas Industry), had become the world’s third-largest corporation. Only private shareholder-owned Exxon-Mobil and General Electric were larger.

With a flick of a switch, those dispatchers sitting in this Moscow room could freeze—and indeed have frozen—entire countries. At the very least, they could send their citizens off in a panic in search of sweaters, scarves, and blankets. What an empowering feeling! Should they choose to, those Gazprom functionaries could not only cut off natural gas from the furnaces and stoves of 40 percent of Germany’s homes but also the natural gas that many German factories need for manufacturing a range of products from ammonia fertilizer to plastics. While Germany purchases more natural gas from Russia than any other country in Europe, all of Western Europe is now also hooked up directly or indirectly to the Gazprom pipeline. In the extreme case, the Baltic states and Finland import 100 percent of their natural gas from Russia.

Here then in front of me was the natural gas distribution brain center for virtually the whole European continent. I could not think of anything comparable in Europe where such an essential commodity can be controlled by one country, and more than that, one company. In this very room the dispatchers factor in weather forecasts, special production needs, holidays, and, while they are reluctant to acknowledge it (in fact they deny it), a customer’s political correctness. Despite the fact that the Russian government owns more than 50 percent of Gazprom’s shares and President Vladimir Putin takes a very personal and intense interest in Gazprom’s operations, Gazprom officials insist that politics never, ever affect their calculations.

“Gazprom is a reliable energy partner” goes the mantra: it adheres to its contracts, guarantees delivery, and assures “energy security.” As Alexander Medvedev, the deputy chairman of Gazprom, told us that same morning, “What is good for a strong Gazprom is good for the world.” Reminiscent of Charles E. Wilson, the CEO of General Motors in the 1950s who boasted that “What was good for our country was good for General Motors and vice versa,” Medvedev’s pairing of Gazprom and the world is understandable but is as much off the mark as was Charlie Wilson’s earlier formulation.

Russia has not hesitated in the past to cut off the flow of both petroleum and gas to strengthen its side of a political dispute, a practice it inherited from its forebears in the Soviet Union’s Ministry of the Gas Industry and Ministry of the Petroleum Industry. Europeans are realizing how dependent on Russia they have become as each year they rely more and more on Russian natural gas imports. Gazprom and, by extension, the Russian government are already beginning to enjoy a power over their European neighbors far beyond the dreams of the former Romanov czars or the Communist Party general secretaries. President Vladimir Putin, with his control of Gazprom as well as another state-owned petroleum company, Rosneft, had become a real-life Dr. No—an archetypal James Bond villain, complete with a yacht and retinue. As President Putin at the time noted in a three-hour meeting following our Gazprom visit, Gazprom and Rosneft are very real and each year are accumulating more and more wealth and international influence, which they are using to advance the interests of the Russian state.

But it is not only Europe that finds itself each day becoming more and more dependent on energy exports from Russia. Although the United States is separated from Russia by oceans, it also is beginning to import and consume more and more Russian energy. As in Europe, the United States is trying to reduce its overreliance on energy imports from the Middle East. As part of this diversification, in 2005 the United States imported close to $8 billion worth of Russian petroleum. In 2006, that jumped by 25 percent to $10 billion. True, that represented only 3 percent of our petroleum imports—small, but an increase from the 2.2 percent of 2004 and a hint that we are likely to increase imports in the future.¹ More than that, in 2000, LUKoil, one of Russia’s largest private oil companies, purchased nearly 3,000 filling stations in the United States from Getty Oil and Mobil and is now busily converting them into LUKoil outlets. It also should be noted that in 2006, Russia became the world’s largest producer of petroleum, producing more than Saudi Arabia. This is not the first time Russia has produced more petroleum than anyone else. It also reigned as the world’s largest producer in the late 1970s and 1980s. Even this was not unprecedented. As Table Intro.1 indicates, Czarist Russia from 1898 to 1901 also produced more oil than the United States, until then the leader.

Equally unusual, even though there are no natural gas pipelines connecting the United States with Russia, Gazprom is also beginning to export LNG (liquified natural gas) to the United States. For the time being, because Gazprom as yet lacks the technology to produce LNG on its own, it is a swap arrangement. These shipments under the Gazprom label actually originate in Algeria (in exchange, Gazprom pipes gas to some of Algeria’s customers in Europe), but by 2010, Gazprom anticipates (unrealistically) that it will supply as much as 10 percent of the natural gas the United States needs as LNG directly from its own fields.² Given that the United States has fairly large natural gas reserves of its own and supplements domestic production with imports by pipeline from Canada, it is unlikely that the United States will ever become as beholden to Russia for its energy as Germany or Austria have become. Yet Russia’s emergence as an energy superpower will have a long-term impact on U.S. and world diplomacy if for no other reason than that our European allies will begin to think twice before saying “no” to Russia.

EUROPE BECOMES VULNERABLE

I had a chance to discuss this new strategic relationship with President George W. Bush at a June 2006 meeting in the Oval Office. The meeting was called to brief him before the G-8 meeting in St. Petersburg, which was to take place a few weeks later. President Putin as chairman of the 2006 meetings had repeatedly insisted that energy security and Russia’s role as a reliable supplier should be the general theme. “The Russian Federation has always abided by all of its obligations, fully and completely, and it will continue to do so.”³ Considering that only seven months earlier during a cold January 2006, Gazprom had curbed its flow of gas to Ukraine, which in turn reduced the flow to the rest of Western Europe, this was a rather dubious concept. Ostensibly, Gazprom justified the drop in gas exports to Ukraine, as well as to Georgia and Moldova, explaining that it did this because all three refused to pay the European market price. But since other Russian customers, especially Belarus and Armenia at the time, were also paying below European market prices, it was widely agreed that Russia was using its gas more as a political than an economic weapon.

As Russia’s customers have awakened to how vulnerable they have become to future cuts in their energy supplies, there are signs that this overdependence on Russian gas is already forcing at least some in Europe to have second thoughts about standing up to Russia. Nor are the European consumers the only ones who find themselves very much at the mercy of Gazprom. So far Gazprom also determines the fate of three other large exporters of natural gas. To their dismay, if they want to sell natural gas to Europe, Central Asian gas producers such as Turkmenistan, Kazakhstan, and Uzbekistan have no alternative but to ship it through the Gazprom pipeline. This is a legacy of the Soviet era when it was only logical to consolidate shipments of gas produced within the republics of the Soviet Union through one unified system. After all, what did it matter if the gas to be exported came from Uzbekistan and transited through Russia? They were both parts of the Soviet Union. But when the Soviet Union disintegrated in 1991, Gazprom assumed ownership of the bulk of that pipeline, and the newly independent countries in Central Asia, which were previously republics of the USSR, had no other outlet of their own to the West. As a result, this post-1991 monopoly control of the natural gas pipeline allows Gazprom to hold down the price it pays to the Central Asian producers for their gas. In 2006, for example, Gazprom paid less than $50 per 1,000 cubic meters while selling this same gas to the Europeans at prices averaging $230 per 1,000 cubic meters.

Working with energy and government officials in Central Asia, some European countries and the United States have sought to break that monopoly by lining up support for a bypass natural gas pipeline that would be built under the Caspian Sea and link Central Asia to Azerbaijan. There it would parallel an oil pipeline that goes then to Georgia and Turkey. To be called NABUCCO, this pipeline would then run through Bulgaria, Romania, Hungary, and on eventually to Western Europe.

To prevent any such dilution of their pipeline monopoly, Putin and the Russians have homed in on Hungary and worked to convince it to back the Russian alternatives. To draw them away from NABUCCO, the Russians proposed that if they supported the Russian alternative version, Hungary would become the Central European hub for redistribution of natural gas to the rest of Europe. By contrast, in the NABUCCO version that excludes Russian natural gas, Austria would be the hub. In a further counterproposal, Russia promised that if Hungary held back and signed up with the Russians, not with NABUCCO, it would be well provided for with assured natural gas deliveries for the foreseeable future. No doubt this is tempting. While Hungary has not disavowed participation in NABUCCO and may yet back it, by the spring of 2007, the Hungarian prime minister began to speak favorably of the Russian pipeline version.⁴ By mid-2007, even the Austrians had begun to back away from NABUCCO. And by January 2008, Bulgaria had also begun to support South Stream, which would be a Russian-sponsored alternative. The Russians understood well that there was still not enough of a market to justify the hundreds of millions, if not billions, of dollars that would be needed to build two, much less three, competing pipelines. Thus, should Hungary opt for a Russian variant, there would be too few customers for NABUCCO, which would make it unprofitable. This would make it impossible to attract the necessary investment, which would spell all but certain death for NABUCCO. This Russian maneuver is a good example of the skillful chess game Putin and his subordinates are now playing, using their natural gas and oil as their rook and queen.

While President Putin disavows any notion that today’s Russia has become an energy superpower, in reality it has. Yet these oil and gas resources are not newly discovered.⁵ However, the challenge has always been to harness those resources and use them effectively. After all, as Russia is the largest country in the world geographically (eleven time zones), it was inevitable that under some of those Russian hectares there would be large deposits of crude oil and natural gas. But Russia has often had trouble locating those deposits, bringing them to the surface, and then transporting them to domestic and foreign consumers. Given the northern latitude and the offshore location where so many of Russia’s energy deposits are located, as well as the distance from foreign consumers, this has not been an easy task. Russian winters are long and very cold (ask Napoleon and Hitler who had tried to conquer that country), and the summers are short, often very warm, and because of the permafrost blanketing much of the north, almost always swampy and full of mosquitoes. As for transportation, there are few or no easily accessible warm water or deep seaports. Nor does it help that the rivers in Siberia almost all run north to the Arctic, not east or west to the most populated areas where both the domestic and foreign consumers of that oil and gas reside.

It is no wonder then that the development of Russia’s energy resources has been belated, challenging, and intermittent. To complicate the effort even more, Russian drilling technology has often lagged behind that of the rest of the world, particularly the type used in offshore deepwater drilling. The gap in technology was especially harmful during the Soviet period when out of fear of ideological contamination, the Soviet Union prohibited many of its enterprises and technicians from having access to the West. At the same time, led by the United States, many Western governments withheld their advanced technology from Russia.

HISTORY REPEATS ITSELF

Given this background, the struggle for access and control of Russian energy resources provides an often overlooked and therefore neglected perspective as to why Russia, be it in the current, Czarist, or Soviet eras, developed as it did. Although not widely known, Russia has led the world in the production of petroleum several times in its history, despite so many difficulties. As we just saw, from 1898 to 1901 Russia outproduced the United States, until then the world’s largest producer. The United States resumed first place thereafter and remained the world leader for seven decades until 1975. (See Table 2.1.) But while U.S. production generally began to decline, petroleum output in the USSR began to increase at annual rates of 5–6 percent. By 1975, the USSR again outproduced the United States and thus again became the world’s largest producer. The Russian Republic alone when it was a part of the USSR produced more than the United States in 1980. Even after the collapse of the USSR, if only for a brief time, Russia remained the world’s largest producer. However, in 1992, one year after the breakup of the USSR, Saudi Arabia’s output exceeded Russia’s. The disintegration of the USSR and the confusion and economic and political freefall that followed precipitated a sharp drop in Russian output. By 1996 production was 45 percent below what it had been in 1990. In 1999, crude oil output began to increase again, but Saudi Arabia continued to outproduce both Russia and the United States until 2006. Then once again in 2007 Russia regained its place as the world’s largest producer. (See Table 2.1.)

As Russia’s petroleum production statistics suggest, petroleum has played an important if not crucial role in Russia’s economic and political life. But just as in other resource-rich countries, this role has not always been a positive one. Unless, as in the United States or Norway, there is an already established integrated market industrial infrastructure in place, there is a danger—as most if not all of the OPEC members have discovered—that relying on that oil and natural gas as the main export earners can corrupt the country. The availability of large deposits of petroleum and natural gas tends to bring with it an overreliance on those resources at the expense of more labor-intensive manufacturing and the development of technology and human capital.

RUSSIA—A VICTIM OF THE DUTCH DISEASE

No doubt the size of a country’s resource endowment does make a difference in the way that country develops. Economists often debate whether countries such as Japan, South Korea, Taiwan, and Switzerland would have developed industrially and technologically as they did if they had been more richly endowed. Conversely, if in 1917 the Germans had sent Lenin in that sealed train to Tokyo instead of Petrograd, it is most likely that the communist country that he would have created there would have ended up with a very different incentive system than the one adopted by what would become the Soviet Union. Because resources were so abundant in Russia, Soviet leaders set very low prices on their metals and fuels. Given the scarcity of such resources in Japan, the odds are that in a hypothetical Soviet Japan, raw material prices would have been much higher than they were in a Soviet Russia, reflecting that scarcity. And if Japan, South Korea, Taiwan, and Switzerland today were suddenly to discover new and abundant deposits of oil and gas, it is probable that, just like Russia, they too would price their raw materials cheaply and thus would also be afflicted with the Dutch disease, so called because once the Dutch found natural gas off their North Sea Coast, the relative prosperity it brought came at the expense of the country’s manufacturing sector. The export of that gas created a heavy demand for the Dutch guilder that the foreign buyers needed to pay for their purchases. This pushed up the value of the guilder. With a stronger currency, the citizens of the Netherlands found that imported goods were now cheaper than they were before as well as cheaper compared to goods manufactured within the Netherlands itself. The strong guilder also made Dutch exports more expensive for foreigners. Inevitably this had an adverse impact on domestic manufacturing and resulted in a loss of manufacturing jobs in Dutch factories.

The increase in the value of the ruble relative to other currencies— precipitated by the increase in both the price of a barrel of oil and the sharp increase in production and the export of Russian petroleum after 1999—also gave rise to what can be called the Russian Disease.⁶ Not only does a booming export market for energy resources have an adverse impact on domestic manufacturers but the appearance of a large and expanding petroleum sector inevitably triggers a ferocious struggle to win control of those oil-producing fields, at least in countries where the state allows the private ownership of energy-producing companies. Related to this struggle for control, whenever petroleum and gas industries begin to dominate a country’s economy, democratic institutions often seem to weaken if not collapse. Venezuela is one of the more recent examples.

Is a large petroleum and natural gas endowment a blessing or a curse? There is no all encompassing answer to such a question. In Norway, where the discovery of natural gas came many years after the country had already been industrialized, the disruption has been relatively minor. That is because the Norwegians understood that the sudden influx of energy export revenue can have a very negative effect on both the economy and the moral makeup of the country. For that reason the Norwegians have made a determined effort to shelter the rest of the economy from this energy windfall. They have set aside export revenues in a special fund to hold down inflation and prevent their currency from gaining too much value. So far they seem to have succeeded. As a result Norway’s oil and gas deposits have not become a curse. By contrast, it is hard to see how the average citizen in countries such as Libya, Iran, Nigeria, or even some in Saudi Arabia has benefited from his or her country’s energy riches.

How have its energy riches affected Russia? Given the predominance of energy in the makeup of both its GDP (about 30 percent) and its exports (almost 65 percent of the 2006 total), it might initially appear that, like Saudi Arabia, energy in Russia has had a similarly adverse impact on the effort to build up Russian industry. But this overlooks the fact that Russian industry has never been a competitive force in world markets comparable to industry in most of Europe, Japan, or the United States. Industry in the Czarist era before the Bolshevik Revolution was only just beginning to respond to domestic needs. In the Soviet years, the development of a domestic industry was a major goal of the central plan era and the Soviets did indeed create new industries. Yet after the disintegration of the USSR in 1991, it quickly became apparent that the domestic Russian industry created during the Soviet era was essentially of the hothouse variety, designed primarily to build up the country’s military-industrial complex. Such industries usually have a hard time when forced to sell in international markets, and those Russian manufacturers rarely were able to succeed on a purely competitive basis. Russian energy resources were used more as a lifeboat to support a non-market-oriented economy and the country’s industrial dinosaurs rather than as a stimulant to growth and the development of a world-class competitive manufacturing complex.

RUSSIA SUFFERS AND RECOVERS

Yet in contrast to its sometimes negative domestic economic, political, and social impact during both the Soviet and post-Soviet eras, Russian energy has played a major role in enhancing Russia’s international political standing. In many cases, it is almost as important as the development of the Soviet Union’s military capabilities. Energy exports opened up doors to Soviet influence in much of the third world prior to 1991, Cuba being the best example. But in a repeat of earlier burst bubbles, with the onset of the energy glut in the late 1980s and throughout the 1990s, Russian energy became irrelevant in the world’s energy balance. With production and exports down by almost 50 percent and crude oil prices hovering at a low of $10–$12 a barrel, Russia had trouble paying its bills and as a consequence suffered a massive financial collapse. On August 17, 1998, the government defaulted on its debt and most of the country’s private banks closed their doors and locked their vaults. As a result, not only the banks but the country as a whole teetered on the edge of bankruptcy. The ruble lost most of its value. But in a remarkably quick turnaround, in 1999 the global demand for energy began to outpace the producers’ ability to respond to that demand. As before in its history, as world energy markets quickly absorbed their spare capacity, Russia’s petroleum and gas suddenly took on a new importance, economically and especially politically. Fueled by petroleum prices for Brent oil that at one point in 2005 exceeded $70 a barrel, Russian companies responded by sharply increasing production. Forty percent of the world’s increased petroleum consumption from 2000 to 2004 came from Russia. As a result Russia found itself inundated not only with dollars and euros but with political leverage that in many respects exceeded anything enjoyed in either the Czarist or Soviet eras.

True, Russia may no longer be a military world superpower, but there is little doubt that despite President Putin’s insistence that it is not one, Russia today is again a superpower. Only now it is an energy superpower.

Nor are Putin and those around him leaving this to chance. At first glance it may seem that much of this is just a matter of luck. But as we shall see, a more careful examination shows that this use of the country’s natural resources and the way they are exploited by what Putin has come to call “national champions” is all part of a carefully thought out grand strategy. Part of that strategy calls for the reimposition not only of state control but of state ownership (renationalization) of at least 50 percent plus one share of the stock of many of the petroleum, metal, and manufacturing companies that were privatized in the mid-1990s. Led by Rosneft where the state has always held majority ownership, companies like Yukos and Sibneft have been effectively renationalized. (How far-reaching this has been we will see in greater detail in Chapter 5, Table 5.4.) That explains why the share of crude oil production produced by the state-dominated companies in the year 2000, the year Putin took over as president, had fallen to as low as 10 percent. However, by 2007, just before he gave up the presidency, state-dominated companies’ share of crude oil production had risen again to close to 50 percent.

With its natural gas and oil pipelines that tie Europe to Russia like an umbilical cord, Russia has unchecked powers and influence that in a real sense exceed the military power and influence it had in the Cold War. No matter how many nuclear weapons it may have had, the USSR was prevented from using them by the knowledge that the United States had a comparable number and would counter the USSR’s use of them and vice versa. This was referred to as Mutually Assured Destruction (MAD), which meant no one country would dare attack the other. Now, however, if Russia decides to reduce or suspend the flow of gas through its pipeline to Ukraine and/or to Europe, there is virtually nothing to restrain it from doing so. There is no comparable Mutual Assured Restraint or MAR. It is also noteworthy that this gives Russia more economic clout with Europe than Saudi Arabia. Because the Saudis export relatively little natural gas, there are no consuming countries dependent on a Saudi pipeline for this commodity. This is an important strategic difference.

In the pages that follow, we will see how the ups and downs of the Russian energy sector provide a unique insight into what is taking place in the country as a whole. Our account should also help us understand some Russian paradoxes. Given that in the late 1970s and early 1980s, Russia (then part of the USSR) was the world’s largest producer of petroleum, why in 1991, with all that mineral wealth, did the Soviet Union collapse? What role, if any, did the CIA play in that collapse? Why wasn’t Russia an energy superpower then and why is it now? What are the implications of all this for Europe and the United States? How much of this is a matter of endowment and how much of it is due to a carefully designed policy? Who are the beneficiaries of Russia’s newfound wealth and power? Using the chess metaphor, what is Putin’s end game? These are some of the questions we will seek to address in what follows.

There is something about petroleum that is controversial and intriguing. And there is something about Russia that is mystifying and absorbing. When the two converge in a study of Russian petroleum, the result is bound to be tantalizing and engrossing, more like a fictional “who done it” than an accountant’s annual report. The role of oil and gas in Russia is a tale of discovery, intrigue, corruption, wealth, misguidance, greed, patronage, nepotism, and power—except for the absence of sex (and who knows?), a little something for everyone. Admittedly it is a story that often bears considerable similarity with those of other oil-producing countries. Yet as with all things Russian, it has many features that are unique to Russia. Most significantly, after a long period of failure to sustain itself as a military superpower, Russia has emerged—even if inadvertently—as a different breed of superpower, one whose power rests on economics and energy. How is it using that clout and what does this imply in the years ahead? We begin in the beginning with a look at how Russia emerged as the world’s largest producer of petroleum in 1898 and how what happened in the immediate years that followed has been repeated several times since.