Petrostate: Putin, Power, and the New Russia

THE 1998 FINANCIAL MELTDOWN

The 1998 financial crisis hit Russia hard. There were obvious signs that the Russian fiscal system was in desperate shape, but at the time, few saw that a collapse was eminent.¹ Indeed, the almost universal conventional wisdom was that Russia had successfully managed its transition from Communist central planning to market capitalism and that the future was bright. Many had come to believe that Russia had become the next Klondike. They urged investors to put in their money before share prices rose even higher! Only fools and anti-Sovietchiks could think otherwise. Typical were studies such as Anders Aslund’s How Russia Became a Market Economy, published in 1995, and Richard Layard and John Parker’s The Coming Russian Boom, published in 1996. Both appeared just in time for investors to buy in before the financial crash that followed shortly thereafter in August 1998.² While the economy and its stock market have recovered significantly since then, there were many as we shall see who took their advice at the time and lost considerable sums as a result—in several cases, hundreds of millions of dollars.

It was easy to be misled. Bullish signs were everywhere. By October 6, 1997, the RTS index, the Dow Jones Index of the Russian Exchange, hit 571, an all-time high. That represented an almost fivefold increase over just a half dozen years. Investors who bought shares on October 31, 1996, in the Lexington Troika Dialog Russian Fund, which invested only in Russian companies, had a threefold increase in one year, a higher one-year return on their investment than stock market investors anywhere else in the world. Bankers in London, Frankfurt, and even New York trampled over each other to buy Russian stocks and lend money to Russian companies and government borrowers. Few could resist the frenzy.

What such analysts and investors chose to discount or ignore, however, was the deplorable state of the Russian economy. As of 1998, the officially reported GDP, as well as crude oil output, had fallen by 40 percent or more from its 1991 level. At the same time, there was also inflation. In 1992 alone, prices rose twenty-six-fold, and then more than doubled each year for a several years thereafter. By 1997, price increases had moderated to 11 percent a year, an improvement, but by most standards, still high. Overall, by December 1999, it took 1.6 million rubles to buy what 100 rubles could have purchased in December, 1990. Of course there wasn’t much on the shelves to buy in 1990, but be that as it may, this hyperinflation wiped out whatever savings most Russians had built up.

Nor did it look like inflation would be less of a problem in the future. How could it be, when the government was generating an immense deficit and growing debt each year? Few Russians were paying their taxes and those that made a payment rarely paid as much as they actually owed. Combined with inflation, the underpayment of taxes meant that each year the budget deficit grew larger, which in turn meant that the government had to borrow even more money.

By mid-August 1998, government authorities concluded they could not continue what, in effect, was “kiting their checks.” This involved writing a check to pay a bill from a bank account with not enough money in it at the time but with the expectation that there would be a check from another bank a few days later, which would cover the first check before it was presented for payment at the first bank. This is done in the hope that neither bank would realize that initially there had not been enough actual money to pay the bill. The Russian Central Bank and the Treasury had simply run out of money to pay the bill. When a government bond matured, the only way Russia could compensate the bondholder was to roll over the loan and issue another bond in the hope that the original bondholder would accept the new bond as a replacement for the old one and not ask for cash. Alternatively, the government could hope that someone new would be foolish enough to buy a new government bond so the funds could be used to pay the first bondholder for the same amount he had paid for the bond, plus interest. But because the revenue the government collected was so little and slow in coming in and the interest rate it had to pay to attract lenders willing to buy those reissued government securities was so high, after a time the government was forced to borrow larger and larger sums of money just to pay the ever-increasing amount of interest. It was a marathon race without a finish line.

Since this fiscal slight of hand was unsustainable, the government eventually was forced to default on its debt. Simultaneously, it found it no longer had enough dollars to meet the demand of those who wanted to exchange rubles for dollars at the official rate of exchange. In other words, it had also run out of dollars. Unless it acquired enough new dollars, it would eventually have to devalue the ruble and require that those who wanted to buy dollars pay more rubles for them. As of mid-August 1998, because it could not find enough lenders willing to buy new or reissued government securities, combined with the fact that it had run out of dollars and convertible foreign currencies and could not pay its bills, the Russian government, in effect, had become bankrupt.

It was inevitable that the Ponzi-like scheme the Russian Treasury was running—where each day it had to find more and more new lenders so it could pay off earlier lenders—could not endure. By August 17, 1998, the Treasury and Central Bank were forced to announce that they could no longer redeem the country’s bonds and pay back its lenders. This collapse was precipitated and made even more serious by the financial upheaval that hit Southeast Asia earlier in 1997. As Thailand and what had seemed to be the other dynamic economies of Southeast Asia fell into recession, commodity prices collapsed. Since most of what Russia exported was commodities, this hurt Russian export revenues. When speculators around the world sensed that Russia might also be vulnerable, they began to sell off their Russian stocks and bonds, thereby anticipating and precipitating such a collapse. This increased the hesitancy among those investors and governments who might otherwise have been willing to provide additional financial support. The IMF did provide a last-minute loan, as did Goldman Sachs, but both loans proved to be inadequate and controversial. Because Russian officials met with the owners of some of the oligarch-run banks before the government publicly announced the debt and a foreign currency exchange moratorium, some of the private Russian bankers used their insider information to sell their government securities and cash out their ruble holdings for the dollars sent in by the IMF and Goldman Sachs before outsiders could seek similar protection. This further undermined confidence in both the government and public officials.

The consequences of such domestic and international economic and financial mismanagement were far-reaching. Since government securities (that is, bonds and short-term securities called GKOs) were the main assets on the balance sheets of most of the country’s banks, and since these securities were now all but worthless, most Russian banks were no longer viable. In all but a few banks, liabilities exceeded assets. Many of the oligarchs who had only recently been at the top of Russia’s income pyramid found their banks were worthless. For a time it looked as if as many as 1,500 Russian banks would have to close their doors.³ In effect, Russia found itself in the midst of a bank holiday similar to the one Franklin D. Roosevelt declared in the United States in the early 1930s. Some bankers, like Khodorkovsky, managed to survive because before his bank Menatep went bankrupt, Khodorkovsky used it to finance the purchase of properties such as the oil company Yukos, which he bought through the Loans for Shares auctions. While most of those companies were not wildly profitable, they made enough to sustain Khodorkovsky’s other operations. But like Menatep, most other banks simply had to close. It did not make Menatep depositors very happy to learn that Khodorkovsky had arranged to transfer the few viable assets that remained out of his Menatep Bank into another financial entity that he operated in St. Petersburg. There they were beyond the reach of all the helpless depositors who had put their money into Menatep.

Russian industrial output and the stock market also took direct hits. The gross domestic product was 5 percent lower in 1998 than 1997. The impact on the Russian stock market was much more far-reaching. By October 1998, just a year after the October 1997 record RTS high of 571, the index fell to a mere 39. For all intents and purposes, the Russian stock market had disappeared.

The impact was not restricted only to those who had invested in the Russian stock market or to Russians. Western banks that had been lending so eagerly to Russian borrowers found themselves with worthless bonds. Some had to write off several hundred million dollars’ worth of loans. Credit Suisse First Boston, for example, lost $1.3 billion and Barclay’s Bank in England lost $400 million.⁴ In the United States, Bankers Trust wrote off a comparable amount to that lost by Barclay’s Bank.⁵ More than that, there were fears that the whole U.S. financial world would be similarly affected when the monster hedge fund, Long Term Capital Management (LTCM), in Greenwich, Connecticut, acknowledged that it had lost $1.86 billion of its capital and was insolvent. It was not that the Fund itself had invested in Russia. Rather, it had lent money to other investors who were affected by the moratorium on Russian debt and the collapse of the ruble, none of whom could now repay their loans. Were it not for the timely intervention of the U.S. Federal Reserve Bank, it was likely that the LTCM collapse would have triggered a cascade of other defaults throughout the financial system. Out of concern over the impact of LTCM, the Dow Jones Index dropped by over 20 percent.

Banks and the Dow Jones Index were not the only ones affected. In the panic that followed, many foreign investors who had already set up operations in Russia—not the least of which was Pizza Hut—and imported what they sold were forced to close down. Many decided it was best simply to walk away from investments worth tens of millions of dollars. Others who were thinking of investing simply went elsewhere. Simultaneously, the price of petroleum, Russia’s most important export product, fell from $26 a barrel in 1996 to almost $15 a barrel (see Table 2.1). With its banks closed, its credit worthless, and its main export product earning only 60 percent of what it had two years earlier, Russia saw many of its businesses close or come to the verge of closing, and the prospects for the Russian economy were bleak.

The drop in oil prices in the early and mid-1990s had a devastating impact on oil production. With oil prices so low, by the time the petroleum producers allowed for production costs, taxes, and transportation expenses, there was little and often nothing left over for profit. So the new owners (many of whom were now private entities) not only halted exploration for new fields, they also cut back production in existing fields.⁶ As a result, Russian crude oil output fell nearly 40 percent from 1990 to 1998.

A QUICK RECOVERY

But sooner than might have been expected, the world economy began to recover. Led by an increase in commodity prices in southeastern Asia, where the recession began a year earlier, energy prices also began a quick recovery. By 2000, oil prices hit $33 a barrel, double what they had been only two years earlier (see Table 2.1). What had been a glutted market almost overnight turned into a tight market.

Much of the impetus for this change was due not only to a recovery in Europe and the United States but an ever larger increase in demand for oil and gas in India and China. Whereas China was actually a net exporter of petroleum in 1993, by 2005 it had become a major importer, forced to import 40 percent of its petroleum.⁷ In 2006, it imported 138 million tons of crude oil and 24 million tons of refined petroleum.⁸ Only the United States imports more. As the Chinese economy grew, this new wealth brought with it an even higher demand for petroleum. Chinese consumers’ increasing use of cars and air conditioners, machines that are particularly heavy users of energy, was especially important in driving up demand. Simultaneously, China continued making massive investments in heavy industries such as steel, aluminum, and cement plants, all of which require very intense input of energy.⁹ So in 2004, while China’s GDP rose about 9 percent, oil consumption rose 16 percent. Overall, from 2001 to 2006 China’s energy consumption rose an average of 11.4 percent annually, which was greater than the 10 percent annual growth of its GDP during similar years.¹⁰ Oil consumption did not increase as much in the years immediately following, but still by 2006 China consumed about 7.5 million barrels of petroleum per day (350 million tons), 6–8 percent of the world’s total and second only to the United States, which consumed about 20 million barrels per day (940 million tons).¹¹ Some Chinese economists project that energy consumption in China will more than double between 2006 and 2020 and triple by 2030.¹² This would mean China will be importing 500 million tons of petroleum a year, which approximates Saudi Arabia’s entire production. (Some of this would come from countries that no longer need to consume as much because they have become more efficient in using what they have. But that would not free up enough to satisfy China’s need. Who the suppliers will be for the additional coal, oil, and gas needed to feed China’s voracious energy consumption is not clear.)

Recognizing their problem, the Chinese government, for example, seeks to reduce energy consumption per unit of GDP by 20 percent from 2006 to 2010. That would help, but since China grows by 10 percent a year, much of that saving would be absorbed by the higher rate of growth. Moreover, so far the Chinese have been able to reduce energy consumption per unit of GDP by only 3 percent a year.¹³

The story is much the same in India. It now imports two-thirds of the energy it consumes. The expectation is that it will have to import even more to fuel its future growth, especially if it continues to grow annually at 8 percent as it did in 2006. What makes China’s and India’s appetite for energy particularly important for Russia is that these newly enriched super-size populations have created an unprecedented new market situation. Their incremental demands in the early twenty-first century have sopped up most of the world’s available excess oil-production capacity and more than offset whatever energy conservation may have been achieved in countries like Japan or Europe and in 2006, even the United States.¹⁴ From 2001 to 2005, China was responsible for 30–40 percent of the increase in oil consumption. Emerging market countries as a group in 2005 generated 90 percent of the incremental growth in demand.¹⁵ No wonder prices rose to what seemed to be new highs.

If allowance is made for inflation, 2007 oil prices were not, in fact, at record levels. April 1980 oil prices, for example, if adjusted for inflation in mid-2007 would have amounted to $101, about equal to what seemed to be the record $100-a-barrel price of January 2008. Nonetheless, in mid-2007, the International Energy Authority predicted that because of growing market pressures, real energy prices would continue to increase through 2012. As they saw it, world demand for petroleum would grow at an average of 2.2 percent a year while oil supply in non-OPEC countries would expand at only 1.1 percent. This would reduce OPEC’s spare capacity and lead to continuing high energy prices.

The tightening of the market for energy products and the increase in prices that followed, even if not at a record level, had a direct and immediate impact on Russia. After a half dozen or more years of asset stripping and a corresponding reluctance to invest in new exploration and development, the oligarchs and managers of energy-producing entities came to realize that with higher energy prices they could make more money by putting their funds into exploration and production at home rather than by stripping such assets and investing the proceeds from their sale abroad. Their decision to increase production was also affected by the state’s decision in 1998 to begin liberalizing taxation by instituting a flat 13 percent tax on income. It also helped that after the devaluation of the ruble in August 1998, the cheaper ruble meant that foreigners could buy more Russian products with their dollars and euros, which helped to increase Russian exports.¹⁶

So the oligarchs began to invest in geological exploration and better equipment. This included using more advanced Western technology. In September 2006, I had a chance to see how important Western technology has become for the Russian oil industry when I visited the Yuganskneftegaz Priobskaia oil field in West Siberia. This was the oil division that had been taken over by the state-owned Rosneft company from Mikhail Khodorkovsky’s Yukos. Almost all the drilling there was being done by the American-French company, Schlumberger. Halliburton, Vice President Dick Cheney’s former company, is doing much the same thing elsewhere in Russia. They both are using technology denied to the USSR during the Cold War. When the Cold War ended, the Russians still were unable to use this technology because with oil prices so low, they could not afford it. Once oil prices rose, however, Russian companies were able to hire such service companies and in doing so, they gained access to deposits that would otherwise be beyond the reach of their indigenous technology. Almost immediately there was a sharp jump in production, the first time there had been a meaningful increase since 1987. Contrary to the earlier prediction by the CIA that Russian oil production would fall off sharply, in 2000 Russian oil production rose 6 percent and by 2003, 11 percent. While the rate of growth fell to 2 percent in 2005, by 2006 Russia was even out-pumping Saudi Arabia. Just as in the periods from 1898 to 1901 and 1975 to 1992, Russia once again became the world’s largest producer of petroleum (see Table 2.1).

Since Russian GDP turns out to be almost entirely dependent on changes in oil production, after years of decline Russia’s GDP also increased significantly. As Table 4.1 indicates, there is an almost perfect correlation between oil production increase and decrease and changes in GDP. Moreover, with more output, there was more to export. By 2006, Russia’s foreign trade surplus hit $140 billion, much of which went into Russia’s currency reserves. In 2006 alone, Russia’s reserves increased by more than $100 billion to a total of $300 billion by year’s end. This meant that as of mid-2007, with more than $420 billion in the state treasury, Russia had the world’s third largest holdings of foreign currency reserves and gold, behind only China, with more than $1.4 trillion, and Japan, with $900 billion.¹⁷

With so much cash in hand, the Russian government moved quickly to pay off its loans. As of September 2006, its foreign sovereign debt amounted to about $73 billion, less than half of the $150 billion it owed in the aftermath of the August 1998 financial collapse.¹⁸ Much of this debt was prepaid in advance of when it was due. In August 2006, for example, Russia paid $23.7 billion to the Paris Club (creditor countries that join together to try to collect money they are owed by other debtor countries), some of it in advance of the due date.¹⁹ Along with the buoyant yearly growth of its GDP, this prepayment helped to improve Russia’s credit rating. By contrast, while the government was paying down its debt, the private corporations and banks moved in to take advantage of the more favorable credit ratings and as of October 2006 had increased their borrowings to more than $210 billion. Much of this went to corporations like Gazprom, Rosneft, and UES to finance their purchase of other properties.²⁰ There were fears that with private corporations seduced by so much cheap money, too much of their borrowing was being used for peripheral projects that might some day prove to be a problem. Despite the pay-down of government debt, the ratio of overall joint private and government debt to GDP increased from 19 percent at the end of 2004 to 23 percent in 2005. Nonetheless, the overall financial ratings for Russia and its corporations increased markedly from their 1998 low point.²¹ In July 2006, for example, the financial rating company Fitch Ratings lifted Russia from a risky to a reasonable investment rating.²²

Those fortunate enough to have ignored Layard and Parker’s book and its advice to invest just before the 1998 financial crash but who did invest after 2000 in Russian stocks (except, of course, for Yukos) probably did quite well. By then the boom had indeed come to Russia. When Putin took over as prime minister in August 1999, the capitalized value of the country’s publicly traded stocks amounted to $74 billion. By 2006, the capitalized value exceeded $1 trillion.²³

EUROPE DIVERSIFIES

At the same time that Russia’s energy sector brought prosperity to most of those who invested in it, energy imported from Russia had also become attractive to those seeking to reduce their dependence on energy from the Middle East. Given the political and military turbulence in the Persian Gulf, Europe was eager to avail itself of a supplemental source of energy. Since Russia was part of the European continent, petroleum and gas could be delivered by an on-land pipeline as well as by ship, railroad, and highway. This meant not only a shorter journey but also one no longer vulnerable to terrorism in the Persian Gulf or Suez Canal, not to mention OPEC hijinks and 1973-type political embargoes.

The land link between producers in Russia and consumers in Europe is particularly important for natural gas customers. As we just noted, unlike petroleum, which is a liquid and thus can be delivered easily by railroad tank car, truck, and pipeline, most gas can be delivered only by pipeline. The only other alternative to pipeline-delivered natural gas is LNG, carried by expensive, specially designed ships. Railroads and tank trucks are unsuited for transporting commercial quantities of natural gas.

Given all the advantages of a natural gas pipeline, it was no wonder that despite Ronald Reagan’s best efforts, the pipeline from the USSR to Europe was built. As German Chancellor Gerhard Schroeder later also noted, from an environmental point of view, natural gas would be more environmentally friendly than coal or nuclear energy. More than that, the Russian Republic had the world’s largest reserves of natural gas. Initially, Germany received most of its gas from the North Sea. But since the North Sea fields were more modest in size, before long, Russia became the largest supplier of natural gas to most of Europe. As the North Sea fields, especially the gas provided by Norway, begin to decline, Russia will undoubtedly provide an ever-larger share.

Of course, there was always the danger, much as President Reagan had warned, that like some OPEC petroleum suppliers, Russia might threaten to cut off the flow of its gas for one reason or another. After all, the USSR and then Russia did just that to several of its petroleum customers. Yet except for an occasional weather-related problem, Russia has behaved honorably with most of its West European customers. This was the case even during occasional tense Cold War confrontations. More than that, when OPEC cut back petroleum production and imposed an embargo on the United States and the Netherlands in 1973, the USSR refused to participate. Instead, as petroleum prices rose, it not only continued to honor its contracts but it expanded its exports of both petroleum and gas, and by doing so, it took advantage of the high world prices resulting from OPEC’s heroics. As its reputation for reliability grew, whatever hesitancy some may have had about becoming dependent on Soviet natural gas dissipated, and Soviet supplies came to be accepted throughout Europe as an integral and dependable part of the region’s supply network.

WHO OWNS GAZPROM?

With the collapse of the Soviet Union and its communist system, for the first time foreign and private individuals and companies could invest and buy shares of stock in these newly privatized Russian entities, including most of those producing energy. In December 1998, for example, Ruhrgas of Germany acquired 2.5 percent of Gazprom stock for $660 million and another 1 percent in May 1999 for $210 million more. Combined with another 1.5 percent of stock it controls indirectly, Ruhrgas at one point owned or controlled over 5 percent of Gazprom stock. For a time, nonstate investors, mostly Russian entities, owned 61.63 percent of the company’s stock. However, the state owned more than any other single holder and so, at least in theory, it has the right to determine management control.

Yet without 50 percent plus one share state ownership, there was always the possibility that a foreign group could accumulate enough stock to take control. When Putin became president, one of his priorities was to prevent such a possibility. Accordingly, in mid-2005, he arranged for state-run Rosneft to buy up another 10.74 percent of Gazprom shares. With these extra shares, the state or state-owned entities then held 50.002 percent of the company’s shares. Another 29.482 percent was controlled by other Russian businesses and institutions. Of the remainder, 13.068 percent was held by Russian individuals, and 7.448 percent by nonresident individuals, companies, and groups.²⁴

Gazprom has worked to keep tight monopoly control not only over the country’s natural gas pipeline network but also over its natural gas output. Occasionally, when the Russians feel unable to master the technology required to work particularly difficult sites such as Sakhalin and the Barents Sea Shtokman field, they have agreed reluctantly to allow foreign companies to work a few such fields on their own, without Russian or Gazprom involvement. But as in the past, once their national treasury begins to overflow and new confidence builds, the Russians quickly move to circumscribe foreign involvement and invariably they take development back into their own hands.

AN OPENING FOR FOREIGN FIRMS

Because the petroleum ministry, unlike the gas ministry, was not held together during privatization as a unified whole in an entity comparable to a Gazprom, privatization provided more of an opportunity for foreign companies to set up their own petroleum-producing subsidiaries and enter into joint ventures. Philbro Energy Products created a company with the romantic name “White Nights.” It was one of the first joint ventures in the post-Communist era. Its concept was a laudable one. Drilling practices in the Soviet era were notorious for their poor conservation efforts and sloppy operating methods. Against this background, White Nights proposed forming a joint venture with a Russian company to take over some of the already worked and even abandoned oil wells. They were convinced they could restore them or increase their yield by utilizing advanced Western technology. So they created a joint venture consisting of a group from Anglo-Suisse and Philbro Energy Products, a subsidy of the American company Solomon Brothers. They joined with Varyeganneftegaz Oil and Gas Production Association, whose oil wells they would be reworking. The joint venture was predicated on the assumption that without foreign assistance, output from the Varyeganneftegaz field would decline at a rate of about 25 percent a year. Anything the joint venture produced above and beyond that trend line would be considered profit for the joint venture and would be shared equally by the Russian and Western partners.

While the White Nights project succeeded in producing more than Varyeganneftegaz alone working without Western technology would have been able to do, from the point of view of the Western partners, the project was nonetheless a failure. By the time all the taxes were collected (many imposed just for the occasion), the increased transit fees deducted, and the bureaucrats properly mollified (paid off), there wasn’t all that much left over to share. It was not a gratifying or unique experience.

For more than a decade, another company, Conoco, faced similar problems and similar losses.²⁵ Conoco entered the Russian market as early as 1989. It joined with Rosneft in a venture called Polar Lights in 1991 to develop wells in the Timan Pechora Basin not far from Arkhangelsk.²⁶ Conoco also formed a joint venture with Northern Territories.²⁷

But after unending extortion and interference from various federal and regional government officials, particularly Vladimir Butov, governor of the Nenets Autonomous District that encompasses the Timan Pechora fields, several Western firms including Exxon, Texaco, Amoco, and Norsk Hydro of Norway abandoned similar efforts, including a joint venture called Timan Pechora Co.²⁸ Their run-in with Butov is a good example of the political interference that the oil companies, domestic as well as foreign, often encounter. Butov was elected governor of the energy-rich Nenets region in the northern part of European Russia in 1996. This was despite two earlier criminal convictions. His most recent difficulty in 2002 was the result of his refusal to recognize a Moscow court order that awarded an oil field to a company other than the one he favored.

While the other companies walked away from the millions of dollars they had already invested in the region, Conoco held out. But that was largely because they were stubborn, not because they were making a profit. Among other forms of harassment, Conoco had to deal with six different local taxes, almost all of which, after a time, were increased. By 1999, they found themselves having to pay twenty different taxes.²⁹ The federal government also surprised them by instituting a heavy export tariff after the agreement to begin the joint venture was signed.³⁰ That was not all. Permission to export their output was revoked periodically. They were denied access to the export pipeline. To top it off, one of the fields Conoco had hoped to develop in the Barents Sea was suddenly transferred to a Russian firm without warning or compensation.³¹ Over the decade, ConocoPhillips, as it is now called, invested $600 million in return for which it earned little and sometimes nothing.³²

IF AT FIRST YOU DON’T SUCCEED

Despite these early difficulties, ConocoPhillips decided to try again. As company officials debated whether they should go back to Russia, ConocoPhillips, like other major energy producers, concluded that energy companies seeking new untapped reserves do not have many options, and those reserves they do find are likely to be located not only in difficult geographical areas but within politically problematic countries.³³ So after much internal discussion and debate within ConocoPhillips, in July 2004, the CEO of ConocoPhillips, James Mulva, and the CEO of LUKoil, Vagit Alekperov, met with President Putin to ask if it would be okay for ConocoPhillips to spend more than $7 billion to buy up to 20 percent of LUKoil’s stock.³⁴ For ConocoPhillips, despite everything that had gone wrong in the past, this was worth the risk. By investing in LUKoil, they acquired access to crude oil reserves at a cost of $1.70 a barrel. As the going price at the time was around $40 a barrel, that was quite a bargain.³⁵

That both CEOs thought it prudent to check with Putin in advance tells us how central Putin and his government’s role have become in what elsewhere, certainly among the other non-Russian members of the G-8, would usually be a purely commercial decision. But Putin and those around him had earlier signaled considerable displeasure at what, for a time, almost seemed to be a coordinated campaign by foreign energy companies to buy up control of Russian natural resource companies. As we shall see, that was one of the reasons the Kremlin was so concerned about Mikhail Khodorkovsky and the rumors and evidence that he was trying to sell off Yukos, in whole or in part, to Exxon-Mobil and Chevron. To the nationalists in the Kremlin and to the public at large, that was a heretical if not treasonous act. It was bad enough that, also in 2003, TNK (Tyumen Oil) sold half of its interest to BP and allowed BP to become the managing partner after the merger.

The way BP became a major player in Russia makes a good case study of how hazardous such a quest in Russia can be. BP itself did not initially invest directly. Instead, in 1998, it bought up AMOCO, a U.S. company that in 1997 had bought a 10 percent share in Sidanko, a Russian oil company, for $484 million. (We discussed Sidanko’s privatization in Chapter 3.) By resort to chicanery in a bankruptcy court, TNK managed to destroy Chernogorneft, a Sidanko subsidiary, which it then seized from BP/AMOCO for itself. In response, BP/AMOCO decided to play it safe and wrote off $210 million of its investment in Sidanko, not something stockholders like to hear. This was followed by vituperation and lawsuits in U.S. courts against TNK. But as is sometimes the practice in post-Soviet Russia, the fact that businesses are violent enemies one day does not preclude them from holding their noses and forming a partnership the next. Thus, in August 2003, BP and TNK agreed to reconcile their differences and, of all things, form a 50-50 partnership. This cost BP $7 billion but it made geological as well as legal sense as BP’s and TNK’s oil fields were adjacent to each other and coordination rather than competition would be more likely to result in the maximum volume of extraction. But as both BP and ConocoPhillips have subsequently discovered, partnerships with a Russian petroleum company are not always warm and cuddly. Because of almost unbridgeable cultural differences, not to mention the premeditated attacks on one another, as often as not the partners came to feel that their union was more like a shotgun wedding than a marriage made in heaven. Viktor Vekselberg, TNK-BP’s chief operating officer and one of the main Russian owners, acknowledged as much in an interview reported in the New York Times.³⁶

To further complicate matters, President Putin himself has criticized the BP investment. He has also referred to the Production Sharing Agreement (PSA) as “a colonial treaty” and expressed his regret that the Russian officials who authorized such arrangements had not been “put in prison.”³⁷

Cultural differences are not the only hazard faced by Western expatriates working for the TNK-BP partnership. The company has also had problems with Russian government authorities. Although Russia is now more open to foreign business investment—even foreign investment leading to operating and manufacturing control—than in the Soviet era, not everything has changed. The sense of paranoia and xenophobia is still very much alive. Non-Russian executives in TNK-BP, for example, are prohibited by Russian law from having access to official state data about Russia’s petroleum and natural gas reserves. These reserves are regarded as a state secret; foreigners who acquire such data risk being charged with espionage. But how can anyone operate a petroleum or natural gas company without data about that company’s reserves? To avoid arrest, TNKBP buys petroleum reserve data from Western companies. John Grace reports that TNK-BP uses Degolyer-McNaughton or Miller and Lenz. Other maps are also freely available on the Internet.³⁸ Nonetheless, in October 2006, some Russian government officials were charged with turning over state secrets to TNK-BP employees, and some TNK-BP subsidiaries have had their state secret access licenses revoked.³⁹

In yet another reflection of Russia’s historic xenophobia, in October 2007 Putin complained that there were too many foreign managers in senior positions in Russian companies, especially those producing raw materials. As he put it, “a thin top management stratum dominated by foreign specialists” is the reason why Russia imports so many foreign made goods and hires so many foreign specialists.⁴⁰

In all fairness, the way the Russian government reacts when foreign investors attempt to buy their energy resources is not that atypical of how most countries react in a similar situation. If anything, most members of OPEC, for example, are even more protective. But while Russians restrict what foreigners can do and know within Russia, they see no problem when Russian companies seek to buy energy producers in other countries. Thus, Putin helped LUKoil dedicate one of its new gasoline stations in New York City after LUKoil bought up the Getty oil filling-station network, a long established U.S. business operation. Neither the U.S. government nor the Congress did anything to hamper or limit LUKoil’s acquisition. Of course, LUKoil purchased Getty’s 1,300 filling stations, not its oil wells, which might have triggered a more protectionist reaction. While some Americans would likely react negatively to such foreign investments because of feelings of nationalism and fear, Russian investment in the U.S. energy sector—at least in petroleum production, refining, and servicing—is a good idea. The Russians are more likely to export petroleum to us and avoid any halt in deliveries if they have operations in the United States. Otherwise, some strategists argue, in the event of an embargo these facilities would have to be closed down. At the same time, of course, the properties Russians buy in the United States can serve as hostages if that should ever be necessary to offset similar pressure on U.S. companies in Russia. In any event, U.S. investment in Russian companies and Russian foreign direct investment in the United States symbolizes Russia’s emergence as an economic and a political player of consequence.

IS THIS JUST ANOTHER BLIP?

Given how often runups in the price of energy have been followed by rundowns, might the high energy prices of 2006–2007 be just a temporary increase? During almost all of the previous energy price hikes, it certainly seemed that higher energy prices were here to stay. For that matter, when energy prices subsequently fell, few thought prices would rise again. As a glance at Table 2.1 suggests, however, price cycles, with their ups and downs, appear to be an inescapable part of the world’s economic energy life.

The way economics works, it is to be expected that almost all economists would insist that energy price cycles are inescapable. Energy markets can be likened to the corn-hog cycle that economists teach to their students. When corn is scarce corn prices rise, which makes it too expensive for many farmers to breed hogs. So they kill their hogs, which reduces the demand for corn. This precipitates a drop in corn prices, which makes it cheaper to breed hogs so the demand and the price of corn rise. In much the same way, although you can not grow or kill oil wells like you can breed or slaughter hogs, when energy prices rise, energy becomes too expensive for some users who then look for substitutes or cut back. Not only are there fewer buyers (less demand) at higher prices, but the higher prices stimulate suppliers to offer more for sale. They want to sell more not only to earn a higher profit but also because the higher prices make it profitable to develop substitutes or to open up marginal sources of supply where heretofore the costs were too high to operate profitably.

While the supply and demand process needs no human organizer or controller to make it work, the Saudis have traditionally sought to ensure that swings in the price of petroleum were not too extreme. Consequently, when crude oil prices fall too low, they lobby the other members of OPEC to reduce output in order to tighten supplies and nudge up prices. On occasion, they have acted unilaterally. Similarly, when prices climb too high, the Saudis use their standby capacity to increase output because too great a price rise would stimulate the search for substitute fuels and conservation, measures that could prove hard to undo.

The rapid growth in prices in the early 2000s induced just such a Saudi reaction. After skyrocketing from $15 a barrel in 1998, to $77 a barrel in July, 2006, oil prices leveled off and for a time in early 2007 fell to slightly under $50. At that point the Saudis responded by curbing production by almost 1 million barrels a day (50 million tons) to prevent a further slide in prices.⁴¹ But since the Soviet Ministry of Petroleum and now the Russian oil companies are not part of OPEC, Soviet and then Russian producers have traditionally tried to take advantage of Saudi and OPEC cutbacks by doing just the opposite. When OPEC has reduced output the Russians usually have increased theirs. That explains why in late 2006 when the Saudis reduced their output, Russia once again became the world’s largest producer of petroleum.

In post-1998, however, there was something different about the way energy producers and consumers reacted. Producers did increase and reduce output in tandem with price increases and decreases (at least OPEC producers did), and the higher prices did revive interest in and production of renewable biofuel energy substitutes such as ethanol. Yet as prices approached the $100 a barrel mark, there seemed to be a new factor pushing prices to that level. There seemed to be less and less slack in the market. According to calculations of Fatih Birol, the chief economist at the International Energy Agency, the world needs 5 million barrels a day (250 million tons) of spare oil production capacity to avoid energy disruption.⁴² That is equivalent to almost half of Russia’s annual production. In 2005, there was only 1.5 million barrels (75 million tons) spare capacity.⁴³ Paolo Scaroni, CEO of the Italian energy company Eni, estimates that as of 2006 the world’s spare petroleum capacity had fallen from 15 percent of world consumption to 2–3 percent.⁴⁴ That suggests that energy prices are unlikely to drop in the near future. What remains to be seen is what sources of supply that before were too marginal will now become profitable and how extensive such new projects will prove to be.

THE NEW DEMAND EQUATION

Equally important, not only did there seem to be less spare capacity but energy consumption seemed to be increasing faster than normal. According to an estimate by Edward Morse, chief energy economist at Lehman Brothers, the investment banking firm, overall world energy demand rose by 10 million barrels a day (500 million tons) from 2000 to 2006.⁴⁵ Subsequently, the high petroleum price in 2006 precipitated a drop in consumption of 100,000 barrels a day within countries that belong to the Organization for Economic Cooperation and Development (OECD), especially the United States. But as we noted earlier, demand in the developing countries, especially in China and India, rose faster than elsewhere thus offsetting that drop. While petroleum consumption in the United States has risen by 17 percent since 1995 to a massive 20.7 million barrels a day, the comparable figures in India were a 57 percent increase to 2.5 million barrels a day and for China, now the world’s second largest consumer of petroleum, there was a 106 percent increase to 7 million barrels a day.⁴⁶

It is always risky to predict the future, especially when it comes to the discovery of new energy supplies and energy prices, but the recent very rapid growth in demand within the developing world is unlikely to abate. As the GDP continues to rise rapidly in countries like India and China, their energy consumption is likely to grow even faster as their new wealth brings an even faster demand for energy intensive products such as automobiles, refrigerators, and air conditioners. Because all three items are considered to be icons of the middle class, demand for such products is especially strong. Given that each Chinese consumes the equivalent of two barrels of oil a year and that each American consumes twenty-six barrels, the odds are that even with higher prices, China will substantially increase its energy per capita consumption; this means that future worldwide energy demand will continue to increase rapidly and outpace discovery of new energy supplies.⁴⁷ It is this demand and supply dynamic that enhances the financial and political clout of energy-rich Russia. Undoubtedly, as is in the past, sometimes there will be an increase in supply and a slowing of demand growth (and even occasionally a decline), but it is the coming of affluence to India and China that changes the equation. As their demand for energy continues to grow, this will provide enormous economic and political opportunity for Russia.

ARE RUSSIAN RESERVES LARGE ENOUGH?

With this new dynamic, future energy markets and supplies are bound to be tighter and substitutes and supplemental supplies harder to find. While this strengthens the hand of all energy producers (and partly explains the behavior and danger of someone like Hugo Chavez in Venezuela), it is particularly important for Russia. Russia is doubly blessed. While its proven reserves of 10.9 billion tons of petroleum or 79 billion barrels (6 percent of the world’s reserves) are not nearly as large as Saudi Arabia’s 36 billion tons (264 billion barrels), they nonetheless make up 42 percent of the non-OPEC country reserves. Moreover, much of Russia remains unexplored by geologists, and while it is unlikely that there are any giant fields left to be discovered, given high enough prices and the right time and infrastructure there is probably still more petroleum to be found.⁴⁸

In more recent times, as the country has allowed in Western petroleum companies and their more advanced technologies, companies like BP have found that the reserves they purchased were actually larger than they and the previous Russian operators had originally thought.⁴⁹ In April 2004, Lord John Browne, then CEO of BP, indicated that TNK-BP, which officially reported it had proven oil reserves of six billion barrels, could actually have considerably more. Although most geologists think it unlikely, Lord Browne said the total could be as high as 30 billion barrels. Robert Dudley, CEO of TNK-BP, predicted that the enhanced recovery techniques used in the West alone would make it possible to increase output by 750 million barrels. Most of the higher estimates result from advanced technology: when BP, with its Western knowledge and equipment, was able to put to work its “stronger pumps and more powerful tools,” it was able “to crack open the underground sandstone,” which holds in the crude oil and which TNK on its own could not tap.⁵⁰ The expectation is that as technology continues to advance, there will be similar happy surprises.⁵¹

Even if no large reserves are found, the present reserves are enough to provide Russia with an enormous financial windfall. As a look at Table 4.2 indicates, each year Russia generates an enormous trade surplus. In 2006, for example, the surplus amounted to $140 billion. That contrasts with $20 billion in 1995, when petroleum prices were much lower. Petroleum exports were $140 billion in 2006, which accounted for almost half of the overall export earnings and the entire trade surplus. Strategically, petroleum has brought Russia unaccustomed wealth. In addition to over $120 billion in its Stabilization Fund in 2007, it also held over $420 billion in the treasury and Russian Central Bank, which as we saw earlier in this chapter provides Russia with the world’s third largest stash of dollars, gold, and convertible currencies.⁵² This cash windfall has allowed it to prepay its debt to its creditors in the G-8 countries and several other groups. Not bad, considering that in 1998, a bare nine years earlier, the vault was effectively empty.

While its petroleum exports provide Russia with its new financial wherewithal, it is natural gas that brings Russia unprecedented political clout. Combined, the need for these two commodities makes Europe very dependent on Russia. At the same time, some Europeans insist that the Russians are equally vulnerable. As they see it, once an expensive pipeline is built and natural gas deposits developed, Russia will be as dependent on its customers in Western Europe to buy and pay for that gas as Europe will be to have access to it.⁵³ That may be true, but only as long as Europe acts as a united bargainer and no European country seeks to sign a private agreement with Russia. It also assumes that Russia cannot find an alternative customer in need of natural gas. That also assumes that neither Gazprom nor Russia has a leader capable of trapping the Europeans into playing off against one another or of finding other large customers in a world frantic to assure themselves of secure energy supplies. As we shall see shortly, that mind-set seriously underestimates the analytical insights and talents of those in the Kremlin, especially Vladimir Putin or his successor. It also seems to overlook the Russian penchant for chess and the ability to check the moves of their opponents. Just how premeditated and masterful Putin has proven to be will be the subject of Chapter 5.