From the May 2010 issue of Research Magazine • Subscribe!

Russia's Power Failure

A would-be "energy superpower" fizzles.

When commodity prices were at a peak in 2007-08, and oil prices in particular hit $147 per barrel, Russian leaders declared their intention to make Russia an "energy superpower." Not only did they expect a never-ending flow of petrodollars, but they intended to use Russia's vast energy resources to reclaim a seat among the world's most powerful nations. Being the main supplier of natural gas to Europe, they aspired to flex their political muscle and get their way by turning the spigots on and off.

To this end, Russia announced two new gas pipelines, the Nord Stream and the South Stream, to diversify delivery routes to Europe, and began building oil and gas pipelines to the Far East. As befits an "energy superpower," Russia effectively pushed foreign companies out of key exploration projects.

Even under best-case scenarios for energy prices, using natural resources as a political tool has always worked poorly in the past, not just for Russia but for OPEC, Venezuela and other producers. Given today's market conditions, Russia's energy policies have proved nothing short of disastrous. But it could have been predicted -- because "energy superpower," like any "commodity superpower," is a contradiction in terms.

Unpredictable Prices

Energy prices are remarkably hard to predict. Time and again, analysts fall into the trap of projecting existing trends forward. Back in 1973, months before the first oil shock, there were forecasts of an oil glut and dirt-cheap oil. The 1970s, conversely, were marked by fears that oil would run out by century's end. Then, after such fears failed to pan out, oil prices rocketed in the first decade of the new millennium and we were told that this time the feared imminent shortages were genuine.

Today, we're once more going through a period when oil supply is increasing and demand is sluggish or declining. There is suddenly talk of a green revolution that will permanently depress demand.

Such forecasts exacerbate cyclical price swings. They set into motion energy conservation efforts when prices are high, while also encouraging producers to invest ino exploration projects which come on line just when a fresh glut develops.

Oil-exporting nations benefit from high oil prices, but they are also their greatest victims, over-investing and taking on extra debt on expectation that petrodollars will flow in indefinitely. Their debt problems, in turn, hurt creditors and their need to service debt at a time when prices are low forces them to dump more oil into already oversupplied markets.

Russia presents a classic example of such overreach and over-commitment, and financial problems that will plague it in the near future are already becoming evident. But in Russia's case, the wasteful and misguided spending has been exacerbated by outsized political ambitions.

Russia's perennial squabbles over natural gas transit through Ukraine and Belarus, which in recent winters left Europe shivering, convinced EU governments to look for new supplies just as Russia prepared to sink some $20 billion in the construction of two new pipelines running westward.

Spending in the East

In 2009, Russia opened its first plant producing liquefied natural gas (LNG) in the Far East. But plans to conquer the U.S. market, where Gazprom, Russia's state-owned natural gas monopoly, aspired to capture a 10 percent market share, have been put on hold. The main problem has been that demand for LNG in the U.S. has declined and prices have been driven down by a sharp increase in the production of natural gas from shale. Gas and oil from shale is still costly to produce and environmentally dangerous, but these are technological problems that are being rapidly solved, potentially swamping oil and gas markets over the long run.

The Asia-Pacific market is a legitimate place for Russia to sell its energy, but it has also been a trump card Russia hoped to play to frighten its European customers by showing that it can find alternative markets for its oil and gas. Late last year, Prime Minister Vladimir Putin opened the first stage of the Eastern Siberia-Pacific Ocean pipeline, which will deliver oil from Western Siberia to China. The cost has been put at $12.2 billion. China, meanwhile, took full advantage of Russia's desire to do business. It has obtained a highly advantageous, secure long-term contract for oil in exchange for a $25 billion loan.

In fact, Russia's state-owned behemoths need lots of money in order to carry out their government's ambitions. The Siberian gas program will need $90 billion over the next decade, and Gazprom has a near-term investment budget of around $25 billion.

The situation is tailor-made for foreign participation, given foreign companies' deep pockets and expertise. But the government keeps Russia's energy sector virtually closed to foreigners. Meanwhile, fewer and fewer foreigners hazard to invest in Russia since the overall investment climate there has degenerated markedly in recent years. Foreign companies, including BP, Shell and IKEA, have had a hell of a time with Russian courts, regulators, government agencies and other authorities.

Meanwhile, Gazprom's debt stands at more than $55 billion, having increased by $13 billion in the first nine months of 2009. Oil company Rosneft's debt doubled from 2005 to 2008.

Problems have already started to emerge, even though oil prices have held up well through early 2010. Russian consumers and businesses are being soaked by the state-owned natural gas monopoly and a handful of large domestic oil companies. Prices at the pump showed none of the decline seen in world markets since 2008, and rates paid by consumers and businesses for natural gas have been climbing steadily.

There will be more hardship for state-owned energy companies if prices don't recover and worldwide demand doesn't come back. This means that Russia will have to sell more oil and gas for its major conglomerates to service their debts. That's happened before, for example in the 1990s, when financially strapped OPEC members drove oil prices below $10 per barrel.

Harsh Realities

There is a lesson in all this for commodity producers -- even though it's an old tale, repeated many times before. Oil prices can never hold the world over a barrel. It works for a short while, but over the long run rich oil consumers are more flexible, more technologically advanced and more politically savvy. OPEC learned its lesson the hard way after riding high briefly in the 1970s. Since then time and again it's commodity producers who end up with the short end of the stick.

This merely confirms the fact that for a less developed nation being rich in commodities is a curse, not a blessing. It retards economic development and fosters unrealistic expectations for its population as well as its rulers. This is why they tend to remain poor and politically unstable.

On the other hand, the U.S., Canada and Norway are examples of rich industrial countries that have been further enriched by their oil, gas and other commodities. Diamonds mined in South Africa, a country with a solid industrial infrastructure, are a boon, whereas those found in the rest of Sub-Saharan Africa tend only to compound their misery.

Mexico was a heavily indebted and financially unstable country while it was mainly an oil producer. Having built an industrial infrastructure over the past decade and a half, it has become a paragon of financial stability in Latin America. Meanwhile, Argentina, once an industrial hub of the Southern Hemisphere, may return to the instability of the 1960s and 1970s thanks to its newly found oil wealth combined with misguided government policies.

Russia's energy superpower gambit never had much of a chance to get off the ground. Its government should have been working on reviving its industrial infrastructure and improving the investment climate in the country instead of aspiring to dictate its will to its energy customers. It may now find that the world -- or rather its international creditors -- start dictating their terms and conditions.

Alexei Bayer, a native Muscovite, is a New York-based economist.

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