Jun 08, 2022
On February 24, as Russia invaded Ukraine, Guardian reporter Fiona Harvey posed the interesting question: "Is Putin's Invasion About Fossil Fuels?" Indeed, modern warfare is enabled by fossil fuels. Historians have remarked on the decisive role that access to oil made in World Wars I and II. Defense analyst and author Michael Klare refers to wars over access to fossil fuels as "resource wars," a term sometimes applied to the Iraq War. But Russia is already a hydrocarbon-rich country, having recently climbed to world class status as an oil producer.
To build your economy too tightly around oil and gas is a very bad idea for democracy and social development.
Harvey concluded in her article that Europe's dependency on Russian oil and gas exports had allowed Putin to weaponize those assets, but argued that this did not cause the war, a logic that recurs in media accounts. But the quandary remains: Why would a calculating politician like Putin put his lucrative oil and gas trade with Europe at risk by resorting to war? This article examines the chronic weaknesses of Russia's own petro-state to offer an alternative context on Putin's turn to war, as well as strategies that might help end the war.
On the one hand, Russia is a hydrocarbon powerhouse--second only to the United States and Saudi Arabia, but internal contradictions have long plagued the nation's rise to world-class status. Energy scholars often refer to a "resource curse" that plagues many petro-states. In short, to build your economy too tightly around oil and gas is a very bad idea for democracy and social development. All that revenue flowing in can fuel corruption, while the magic of black gold leads politicians to neglect other sectors of the economy.
Russia's overreliance on fossil fuel exports puts the nation's GDP and domestic spending at risk every time oil prices drop or its exporters lose market share. With three crashes in global oil prices since mid-2008 and relatively low prices for most of the past 7 years, Putin has had every reason to be concerned. US sanctions (over Russia's 2014 militarism in Ukraine) had crimped the country's oil revenues and European Union (EU) regulations were eroding Russia's advantage, raising the specter (for Putin) of electric cars and stranded hydrocarbon assets.
Russia's oil problem
It is hard to overstate the centrality of hydrocarbons to the Russian economy. Oil and gas make up 60% of the country's exports and 45% of 2021 budget revenues. Fossil energy has ranged from 15 to 25% of Russian GDP, with 80% of that revenue from oil. Nearly half of that oil is exported to Europe, with most of the rest sold in Asia.
But low oil prices during much of the last decade hurt Russia's oil revenues. While the US oil sector also see-saws through boom-bust cycles, Russia has an added problem--unlike Western companies, Russia's oil sector faces a variety of capital and other constraints that hinder its ability to boost production in high oil price years.
Oil production was in the doldrums when Putin was elected in 2000. Then from 2003 to 2008 steady demand for oil (from China) and high oil taxes in Russia (90% of revenues) led to a flood of oil "rents" to the state and rapid GDP growth, but offered only weak incentives for companies to develop new fields, argues Thane Gustafson, a Georgetown University specialist on Russian energy. To this day, Russian oil production relies heavily on inefficient water-pressure extraction in Soviet "legacy" reserves, because of the high cost of developing new fields. Also, two-third of new reserves have unconventional oil (eg. shale oil, deep water) that requires new technologies and large capital investment to extract. Hence the very slow growth of Russian production.
Many countries that can't foot the bill to exploit their own oil reserves sign contracts with foreign oil companies, but Russia's high tax rate, chaotic regulatory system and official distrust of foreign companies were barriers. Russia had begun to see progress in fracked shale oil and gas production in 2019 with foreign collaboration, but most such deals have collapsed due to the pandemic and new sanctions imposed this year.
Kicking the (Ukrainian) Dog
Although it makes up only 20% of Russian hydrocarbon revenue, natural gas receives more attention than oil in media accounts because Europe relies on Russia for 40% of its supply, much of it via a pipeline hub in Ukraine. Putin has close relations with directors of Gazprom, the majority state-owned monopoly that controls domestic and foreign gas sales.
After the Soviet Union's breakup, several former Soviet republics, strapped for funds, still relied on Russia for cheap gas. When oil prices began rising in 2003, Putin raised prices and cracked down on those with gas debts. In Ukraine, disputes also involved Russian transit fees owed for use of Ukraine's hub for exports to Europe.
Putin maximized his leverage by dealing with each state bilaterally. Margarita Balmaceda, a Seton Hall professor who studied these relations, found that he offered special deals to Russian allies like Belarus but imposed high rates on states leaning toward the West like Lithuania and Bulgaria. Ukraine claimed neutrality, but this only papered over the tensions.
Ukraine's strategic role managing the gas hub to Europe and its former geographic importance in the Soviet era meant that disputes over price were also geopolitical. The timing of major disputes with Ukraine suggests that Putin also sought to divert the Russian public's attention from problems with its own oil-based economy. Oil revenues underwrote cheap domestic gas and other public benefits in Russia, but the country hit economic rough spots just prior to disputes with Ukraine in 2006, 2009, and 2014.
The first dispute followed a disputed Ukrainian presidential election in late 2004 that prompted public protests when the pro-Russian candidate, Viktor Yanukovych, was accused of fraud. His opponent, Viktor Yushchenko, was declared the winner, and in April 2005 the new president poked the Russian bear by declaring a Ukrainian goal of joining NATO. Putin responded within weeks demanding more than a three-fold increase in gas price, which set off months of fruitless negotiations. This culminated in January 2006 when Russia cut back the gas supply to Ukraine's hub, causing three days of low pressure in the system that reduced flow to several European countries.
Behind the scenes the Russian oil sector had been scrambling to deal with a 25% drop in foreign investment (tied to Putin's controversial jailing of a Russian oil CEO) and slowing growth in oil production. Also, in fall 2005 Hurricane Katrina curtailed US production triggering new volatility in oil prices. Political scientist Paul D'Anieri, who studied Russia's relations with Ukraine, saw this dispute as a turning point when Putin began to view Ukraine as the linchpin in conflicts with the West.
A second gas price dispute erupted in January 2009 when Putin ordered a complete supply cut-off by Russia for 12 days, leaving millions of people without heat in seven European states. EU negotiators mediated the talks. Again, Putin's timing was not random. It coincided with the low point of the 2008 financial and oil price crash, which set off a profound slump in Russia's domestic economy.
The most serious conflict followed the EuroMaidan protests of 2013-2014. Then-President Yanukovych unleashed the storm by suddenly backing out of an EU trade association accord in return for Putin's promise of large loans and a lower gas price. In February, as crowds demanded his resignation, Yanukovych fled to Russia. Within weeks Putin annexed Crimea and provided arms to Russian separatists in Ukraine's Donbas region.
Again, Russian domestic unrest likely played a role. Still shaky from the 2008 crisis, Russian budget revenues had sunk again amid weak oil demand due to the EU debt crisis, spurring a series of street protests over corruption and high costs of living in 2013-2014. Then in June 2014, as the US Federal Reserve rolled back its bond buying (corporate stimulus) program oil prices began a steady fall.
While Crimea had significant offshore gas fields, Russia's wealth in gas reserves, led most analysts to dismiss fossil fuels as a motivator of the occupation. But Frank Umbach, an energy specialist at King's College, London, argued that Putin's move was strategic because it ended a plan by Ukrainian politicians to exploit their offshore reserves as a way to phase out reliance on Russian gas imports.
The EU regulates Gazprom
Not long after the 2009 gas dispute, the EU began to push back on Putin's fossil dominance with a series of regulatory and judicial actions that reduced Russia's leverage in oil and gas sales to Europe. The EU's Third Energy Package aimed to reduce corruption and build a framework for climate policy. One rule, known as "unbundling"-- forbidding the same company to have a monopoly over both energy infrastructure and fuel--directly targeted Gazprom.
This came to a head with dawn anti-trust raids in September 2011 on Gazprom's (and affiliates') offices in 10 EU countries. Gazprom was charged with unfair practices of demanding higher prices from vulnerable countries (eg. Bulgaria, the Baltic states and Poland) compared to rates in the wider EU market. Potential fines were set at EUR10 billion.
After this, several EU countries invested in new gas infrastructure to reduce reliance on Gazprom. These changes (combined with a weak market and US sanctions over Russia's 2014 aggression in Ukraine) heavily impacted Gazprom profits.
After being hit with sanctions, Russia stepped up talks with China over hydrocarbon deals. China jointly invested in two pipelines (for oil and gas) from Russia and a gas project on the Yamal peninsula, but these have not been very profitable for Russia to date. Most proposed deals did not pan out due to transportation and infrastructure costs and because China prefers to work with its own companies. As Gustafson put it in an online interview, "Russia does not loom as large on China's radar screen as Russia would like."
Prior to the pandemic, as higher prices boosted Russian oil production, a new fly marred the ointment when Gazprom was hit by a series of arbitration cases. The long-running dispute over Russian transit fees owed to Ukraine was finally resolved in 2018 when a Stockholm tribunal ordering Gazprom to pay $4.63 billion to Ukraine's national gas company Naftogaz Ukrainy. Putin initially lashed out threatening to terminate transit gas through Ukraine, but Russia paid the fine. Gazprom also fought an arbitration case brought by Poland's main gas supplier which ended (shortly after the Ukraine invasion) with a ruling against Russia and a $1.5 billion fine.
Proposed new EU climate rules also provoked debates in Moscow. Brussels issued a blueprint last July for a carbon border tax on manufactured goods that would put teeth into Europe's carbon market which until now has placated corporate emitters with subsidies. The tax, to be phased in from 2023 to 2026, would hurt profits of Russian aluminum and steel exports, which have high carbon footprints.
The bad taste left in Putin's mouth from fighting the judicial cases, coupled with pending climate regulations, may have influenced both the invasion of Ukraine and the April 26 cut-off of gas to Poland and Bulgaria for their refusal to pay for gas in rubles.
A Global "Energy Superpower"
While Putin is known for his aggressive, zero-sum approach to political goals, geographers Stefan Bouzarovski and Mark Bassin observed that he is also an energy policy wonk, who has long seen Russian power as interwoven with exploiting Russia's energy wealth. In speeches Putin has often referred to Russia as a global "energy superpower."
In 2018-2019 the return of high oil prices aided Russia in forming foreign partnerships to develop new reserves. Putin's petrostate pride and appetite for risk were likely further boosted by his prominent role with Saudi Arabia leading OPEC-Plus.
The cartel instituted supply cuts that helped stabilize oil prices after the 2020 crash--all at a time when US frackers were on their back foot. Heady stuff indeed. Other OPEC leaders were reportedly annoyed as Putin and his Saudi counterpart Mohammed Bin Salman increasingly set production quotas on their own, without consulting with the group.
At home, however, despite upbeat Kremlin reports that the oil crash only led to a 3% drop in 2020 GDP, a new Stockholm Institute for Transition Economics analysis suggests the real drop in GDP, as well as domestic purchasing power, was closer to an alarming 9%.
Echoing the pattern of Putin's earlier disputes with Ukraine, such domestic problems may have nudged Putin to pick a fight abroad. Last October, as the West reopened economies, Moscow and St. Petersburg went into lockdown amid a Covid-19 upsurge. Only a third of Russians were fully vaccinated, and the official 230,000 Russian deaths from the virus surpassed that of any country in Europe or Asia, except India. After months of dismissing the virus, Putin suddenly offered a paid week of vacation for Russians in early November.
At the same time, Russian oil companies were struggling to bounce back from months of "shut-in" (curtailed) production during the pandemic. Mature wells, which generate the bulk of Russian output, often lose productivity when they sit idle, plus oil field equipment and supplies rose steeply due to the supply chain problems.
One indicator of production is "spare capacity"--the ability to bring significant new oil onto the market rapidly. New data shows Russia's spare capacity dropped more rapidly than other major OPEC producers in recent months. Also, Russia has lagged behind its targets in boosting production after OPEC-Plus quotas were lifted, despite the lure of high prices.
After the February 24 invasion, new US and EU sanctions caused a 60% crash in the ruble's value, but soaring oil and gas prices boosted Russian revenues in March and April, allowing Putin to restore much of the ruble's value and shore up the domestic economy. Awareness of this spurred the EU's May embargo on imported Russian tanker oil, set to be phased in over six months.
Even before the embargo, several private oil trading firms said they would end trade with Russia. However, the International Energy Agency reported that Turkey and India bought more oil from Russia since the war began, possibly lured by 30% discounts. South Korea and China also are importing Russian oil. Citing sanctions, the International Monetary Fund predicted an 8.5% contraction in Russia's economy, but not in time to prevent a drawn-out war.
The above narrative of Russia's windfall profits one day and financial crisis the next reflects the curse of Black Gold's allure, and inevitable betrayal--an operating hazard for economies too heavily reliant on hydrocarbons. It's not farfetched that a petro-autocrat might look for a military fix.
These skirmishes illustrate how deeply interwoven petroleum politics has become with the culture and geopolitics of Russian's foreign policy. This is not the Cold War. Oil dependence is Putin's bane, and ours. As we watch the daily tallies of destruction in Ukraine, I am reminded of Ralph Waldo Emerson's quote in response to his own era's fossil-fueled disruptions: "Things are in the saddle, and ride mankind."
© 2023 Resilience
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