Putin’s Petroleum Problem

How Oil Is Holding Russia Back—and How It Could Save It

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Last winter, a wave of mass demonstrations suddenly broke the surface calm of Russian politics. A new middle class, born of the oil-based prosperity of the last decade, took to the streets to voice its opposition to the perceived corruption of the political elite, especially United Russia, the ruling party of then Prime Minister Vladimir Putin. For a time, as the protest movement gained momentum, the very foundations of the regime appeared to shake. But in the March 2012 presidential election, Putin managed to win comfortably in the first round, and despite widespread charges of manipulation, even the opposition conceded that he had earned a convincing victory. 

The unprecedented protests and Putin's return to the presidency renewed speculation about whether Russia will keep moving toward political and economic modernity or lapse back into Soviet-style stagnation instead. The answer to that question can be found in the country's most important economic sector: oil. Since the collapse of the Soviet Union, the Russian government has become increasingly dependent on revenue from oil exports. It taxes the lion's share of the profits of producers and transfers them to the rest of the economy through state-mandated investment programs and state-funded welfare, pensions, and subsidies. The spectacular growth of state income generated by oil has helped keep Putin in power, enabling him to secure the support of key interest groups and maintain, at least until recently, a high level of popularity. 

For now, high oil prices are keeping this system running. But sustaining it requires a steadily expanding stream of revenue from commodities, especially oil. In the coming years, however, oil profits are more likely to shrink than grow. For the past two decades, Russia has coasted on an oil legacy inherited from Soviet days. The assets of that era are now deteriorating. Russia is not running out of oil, but it is running out of cheap oil. Much of the oil still in the ground will be more difficult and costly to find and produce. As expenses go up, profit margins will decline. At the same time, the oil industry will have to spend more of its remaining profits on its own renewal. 

Neither Russia's oil industry nor the Russian state, however, is adequately prepared to deal with the coming challenge. Both have spent the last two decades competing for control of the country's oil assets instead of cooperating to modernize the industry and prepare for the next stage of development. The state's fiscal and regulatory system, although it has been successful in extracting revenue, constrains investment and stifles innovation. The result is an industry that lags behind its foreign peers, and this at the very moment that the global oil industry is experiencing an unprecedented technological revolution. At the same time, Russia is showing some of the classic signs of what economists call "Dutch disease," the economic stagnation, especially in manufacturing, caused by an overreliance on commodity exports at the expense of other parts of the economy. In the words of Alexei Kudrin, Russia's finance minister from 2000 to 2011, "The oil industry, from being a locomotive for the economy, has become a brake." 

Although Russia's leaders view the country's dependence on oil with growing anxiety, there is no realistic escape: oil will dominate the future of Russia for years to come. But Moscow can still choose how to deal with that dominance. On the one hand, the state could further expand its role in the oil industry, squeezing out private shareholders, forcing down dividends, and dictating where the oil companies invest their resources. But that is unlikely to provide much incentive for efficiency or innovation. On the other hand, it could follow a more productive path. The government could rein in its spending, thereby reducing the need for oil revenues, and loosen its grip on the oil industry, so as to encourage the type of innovation that will renew it.

And so oil, paradoxically, is both a force for prolonged political and economic stasis and Russia's best hope for escaping it. For political leaders in Moscow, the oil industry inherited from Soviet times still generates enough income to support a comfortable political and economic system in which it is all too tempting to linger. Only if this industry modernizes will Russia have the revenues to support any sort of transition -- and that will happen only if the state and its policies modernize along with it. Yet for now, thanks to high oil prices, the leadership seems more inclined to choose the status quo than adaptation.

BUST AND BOOM

The origins of the present dilemma lie in Russia's difficult exit from its Soviet past. Russia wasn't always so addicted to oil. Only in the last decade and a half of the Soviet Union's existence did its leaders use oil and gas exports as a means of propping up their sagging system and avoiding change. Then, when the Soviet industrial economy imploded, it left natural resources, most notably oil and gas, as the chief remaining sources of value.

The oil industry of the Soviet era was highly developed but flawed. Most of its production came from a handful of giant fields in western Siberia that had been damaged by shortsighted practices caused by political pressure to maximize production. Keeping the oil flowing required massive increases in capital investment, but with the sudden drop in world oil prices in 1986 and the financial crisis that followed, the weakened Soviet state was no longer able to provide the requisite financing. With the end of the Soviet system, oil investment collapsed, and production plummeted. Russia's oil output, which was the highest in the world as late as 1987, dropped steadily over the following nine years, before bottoming out in 1996 at around half the Soviet-era peak.

The government began denationalizing the oil industry in 1992, and a new generation of privately owned oil companies was born. But the oil in Russia's ground still belonged to Moscow, as did the pipeline system. The state still controlled the borders and the customs posts, however tenuously. It retained the authority, if not always the actual power, to control exports, especially of crude oil. Thus, despite its apparent liberation, the oil industry remained enmeshed in a system of government controls that, although half comatose in the 1990s, could be revived at virtually a moment's notice. 

Nevertheless, privatization, combined with a timely recovery of oil prices, had its effect. Oil production began growing again in 1999 and by 2002 was increasing at nearly ten percent per year, with seemingly no end in sight. In 2002, the newly privatized oil companies accounted for over 83 percent of Russian oil output. Two new industry leaders, Yukos and Sibneft, under the command of two self-made entrepreneurs, Mikhail Khodorkovsky and Roman Abramovich, applied production methods and management techniques -- chiefly, hydraulic fracturing and horizontal drilling -- never seen before in Russia. Other private oil companies were following close behind, and investors snapped up shares in them on Western stock exchanges.

Putin, when he was elected president in 2000, initially sounded like a classic economic liberal, championing capitalism and economic reform. He appeared to have reached a modus vivendi with the private-sector oligarchs of the Yeltsin years, based on a principle of mutual noninterference. Foreign oil companies became increasingly active in Russia, and the new Russian oil industry launched ambitious plans for investment in Caspian Sea reserves, a pipeline to China, refineries in Europe, and a major new supply line to North America. To many observers at the time, it appeared that the victory of free-market capitalism in Russia was all but complete. 

But as oil prices rose throughout the decade, Russia's young oil companies became irresistible prizes for an increasingly powerful state. Behind the apparent dominance of the private companies, a newly resurgent state-owned oil corporation, Rosneft, was rapidly gaining strength. The Russian government, armed with powerful new tax laws, was already capturing a growing share of the private companies' profits and would go on to capture far more. Khodorkovsky's resistance to the state's reassertion of power brought him into bitter conflict with Putin (especially when Khodorkovsky's political ambitions became clear), and in 2003, Khodorkovsky was arrested on charges of tax evasion, and the government began expropriating Yukos. In the wake of the Yukos affair, the double-digit growth in Russian oil production soon subsided. By the middle of the decade, the private sector had been clipped back, the private owners had been humbled, the oil boom was over -- and the state was back. 

Even so, oil production continued to grow, if more slowly than before, and for a time, the Russian political and economic system seemed to have reached a stable equilibrium. But then came the 2008 global financial crisis and the recession that followed. Global oil prices dropped sharply, and in 2009, Russia's GDP fell by 7.8 percent -- the steepest drop of any major economy. The oil companies cut back spending, and in 2008, Russian oil production declined for the first time since the mid-1990s.

PROFITS IN PERIL

In the years since the crisis, overall oil output has recovered, but signs of trouble are everywhere. Russian oil production is on track to increase this year by about one percent, but only at the price of a skyrocketing rise in capital spending. Investment in the oil fields, which was up by 34 percent in 2011 to a record $31 billion, could well reach $40 billion this year. Despite the industry's best efforts, its western Siberian core has entered a long-term decline. If overall output is still growing, it is only thanks to a handful of new fields, located mainly in the frontier regions of eastern Siberia, where production is more expensive. The Energy Ministry has warned Russia's leadership that, on the current trajectory, oil production could well be in decline by 2020. 

To prevent that outcome, the industry will have to search beyond its Soviet-era perimeter for new sources of oil: offshore in the Arctic, in the remote eastern Siberian wilderness, and in the deeper horizons of western Siberia. The fields in these places are variously deeper, hotter (or colder), higher in pressure, higher in sulfur content, more remote, or more geologically complex than those tapped in Russia today. So it will take more time and more money to extract oil from them. 

The problem, however, is that Russia's oil industry has been slow to replace the inefficient practices of the command-economy era with more modern management structures and techniques. Although hydraulic fracturing and horizontal drilling have by now become standard throughout the Russian industry, global oil technology has since moved on, and the Russian oil companies have yet to follow. In particular, the Russian oil companies have only limited experience in the Arctic offshore, which will likely provide much of Russia's oil and gas in the future.

The basic reason for the industry's failure to evolve is straightforward: so long as the inherited fields continue to produce, companies see little need to change. In addition, the state's heavy tax burden and restrictive regulations have left the companies -- both state-owned and private -- little incentive to invest in new technology or to improve their efficiency. And without progress on these fronts, expenses will continue to rise inexorably. Higher costs will mean lower profits and, ultimately, lower revenues for the state.

In other words, the Russian state's primary source of income is in jeopardy, even as its dependence on it continues to grow. Oil and gas (the price of which is largely linked to oil) together account for about 30 percent of Russian GDP, and since 2000, the steady rise in prices has driven about half of Russia's GDP growth. Today, oil provides nearly 40 percent of the government's tax revenues. Thus, the Russian economy and state are acutely vulnerable to any decline in oil profits.

The pressure would be especially severe in the event of a decline in oil prices. Oil prices are back to record-high levels, and it is easy to imagine them staying that way. Rising demand from Asia and the Middle East, continuing increases in the costs of finding and producing oil, and growing instability in places where oil is produced (including the Middle East and Africa) could well keep pushing oil prices higher and higher. But it is not difficult to imagine the opposite scenario. In North America, the production of gas found in underground shale basins and of "tight oil" trapped in compact rock formations, made possible by new technology, is gathering speed at an astonishing rate, far outstripping all forecasts. As innovative techniques for producing shale gas and tight oil spread to the rest of the world, they are dramatically altering the outlook for energy production. The global economy may now stand on the threshold of a new era of more abundant hydrocarbons, possibly at lower prices.

Normally, one might expect plentiful supplies and lower prices to stimulate consumption, but that may not be true for tomorrow's oil demand. Today's high prices have eaten into demand so much that the effects will be felt for a long time (just as they were for two decades after the oil shocks of the 1970s). Oil use has already peaked in the industrialized world, chiefly in Europe and the United States. Meanwhile, economic growth has slowed in many of the emerging-market countries, particularly in China and India, causing the growth of oil demand to slow as well. Lastly, some of the potential growth of oil demand will be met by natural gas. All these forces could combine to hold back oil demand and keep oil prices in check.

For now, the forces pushing prices higher are still dominant. But those that will eventually depress prices are getting stronger, and the likelihood of a longer-term environment of lower oil prices is increasing. Yet even if oil prices do no more than remain at today's levels, the combination of higher oil costs, lower profits, and a lower tax take for the government places Russia's entire system of distributing oil wealth at risk.

ESCAPE PLANS

Many in Russia's ruling elite realize that trouble lies ahead. Since the 2008 crash, a remarkable debate has begun about the dangers of natural resource dependence -- one of those periodic self-examinations for which the Russians are famous. But although the goal is clear, there is no consensus on how to achieve it. Instead, there are three competing plans for escaping from oil dependence: a program of high-tech modernization, associated with Russian Prime Minister Dmitry Medvedev; a market-reform model, championed by Russia's former finance minister, Kudrin; and Putin's preferred plan of maintaining the same strong state role as today.

During his four years as president, Medvedev put forward an ambitious agenda of economic modernization and diversification, amounting to a call for a change of direction from the policies of the previous decade. "For centuries," he declared in 2010, "we have shipped our raw materials abroad, and imported all the 'smart' products." This state of affairs has profoundly discouraged would-be innovators and entrepreneurs. One of Medvedev's supporters, Andrei Klepach, a deputy economic development minister, put the situation even more pungently: "Russia," he said, has become "a country that exports oil, girls, and future Nobel Prize laureates."

The program Medvedev advanced centered on high-tech innovation, in computers, nanotechnology, advanced medicine, nuclear power, and space. Drawing inspiration from Silicon Valley, he announced plans for a new innovation center called Skolkovo. He even opened a Twitter account to signal the new direction. Energy played an important role in his program, but the focus was not on increasing supply but on limiting consumption by becoming more energy efficient. Meanwhile, Medvedev and his supporters contended, the government should invest oil revenues in high-tech manufacturing and put as little as possible back into the oil sector itself. For many Russians, however, Medvedev's program, in its ambition and sweep, was disturbingly reminiscent of the Soviet five-year plans. It involved the same top-down modernization by political mandate, the same drive to overcome decades of lag in one giant leap. 

In contrast, the vision put forward by Kudrin -- whose policies did much to keep Russians' finances on an even keel -- marks a return to the agenda of market-oriented reform. In his view, state budgets have spiraled out of control, and the days of rapidly increasing oil production and high oil prices are coming to an end. Kudrin openly criticized Medvedev's modernization program and the Kremlin's plans to increase military spending. He reserved special ire for the Ministry of Economic Development's aim to fund Russia's modernization through annual deficits. The state should strive to create the best possible investment climate, Kudrin argued, and stop trying to channel investment through large state corporations, since these breed corruption and lead to capital flight. Only if inflation remains low, the currency stays stable, and property rights are protected will entrepreneurs have an incentive to take risks and invest in Russia. In many ways, Kudrin's formula represents a revival of the program Putin appeared to back in his first term. But in 2011, finding no support for his proposals, Kudrin resigned from the government.

Putin's vision differs from Medvedev's and Kudrin's not so much in its goals as in its means. For Putin, oil and gas remain the only realistic source of capital for Russia's growth, and the best way to enhance the industry's performance is to maintain strong state control. He sees oil as still abundant in Russia and contends that if supplies seem short, companies must simply look harder. In his conception, private oil companies' loyalties should lie not with their shareholders but with the state. In fact, Putin's preferred vehicle for finding, producing, and transporting oil is a large state-owned company that mostly exports refined products, rather than crude oil. In his view, the state remains the engine of growth and progress; the job of the oil industry is simply to provide the fuel for it. 

Putin denounces Russia's dependence on oil just as Medvedev and Kudrin have. But his view is tempered by the belief that oil can play an indispensable role for decades to come, not only as a source of revenue but also as an instrument of regional development at home and geopolitical influence abroad. Unlike Medvedev and his team, Putin praises the oil industry as a potential technological leader, although to him, it takes second place to supposedly more advanced industries, such as the military sector. As he sees it, the state should continue to channel revenues from oil to support other strategic sectors.

Characteristically, Putin has sought to push the Russian oil companies toward change through a combination of exhortation and administrative pressure, along with an assortment of ad hoc tax breaks. He has encouraged Rosneft, now under the leadership of his longtime associate Igor Sechin, to conclude a series of alliances with major foreign oil companies to develop Russia's skills in Arctic offshore exploration and production. These partnerships could mark an important new chapter in the relationship between the Russian oil companies and the global oil industry. Putin and Sechin's strong support for them suggests they understand the urgency of the situation and are responding to it -- yet by essentially the same state-led means that they have favored in the past.

So far, as Putin begins his third term as president, his vision dominates. One might suppose, indeed, that with Medvedev's demotion to the premiership and Kudrin's departure from the government, their views have lost influence altogether. Yet in reality, all three remain strongly represented, and the actual direction of policy is likely to reflect a continuing competition among them.

Despite their apparent differences, all three visions are bullish on Russia's capacity to compete in the global economy as a leading producer of high-tech products and services. But that, to put it mildly, is a brave bet, no matter whose vision prevails. Russia, with its diminished human and physical capital, will be hard-pressed to keep up with the emerging economies of Asia and the mature knowledge economy of the United States, which continues to lead the world in innovation and entrepreneurship. For the foreseeable future, hydrocarbons will remain Russia's chief comparative advantage.

THE COMING FISCAL CRISIS

Although Putin managed to win the presidential election with ease this time, in 2018, when he could run yet again, it will not be so easy. By then, Putin will have been president for 14 years and the de facto head of the country for nearly 19. The opposition will be better organized, and given the rapid spread of the Internet and social networking in Russia, it will have gained strength and depth outside the capital. By that time, a whole post-Soviet generation will have come of age. New leaders will have emerged, possibly from regions outside Moscow, where political life is waking up. The opposition will find increased support from a population that will feel even more alienated by the perceived excesses of the favored elites than it does today. Whatever signs of wear the regime is showing today will be all the more severe by the end of the decade. 

Still, so long as the Kremlin is able to retain the loyalty of the business and political elites and continue running the welfare system on which the majority of the population depends, the regime is likely to remain stable. But sometime in the coming decade -- just when is impossible to predict, because it hinges on so many variables -- the state could well see oil revenues decline, even as its reliance on them grows. Even if world oil prices remain at their current highs, Russia's budget and trade balance surpluses will shrink, and the tide of money that has enabled the Kremlin to meet everyone's growing expectations for the past decade will vanish. Then and only then will the preconditions for the end of the Putin era be present.

At that point, Russia will not necessarily plunge into crisis overnight. Thanks to a decade of prudent fiscal and monetary management -- largely the work of Kudrin -- the government will likely have plenty of room to borrow; Russia's external debt is currently at an ultralow 15 percent of GDP. The ruble could be allowed to devalue, which would curtail imports and make exports more competitive. Russia could spend from its foreign currency reserves, which rank today as the third largest in the world. Yet these are only temporary fixes. Major spending programs will have to be cut back, including socially sensitive ones, such as pensions and subsidies. The state's rainy-day funds will be depleted. Inflation will eat away at the population's savings. The promise of growing prosperity, which has sustained the popularity and legitimacy of the present regime for so long, will erode. 

In the midst of all this, the state will finally be driven to confront head-on the difficult choice it has long avoided: whether to lessen the tax burden it imposes on the oil industry so as to enable the industry to invest in the next generation of fields and technologies. What the state was unwilling to do more than marginally in the past it will be forced to do on a much larger scale in the future, when it will no longer enjoy comfortable surpluses. In this and other ways, the politics of the expanding pie will give way to the much more painful politics of the shrinking one. 

One can imagine two ways Russia could respond to this crisis. The first response would be counterproductive. Until now, oil profits have been divided among three main groups: shareholders, consumers, and the state. As the flow of profits tapers off, the temptation will grow for state players to squeeze out the remaining private owners, and the result would be a campaign of nationalizations. Were that to occur, the interest groups within the present power structure -- the rival security services, the various generations of oligarchs, and so on -- would fight with one another over the spoils, and a weakened Kremlin would have a hard time keeping order. Despite lower oil revenues, policymakers would remain reluctant to cut welfare payments to the population, causing budget deficits to grow. With taxes still prohibitively high, the oil companies, even though they will be increasingly state-owned, would respond by cutting back investment, leading to lower production. The result would be a downward spiral, as revenues shrank and the state sank deeper into debt. 

But Russia's leaders could pursue a second, more constructive response. The state would have to reduce its dependence on oil revenues. This would mean adopting the main recommendations of Kudrin's program: reforming the pension and welfare systems, cutting back subsidies to regional governments and dying industries, trimming military expenditures, and generally restoring budgetary discipline and improving the investment climate. Meanwhile, the state would have to refrain from wasteful ad hoc tax breaks and subsidies for the state's pet causes and replace them with a modern and predictable system of profit-based taxation. It would also have to improve the regulatory and legal systems and stimulate changes in the structure of the oil industry itself, so as to encourage the innovation and entrepreneurship that will bring about its renaissance. This combination of budgetary and industrial reform is crucial; Russia will not be able to manage the coming crisis unless it fixes both its oil dependence and its struggling oil industry.

Some of the country's energy insiders see another way out, however. Lately, news of the accelerating revolution in the production of tight oil in the United States has taken Russia's oil sector by storm. The surprise turnaround of oil production in the United States has suddenly raised hopes that the Russian oil industry could achieve, by essentially the same means and in equally short order, a revival of its western Siberian fields and a new lease on life.

This is an alluring vision, but it depends on one big assumption: that the competition, innovation, and trial and error that have driven the tight-oil revolution in the United States can occur in Russia. But these are the very elements that are mostly missing in the Russian oil industry today, and unless Russia undertakes meaningful reforms, the potential of tight oil there will be only partly and slowly realized.

Will Moscow choose reform? Over the past two decades, the country has revolutionized its economy, rewritten its laws, and reentered the world. In the process, talented and determined people have laid valuable foundations for a modern state. At the same time, the Soviet past continues to hold both people and institutions in its grip. The attempt by Putin to create what he calls a "vertical of power" -- his system of centralized control -- has impeded progress and bred corruption. That formula will lead to a dead end. And so Russia now stands at a crossroads. Whichever path it chooses, oil will be a central part of the choice -- whether as a prize in a new division of spoils or as a catalyst for reform.

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