Opening Remarks

Why Is Vladimir Putin Acting So Crazy?


(Corrects spelling of Vladimir Putin's name in the headline.)

Behind this week's coverBehind this week's cover

For Russian leaders, sticking it to the Americans has long been a source of both personal satisfaction and political gain. By that standard, President Vladimir Putin is riding high. He’s enraged Washington officialdom by supporting Syrian President Bashar al-Assad—despite his apparent use of chemical weapons against civilians—and obstructing efforts to rein in Iran’s nuclear ambitions. Activists in the U.S. and Europe have called for a boycott of the 2014 Winter Olympics in Sochi over the country’s harsh new antigay law. The Kremlin’s decision to shelter National Security Agency contractor Edward Snowden, wanted on espionage charges in the U.S., prompted President Obama to nix a one-on-one meeting ahead of the Group of 20 summit in St. Petersburg, Russia, on Sept. 5 and 6.

Since reclaiming the presidency in May 2012, Putin has become the biggest impediment to the Obama administration’s foreign policy aims. That’s undoubtedly played well with Russians yearning for the days when the country was a superpower. Yet beneath Putin’s swagger lie weaknesses at the core of the economy that threaten Russia’s future—and with it, his power base. And for that, he can blame a familiar nemesis: the U.S.

His difficulty has nothing to do with intercontinental ballistic nuclear missiles—and everything to do with natural gas that’s cooled to -260F at normal pressure, condensed into liquid form, and transported on special tankers to markets around the world. America’s surprising return as an energy superpower is complicating life for the Russian petro state. The rise of a vibrant, global, and pipeline-free liquefied natural gas (LNG) market is a direct threat to Russia’s interests in Europe, where Gazprom (GAZP:RU), the state-owned energy giant, supplies about 25 percent of the gas. So is the shift in pricing power from suppliers to consumers as a result of the huge supply shock emanating from North America.

Russia is still the world’s biggest overall energy exporter: It’s the No. 1 oil producer and No. 2 in gas after the U.S. However, the country’s known oil reserves—primarily between the Ural Mountains and the Central Siberian Plateau—are enough to sustain current production levels for just 20 years, according to a study in December by the European Bank for Reconstruction and Development (EBRD), vs. 70 years for Saudi Arabia and 90 years for the United Arab Emirates. Untapped oil and gas reserves in eastern Siberia and the Arctic will take massive investments to explore.

Putin’s aware of the problem. “For many years we have had a situation when prices for our main export goods rose fast and almost without interruption, and this made it possible for Russian companies and for the government to cover high expenses,” he told global executives at the St. Petersburg International Economic Forum on June 21. “But this situation has changed now. There are no simple solutions and no magic wand we can wave to change things overnight.”

That may be true, but the country has little time to waste. Many Russians, and in particular members of the president’s inner circle, have benefited hugely from the country’s energy-export windfall. Now that foundation is slipping away. The question is whether Putin’s power will, too.

When he took over at the start of the last decade (he served as president from 2000 to 2008 and premier for four years after that), the global economy was in the early stages of a commodities supercycle. Accelerating global demand, led by a China growing at about 10 percent annually, coincided with rising prices for oil, gas, copper, coal, and other natural resources. Political instability in Venezuela, the start of the Second Gulf War, and Hurricane Katrina all constrained supply and refining capacity, sending energy markets into overdrive.

Through 2008, Putin oversaw an average of 7 percent growth in gross domestic product and a huge expansion in Russia’s middle class. At its 2007 annual meeting, Gazprom, the world’s largest gas producer, served red and black caviar. Management Committee Chairman Alexey Miller said the company, whose market value at the time was $360 billion, would someday be worth $1 trillion.

Russia’s phenomenal run of prosperity would have been an ideal time to diversify the economy beyond energy, a goal that harks back to the days of Soviet leader Leonid Brezhnev. Instead, energy’s share of the economy actually increased; as of late 2012, oil and gas accounted for about 70 percent of exports, compared with less than 50 percent in the mid-1990s, providing half of the government’s revenue and roughly 17 percent of GDP, according to the EBRD. Gazprom alone represents 14 percent of the Russian stock market’s total capitalization. “It has been an issue since the late 1970s and early 1980s, and it has gotten worse,” says Alexei Kokin, an energy analyst with UralSib Financial. “I don’t see that changing.”

Russia’s energy dependency problem became impossible to ignore in 2009 as the global recession crushed oil prices, which fell to $34 a barrel from a precrisis high of $147. Russia’s economy contracted almost 8 percent, the steepest drop among the G-20 industrialized nations that year. Since 2010, the economy hasn’t come close to hitting the 5 percent to 6 percent mark that Putin has said it needs to close the gap with leading developed nations. On Aug. 9 the government said the roughly $2 trillion economy unexpectedly slowed in the second quarter, growing a below-expected 1.2 percent from the previous year, the sixth consecutive quarterly deceleration. As for Gazprom, it’s worth all of $94 billion, down 74 percent in six years.

Photo illustration by Crash!; Putin: www.kremlin.ru

Putin, 60, has long viewed the nation’s natural resources as a foreign policy lever. He learned about the economics of scarcity growing up in the 1950s in a decrepit communal apartment complex in postwar Leningrad (now St. Petersburg). “There were hordes of rats in the front entryway,” Putin said in an autobiographical compilation of interviews, First Person, published in 2000. “My friends and I used to chase them around with sticks.” In a 2012 interview he said that his elder brother died from diphtheria during the Nazi siege of Leningrad; his father barely survived his combat tour with the Soviet army.

Many years later, as deputy mayor of St. Petersburg, Putin wrote an academic thesis advocating that Russia flex its energy muscles. Once in power, he did just that: In price disputes, Russia turned the taps off on its gas pipelines to Ukraine in 2006 and 2009 in the dead of winter, causing shortages elsewhere in Europe. Gazprom has been able to extract high prices, particularly in former Soviet states, by indexing its long-term contracts to the price of oil.

Putin renationalized the oil industry and dialed back the involvement of Western oil companies. Authorities arrested and later convicted Yukos Chief Executive Officer Mikhail Khodorkovsky in 2003 on tax charges just as the company entertained selling stakes to ExxonMobil (XOM) and Chevron (CVX). Approximately $27 billion in state tax claims bankrupted Yukos, whose assets were sold off to other companies. After pressure from Moscow, Shell (RDSA) gave up part of its stake in an LNG venture in Sakhalin to local interests. British Petroleum (BP) sold its stake in an Anglo-Russian joint energy venture called TNK-BP to Rosneft (ROSN:RU) after a dispute with investors in the country.

At the same time, Putin placed loyalists throughout most of the oil industry or secured the allegiance of executives. In December a report by Yevgeny Minchenko and Kirill Petrov for Moscow-based consulting firm Minchenko Consulting Communication Group portrayed Putin as an energy czar with direct control over “long-term gas contracts, management of the gas industry, and, basically, Gazprom, as well as the control over backbone Russian banks” such as VEB, VTB, and Sberbank.

Taxes on the energy industry are vital to the Kremlin patronage system. They give Putin the means to woo key constituencies such as the military, security, and political elites; to improve government pensions; and to spend in poorer regions in the Muslim North Caucasus and other rural areas. During his 2012 campaign, he promised to improve wages for doctors and teachers, increase retirement checks, and invest in Russia’s military arsenal. The former KGB career officer is unlikely to loosen his grip on the state-owned energy sector, because that would endanger his grip on power, says one economic adviser who declined to be identified for fear of offending the president.

Five years ago, peak oil theorists predicted that global production would soon hit its high-water mark and then decline inexorably, with the U.S. growing even more dependent on overseas energy imports. Those trends seemed to play into Putin’s hands. What he didn’t anticipate was that U.S. oil production—thanks to horizontal drilling and hydraulic fracturing technology, in which pressurized water and chemicals are blasted into rocks to release energy—would increase 46 percent. That equals the entire output of Nigeria, estimates Daniel Yergin, vice chairman of consulting firm IHS. “Think of it like a non-OPEC country appearing in North Dakota or southern Texas,” Yergin told executives at the St. Petersburg forum in June.

Between now and 2018, North America will provide 40 percent of new supplies through the development of light, tight oil and oil sands, while the contribution from the Organization of Petroleum Exporting Countries will slip to 30 percent, according to the International Energy Agency, which also sees the U.S. emerging as the biggest oil producer by 2020 and a net exporter of oil by about 2030. Meanwhile, the agency trimmed global fuel demand estimates for the next four years.

The U.S. is also on pace to add 2 trillion cubic feet per year of natural gas once three just-approved LNG projects start operating, an 8 percent increase in total U.S. capacity based on 2012 production levels. More LNG facilities are coming onstream in Australia, South Korea, Mozambique, and Tanzania. Yergin predicts natural gas, both conventional and liquefied, will be the No. 1 energy source by the end of 2030.

Russia’s worry is twofold: An expanding supply of affordable LNG, which is transported by ship, is forcing Gazprom to either cut prices or lose share. (Weird and surprising fact: As American utilities shift to gas, displaced U.S. coal is flooding into European markets. The U.S. may supplant Russia as the world’s No. 3 coal exporter by yearend, according to Goldman Sachs (GS).) Second, the Russian gas giant is under pressure to adopt spot-market pricing instead of tying its prices to oil. In June, Gazprom agreed to revise its gas contracts with German utility RWE after losing an arbitration case; it’s renegotiating supply contracts with other utilities, including Eni (ENI:IM) and EconGas. The European Union is also drafting an antitrust complaint against Gazprom for abusing its dominant position, say three people familiar with the probe who asked not to be named. The company declined to comment. Longer term, the Russians may even have to contend with shale energy assets being developed by Western oil majors in Poland, Ukraine, and Lithuania, all Gazprom profit sanctuaries.

With the LNG trade expected to almost double to 450 million tonnes a year, according to Bloomberg New Energy Finance, the Russian government is expected to take up legislation that would for the first time allow companies other than Gazprom, which has been slow to respond to big industry changes over the last decade, to export LNG. Energy Minister Alexander Novak said in June the country is also committed to building out its LNG capacity—Russia has just one plant up and running in Sakhalin—and more than doubling Russia’s share of the LNG trade from 4 percent to about 10 percent by 2020. With Gazprom’s traditional gas business facing pricing and demand pressure in Europe, Russian companies need to be bigger players in faster-growing Asian markets. “We are really behind the curve and need to accelerate,” says Ildar Davletshin, an oil and gas analyst with Renaissance Capital.

The challenge for Putin is to simultaneously revive the country’s colossal energy sector—and then place Russia on a track to break free of its hydrocarbon dependency. The country needs to make huge infrastructure investments in the east and to expand nonenergy sectors where Russia has real potential, such as information technology, airplanes, helicopters, engines, turbines, and industrial pumps and compressors.

The country’s recent entry into the World Trade Organization could be an opportunity to reduce or eliminate import tariffs and trim domestic subsidies. Putin’s near-total control of Russia’s political apparatus—he’s marginalized, intimidated, or silenced any potential opposition—gives him the space to push through painful reforms. It would require not only the kind of tough-mindedness the bare-chested outdoorsman and YouTube sensation is known for but also a fair amount of business savvy and strategic vision. Failing to reform risks condemning Russia to a future of middling growth, declining standards of living, and diminished stature abroad. If Putin truly wants to restore the country to economic greatness, Russia will need a 12-step program for its energy-addicted economy.

With Anna Shiryaevskaya and Jake Rudnitsky
Bremner_190
Bremner is an assistant managing editor for Bloomberg Businessweek. Follow him at @bxbremner.

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