The Future of Russian Oil (part1)
The Future of Russian Oil (part1)
Russian power and sanctions
Anticipating Russian oil & gas production is vital to any proper geopolitical and economic forecast in the immediate future. So exceptionally, I will keep this report free to read for all, as I will likely have to constantly refer back to it in the next 24 months.
An Ugly Energy Divorce
The divorce between the EU and its main energy supplier, Russia, is almost done. Of course, the war in Ukraine is the catalyst, but it comes after a long period of increasing hostility.
On one side the EU/NATO/USA have had hopes for regime change in Russia and have actively tried to do that in the former Russian empire satellites of Ukraine and Belarus. Ukraine in 2004 (Orange revolution) and then again in 2013-2014 (Maidan). Belarus most recently in 2020-2021.
On the other side, Russia has been unwilling to let go of its former imperial/soviet colonies. It was also unwilling to change an identity based on the Orthodox religion, something wholly incompatible with liberal Western values.
So that the two were on a collision course is no surprise. They were nevertheless highly co-dependent on each other economically.
The blowing up of Nordstream 1 & 2 is just the last straw.
I have amply documented the damage the shortage of gas, coal, oil, and power from Russia will do to the EU economies. But what about the effects on Russia?
Limited Economic Effects
First I will precise that I am ignoring plenty of US-based think tank “analyses” as they have proven to be mostly wishful thinking. We were predicted an immediate and dramatic collapse of the ruble and the Russian economy. Almost 8 months later, we are still waiting… Considering the same has been forecasting the “imminent” collapse of Russia for 1-2 decades, we should not be too surprised.
Currency
Let’s start with the ruble. On one hand, it is clear that its current strength is the result of tight currency and capital control.
Still, I fail to see why it should collapse. Russia cannot import much but exports plenty. The country has little debt, and massive reserves in the form of gold, even after losing $300B of dollars and euro “frozen” reserves.
Bypassing/Ignoring Sanctions
The other thing the sanctions against Russia have taught us is that most of the world does not care. If Brazil, India, China, Iran, and other large countries still trade happily with Russia, the EU sanctions are toothless. I would estimate that roughly, 1/2 to 2/3 of the world population has not ostracized Russia. So all the talk about an “isolated Russia” is really just the Western world talking to itself.
Managing to truly enforce sanctions will also prove tricky. If a car or car parts are bought by a Chinese, Indian or Turkish company, how can you prove it is not going to be shipped back to Russia for a profit?
Contrary to more wishful thinking, the essentials of an economy, tractors, construction engines, or electric and electronic components are not an exclusivity of the West.
I would give another 6 months before Asian businesses grab this 150million people market, them to buy from them.
Popular Oil & Gas at a Discount
I have previously highlighted Russia's cooperation with Iran and China.
But India as well is buying all the oil it can.
“Brazil Is Trying To Boost Diesel Imports From Russia”.
Even American ally Japan cannot do without Russia's energy.
Overall, energy at a discount is going to find buyers if it can leave the country. And because global prices have risen in response to the Ukraine war, this did not hurt Russia at all.
In fact, Russia’s energy revenues are at an all-time high. Gazprom's core earnings for H1 have doubled, even without counting the ruble strength. It is also distributing $21B in dividends and is boosting its investment plan with more capex spending. And it’s not just gas, even Rosneft’s oil brought 7% more this year, despite the discounts.
Popular perception
I think beyond abstract numbers, consumer sentiment and anecdotical evidence are useful. From what I gather from people living in Russia, the war had very little economic impact. It had a psychological impact, like the loss of all Western brands, to the despair of a friend’s wife.
But there is no significant shortage in shops, unemployment, or economic hardship. At most, some white-collar employees in finance are forced to relocate to Dubai. Overall, for the average Russian, it was indeed a “special military operation” and not a war, at least until the recent mobilization.
Long-term Damages
Did the sanction have zero effect? No.
What I expect will be the most impacted is niche supply. From niche applications in the industry to consumer electronics, etc… This will take a while to learn to either do without or find an alternative. It will also be rather costly.
So we can expect a serious decline in Russian productivity in the medium term. Some tractors and machinery will not be repaired or maintained, many factory lines will be idle for months, etc…
It might even impact the defense industry, although I imagine this will be corrected soon or given a high priority to get the missing components through unofficial back channels.
Another sector that will suffer immensely will be civil aviation. Over the long run, I expect the fleet of Airbus and Boeing planes to be either cannibalized to maintain the fleet, or sold/exchanged for other suppliers with friendly countries.
This could be locally made, like the MC-21 300.
Or it could be Chinese, as its Comac C919 just got certified. Although this plan used 60% of American source parts, so it probably will not be sold to Russia. Yet…
High tech is a trickier part. Software should be fine under the auspices of Yandex (The Russian Google+Uber) and a widespread habit of using hacked software in the non-Western world. Most chips can be provided by China. But the most advanced applications like AI, something Russia was lagging behind already, are probably off the table.
This will also impact complex oil projects.
Assessing the effects of sanctions on O&G accurately is rather complicated, so I will devote to it a full chapter later.
Long-term Positive Effects
Something almost never discussed is the positive effect of the sanctions. And I am not talking about the rise in oil & gas prices. After all, we have a template with the previous round of sanctions by the EU, a set of sanctions that ALREADY THEN consisted mostly of the EU shooting itself in the foot.
In 2014, in response to EU sanctions, Russia banned food imports from the EU. It had the consequence of boosting massively the local production of high-value products previously imported from the EU, like wine, cheese, etc…
I expect a similar but much wider effect with the current sanctions. It is dubious that Starbucks leaving Russia will leave it without coffee shops. If a very small country like Estonia can have a local Starbucks-like franchine profitable, I imagine Russia can as well.
This will be true as well for plenty of products that used to be imported, especially relatively low-tech items. Things like washing machines, appliances, clothing, etc…
Overall, the more isolated Russia will be, the more its local entrepreneurs are likely to profit from a closed market, which is the exact same thing that helped China develop its local giants.
So far substitution efforts have mostly failed simply because buying Western components and pretending to have done substitution was easier. Now that this is not an option, actual substitution will likely happen.
How big was Russia's economy anyway?
PPP
A regular comment made about the Russian economy is how it is smaller than Italy’s if measured in GDP. It is both factually true and utterly misleading. For the calculations, I rely on the analysis of Jacque Sapir, a French economist. You can find directly his comment in the thread below (in French):
When discussing not dollar-measured GPD, but actual power, the first thing is to compare economies in PPP (Parity of Purchasing Power). This is because if all costs are lower in a country, $1 buys a lot more in said country. For example, Russia can buy more tanks, pay more soldiers and build more infrastructure than the US for the same dollar-measured costs.
When using PPP, Russia has a GDP equivalent to Germany. By that same metric, China has a larger PPP-adjusted GDP than the USA.
Economic structure
Then comes an extra factor. We can divide economic activities into primary (food), secondary (industrial), and tertiary (services). Tertiary activities are generally responsible for a little bit of efficiency increase, like contract law, administration, etc…
But most tertiary jobs increase life quality. Things like restaurants, art, media, enteirtainment, etc…
When it comes to war and “hard” power, the main factor is industrial capacity. You might have fewer deli shope and fewer concerts, but this matters little on a battlefield. Russia has a similar industrial percentage to Germany (26%), and MUCH higher than Italy (19%) or France (14%), or the USA (15%). For reference, China is an astonishing (considering its size) 36%.
So when measuring industrial “hard” power, the Russia+China pair is probably much more powerful than the Germany+USA+France+Italy. And with a much more secure supply of energy (Russia), base metals (Russia), and key metals like rare earth (China).
GDP miscalculations
Lastly, a personal grudge I have against GDP measurement is its bias toward the commercialization/financialization of work. If I hire a company to plant fruit trees in my garden or repair my house, it creates GDP (and costs extra taxes). If instead, I do it myself it does not count.
For this reason, I am convinced countries with a strong tradition of DIY (food growing, maintenance, construction) like Poland or Russia have in fact a much higher “GDP” than officially measured. Undeclared “black market” work adds to this.
Because of its large industrial powerbase, PPP effect, and GDP chronic underestimation, I think Russia's economy is much more able to sustain a long attrition war than commonly judged.
So it is likely to have time to handle the 2 key needed reforms in its oil&gas productions and exports: localizing technologies and redirecting flows.
Oil & Gas Technology
With the overall picture clearer, let’s get to the meat of the question.
Will Russia be able to maintain its energy production, responsible for most of its exports and a large part of the financing of its war machine?
Due to the limit on Substack’s email size, and for better readability, you can find this analysis in Part 2, which I will publish tomorrow.