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Putin Has Squandered Soviet Energy Legacy, Part 2

This is part two of a condensed and lightly edited transcript of an interview with Soviet and Russian energy specialist Thane Gustafson. In part one, he described the evolution of the Russian energy industry under President Vladimir Putin until the eve of the war in Ukraine. Part two picks up with him describing the impact of the war on Russia’s oil industry.

Denning:  You say Putin’s war has set in motion a process that will drag down the long-term competitiveness of Russia’s oil industry. How so?

Gustafson:  The big question is the long range effects, beginning about five years out. How the withdrawal of the services companies; the interruption of supply lines, of equipment; the exit of the Western majors; and the financial difficulties that the Russian government is going to have — all of those are going to act as drags on the ability of the Russian oil industry to continue modernizing. And yet it must continue modernizing because, like all natural resources, the initial resource gradually gets used up and you have to move out to increasingly marginal development opportunities, while constantly using new technology

The traditional core of the oil industry in West Siberia is clearly in decline. The Russians even now are fighting a rearguard action there. Hence the importance of those three techniques I mentioned earlier. But the big thing to focus on as an example of the tests that lie ahead is [Rosneft CEO] Igor Sechin’s favorite project, Vostok Oil.

LD: Why is Vostok so important and what makes it so challenging?

TG: Vostok is a mixture of things, but the main thing to know is that it lies outside the administrative boundaries of West Siberia in a place called the Taymyr Peninsula, but it is the northeastern edge of the geology of West Siberia.  Some of that, such as the Vankor field, is already producing. The big question concerns the fields now being explored, of which one of the best known is the Payakh field. Sechin has said to Putin: If you grant me the full support of the state, I will produce for you a hundred million tons of oil a year from Vostok Oil — two million barrels a day — by 2030, and I’ll keep going from there.

But here’s the thing: Vostok Oil is a pile of challenges. It’s virgin territory. You’ve got to build a new port system to be able to export the oil to Asia by tanker. So that’s tied to the rate of global warming. You have to build an entire infrastructure with buildings that have to be reinforced against permafrost melting. Novatek sank 60,000 piles into the ground to support the buildings at Yamal LNG [another Arctic project].

Then you need a whole network of new pipelines to bring the oil to that new port on the Arctic coast. But those pipelines and the port don’t yet exist. You’ve got to bring in maybe a hundred thousand workers. Now, the good news is that’s a hundred thousand jobs, but the bad news is that’s a hundred thousand people you’ve got to induce to go up there either full-time or part-time. And you realize that all of this adds up to infrastructure — and investment. It’s not so much the impact of the sanctions per se, directly.

The one place where the sanctions probably have a direct impact is in the supply of oil tankers and such. Sechin’s got a plan for that, too. He’s directly responsible for the development of a new shipyard called Zvezda, or “star.” He had, until the invasion, support from South Korean shipbuilders. They are now pulling back and the project is behind schedule. No Zvezda, no tankers; no tankers, no Vostok Oil.

LD: Back to gas. Another theme of The Bridge was that Europe expected the far-reaching changes it enacted in its own gas industry would give it an advantage in dealing with Gazprom. Now, those expectations are pretty much dashed. Can you talk about what things look like beyond this war?

TG: In retrospect, you can fault the European Union and the Germans for three major things. One, I think the EU had too much faith in the power of its new regulatory and market mechanisms. Take, for example, the doctrine of the Single European Market, which took the concrete form of three far-reaching gas and power directives. I think the EU believed that if you enforced those directives — with the Russians kicking and screaming the whole way, by the way — and applied the whole panoply of regulatory, neoliberal weapons, that Europe would have the advantage in any bargaining relationship. That the burden of risk would shift onto the supplier and that Europe would be able to control the show.

You have to give the Russians credit for having been very candid on this. Gazprom explicitly warned the EU, saying: Are you sure that you want me to be on my computer screen every day, setting the level of Russian gas exports to Europe on the basis of the day-ahead spot price? Be careful what you wish for.

Number two is the Germans had too much confidence in the Energiewende [Germany’s energy transition program] and the rate at which they would be able to shut down nuclear, and ultimately coal, and increase renewables. And then, in the fullness of time, cut their dependence on gas. Exhibit A is the way they waved away all talk of an LNG terminal in Germany up until just recently. But their strategy depended crucially on the continued availability of Russian gas.

Third is the over-optimism of the European business community, particularly in Germany. Ever since Soviet times, there had been a strong faith, shared with much of the German political establishment, in the power of “Wandel durch Handel,” or “Change through Trade.” That good business relations would favor the transition of Russia to a “normal” political system. The depth of that relationship [with Russia] was extraordinary. There’s a whole generation of people whose entire careers in Germany were built — think of Wingas, for example — on the reality of partnership; close, intimate, friendly partnership. They couldn’t believe that the Russians would just commit gas suicide.LD: In a way, given the gas relationship began under the Soviet Union, you could almost understand that the Germans might look at that experience and say: look, we were able to do business even with those guys. So surely these are the same people, just a different government. What did they get wrong about that?

TG: What they got wrong is that they held onto those three items of faith too long. Basically, all three come out of the neoliberal view of the world, despite the growing signs by about the mid-2000s that Putin himself and the Russian political center of gravity were shifting away from collaboration, cooperation and friendship, toward a stance of hostility and resistance. The key date is 2007 when Putin made his famous speech at the Munich security conference and his bitter denunciation of the US and secondarily of Europe. That should have been a wake-up call.

And yet, think of the major Western projects in the automotive sector, Renault, think of the partnership between Total and Novatek in LNG, think about Siemens modernizing the Russian locomotive system. All of those were at the express invitation and encouragement of Putin himself. He made himself the ambassador for these projects, so you were getting dual messages out of Russia.

LD: There was a great line in your last book, “ Klimat: Russia in the Age of Climate Change,” where you said Russia is already one of the chief causes of climate change but, as time goes on, it will also be one of its chief victims. You published that a few months before Russia invaded Ukraine. What did you mean by that, and how does the invasion, this new landscape, interact with or change that thesis?

TG: That book is very much a thought experiment about a set of hypothetical futures. The central question is: what if peak oil demand turns out to be real and it is followed by a decline? What would be the impact on Russian revenues and, by extension, the budget of the Russian government and the whole political system that is underpinned by those revenues?

So I went on a systematic tour of all the possible alternative money earners. There’s a chapter in there on nuclear power, on agriculture, coal, renewables. And then I added it all up and you come to totals that don’t even compare with the last peacetime — and pre-pandemic — revenues from oil and gas. Oil accounting for four fifths of the hydrocarbon revenues, by the way, and gas, only one fifth at the time.

As to benefits of climate change, the one Putin keeps talking about is opening up the Arctic Ocean, the Northern maritime passage. That is the basis of Russia’s policy on LNG, and also Sechin’s Vostok Oil. Putin also talks about possible benefits of climate change for agriculture. The jury’s very much out on that. The biggest question concerns Russia’s grain exports. But even at their best, Russian agricultural exports are unlikely to add up to more than $40 billion a year — that’s Putin’s target — and that’s far less than the roughly $425 billion that oil and gas generated in 2019.

Based on the various modeling exercises of the oil companies and others, the consensus on the eve of the pandemic was that Russia’s hydrocarbon revenues would remain strong during the 2020s. But that the impact of a possible peak in oil demand, and a possible leveling-off of gas demand by 2040, would start to kick in by the beginning of the 2030s. So you have two periods: one of reprieve, so to speak, and the second of increasing stress on the system.

How does the invasion affect that? The first consequence is the self-destruction of Russia’s gas market in Europe. The second is the likely decline in Russia’s oil exports to Europe, as the embargo kicks in, forcing Russia to accept discounts and higher costs to move its oil to other markets. Both of these will affect Russia’s revenues in this decade.

There has been a good deal of talk that the sanctions aren’t working because the price spike has more than offset any decline in export volumes. It is true that the immediate result of the spike has been an increase in Russia’s dollar revenues, but that is turning out to be a mixed blessing for Moscow, causing the ruble to appreciate. That’s awkward because if you sell your oil in dollars but your ruble is overvalued, you get fewer rubles. And the revenues of the Russian budget are in rubles. So you get indirect financial hits that arise in the wake of the invasion and the sanctions.

I think the net effect of all that will be seen in retrospect as having blown a good deal of that favorable decade of the 2020s. And Putin will have only himself to blame.

Then the final question, and this brings us back into the orbit of Klimat: For the time being — say, the next two to five years — energy security will be the main priority. But at what point does climate change come back to the fore? I think Germany is ground-zero on that question.

TG: Take LNG. For years the Germans rejected LNG, saying we won’t need it because Europe’s gas system is nicely interconnected and, besides, we’re not going to need gas for very much longer. Now they’re saying, wow, we’ve got to build some LNG terminals here and some new pipeline connections. And we’ve got to rent some floating LNG re-gas vessels. All that investment is, in effect, locking in a long-term dependence on LNG, which is driving the German greens crazy.

So there, you have a good example of the competition between the green agenda — God save us from global warming — and then the energy security agenda, which is God save us from the Russians. Which of those two agendas is going to win out? And when?

We know the answer for this winter: It’s all energy security all the time.

But meanwhile, very quietly in the background, Brussels keeps on pushing its climate change agenda with things like reform of the emissions trading system. That has inched its way through the endless European labyrinth. It’s gone through the parliament. Now it’s going to be submitted to the “trilogue.”(1) And then that will have to go back to Brussels for coordination. Then it’ll be resubmitted. But the point is that the climate-change agenda keeps inching along. It is not dead. Will it ultimately be strengthened or weakened by the measures taken to improve energy security? That’s not yet clear.

LD: Coming back to where we started, Gorbachev is regarded by many as the perhaps unwitting undertaker of the Soviet Union. Will Putin be remembered as the unwitting undertaker of the Russian energy sector, and the political system that it supports?

TG: Certainly on the gas side. Revenues from LNG are not going to come close to replacing what Gazprom will be losing. It’s hard to construct a scenario under which Gazprom’s business is reborn in Europe.

LD: Can China compensate?

TG: Partly that’s an infrastructure question. The pipeline capacity doesn’t exist yet. Nor, it would seem, does the political will, for all the professions of no-limits friendship between [Chinese president] Xi Jinping and Putin.

The test question is whether the [proposed gas pipeline] Power of Siberia 2 goes forward. The current Russian plan is to run it from West Siberia, through Mongolia and into China. And every time you turn around, there’s a press release from Gazprom saying hurray, hurray, we’re on our way. And the Mongolian government has adopted policy arrangements that point in the same direction.

Not one word from the Chinese. Until you see a fast-track Power of Siberia 2 project actually putting pipe on the ground, I think there’s your answer to the prospects for a serious pivot to the east of Russian gas exports. At best, it’s 10 years away, and probably more. As Putin ruefully admits, the Chinese are tough negotiators.

TG: The core answer is the same for both gas and oil: that Putin had a tremendous opportunity to use the reconsolidated and modernized production of energy, and to put those revenues to work in reshaping the Russian economy in a modern direction and reversing the misshapen Soviet economy, which is still the essential structure of the Russian economy today.

Exhibit A on this point: Look at a map of the distribution of Russian cities compared to, say, Canada. You’ve got over a hundred cities with populations of one million, and they’re all separate dots. They’re like the pimples in a bad case of chicken pox. Those are what the Russians call millionniki; they are there mainly because of the military-industrial facilities they supported in Soviet times. They have no viable economic function in a market economy. They are capitals of cold. Places in the Urals like Chelyabinsk or Perm, or even worse, in Siberia, like Omsk or Novosibirsk.

This is ironic, of course. The world is worried about global warming, and rightly, but Russia still suffers from the curse of cold, and from the pattern of urban settlement inherited from Soviet times. Nothing has been done to change that structure. Instead, Putin mostly encouraged investment on the far Arctic Ocean coastal frontier. This will worsen that imbalance.

TG: Because all of that new investment is concentrated up there in the capitals of cold. If those oil and gas assets end up as stranded assets, that’s more Soviet-style wasted investment. So I think the bottom line is that Putin has blown, economically speaking, the tremendous opportunity afforded by the remaining energy endowment, to say nothing of the geopolitical legacy.

(1) An ad-hoc group made up of representatives of the national governments, the Parliament, and the Commission.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Liam Denning is a Bloomberg Opinion columnist covering energy and commodities. A former investment banker, he was editor of the Wall Street Journal’s Heard on the Street column and a reporter for the Financial Times’s Lex column.

More stories like this are available on bloomberg.com/opinion

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