March update

February 7th marked the opening of the Sochi Winter Olympic Games and for the next 2 weeks, the eyes of the world were on a place so absurdly ill-suited to winter sports, that the conclusion had to be “only in Russia”. Average February temperature in this seaside resort on the Black Sea is 12 deg C, whilst the mountain events were held in Krasnaya Polyana (Caucasus Mountains), where average winter temperatures are 5 deg C. This makes it about 1 degree warmer than York, so perhaps an Olympic bid for the Howardian Hills should be considered come 2022…

In Russia, all things come back to oil and the extravagance of the Sochi Games (at $50bn, expenditure exceeded the cost of all previous Winter Olympics put together) was only possible because of Russia’s huge mineral wealth. The country of course has always been an oil and gas powerhouse (1st, 2nd or 3rd biggest producer in the world depending on which statistics you believe) but it was the breaking up of the Soviet Union that transformed the industry. Suddenly free market export channels opened up and as commodity prices soared, the old-communist guard bathed in the wealth generated by enormous oil and gas exports (currently worth $1bn per day!). In political terms, Russia’s influence continues unabated and this again is a result of its oil and gas hegemony. Just look at the recent protests in Ukraine, where energy dependence on Russia is ultimately at the core of the every argument. And why would it not be? After all, the Ukraine is a country where average winter temperatures are minus 6 deg C and 70% of heat comes from Russia…

But scratch below the surface and the story of Russian oil and gas is not so rosy. Firstly oil reserves may be staggering in size, but production capacity lags way behind – not surprising in a country where historical corruption, soviet era-technology and state bullying of western companies has been the order of the day. We should not be surprised then, that oil production in 2010 (over 13m barrels per day) has dropped by an incredible 30% over the last 3 years, to the current level of 10m barrels per day. In this sense, the Russian oil industry is rather like a giant ATM cash machine, where thousands of pounds sit in the vault, but a £200 daily withdrawal limit means that emptying the vault is a slow process. Such inefficiency shows no sign of diminishing wherever you look in the sector; Russian refineries are so basic and under-invested that they continue to produce inordinate amounts of worthless fuel oil (flooding the market and helping no-one), whilst at the same time, the gas industry flares (ie, wastes) 40bn cubic meters of gas into the atmosphere each year.

Russian crude from the Urals will soon be a constituent grade of the Brent Crude price benchmark

Compounding Russia’s problems is the increasingly truculent behaviour of the EU – Russia’s biggest “customer”. First came anti-competition raids on Russian oil & gas offices throughout Europe and then we had the unprecedented climb-down from Gazprom (Russia’s state gas company) in accepting that European gas prices must be decoupled from (high) oil prices and an agreement that $5bn would be paid to European customers in price refunds – approximately doubling the refunds of the previous year ($2.7bn in 2012-13).

But if EU leaders are smelling blood, the should probably get their olfactory senses double-checked, for the Russian Bear has a horrible habit of proving rather resilient. The recent announcement that JP Morgan is to sell its oil business to Russian trading giant Mercuria, only goes to show that where western companies fear to tread, Russian businesses continue to step fearlessly. Furthermore, such is the decline in North Sea oil production that it now seems inevitable that Russian crude from the Urals will soon be a constituent grade of the Brent Crude price benchmark, adding further power to the Russian market. Most significant of all was the reaching of full capacity last year on the Eastern Siberia Pacific Ocean (ESPO) pipeline, whereby 100% of Russian oil can now be exported via Russia’s Eastern Seaboard (Kozmino, nr Vladivostok) to the USA, China, Japan, South Korea and all of South-East Asia. In fact with export options to the North (via Arctic Sea shipping channels), the East (through ESPO) and the South (the Black Sea), Russian producers now have the ability to bypass Europe and their meddling Brussels bureaucrats all-together. So imagine that folks. Not only are we to have a situation where Russian oil becomes (over time) the main player in the benchmark Brent crude price, but the logistical options available to Russia now mean that oil can flow east rather than west – glutting or starving markets – subject to price and political desire.

That Russia has deep internal economic and political problems cannot be in doubt. Political opposition to the ruling party is no more tolerated now than it was in the days of the Soviet Union. Power and favour is funneled down from the top and cronyism is endemic. The economy is so badly skewed to the oil and gas industry (75% of exports / 30% of GDP) that all other industries are in a perpetual state of decay, with no incentive to reform. But these are problems for the Russian people and are arguably of little interest to the outside world. What does matter to the rest of world and particularly Europe is our continued reliance on Russian energy and the prospect of this reliance becoming more costly over the coming years.

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