The Globalist

Putin, Yukos and Russia

Reproduced by permission of The Globalist.

Today's Russia is marked by a real paradox: On the one hand, Russian energy companies have restructured themselves, improving their efficiency and performance sufficiently to ride out oil bust cycles.

Addicted to oil

On the other hand, the Russian state has "restructured" in the opposite direction—it has become even more dependent on the oil price than before.

Looking carefully at Russia's economic growth since 1997, there is a clear correlation between growth and the rise in world oil prices.

This is particularly tricky, as world oil prices are currently far above what has been considered "normal"—and oil is known as a commodity that goes through well-documented boom and bust cycles. The median world oil price for decades—in fact as far back as 1869 in the United States—has tended to be around $18 a barrel (adjusted for inflation).

Since 1999, however, Russia has become addicted to a price regime well above this. It could expect little growth at the median price—and perhaps no growth or even a collapse in growth rates at prices well below the median.

A growing dependence on the energy sector

In 1998, when world oil prices dipped to around $10 a barrel, this drop coincided with the worst of Russia's economic crises and the collapse of the ruble.

High oil prices and Russia's oil production rebound after 1999 were good news for the Russian federal budget.

Importance of natural resources

Natural resources constitute around 80% of Russian exports and oil and gas account for 55% of all exports—making Russia's budget particularly dependent on the energy sector.

In fact, 37% of Russia's budget revenues are provided by taxes on oil and gas.

Recent research by the World Bank and the IMF has shown that each dollar increase in the price of a barrel of oil (Ural crude) raises Russia's federal budget revenues by as much as 0.35% of GDP.

And indeed, the IMF's Resident Representative in Moscow, Goohoon Kwon, has argued that the oil sector accounted for as much as 80% of total revenue gains at the general government level in the period from 1999 to 2001. At the same time, changes in the world oil price accounted for 60-75% of oil revenue gains between 1998 and 2001.

Oil and reform

Just how important the oil price is for Russia could also be seen during a brief period from October 2001 to March 2002, early in President Putin's first term as President. When oil prices dipped to around $15 a barrel, reforms faltered in a number of regions.

Economic and political tensions mounted in the Urals and Siberia, prompting Putin to make an emergency visit to Krasnoyarsk to meet with local leaders.

Stimulating growth

That mini-crisis had a ripple effect. Russia's industrial companies that had been profitable only the year before posted losses in 2002—largely as a consequence of canceled orders from the oil and gas sectors.

After this mini-bust, we are back to boom times. In March 2004, Putin's Minister for Trade and Economic Development, German Gref, went so far as to warn the president that 75% of Russia's GDP growth was in his estimation due to the high level of world oil prices. He noted that prices would inevitably go down—bringing GDP growth down as well.

Gref cautioned that Russia's time to take action to stimulate other sectors of the economy might be very short. Putin, however, disagreed with Gref's pessimism.

He responded that oil prices were not likely to go down in the foreseeable future. Putin stressed that tax reform—rather than major sectoral restructurings—would suffice to stimulate the development of industry and the growth of Russia's consumer market.

Reclaiming government revenues

In many respects, the mere fact that GDP growth and budget revenues are now tied to high world energy prices is a mark of considerable success for the Russian government.

Vladimir Putin's greatest accomplishment since 2000 may be that he has ensured that as much of the windfall revenues from high oil prices as possible has gone into government coffers—rather than into the hands of private oligarchs.

Superprofits and loopholes

Prior to 2000, this was not the case. Oligarchs—like Mikhail Khodorkovsky of Yukos and Roman Abramovich of Sibneft—were able to retain the superprofits from the oil price windfall for themselves.

They accumulated staggering personal fortunes and boosted the value of their companies. To maximize profits, they exploited tax avoidance loopholes, engaged in transfer pricing—including creating a series of on and off-shore trading companies to purchase oil at low cost from production sites and then sell it back again through intermediaries—and other methods.

Analysts calculate that Yukos and Khodorkovsky alone may have cost the Russian treasury billions in potential revenues.

Capturing the oil windfall

Putin has now reversed this trend to capture the oil windfall for the Russian state's disposal and disbursement.

To that end, he successively imposed a tight fiscal policy, pushed Russia's energy oligarchs to place equipment orders with important domestic industries and to support key—but cash-starved—areas of Russian science. And he ultimately raided oligarch holdings directly, as in the action against Khodorkovsky and Yukos.

Domestic clean-up and reform

The Russian government has now claimed $3.4 billion in back taxes from Yukos for both the years 2000 and 2001, with additional substantial claims for 2002 and 2003.

It now plans to auction off Yukos' main subsidiary Yuganskneftegaz to meet the company's debts.

The high oil prices and budget surplus have alleviated the pressure on the Russian government to restructure the economy and to tackle the hard reforms remaining from the agenda outlined by Putin's economics team in 2000.

These include natural monopoly reform (electricity, gas, pipelines and railways in particular), housing and communal services, education and health—as well as the financial sector, civil service and public administration and corporate and social taxes.

A helpful budget surplus

Many of these reforms have been long in planning, with elaborate concepts drawn up—but little sign of implementation.

Some long-promised reforms, like a far-reaching military reform, seem to have been virtually abandoned.

Softening inevitable blows

With a large budget surplus in hand, the government can still keep the failing areas of the economy and Russian state institutions functioning.

But Putin's economic team, led by German Gref and Finance Minister Alexei Kudrin, also fully recognizes the imperative to try to advance some of the more costly and difficult issues while the cash is still available.

One of them is the social benefits reform that will take effect on January 1, 2005. The budget surplus can help to soften the inevitable blows, as well as to seed and grow new initiatives and benefits delivery mechanisms.

Risky business

But what is the real risk of a drop in world oil prices along with Russian oil growth rates and production? This is what happened in the late Soviet period, with serious consequences for the USSR's economy.

There are many discussions within Russia about declines in Russian production in the next few years. But for now, oil prices seem set to stay high and energy analysts remain generally bullish on Russian production growth.

President Putin is certainly gambling that the oil price windfall will continue and that the state will remain flush with petrodollars for some time ahead. However, if there is no forward planning and further movement on reform, Putin will be raiding the oil piggy bank now—and thus short-changing Russia's future.

Adapted from "Energy Empire: Oil, Gas and Russia's Revival," The Foreign Policy Centre (September 2004).