18.05.2005
Unrelenting Oil Addiction
№2 2005 April/June

The economy of the Soviet Union was thrown off balance by a
great increase in oil revenues in the final 15 years of its
existence. According to the All-Russia Research Institute for
Complex Fuel and Energy Problems under the U.S.S.R. State Planning
Committee (Gosplan), the share of fuel and energy exports in hard
currency revenues reached its highest level (55 percent) in 1984.
In 1985, oil exports accounted for 38.8 percent of hard currency
revenues; by 1987 this figure had decreased to 33.5 percent. In the
opinion of many analysts, a reliance on natural resource exports
was the primary cause for the sweeping crisis of the Soviet system.
Does today’s Russia, which has an economy that still relies on oil
and gas exports, face a similar threat?

In analyzing the significance of energy exports for the Soviet
economy and the related differences between the Soviet Union and
modern Russia, we will focus our attention solely on oil and leave
the question of gas on the sidelines. In Soviet times, the
significance of gas in foreign trade was incomparable with that of
oil: the bulk of gas exports to the dollar zone were supplied under
barter arrangement, such as the gas-for-pipelines agreements.

THE ROOTS OF RUSSIA’S OIL ADDICTION

The concept behind the strategy of Soviet exports, formulated in
the 1970s (which has very many supporters today), was that the
Soviet Union had immense oil resources, but technological progress
could result in discoveries of new, inexhaustible and cheap sources
of energy. This meant that the country’s riches might remain
untapped. The 1973-1974 world oil crisis gave a strong impetus to
the export of energy resources. Through the efforts of OPEC member
countries, world oil prices increased four-fold, and that was
followed by several other price rallies which brought substantial
revenues to oil exporters. From 1975 to 1985, the Soviet share of
oil intended for export to the dollar zone was steadily decreasing,
while revenues began to grow exponentially. It seemed there was a
real opportunity for technological advances in agriculture,
machine-building and the consumer industry. There were plans for
implementing the funds obtained from energy resource exports for
boosting the development of those sectors and providing them with
investment in order to meet the demand for their products. Crude
exports seemed the easiest way to achieve this goal: raw materials
are always in demand, and a country rich in natural resources does
not need to develop or introduce advanced technologies, raise the
culture of production, or look for progressive forms of management;
nor are such steps required when manufactured goods are imported in
exchange for mineral resources. (The effects of this approach were
realized much later. During an economic conference in 1987, a
Gosplan official noted: “Had there been no Samotlor oil, events
would have forced us to start economic restructuring 10 or 15 years
earlier.”) Between 1985 and 1988, however, world oil prices hit
rock bottom and aggravated the problem.

The government failed to realize that commodity exports led to a
greater dependence on foreign partners than imports. If the country
failed to export the planned volumes of resources, or had to sell
them at lower prices, it would lose the opportunity to acquire
foodstuffs, consumer goods and other vital commodities.
In the 1980s, the economy was tuned to the needs of the extracting
sector in general and the oil and gas sector in particular. In
1988, oil output was up 21 million tons from 1980; oil exports,
including oil products, increased 48 million tons, while hard
currency revenues (estimated in unchanged prices) were 1.5 times
lower.
Meanwhile, oil and gas production costs steadily increased, as
investment resources grew more and more expensive. Between 1970 and
1986, capital investment growth rates in the oil and gas sector
were on average substantially higher (3-5 times) than throughout
the national economy. In 1970-1973, before the energy crisis hit,
the oil industry’s share in overall capital investment ranged
between 8.8 and 9.3 percent, while in 1986 it reached an
astonishing 19.5 percent. The accelerated development of the oil
and gas sector brought about a disproportionate “swelling” of the
primary industries (metallurgy, heavy machine-building, chemicals).
Rather than being invested in the development of advanced,
science-intensive technologies, revenues from energy exports were
spent on imports of foodstuffs, consumer goods, and equipment for
traditional, rather than advanced, industries, particularly on huge
subsidies to agriculture. It was during that period that the Soviet
Union turned into a major grain importer: in 1970, the country’s
net grain exports totaled 3.5 million tons; in 1974, imports
equaled exports; and from 1975 grain imports amounted to tens of
millions of tons. The peak year was 1984 when 26.8 million tons was
purchased from the U.S. and Canada alone. Handling machinery, ships
and agricultural machinery became the biggest import items, while
the import of oil and gas equipment was unprecedented in terms of
growth, increasing 80 times between 1970 and 1983 in value terms;
taking account of the import deflator, their physical volume
increased 38 times over that period.

Naturally, machinery imports were not free from ideology, with
the bulk of the items being imported from East European countries.
This certainly did not promote the Soviet Union’s technological
level. However, oil and gas equipment had to be imported from
developed Western nations: Italy, West Germany, France and Japan
taken together accounted for 60-80 percent of all such imports. At
the same time, the Soviet Union purchased some oil and gas
equipment from Romania to support the Ceausescu regime. In
hindsight, it would have been reasonable to actively import
oil-refining equipment from the developed countries as well, but
the Communist economic system decided otherwise, yet again showing
its lack of wisdom and further deepening disproportions in oil
production and refining.

Oil extraction was becoming an increasingly costly venture,
while the bulk of capital investment was geared toward maintaining
the existing production levels. In 1966 through 1970, that goal
required less than 50 percent of all capital investment in the oil
industry. This figure was up to 64 percent in 1971 through 1975,
and 77 percent in 1976 through 1980. Relative capital investment
per ton of new reserves grew from 21.3 rubles in 1975 to 97.1
rubles in 1988, after which Gosplan’s expert commission anticipated
exponential growth. This increase in costs necessarily reduced
investment in housing construction, the non-production sectors and
environmental protection. Yet, through 1985, even such costly
measures failed to keep production levels even. It was only in 1986
that huge investment (31 percent more than in 1985) helped to
somewhat increase the output. Newly acquired technologies and
equipment often failed to yield the desired results, while some new
equipment worth billions of rubles was never employed. Imported
equipment required spare parts and maintenance, thereby
intensifying the Soviet Union’s dependence on equipment
suppliers.

The flaws of this economic model were predestined by two key
factors: 1) defective practices which heeded the slogan “Explore
more, extract more at any rate” and its negative consequences; and
2) dependence on world oil prices, which the Soviet Union could not
influence no matter how much crude it exported. The effects of this
dependence were soon revealed: hardly had Soviet oil exports gained
momentum when world oil prices began going down in 1984, hitting
rock bottom in 1986-1988. This certainly contributed to the
collapse of the consumer market, production and investment in
1989-1991, pushing the economy to ruin.

REAL AND IMAGINARY FEARS

What are the similarities and differences between the Soviet and
Russian commodity export models?
Actually, there is not much difference between the Soviet Union and
today’s Russia in the percentage of energy supplies in overall
exports, or in the dynamics of absolute volumes of energy supplies
to the world market. In the 1980s, the share of fuel and energy in
export revenues ranged from 40 to 54.4 percent (the 1984 high) in
the Soviet Union. In Russia in the 1990s, the share of minerals,
including non-fuel minerals, was roughly the same at between 42 and
48 percent (the year 1992 was an exception that requires a special
analysis), with the share going up to 53.8 percent in 2000
(including 52 percent for fuel and energy resources).

The share of fuel and energy exports in allocated fuel and
energy resources in the Soviet Union was 14.7 percent on average
during the high price period (1980-1985) and 16 percent when prices
plummeted (1986-1988). In Russia in 2000 the same index stood at
25.3 percent. One may find that the change is not in Russia’s
favor. Yet one must take account of the fact that the Russian
Soviet Federative Socialist Republic (RSFSR) used to produce around
80 percent of the Soviet Union’s fuel and energy resources, and
hundreds of millions of tons of oil and gas flowed from Russia to
other Soviet republics. The share of net exports in the RSFSR’s
allocated fuel and energy resources was 23.8 percent in 1980 and
28.3 percent in 1985, which means that Russia’s net fuel and energy
exports amounted to 474 million tons of fuel equivalent in 1985,
462 million tons in 1990, and 503 million tons in 2000.

Furthermore, unlike the Soviet Union which was driving itself
into a corner by fuel exports, today’s Russia, despite the numerous
problems associated with its transitional period, has radically
restructured its fuel balance in favor of supplying consumer
sectors, and it no longer sees the exhaustion of energy resources
as an end in itself.

While in Soviet times there were reasons to speak of mineral
extracting sectors – particularly oil and gas extraction – as a
burden on the economy, analysts now tend to speak of the oil and
gas sector as a locomotive promoting economic growth. This growth
has been sound enough, which is made evident by the steady increase
in the energy efficiency of the Russian economy. According to our
estimates, an average elasticity ratio of energy consumption in
relation to the Gross Domestic Product was about 25 percent in 1999
through 2002 (data for later periods is unavailable): while the GDP
was up 27 percent over this period, fuel and energy consumption was
up 7 percent, and in 2002 fuel and energy consumption did not grow
at all, while the GDP was up 4.5 percent. There are grounds to
suggest that the increase in energy efficiency will last for
another three to five years, and after that, hopefully, Russia will
have a stable rate of decrease typical of post-industrial nations
where the elasticity ratio has been around 0.5 for quite some
time.

Still, there remains the danger that Russia may turn into a “raw
materials appendage” of the world economy. Most analysts believe
that revenues from the export of raw materials, particularly oil
and gas, are critical for replenishing the country’s budget and
sparking its economic growth. According to rough estimates, the
contribution of petrodollars to economic growth has ranged from
one-fifth to one-third in recent years.

Debates have been particularly vigorous over ways to spend
petrodollars: whether they should be used to repay foreign debt,
invested in the real sector, or used in the non-productive sphere.
This is a sign of the so-called ‘Dutch disease,’ which first
manifested itself in the 1970s when the Netherlands used ample
revenues from gas production to maintain rapid growth in public
spending. Domestic demand of industries and other economic sectors
required no substantial increase in gas consumption, so the bulk of
gas was exported.

This policy resulted in a steep growth in imports of various
goods and in the rerouting of capital from sectors competing in the
world market into sectors protected from competition by natural
conditions. This led to a protracted slowdown in economic growth
and to an increase in structural unemployment, which was
characterized as a disease.

Similarities with the current situation in Russia are quite
obvious. In fact, Soviet analysts began realizing threats posed by
an excessive focus on mineral extraction back in 1972, when a book
by S. Yano, a Japanese scholar, was published in the Soviet Union.
In it, he claimed that a lack of mineral resources may be
beneficial for a country [Yano, S. The Japanese Economy on the
Verge of the 21st Century. Moscow, Progress, 1972, p. 26. – Russ.
Ed.].

This statement caused some confusion among the Soviet
economists, but the subsequent economic development of many
countries, above all Japan, confirmed that the Japanese researcher
was right.

 Yet history knows of many countries where natural rent
yielded their people substantial benefits: Britain, Norway,
Australia and, partly, the U.S. and Canada. These countries treated
their mineral resources in line with advice from Sir James Steuart,
an 18th-century economist and one of the last mercantilists: “The
earth’s spontaneous productions being in small quantity, and quite
independent of man, appear, as it were, to be furnished by nature,
in the same way as a small sum is given to a young man, in order to
put him in a way of industry, and of making his fortune.” [James
Steuart.  An Inquiry into the Principles of Political Economy.
1767.]
The U.S. economy developed in large part due to its rich natural
resources; iron ore played an important part in the emergence of
Sweden’s national wealth; coal and nonferrous metals provided a
foundation for Britain; Germany relied on coal and iron ore; and
Canada on a wide range of mineral and other natural resources. But
all those countries mostly relied not on their natural resources –
used as the economic foundation of the Soviet Union and now, for
example, in Kuwait – but on Benjamin Franklin’s spirit of
capitalism formula, “Remember that money is of the prolific,
generating nature. Money can beget money, and its offspring can
beget more, and so on.”

The director of the Expert Institute under the Russian Union of
Industrialists and Entrepreneurs, Yevgeny Yasin, has reasonably
noted: “The raw materials sector does not draw investment away from
other sectors. It just earns more because its products are in
demand in the world market.” In Yasin’s opinion, the extracting
sector only looks prosperous because other sectors are poor. This
comparison produces an impression that Russia is suffering from the
Dutch disease. But the decline of the manufacturing sectors was not
caused by rapid development of the extracting sector, which was the
case in the Netherlands. This happened for many other reasons
rooted in the country’s Communist past when huge economic sectors
developed in a closed system with no visible contact with
consumers; they proved unprepared for the realities of a market
economy.

Today, Russia’s manufacturing, as well as other economic
sectors, has learnt many lessons from its competition with imports.
In particular, high technologies are not limited to Russia’s
defense-related industries only (which was the case in Soviet
times); they also appear in the civilian sectors, such as the food
industry, construction, communications and healthcare. Even such an
underdeveloped sector as agriculture, which still remains
essentially Soviet, has been showing meaningful changes: Russia has
cut down bread grain use as fodder grains by about 15 million tons
a year and has become its exporter; productivity in livestock
breeding has been steadily increasing since 1996; and agriculture’s
load on the economy has been considerably eased.

True, Russia has certain similarities with countries that have
lived through the Dutch disease or those suffering from it today.
First, the bulk of wealth is controlled by a relatively small group
of people and there is a certain trend toward replacing domestic
production with imports. However, Russian oil and gas revenues have
a rather solid foundation compared with the Netherlands’ short-term
resources base. Russia can get steady revenues from oil production
and exports – if world prices are high enough to make extraction
cost-effective – and spend them for public needs for many years,
while retaining an external surplus. Economic restructuring and
privatization releases ample resources which can be used to meet
domestic demand, provided that there is such a demand.

Is it necessary to regulate production and exports? Regulation
of that kind is not a market instrument, but it could be used for
attaining two important goals:

– securing a stable revenue inflow, which is only possible if an
optimal relationship between prices and export volumes is
observed;
– regulating extraction by limiting output volumes, which may
prompt companies to cut down investment in extraction, increase
investment in refining, while starting investment in other economic
sectors (provided that there is a mature equity capital market and
financial system).

How dangerous is it to cut investment in oil production? The
specific feature of the oil and gas industry, as well as of the
whole extracting sector, is that it requires a constant inflow of
capital investment, even for simple reproduction. Drastic cuts,
followed by the discontinuation of state investment in the
extracting sector in the past decade, were not compensated by funds
from other sources. As a result, production volumes have abruptly
declined, which many saw as crisis in the sector. But in terms of
end results, there is no deep crisis in Russia’s extracting sector
as effective demand for raw materials and fuel, which has gone down
substantially, is being met and exports have been growing steadily.
Investment growth in any sector is not an end in itself; it is just
a means of maintaining and increasing profits. If there is no need
to increase investment to attain this goal, money can be rerouted
to other spheres.

CHANGES REQUIRED

Core assets in most sectors of the Russian economy are outdated
and require radical modernization. No new serious production
capacities emerged in the 1990s in sectors other than those
producing raw materials or guaranteeing quick returns (such as the
food industry). After the Soviet Union’s collapse, Russia’s newly
established financial institutions only seriously considered
projects that offered a payback period of one year or, in rare
cases, two years (this explains why they were so enthusiastic about
financing trade operations – many have benefited from it, as well
as from “interaction” with government finance). Now a payback
period they may consider has increased somewhat, yet it is still
insufficient: the implementation of effective industrial projects
takes, as a rule, more than five years, while certain strategic
projects that are vital for Russia may have a substantially longer
payback period.

The mismatch is very significant. It stems from a whole range of
factors that are still in place in the country, including
relatively high inflation rates, political risks, tax instability,
as well as the preference given by domestic capital to only highly
profitable projects, and the underdeveloped infrastructure for
attracting long-term investments. It is hard to predict at what
stage of Russia’s financial system development this backwardness
may be overcome. Regardless, the situation over the last 15 years
gives no grounds for great expectations and requires a change in
the modes of economic interaction with old-time partners. This
primarily concerns European countries, now united in the European
Union, which have been Russia’s major partners since Soviet
times.

During the Cold War and in the post-Cold War years, this
interaction was based on Europe’s interest in uninterrupted
supplies of Russian energy resources. This is a natural base for
economic relations because:

– Russia is rich in energy resources, while Europe is
experiencing increasing shortages;
– the EU and Russia are located close to each other, which makes
the costly transportation of energy resources, especially in the
natural gas case, more efficient.

It is also important that those relations were established in
the previous period, despite the problems that arose from the
protracted confrontation.
Obviously, there are many reasons in favor of retaining and
developing energy cooperation. Still, it has natural limits and
drawbacks.
First, the EU is particularly concerned about the reliability of
supplies and related diversification of supply sources.
Those factors should not be overestimated, though. There are no
formal limitations in the European Union on the share of energy
supplies from particular countries (including Russia). Furthermore,
Russian natural gas supplies, for example, prevail in the import
portfolios in a number of EU member countries. Besides, the
European Union’s worries could be alleviated through strengthening
ties with the suppliers, above all Russia. In its documents, the EU
has increasingly mentioned the need for taking joint efforts to
improve the security of supplies. However, it has not gone to any
practical mechanisms so far to achieve these goals.

Second, the potential of Russia’s fuel and energy sector is not
limitless. This particularly concerns the expansion of oil
supplies. Furthermore, regional aspects matter a lot – it would be
expedient to supply nearby countries with promising reserves from
East Siberia and Russia’s Far East. These plans have even given
rise to “jealousy” in Europe when high-ranking EU officials voiced
their displeasure about Russia’s intentions to export energy
resources eastward, and beyond to the U.S.
Finally, and most importantly, Russia certainly cannot be content
with the EU viewing it exclusively as an energy resource supplier,
albeit a strategically important one. Energy exports, despite the
“multiplicative effects” they suggest, certainly cannot guarantee
modern living standards in a country that possesses a population
level comparable to Russia’s. This certainly does not mean
rejecting the natural advantages of possessing abundant mineral
resources, but rather integrating them into the modern structure of
the economy. If Europe’s attitude to Russia remains unchanged, and
it continues to view Russia as merely a raw materials supplier,
this will injure Russia’s national pride and create obstacles for
tapping Russia’s other huge potentials, such as, in particular, its
high educational standards, professional skills, etc.
It is important to remember that Europe itself is searching for its
place in the post-industrial world. The EU’s policy for making the
Union one of the world’s fastest-developing regions has been facing
serious challenges, and it has failed to achieve many of its
objectives.

In this context, the EU leadership’s search for inexpensive
energy resources, launched in the second half of the 1990s, was
actually an attempt to improve Europe’s competitive positions on
the world market through little effort and, if possible, at the
expense of energy suppliers. Indeed, international practices show
that market liberalization sends prices down as supply grows and
suppliers get easier access to market infrastructure and consumers.
Domestic electricity and natural gas prices in EU member countries
were higher than those in the U.S. and Britain, where
liberalization had been accomplished in the 1980s and 1990s.
European energy markets remained divided into national segments
controlled by the state, national monopolies or companies that had
domineering market positions. Between 1998 and 2000, two EU
directives launched the liberalization process. This policy has
helped cut down electricity tariffs since key suppliers are based
in the EU. On the natural gas market, however, progress has been
very slow, and the reform has not been much of a success.

The EU is worried about falling increasingly behind the United
States, the leading economy in the world. The European economy is
essentially more traditional and post-industrial phase factors (the
development of financial markets and tools, IT, biotechnology,
pharmaceuticals and other technologically advanced and innovative
sectors), which boosted the unprecedented growth of the U.S.
economy in the 1990s, are represented in Europe on a much smaller
scale. In the epoch of rapid change, the European economy has shown
its institutional weaknesses, inflexibility and inability to adapt.
A recent debate in the European Union produced some interesting
results. Its participants were asked to define Europe’s future
place in the world by choosing between “Europe as an active leader”
and “Europe as a passive outsider.” The result was paradoxical: It
may happen that in the future Europe will be an “active
outsider.”

The EU could solve its economic problems by invigorating its
cooperation with Russia in deeper processing of raw materials. For
Russia, this would mean desirable changes in the bilateral
agenda.

In Soviet times, this problem was a most important sphere of
interaction between the Council of Mutual Economic Assistance
(CMEA) and the West. Although the Soviet Union was a powerful
industrial nation, much of its industrial projects and the
development of whole sectors relied on equipment supplies from the
West. Problems were partially resolved through internal cooperation
in the CMEA framework, which in modern conditions is virtually
tantamount to Russia’s interaction with a number of EU member
countries. The share of machinery and equipment in the Soviet
Union’s imports from developed capitalist nations grew from 29.8
percent in 1980 to 43.8 percent in 1990. Buying complete sets of
equipment for industrial plants, specifically in the petrochemical
industry, was a usual practice. Meanwhile, the Soviet Union was
frequently short of hard currency to pay for equipment supplies.
Thus, the export of energy resources, primarily oil, became the
main source of hard currency revenues in the 1980s.

Most of the facilities launched as a result of those supplies
have now been in operation for more than 15 years and possibly even
20 years. When it is considered that much of the equipment from the
West was not advanced at that time, and that many new high-tech
sectors have emerged in the world since then, it is no wonder that
Russia is now lagging behind.

European nations also face the problem of modernization that has
been aggravated by the fact that, given the conditions of global
competition, locating new production capacities in the EU member
countries is not always the most efficient solution. In the past
few years, many are turning to Asia, and particularly China, to
solve their problems. Many sectors, primarily those requiring
substantial labor inputs, have moved the bulk of their capacities
into that growing “global factory.” But where first process stages
of raw materials are concerned, China’s attractiveness becomes more
questionable. Placing these facilities closer to supply sources
seems more expedient. In this sense, Russia looks like an extremely
promising player.

The agenda of Russia-EU cooperation should include the creation
of a large-scale symbiotic relationship between the economies of
Russia and the EU, thus ensuring that:

– the EU would receive from Russia both primary energy resources
and raw materials and products of their processing, thus relatively
reducing its energy demand and benefiting from participation in
highly efficient projects on Russia’s territory;
– to this end, the EU (particularly its business structures) would
take an active part in formulating and implementing such projects,
using its know-how and expertise, supplying high-quality equipment,
and promoting the development of financial mechanisms and direct
investment;
– Russia would create most favorable conditions to reach these
goals at all levels;
– the EU and Russia would give businesses clear signals that they
regard this kind of cooperation as their priority.

Naturally, raw materials processing can hardly be described as
environmentally safe. But economic restructuring in this sphere,
together with related economic benefits, would offer Russia other
advantages.

First, the level of pollution emissions in Russia is now
substantially lower than it was in 1990, giving it opportunities
stipulated by the Kyoto Protocol to invest in more advanced and
ecology-friendly production facilities.

Second, replacing outdated equipment which fails to meet modern
requirements could offset the negative environmental impact that is
related to the increasing use of raw materials processing.

Finally, the expansion of raw materials processing and an
increase in its rates would provide the economy with substantial
amounts of structural materials, metals, and substances used in the
manufacture of high-tech products. A growth in supply will most
likely promote demand; this in turn would boost those sectors
producing high added value products and intended for end
consumption. This will encourage competition for investments and
promote the technological development of the Russian economy.

Projects of this kind could be included in partnership programs
between the state and private enterprise and implemented on a
commercial expediency basis. Lately, the need for such programs has
been voiced in many circles; it is time to give these proposals
consideration.