Unrelenting Oil Addiction

18 may 2005

Alexander Arbatov

Vladimir Feygin

Victor Smirnov

Resume: 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.

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.

Last updated 18 may 2005, 16:39

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