Russia's ability to remain a global supplier of energy in the future, as well as the strength that the Russian energy sector gives the Kremlin, are becoming increasingly doubtful today. After ten years of active energy exports and large revenues, Russia has reduced the prices of gas supplied to Europe, and forecasts for the revenues of its energy giant Gazprom have declined since the beginning of this year.
Russia has the world's largest proven reserves of natural gas and periodically replaces Saudi Arabia at the head of the list of leading oil-producing countries. This country provides a third of the European demand for oil and gas, and begins to increase exports to East Asian markets that are experiencing energy shortages. The energy sector for Moscow is more than a simple commercial asset. For more than a century, he has been one of the foundations for the stabilization of Russia and the source of its increasing power. The Kremlin has called energy security the main component of Russia's national security, especially since recent changes in global and domestic trends cast a shadow of doubt on the strength and durability of the energy sector.
The Russian energy sector has strengthened, then weakened throughout stories country. The management of this cycle was put at the forefront of Russian domestic and foreign policy in tsarist times. And now this historical burden fell on the shoulders of the regime of Vladimir Putin.
Russian imperatives and energy factor
Russia is basically a vulnerable country because it is surrounded by other great powers, and its borders are not very convenient for defense. In addition, Russia has a huge, mostly inhospitable and dismal territory inhabited by various ethnic groups that have long been at odds with the central government of Moscow. In this regard, it faces the urgent need to preserve its integrity as a state and strengthen its position as a regional power. First, Russia must consolidate its society under a single authority. Secondly, it needs to extend its power to the nearest geographical environment in order to create buffer zones as a defense against other powers. (The formation of the Soviet Union is a clear example of such an imperative in action.) Finally, it must skillfully use its natural resources to ensure balance with the great powers beyond its periphery.
To achieve these goals, Russia throughout its history has used a variety of means, from the export of agricultural products to outright military conquests and intimidation. Since the end of the 1800-s, Russia has included national energy resources in the inventory of important means to achieve its main strategic goals. By the mid-twentieth century, the Russian energy sector had become one of the main pillars of its economic and political power.
Revenues from oil and gas exports show how the energy sector allowed the Kremlin to rally the country. Revenues from energy exports began to flow into the treasury of the Russian Empire at the end of the 1800s. Export revenues from oil sales at that time accounted for 7% of total export earnings. At the end of the 1920s, that is, at the early stage of the existence of the Soviet Union, this figure rose to 14%. And by the 1950 years, the state budget was already half replenished by energy revenues. Such an inflow of capital was and remains an important tool to help Russia build up the military and industrial base necessary to maintain its status, if not global, then at least a regional power. However, since the Russian state has become dependent on energy resources, these revenues make it extremely vulnerable.
In addition to ensuring export earnings, the energy sector contributes to the creation and preservation of an internally stable and industrialized state. Domestic energy consumption in Russia is enormous, which is explained by the very cold weather that lasts most of the year. But despite the inefficiency of the energy sector, large energy losses and high costs of its production, the country's internal reserves allow Moscow to maintain low energy prices for its citizens and those enterprises where they operate.
The energy sector also enhances Russia's ability to extend its influence to its closest neighbors. Moscow uses its energy resources in different ways as a lever of pressure on buffer states. Here and control over the production of energy in the regions (which previously existed in the oil fields in Azerbaijan and Kazakhstan), and the supply of energy at a discount to neighboring countries, and control over their energy transport infrastructure. Russia uses a similar strategy when building relations outside the post-Soviet space. For example, this country is one of the two main suppliers of energy resources to Europe, and, moreover, it is the only European supplier possessing large reserves of oil and gas and has long been selling them at low prices. Russia's physical bond with Europe and its ability to lower prices, crowding out any competitors, became the basis of its relations with many European countries.
Evolution of the Russian energy strategy
The usefulness of energy resources as a means of achieving the three main goals of Russia has changed over time, because Russia had to adjust its strategy based on shifts in the domestic and world situation. The advantage of Moscow is its flexibility in managing the energy sector.
The importance of the Russian energy industry was proven at the end of the 1800s, when the monarchy saw the enormous potential for strengthening the Russian Empire, which consisted in the large-scale development of the energy sector. However, the empire had neither the technology nor the capital to create a domestic energy industry. The monarchy found a solution by removing some restrictions on foreign investment and inviting European and American companies to develop oil fields in Baku and the Volga region. A short period of warming began in relations between the Russian Empire and many of its western partners, in particular, with Great Britain, France and the United States. All parties soon realized: the only way to make the Russian oil business highly profitable, despite the high costs associated with the harsh climate and vast distances, is to increase production. At the turn of the century, the Russian Empire mined 31% of global exports.
As the importance of the Russian energy sector increased, it became clear that it was greatly affected by the internal stability of Russia. The Bolsheviks in the early twentieth century used the energy sector in their attempts to overthrow the monarchy. The oil-producing regions were the main centers of activity for the Bolsheviks, because the mining industry was one of the few where the workers were well organized. In addition, the Bolsheviks used a network of railways, which carried oil, to distribute propaganda materials throughout the country and abroad. In the 1904 year, when the empire brutally suppressed an uprising in St. Petersburg, Bolshevik protesters set fire to oil fields in Baku. This resulted in a two-thirds reduction in Russian oil exports. Moscow and foreign markets have realized how strongly oil exports from Russia depend on its internal stability.
The modern Russian energy strategy began to take shape after the end of the Second World War. When the Soviet Union became one of two world hegemons, towering over a divided Europe, Moscow decided that now nothing could prevent it from establishing its dominance in the field of global energy. Between 1950 and 1960, oil production in the USSR doubled, and the Soviet Union once again became the world's second oil-producing state and the main supplier of this fuel to Eastern and Western Europe. Revenues from oil exports again accounted for almost half of total exports from the USSR.
Since the Soviet Union produced oil in huge quantities, and the cost of labor under the Soviet system was low, Russia could sell its oil at prices that were almost 50% lower than in the Middle East. By selling oil at discounted prices to the countries of the Soviet bloc, and then to Western Europe, Moscow weakened Western regimes and strengthened its position on its own periphery. The CIA called this strategy a Soviet economic offensive. It was more important for the Soviets not to earn money (although they also earned money), but to form their sphere of influence, weakening the West. Such a strategy entailed considerable costs, since Moscow received less revenue than it could, and oil produced inefficiently, quickly depleting its fields.
In 1970, oil prices rose to the skies due to a series of crises that occurred mainly in the Middle East. At the same time, Russia has already begun to feel how difficult it is to hold the huge Soviet Union on its shoulders. The regime of the Soviet leader Leonid Brezhnev had a choice: to take advantage of high world prices, raise them for Eastern Europe and gain economic benefits, or continue to subsidize the Eastern bloc, tying him to Moscow and not letting him think about other sources of energy. It was a choice between two immutable duties: maintaining internal stability in the USSR and preserving the buffer zone. As a result, Moscow decided to defend its interests and in 1975, it raised the price of oil to its customers. Then she raised them in accordance with the rising prices on world markets. By 1976, oil prices in the eastern block almost doubled. They remained lower than the world, but rose high enough to force some countries of the block to take loans.
Tips until the middle of 1980-s tried to maintain a high level of income from the sale of energy. During this period, due to such sales, the USSR received almost half of the currency earnings. But in the middle of 1980, the Soviets received a double blow when oil prices plummeted and the West imposed an embargo on Soviet oil, which is why Saudi Arabia filled the markets with its fuel. Moreover, the Soviet Union significantly lagged behind the West in technology, especially in energy and agriculture. In response, starting from 1985, the Soviet Union began to move to a market economy in the field of energy, raised prices for the countries of the Eastern bloc, demanded to pay for fuel in hard currency and allowed foreign companies to return to their energy sector.
But the changes in the Russian strategy were shallow and belated. With their help, they failed to prevent the collapse of the Soviet Union. For a decade, after the collapse of the Soviet bloc, the energy sector of Russia was in a state of chaos. Started under Mikhail Gorbachev in the 1980s, energy liberalization took on extreme forms when Yeltsin ruled the country in 1990s. As a result, mining fell by half, while the Russian energy sector was divided amongst foreign corporations and the class of Russian oligarchs that were growing stronger at that time.
The situation changed in 2000, when Vladimir Putin came to power. One of the first tasks on Putin’s agenda as part of stabilizing the country was the consolidation of the energy sector under state control. This meant a radical change in liberal politics, begun two decades earlier. The government essentially nationalized most of the energy sector, putting it under control of the three state colossus: Gazprom, Rosneft and Transneft. The Kremlin began to negotiate more aggressively when concluding supply contracts with the former Soviet republics and with Europe. He forced them to purchase large volumes at extremely high prices, because these buyers had no alternative supplies. The Kremlin also began to cut off supplies to some markets, thus trying to influence other political negotiations. At the same time, he placed the blame for the cessation of supplies on problem-creating transit states, such as Ukraine.
Although Moscow’s energy strategy has become quite aggressive, it has helped strengthen and stabilize Russia. Revenues from the sale of energy resources in Russia began to grow rapidly thanks to the rise in world oil prices and high natural gas prices, which the Kremlin has set for Europe. Russia has additional funds that it began to invest in the political, social, economic and military spheres. Energy policy also helped Moscow to strengthen its influence in the post-Soviet space and forced Europe to retreat and abandon opposition to the revival of Russia. Of course, those financial crises that swept Europe and Russia in 2008, reminded Moscow how badly it needs its largest energy buyers when oil prices fall and demand begins to decline.
Problems of maintaining the Russian energy
Most of all, Russia is concerned about its dependence on fluctuations in energy prices. Since the Russian budget is half replenished by the sale of energy resources (the share of oil in this amount is 80%, and the share of natural gas is 20%), the state can be seriously affected if energy prices fall. The Kremlin has already lowered its budget forecasts for oil prices from 119 to 93 dollars per barrel, although even at this price the government is taking a lot of risks. Stratfor does not predict oil prices, but historical patterns show that major international crises and changes in world consumption and production have a significant effect on oil prices and on Moscow’s revenues, contributing to the destabilization of the country.
Revenues from natural gas exports are now also in question. Europe, which is Russia's largest consumer of its fuel, is starting to receive gas from other sources, which is why the Kremlin has been forced to cut prices in recent months. This year, Gazprom may cut prices to European consumers in the total amount of 4,7 billion dollars, which is approximately 10% of the corporation's net income.
In its current form, the Russian energy sector is under a great load. The consolidation of the industry under the control of two large state corporations gave the Kremlin many advantages. But after ten years of such consolidation, weaknesses began to accumulate in the industry. The Russian gas giant Gazprom, without any competition, is lagging behind in technology and is considered an unfavorable company for foreign investment. The Russian oil giant Rosneft has recently begun to turn into a major monopolist, like Gazprom, and therefore it may fall into a similar trap. Since for the implementation of future energy projects Russia will need more advanced technologies (because they have to be implemented in remote places and in harsh climatic conditions) and more capital, Gazprom and Rosneft need modernization and foreign investment.
Corruption is also an important factor. According to various estimates, Gazprom, due to corruption and inefficiency at work, loses 20 to 40 percent of its revenues. Rosneft has similar problems. Such losses would be acceptable if Moscow’s revenues from the sale of energy resources remained at the same high level. But if prices decline in the future, or if the costs of maintaining and expanding the energy sector increase, such losses will no longer be acceptable. The Kremlin is investigating Gazprom structures, but since corruption in Russia has been very widespread throughout its history, it can do little to eliminate the violations in its gas corporation.
Moreover, Europe’s dependence on Russian energy is decreasing. The gas shortage that all of Europe faced during the Russian-Ukrainian crises 2006 and 2009 has become a grim reminder of the vulnerability of European countries and their dependence on gas exports from Russia. European countries, acting unilaterally and through the European Union, began to develop strategies that allow them to reduce both Europe’s vulnerability to disputes between Moscow and transit countries, and its general dependence on energy supplies from Russia.
One of the areas within the framework of such efforts was the accelerated creation of new and modern enterprises and facilities ensuring the import of liquefied natural gas. Due to this, some countries, and above all Lithuania and Poland, will gain the opportunity to import natural gas from supplying countries all over the world, evading the influence of traditional Russian leverage, which is the physical bundle. This is especially important in light of the accelerated development of unconventional gas sources in the world, in particular, shale reserves in the United States. Another attempt in this direction is the development of a pipeline project through which non-Russian natural gas will be supplied to the European market. Although this attempt is less successful today, in the future it will reduce Europe’s dependence on Russian natural gas.
In addition, a set of pan-European measures, including a third energy package, provides EU member states with political and legal tools to weaken Gazprom’s dominance in the relevant natural gas supply chains. This common mechanism allows European countries to more firmly oppose certain commercial practices that they consider monopolistic. The latest example was the European Commission investigation into the pricing strategy of Gazprom in Central Europe. Because of such measures, as well as because of EU-funded efforts to create connecting gas pipelines between the countries of Central Europe, it becomes more difficult to use gas pricing mechanisms as a foreign policy tool. This is an important change in the last decade. Earlier, Moscow, as a reward for closer ties with Russia, reduced gas prices for countries (for example, Belarus), while increasing them to those states that provided it with disobedience (for example, the Baltic countries).
Finally, Russia faces another simple but rather gloomy prospect: the intensification of the financial and political crisis in Europe will lead to a reduction in energy consumption on the continent, or at least prevent consumption growth in the next decade.
Russia's next step
The Putin administration is well aware of the challenges posed by the Russian energy sector. Russia's attempts in the past decade to reduce its dependence on energy exports through accelerated industrial development have not been crowned with particular success, and the country continues to link its fate with energy resources. The Russian strategy of using energy exports as a tool of foreign policy and a revenue generator sometimes causes controversy. In order to use energy levers in foreign policy, Moscow must be able to lower or raise prices, and also threaten with a cessation of supply. And this is a very negative impact on the receipt of export profits.
The global and regional conditions have changed so much that Moscow has to make a choice between the foreign policy and economic aspects of its energy strategy, determining its priorities. And she definitely decided that earning income is much more important. The Kremlin has begun to develop a set of measures designed to adapt the country to the changes that will occur in the next twenty years.
First, Russia is trying to eliminate the very dangerous uncertainty that exists in its relations with the key transit countries, which have always allowed it to supply energy to Europe. The construction of an oil terminal in Ust-Luga on the Baltic Sea will allow Russia to bypass the Belarusian pipeline system, supplying oil and oil products directly to consumers. The construction of the Nord Stream gas pipeline under the Baltic Sea and then the South Stream through the Black Sea will give Russia the opportunity, if necessary, to pump gas bypassing the Ukrainian and Belarusian transport systems. These two pipelines will mainly provide gas supplies to large European consumers in Germany and Italy, with which Russia seeks to maintain long-term strategic partnership relations.
These bypass systems will allow Russia to supply gas to its major European buyers, thanks to which Moscow will continuously receive such important for her revenues from energy supplies. Such a flexible strategy of energy exports will increasingly deprive Minsk and Kiev of the levers of influence on Moscow, and Russia will get additional opportunities to turn Ukraine and Belarus into vassal buffer states. This is one of the few political goals that Moscow still intends to pursue as part of its energy strategy.
In addition, Moscow is adapting its energy strategy to new conditions, when European consumers are increasing diversification and liberalization measures. Gazprom has begun to expand its policy of gas price discounts, which it used to hold exclusively for strategic partners, such as Germany and Italy. The Kremlin understands that its only hope of preserving gas revenues in the face of a possible global revolution in shale gas production is long-term contracts with consumers at competitive prices. Moscow will continue to show that it is able to offer guaranteed high volumes and low-cost supplies to European buyers that suppliers of liquefied natural gas can rarely afford.
Finally, Russia pays great attention and allocates significant funds to develop ties with the growing energy markets of East Asia. It diversifies its exports, insuring in case the problems in the European market increase. In all the strategies that Russia intends to pursue in the next decade, there is one thing in common: they will require large funds for their implementation. The ESPO (Eastern Siberia - Pacific Ocean) oil pipeline alone will cost almost 15 billions of dollars. Despite the negative consequences of the 2009 financial crisis of the year, Russia still has huge financial reserves that are designed to implement such large-scale projects. But these tools are not infinite.
It seems that the Kremlin is well aware of the challenges and challenges Russia will face in the next twenty years, when the next energy cycle comes to an end. Unlike Brezhnev and Gorbachev, Putin has proved his ability to develop effective changes in the policies and strategies of the Russian energy industry. The fact that Russia is heavily dependent on oil prices still worries Moscow. But Putin so far succeeds with a proactive response to external changes in energy consumption and in the structure of production, especially those that affect the gas market in Europe. However, the long-term sustainability and viability of the model to which Russia is heading is still in doubt.