Vladimir MilovOn March 16, 2006, the Carnegie Endowment for International Peace hosted a meeting entitled “How Sustainable is Russia’s Future as an Energy Superpower?” with Vladimir Milov, of the Institute for Energy Policy. Carnegie Senior Associate Andrew Kuchins chaired the session. Milov’s remarks are summarized below.

Today energy is the decisive driver of Russian foreign and domestic policy. Presidential Aide Vladislav Surkov’s recent speech to United Russia activists showed the government is prepared to sacrifice everything to become an energy superpower. In Surkov’s words, if you have long legs, you should do the long jump, not play chess. But the plan to become an energy superpower will not succeed.

Not only will the Kremlin plan ultimately fail, but it is also causing harm now. The authorities promote the “energy superpower” idea instead of fixing economic and social problems. Sustainable development and international competitiveness have vanished from the agenda. Instead there is only this phantom idea, which holds out the promise of a footprint in the global geopolitical landscape.

In discussing the resource curse, people normally mention weak institutions, corruption, and perverse political incentives. But Russia faces a more basic problem—it doesn’t have enough resources. Only a few petrostates have enough resources per capita to create a good life for their people. All have small populations. (Norway, Kuwait, the United Arab Emirates, and Qatar are in this category.) With Russia’s large population the state cannot rely only on resource revenue to promote development. Even if the state were to expropriate all oil profits, it would have only $80 per person per month to redistribute. Moreover the Russian economy is extremely energy-intensive and the country’s large territory imposes significant transportation costs, limiting export capability. So the Kremlin cannot build an economic and social policy on energy alone.

President Vladimir Putin has abandoned the reform agenda of his first term. He has done nothing to address problems in banking, the army, pensions, and infrastructure. Now the government focuses only on the “national projects,” i.e. redistribution.

Such thinking is especially misguided given the problems in the energy sector. Increasing state encroachment is undermining growth. While private companies continue to perform well, state enterprises stagnate. The return on assets in Gazprom and Rosneft is stable under 10 percent, well below average for the oil and gas industry. These companies have a lot of capital but can’t use it efficiently.

Russia faces an investment crisis, especially in gas. In 15 years Gazprom has done nothing to develop the fields on the Yamal peninsula. It first received development licenses for these fields in 1993. Having done nothing, Gazprom requested and received an extension of the licenses in the late 90s. Gazprom has again done nothing and soon the government will have to extend the licenses again. According to the OECD Russia will not bring any new fields on-stream before 2010, and 2015 is a likelier date. These new fields will require years of investment before they begin production. Meanwhile production on Gazprom’s two largest mature fields has declined 20 percent over the last six years. As a result Gazprom still has not restored its 1999 production levels, despite its many acquisitions.

The twin “national champions,” Rosneft and Gazprom, both engage in non-transparent deals and carry enormous debt. This limits the companies’ ability to borrow and invest. Neither the Russian financial system nor Russian companies can develop capital-intensive green fields. In these circumstances Rosneft and Gazprom have made the worst possible mistake, closing the doors to international companies. Gazprom is dumping tons of cash into low-return sectors like electricity and businesses that require investment beyond its means.

The Yukos case continues to afflict Russian energy. If Yukos’ remaining oil assets had maintained their 2004 production levels into 2005, then overall Russian production would have grown five percent. But Yukos production declined, so overall production grew less than 2.5 percent. State prosecution of Yukos has now gone on for several years to no useful end and the state will redistribute more assets to state companies in the near future.

The “energy superpower” concept is an illusion with no basis in reality. Perhaps most dangerously, it doesn’t recognize the mutual dependence between Russia and energy consumers. Because of political conflicts and declining production, future supply disruptions to Europe are likely. As a result, there will come a day when European gas companies demand elimination of the take-or-pay conditions in their Russian contracts. This will threaten Gazprom’s ability to borrow. Putin’s attempt to use energy to increase Russian influence could backfire in the long run.

Q: What will future oil production look like?
Milov: Oil will stagnate for two or three years, then maybe decline if state encroachment continues. But for now there is still some private-sector dynamism. More redistribution, tax pressure, or infrastructure problems could provoke production decline. There’s some cushion in oil because of major investments by the oligarchs. Marshall Goldman is wrong when he says they engaged in asset stripping. Gas is much worse. Beginning in 2008 there will be nothing to offset declining production. Independent producers would have covered the gap, but Gazprom continues to gobble up some independent companies and threaten the rest, torpedoing investment. Gazprom isn’t really a company. It has some shares, and some very nice investor relations people, but it’s a Soviet institution. The joke about Gosplan—if it took over the Sahara, there would soon be a sand shortage—applies here. Soon Gazprom will face a choice to cut either domestic supply or foreign supply. As happened this past winter, they’ll choose both.

Q: Does the Kremlin know it has a fake strategy? Does it understand the risks?
Milov: They aren’t experienced in building any strategy at all. In 1996 they lost the Saint Petersburg gubernatorial elections to Yakovlev, so they had to move to Moscow. They are essentially opportunists. For example, their response to the protests over monetization of social benefits was to throw money at the problem, when a simple transition period would have solved it. The Saint Petersburg group doesn’t understand the problem of transition from brown fields to green.

Q: How long can this approach last?
Milov: That depends on two things: the oil price and Russian society. People are tired after 20 years of changes. They want to avoid challenge and change, to get on with their lives. Surkov and company sense this and take advantage. Any society will get weary of its leaders when they have held power for 10 to 15 years, but it’s hard to say when this feeling will set in for Russians.

Q: What about the G8 summit? Is there anything the “seven” can say to the “eighth?”
Milov: Energy security is a serious topic for such a non-serious presidency. The situation on international energy markets is vulnerable, making it hard to push Russia right now. So there will be a fake summit. The Russian documents prepared thus far have been politely called “too general.” I have no hopes for it.

Q: Which is the bigger problem for Gazprom and Rosneft, debt or management?
Milov: Gazprom can solve the debt problem in five minutes by selling licenses to international majors. That’s not going to happen, but the personnel issue is still worse. Most of the important corruption is not between business and regulators, but between the state and state-owned or parastatal enterprises. Management has neither efficiency nor development on its priority list. The system needs change before people can change their behaviors.

Q: Is Gazprom locking up Central Asian gas to cover its projected shortfall?
Milov: Yes, at least in part, but there isn’t enough of it—Gazprom will market 100 bcm of Central Asian gas in 2010. The recent Ukrainian deal shows there’s something else at work. RosUkrEnergo received an option to re-export 15 bcm, the profit from which previously went to GazExport [part of Gazprom]. There are stronger forces than Gazprom behind these deals.

Q: What will happen to Shtokman?
Milov: There are three problems. Where will the gas go? To an LNG plant on the Baltic, an LNG plant on the Barents Sea, through the North European Gas Pipeline, or through some combination of these? What will be the tax regime? Clearly they need a PSA, but to do that they will need to repeal some taxes on PSAs, which [Finance Minister Aleksei] Kudrin doesn’t want. Also, what of the financing? They can’t do equity financing and have Gazprom maintain a majority stake. But 100 percent debt financing is impossible. So either Gazprom gives up equity control or the project doesn’t happen. It took Gazprom a year just to make a short list of potential partners. Perhaps the whole thing will be postponed. If it happens, the field might begin producing in 2014 or 2015. It will cost at least $12 to $15 billion for the first stage.

Q: What is the outlook for Kovykta?
Milov: The main question is, will China be ready to buy the gas at a reasonable price? Only Northeastern China is a reasonable market for Kovykta gas. For now China can’t agree on the price. They want $40, but Russia needs at least $75 to make the field profitable.

Q: Is there a struggle between Rosneft and Gazprom? Does Rosneft have the money and technology to develop Eastern Siberia?
Milov: There is still room for acquisitions, so Rosneft and Gazprom can continue to coexist. Rosneft CFO Sergei Alekseyev was forced to resign, which shows some new weakness in Rosneft management relative to the Kremlin. This was not the case before, for example when Rosneft management successfully engineered the failure of the merger with Gazprom. Sibneft, by the way, will quickly be taken out of Gazprom. As for Eastern Siberia, it’s the same story as Gazprom and the Yamal Peninsula, only Rosneft is even worse at doing equity projects.

Q: What do you think of the Rosneft IPO?
Milov: This likely will not be a traditional IPO, but rather something that resembles a private offering to strategic investors. I don’t think there is agreement on this yet, so some delay is possible.

Summary prepared by Matthew Gibson, Junior Fellow with the Russian and Eurasian Program at the Carnegie Endowment for International Peace.