As recent data shows, Russia’s recovery remains slow and non-impressive, with GDP expected to contract by up to 9 percent in 2009. At the same time, the ruble has appreciated steadily since March, escalating debates among authorities on exchange rate policy and forcing the Central Bank to articulate a clear one. With domestic demand still weak, President Medvedev and Prime Minister Putin have spent significant time expanding Gazprom’s presence in European markets. Meanwhile, the country’s second biggest oil company, Lukoil, is actively moving its business outside of Russia.
Recent Data
In his mid-December statement, Finance Minister Kudrin estimated that Russia’s GDP will decline by 8.7 percent in 2009, while the Development Center predicts a 9 percent fall.
Rosstat’s seasonally adjusted GDP data for the third quarter, released at the very end of December, was rather controversial. It showed that, after stagnating in the second quarter of 2009, Russian GDP grew 1 percent in the third quarter (q/q). If the inventories effect is deducted, however, GDP appears to have contracted by 2.5 percent (q/q).
Third quarter data demonstrated a significant decline in domestic demand, suggesting that the recovery has not yet started in Russia.
In any event, third quarter data demonstrated a significant decline in domestic demand of -5 percent (q/q), suggesting that the recovery has not yet started in Russia. The government foresees a very slow recovery (1.6 – 2.5 percent) in 2010, with oil prices at $58-70/bbl. At this pace, Russia may take at least 3 years to return to pre-crisis GDP levels.
Contracting demand has also led to a rapid decline in inflation: in the past four months, consumer prices grew 0.5 percent, a historically low rate for Russia, bringing inflation in 2009 to 8.8 percent. While the government predicts inflation of 7.5–8.5 percent for 2010, it could be as low as 5 percent, annualized, in the first half of the year.
Exchange Rate: Central Bank Remains Mysterious
With the current account surplus holding strong since spring due to the recovery in oil prices, the ruble has been appreciating steadily since March. By mid-November, it had appreciated 15 percent against the U.S. dollar-Euro bi-currency unity (BCU) the Russian Central Bank uses to set the exchange rate. As a result, significant flows of carry-trade money entered Russia, garnering criticism from Russian industrialists that was echoed by Finance Minister Kudrin.
Though Russian imports have been recovering through 2009 as well, the Central Bank was forced to abandon its free-float regime to prevent further appreciation. Putin and Medvedev focused on this issue in several meetings and, in mid-November, the Central Bank formulated the following policy: the Ruble will float freely within a narrow band (currently RUB35 -38/BCU) while the band itself may move within a broader band (RUB26-41/BCU) announced at the end of January; at the same time, the Central Bank will use currency interventions, whose size, level, and direction it will determine on the basis of export-price dynamics, the volume of foreign trade, and inflows of private capital.
By targeting a free-float regime, the Central Bank is hoping to minimize its presence in the foreign exchange market, as well as its commitments on the future of the exchange rate.
Gaz Flows: New Streams
Over the last two months, Gazprom, which first looked into expanding pipelines to Europe after the first “gas war” with Ukraine several years ago, made significant progress on obtaining permits for two new pipelines to Europe: the North Stream, which travels to Northern Germany, Denmark and the Netherlands via the Baltic Sea, and the South Stream, which goes to the Balkans, Austria, and Northern Italy via the Black Sea, as well as to Sicily via the Adriatic Sea. Putin and Medvedev were actively involved, visiting many of the transit countries and invited their leaders to Russia. Though many experts and politicians believe Russia is using gas as a political weapon, Gazprom officials and Russian leaders contend that the new export routes are simply a way to increase the supply of Russian gas to Europe.
Many experts doubt that Gazprom will have enough gas 5–10 years from now to fill the new pipelines to Europe.
Given that Gazprom is competing with LNG for the European market, there may be truth to their claim. Compared to Gazprom’s current pipelines, inherited from the USSR, LNG’s are more flexible, with the ability to reach more destinations. With new pipelines, Gazprom could access new destinations and its lines could even be interconnected with European pipes.
On the other hand, many experts doubt that Gazprom will have enough gas 5–10 years from now to fill the new lines, which should deliver at least 60 bcm/year, with the potential to increase to 90 bcm. Before 2009, Gazprom relied on Turkmenistan for 50 bcm/year, but, with Turkmenistan’s recent reorientation of export flows to China and Iran—as well as Europe’s consumption potentially recovering in the future—Gazprom may be short of gas in 2–3 years. A new pipeline from Turkmenistan to China was opened in mid-December and China intends to import up to 30 bcm/year by 2013. The existing pipeline from Turmenistan to Iran was also extended, allowing for flows of up to 20 bcm/year, up from 8 bcm/year. Of course, Turkmenistan has significant potential to increase production, but doing so will require time.
As LNG inflows grow and (if) nonconventional gas becomes a reality in Europe, Gazprom will likely face significant problems. As a result of its relatively high production and transportation costs, Russia’s gas prices will not be competitive in European markets. Gazprom’s use of long term take-or-pay contracts leaves it with only one option for sustaining its competitive position: signing new, long term contracts as soon as possible—before new gas producers emerge in European markets.
Historically, Lukoil has been one of Russia’s most ambitious oil companies and the radical downgrading of its expectations should be taken seriously.
New Strategy of Lukoil: Out of Russia?
Lukoil, the biggest private oil company in Russia (second only to state-owned Rosneft) recently announced a new strategy that is notably less ambitious than the previous one, potentially raising concerns about the long term prospects of Russia’s oil industry. At the same time, it has significantly increased its stakes abroad and will shift towards higher dividends (30 percent of net profit compared to 15 percent currently).
The previous strategy, approved in 2006, aimed to increase annual production (which was 95 mmt in 2009) to 125–145 mmt and refining capacity (70 mmt in 2009) to 100 mmt. According to the new strategy, however, the company will not increase production above 100 mmt or refining capacity above 72 mmt before 2019. Historically, Lukoil has been one of Russia’s most ambitious oil companies and this radical shift in expectations should be taken seriously.
There are three possible reasons for such a change.
First, even today, oil production is much more expensive in Russia than it is in many other oil-producing regions, largely due to the cost of pipeline transportation. In addition, while the current oil fields, discovered in Soviet times, are located in Western Siberia, new deposits are generally located further east and north, necessitating even larger infrastructure expenditures even though the deposits are much smaller in size.
At the same time, the taxes imposed on the oil industry since 2003 leave oil companies with no more than 10 cents for each dollar increase in price per barrel exported. Because the Russian oil industry exports 40 percent of production, companies are left with little money to invest in new development. In fact, Lukoil’s strategy statement, which questioned the long-term stability of current oil prices, suggests that the company is not able to finance aggressive organic growth.
Lukoil has made significant investments abroad, potentially establishing Iraq as the second pillar of its production.
In addition, over the last two years, the Russian government has clearly indicated its preference for state-owned oil and gas companies: state-owned companies receive new licenses without tenders, get preemptive rights to buy assets sold in Russia, and have obtained a monopoly on all off-shore deposits. Of course, that makes competition tougher for private companies, who have to deal with “routine” bureaucracy on a daily basis. Carnegie’s Moscow Center recently hosted a roundtable on Risks for the Russian Oil and Gas Sector, which concluded that institutional breaks are one of the most significant risks for the future of the industry.
Having cut the outlook for its production in Russia, Lukoil has made significant investments abroad. In mid-December, the company, in a consortium with Norway’s Statoil and an Iraqi state company, won the tender for developing Western Kurna-2, a gigantic Iraqi oil field. The consortium plans to increase production capacity there up to 90 mmt within the next seven years. If that level is reached, Lukoil’s 63.7 percent share in the consortium will entitle it to 57 mmt of oil, establishing Iraq as the second pillar of its production.1 This acquisition, added to Lukoil’s new stake in the Italian ISAB refinery, places 25 percent of the company’s refining capacities outside of Russia. Together, these moves represent a huge step toward Lukoil becoming a truly international company.
Sergei Aleksashenko, former deputy minister of finance of the Russian Federation and former deputy governor of the Russian central bank, is a Scholar-in-Residence in the Carnegie Moscow Center’s Economic Policy Program.
1 According to Lukoil Vice President Leonid Fedun, the new strategy was approved several weeks before the company obtained access to Iraq’s deposit, meaning that production in Iraq will add to approved levels. At the same time, the company will not change its new dividend level, arguing that it will be able to reallocate investment from Russia to Iraq.
