Pride and Prejudice

Russians have a complicated attitude toward their natural resources. While they are proud of Siberia’s mineral wealth, they are embarrassed of the country’s dependence on oil and gas exportation. Thus, Russian officials are always talking about the diversification and modernization of the Russian economy. Meanwhile, diversification takes place of its own accord, albeit in response to the anemic growth in oil and gas production and not because of the vital development of non-energy sectors.

There is nothing inherently bad about the oil and mining industries. Australia and Norway, both highly developed countries, continue to garner the majority of their incomes from exporting mineral resources. Negative attitudes toward this sector prevail due in part to the average Russian citizen not understanding how oil revenues affect him. The answer is that in Russia, the inflow of oil money keeps salaries high compared to the country's labor productivity, while taxes on oil bankroll salaries in the outsized military and public sectors.

As the history of the Russian oil industry shows, profits could have been much greater if the industry hadn’t stopped expanding in 2004.

 

Oil Flow, Interrupted

The golden age of the Russian oil industry came between 2000 and 2004.  Russian oil companies adopted western-style management techniques and, as a result, were readily integrated into the global market. Their ambitious owners were on track to turn Soviet-era institutions into transparent, international corporations. Massive reserves, combined with western technologies and capital resources, promised the further development of the Russian oil industry. During this era, ConocoPhillips formed a partnership with Lukoil, BP created a joint venture with TNK, and Shell became the largest investor in Russia.

Between 2000 and 2004, the average oil production increase reached a 7.5% growth rate, sufficient to double the nation’s GDP in 10 years. Rapid development was made possible by intense competition, the introduction of world-class technologies, and increased access to international markets. The health of the Russian oil industry portended a great future and could have been an inspiring success story for the country.

Then, in 2005, everything changed. Between 2005 and 2011, the annual oil production increase cut off at 1.4%. High oil prices and energy consumption in Asia failed to stimulate the Russian oil industry. Naturally, pro-government analysts provided their version of events: oil fields in western Siberia and the Volga-Ural region had passed their production peak, while new fields in the Arctic, East Siberia and the sea shelf require huge, as-of-yet unavailable investments in order to be developed. Despite these claims, the reality is that Russian oil companies had the capability to sustain the level of production for the next 20 years. Geology and geography are not the chief constraints on growth. The root of the problem is actually government policy, which has, for the past six years, successfully prevented the domestic oil industry from benefiting from optimal market conditions.

 

Run-of-the-Mill Resource Nationalism

The Russian oil industry’s stagnation was triggered by increased taxes;  new restrictions on exploration and development for international companies; the de facto abolishment of private property rights in the natural resources sector; and the presence of state-owned corporations on the Russian market. In effect, the barriers to private enterprise have prohibited it entirely.

The destruction of private property rights, the most damaging of the policies that brought about the current stagnation, was not limited to the Yukos case. In 2007, Shell lost its control of Sakhalin-2, the largest natural gas project in contemporary Russia, just before it began generating revenue. The same year, the owners of RussNeft, a fast-growing second-tier company, were forced to sell their company shortly after its business model proved effective.

 

Shell's Sakhalin-II LNG plant

 

The remaining private companies faced serious restrictions. In 2010, TNK-BP had to sell its license on the Kovykta gas field to Gazprom, after failing to obtain all the necessary government permits. This acquisition, which secured Gazprom’s monopoly over the Russian natural gas industry, means that development of this field, which had been slated for the beginning of the 2000s, is now unlikely to begin before 2020.

Novatek, the second-largest Russian natural gas company, was prevented from selling its shares to French oil giant Total in 2004, although the sale finally took place six years later. In the meanwhile, Gazprom and Gennady Timchenko, an old friend of Vladimir Putin’s, had acquired 44% of Novatek. The independent company ended up the partner of its competitor.

Finally, Lukoil, Russia's largest oil producer that isn’t owned by the state, didn't win licenses for any large new oil fields in Russia for many years. Disappointed by the fact that there was no room for non-state-owned companies in Russia, ConocoPhillips sold its 20% stake in Lukoil.

Despite the preferential treatment from the government, Gazprom and Rosneft, two state-owned behemoths, have not demonstrated healthy growth. In the absence of real competitors, they have been slow in developing new fields. For instance, Rosneft's major conquest had been the Vankor field. Not only was this project completed years later than was initially been planned by Yukos, its previous owner, but development ended up costing several times Yukos’ original estimates. On top of that, Gazprom's output decreased during the development period because the monopoly's sales strategy collapsed in the face of unexpected competition on the European market. What had started as a boon ended as a bust.

Overall, the government policy in the oil and gas sector is an example of resource nationalism. Current policies secure the interests of the ruling class at the expense of overall economic growth.  How did this happen?

 

Alexey Miller (left) was appointed chairman of the Gazprom board of directors by Vladimir Putin in 2001

 

At the beginning of the millennium, Russians had wanted greater government regulation over natural resources because of the public perception that a small handful of oligarchs were the only ones profiting otherwise. For similar reasons, the public mistrusted international companies.

Government control over the energy industry was instrumental in boosting tax revenues and ended up maximizing the income of the ruling class. Moreover, controlling the country’s largest and most profitable industry was essential to establishing the dominance of Putin and his cronies. The economic power of independent oil companies could have transformed into political power, which would have limited the power of the current regime. In summary, the ruling class benefits from tight government regulation of the oil industry, and to them, their interests outweigh the overall interest of economic development.

What if there were a more liberal policy in the natural resources sector?  This kind of policy would limit the government’s ability to increase public spending and thus alienate millions of Russians who directly or indirectly depend on government funding. The opposition, which would be well-funded in this scenario, would demand more “fairness,” meaning the nationalization of natural resources companies. It would have a good chance of winning elections and implementing its radical economic program. As a result, the same resource nationalism would be implemented by a different political team.

 

Between Two Models

Despite its pitfalls, resource nationalism is typical for resource-rich countries. For example, the economic development of Iran and Venezuela is severely constrained by such policies. According to the 2012 BP Statistical Review of World Energy, although Iran controls 9.1% of the world's oil reserves and 15.9% of the world's natural gas reserves, its share in the world production is only 5.2% for oil and 4.6% for natural gas. Venezuela, with 17.9% of world oil reserves, produces only 3.4% of the world’s oil. Both countries went through the process of nationalization and subsequently exiling international companies.

 

President Mahmud Ahmadinejad of Iran (left) and Venezuelan President Hugo Chavez are both proponents of resource nationalism

 

Unlike Iran and Venezuela, Russia can boast of its prudent macroeconomic policy from 2000 to 2006, a more developed and diversified economy, less social populism, and less outlandish elites. Compared to Iran and Venezuela, Russia's resource nationalism is more civilized: brutal violence was not the major instrument in implementing government policies; the government tried to follow some procedures; in most cases, oil company owners received sizeable compensation for their acceptance of the new economic order.

In contrast to all of these examples, Australia is a an economy based on the exportation of natural resources that ranks high on most lists of wealthy nations.  It is no coincidence that the Australian natural resource industry is driven by public companies that adjust swiftly to changes in market conditions and attract investments into the national economy.

 

All Bets On Resources

Intensive growth of the natural resources industry is Russia’s most obvious opportunity for finally escaping the middle income trap. There is not much room for growth through simply providing basic goods and services to Russian consumers, since most of them already have everything from food to Internet connections. Furthermore, the Russian population is aging and shrinking; there is little by way of a functional justice system or efficient state institutions; overall, Russia doesn't have any competitive advantages that could fuel its growth in the midterm.

Economic development could be based on the growth of new, more sophisticated sectors. Building these sectors will require years of stable favorable conditions. The hands-on management approach preferred by the Russian government isn’t suited to the needs of a modern postindustrial economy, which requires private initiative and individual creativity, not central planning and government investment.

 

 

Facilitating the growth of the natural resources industry should be a priority of government's economic policy. Otherwise, the country might see a significant decline in its oil and gas production.

The most important and complicated task of the necessary economic policy is restoring the institution of private ownership, especially in the realm of natural resources. Dialogue with key players in the global energy sector that addresses their concerns about institutional risks could once more attract their investments. Together with high profit margins and the thirst for new oil reserves, these conversations will make them eager to take their chances on Russia again.

Finally, a more rational public opinion of country's natural resources is necessary for promoting private initiative and opening the natural resources industry to international investors. The Australian economic model demonstrates that the export of raw materials could be the foundation for a high quality of life. As for the “diversification and modernization” of the Russian economy, those should be left to the private sector. It has been demonstrated time and again that aggressive government involvement in this arena—namely, direct investments and tax stimuli—does more harm than good.