By Joseph Webster
Few Russians are nostalgic for the nightmarish 1990s, a time when GDP fell by approximately 40%, inflation skyrocketed, and life expectancies tumbled. While history doesn’t repeat itself, it often rhymes: Russia won’t relive the nightmarish 1990s, but the pattern of declining living standards in contemporary Russia increasingly resembles the last decade of the 20th century. Russia will likely suffer a second lost decade and confront an economic crisis in the medium-term due to its energy dependence.
The Russian economy: The Private Sector, Gas, and Oil
According to the IMF, hydrocarbon-related production accounted for 53% of Russia’s exports and 36% of all federal revenues in 2016. While the contribution of oil and gas to Russian GDP is unclear (approximately 30 percent, according to Thane Gustafson), the Russian economy is heavily dependent on energy, particularly oil. The graph below illustrates the strong correlation between oil prices and the Russian economy, although the relationship has recently weakened due to the exhaustion of the oil-based growth model and the ruble’s depreciation, which muted the impact of lower oil prices on GDP.
Sources: International Monetary Fund World Economic Outlook database; Energy Information Administration; Bureau of Labor Statistics; author’s calculations
The IMF’s medium-term projections assume that Brent oil will trade in the low-to-mid $50s (it currently trades at about $69), sustaining 1.5% annual real GDP growth for Russia from 2019 to 2022. Those assessments may prove overly optimistic.
Trends in Oil Consumption
Fuel-efficient Electric Vehicles (EVs) – along with ridesharing, autonomous vehicles, and the 2020 global marine sulfur emission caps – will likely constrain medium-term global and regional oil demand. China, the EU, and India are all implementing plans for EVs; EVs could penetrate 30% of the EU’s 2025 auto sales, according to UBS. While passenger vehicles account for only 20% of global oil demand, electrified commercial trucks will also likely hit roads in the medium-term. EV adoption, ridesharing, autonomous vehicles, marine sulfuric emissions caps and their effects on demand and margins for Russia’s comparatively “sour” (that is, sulfuric) Urals-Volga crude, and the EU’s rising fuel standards will likely limit Russian oil exports to the EU, Russia’s most important export market. Russian oil is finding its way to other markets, particularly Asia, but greater distances will likely squeeze profit margins.
Trends in Oil Production
Increasingly efficient US tight oil (often referred to as “shale oil”) and deep-water extraction techniques are transforming energy markets and, barring a political crisis and/or supplier outage, capping oil prices. Tight oil producers will likely dig thousands – perhaps tens of thousands – of new wells in the US, Canada, Argentina, Mexico, China, and Algeria, enabling them to experiment with different production techniques, spread R&D and equipment costs over more units, and lower prices. Russia has the ingredients to capitalize on tight oil (such as technically recoverable reserves and skilled professionals), but not (yet) the recipe: the legal and entrepreneurial conditions (particularly for small and medium-sized firms) that led to the US tight oil boom are largely not present in Russia; Western companies are unlikely to engage in technology transfer with sanctioned counterparts; and Russian credit markets are not robust.
While energy markets are uncertain, oil prices are unlikely to rise significantly above $40 a barrel in the medium-term. Anticipation of a secular demand decrease, new non-OPEC producers, and fear of “stranded assets” could cause low-cost energy producers to reduce domestic consumption and increase export production volumes. Oil prices will occasionally flirt with the $30s or even the $20s if US tight oil technologies continue to improve, another global recession occurs, individual producers attempt to flood the market, electric vehicles and trucks are rapidly adopted, or, most likely, if two or more of these factors occur simultaneously. The Russian oil sector may experience troubles regardless of the world price: profit margins are narrowing as the most productive wells mature, and, barring new production in the (potentially prohibitively costly) Arctic or in Russian oil companies’ international portfolios, Russia’s oil production volumes may decline after 2020. Unfavorable trends in oil prices and domestic production may produce an economic crisis in Russia.
Private Sector to the Rescue?
There may be no better explainer of the sad state of the Russian private sector than Leonid Ragozin’s exploration of judicial expropriation. Extensive state corruption, deteriorating public finances, interventionist policies, and emigration of the professional class suggest that Russian entrepreneurs brave an increasingly challenging business climate. Emigration and demographics ensure that Russia’s labor force decreases by 0.5% every year, while growing political tensions over migrant laborers could result in more restrictions on foreign labor and compound Russia’s demographic and economic challenges. The Russian private sector will likely become even less efficient if present trends continue.
Gas Markets and Russia
Gas production could be a growth sector for the Russian economy. Russia has among the lowest gas production costs in the world and its chief export market, Europe, is experiencing decreasing indigenous gas production and rising overall gas demand. Russia is also adding export capacity through the long-planned Power of Siberia pipeline to China and a Liquefied Natural Gas (LNG) expansion, primarily via the Yamal LNG train majority-owned by Novatek. Expansion of gas rents would have a limited impact on the Russian economy. Gas rents are significantly less lucrative than oil rents and gas accounted for only 11% of Russian exports in 2016, according to the IMF,. Russian gas will also face increasing competition from the US, Australia, Qatar, and others, as well as renewable alternatives such as solar and wind energy. Moreover, Igor Sechin’s Rosneft is challenging Gazprom’s pipeline-export monopoly. If Russian Prime Minister Dmitry Medvedev is not re-appointed to his current position, Gazprom will lose an important champion (Medvedev was the former chairperson of Gazprom and is close to Alexey Miller, the current head of the Russian gas giant). Domestic political competition has unclear but potentially negative implications for gas rents.
That 90s Show: A Sequel, Not a Repeat
Russia’s private sector will likely continue to face state-imposed headwinds, and revenues from gas will remain marginal. Serious reforms are badly needed but take time to implement. Russia’s medium-term economic performance will therefore largely be determined by trends in oil markets, which appear decidedly unfavorable. Russia will likely continue to experience another lost decade of flat or even negative growth. Russia is unlikely to exactly repeat the poverty and economic chaos of the 1990s, but its outlook is grim.
Joe Webster is an independent writer based in Houston, Texas