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The Oil & Gas Weapon That Must Be Deployed Before A No-Fly Zone

  • With support for a no-fly zone in Russia growing around the world, it is important to recognize that Western powers still have one powerful economic weapon left to deploy.
  • While the sanctions imposed on Russia are unprecedented, it would be a mistake to suggest that Western nations have done all they can.
  • The West has long been dependent on Russian energy exports, which is why sanctions have so far avoided oil and gas exports, but the impact of such sanctions would be unparalleled. 

Russia as a gas station

In 2014, John McCain memorably stated that Russia is a gas station masquerading as a country.  This claim holds true even more today than when McCain said it eight years ago. In 2021, $1.18 Trillion of Moscow’s total $2.37 Trillion government revenue was collected from oil and gas. This accounts for almost exactly half of the government revenues in 2021. By comparison, in 2020 (the most recent year available), “the oil kingdom” of Saudi Arabia received 53% of its government revenues from oil and gas.

While the high federal revenue that Russia generates from oil and gas may surprise some readers, what is even more striking is that oil and gas only account for between 15-20% of Russia’s GDP. Thus, a sector that constitutes less than a fifth of the economy is filling around half of Russia’s coffers. Compare this to Saudi Arabia, where 53% of Riyadh’s funds come from oil and gas but the sector accounts for a proportionate 50% of Saudi’s GDP. Putin’s public takeover of Russian oil and gas in the early 2000s led to disproportionate funding from the industry which gave it the moniker of a “rent-seeking revisionist.” Thus, perhaps it is more accurate to say that the Russian State is a gas station (which also sells substantial amounts of steel and commodities) masquerading as a country.

Putin’s ability to “capture” Gazprom - Russia’s largest company - serves as a telling example of the concentration and politicization of the Russian oil and gas industry. In 2000, Putin installed his close associate Dmitry Medvedev as chair of the company, a position where he remained until he relieved Putin as President for one term in 2008. During his tenure at Gazprom, Medvedev consolidated the industry with the Kremlin’s blessing. Once Gazprom reached monopoly status, the company began to use its prices as a political tool. It artificially increased domestic supply to lower costs and garner political support while simultaneously limiting supply and raising prices to certain countries in Europe. Some states such as Germany have perennially paid for expensive gas, others such as Ukraine, Moldova, and the Baltic states have faced intermittent gas shortages and price hikes due to politically motivated causes. All the while, Gazprom substantially increased its contributions to the Russian state, which accounted for a whopping 25% of Russia’s federal tax revenue in 2011.

Former Deputy Prime Minister and close Putin associate, Victor Zubkov, currently serves as the chairman of Gazprom. In 2020, the state-owned company accounted for nearly 90% of all of Russia’s gas production. The oil industry is not as concentrated as the gas sector, but it is still largely controlled and directed by the state. In 2020, over 80% of Russian oil production came from the following five firms:

  • Rosneft: majority state-owned
  • Surgutneftegas: close ties to Kremlin
  • Gazprom: majority state-owned
  • Tatneft: wholly state-owned
  • Lukoil: it’s complicated

To better understand Moscow’s economic lifeblood, view the export chart below. In 2019, Russian exports totaled $407 Billion, which translated to 28% of Russia’s GDP. Of these exports, 63% were fuels and energy products (of which crude oil and natural gas accounted for 26 percent and 12 percent respectively). Thus, almost two-thirds of Russia’s exports are in an industry that is captured by the state and where revenues will flow directly into Moscow’s coffers. Base metals and steel are another notable source of export revenue for Moscow at roughly 15% of exports, but they pale in comparison to the oil and gas revenue.

Refined

Figure 1: 2019 Russian Exports by Category (sum $407 Billion)
 
Why sanctions should not target the Russian population 


While the White House and Treasury have moved away from using the term “targeted” to characterize the sanctions regime, they still
argue that the objective of sanctions is to manage Putin’s long-term strategic ambitions, which would presumably come about through degrading Russia’s federal government funding. Yet the current sanctions regime broadly inflicts pain across several sectors in the Russian economy and insulates the Russian government’s largest income stream. Some may question whether the sanctions regime should be precise, after all, wouldn’t sanctions that hurt the Russian population lead to discontent and possible regime change? There are several reasons why broad sanctions regimes should be avoided, but the principal reason is that they come at the expense of large swathes of the population who do not have the power to influence policy and generally they don’t work. The literature shows broad sanctions to be unreliable in forcing policy change. Moreover, measuring for GDP decline after sanction imposition is unfulfilling given the many confounding variables such as commodity prices. For instance, the weak economic growth in Russia in 2014 and 2015 has now been attributed to low oil and gas prices, not sanctions as some originally thought. 

Related: Mission Impossible: Can Biden Bring Oil Prices Down?

The history of sanctions with broad effects has resulted in nationalist fervor and people rallying around the flag rather than people voicing discontent towards their own government. Such sanctions expand the role of the state in the domestic economy through import substitution and more autarky. By contrast, sanctions that target gas and oil specifically would damage the state’s capacity to govern and cause reputational loss to Putin without inflicting widespread economic pain. The oil and gas sector in Russia accounts for nearly half of federal revenues but only a small percentage of GDP and merely 5% of the workforce. 

The current sanctions regime is targeted in name only

Of the sanctions provisions undertaken, few are targeted. The war on the ruble and runaway inflation hurt Russian consumers. In fact, the only people spared are the ultra-wealthy who have foreign-denominated assets squirreled away. Sanctioning Russian oligarchs and politicians may seem like a reasonable strategy to sow discontent among the Russian elite, but this strategy was implemented in 2014 and now reaps diminishing returns. Security Council Secretary Patrushev, FSB Director Bortnikov, and Director of Foreign Intelligence Naryshkin, along with most of Putin’s inner circle, have already been blacklisted by the US treasury in response to their role in the annexation of Crimea. 

As Alexander Gabuev of Carnegie Moscow points out in The Economist, separating the Russian consumer from Western goods could have the unintended consequence of helping Russian oligarchs fill the void through import substitution. One striking example is the booming growth of Russian agribusiness since the self-imposed reciprocal food bans that Russia imposed in 2014. Barring Russian travel and especially Russian student exchange almost exclusively hurts the Russian middle class and coincidentally ends important forms of cultural exchange with the West.

Perhaps tech sanctions are the most successful example of a targeted sanction. While blocking Russian access to high-tech goods and specifically semiconductors is a good start, it has shortcomings. Russia currently buys 70% of its semiconductor chips from China (albeit lower quality chips). Furthermore, most of the world’s neon gas and pallidum, which are integral to the semiconductor supply chain, are sourced in Russia and Russian-occupied Ukraine, making long-term tech sanctions impractical.

Finally, the SWIFT “ban” works in precisely the opposite way of a targeted sanction by specifically excluding oil, gas, and mineral sectors. As Columbia Economic Historian Adam Tooze said, these provisions “must indicate to (Russia) that the West does not really have the stomach for a painful fight over Ukraine.” While this is not a comprehensive list of all of the Euro-American sanctions, the trend is clear, the lifeblood of the Russian state is still flowing. 

Targeted sanctions are oil and gas dependent

9 of the top 10 richest men in Russia (not including Putin) are either in the steel or energy industry. Furthermore, Putin’s wealth by all estimates comes at least in large part from the energy sector. While it may be impossible to find where he hides his assets, sanctioning Russian oil and gas would prevent Putin from amassing even larger sums. There is no better-targeted tool than restricting Russia’s oil and gas exports. Commentators argue that the so-called “nuclear option” of sanctions has already been deployed but that is not entirely true. 

According to Javier Blas of Bloomberg, in the first 24 hours of the Russian invasion alone the EU, UK, and the US collectively bought more than $350 of Russian oil, $250 million worth of Russian natural gas, plus tens of millions of dollars worth of other commodities. The sum of one day’s worth of ongoing energy exports from Russia dwarfs the military and humanitarian assistance that Western governments have sent to Ukraine. The $700 million recorded in one day is also larger than the entire value of arms and military equipment shipments made by the US in 2021. 

These observations are not made to downplay the actions of Western governments, but rather to show the scale of energy dependence that the West and primarily Europe have upon Russia. Self-congratulatory messages from DC and Brussels lessen the urgency to act and even obscure the pivotal issue of energy dependence altogether. In the short term, it is possible that the US will be able to end energy imports and financing in its domestic markets. The EU, however, is not in a position to take steps to wean itself off Russian gas at least until spring comes. Europe is also unlikely to find an alternative oil source in the short term unless there is a sudden change in Venezuelan and Iranian sanctions negotiations. In the medium-term, Europe can invest in larger LNG terminals, embrace alternative energy sources such as nuclear and increase its strategic reserves to become less susceptible to Russian energy coercion. 

The risk of not including provisions for oil and gas in the sanctions regime is that NATO could resort to much riskier measures including limited military engagement if policymakers think that all economic deterrents have been exhausted. War optimism is rife in the US and according to the latest poll data, 74% of Americans support creating a no-fly zone over Ukraine which could lead to a disastrous military escalation between NATO and Russian air forces. The West has long been dependent on Russian energy exports and this could be the final wake-up call to change course and weaken Putin’s ability to impose his will on Europe through energy coercion.

By Daniel McVicar via Global Risk Insights

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  • Mamdouh Salameh on March 16 2022 said:
    The West can neither sanction Russian oil and gas exports nor can it impose a No-Fly Zone over the Ukraine unless it is prepared to start a war between NATO and Russia leading to World War III and a nuclear one to boot.

    There is no need to expose the world to a potential nuclear war since the Ukraine President Volodymyr Zelenskyy has already admitted that his country isn’t going to join NATO, thus conceding one major demand of President Putin. Furthermore, those hot headed in the West who want to impose a No-Fly Zone should calm things down rather than stir things up. If in the first place they had the common sense and the farsightedness to persuade Ukraine to forgo its aspirations for membership of NATO, they could have avoided the whole conflict and the destruction that has befallen it. Was defending Ukraine’s democratic right to join NATO worth bringing the world to the brink of a nuclear annihilation?

    Henry Kissinger, one of the world’s foremost strategic thinkers said with extra prescience called for the neutrality of Ukraine saying that Ukraine should not join NATO but should pursue a posture comparable to that of Finland. That nation leaves no doubt about its fierce independence and cooperates with the West in most fields but carefully avoids institutional hostility toward Russia.

    The West didn’t sanction Russia’s oil and gas exports because it would have inflicted far more damage on the western economies and the global economy than on Russia’s.

    The United States is the world’s second largest importer of crude oil after China importing 9.0 million barrels a day (mbd). It is the most vulnerable among the major economies of the world to oil price shocks.

    The EU which depends on Russian gas supplies for more than 40% and on oil supplies for 30% can never be able to replace Russian gas supplies now or even in the next 10 years. Any rash action of sanctioning Russian oil and gas exports will inflict a huge damage on the EU economy reducing its growth rates virtually to zero.

    For Russia, it will sell a big chunk of its gas and oil to China, the world’s largest energy market. Another chunk will be sold to India and other countries who don’t recognize Western sanctions and the remainder will be bought discretely by oil traders.

    Moreover, no one producer in the world or even a group of producers can ever replace 8.0 mbd of Russian oil exports well into the future.

    Dr Mamdouh G Salameh
    International Oil Economist
    Visiting Professor of Energy Economics at ESCP Europe Business School, London

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