Exclusive: Putin's House of Cards Coming Down

by ALEX ALEXIEV January 10, 2009
To little notice in America, a drama is being played out in Eastern Europe that future historians may mark as the beginning of the end of Russia’s neo-imperialist ambitions under Vladimir Putin, as the economic house of cards he built collapses and the tyrant himself heads for the dustbin of history. Turning off the natural gas spigot in the middle of a harsh winter to much of Eastern Europe that is completely dependent on it – and has few alternative sources to heat its schools and hospitals – is the kind of overreach that imperial hubris often drive dictators past the tipping point and ultimately to their downfall.
Few believe that to be the case today and indeed most enlightened opinion in Europe seems to be playing to Putin’s tune. Thus, the ever-eager-to-appease-Russian-misdeeds Western European elites have fallen in line behind the Kremlin mantra that the conflict with Ukraine is a purely commercial affair unworthy of European involvement. Meanwhile, Moscow’s army of European lobbyists, led by paid Gazprom lapdog and former German chancellor Gerhard Schroeder, sing the praises of ever greater European dependence on Russian energy.
Yet, Europe’s cowardice notwithstanding, it is difficult for anybody with even a basic knowledge of the facts not to see that this time Putin has miscalculated badly and is playing a losing hand from an increasingly untenable position. None of this is to say that Ukraine is totally without fault in the conflict or that we should disregard some disturbing evidence of corruption in high places in Kiev with respect to the gas business.
Still, Putin’s gamble has little to do with business and everything to do with a desperate attempt to get some political mileage and perhaps temporarily arrest Russia’s accelerating economic and political slide. But by doing that with his favorite strong-arms methods of economic and political blackmail, he has guaranteed that this time his policies will backfire dramatically.
There are several facts seldom discussed in the Western media that need to be considered before one can truly understand the nature of the conflict.
First, to dispense with the argument that this is a purely commercial dispute, it is worth pointing out that Russia has a sliding scale of prices it charges for its gas to ex-Soviet republics depending on the degree of their political sycophancy to the Kremlin. Obedient clients, like Armenia and Belarus, are charged $110-$120 per 1,000 cubic meters, more independent countries like Georgia and Moldova pay $270-$280, while current bête noir Ukraine is asked to pay a punitive $500. This despite the fact that Russian natural gas – the price of which is pegged to oil with a six-month lag – will soon be worth less than half that even in the expensive Western European market. There is nothing commercial about these extortionate Russian demands that were first announced just two days before 2009 and a week before the gas was turned off.
Secondly, Moscow’s claims that the gas stoppage aims only to punish Kiev for its ostensible misdeeds are completely bogus. Ukraine has by far the largest gas storage facilities in Eastern Europe going back to Soviet times when it was the center of the gas industry and can easily survive the cutoff for the entire winter season by using its stored reserves. The real victims are the half a dozen Eastern European countries that have neither alternative supplies nor large storage facilities and are already in the midst of a dire socio-economic emergency. The Kremlin, of course, knew that very well and the fact that it consciously and callously caused such hardship will not soon be forgotten.
Third, the conventional pundit wisdom that the Kremlin as the supplier is in the driving seat in the conflict looks less wise when the reality on the ground is considered. The fact is that Russia is almost certainly more vulnerable than Ukraine to any prolonged stoppage of the gas flows. Ukrainian pipelines carry 80% of Gazprom’s exports to the West and the lion’s share of its export earnings. Even a few months without these cash flows are likely to bring the already teetering Russian “national champion” to its knees. Therefore, the conflict will be settled quickly and it’s not going to be exactly on Russia’s terms.
Given that Putin was certainly aware of these problems, it is interesting to speculate why he engaged in such a crass power play anyway. While it is difficult to put oneself in the mind of a bully, some have speculated that the Kremlin hoped that the artificial gas crisis and the accompanying market instability would cause a spike in oil prices and reverse the downtrend that’s wreaking havoc with Russian revenues. Others have claimed – and indeed, both Putin and Schroeder have been beating the pavement on that in the past few days – that the crisis was engineered by the Kremlin to convince Western Europeans to line up behind two more Gazprom-planned gas pipelines (Nord Stream and South Stream) that bypass Ukraine, Poland and the Baltics. Whatever the motivation, there is little evidence that any of these purported outcomes are more likely now than before.
Perhaps Putin’s desperation could be better understood by sketching out to what extent Russia and its oil and gas industry are in the middle of the economic equivalent of a death spiral, with potentially dire political consequences for the Kremlin. It was only six months ago that Gazprom, at that time the third largest company in the world with $350 billion capitalization, confidently forecast that it will become the largest in the world with $1 trillion valuation by 2015. Many a Western banker also nodded in agreement to Gazprom’s other prediction of $250/barrel price of oil in 2009. As Putin managed to build monetary reserves of $600 billion – the third largest in the world – Russia did look invincible for a time. He also bribed the Russian people into political acquiescence by jacking up salaries and pensions 200% since 2000, even though GDP and productivity had gone up barely a third of that.
Alas, it was but a house of cards. With no industrial production worth mentioning, its infrastructure badly dilapidated, virtually all of its food imported and mortality rates only found in sub-Saharan Africa, Russia under Putin had become a classic banana republic with oil and gas. It lived or died depending on the price of bananas over which it had no control.
It had also instituted an economic model based on a complete symbiosis between personalized political power and corporate interests, which is the true mark of a fascist state, according to Mussolini. With Putin and his puppets directly controlling all key businesses and using mafia-like methods to eliminate potential opponents and foreign interests it seemed to work for a time. But it was rotten inside. Unable to build value with equity capital, the Kremlin’s favorite state champions and corrupt tycoons depended not only on high commodity prices but also on ever larger injections of foreign loans even as the rights of foreign partners were brutally limited. It was an irrational economic model bound to fail and it did as oil prices collapsed.
Today, Gazprom, run from top to bottom by Putin’s cronies, with a market capitalization of $85 billion (or barely a quarter of what it was) and a debt burden of over $60 billion, is already in serious trouble. Putin and his coterie have made a significant contribution to its woes. According to a well-documented book by former Russian prime-minister Boris Nemtsov and top energy expert Vladimir Milov titled Putin and Gazprom, the Putin mafia pilfered assets worth $80 billion from the company during the 2004-2008 period.
It will get much worse. As gas prices and the company’s revenues plummet in the next few months, it is quite conceivable that Putin’s prize possession would shortly owe more than it’s worth and become technically bankrupt. It is already begging the Kremlin for $5 billion in emergency handouts and paying 500 basis points over Libor for bridge loans to avoid default on loans coming due.
Its longer term prospects look no brighter. With current production in decline and most of the new fields to be developed in the forbidding and extremely expensive Arctic region, Gazprom needs a minimum investment of $20 billion per year over the next 10 years to stave off production collapse. With its credit-worthiness in tatters and foreign capital now avoiding Russia like the plague, it is unlikely to have an easy time finding it.
Nor is the oil sector in better shape. Over the past eight years, Russian state coffers were filled by exorbitant export and extraction taxes levied on oil producers that together amounted to more than $50 per barrel. At current market prices below $50, the oil companies lose money on exports and are shutting down wells. With most major oil fields well past their peak and many nearly depleted, the oil industry needs new investment as badly as Gazprom, but is even less likely to get it. Western oil companies and banks that were once eager to pay any price to get into Russian oil are now wondering how to cut their losses. In just one example, Conoco/Phillips’s 20% stake in oil major Lukoil worth $1.3 billion only four months ago is now worth less than half that and falling further.
All of this is, of course, very bad news for the oil and gas sector but it is an unmitigated disaster for a government whose very economic model is doomed if that sector does not perform. According to finance minister Kudrin, Russia needs an oil price of $95 per barrel to avoid an economic downturn and is facing huge budget deficits if it falls below $70. We’re now well past these points on the way down and the inevitable bursting of Putin’s make-believe economics bubble is taking place in front of our eyes.
Russia’s monetary reserves are now nearly half gone as a result of Putin’s wrong-headed policies of propping up with state funds dysfunctional Soviet-style enterprises and corrupt oligarchs, while bleeding billions on a weekly basis in a futile effort to avoid a massive ruble devaluation. Worse for the Kremlin, the inevitable political backlash to Russia’s economic meltdown that can no longer be concealed will not be long in coming. With Russian savings currently being wiped out by creeping devaluation, unemployment spreading rapidly and food inflation approaching 30% outside of Moscow it is only a question of time before people take to the streets. And this time it would be difficult for Putin’s media to convince people that it is all America’s fault.
Finally, to go back to Putin’s arm-twisting in Ukraine, it is virtually certain that when all is said and done, Eastern Europe and, hopefully, parts of Western Europe as well, would decide that continued energy dependence on Russia is very bad for one’s economic health and engage in a crash course of developing alternative sources. It is likely to involve a new emphasis on nuclear energy with several reactors already in the planning stages, clean coal power stations as well as coal gasification and liquefaction and liquid natural gas terminals among others. Hopefully, the new focus will involve renewed efforts to build the Nabucco gas pipeline that bypasses Russian territory, as well as stopping the construction of the new Gazprom pipelines.
The United States should wholeheartedly support these policies and while at it think of dealing with its own energy dependence.
FamilySecurityMatters.org Contributing Editor Alex Alexiev is a contributing editor to familysecuritymatters.org and an adjunct fellow at the Hudson Institute Washington, D.C. He is the author of a forthcoming book on shariah finance titled Jihad on Wall Street: Shariah Finance in the War Against America.

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