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Posted on 12/10/2001, 2:24:38 PM by Voronin

The Motherland Arises

By Matt Taibbi

From the very first moments after the attack, journalists agreed: September 11 would be remembered as “the day that changed everything.”

Last week, there was an event that passed almost without notice around the world. But November 23, 2001 might very well end up being remembered, like September 11, as another day that changed everything. That was the day that Russia jumped into the ring for a fight with the Organization of Petroleum Exporting Countries (OPEC), setting in motion a chain of events which should radically alter the landscape of the international economy for a long time to come.

Falling oil prices (to $19 per barrel, down from the mid-twenties last year) had prompted OPEC, a mostly Arab cartel of oil-producing states that is responsible for some 40% of the world’s petroleum output, to announce plans to cut production by 1.5 million barrels a day. In return, OPEC asked the major non-independent producers— Mexico, Norway and Russia— to cut production by 500,000 barrels a day.

OPEC had every reason to expect that the other nations would go along with their request. For one thing, they always had: since the early seventies, OPEC has more or less dominated the decision-making process surrounding the pricing of oil, and non-member states have tended to cooperate with such requests for production cuts.

In OPEC’s favor here was the truism that all oil-producing states will always be equally anxious to keep prices high. On the other hand, OPEC would never cut production to the point where it might suffer serious losses due to reduced volume. These two factors have combined to create a fairly stable equilibrium in prices for almost thirty years, and allowed OPEC to maintain its influence on the world economy despite its relative political isolation— most of its members are non-Western second world countries.

Mexico and Norway immediately complied with OPEC’s production cut plan last month, pledging cuts of 100,000 and 200,000 barrels a day, respectively. OPEC expected Russia to pledge a cut of 150,000-200,000 barrels a day. But Russia hesitated, announcing no cuts at all.

In a panic, Saudi Oil Minister Ali Naimi flew to Moscow to meet with Prime Minister Mikhail Kasyanov to talk things over. In what one Moscow-based investment banker called “the biggest ‘Fuck You’ you can possibly imagine,” Kasyanov in that meeting told Naimi that Russia would agree to a cut of 30,000 barrels a day.

This amount was not only more than six times less than what OPEC wanted, it was even less than what Russia usually cut anyway in exports in the winter to safeguard against heating fuel shortages at home.

“Telling Naimi that they would ‘go along’ with a 30,000 barrel cut, after Naimi had come all this way to plead his case, was worse than if he’d said they weren’t going to make a cut at all,” one industry observer said. “It was an insult, plain and simple.”

He added that when news of Kasyanov’s brush-off of Naimi reached his company, all the Russian traders in the office cheered. “They thought it was so cool,” he said.

When all the other oil-producing nations immediately denounced Russia’s move, the government briefly indicated that it might reconsider its position. But on November 23, after a meeting with the heads of Russia’s major oil companies, the government slapped the Arab world in the face again, announcing that it was ready to “compromise” by increasing the size of its production cut— to a laughable 50,000 barrels a day.

Russia’s decision may eventually topple the government of Saudi Arabia and other OPEC states. It dramatically altered the balance of world energy power in favor of Russia and the West over the Gulf states. And it put the future of OPEC, the world’s most powerful commodities cartel, in serious jeopardy.

“This is the most serious threat that OPEC has ever faced,” said Chris Weafer of Troika Dialog.

How and why Russia was able to pull this off this power play is a fascinating story; to follow it is to understand just how far Russia has come in the past few years in its quest to return to world prominence, and also how radically the relationship between Russia and the West appears to have changed— for the better.

OPEC has always been a thorn in the side of the West. Its very existence is an affront to Western industrial might. Formed in 1960, the five original member states— Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela— had united specifically to prevent the great Western powers from taking too much advantage of these smaller states.

For the first ten years of its existence, the cartel was relatively ineffective. Among other things, it suffered from the weaknesses traditionally inherent in cartels. For example, in any commodity cartel, each member has an incentive to cheat on the others by producing more than the agreed-upon amount. If four states cut production and the fifth does not, the fifth naturally benefits from the increased price without having to make the sacrifice in volume. Though all OPEC countries continue to cheat up until the present day, the problem was much worse in the cartel’s early years, before it had given members any reason to have faith in its effectiveness.

OPEC’s share of world oil production was also only 28% in 1960, making it difficult to exercise any real power. That figure would rise to 41% by 1970, when the cartel started to turn around.

OPEC also suffered at first from the traditional problems that had faced oil producers since the birth of the industry, mainly that supply levels fluctuated wildly. In the 1960s, there was a worldwide glut of oil, which sent prices plummeting. By 1970, the world price of oil was just $1.30 a barrel. Powered by the seemingly endless supply of cheap fuel, the Western economies grew rapidly until the early seventies, when industry finally grew to a point where demand for oil outweighed production. This coincided with political factors which united the OPEC countries (which had grown in number to 13 by 1975) against the West, ending the political divisions which had undermined the incentive to cooperate.

The key event was the October, 1973 war between Israel and Egypt. When Richard Nixon announced a $2.2 billion military aid package to Israel, Arab states began an oil embargo against the United States and several other Western countries. As a result, oil prices jumped almost immediately from $3.00 before the war to over $11 a barrel. The jump in prices was unprecedented in this century and both enriched the Arab states and solidified their status as energy power brokers. It also contributed greatly to a slowdown of industrial growth in the West, cutting its formerly booming economies down to size. Industry in the West never fully recovered from the blow inflicted by OPEC in the early 1970s.

Countries like the United States, therefore, have throughout had every reason to look for additional sources of leverage against OPEC. But there were none. “For 25 years, Western economies were screwed,” said Weafer. “There was nothing they could do. There was no alternative.”

None, that is, until now. In its heyday, the Soviet Union was the world’s largest oil producer, churning out 12 million barrels a day (compare that number with the 7.5 million bpd now produced by Saudi Arabia, currently the world’s largest producer). But the Soviet Union for obvious reasons was not about to be that alternative to OPEC oil that the West needed. In fact, the contrary was true; the U.S. tried frantically throughout the Cold War period to exert influence over Arab oil-producing states in order to maintain its own independence in the oil game vis a vis the Soviet Union.

When the U.S.S.R. collapsed, the Soviet oil industry, along with the rest of Russian industry, suffered a catastrophic decline in production. The problems the industry faced went beyond even the overall chaos of the period; they were also the result of typically Soviet slash-and-burn production methods that left many of the country’s wells crippled. During the Gosplan period, the directors of Soviet oil companies took all kinds of short cuts to meet their production targets, including flooding the wells with water to increase the pressure. By the 1990s, many of the country’s wells were severely damaged.

“There were some wells that were producing 90% water in the early nineties,” said one industry analyst. “It was a disaster.” (The worst example was the giant Samotlor field, operated by TNK subsidiary Nizhevartovskneftegas, which had a 91% water content at one time).

The recovery of the oil sector was relatively slow in the nineties for a number of reasons. For one thing, it was naturally limited by the lack of domestic demand during a period of overall industrial collapse. Another reason was that the newly-privatized oil companies were marauded by their own directors, who funneled profits and revenues offshore rather than reinvesting in their companies. Without new investment and reinvestment, there was no way to increase production.

But a few years ago, things began to change. A number of factors contributed to a significant rise in Russian oil production. First, there was the ruble collapse of 1998, which made reinvestment in their own businesses more attractive than before. Buoyed by a rise in prices, and the reality that there was increasingly not much left to steal, the heads of Russia’s biggest oil companies began to invest in pipelines, foreign retail networks (i.e. LUKOil’s interest in Getty), and modern oil-field services technology.

Also, the Russian government changed its oil strategy with the arrival of Vladimir Putin on the scene. Troika’s Weafer said that Russia’s recent break with OPEC should not come as a surprise to anyone who’s followed Putin’s public statements about oil in the last two years.

“Going back to his first statements on the subject in September of 1999, when he was Prime Minister, Putin must have said 25 times that Russia needed more revenue from oil, that lack of oil revenues were what caused the 1998 crash,” he said. “And he made it clear that his solution to the problem was to reorient Russia to an oil consumer economy. He made it clear that Russia was going to increase production.”

The plan that Putin hinted at, and which is being implemented now, represents just about the only way that OPEC’s grip on the world’s energy prices can be broken. The Russian government decided to break with the traditional policy of keeping prices as high as possible. Instead, it now plans on simply achieving the same revenues at lower prices by increasing the volume. The object here is a policy based on “total dollar receipts”, not on profit margins.

Russia can get away with this for two reasons. One is that production is up and projected to go up even more with the further development of Siberian oil fields— some estimates place the potential increase as high as 4 million barrels a day more. This would give Russia the bounty it would need to keep producing in massive quantities even as the price falls. The other reason is that Russia’s economy is more diverse than that of the OPEC countries, meaning that it will be able to survive price falls for a much longer time. In a battle to see who’ll say “uncle” and cut production first, countries like Saudi Arabia — for which oil revenues comprise over 90% of the economy — are bound to lose in a confrontation with Russia.

“Russia can make enough from tax revenues on oil sales to meet budget targets for the year 2002 even if the price drops to $13,” Weafer said. “For 2003, it can survive prices of $12. For 2004, it can survive $11. That would absolutely kill Saudi Arabia.”

Weafer and other observers feel that this situation could very easily bring about a collapse of the Saudi government, which has been plagued by mounting internal tensions for some time now.

“I’ve felt for some time, even before 9/11, that there was a real possibility that the Saudi government could collapse,” said one industry source. “It doesn’t have the capacity to survive a price war.”

The benefit to Russia in all of this comes at the inevitable moment when the OPEC nations, realizing they are fated to lose the price war, give in and announce production cuts. Russia will then be able to take a free ride on the backs of the Arab nations, producing as much as it wants while the OPEC countries take on the burden of keeping prices high. By the time this comes about, Russia will have a dominating position in the international oil industry. After a decade in which journalists and academics scoured the country for phantom evidences of economic improvement, this accomplishment— already a fait accompli in the eyes of some observers— will represent Russia’s first real triumph internationally in the post-Soviet era.

“This will be the first time... well, the first time Russia was actually able to do anything,” said the Moscow-based investment banker.

This is probably why presidential advisor Andrei Illarionov last week classified OPEC as a “historically doomed organization.”

It would be a mistake, however, to attribute all of this good news to savvy policymaking on the part of the government and sound investment strategies by the oil magnates. In fact, there is plenty of evidence that Russia would not be able to stop producing, even if it wanted to, and that ordinary greed and corruption will play as much of a role in the slaughter of OPEC as polite-sounding concepts like “total dollar receipts” policies.

The primary obstacle to controlling Russian oil output is a structural one. Unlike most of the OPEC countries, which have state-run oil companies that can be manipulated at will, the Russian oil industry is almost entirely privatized; there are upwards of 50 oil-producing companies, and six major ones. What’s more, none of these companies has ever shown anything like an inclination to voluntarily reduce production.

Weafer’s colleague at Troika Dialog, Ivan Mazalov, noted in a recent report in regard to Russia’s 50,000 barrel cut that “it is important to realize that Russia does not mean to implement its promises, which is evident even in the way in which the promises are formulated; cutting production across 50+ oil producing companies, the vast majority of which are private, will be impossible to implement.”

Mazalov adds that the absence of central production growth planning renders the whole production cut affair “essentially meaningless.” He also took exception to the method of determining the cuts, which would be reductions in projected growth rates rather than current production levels. The Russian companies can therefore manipulate the whole process simply by overstating the growth projections.

Russia does have one method of exerting control over oil exports— the state pipeline network Transneft. Transneft has a virtual monopoly over pipeline use in Russia and gives out access to its network to Russian companies according to quotas determined by the Energy Ministry. Theoretically, all companies have equal access, but as one analyst put it, “some companies get more equal access than others.” Furthermore, the Russian companies are notorious for circumventing the government quotas. Petroleum Intelligence Weekly estimates that upwards of 60,000 barrels per day— more than the proposed cuts— “leak” through the quota system.

Although all oil-producing companies cheat on quotas (OPEC member Nigeria, for instance, is notorious for shamelessly overproducing after announced OPEC cuts), the Russians, as is their wont, seem more enthusiastic in their cheating than other countries. Every scheme humanly possible to dream up has seemingly been tried and tested by Russia’s oil giants. There was the export exception awarded to Tatneft to finance the construction of a hockey stadium in Yaroslavl, a stadium that was meant to host the World Hockey championships in 2000. The championships ended up being held in St. Petersburg when the stadium was mysteriously not finished on time. Then there were the exceptions granted to various companies to export oil in exchange for commodities like Cuban sugar; the sugar is cheaper to buy on the world market, so that’s what the companies do, and use their exception to sell their oil rather than trade it.

There are uglier forms of cheating, ones not restricted to Russia by any means. Russia is thought to be a key middleman in the smuggling of embargoed Iraqi oil to the West. The U.S. Department of Energy reported last week that imports to the U.S. of Iraqi oil had reached a new high of 1.274 million barrels a day— just surpassing the previous high of 1.12 million before the Gulf war in 1990.

“A lot of that oil comes through Russia,” said one analyst, noting the strong presence that notorious embargo-breaker Marc Rich had in the Russian oil industry in the early part of the last decade.

The issue of cheating in Russia is played up relatively often in the Western business press, primarily because it is a real issue for countries that are, for instance, members of an actually functioning cartel like OPEC. But the issue of is probably not all that relevant in fact. As Weafer notes, Russia never intended to comply with any proposed cuts. Across the board, the Russian oil majors are planning huge production increases for the upcoming years. (Sibneft, for instance, plans to increase production by 23% in 2002). A spirit of collective sacrifice and cooperation has never exactly been the strong point of people like Mikhail Khodorkovsky or Roman Abramovitch, who showed that they were willing to step over each others’ corpses to rob the country blind during the privatization period.

“It’s the same old gangsters,” said the analyst. “They’re not going to stop selling for any reason.” Or, as Petroleum Intelligence Weekly put it, “When the oil price falls, Russian oil companies just think they should export more.”

It’s an attitude that to some sounds like the exact opposite of good business sense— but in this case, it’s going to work out perfectly for Russia. And for its new close ally, the United States.

It is probably not a coincidence that Russia chose this particular moment, just a few months after terrorists bombed New York, to launch its attack on OPEC. Russia’s decision to support the U.S. war effort brought the two countries together to such a degree that there is now a remarkable coincidence of interests, both political and commercial, between the two states.

The United States as it considers expanding the “war against terrorism” to other Arab countries needs a reliable, non-OPEC source of oil. The U.S. is also anxious to find ways to exert pressure on those Arab countries that are sitting on the fence about whether or not to support the U.S. military action. As one analyst noted, the U.S. could not have found a better way to “punish” Saudi Arabia for its lukewarm support of the Afghanistan campaign than to silently encourage Russia to defy the proposed cuts. In return for its effort to pressure OPEC, Weafer said, Russia can probably expect a favorable new attitude from the West toward debt restructuring, as well as the apparent ceding of pipeline interests in the Caspian region.

“Debt restructuring will definitely be part of a quid pro quo,” he said. “It’s not a coincidence that this is happening as Russia promises to give up its listening posts in Cuba, and that the U.S. is apparently giving up its Caspian pipeline plans. It’s like both sides are saying, ‘We’ll get out of your sphere of influence if you get out of ours— like they’re drawing up boundaries.’”

The most obvious reason why the U.S. would encourage Russia to undermine OPEC is that the U.S. remains a net importer of oil. It will benefit enormously from the reduced oil prices that are sure to follow last week’s announcement. And as the banker noted, the U.S. can consume Russian oil in the future without having to be concerned about being dependent on it. “There will still be that oil in the Gulf, and the U.S. can always just go in and take it,” he said. “They’ll have to sell to someone and they’ll have to sell to us.”

For years this newspaper has criticized journalists and politicians for celebrating a “friendship” between Russia and the United States that was manifestly not there. For all the cheerleading of the privatization era, the mutual interests between the two countries back then were really restricted to a few cynical and self-serving politicians and businessmen on both sides.

But whether or not you feel like celebrating this new relationship between Russia and the United States, there’s no denying that in the last two months the friendship, if you want to call it that, has become a fact. For the first time since World War II, Russia and the United States are Mutually Interested— and this is something that naysayers like us may have to get used to.

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