What Makes Russia's Economy Run?

Russia Is Headed for Recession

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Most Russians applaud Putin's tough military standoff against the West. Photo: Getty Images

Russia's economy is $3.47 trillion as measured by Gross Domestic Product (GDP). It was the seventh largest in the world in 2015. Russia has a mixed economy.  It's come a long way since the 1991 breakup of the Soviet Union and its command economy.

Today, only the oil and gas sectors are state-owned. Gazprom is Russia’s state-owned gas company, and owns the world's largest gas reserves. But they are declining, and prices have fallen.

 Rosneft is 69% controlled by the state, 20% owned by BP and 20% publicly-traded. But it has severe financial problems. The rest has been privatized. (Source: "Russia's Wounded Giant," The Economist, May 23, 2013."Russian Oil Major Rosneft Seeking Government Relief," Forbes, October 22, 2014. )

Most experts agree that Russia's economy is controlled by a small circle of powerful oligarchs. These well-placed, extremely wealthy insiders either own or manage most strategically important Russian businesses. Contrary to popular opinion, President Vladimir Putin doesn't control them, but instead mediates their competing interests. This system started in the 1400s, during the expansion of the Grand Duchy of Muscovy, and operated successfully through czars and Communist regimes. (Source: New York Times, Russia's Oligarchy Alive and Well, December 13, 2013)

Russia's Aggression in Ukraine Threw It Into a Recession

The United States and European Union imposed trade sanctions on Russia in 2014.

 That targeted the pocketbooks of the country's oligarchs. As a result, they've sent $75 billion out of the country, or 4% of the country's entire economic output as measured by GDP.  In January 2015, Standard & Poor's cut Russia's credit rating to junk bond status, the first time in more than a decade.

(Source: Chiara Albanese, "Russia Rating Slips to Junk," Wall Street Journal, January 27, 2015)

The International Monetary Fund correctly warned that Russia would be in recession in 2015. In fact, its economy contracted 3.9%. It wasn't just the sanctions that did it. Russia's economy was crippled by low oil prices and a plummeting ruble. For more, see "Ruble, Ruble, Oil and Trouble."

In 2014, Russia invaded Crimea to secure its only warm-water port. Putin covertly supported rebels who want to secede from the EU-friendly leadership in Kiev. Russian military equipment was used to shoot down a Malaysian Airlines commercial jet in July 2014. For more see Ukraine Crisis.

Russia Is the Energy Supplier to Europe

Russia supplies 30% of Europe’s oil and 24% of its natural gas. It aggressively use pipeline politics to get its way. It invaded Crimea to keep access to the warm-water port when Ukraine made attempts to join the European Union. Putin knows that the EU hesitates to defend Ukraine because it can't afford to lose its energy supply.

Would Putin actually do that? Absolutely. In 2006, he cut off gas supplies to the Ukraine, through which Europe’s gas must flow, in a successful bid to charge higher prices.

Putin used energy revenues to diversify into other European businesses. That means any sanctions on Russia's economy will hurt these companies, as well. 

He's also put pressure on foreign energy contractors to increase their profit-sharing to Russia. In the past, Russia has:

  • Arbitrarily changed its agreements with Royal Dutch Shell and ExxonMobil.
  • Granted a license to the Russian-owned oil company Rosneft to operate in ExxonMobil’s area.
  • Revoked Shell’s license for a $20 billion Liquified Natural Gas project at the Sakhalin-2 island.

On the other hand, the EU is concerned that Russia doesn't have the infrastructure to meet is future energy needs. To do that, Russia needs $738 billion in investment by 2020. 

Russia Invaded Georgia

In 2008, Russia used its peace-keeping troops inside Georgia to capture the city of Gori and the state of Abkhazia.

This was in response to Georgia's invasion of South Ossetia, another semi-autonomous state along Georgia's border with Russia. Abkhazia and South Ossetia wanted independence from Georgia.

Georgia is in a strategic location between Europe and Asia. It's an important transit point for gas, oil and other goods by building the Baku-T'bilisi-Erzerum gas pipeline, and the Kars-Akhalkalaki Railroad. In fact, Russia attacked the area that contains the important Baku-Tbilisi-Ceyhan oil pipeline, owned by British Petroleum. (Source: The Economist, Georgia and Russia rattle sabers, April 20, 3008; IHT, Fighting escalates in Caucasus, August 9, 2008; CIA World Factbook)

Former Georgian President Mikheil Saakashvili courted U.S. alliances. Georgia and Ukraine, both members of the World Trade Organization, threatened to block Russia's WTO nomination. Germany and other EU members blocked U.S. attempts to give Georgia and Ukraine NATO membership. For more, see Five Years On, Georgia Makes Up with Russia.

Russia's Complicated Relationship with the World Trade Organization

Russia became a member of the WTO on August 22, 2012. This allowed Russian businesses greater access to foreign markets, allowing its economy to expand beyond energy. Foreign companies such as Shell, Boeing and Ford could now profit from joint ventures, including exploration of Russia’s natural gas resources.

In 2006, Russia and the United States signed a landmark trade agreement that helped its membership process. The agreement reduced tariffs on cars, increases foreign ownership of financial businesses, and protects of intellectual property rights. Russia relaxed its insistence on inspection of all meat products.

The U.S. also approved Permanent Normal Trade Relations (PNTR) with Russia. That means removing a Cold War-era trade restriction known as the Jackson-Vanik amendment that linked U.S. trade benefits to the emigration policies of communist countries. Congress approved PNTR for Ukraine, which became a WTO member in 2008. 

Gazprom and Sakhalin-2

Russia is positioning the state-owned gas company Gazprom to take control of all the natural gas the country produces. Most of which has been promised to China, Japan and other Asian countries. Russia has close to one-third of the world's proven natural gas reserves, but controls only 20% through Gazprom.

Gazprom bought majority ownership in the Sakhalin-2 energy project for $7.45 billion on December 15, 2006. Sakhalin-2 is the largest integrated gas-and-oil drilling project in the world and, at $20 billion, the largest Foreign Direct Investment (FDI) in Russia.

Sakhalin-2 will access 10% of the Sakhalin Shelf off the northwestern coast of Siberia. The Shelf is estimated to contain 1.2 billion barrels of oil and 17.1 trillion cubic feet of natural gas. Sakhalin-2 was run by Sakhalin Energy, a consortium of Dutch-based Shell Oil and the Japanese companies Mitsui and Diamond Gas (Mitsubishi). In 2005, Shell doubled its estimated completion cost to $22 billion, and extended the estimated completion date to 2008.

In 2006, Russia threatened to revoke the project's environmental license, on grounds it would destroy the feeding grounds of the last 123 Western Gray Whales, leading to their extinction. The threat was also a ploy to allow Gazprom to gain control of the foreign-financed project, which is now 80% complete. In this way, Russia gained more of the profit from oil and gas sales.

The original agreement, which was signed during the Boris Yeltsin days, did not allow Russia to profit until all costs were reimbursed. When gas prices rose, Russia used its regulatory powers to renegotiate the terms of the agreement.

In May 2007, Gazprom announced plans to buy all the natural gas produced by Sakhalin-1, in which Japan has a 30% investment. This means that all the natural gas would go to Russia, and none to Japan, despite the years of financial investment and technical expertise Japanese companies brought to the project. This announcement came just months after Gazprom bought majority ownership in Sakhalin 2.

Sakhalin-1 was more difficult for Gazprom to take over than Sakhalin-2 was, according to Tass, the Russian news agency. That is because Sakhalin-2 was coming in way over budget, giving the government an excuse to “find” environmental regulations that had been violated. Sakhalin-1 is operating as planned, so any government take-over will be more blatant and difficult to finesse.