March 26, 2020 (01:29)

Russia, where are you rushing off to?

Sergey Khestanov – Russian economist, associate professor of ‘The Russian Presidential Academy of National Economy and Public Administration‘, macroeconomic adviser to the general director of the Moscow investment company ‘Otkrytie Broker’.

 

 

The dependence of the Russian economy on oil prices is quite high: officially, about a third of the federal budget revenues come from export earnings, of which about 80% are in the oil and gas sector. However, the figure of “about a third” is a very crafty estimate. This estimate does not take into account those sectors of economy that are not exporters, but at the same time either work for exporters or are highly dependent on exports. Taking into account the latter, the dependence of the Russian economy on exports reaches 50-60%. This leads to the fact that all the main indicators of the Russian economy are highly dependent on oil prices. The picture is especially dramatic given the history of the fall in oil prices from 1986 to 1991, which caused the collapse of the USSR.

 

Russia rather unexpectedly decided to withdraw from the OPEC+ arrangement. Many, including the managers of the TOP 10 Russian private oil companies, were very surprised by this decision. The tactical consequences of this decision turned out to be simple and quite predictable: oil prices (both Brent and WTI) fell sharply. The Russian ruble and Russian stock indices fell sharply. These consequences have not been yet fully transferred into price increases (and decrease of imports) for Russian consumers, but it is already clear that they will be significant. The scale of the decline in the welfare of Russian citizens will be no less than during 2014-2015 or even higher than that.

 

It can be argued for a long time that the OPEC+ arrangement itself was doomed to collapse sooner or later: it is impossible to reduce production infinitely long, giving up market share to countries that are not participants in the OPEC+ arrangement. Sooner or later, the loss of market share would force to abandon the OPEC+ arrangement. The growth of oil production in the USA looks especially dramatic to OPEC+ countries, as the volume of oil production in the USA has more than tripled since 2013. This is a very significant increase, given that from 1971 to 2013, US oil production was steadily declining.

 

And, suddenly, a rapid growth began in 2013. It is noteworthy that the rate of this growth was many times higher than the rate of decline in production in the period from 1971 to 2013. The reversal of a trend lasting more than 40 years is an extremely interesting phenomenon: something very serious must happen in order for the decline in production, which lasted more than 40 years, to give way to rapid growth. And a possible reason for this is the fact that investors realize that the role of oil as a strategic raw material will begin to decline relatively soon. At the same time, oil companies are rushing to produce oil and sell more, until a drop in demand takes place.

 

There have already been similar precedents in the history of economics, namely, a strong drop in demand for fossil nitrate after the discovery of the synthesis of ammonia, urea and carbamide from carbon dioxide (which is 70% nitrogen). This discovery devalued fossil nitrate, the role of which decreased, as it has lost the status of strategic raw material and has acquired the role of local fertilizer. Perhaps, within about 10 years, an energy transfer is coming, which will fundamentally reduce consumption of fossil fuels.

 

But even if we assume that a noticeable decrease in oil consumption will occur over the next 10 years, then in this case, the cartel strategy looks more rational too. It is still impossible to strongly increase exports in a falling market. The price will fall strongly, because the oil market is very inelastic and even a slight imbalance in supply and demand causes significant price fluctuations. And it happened this way: after the collapse of the transaction, the price has already fallen by one and a half times.

 

In addition to falling prices, there is a classic price war on behalf of the Kingdom of Saudi Arabia. Saudi Aramco trailers intentionally offer significant discounts to buyers of Russian oil. Unfortunately, the Russian and Saudi (and Iranian) oil are slightly different, which allows them to compete fiercely with each other. Logistics of supplies implies a time lag of about two to three months, after which the scale of the problem will become clear.

 

There have been no precedents for such aggressive dumping in the recent past, therefore it is too early to draw conclusions earlier than three months later. The drop in Russian oil exports alone will provide very interesting material for analysis. The fall in the price of Russian oil also creates another problem – part of Russian production may become unprofitable. Most Russian deposits are quite old, and require significant maintenance costs. If the price remains low for a long time (more than a year), a drop in production is very, very likely. And the drama of the USSR collapse is not only a drama of falling prices, but also a drama of falling production.

 

Unlike export volumes, the price fell immediately after Russia refused to cooperate. The national currency, ruble, immediately reacted with a fall, the central bank of the Russian Federation announced supportive measures of the national currency, as a referendum on amendments to the Constitution is expected on April 22 in Russia. A common practice in such cases is support of the exchange rate by the authorities and control of inflation by means of administrative measures. Something similar is taking place now.

 

However, after April 22, this support will cease, and then the Russians will feel all the consequences of a sharp weakening of the ruble, namely, rising prices. Even with the devaluation that has already passed, price increases will be significant.

 

About a third of the average Russian consumer basket is imported, so inflation will accelerate seriously. However, indexation of pensions, allowances and salaries of budget employees, if any, will obviously not block inflation. In addition to price increases, there will also be a change in the structure of citizens’ consumption: demand will shift to cheaper goods. The consumption of imported goods will decrease, as imported goods will increase in price more than anything else. Trade will collapse, part of retail trade will leave the market, unemployment is expected to grow, rising prices will hit all sectors of the business, which somehow supply private consumption, tax collections from citizens will be reduced.

 

The state-owned companies, on the contrary, are not particularly threatened. Only those who are not exporters will have to optimize costs. The exporters will be strongly supported with the weakening of the ruble. Especially given that the devaluation period can be long.

 

Devaluation will also help the federal budget. The collapse in oil prices has already caused a deficit of about 0.8% of GDP instead of a very recent surplus. The easiest way to compensate the deficit is by weakening of the ruble.

 

Thus, the reaction of the oil market and the ruble exchange rate that has already taken place allows us to conclude that Russia’s GDP in 2020 will fall by 1.5-2%, and inflation will rise to 10-15%. And these are only preliminary estimates, provided that the price of oil does fall even lower. And this cannot be ruled out.

 

Another risk is decline in oil production. The decline in production greatly affects the economy of oil companies, as they have a considerable share of fixed costs (maintenance of infrastructure). And these costs will have to be allocated to a smaller amount of produced oil.

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