RUSSIA:

Heritage Foundation panel discusses Russia's growing influence on energy issues

Russian President Vladimir Putin has said energy security will be a top priority at the Group of Eight Summit in Russia this summer. But some foreign officials are concerned that Russia is using its oil and gas assets as a political weapon against energy-dependent nations. Today's E&ETV Event Coverage features experts discussing this issue at a Heritage Foundation event earlier this month, with remarks from Dr. Margarita Balmaceda of Harvard University, Dr. Stephen Blank of the U.S. Army War College, Dr. Ariel Cohen of the Heritage Foundation, Adnan Vatansever of the Institute for the Analysis of Global Security and Andrew Kuchins of the Carnegie Endowment for International Peace.

Transcript

Andrew Kuchins: It's remarkable how much we can understand, I think, about Russian realities today by looking simply at the oil price. That's just not the case today, but I think it's been the case for several decades actually, going back to the first oil crisis in 1973. I think we can track a remarkably strong correlation between the oil price, or more specifically, the revenues which the Russian government is able to take in from oil and gas exports, with several issues; economic growth obviously. Also, the impetus or lack there of for structural economic reform. I'd also argue that there is a very strong inverse correlation between the oil price and Russian proclivity to democratization or lack thereof. And the topic today, I think, is a direct correlation between the oil price and Russia's assertiveness in foreign policy.

So what we're seeing today is not exactly new, is that we've seen this kind of assertiveness in the Soviet period from 1973 to '86 when high oil prices were fueling a very assertive Russian foreign policy, the demise of d├ętente, the competition in Asia, Africa, Latin America, the Afghan war, etc. Cliff Gaddy and Barry Ickes have done a very interesting study in which they indicated that at its peak Soviet revenues from oil and gas exports amounted to about $250 billion per year in 2005 dollars. In 1998, it amounted to about $25 billion. I'd say that that kind of dough, in a highly centralized political system, can buy you a lot of clout.

These questions about Russia's reliabilities and energy supply or its willingness to use energy as a political tool, even as a means to re-establish an old empire, to put it in very provocative terms. These questions had come into high relief on January 1, of course as we all know, with a decision of Moscow to cut off gas supplies to Ukraine, the same day in which Russia took over the chairmanship of the G8. The main theme being energy security. No doubt this indicates Moscow's rather dark and ironic wit. But let's also note that questions about Europe's energy dependence, dependence on Russian gas and political linkage it affords Moscow, is also not a new question. This was first raised, as I recall, in this town in the early 1980s with the dispute between the Reagan administration and our European allies about the advisability of the gas pipeline.

So are we talking about old wine in new bottles or new gas in old and new pipes? I don't know, but there's no question that the dramatic increase in energy revenues has fueled Russia's virtual macro economic miracle. And it has many buzzing in Moscow about Russia's new status as an energy superpower. And the question that our distinguished panelists will be addressing today is just how Russia is using its energy assets; oil, gas, electricity, nuclear power. How it's using those assets to serve its foreign policy goals or political goals as opposed to serve commercial interests. Or to what extent do those interests actually coincide?

So with that lengthy introduction, let me also note that this session today is to mark a new series titled Russian Foreign Energy Policy Report Series, which is directly addressing these questions. There'll be nine reports total I believe in the series. And we have four of the authors today for the recently, or to be published, published reports.

Adnan Vatansever: Now what I'm going to speak about is part about Bulgaria, but I just want to go over broader trends, which is about the involvement of professional companies in the petroleum sector beyond their borders, basically in Europe and part of Western former Soviet Union republics.

And I want to start with a piece of news that I saw about two weeks ago. The head of Russia's largest oil company, Lukoil, announced that in the near future they are planning to involve in very large scale acquisitions beyond their borders. Now this appears to be an interesting announcement. And the details of their plans are not disclosed yet, so we don't know what exactly are the targets. They have said that it's going to be somewhere in the U.S. and also in Europe, but have not specified the exact acquisition targets.

Now this appears to be an indication for just another way of acquisitions by Russian oil companies in areas beyond Russia. There was another wave of acquisitions, which started in '98. And between '98 and 2000 there were like a lot of refineries in Eastern Europe that were taken over by Russian oil companies. Now I just want to go over this whole waves of acquisitions and mainly address three major questions.

The first question is what has driven Russian oil companies beyond their borders? The second is why their major targets have been in Eastern Europe? And the third question is what has been the approach of the Russian government towards these kinds of acquisitions?

Now regarding the first question, why Russian companies have expanded beyond their borders. The common wisdom has been that in the past few years the oil prices have gone up and these companies are quite rich in terms of cash. And they simply can afford spending some money for acquiring assets abroad. Now if we go more into details and revise the, and review the strategies of Russian oil companies, it appears that the issue is actually quite more complex.

If we go back to the leading company in Russia, Lukoil, which actually initiated this process of acquisitions abroad it appears that they started thinking about acquisitions as early as sometime in 1997. And their first acquisition occurred in '98 in Romania. And after that by '99 they had two more refineries in Bulgaria and Ukraine. And this is basically a period of very low oil prices, which is actually quite surprising that they have started this strategy much of earlier. And it doesn't have really much to do with oil prices.

Now the later acquisitions, which we have seen in the following years, has to do with oil prices, but overall the strategy is much more complex. So I've reviewed the strategies of several companies and found out that there are basically several reasons why they have expanded abroad.

Now first of all it has to do with issues that are peculiar to Russia. Now if we look at the Russian oil sector it appears that by late 90s the oil sector had consolidated around ten companies. And the available assets for acquiring were getting smaller and smaller and getting more expensive because Russian companies were competing with each other and bidding up the price. Thus assets beyond Russia's borders, especially in Eastern Europe, started to appear quite attractive.

Now the next reason is that, again, related to Russian specifics. It is that Russia is too large and also it has serious constraints. It has had serious constraints regarding its export infrastructure, export for crude. Given these circumstances there have been quite frequent collapses of the domestic oil market. The fuel prices have collapsed quite often. And this has resulted in serious consequences for the oil companies. As a result, many of them have perceived that expanding into Eastern Europe can be just a means to minimize their risks. This is just another kind of vertical integration that is going to minimize their losses in the future in case of a price collapse within Russia.

Now another thing is that many of these companies have perceived themselves to be on par with international oil majors. And if we look at some big numbers, mainly about their reserves, it appears that many of them are actually quite above some biggest international oil companies.

If we look for instance at Lukoil, they have announced that they are second in terms of reserves, just after Exxon Mobile. And actually about a month ago they announced that they have made some new acquisitions and new discoveries in the Caspian region. And they might be actually number one private oil company in the world in terms of reserves, crude oil reserves.

So what they have seen is that, they have perceived that if they expand beyond borders, if they turn into international majors, they are simply, this is simply what should be expected from them because they are just another large company that should operate in world.

Now another reason for their expansion, again, has to do with the specific environment of Russia. It has to do with mainly about taxation of exported crude. What most companies have hoped is that if they have assets, if they have refineries abroad, they are going to be able to export a larger share of their production.

And the next question which I want to address is why Eastern Europe has emerged as the primary area for Russian oil company acquisitions. Now one of the reasons is it has to do, again, with the timing of the privatization within Russia's oil sector and the privatization in Eastern Europe. In Russia it occurred in mid-90s and it was pretty much completed by the end of '90s, so you had about ten companies. It continued afterwards, but there were smaller pieces that were privatized.

When we look in Eastern Europe and countries like Ukraine or the Baltics also, what we see is that major privatizations occurred at the end of '90s. So simply there were available assets for taking, to be taken over by foreign companies.

Now the interesting thing was that Western oil companies did not show much interest in these assets there simply because in many of these countries the oil prices, the fuel prices were regulated. And it was quite clear that these companies would be making losses if they got involved there. For Russian companies this was much more familiar environment. The lack of transparency in tenders or in the take over deals was simply something that they were used to work with already in Russia.

And the other thing was that the local authorities, in many of these countries, were pretty much positive about Russian acquisitions at that time. This is particularly true about several countries where the oil sector was suffering seriously because of lack of access to crude. This was, for instance, the case in Bulgaria, in Ukraine and Romania, where Lukoil acquired refineries in each of these countries. This was much less the case in Central Europe where the oil sector was much stronger financially. And Russian companies try to acquire assets there, but they failed to acquire them.

And probably the other reason that they wanted to involve there was that Russian companies had a much more optimistic view about the prospects of the fuel market in this region. Simply if you look at the car ownership rate there, it was much smaller and it was expected to grow. And they expected that the demand is going to grow so having a refinery would be quite beneficial in this particular region.

Now the final question that I want to address is about the stance of the Russian government regarding these Russian oil company acquisitions. Now overall, you can see lots of announcements by Russian officials, which have perceived this as a kind of leverage, which is going to be quite useful in the future in dealing with these countries. Simply many of them have become members of NATO. Many of them have become members of the E.U. And some of them are going to join, like Bulgaria and Romania. And having Russian oil companies operating there with large assets was considered as an important leverage.

Now certainly there was not unanimity within the Russian government about these takeovers. Some of them considered this as a reason for capital flight. And these companies should not be allowed to do that. They should invest within Russian oil refineries themselves. But Putin especially was very supportive. He always claimed that this could be considered as capital flight, but it's a price that Russia needs to pay, just for foreign policy purposes.

And if you review Putin's statements for the past few years, you can see that Putin has, in many instances, he has praised Lukoil for being a leader in these kinds of acquisitions. And several years ago he was urging Yukos to do the same as Yukos was gradually emerging as the biggest company in Russia. And Yukos did involve in major acquisitions like in Lithuania it got a refinery complex. It got a mid stream assets, a company in Slovakia. And it got involved in the reversion of Adria pipeline system.

Now having said this, it would be probably an exaggeration to say that Russian government's involvement here is basically in terms of planning Russian acquisitions. It would be really probably wrong to say that Russian government planned any of these acquisitions at all. Now probably the most important proof of that was the peak period was '98 and 2000 for these acquisitions. And the Russian government was quite weak at that time versus oil companies. Most of them were able to define their goals quite autonomously.

The other thing was that many of these acquisitions were, in many of these acquisitions the stance of the government was coordinated very poorly. You can see several Russian companies bidding together, not together, but bidding against each other for the same asset in Eastern Europe. And they were trying to get the support of different officials within the Russian government. And it was not clear which, who is supporting whom at that point.

And the final thing what could be said about Russian government involvement was that their support was mainly verbal. And in practice they haven't done much for the Russian oil companies. For instance, many of them, as I said, expected that they would get extra export allocations thanks to having assets abroad. But this did not happen.

If you look at the numbers of Lukoil, they have emerged as one of the companies that has one of the lowest ratio for export versus production in Russia today. And even though they have quite a lot of sizable assets beyond Russia's borders. Now all of this does not mean that if we have another wave of acquisitions Russian government stance would be the same. It could be quite different from now.

And actually there are three novelties that have occurred in the past year. I just want to go over briefly over them. The first one is that Russian government has expanded its influence in the oil sector. It is controlling several companies already and it has much stronger power versus the oil companies versus private oil companies, such as Lukoil. The other thing is that Gazprom, as a result of its acquisition of Sibneft, has emerged as just, as another oil player, not just gas player, but oil player in the Russian energy sector.

And the third thing is that as Russian oil companies have grown, in terms of production, their valuation has also grown in the past few years. And currently many of them stand at, in terms of value, at around $60 to $80 billion. Compared to some central European companies this is quite a big number.

A few years ago they were pretty much on the same ranks with some of the central European companies, which were able to resist the acquisition of Russian oil companies. Now the gap is pretty huge.

Now again, I just want to go over Bulgaria, what happened to Bulgaria specifically in terms of Russian involvement? Now Bulgaria is a specific case here because it appears to be the country that has emerged as the most dependent on Russian energy outside the former Soviet Union space. That is the most dependent Eastern European country.

Now if we look at its oil sector, it has one single operating refinery, which is controlled by Lukoil. Its retail fuel outlets are controlled by Lukoil and partly by Petrol, a company, a Bulgarian company, but backed primarily by Russian capital. Its gas sector, it imports 100 percent of its gas from Russia. And it has very negligible domestic gas production. And its power generation, it has a nuclear power plant which produces about 40 percent of the electricity. And this plant depends on Russian nuclear fuels.

Now within this context it is really interesting to see how Gazprom is trying to leverage its position. As I said, it is already providing 100 percent of the gas for Bulgaria. And it has recently pressed the government to revise the existing transit deals as Bulgaria is transiting about 60 to 70 billion cubic meters for Turkey and for Greece. And not similar to Ukraine, but quite much in the same direction, Gazprom has pressed the Bulgarian government to revise the treaty so that it could be more beneficial in terms of prices for the Russian company.

In the meantime we see the implications of Gazprom's emerging as an oil company also. It has shown interest in building the Burgas-Alexandroupoli pipeline and the future of this pipeline depends very much on the Russian, what they are going to say, if they are going to support it. And another thing is that quite recently there was a tender for the nuclear, for establishing a nuclear power plant, a second nuclear power plant in Bulgaria. And it appears that there were two companies that bid for this plant, for constructing this plant. And one of the companies is controlled by Gazprom and the other company, in the other company, Gazprom has a major stake.

Now to summarize this, it appears that Gazprom is trying to use its leverage to get control, to expand its involvement further into the sector, such as getting control of Bulgaria's gas pipeline system. And as a response to all of these demands the Bulgarian government, its response has been quite interesting. They have simply said that they are too small to deal with Gazprom and they simply have to submit to at least some of the demands of Gazprom. Thank you.

Margarita Balmaceda: We have a great start. I don't know whether I can do as well as you have presented the framework for the users. Many of you followed the January crisis in Ukrainian-Russian gas relations. For me this crisis was very important, not only because of its direct implication for, implications for Ukraine and for Europe, but also because of what it tells us, more generally, about the sources of foreign policy in the former Soviet Bloc. What do I mean?

Basically this crisis has led us to think again about the relationship between the business and the state in Russian foreign policy. I must confess that in the last years I had grown somewhat skeptical about the view that the Russian state could dictate the behavior of companies or use them for foreign policy goals. And I must say that the January crisis has forced me to rethink my hunches, but actually it has forced me to rethink them twice. And I'll get to these in a few minutes.

But first let me give you a little bit of a framework of how do I look at the question of the relationship between state and business in Russian energy policy? Very often people ask me, if you go to Eastern Europe this is the number one question, who has the upper hand in Russian policy towards Eastern Europe? The government or the oil and gas companies? And we could look at this question for ages, forever.

Is the state using the companies for its interests or are the companies using the state for their interests? But I think that in order to understand this we need to understand that the issue goes beyond whether there is a coincidence of interests between state and companies. But we need to look at the existence of all kinds of interests within some of these economic actors within some of these companies.

For example, in the case of Gazprom, we have seen that what I call private interests within the corporation. These interests have been very, very strong, especially until 2001 when Mr. Yakitiv was eased out of the chairmanship of the company. We have seen many, many situations where the interests of top managers within these companies have often competed or taken precedence over the interest of the corporation as a corporation.

And it is exactly this question, of how those private interests within the corporation are going to fit in with the foreign policy aspect, which is the question that I find most exciting today. It is looking at this question that perhaps gives us a sense of what is new in this situation. But for understanding this, for understanding the situation, we need also to understand the domestic situation in the countries we are talking about.

And it is looking at these domestic situations that perhaps helps us understand the paradox for example of a situation where, in the case of Ukraine, where relations have been quite strained. Even before the oil revolution, Russian energy companies had indeed been able to make very significant inroads, what has to be because of the rules, where theoretically they should be building up, you know, state, energy relations have been quite strained.

We need to look at the domestic side of the question because in countries like Ukraine and in all the countries in the region, the energy sector has been a primary arena for the collusion between kinds of transparent or untransparent interests across the border. And those interests are very often able to accrue very significant profits, very significant rents, exactly from the situation of energy dependency. This is what I call the rents of energy dependency.

And it is the struggle for these rents, for this profit, that very often drives the energy policy situation in some of these countries. In the case of Belarus, let me say two words about the case of Belarus and then I will say a few words about the case of Ukraine. What we have seen is a situation where President Lukashenko has used its relationship with Russia to maintain Belarus economically and energy dependent on Russia. But in a way that is, at least in the short term, advantageous to Belarus.

He has been able to use his political relationship with Moscow to accrue for Belarus lower, relatively low gas and oil prices. Not only in order to keep the whole Belarusian economy afloat, which is quite a feat because this economy could not go very far without that help, but more directly to finance his own power. And you know that their election is coming up in Belarus in two weeks.

And there are a number of ways in which such rents of dependency, in a larger political sense, have been accrued in the Belarusian-Russian relationship through the indirect subsidization of the whole economy, through lower than international prices for oil and gas, through the possibilities opened by barter arrangements, through the extra income Belarus receives through transit, through semi-legal energy transactions. And most importantly through the direct and indirect re-export of energy sources.

Adnan spoke about the role of refineries as a way for Russian companies to go around some of the export restrictions imposed by the Russian government, to go around some of the pipeline capacity limits. Russian oil companies have found it very advantageous to refine their oil in Belarus and export it farther. I'm not going to talk about the issue of ownership of these refineries. This is something I do in great detail in the report I wrote for a series, but important thing here is that these also provides tremendous income for Belarus, last year about $4 billion. In fact, this accounted to about 33 percent of Belarus' total exports. That is a huge role.

In general we could argue that Gazprom's, and to a certain extent the oil companies, interest in Belarus and those of the Russian state are compatible; to safeguard transit, Belarus' role in gas transit to Western Europe, to maintain political influence in Belarus. However, what we see is not so much a simple coincidence of interests, but a situation where companies such as Gazprom, by acquiescing to giving Belarus lower than international prices, acquire points in their relationship with the Russian state that they can later cash in in other situations. And this is very interesting. It's also related to Gazprom's acquisition and redemption of points within Russia.

So what we see is a situation where the company's, Gazprom's relationship with the state, seems to be different in the case of Belarus and the case of Ukraine. In the case of Belarus we seem to see a situation where its behavior in Belarus is a kind of continuation of its behavior inside Russia, this kind of conversion of points situation. In the case of Ukraine, and I'm going to talk about Ukraine in 30 seconds, what we see is a situation where those private interests within the corporation have played a much larger role.

Let me turn to the Ukrainian case. I'd like to make some sense of the Russian Ukrainian gas crisis. If you're interested in the gas crisis, we at the Harvard Ukrainian Institute hosted a conference just three weeks after the crisis. It's on the Web under HURI Harvard Edu, the whole video. So if you're interested in all the details you can look at that. But let me just say, tell you a little bit about my true readings of this crisis.

First there is the, what I would call the state interest story. The straight story of state interests, Ukrainian state interest, versus Russian state interests. On January 1, as you know, Russia stopped gas deliveries to the Ukraine threatening to bring the Ukrainian economy to a standstill. At issue was, officially, the question of prices. This is a little bit a complex issue because there was a valid contract or a seemingly valid contract in place. So we know that the reality went well beyond prices.

We know that Russia was willing to use the threat of stopping gas supplies to the Ukraine for foreign policy purposes. In particular to get Ukraine to join a pro-Russian economic political and military bloc and to keep Ukraine from joining a Western oriented political and economic bloc. And also to consolidate Gazprom's control over Ukrainian pipelines.

So in this first reading of the situation the stoppage of gas supplies and the threat of stopping gas supplies is used as a way for Russia to impose on Ukraine a certain foreign policy behavior.

The second reading is the after January 4 story, the private interest story. And if you look at the story as it developed after January 4, and especially as it developed in Ukraine after January 4, and as more and more details of the situation came to light after January 4, the story is a much more complex one. A much more complex one because as more and more details emerge of the actual agreement that was signed between Russia and Ukraine on January 4 and older agreements that have not been made public, the idea of Ukraine as a victim pressured by Russia, that doesn't seem to hold so much water anymore.

What seemed to be at play here was a situation where the future of Ukraine was now being decided not even in the Kremlin, but it was being decided somewhere under the table. But in Moscow, Kiev, Vienna, Switzerland, these are all cities which are related to the company Ross uker Inervo, which now takes the larger role in this situation. And a situation where all kind of very strange actors are going to benefit from that situation of energy dependency.

Leaving aside the question of prices, this agreement is terrible for Ukraine. And mainly, I know I'm short of time, because it spells big trouble on one area which I personally think is very important, which is called contractual diversification. Diversification is not only about where your gas comes from, it's not only about the nationality of your gas. It's what kind of contracts you have. And yes, according to new contracts, Ukraine will import more gas from Turkmenistan. However, all of those contracts are going to be done not even to Russia, but by one single firm and that firm is now going to control all gas imports that Ukraine receives. So that is zero contractual diversification, even when there is seemingly geographical diversification.

Was this an alternative that Ukraine had to agree to because otherwise Russia would have applied direct economic pressure for foreign policy goals? Or is it simply that too many people on the Ukrainian side and the Russian side have found it profitable to agree to this? And my own research on Ukraine and energy policy, which I conducted in Kiev for a year, tells me that this is probably the case.

Now there is still a third reading and I'm going to finish with this third reading. As events in the Ukraine continue to unfold a third reading of the situation starts to speak louder and louder. And this is a reading which talks about a situation where, yes, there're private interests within corporations, within Gazprom, within Naftogaz of Ukraine entity, Ukrainian oil and gas company, that are benefiting from this mathiolite agreements. But there seems to also be a situation where the Russian state, or more completely President Putin, is using these semi legal, semi mathiolite agreements to pursue foreign policy goals and to bring trouble to Ukraine.

We think of Mr. Putin as somebody who brought order to the Russian house. This doesn't seem to be the case. There is so many, there's so much evidence that he's also involved with some of these companies. So what we see here is a new kind of game. Not the direct use of energy companies for foreign policy goals, not the simple use of these companies for the private benefit of managers of these companies, who may be making a buck or a lot of bucks on the side through the establishment of shell companies and so on. But a much more dangerous game.

Again where those under the table mechanisms may be used for the pursuit of foreign policy goals. And let me say that foreign policy goals can be many things. Encouraging corruption in the Ukraine, making it continuously attractive for managers in Ukraine to acquiesce to these corrupt goals, is a great way to weaken Ukraine and to make it impossible for Ukraine to be energy independent. This is just, in a nutshell, how I see the situation. And I thank you for your attention.

Stephen Blank: I have to state first that what I'm about to say does not in any way represent the views of the Army, the Defense Department or the government. The question of Russian and Chinese energy relationships is a huge topic, far too big to be settled in 15 minutes here. The topic alone of Chinese energy policy has received enormous attention and rightfully so because of the size for China's growing demand for energy and the geopolitical repercussions of that factor alone. And then when you add the Russian factor you've really covered the waterfront.

Now for example, in the Sino-Russian relationship as such, there's a tendency, and I think it's a justified tendency, to believe that Russia and China are pursuing a course of political and even military alliance, or partnership at any rate, against American interests in Central Asia and East Asia. And that's certainly true.

We're not going to discuss that today here. Rather I'm going to focus on the energy relationship of these two countries, which is much more contentious, anything but effective partnership. It also, however, is not just simply confined to East Asia. It is also very important in any analysis of what is happening today and what may happen tomorrow in Central Asia, just as the Ukrainian case has great relevance to Turkmenistan and perhaps other Central Asian energy producers. So there's the Russo-Chinese, and for that matter, the whole Russo-Asian. And that would be if you were looking at Japan, South Korea and for that matter India as well.

What strikes you as you start looking at Russo-Chinese energy relationships is that they are not driven by market logic. Rather politics is in command. And by politics I mean not only foreign affairs and geopolitical aims, which most of us can readily understand in terms of Russo-Chinese relationships by following the media and the relevant academic sources. Or even sometimes just looking at a map long enough. An art that's being lost in American schools as I can attest from personal experience.

But it's also bureaucratic politics within Russia. As a matter of fact the bureaucratic politics within Russia coincide with the foreign policy struggles over the question of providing oil and gas to East Asian countries. So if you were to look not just at China, but at South Korea and Japan, you'd see that the lineup on that issue of providing, whether it's gas or oil, and they're two very different situations, lines up very nicely with certain segments of the Russian bureaucracy take the position that Japan and South Korea and China have taken. And others take different positions, depending on which state we're talking about. So you are dealing with the classic two level game, if you like, in political science with domestic politics and external politics as well.

China's energy policy, and I'm drastically summarizing here, is first of all to seek guaranteed and reliable energy access. And it's trying to do so on a global level. We all know they're in West Africa, they're in Latin America, they're all over the Gulf in the Middle East. They are looking at the East China Sea, the South China Sea and so on. The reason they are seeking global access is because the Chinese orientation is not to rely on the fact that they have money and can buy in the markets, which is the American view of how you do it. But rather China really wants to hold the energy in its hand from wellhead to wellhead as much as possible.

Furthermore, because China is not such a major importer and imports so much of its energy from the Gulf, about 15 to 17 percent from Iran alone. And big deals have been signed with the Saudis as well. China believes that its energy security, and hence its economic and thus domestic security rests on its ability to ensure that its energy supplies will not be interdicted in time of crisis by the U.S. Navy operating in the Indian Ocean and the Persian Gulf. Or by the explosion of some major crisis in the Persian Gulf. The Iran crisis right now and Iraq readily come to mind. If something were to happen Saudi Arabia would have a similar situation.

Therefore it needs to be able to rely on energy shipments that are reliable, large scale and that do not cross bodies of water that America can interdict. Hence it's driven to both Central Asia and Russia. It is however in a difficult situation when it comes to dealing with these states for a number of reasons. China believes that it needs to have equity ownership in energy production and refining operations. So it tries to buy these stakes at prices much higher than are justified even at today's high market prices.

And they are willing to pay top dollar. In return they will also sell you weapons, which is a rather nasty habit, but one we have to take into account. However, Russia, looking at China as an energy consumer, even though it's an ally and friend in many respects, sees an energy rival. Why is that? Russia is governed by the logic of monopoly. This is true for its politics and it's true for its energy sector, which is the key strategic economic sector in Russian politics.

In contest of Margarita, I would say that at least if you look at the Asian dimension, you really see state interference at a very high level and at a constant level. The problem is it is a state interference that is not focused on any particular strategic direction. And rather manifests itself as constant bureaucratic battles, the classic bureaucratic jungle if you like of Russian politics, dating back to late czarism. Anybody who has ever studied institutional history of Russia will recognize the phenomenon very quickly.

Russia will not, as part of the monopolist logic now, essentially allow private firms or foreign firms to have any meaningful equity ownership in its energy stakes. One of the reasons Yukos went under is because it was attempting to make a partnership with the American oil firms. The Kovykta experienced an example, Kovykinski gas field in Siberia is supposed to be the sort of great white hope of the future with regard to gas for China and South Korea. And that field was owned by a corporation called Russia Petroleum, which is really company jointly managed by British Petroleum and TNK.

Gazprom has destroyed any possibility of that company ever being able to sell gas to China. Why? Because Gazprom wants the monopoly. There's no other simple way to describe it. So what we find in this monopolist logic, whether we're talking about gas or oil, is that Russia is determined to prevent anybody else from selling directly to China or to prevent China from having equity ownership in Russian firms. You remember the controversy about Slovneft a few years back. And even if they say they will let China buy in Russian firms, the Chinese have figured out that this is really a plot to get them to subsidize Russian companies. It's a swindle in plain English.

The rivals here are institutional, Gazprom, Rosneft, Granneft, the Minister of Energy and the Ministry of Natural Resources. Now even though Deputy Prime Minister and Minister of Energy, Khristenko, just recently said that Asia is the future. And we look forward to selling the humongous amounts of energy to China, Japan and South Korea. The fact of the matter is that they're selling rather little at present. And basically only from Sakhalin, which is a multinational gas operation where you have Indians, you have Americans and Japanese and you have Shell. By the way, Shell is being steadily squeezed out by Gazprom and by some of its own missteps in this matter.

Furthermore, the oil that is now being sold to China goes by rail. And those of you who are in the energy business know this is an extraordinarily wasteful way of selling oil to China, which is desperate for the oil. And that the proposed pipelines, either from Angatta to Daching or from Angatta to Nahoytka, or more accurately ... have not even been started yet. Putin, in January, ordered the beginning of the construction. We will see to what extent this is carried out.

But under the best of circumstances Japan will not be receiving oil from China, and that's under the best of circumstances. I mean from Russia, excuse me, before 2012. That's a long way off. And Japan cannot afford to wait six more years on the basis of a maybe. Furthermore, the constant struggles between these ministries, some favoring pipelines to Japan, some favoring pipelines to China. And all of them trying to jack up the price of this so that the Chinese and South Koreans and Japanese will pay ever larger amounts to them to get the pipelines built. And those payments also include money under the table. We have to be quite obvious about that. Indicate that the primacy as well as rent seeking in these major bureaucracies. For example in Transneft, to take a different example, the vaunted pipeline to Mortemonsk, the question of where it's going to be built is at issue because the director of Transneft wants the pipeline built adjacent to land that he personally owns so that he can triple the price, the value of the lands. That's held up that issue. The same kinds of things are true in Asia.

So if you look over the last three or four years at Kovykta over the tangled history of Daching and Garohe, Daching ... what you find is that all these governments are making decisions that are not based on sound economic logic. And are trying evermore, first of all, to essentially shaft the other bureaucracy. At the same time, also, to get South Korea or China in particular and Japan to pay more money for this so that it gets built.

These decisions as to where these pipelines are going to be built have been made in spite of the fact that nobody knows how much energy there is in the area, whether or not the pipeline either to China or to Japan will be able to carry enough oil or gas to justify the construction of the pipeline, whether there's enough gas and oil in these areas, it's mainly eastern Siberia all the way to the Pacific, whether there's enough energy there to satisfy the projected, the increase in Russian domestic demand. And furthermore, where the rest of the capital, even if China, Japan and South Korea pay everything that the Russians want, is going to come from.

So what you have is a decision making process that is anything but commercial in its logic. But extraordinarily bureaucratic. Anybody who works in a bureaucracy will know that. And it is political and dominated by such. The same thing is true in Central Asia where we find the Russians have used their power steadily to compel Central Asian governments, who deal with China, to allow the Russians to send their oil or gas through those pipelines. Or to force them to send their oil or gas back to Russia, where they can sell it cheap to subsidize Russian domestic consumption, which is at way below market prices. And something the E.U. constantly complains about.

And then the Russians sell their own gas and oil abroad at market prices and manipulate those price differentials for the rent seeking that Adnan and Margarita have discussed. So you see this in Central Asia, which essentially means that the Russians are trying to perpetuate Central Asia's unilateral dependence on Russia and it's near colonial backwardness through this kind of rent seeking and coercion.

So the conclusions for this are rather negative, first of all for China. China is going to get energy from Russia down the line. It's already getting energy from Russia, but it's not going to get the energy in the amounts or at the price that it really wants. Therefore it is being compelled to turn back to the Gulf and to Central Asia and to other places evermore because there's no other alternative. So the saliency of China's position in the Gulf is going to remain and grow in importance, forcing us, in the United States, to come to terms, for example, as Levitt and Bader wrote in the Washington Quarterly, with the deals that China needs to make in order to move forward.

Secondly China is beginning to understand that an anti-market orientation may not be the best way to go. The most recent deals or statements that came out of its meetings with the E.U. and with India indicate a desire for less unilateralism and perhaps a more favorable attitude towards cooperative and more market based solutions. Some Chinese scholars have been arguing for this for some time. There are other signs, for example, with Pakistan and Central Asia as well that China is interested in securing alternative supplies.

So in other words the Chinese problem is going to, or what some people regard as a threat is going to be made worse by the fact that the Russians have been consistently unable and unwilling to satisfy China. And have undermined that pillar of the Russo-Chinese relationship. However the consequences for Russia are no less severe. First of all energy is Russia's main instrument of power if they can become a player in the Far East. If they cannot deliver energy in the amounts that they have previously agreed to or at prices that they have previously agreed. And are consistently trying to, essentially, swindle their partners. Their partners are going to get very angry at them and continue to disregard Russian promises and Russian interests. And there are signs of this already happening.

For example, the South Korean government was so furious at Putin's refusal to commit himself to a pipeline in South Korea, that President Roh refused to discuss the issue at their joint press conference even. And the Chinese diplomats are clearly not happy about what's happening as well. Furthermore, the logic of monopoly is already exacting a severe price on the Russian economy and political system. Gazprom's rate of production is falling. The state oil sector rate of growth is falling. Zhukov, Deputy Prime Minister Zhukov, Chubais and Putin have all stated Russia is facing an energy crisis, particularly in the electricity sector, by the year 2010, because it continues to subsidize domestic consumption and engage in wasteful un-market like economic policies.

The Asian area is not going to produce the revenues that Russia expected because the pipeline hasn't been built. The pipeline from Mangaro, whether they're supposed to go to Nahotko or to Daching was supposed to start last year. It hasn't started. It's not likely to start any time soon I suspect because there will be constant bureaucratic obstruction. Let alone all the structural factors that add to the high costs.

So the wisdom of relying on Russian energy, whether you're China, Japan, South Korea and I would daresay even the United States, I think is moot at best. I think all these consumers are going to be forced back into the Gulf or other areas in greater or lesser degree, depending on where they're buying energy now because Russia simply cannot be relied upon.

Finally, two points, this whole sorry story and its, I've laid it out in detail in the manuscript here, shows once again the superiority of market mechanisms over Oriental despotism. And if you look at Russia today the structure of government is very czarist. Secondly if the Russian government cannot use energy to leverage either economic growth or foreign policy objectives to the extent that it seems to, what will result in Russia, I believe, down the road is once again crisis and internal conflict. Thank you.

Ariel Cohen: Thank you Andy, thank you all for coming. I'm the last thing standing between you and lunch, so I'll try to wrap it up quickly. Instead of going and discussing the general geopolitics of energy, I want to focus on Kazakhstan a little bit and then sort of jump to conclusions. Kazakhstan was pushed back in its energy development under the Soviets. My dad worked on North Caspian, what is called North Caspian Depression, the area that now we found has so much oil and gas. But prospecting and exploitation or two different things. So while they were projecting in the late '60s early '70s large reserves of primarily oil but also gas, little was done under the Soviets.

The first big project was Tungese. The negotiations between Chevron and the Soviet government started under ... . And then as the Soviet Union collapsed the negotiations went on with the government of Nusultan ... . Other large fields, Kashaghan, the gas field of Karchargah, are major global level findings, but there's still a process of development and decisions about pipelines, where pipelines go, who finances them, etc. Kazakhstan is blessed by large reserves of hydrocarbons and relatively small uneducated populations. So it makes Kazakhstan a success story as far as energy in Eurasia is concerned.

The Russian role is that of transit obviously. The major pipelines are going to the direction of Simara for oil. And the gas pipe, gas network that existed in the Soviet times is still in place. The first pipeline out of Kazakhstan that was privately funded and developed is the CPC, the Caspian Petroleum Consortium, that was developed to lift Tungese oil and was completed in the 90s. It is the only oil pipeline that is privately owned and foreign owned and is functional now in the territory of Russia.

As I said it goes to ... and there are some problems with that because the Turkish Straits are clogged with oil traffic and cargo traffic. And the question for Kazakhstan, if they are to go from the current level of exploitation of one million barrels a day in 2005 to 3 million by 2015, that's tripling of the output. Putting Kazakhstan in the same category of oil exporters as Kuwait, Iran and Iraq, hopefully Iraq. So then the question arises where this oil and gas will go.

Of course Russia would like the exports to go through its territory. And that's the Russian position throughout, vies a vie Kazakhstan and vies a vie Azerbaijan. But the Kazaks want to diversify, President ... is on the record many times over saying they want to diversify. As the State Department slogan used to be in the '90s, happiness is multiple pipelines.

So where can they diversify? They can build a pipeline to China, which they did. As of the first of January of this year there is a rather small, 250,000 barrels a day, pipeline to China. They are looking at a gas pipeline to China that would include Uzbekistan and Kazakhstan, but also possibly, quite possibly, Turkmenistan, which means that the West is losing access to ... gas, direct access because of course there's a whole Ukraine deal that Margarita mentioned. That is Turkmen gas being bought rather cheaply by the Russians and then resold to Ukraine and to points west.

But Kazakhstan can also build a pipeline diagonally across the Caspian Sea to hook up to ... . They can build a pipeline, a gas pipeline, along the same route to connect to Charedonize ... pipeline. So there is an option for Kazakhstan also in the direction of Turkey and Europe. There is also an Iranian option that is quite interesting and lucrative. A, because Iran has a developing internal consumption of oil and gas that they could lift from Kazakhstan and then do a swap out in the gulf.

But this is increasingly a moot point because U.S. will do everything that is in our power to prevent pipelines to be built from Kazakhstan to Iran. Nevertheless, the Iranian port of Necca is developing quickly and the infrastructure there is growing. So more and more Kazakh oil is making its way by barge across the Caspian to Iran.

As was mentioned by my colleagues already, China is becoming a growing factor in Kazakhstan. And indeed what we're seeing is competition between Chinese interests and Russian interests. And I think the best case study for that is the announcement on the 23 of August, 2005, by China National Petroleum Company, CNPC, that they will put a $4.2 million bid for acquisition of Calgary based Petro Kazakhstan Lukoil moved mountains to prevent that transaction from happening, including escalating it to the level of Putin not ... summits. And what is of great interest to Lukoil is not just the reserves, which I agree with Steve, Chinese are willing to pay top dollar and beyond for reserves, but very lucrative refineries that Petro Kazakhstan owned that Lukoil is now putting a claim to regardless of the outcome of that transaction.

The Tangese field, again, is an example of high risk high reward. It was negotiated in a very challenging historic period of the collapse of the Soviet Union. And positioned to the Kazakh independence. I think that Chevron was very capable in negotiating relations with Kazakhstan and with Russia for the transit. But I also believe that today we are in a different environment. Governments are asserting themselves much more, both in Kazakhstan and in Russia. So it will be more difficult to negotiate a foreign owned consortia, even with Russian participation.

And another good example of how this environment is changing is that the recent acquisitions in the Caspian, the maritime projects, are primarily Russian owned or Russian-Kazakh joint ventures. There's very little Western ownership in the literal projects.

The reserves, as I said, are very impressive. I do believe there will be major discoveries in the future in Kazakhstan. In gas the situation reminds me of Turkmenistan-Russian relationship somewhat because senior Kazakh officials told me that they're happy with the $40, $50, $60 range per thousand cubic meters of gas as a selling price to Russia. Market wise it's a very low price and of course Gazprom will turn around and resell that. But the Kazakhs are limited in the gas exporting capacity. In a graph on page 23 of my report the gap between production and exports, the exports are pretty steady between 1990 and 2005, five to six billion cubic meters. Whereas the gas production grew from the lowest point in '95 at about six billion cubic meters to as high as 28. So this has more than quadrupled between '95 and 2005.

And Kazakhstan is very aggressively putting infrastructure and developing projects to have more production in oil and gas and also in uranium. Kazakhstan is planning to become a major player in the uranium business. What is Russia doing? Russia managed the negotiations without big flare ups on demarcation of the Caspian Sea. Why is it important? It's important because the whole legal regime of the Caspian Sea, you probably know, was challenged by Iran and still is challenged by Iran.

But Russia very capably negotiated bilateral deals. A demarcation with Azerbaijan, a demarcation with Kazakhstan. And Kazakhs had to yield, for example, in those gas fields that straddle both Russian and Kazakh territorial waters. The Kazakhs, in some cases, ceded control, but they got a recognition of a maritime border in recognition of Kazakh rights to the literal and the mineral rights. That's very important for Kazakhstan.

Russia is developing the gas pipeline infrastructure known as Central Asia Center, Center meaning Russia. That's a Soviet era pipeline, which if they increase the capacity they can have a bigger thorough put and more exports to Europe, as high as 100 billion cubic meters per year. Russia is, as you also know, is pushing an OPEC like cartel to control exports of gas. That will be very interesting because of course Russia with its dominant position will be the Saudi Arabia of that gas OPEC. So Russia is sitting pretty as long as the energy prices are high.

Kazakhstan fared pretty decently in this relationship with the 'elder brother', quote unquote. Why? Because if you think historically only a hundred years ago it was purely a nomadic society. It was a society, it was an area that was colonized by Slavic settlers. Then it was really a prison of nations to use Lenin's term, when Stalin exiled millions of people there, Volga Germans, Ukrainians, you name it. So there was no nation state to go back to. So in relationship with Russia they did quite well I think because of the seniority of the weight pulled in the Soviet, late Soviet and post-Soviet leadership.

And Russia did not play an ethnic card in Kazakhstan, which could have destroyed that country, at all. If they used the Russian diaspher in Kazakhstan, in Northern Kazakhstan, which is in areas adjacent to Russia, which some people suggested they should do. Alexander ... who once was my hero, did articulate claims to northern Kazakhstan and eastern Ukraine. But Russia never pursued that route. And as a result you have a pretty stable Kazakhstan, which allows Western investors to play, as well as recognizes Russia's interests, as well as playing a game with China.

It is quite interesting to me that two top aides and ministers in the Kazakh government are trilingual in English, Russian and Chinese. You won't find many countries with that skill mix among very top people. So as long as Kazakhstan can build enough pipeline capacity to export its reserves, as long as it can continue playing a balancing game between Russia, China and the U.S. and as long as it doesn't slide into either political instability or secession problems as some recent events may suggest or some commentators suggested after recent events in Kazakhstan, I believe Kazakhstan is an example how you can, if you wish, sleep next to the Russian bear. And the answer is very, very carefully. Thank you.

[End of Audio]

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