EU Energy Policy Blog

The Kremlin has only a limited ability to use Russian oil and gas as a “weapon.”

The Russian market is dominated by ten vertically integrated oil companies, which control 95 percent of Russia’s crude production and more than 80 percent of its refining capacity. While the Russian state now controls a significantly higher share of the domestic oil industry than it did during the 1990s, state-controlled companies at present make up only around 25 percent of the country’s oil production and around 16 percent of its refining capacity, thanks to a series of takeovers of private companies by state-owned Rosneft and Gazprom. 2 The domestic Russian oil market is fairly competitive, with prices determined by world markets and by the taxation policies of the Russian government.

From these few facts, three simple considerations can be deduced. First, given that the Russian state does not hold a majority in domestic oil production despite recent takeovers, the Kremlin is able to “steer” the oil industry for political purposes only indirectly, i.e., via tax incentives, export regimes, pipeline access, predetermined auctions on new fields, and the like. While these are by no means negligible instruments, they hardly render Russian oil an effective foreign policy tool. Second, Russian oil companies — state- or nonstate-controlled — trade their oil on a global market. Unless a majority of Russian crude is bound in bilateral contracts, a rather unlikely scenario in the foreseeable future, Russian oil companies do not have great leverage over individual consumers. Whenever Russia decides to cut oil supply to a consuming country, it will have no major effect, as the targeted country can purchase the shortfall on the spot market and circumvent the “blockade” (unless all producer countries, i.e., opec, decide collectively to block oil supply to their customers — which is unlikely to happen, especially if a non-opec member pushes for it). In case of some Central European countries like Slovakia, where the existing pipeline infrastructure does not allow replacing Russian crude oil in the short run, potential cut-offs can be largely absorbed by using alternative transport routes such as railroads.

Third, and related, the Russian state may well initiate further renationalizations of oil assets and expand state control over the oil industry in the future. But such moves will only diminish the performance of the Russian oil sector and reduce output growth rates, as similar experience in other countries has shown. Yet they will not affect oil markets as such, nor are they likely to render oil an effective foreign policy tool.

That leaves gas. True, Russia holds the world’s largest gas reserves, and it has emerged as the most important supplier country to Western and Central Europe, where it covers up to 100 percent of imports for some countries. And, true, this dependence will become even more pronounced in the near future, when depleted European resources need to be compensated by higher imports — also from Russia. Despite this apparent dependence of European gas customers, however, there is no real case for an “energy weapon” for two reasons, both of which lie in the nature of the gas market. First, since exploration of gas fields and pipeline construction are extremely expensive and time-consuming, producers and consumers engage in long-term contracts that usually cover 20 years or more and entail destination clauses prohibiting secondary trading. Based on these take-or-pay contracts, the producer is able to invest in a multibillion-dollar project, as there is a constant and reliable return on investment. The consumer enjoys a guaranteed supply for several decades, thus reducing uncertainty and costs. Second, gas is a regional play, as it is almost exclusively transported via pipelines. 3 Hence, if either the producer or the consumer wants to opt for exit and start dealing with an alternative contractual partner, he has to make a high additional investment, i.e., build a new pipeline. Given extremely high upfront costs, it becomes very costly for either involved party to leave an established bilateral contractual gas relation. A quick look at the dense pipeline grid connecting Europe and Russia reveals that neither side can be interested in dumping all the money each have invested; nor do they have a real choice.

Russia does not have the option to sell its gas to, say, China, since the existing infrastructure is insufficient, at least in the short run. Nor can the Europeans simply turn away from their Russian provider. In other words, both sides are mutually dependent, from the very moment they have committed to a contract. What follows from the structural logic of the gas market is that there is only a limited possibility for Russia to use natural gas as a foreign policy instrument and unilaterally cut gas supplies to a consuming country without significantly and immediately affecting its own budget revenues. This does not look like an attractive move for a country whose largest share of federal budget income stems from hydrocarbon sales.

This is qualified somewhat with respect to small purchasers like Moldova or Georgia, where a cut in gas supplies hurts the affected country much more than the implied loss of revenues hurts Russia. This asymmetry provides Russia with a certain amount of leverage in the short run. As the past has shown, however, attempts to exploit this asymmetry have not caused major policy change in the affected countries. A strong limitation for Russia to make use of the asymmetry lies in the fact that many smaller purchasers are at the same time transit countries. This implies that a cut in gas supplies always affects the consumers on Western European markets — a market Gazprom aims at serving reliably, and which it has already severely threatened by the cutting of supplies to Ukraine.

Dr Andreas Goldthau, Transatlantic Fellow RAND Corporation and adjunct Professor at George Washington University

P.S. Another 4 myths about Russian Energy Inc. are critically examined in my recent paper in Policy Review.

This entry was posted on Sunday, February 17th, 2008 at 10:52 pm and is filed under English, Gas, Oil. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.