WASHINGTON, December 16, 2014 – The collapse of world oil prices has made three things abundantly clear: OPEC is a paper tiger; the Russian economy is a fraud; and the laws of economics are as unforgiving as the law of gravity.
The two big losers in the collapse are Iran and Russia. The budgets of those governments are predicated on oil selling at more than $100 per barrel. Russian oil has a production cost of about $40/bbl, but over half of the Russian government’s revenues come from oil and gas exports, which account for almost three-fourths of Russia’s total exports. Most of the growth of Russia’s economy and incomes over the last decade has been due to rising oil revenues, and oil is what keeps the rest of Russia’s creaky economy going.
The collapse in oil prices has speeded along the collapse of the Russian ruble. The ruble was already under stress due to western sanctions over Russia’s invasion of Ukraine (Crimea), but now it has lost more than half its value since the beginning of the year. The very faint silver lining was that the ruble has crashed even faster and harder than the price of oil, which meant that Russian firms could still service internal debt from oil revenues; the dollar price of every barrel of oil sold was lower, but it bought more rubles.
But Russia’s central bank moved to stop the ruble’s fall. They raised interest rates from 10.5% to an eye-watering 17%. If that does hold up the ruble and if oil continues to fall, they won’t even be able to service their ruble debt. Forget Russian firms’ dollar debts; they may be forced to default on those.
If Russia had a real economy, the oil collapse would be painful, not disastrous. But the only healthy sector of Russia’s non-energy economy is industrial output for the military. The rest of the industrial sector has been starved of investment, and no one trusts Russian banks, least of all Russians. Unable to attract savings, banks are unable to provide investment funds.
Russia was already suffering from slow growth. The dizzying collapse of oil prices all but guaranteed a recession. The seven-point hike in interest rates is toxic icing on a bitter cake. In order to prop up the ruble, the Russian government has almost inexplicably decided to collapse its economy.
The Russian central bank has always had a proclivity for the dramatic, but interest hike makes no rational economic sense. It was a move of political desperation. It would have been better to default on some dollar debts and allow some industries to survive.
From here things will only get worse for Russia. Oil prices won’t turn around any time soon, and that’s because OPEC is impotent. Saudi Arabia is the only OPEC producer that matters anymore, and the Saudis can pump oil for $4/bbl. It’s likely that the Saudi decision to hold production and let prices fall is as much a weapon against Iran as it is an attempt to drive American shale oil producers out of business. Because that weapon also hurts Russia, the American and Saudi governments may well be doing a lot of winking at each other at this point.
Shale oil is hit hard by this and we shouldn’t see a lot of new investment in wells in North Dakota and the Permian Basin. The firms that invested there are taking a beating, but the technology for pulling oil from shale is improving rapidly. Also, wells for shale oil produce over very short time spans. They can come online and go offline very quickly. If the price of oil goes back above, say, $70, there will be ample production of shale oil.
That makes the profitable price of shale oil extraction the barrier above which prices can’t go without causing a surge of production. The economics of oil extraction have changed. We’ve always seen wild price swings, but shale oil is going to put a damper on those, after this very dramatic correction (or over-correction, according to many experts).
Oil prices are unlikely to return to the levels the Russian and Iranian governments need to balance their budgets and fund various programs. In Russia’s case, those programs include an ambitious modernization program for the armed forces – new attack and ballistic missile submarines, new ICBMs, a new generation of fighter aircraft, and new ventures in space. They also include the absorption of Crimea and the eastern parts of Ukraine.
The Russian economy is broken, it has been for a long time, and the price of oil has been covering it up. The only way out now is to fix it, and they’ve squandered every opportunity to do that for the last 20 years.
None of this means that President Putin is going to pack up his troops and go home. In the West, we tend to look at authoritarian states as behaving according to the same rational rules as other states. But they don’t. Putin and the people around him will invade Ukraine if it keeps them in power, regardless of what’s in the bank. Their goal isn’t to optimize state finances, after all. We look at that invasion and scratch our heads and wonder, “how can they afford it?” They look at their political position, at the fact that their position depends on a dramatic act of national self-aggrandizement, and ask, “how can we not?”
In the limit, of course, that thinking hits cold, hard financial reality. You can’t will armies out of thin air or pay them with war spoils they way they did back in Ivan the Terrible’s day. You have to pay the workers who build the weapons with more than pots and pans.
But the limit is well beyond the point where westerners can go, so we shouldn’t predict Putin’s behavior from the assumption that he sees his limits the way we would. The collapse won’t force him out of Ukraine; it might make him even more bellicose. He blames the West for the collapse, he claims that Russia is suffering because the West resents Russian greatness, and he says that he won’t lie down and let Russia be bullied by our use of the oil weapon.
The Russian people may eventually decide they’d rather live without Putin, but we shouldn’t underestimate the Russian capacity for suffering. If things get too bad, Putin will be out, but Russians believe in the special importance of their country in the world and their fundamental greatness. American style nationalism isn’t all that foreign to Russians.
Russians don’t want to be like America any more than Americans wants to be like Europe. As Peter the Great said, they will take from the west what they think will work for them, then “turn our ass on the rest.” Peter’s goal was never to make Russia just like the west, but to use western tools to support Russian greatness. Putin’s rising poll numbers this year weren’t because of growing prosperity, but because he was making Russia great and showing the world that Russia can stand up to anyone.
No one can do more than guess at how low oil prices will go. There’s no reason to assume that $50 or $40 is a hard floor. Many of us will enjoy filling our tanks with cheap gasoline. The Keystone XL pipeline may be put off as a bad investment rather than for political reasons. People who support more use of solar and wind power will see the expansion of their pet projects slowed or stopped. Russia and Iran will be squeezed harder and harder.
And once again, supply and demand plunge the invisible iron fist into the guts of policy makers who slept through their economic classes. Putin is no match for Adam Smith.