Steve LeVine covers foreign affairs for Business Week. He previously was correspondent for Central Asia and the Caucasus for The Wall Street Journal and The New York Times for 11 years. His first book, The Oil and the Glory, a history of the former Soviet Union through the lens of oil, was published in October 2007. Putin’s Labyrinth, his new book, profiles Russia through the lives and deaths of six Russians. It was released in June 2008.

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A Blog on Russia, Central Asia and
the Caucasus

Saturday, January 3, 2009

Russia-Ukraine: A Market Dispute

Are the Russians and Ukrainians simply fated to go to the mat every year about this time, causing grief to their neighbors? Or is something else at work in their antagonism?

The philosophical answer is that, while it's hard to imagine these two former Soviet states living as friendly neighbors any time soon, the current dispute is a separate matter.

It can be reduced to a difference of outlook: Do you expect oil prices to rise to $60 a barrel this year, or to drop back down to between $30 and $40 a barrel? (Oil has surged in the last two trading days to about $46 a barrel because of the fighting in Gaza.)

In Europe, natural gas prices follow oil, and Russia is clearly of the consensus view that oil will average somewhere in the neighborhood of $60 a barrel this year. That corresponds to a natural gas price of about $350 per 1,000 cubic meters. (Here's the loose formula to get the natural gas price: divide the oil price by six, then multiply the result by 35.3).

Hence the claim by Russian Prime Minister Vladimir Putin that the demand by Gazprom, Russia's natural gas behemoth, for $250 per 1,000 cubic meters from Ukraine this year amounts to a "humanitarian gesture."

Ukraine, however, has embraced oil's most recent price band. It's arguing that oil will average $40 a barrel this year, or $235 per 1,000 cubic meters of natural gas. That's precisely what Ukraine has counter-offered to Gazprom.

(As a separate matter, if Europe truly is paying $500 per 1,000 cubic meters, as Gazprom has claimed, it is seriously overpaying. That corresponds to $84-a-barrel oil.)

(Another baffling issue is Russia's claim that it's owed a $600 million late fee on top of the $1.5 billion natural gas bill that Ukraine already has paid. That's a 40% penalty, and Ukraine is only a month late.)

The subtext is the nature of the two countries' contract, which is based not on the spot price of natural gas, or a forecast, but a formula that lags current prices by eight months. In other words, when Gazprom is retorting that it in fact could charge Ukraine $418 per 1,000 cubic meters if it so wishes, that's Russia's estimate of the price of natural gas last May.

In the end, look for the two countries to settle some place in the middle, say at $50 a barrel oil, which would entitle Gazprom to charge $294 per 1,000 cubic meters. But don't be surprised if Ukraine bends a bit more toward Russia's demand than a down-the-middle compromise; indeed, I wouldn't be surprised if Ukraine agrees to Gazprom's offer of $250 per 1,000 cubic meters.

The dispute has more bite than previous rows because of the economic times. Ukraine is in an economic fix, as is Gazprom.

Regarding the latter, Gazprom's troubles go far. It doesn't produce much of the gas it ships to Europe, but markets gas it buys mostly from the Central Asian state of Turkmenistan. In order to obtain long-term rights to that gas, and not have it siphoned off by a covetous West, Gazprom has agreed to pay the Turkmen about $340 per 1,000 cubic meters.

Given market prices, that means that Gazprom might be forced to sell to Europe this year at a loss, unless it unilaterally cuts the price it pays to the Turkmen, who in that case could respond by withholding supplies.

"Gazprom is in a tough spot," says Kenneth Medlock, a natural gas expert at Rice University's James A Baker Institute for Public Policy, who helped me with the calculations for this article. If Gazprom loses the Turkmen supplies, Medlock said, "they are going to have trouble meeting their contractual commitments" to Europe.

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Tuesday, December 30, 2008

Afghanistan: Central Asia Takes Center Stage Again

With the Taliban having made Pakistan an insecure supply route for war materiel headed into Afghanistan, NATO and the U.S. are looking again to Central Asia for help.

Thom Shanker of The New York Times has filed a piece this morning detailing talks with Uzbekistan, Tajikistan and Azerbaijan about serving as alternate supply routes. The talks also include Russia, which exerts considerable influence in the former Soviet region.

Uzbekistan, Kyrgyzstan and Tajikistan were primary staging grounds for the 2001 dislodging of the Taliban from Kabul. Since then, the U.S. has created some distance from those regimes, in Uzbekistan's case because of its horrendous human rights record.

Look for Washington to argue that engagement is the best way to get some moderation in Uzbekistan. That will be no more true now than it was the dozen other times over the past decade and a half that the U.S. has employed that logic.

However, if the U.S. is intent on a surge of some 30,000 troops in Afghanistan, which appears to be its plan, fresh agreements may be the only way to supply them. Today, for instance, Pakistan itself closed off the Khyber Pass as it carried out a new offensive against militants based in the border area.

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Friday, December 26, 2008

For Big Oil, a Day of Reckoning

Most of us are elated with gasoline prices, especially those driving to see relatives. We are down on the Chesapeake shore, and filled up the mini-van for $1.49 a gallon. But if you are an oil company, these aren't happy times.

Chiefly, if you are a petro-state or an oilman, you've probably got whiplash. Last summer, customers were paying you up to a whopping $147 a barrel for your oil, and though few except perhaps Arjun Murti over at Goldman Sachs thought those prices would stick around, it was equally so that almost no one expected to be paid as little as $32 a barrel just a few months later (and $36 today). Russia, Venezuela, Iran and most of the rest of the oil producing states simply cannot balance their budgets.

But, focusing for now on oil companies big and small, matters are about to get worse. As others are pointing out, that will become clear in just a few days -- on Dec. 31 to be precise. One might call it the day of reckoning. The Wall Street Journal's Ben Casselman was ahead of the pack in writing about this.

But what these reports aren't pointing out is that, if projections are anywhere near correct, this isn't a one-year matter. The companies may be in for trouble for at least the next couple of years. (After alarming the skittish market in the summer by forecasting $200-a-barrel oil, Goldman Sachs is now predicting average $45-a-barrel oil next year. The World Bank expects an average of $75 a barrel oil over the next two years.)

Here's why: It's the price of oil on Dec. 31 that all oil companies -- at least those that sell shares to the public -- must use as a measuring stick of just just how much in the way of proven oil and gas reserves they own. The most important factor in this calibration is how much it costs a company to drill a barrel of oil in, say, Canada, or the Gulf of Mexico. If they cannot drill that barrel economically at $40 a barrel (presuming that's about the price five days from now), it must be stricken from the books. Along with that number, the companies report their so-called "reserve replacement" -- to what degree managed to replenish the oil and natural gas they drilled during the year.

Those numbers must be reported to the Securities and Exchange Commission on a company's 10-K statement. That's where the trouble begins: When the companies go public with their reports in February and March, Wall Street will use the numbers to help calculate how much their share price is worth; and banks and venture capitalists will do the same to determine whether to lend to oil drillers in this tight financial environment, and if so at what interest rate.

Even for 2007 -- when oil ended the year at about $95 a barrel -- the struggle for some of the companies to replace reserves was already apparent. By the SEC rules, Exxon replaced just 76% of its reserves (though by its own internal methods it said it replaced 101%). Chevron replaced just 10%-15% of the oil and gas it drilled. BP said it replaced more than 100%.

But at $35 or $40 a barrel, those percentages are going to be far lower. Stay tuned for some news-spinning from Big Oil's public relations arms in the coming weeks and months. The companies' share prices have already been pummeled this year by Wall Street.

Some say that a focus on reserve reports is something for "unsavvy investors" and commentators -- "the resources are still there for a price," said this fellow calling others unsavvy.

That view is correct to a point -- Dec. 31 is an arbitrary date to judge one's reserves. But it's a narrowly drawn view, concentrating only on the presence of fossil fuels in the ground. It ignores that that oil and gas is becoming far harder and more expensive to drill; it's situated in smaller and smaller reservoirs, requiring the drilling of more and more wells to produce the same volume of oil; and it's largely controlled by petro-states that, even if low oil prices drive petro-states to be friendlier toward international oil companies, are still likely to demand far tougher terms than they did, say, in the 1990s.

In short, company reserves are becoming smaller, and the focus on reserves reporting is demonstrably relevant.

Some good news for the companies is that the SEC is going to change the reporting rule starting in 2010 -- companies will be able to use an average of the annual price rather than the year-end price.

But that's a slender reed of hope if trends and oil forecasts for an average $40-$60 a-barrel oil next year are accurate.

According to inflationdata.com, the average oil price in 2007 was $66.40; so far this year, it's about $98. So that if the current trajectory holds, the price on which the companies will report their 2009 reserves will be relatively low, too.

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Tuesday, December 23, 2008

Blunder: A New Age for Russia

My friend Zach Shore, who teaches at the Naval Post-Graduate School in Monterey, usually writes about foreign affairs with a historical bent -- on militant Islam in Europe, and on Hitler. Now, though, Shore has taken on a sweeping, big-picture theme -- how and why people get trapped into fixed mindsets, and from that make incredibly terrible decisions.

Shore calls his book Blunder: Why Smart People Make Bad Decisions. Much of this slender, thought-packed volume has to do with war and foreign affairs, including events in Russia (which is why I am blogging on the book). But he also applies his theory of cognition traps to business.

In any case, I have wanted to write a couple of year-end looks at the news, including Russia's very different place domestically and internationally from just a few months ago.

In August, Putin's Russia seemed unstoppable, specifically after its five-day war with Georgia punctured the appearance of a new era of U.S. power in the former Soviet Caucasus and Central Asia. Georgia seemed the crowning achievement of a several-year-campaign of projecting Russian power over its borders after a decade of retrenchment following the Soviet collapse. On O and G, we have covered the Gazprom-led rivalry with the West to build new natural gas pipelines into Europe. Russia's Nord Stream and South Stream pipelines appeared to beat out the West's proposed Nabucco pipeline without breaking a sweat.

Not any longer. Simply put, Russia is in trouble. Its much-ballyhooed $600 billion cash reserve base dropped by a quarter by Dec. 1, to about $450 billion, and even further since. Much of that has gone to bailing out banks, select oligarchs and propping up the ruble. But with no sign of an end to the global recession, Putin is allowing the ruble's value to decline rather than pouring limitless reserves into the currency. This Wall Street Journal interview with down-on-his-luck oligarch Oleg Deripaska tells it extremely well. (Note to Barack Obama's Russia team: South Stream is on hold for at least 18 months or two years; Russia doesn't have the wherewithal to finance it; Nord Stream is more likely, but again financing will be a problem. That is an opening that was not present before the financial crisis.)

One thing that Deripaska points out in his conversation with The Wall Street Journal is that a big part of the Russian financial miracle was not oil-driven, but debt-driven. The Putin era's new generation of oligarchs, like Deripaska -- men who obtained ownership of large parts of Russia's industrial sector in the last few years -- is lining up for a bailout from some $110 billion in foreign debt coming due next year. According to Bloomberg's Yuriy Humber and Torrey Clark, that's twice the debt owed in Brazil, China and India. The oligarchs are seeking some $78 billion in loans.

Social tension is rising, and Putin is tightening up. He has significantly broadened the definition of treason. And the Duma has extended the presidential term to six years from four years; should there be a sign of a dire future threat to Putin's popularity next year, look for a snap election and Putin's return to the Kremlin. Short of that, Dmitry Medvedev will remain as president.

In an email exchange, here is how Zach Shore wrapped up Russia's conundrum in the context of the lessons of Blunder:

Russia's recent recession is tied up in cognition traps, the rigid mindsets that invariably lead statesmen into blunders. Just one of them is Cure-allism, the dogmatic belief in panaceas. Cure-allism sabotaged Russia's 1990s transition to a market economy when Western advisers applied the supposed panacea of shock therapy. Cure-allism exacerbated the Asian financial crisis of the late nineties, which engulfed Russia, when IMF experts applied their deregulation dogma to countries needing more regulation, not less. And it has fostered the current global meltdown by insisting on the deregulation of banking and investment schemes.

You might think that after suffering so often from Cure-allism's fallout, Russian leaders would be especially wary of wedding their economy to any one panacea. Yet Russia has allowed its recent growth to be overly fueled by gas and oil prices, believing that these goods could solve the country's deeper revenue problems such as a weak banking sector and an inadequate tax system. Rather than solving Russia's ills, the irrational faith in energy exports has once again revealed the self-destructive folly of Cure-allism.

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Monday, December 15, 2008

Obama Energy Team Stresses Break with Bush

In announcing his energy team, President-elect Barack Obama seemed to take a not-very-subtle swipe at the Bush administration. Obama did so in introducing Steven Chu, his designate for energy secretary, invoking a frequent complaint of critics -- that Bush and his team have neglected science in favor of politics and ideology, and been slow to act on global warming.

Obama said this evening in Chicago that Chu's appointment would "send a signal to all that my administration will value science, make decisions based on facts and understand that facts require bold action."

Indeed, Obama's team -- excluding anyone with any expertise in oil -- seemed to be a repudiation of Bush's fossil fuel-centered energy policy. In addition to Chu, Obama named Lisa Jackson, the former head of New Jersey's state environmental agency, as head of the U.S. Environmental Protection Agency; and Los Angeles Deputy Mayor for Energy and Environment Nancy Sutley as head of the White House Council on Environmental Quality.

Chu is the star of this bunch -- he is a Nobel Prize laureate in physics. Yet an energy expert whose opinion I've come to trust over many years says that the real power will reside in the White House, and in particular Carol Browner, named to hold the new White House post of energy and climate czar. Browner was EPA administrator under former President Bill Clinton. Still, questions have been raised as to how much true influence Browner will enjoy in a White House filled with heavyweights with perhaps competing agendas.

On the light side, Lynn Yarris, the bundle of enthusiasm and science know-how who serves as Chu's spokesman at Lawrence Berkeley Laboratory, says no one at Berkeley -- with the possible exception of Chu's wife -- even knew that he was interviewing for the energy post.

Chu was in London at the time word started filtering out last week regarding the appointment, and went incommunicado. Yarris said at the time that if the talk was true, Chu was so low-key when they spoke, that he must be the best poker player he had ever encountered.

The Berkeley lab has planned a celebration for Chu on Thursday, but given the arc of events, Yarris isn't sure Chu will be back in town for it.

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Wednesday, December 10, 2008

What Chu Means as Energy Secretary

By appointing Steven Chu as energy secretary, President-elect Barack Obama appears to be making concrete his campaign pledge to focus on alternative energy. Obama also is continuing his streak of favoring serious personalities with star power in the cabinet.

Chu is the first Nobel laureate to serve on a presidential cabinet. (He won the prize for physics in 1997.) As the current director of the Lawrence Berkeley National Laboratory, he has been a high-profile advocate of an accelerated program of weaning the U.S. off of fossil fuels.

Expect a highly active, non-ideological and scientifically focused drive to develop alternatives to oil and natural gas.

I talked to Chu in May, when he described being part of an attempted "revolution" since taking over the directorship of the Berkeley lab in 2004. He said:

When I came to the lab, I came with the idea that there are a lot of brilliant scientists here. If I could get the intellectual brainpower to come up with new technologies on the energy supply side, that could be as efficient but less costly than oil, and on energy efficiency and energy storage, that that is something we do need and need quickly. We can't wait a half-century, given what we fear with climate change.

... Do I want my guys to stop basic research and work only on energy? No because they are also working on other revolutions to take place 10 years down the road. But given the magnitude of the problem, it's okay to have some of our best and brightest working on it. In the end, the quality of the solution will depend on the quality of the people working on it.

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Monday, December 8, 2008

Iceland From the World's Grumpiest Man

We're reading a lot about miserable people. There in fact seems to be no end to miserableness. To make one's mood worse, just yesterday President-elect Barack Obama said things will only get worse.

So I decided to consult an expert on unhappiness. Not just unhappiness -- Eric Weiner says he's a grumpy man (even though I can tell you personally that he isn't really) -- but also happiness. In The Geography of Bliss, published a few months ago, Eric ranked the world's cheeriest places.

Since then, it's turned out that the happiness in Eric's No. 1 joyful place -- Iceland -- may have been based partly on the fact that it was running as a giant hedge fund. So, with Iceland's economy in tatters and relying on the IMF, I asked Eric how the Icelanders were holding up.

Here's his response:
People I've spoken with there are certainly anxious and bumming. But they're not, by and large, miserable. The Icelanders are remarkably resilient people. If you lived on a small, cold isolated island in the North Atlantic, you would be, too. Icelanders (like all people, really) derive their happiness from their relationships with others. Not just family and friends, but strangers, too. And, from what I can tell, those relationships remain intact, despite the financial hardship and, in a way, because of it. Here's what Karl Blondal, deputy editor of the main newspaper in Iceland, said to me in an e-mail.

Right now Icelanders are in a state of shock, and not sure how this will turn out - has Iceland been catapulted back into the stoneage - and where things will stand once the dust has settled. A lot of individuals have been hit really hard, pensioners have lost their lives' savings, etc. But there is also a lot of communal feeling, people address each other in a more caring way in the morning, neighbours inquire how each other is doing. One thing about living in a small community is that everyone you know, family and friends, is within reach - those who lose their jobs are not isolated, the risk of estrangement is not the same as it would be in bigger societies. But there will be a lot of anger, living standards will not be as luxurious, but this was an economic disaster, not a natural disaster. The infrastructure is intact, houses are standing, life will go on. As for happiness? Now we can wipe the slate clean. Who knows - this might just as well be an opportunity to forge a better, more open society where power is more diffused, and the old vested interests and economic blocks have been cleared out of the way.

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