Russian Economic Plunge

There’s a couple of things in the news today per Russia and their economic woes. I have to wonder if this is the start of Yet Another Economic Collapse in Russia (old USSR). It will likely depend on how long oil prices stay just how low; yet the increase in supply from new methods of discovery and recovery, and the pressures on OPEC to maintain market share; those are not likely to end soon.

It looks to me like both OPEC and Russia have built their economic models on the expectation that “glut” in the oil markets could never happen again. That we were past ‘peak oil’ and the only way forward was through demand exceeding supply as supply rolled lower. Clearly they misjudged that.

Commodities (any commodities) are volatile in price and supply. “Why?” is pretty simple. There are many supply sources with different costs to produce. Some folks keep producing even while prices fall since they can make some money, even if less than desired. On the upside, any rise in price is faced by a large cost to open new production and often long lead times. Supply is short term price-inelastic (as, often, is demand). If you need a pound of Rare Earth mineral to make a $20,000 car, you will keep buying it if the price is $4/lb or $8/lb. Though at $30/lb you might start a project to replace it with a different mineral in a year or two. Any supply / demand imbalance tends to show up in large price swings. It doesn’t matter much if the commodity is oil, gold, or wheat. (That’s part of why gold is not a particularly good currency. While long term it has more stable value than paper currencies, short term it can swing quite a lot.)

So Russia and OPEC thought that there was only one direction for production and price ‘going forward’ as the whole ‘Peak Oil’ mantra got bandied about. OPEC country budgets generally can only be met with oil prices over about $80/bbl. That is going to be a large problem for them as oil prices stay low. With folks finding new natural gas production methods and using them globally, natural gas supplies are rising outside Russia at a remarkable rate. Russia thought their gas lines to the Western EU would give them economic control of the West. Instead it makes them dependent on gas prices. Essentially the volatility of commodity prices gets reflected in the general economy and currency of commodity dependent producer countries.

To Russia, with FX

So what’s happened? First off, Russia has an FX problem (Foreign Exchange). The Ruble is crashing. This chart shows the USD ($US) vs RUB (Ruble) exchange rate. How many rubles you get for the buck.

Ruble in $US terms

Ruble in $US terms

From FXCharts.org: live currency chart

The small inset in the lower right shows a generally stable Ruble, with occasional steps down, until the recent parabolic spike. Like all spikes, this will eventually fail; but it can have a large exponential rise prior to that fall and the exact nature of the failure can change ( for currencies, it can be anything from central bank interventions to abolition and replacement of the currency ). The main chart shows that spiking rate in more detail. That the West is piling on various exchange controls and sanctions on Russia due to their raids into Crimea and Ukraine also puts pressure on. The Central Bank of Russia has just spiked interest rates from about 10% to about 17%. That kind of interest rate is brutal.

There will not be a lot of investment in projects with interest rates that high. The general population will be rather unhappy with their leadership and economic prospects; though it is unclear what they can do about it.

It will be an interesting example of how monetary policy doesn’t really change things as much as folks expect. In the end, the reality of actual goods and prices tend to overwhelm monetary games. (Part of why having a stable currency and stable interest rates are generally more important than playing ‘money games’ with ‘stimulus’ or monetary policy – and saying that assures I’ll never be hired by politicians to run any central banks ;-)

Longer term, this also puts pressure on OPEC members. Some, like Saudi Arabia, have so much saved up wealth that they can go a few years without income and be fine. (It might put downward pressure on gold and stocks, bonds and property, as they sell some assets for consumption money; but not much else.) Others, like Venezuela and Libya or Nigeria are strongly dependent on oil money today. Money is needed for immediate expenditures and they have nothing much in the bank. These stresses show up in OPEC negotiations. Watch for pressures between those members as this works out. The basic problem OPEC has now is that the rise of non-OPEC supply prevents them from cutting global supply to support prices in any effective way. Saudi is the “swing producer” and expected to turn their taps on and off to regulate price. But Saudi as a % of global is no longer large enough. Under present pressures, OPEC decided to ‘defend market share’; which means continued pumping even as prices drop.

The goal of OPEC is to drive prices low enough to cause some producers outside OPEC to go out of business. Then they can let prices rise and reap the profit. OPEC does this from time to time whenever threatened by alternative oil producers. As ‘tar sands’ in Canada have become a large source, they are trying to prevent that oil from being produced (thus their support for efforts to stop the Keystone pipeline… look behind protests against western oil production and you will find Saudi / OPEC support…IMHO) Tar sands make money at $25 / bbl to $50 / bbl depending on particulars. As oil is now in the $50 handle range, likely headed to $40 handle soon, some of that production is already under pressure.

BUT… If OPEC can’t hold it together long enough to shut in alternative production, it will have a heck of a domestic economic problem, as will Russia.

My Oil Solution

This is likely a good time to remind folks of my proposed ‘solution’ to the OPEC oligopoly manipulations. It is a ‘flexible tariff’ applied ONLY to oil landed from outside of the USA or NAFTA ( or most any other basket of non-OPEC you like). It is used to set a ‘price floor’ for crude that is above the predatory price OPEC uses to drive others out of business. So set that price just above the ‘cost to produce’ that assures suppliers stay in business. Call it $70/bbl or $80/bbl. When oil is above that floor price, the tariff applied is $0. When oil falls below that price, the tariff applied is $Floor-$Landed= $Tariff. So for oil at $60/bbl and the tariff floor set at $70, the actual tariff amount would be 70-60=$10/bbl. In this way the flexible tariff has zero impact on prices when above the price floor for imports, but prevent OPEC predatory pricing (by ‘maintaining market share’ in glut times) from being effective against domestic production.

Do note that this flexible tariff is NOT applied to domestic producers. If NAFTA is used as the border, it would also not be applied to Canadian or Mexican oil. So actual domestic price might well be $55 / bbl or $50 / bbl even as the ‘import price floor’ was set at $70/bbl. In that case, domestic consumption would be largely directed to domestic suppliers and OPEC oil would need to find another home, at least until domestic prices rise to match the import price floor. Market forces still act domestically; the flexible tariff just blocks attempts at predatory pricing by an external market manipulator from being effective.

Also note that given the history of oil prices, an import floor of $60 or $70 / bbl would substantially always do exactly nothing. ONLY during times of predatory prices and ‘glut’ would there be any effect, and that effect would be to stabilize domestic production and assure longer term prices stayed lower.

Back at Russia

Putin is a strategic player, but somewhat weak on economics (as are most politicians…) so he has realized that cold is coming, that Obama will do nothing (being more ‘flexible’ now that the election is over…) and that the EU will do almost as much nothing. Given that, he is moving strategically. Snapped up that warm water port in Crimea. Picked up some nicer grain growing land in Ukraine (expecting Siberian production to fall off?…).

The real question is just “What’s next on his shopping list?”. I’d expect he’s interested in connecting the bit of Russia isolated near Poland back to the main body. Maybe pick up a Baltic state or two in the process. Shorter term, I’d not be surprised if he was interested in taking over Ukraine wholesale. Belarus has already aligned a bit more closely with Russia. I could easily see a Belarus / Russian federation and nipping a ‘corridor’ off of Lithuania in the process. Probably not for a few more years, though. He has to digest what has already been nabbed first.

Will the present economic issues change or halt that strategic direction? I doubt it. Russia has always been a bit isolated, and the Russian people put up with a lot of bad times. So there will be fewer American cigarettes and fewer French wines. Putin can just print more rubles and buy more tanks with them and have more Russians working in domestic ‘industry’ and buying Russian Vodka instead. At most, the EU will complain at him and Obama will have nothing to say at all. Any UN action will be blocked. NATO is too busy pretending to matter to do anything about non-NATO countries and unless direct war is conducted against a NATO state (as opposed to extorting a ‘concession’…) will not do much. In that context, shifting the Russian economy to be more internally driven and isolated from external connections will hardly be noticed. In the end, this will be a Foreign Exchange problem, not a domestic production problem. Selling Russian oil at 1/2 price in $US, with the ruble at 1/2 price too, means that in ruble terms, there was no change. Only in the case where those rubles are spent in the EU or USA or Japan does it show up. Eventually there will be price inflation for goods that can be exported (such as grain and minerals) and for things imported ( western movies, foods and drinks, cars); but that will just stimulate the domestic producers more. IMHO, not many folks in Russia can buy a lot of imported goods anyway. His biggest opposition would likely be from the Oligarchs, and if they get a big enough cut of the action, will be silent.

While there could be a domestic revolt against Putin due to a more general economic collapse, I just don’t see it on the cards; especially given the historic stoic nature of the Russian population. What is clear is that “this will be interesting to watch”…

Sidebar on gas:

As the world cools, exported Russian gas will be even more important to countries like Ukraine. Russia will also need more gas used domestically. There is a race condition between fracking and higher production and more cold with higher demand. It is unclear how this will play out. I suspect that the loss of foreign exchange will not be all that important to Putin, while imposing control on the foreign users via shifting supply to domestic demand will be a very acceptable option. Anyone at the end of a Russian pipeline needs to be finding another source.

Canada and the USA could easily build LNG export facilities and pipelines to them, cutting off that Russian influence. I’m pretty sure they won’t. Couldn’t even get started for a couple of years (see Keystone…). So this is also an interesting opportunity to watch a strategic thinker (Putin) face to face with emotive non-thinker (Obama). So that means folks like the UK and Germany need to solve their own energy supply needs without the US doing anything sane. Will they? Hard to say, but I think they will act, just too late. We have a multi-year development time horizon for development (about a decade or two) while Putin likely has a year or three time horizon. He’s moving faster than the Europeans; and America is not moving at all…

In Conclusion

IMHO this is a Big Deal. Not world shaking, but still very important. While it is possible it could be a watershed moment inside Russian politics; I think it is more likely that it is a return to ‘turning inward’ for Russia; and that is usually bad news for their neighbors.

OPEC is on a missing to drive others out of the business. Non-OPEC countries really do need to take some kind of action to defend their domestic production from predatory price activities by OPEC. It is important to realize that oil is NOT a free market, it is dominated by a Cartel. To take action to mute the power of a cartel to manipulate markets is not interfering in a ‘free market’; it is restoring that market to more stable function.

Enjoy the price drop in fuels, but remember that the end game is higher prices…

Watch for instability in any country dependent on large oil exports for their budgets. Expect oil stocks, drillers, gas companies and such to all be in free fall for a while. Wait for the Dead Cat Bounce before buying any of them, but do start making a shopping list. This is a reasonable time to prep for ‘bottom fishing’ when the carnage is completed. In any case, avoid investments in Russia, or strongly Russian related. They have not done well, and right now are tanking hard:

RSX Russian stock ETF 1yr with Vol ROC DMI

RSX Russian stock ETF 1yr with Vol ROC DMI

From Big Charts: live chart.

While the volume and volatility spikes (and some other indicators) indicate a hard crash, and those are often followed by a Dead Cat Bounce back upward, that’s day trading land, not investing. Further, as this is largely being driven by political events and cartel actions, things can change in an instant and without any visibility before it happens. In that context, no reason to try to catch the falling knife…

“May you live in interesting times”.

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About E.M.Smith

A technical managerial sort interested in things from Stonehenge to computer science. My present "hot buttons' are the mythology of Climate Change and ancient metrology; but things change...
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4 Responses to Russian Economic Plunge

  1. Here in Europe we’ve handed Putin the capability for Hydraulic Despotism by relying too heavily on those imports of Russian energy. We can’t effectively complain about what he’s doing since he can turn off the taps as he did with Ukraine. Until we’ve got home-produced energy and do not rely on imports our hands are tied. The same has been happening for a long time with the OPEC cartel, of course, but although the Saudis realise that a successful parasite does not kill its host, the countries such as Venezuela want high incomes and have not developed a sufficiently-robust system from their profits to survive when the need for oil tanks. I see high oil prices as having overstressed the system of the West and thus as a basic reason for the banking crash – the banking system did not respond to the changed conditions of high energy costs and thus the reduced profitability and growth.

    This should of course have made us redouble our efforts to find an alternative source of power for our industry. While CO2 is demonised, of course, anything that increases the flow of oil or gas will be deprecated. Modern nuclear fission, that will burn the waste from the older designs, looks ideal from an engineering point of view, but again anything with the dreaded N word makes people afraid – maybe this attitude is encouraged by the oil-producing countries who certainly have enough money to pay for the necessary advertising. Even the fusion efforts are somewhat long-term and half-hearted except for the Skunkworks project and DPFF.

    It does seem to me that a lot of these political problems are based on the fear of running out of “stuff”. There is however a very large resource of energy from various sources (renewables, nuclear etc.) that should be able to make any country or area self-sufficient if we use the technology we have effectively. Yep, new technology may be better but we know how to do it now. Maybe that’s why I’m somewhat bemused about the way politics goes.

  2. Gary Moore says:

    Russia reminds me of the two thieves in ‘home alone 2’ especially the fellow who finds a rope tugs on it and then climbs only to find a bag of cement coming at him. The debt sell off by Russia prior to the Crimea lease reclaim was a clear tele-sign for the US and we were ready – I have to laugh though at all the secondary fits – when there is cheap fossil expect the shivs to come out – china and Russia plan to replace the petrodollar? Things come unraveled real fast. In the US we need to convert end stream natural gas into liquid instead of burning it off – flares are the most god-damned ugly sign of inefficiency – the Russians basically have flared over 100 billion dollars in gas over the past decade – as a satellite analyst I have not ever, ever seen such waste. I am aware of the waste end stream composition issues – still nothing that simple catalytic conversion could not solve – we have known how to do this since 1952. When we let even a single mole get away from us we are stupid – and boy are we stupid when we lose over 5% of our stock just in crappy gas transmission. Convert it at the source – all it takes is a bit of cooperation – but then we are idiots there as well.

  3. Paul, Somerset says:

    I’m not sure what Putin has done to earn a reputation as a strategic thinker. Every project he attempts seems to end in a mess.

    He annexed Abkhazia and S Ossetia and discovered they were money pits requiring endless subsidy.

    He had access to a warmwater port in Crimea on a long-term lease guaranteed by international agreement. That has been torn up, he’s lost international support and he’s left with another money pit requiring long-term subsidy. And this one relies on Ukraine for 80% of its electricity and water, 70% of its food, and nearly all of its oil and coal. Winter in the Crimea is shaping up to be a humanitarian disaster.

    The Donbas is industrial. It’s in central Ukraine where you find the black earth needed to grow crops to compensate for Putin’s unilateral ban on western food imports. The area’s industry and commerce are struggling faced with a warzone run by gangsters and patrolled by armed criminals who are too thick to use the weapons supplied by Putin without shooting down foreign airliners.. Its coal mines are of negligible current value. Its miners have voted against secession and its football supporters are fighting to remain part of Ukraine.

    Nothing Putin has done suggests to me that there’s any strategic thought involved. He seems to be an opportunist who reacts to events and so far has chosen the wrong reaction every single time. I find it hard to dismiss the currency crisis as not a long-term problem. To me it looks like a clear judgement on this man’s hopeless lack of expertise or success.

    And I’m not that sanguine about the Russian people somehow being different from ourselves and inured to falling living standards. The generation of the siege of Leningrad is dead. The current population has grown up with full shelves and Western toys. It’s a social and economic curiosity that people can tolerate the absence of things they’ve never had, but grow exceedingly frustrated when deprived of things to which they’ve become accustomed.

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