Assessing the situation in Crimea

ByColin Chilcoat, MA, Energy Politics in Eurasia

The referendum was over one month ago, but the dust has far from settled. The referendum was over one month ago, but the dust has far from settled. As predicted, the Crimean people overwhelmingly supported a transition to Russian authority and Russia has wasted little time incorporating the territory; the Russian ruble has already replaced the Ukrainian hryvnia as the official currency and Ukrainian troops have been, at times forcefully, ousted from their Crimean bases. Practically speaking, Crimea is Russian and that is not going to change. The effect on the Eurasian, and in turn global, energy picture is not as concrete, however.

Outright support for Russia’s actions is, generously speaking, limited. To date, only Cuba, Syria, and Venezuela recognize Russia’s new acquisition. Even Russian-based Yandex, the country’s most popular search engine, has been hesitant to pick sides and displays different political maps for its Ukrainian and Russian domains. On the other side, the United States and the European Union have not wavered in their opposition. The day following the referendum, On March 17th, the US and EU announced their first round of sanctions, which targeted 7 and 21 individuals respectively. The sanctions targeted individuals, both Russian and Ukrainian, believed to be responsible for the current crisis. Three days later both added another 32 names and one bank, Bank Rossiya, to the list. Aside from Putin’s cabinet, notable inclusions are: Gennady Timchenko, prominent businessman whose Volga group is a major shareholder in Russian gas upstart Novatek; Vladimir Yakunin, President of Russian Railways; and the Rotenberg brothers, owners of SMP Bank.

The domestic reaction to the sanctions ranges from markedly indifferent to proud. Following the sanctions on Bank Rossiya, President Vladimir Putin declared he would immediately open an account as a show of solidarity. Russian counter-sanctions had a similar effect in the US, with Senator John McCain remarking that he was “proud to be sanctioned by Putin.” That being said, the sanctions against Russia, despite their focus on individuals, have had a real impact on the economy as a whole, which was already slowing.

Outright support for Russia’s actions is, generously speaking, limited. Trading on the Moscow Exchange (MICEX-RTS) was down nearly 4 percent following the second wave of US-EU sanctions. Gas monopoly Gazprom, oil giant Lukoil, and independent gas producer Novatek were all down an average of 3.8 percent. On the month, state banks VTB and Sberbank are down 25 percent and 17 percent respectively. Furthermore, the ruble hit record lows against both the dollar and the euro, but has since recovered marginally after heavy state intervention. What’s more alarming however is the rate that capital is fleeing the country. Andrei Klepach, Russia’s Deputy Economy Minister, reports first quarter capital flight may be as high as $70 billion, already surpassing by $7 billion the total for all of last year. Goldman Sachs believes this number could balloon to $130 billion before years end bringing with it the real possibility of recession.

Post-2008 crisis, Russia’s GDP growth skyrocketed on the back of high oil prices. The growth was never sustainable however, and significantly slowed by 2010. Attempts to modernize the economy during Medvedev’s presidency have failed to take off and Putin has done little to rectify this well into his third and current term. His work to attain WTO (World Trade Organization) membership and G8 relevance is meaningless at this point. With a prolonged stagnation already all but guaranteed, the Crimea sanctions significantly increase the likelihood of a fifth consecutive year of economic deceleration. Their limiting effect on future growth – especially in the energy sector – and not any immediate hit to the economy, which they admittedly lack, is what makes the sanctions particularly potent. What then can we expect from the US, EU, and Russia?

While clearly the wildcard of the bunch, albeit a very rational one, Russia’s path is perhaps the simplest to forecast. The G8 (Group of Eight) is for all intents and purposes the G7, following Russia’s suspension from the group of leading world economies. The OECD (Organization for Economic Co-operation and Development) has also shut the door on Russia, who stands as one of the most corrupt of the world’s major economies. Isolation á la Iran is not likely, but a heavy cooling of relations among its Western trade partners has already begun in earnest, with the US, Germany, France, and collectives like NATO and the EU leading the way. Russia is not expected to lose any sleep over the matter, however. Sure, economic diversification will slow down– they were never truly all in for modernization – and Russia will hang on to the “developing” moniker for some time, but the status quo is not all bad for Russia. The country still possesses the largest proven reserves of natural gas and the eighth largest proven reserves of crude oil.

Ignoring any derogatory connotation, Russia will more fully embrace its role as a petrostate. Oil and gas revenues are the Russian economy and greater isolation on the world stage only furthers this role. Buyers are in no short supply, but strengthening ties with the East, a region already long coveted, will be fast-tracked. Existing infrastructure like the ESPO (Eastern Siberia-Pacific Ocean) Pipeline and Sakhalin LNG (liquefied natural gas) ensures Russia’s foot stays in the door, but more is needed to take the pressure off any significant drop in volumes to Europe. The head of state-owned Rosneft, Igor Sechin’s recent Asian tour including stops in Japan, India, Vietnam, and South Korea demonstrates Russia’s strategy adjustments. Most importantly, the region is not only a viable end market for crude and LNG, but also a means to replace the billions of dollars fleeing Russia’s borders. Foreign capital, especially from Asia, is critical to the development of Russia’s thus untapped reserves.

Moving to the West, all eyes are still on Ukraine. The IMF (International Monetary Fund) has pledged up to $27 billion in the next two years if Ukraine enacts strict austerity measures to right its economy. Ukraine is not united however, and unrest in the Eastern regions has the potential to reshape the crisis. Pro-Russian Ukrainian activists in the cities of Donetsk and Kharkiv are seeking a referendum in the vein of Crimea, inspiring more of the same, yet opposing rhetoric from Russia and the West. For the time being, the separatist movements seem to have the tacit approval of the Kremlin, while pro-Ukrainian insurgents are banking on Western protection. Last week the EU, Russia, Ukraine, and the US gathered in Geneva in what were the first four-way talks since the crisis began. The resulting Geneva Accord seeks to bring diplomacy back to the table and tasks the OSCE (Organization for Security and Cooperation in Europe) with removing all illegal armed groups from Ukraine. The practical steps for accomplishing this arguably impossible undertaking have yet to be set however, and the Swiss envoy to the agreement admits, “The political will is not there to move out.”

Each day brings further complications and on April 20th three people were killed in Slavyansk, violating an unwritten Easter truce. Further violence is likely to trigger added sanctions with the West eyeing bigger, and more powerful targets; Gazprom CEO Alexei Miller and Rosneft president Igor Sechin are believed to be next in line. However, any further sanctions directly targeted at the wider Russian economy are doubtful barring any explicit military incursion. Put simply the West, and especially the EU, is in no position to drop Russian energy cold turkey. Business interests like those of ExxonMobil and BP are likely to factor into the equation, but energy security remains the big issue.

US gas exports plainly cannot fill that void, now or in the future. European buyers put away a record 505 million cubic meters of Russian gas on March 4th, as the turmoil in Crimea was just unfolding. In a best-case scenario the US can replace up to one-seventh of that total by the end of 2015. Beyond that however, it is unclear how much more relief the US can provide. The arbitrage opportunity is small as any significant volume of exports will increase the parity between the US and European spot prices. US technology and expertise presents an interesting opportunity for European shale plays, but minus the benefit of strong lobbies like in the States, Europeans will be a hard sell on the debatably dirty business.

For now Putin and Russia can stomach the sanctions from the West. Immediate losses are likely to be recovered in the East. However, oil and gas is a slow-moving business and even small lapses in investment carry large implications 10-15 years down the line. The EU and US are running out of cards to play. Ironically enough, energy remains one of the only spheres of cooperation at the moment between the two sides, even if by proxy. Russia has been a notoriously difficult, though lucrative, place to operate for companies like ExxonMobil, Chevron, and BP. Their technology and know-how is necessary as Russia moves to the Arctic and explores unconventional plays. Further sanctions risks making their life a lot more difficult.

 


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