Economic Policy vs. Oil Prices

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Today, with attention riveted to oil price movements, fluctuations in the price of a barrel of oil on the London or New York commodity exchanges seriously affect the mood in Russia. When prices fall, media commentators start predicting a crisis, while if there is an upturn the assumption is that things will sort themselves out. Given that markets are volatile, opinions switch back and forth like a yo-yo. Moreover, a plethora of myths, delusions and fears has built up around the subject of oil prices.

Alarmist predictions distract our attention from the most important issue.

If you don't heat your house as winter is approaching, then all you can do is hope that the winter won't be too severe. If you don't purchase an air conditioner as summer approaches, you have little option but to hope there won't be a heat wave.

Whether there will be a crisis or whether industrial growth will continue in Russia depends primarily on the economic policies pursued and not on oil prices.

Let's look at the main issues regarding oil prices and economic policy.

1. Can Russia influence world oil prices?

No, it cannot. Given that the United States has been hit by recession, Japan is already firmly in recession, and there is a substantial slowdown in economic activity in Europe, it is completely nonsensical to take any measures to artificially support high oil prices. In conditions of recession one cannot have high prices.

The Russian government's ability to influence oil prices is negligible. Russia's share of the world oil market is around 10 percent in terms of export volume and a little more than 6 percent by value. But even OPEC, whose market share today is around 40 percent, cannot control oil prices. It is also worth remembering that over the past decade our market share has already decreased considerably from 16 percent.

If Russia cuts exports, it will simply lose market share. Today, total Russian oil exports to the world market are about 4 million barrels per day. The unused oil producing capacity in OPEC countries alone is around 4.5 million barrels per day. Even if Russia were to suddenly cease exporting oil completely, its share would rapidly be replaced by oil not only from Kazakhstan and Azerbaijan, but also from OPEC members.

2. Should the government establish limits on the production and export of oil?

No, it should not. It is absolutely inadmissible for the state to interfere in the activities of private oil companies, and to set production and export levels. Such interference undermines the very foundations of a civilized market economy.

3. Is there such a thing as a "fair" oil price?

There is no such animal in the zoo as a "fair" price. The market sets the price of a commodity. Administrative interference in setting prices leads to inefficiency and imbalances. If the oil price is fixed above the market's equilibrium, then it leads to wastefulness and extravagance in the oil and gas sectors, and billions of dollars are spent on unnecessary investments. If the price is below the market's equilibrium, then consumers become wasteful and the energy consumption of national industry increases. Disequilibrium in prices leads to waste either way.

4. Is a high or a low oil price better for Russia?

The Soviet economy developed most successfully in the 1950s and the first half of the 1960s. At that time the Soviet economy demonstrated very high growth rates. From the mid-1960s we embarked on large-scale production and export of oil, and the more oil we exported, the lower economic growth rates became, until growth rates de facto fell to zero in the 1980s and became negative in the 1990s.

The same rule applies to the last three years. From September 1998 to April 1999, when the oil price was very low (around $10 per barrel), annualized industrial growth was 18 percent, with machine building growing by 50 percent and light industry by 52 percent. When oil prices grew to $20 per barrel, industrial growth slowed to 9 percent. From October 2000 to June 2001, when very high oil prices prevailed, industrial growth fell to 2 percent, and in some months ceased completely.

A low oil price, as it turns out, is a blessing for the Russian economy, stimulating industrial growth and creating jobs.

A $1 drop in oil prices means an increase in GDP growth rate of about 0.9 percent. Low oil prices make it possible to preserve hundreds of thousands if not millions of jobs. In the period between September 1998 and April 2000, when the oil price was at its lowest, unemployment fell fastest, with the number of unemployed decreasing by almost 2 million.

5. What happens to the budget if the oil price falls?

If the oil price falls by $1, the budget loses approximately $1.4 billion over the year. If the oil price falls by $5, then the budget loses roughly $7 billion. Is this catastrophic or not? Planned budget revenues for 2002 are $67 billion to $68 billion. If the price of oil falls by $5 per barrel, budget revenues will be reduced by approximately 10 percent to $60 billion to $61 billion. However, even in this case, they will be more than twice as high as revenues for 1999 ($25 billion) and even for 2001 (expected to be $55 billion).

There will not in fact be a fall in revenues, but merely a slowing in the growth of budget revenues in dollar terms. Instead of budget revenues growing at 20 percent, they will grow at around 10 percent. Is it a catastrophe?

6. Do we need to cut budget expenditures?

The 2002 budget was calculated on the basis of clearly unrealistic oil prices. If we do not cut budget expenditures for 2002, there is a danger of committing another mistake. In 1998, when world oil prices fell from $16 to $10, the Venezuelan government slashed budget expenditures eight times and the Mexican government 12 times, so that only the most crucial of the state's expenditures were covered. Other oil exporting countries followed similar policies, with the notable exception of Russia. Neither the government nor the State Duma tried even once to introduce amendments to the budget in connection with falling oil prices. The outcome in August 1998 is well known.

7. What should Russia do with OPEC?

OPEC is an unreliable partner. Not long ago, the organization kept inviting us to join the cartel and now it is declaring Russia an enemy and threatening to launch a price war against us. OPEC is an ineffective organization; it is well-known that OPEC decisions on quotas are not adhered to by the cartel's own members. OPEC is historically doomed organization. In the 1960s and 1970s, OPEC's market share was as high as 73 percent; while today it has fallen to 40 percent and will continue to fall. OPEC's success in controlling oil markets in the 1970s and 1980s was linked to the specific features of the world order in the second half of the 20th century, in particular to the Cold War. This epoch is now history and in the new order OPEC's influence is falling and will continue to fall.

Russia's position in the oil price war indeed looks stronger than OPEC's. Russia has a much more diversified economy and we are less dependent on oil than Saudi Arabia, Kuwait or Venezuela.

8. Will Russia succeed in avoiding a crisis?

The answer to this question can be found not in the price of oil but in the quality of government decisions, i.e. the responsibility and consistency of government policy. In April 2001 in his annual address to parliament, President Vladimir Putin formulated the principles that would enable us to protect the Russian economy and economic policy from world market volatility. The president spoke of the need to form two budgets, the second budget being a stabilization fund. He also spoke of calculating the main budget based on conservative estimates of oil prices. A conservative estimate under current circumstances looks like $10 per barrel rather than $18.5 or $23.5.

An aggressive policy in foreign debt repayment is also a factor in stability, reducing exposure to external risks. If we adhere to these principles and do not repeat old mistakes or make new ones, the Russian economy will develop irrespective of the oil price.

Whatever the political battle around the 2002 budget, the government will have to cut some expenditure items. It is better that the government does this itself, rather than wait for this to happen in response to market imperatives, as was the case in August 1998.

Andrei Illarionov is economic adviser to President Vladimir Putin. He contributed this comment to The Moscow Times.