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. Last Updated: 07/27/2016

Rock Bottom for Commodity Prices




Forget about the International Monetary Fund. Forget about "the oligarchy." Forget even about the Cabinet, the Kremlin and the parliament.


All of these actors can exert some small influence on the state of the Russian economy. But in the end, Russia will be swept up and carried along by a force out of everyone's control: world prices for commodities.


Seventy-five cents of every dollar Russia earns comes from the export of oil, gas, coal and metals. World market prices for all of those commodities are now severely depressed. And the bad news for Russia is, they are likely to stay that way, or even slide further, over the next two years.


That means less tax revenue from the oil and gas and metals sectors for the Russian budget.


It also means Russia will earn far less hard currency, further weakening the ruble against the dollar. Not only will a weaker ruble stifle Russian economic growth and foster more inflation, the dwindling hard currency reserves in government vaults will make it that much harder to pay off billions of dollars in loans - which could push Russia into a massive foreign debt default next year, when a whopping $17.5 billion of interest and principal must be paid.


What's more, depressed commodity prices make Siberia's hulking metal smelters and oil rigs look less attractive to potential investors - why shoulder all the risk now of trying to make them more efficient, when their production is worth less than it has been in years?


"If commodities continue to fall it will make a very bad situation even worse," said Anthony Thomas, Central and East European Economist at investment bank Kleinwort Benson in London.


It's easy to see why Russia finds itself in this position. The nation holds some of the world's biggest reserves of oil and gas, coal, iron ore, copper, nickel, diamonds and gold and, with its powerful Siberian rivers, is able to generate the hydroelectric power to fuel massive aluminum smelters. Oil, gas, coal and metals represented more than 75 percent of Russia's export earnings in 1997, placing Russia near the top of the world's resource-dependent nations. Even Canada, often compared to Russia for its bounty of resources, relies on fuel, minerals, metals and other primary commodities for only 34 percent of export earnings, according to World Bank data.


Norway, Australia and New Zealand are the only nations among the wealthy economies of the Organization for Economic Cooperation and Development that equal Russia's dependence on natural resources, earning from 65 percent to 73 percent of export revenue from commodities.


But while these nations enjoy thriving domestic economies, Russia does not. Here, as in many Third World nations, raw materials are the engine that drags the train.


Export of oil alone is widely recognized as having kept the Soviet system alive during the 1970s and early 1980s, allowing the U.S.S.R. to exchange its black gold for the foodstuffs and other goods it needed.


"The Soviet system collapsed exactly when oil prices fell" in the mid 1980s, said Vladimir Drebentsov, an economist and trade specialist with the World Bank in Moscow. "Given the inefficiencies of the Soviet economy, they couldn't survive."


Oil and other commodity prices climbed again in the late 1980s and early 1990s. Those years now look fat in retrospect, as rising demand for raw materials - mostly in the booming Asian economies, and to a lesser extent in expanding American and European economies - drove up prices. This foreign demand fueled a healthy 2 percent to 3 percent annual growth in Russian exports.


But early this year prices began to spiral down again, as demand for commodities plummeted among the Asian nations that had been the fastest-growing group of consumers.


The slide in commodities prices proved a key catalyst to Russia's financial collapse in August. High export earnings had been one of the main support beams holding the ruble steady in 1996 and 1997; collapsing commodity prices kicked that support beam away. Hard currency inflows shrank, eroding the Central Bank's reserves and the value of the ruble.


The consequences of the ruble devaluation are well known by now: crashed banks, a de facto bankrupt government that cannot pay its domestic debts and a wave of major setbacks for businesses across Moscow and the country.In an attempt to bolster the ruble the Central Bank has made a grab for the precious commodity dollars, adopting new rules that force exporters to sell 75 percent of their hard currency earnings for rubles on the Moscow Interbank Currency Exchange, or MICEX.


But fewer and fewer dollars are likely to flow into Russia. Economists are predicting Russia's export revenue this year will fall by 15 percent compared to last year's, to about $75 billion. State Statistics Committee figures agree: They indicate export revenues have already fallen by 14 percent for the first eight months of the year.


As the oil dollars dry up, the ruble will stay weak for the foreseeable future. While some business will enjoy short-term gains from a weak ruble, it leaves everyone else - from consumers to importers to domestic manufacturers - in a bind.


Domestic manufacturers, for example, are grappling with their reliance on imported parts and ingredients as the weak ruble makes such imports noticeably more expensive. Many are already cutting back production. Russia's booming confectionery industry last week reported it would have to scale back chocolate production by 20 percent this year because imported cocoa beans, bought for dollars, had become too expensive.


That same week AvtoVAZ, Russia's biggest auto maker, said it was attempting to cut back on the quantity of imported parts it uses in its Lada and Niva models.


The high costs of imports will prove one of the main factors stalling or even reversing economic growth in Russia for the foreseeable future, the World Bank's Drebentsov said. Although gross domestic product ticked up about one percent in 1997, it fell by three percent for the first nine months of 1998 compared with the same period in 1997 and isn't expected to grow at all in 1999.


When commodity prices go up, it kicks off a chain reaction that eventually lifts the entire economy: Dollars flow back in to Russia, the ruble strengthens, imports become cheaper and manufacturing kicks back into gear. Until that happens, GDP will probably continue to flat-line.


"The environment is not favorable for resumption of economic growth unless, of course, commodities prices change again," Drebentsov said.


The commodity to watch is oil. It is Russia's second-biggest hard currency earner after natural gas, but it is the key because natural gas prices are indexed to oil prices.


Crude oil has fallen from a high of $21 per barrel in October 1997 to about $12.20 per barrel today. It will probably continue to sell for no more than $13 to $14 per barrel in 1999 and 2000, according to the U.S. consultancy Cambridge Energy Research Associates, or CERA.


The Center for Global Energy Studies in London agrees with this forecast, predicting little oil price growth for the next two to three years as Asia recovers.


Prices on natural gas have fallen correspondingly, by about 20 percent over the past six months and will only improve when crude oil prices climb. Even if that does happen, plans to open the European gas market to greater competition in 2000 should exert new downward pressures on prices, said William Powell, natural gas editor at Petroleum Argus, a London-based industry trade journal.


OPEC, the Organization of Petroleum Exporting Countries, may try to drive up the price by reducing supply, but "only rising demand for oil will raise prices on a sustainable basis," CERA said in a recent report.


That won't happen until Asia's economies climb out of recession. The consultancy estimates world oil demand will lag about 2.7 million barrels per day behind the 80 million bpd it would have been at the end of 2000 without the Asian crisis.


Coal export prices, too, have fallen about 22 percent to $21 per unit (6,000 kilocalories per kilogram) in recent months as buyers demand - and get - lower prices to reflect producers' lower costs. Together, oil, gas and coal represented about half of Russia's export income in 1997.


The outlook for the second-biggest export group - metals and precious stones, which contribute one-quarter of export revenue - looks equally depressing.


Two of Russia's three main metals exports, steel and nickel, have taken big hits and are continuing to slide, while the outlook for aluminum is only a bit more promising.


The price of nickel has fallen 20 percent from last year's average and is expected to fall another 6 percent through the end of 2000, according to Flemings Global Mining Group. Russia's lone nickel factory, Norilsk


Nickel, is the world's largest producer of the metal, while the financially troubled Asian states of Japan, Taiwan and South Korea are among its top five consumers. Nickel is used mainly to produce stainless steel.


Until economic crisis gripped Asia, the fast-growing economies of Southeast Asia were also big consumers of Russian steel, snapping up 35 percent of the iron ore and steel Russia ships abroad each year.


"Now this market has disappeared," said one Russian metals analyst.


Prices have plummeted 20 percent since then, and that has U.S. and European steel makers howling in pain and demanding protection. The U.S. Commerce Department is considering erecting anti-dumping trade barriers against Russian steel, which would cut off another strategic market.


"Most metals are at five-year lows or more," said Grant Sinitsin, an analyst with United City Bank/Flemings. "We are in a global economic slowdown."


Some commodity prices are expected to rise. Russia is the world's top exporter of raw aluminum, which is refined into aluminum metal and used to build cars, aircraft, and beverage cans, and depressed aluminum prices are forecast to rise by about 11 percent in 1999.


Prices on precious metals including palladium, gold and platinum are also forecast to rise as investors seek safe-haven investments against perceived weakness in the U.S. dollar. Export revenue of diamonds is expected to remain steady.


Precious metals and aluminum all told represent less than ten percent of export earnings, however, so their expected rise in value will do little to compensate for the weaknesses of export giants like oil, gas, steel and nickel.


The value of the ruble is a reflection of how the world expects Russia's economy to perform. And the ruble is dropping in value. This is partly because Russia is earning fewer export dollars.


But the further the ruble falls, the more a dollar is worth to cover the domestic ruble expenses of producing those barrels of oil.


In the short term at least, the ruble's devaluation has proved a boon for some. Oil producers have watched their ruble expenses plummet in the wake of the devaluation, widening their paper-thin margins on exports to fat returns.


The advantage for metals producers has been even greater: While Russia exports only about one-third of its oil, it sends abroad from 60 percent to 90 percent of its metals. Metals analysts say nickel and palladium giant Norilsk Nickel is especially well-positioned to benefit from a sinking ruble - despite sinking nickel prices - as it exports close to 100 percent of production and has almost no hard currency costs.


Yet Russian companies sell two-thirds of their oil at home, where a deteriorating domestic market will offset to a certain extent any export gains caused by the devaluation. Eventually labor and other ruble-denominated production expenses will catch up to already-rising inflation. Then, natural resources producers will face low world prices - and a domestic market even more mired in barter, inflation and nonpayments than usual.


In the meantime, however, oil and gas and metals producers are enjoying a devaluation-led boom. Exactly how this windfall will be used remains a key question.


In theory, the oil, gas and metals barons could reinvest profits into their holdings, to upgrade production and open new oil and gas reserves. Modernization is sorely needed, particularly at outdated steel mills and aging Siberian oil fields.


Already, crude oil production has dipped by one percent in the first nine months of the year, while oil refining fell by 8.1 percent as export and domestic demand for oil products sank. Investment bank United Financial Group predicts a 5 percent crude production decline in 1999.


Any government move to lean too heavily on oil companies with tax hikes would worsen this trend, said Julian Lee, an analyst with the Center For Global Energy Studies.


This "would support the macroeconomy for the short term, but if industry doesn't have the money to invest in long-term production, then you won't have an oil industry left," Lee said.


Finance Minister Mikhail Zadornov wants to take a cut of the windfall with a new tax on exports. But the oil barons have greeted that proposal with open hostility. Mikhail Khodorkovsky of the Yukos holding company last month led a charge against Zadornov's proposal, claiming that Russian oil production would already sharply drop next year, so much so that Russia might soon have to import oil. First Deputy Prime Minister Yury Maslyukov later repeated this dire warning in a speech to industry leaders.


Most analysts brushed off such talk as scare-mongering, noting that Russia's 1997 production was three times its domestic demand, leaving plenty of breathing room even in the event of drastic production cuts.


But even if the government does not suck up all of the oil dollars, there is no guarantee that today's profits will be reinvested into tomorrow's commodities production. Even in good times Russia's fickle oligarchs were loathe to invest profits back into production, preferring to treat their enterprises as cows for the milking.


Those same commodity kings, such as Khodorkovsky, founder of Bank Menatep, and Vladimir Potanin, founder of Uneximbank and the winner of the 1995 Norilsk Nickel privatization, have seen their banking empires collapse and their foreign debts soar as a result of the devaluation.


Nor are foreign strategic investors, who had once been chomping at the bit to tap Russian oil, as eager to play ball. Political and economic instability prompted France's Elf Aquitaine in August to abort a planned equity investment in Russia's Sibneft that would have sunk millions into the development of a huge field called Sugmut.


Russia's dependence on commodities is commonly known as "Dutch Disease." The term refers to the Netherlands' discovery and export of natural gas, which caused a sharp appreciation of the guilder. This killed off local industries by making production too expensive, either to export or to compete with imports.


How and whether Russia can widen its industrial base beyond natural resources has become a hot topic as Yevgeny Primakov's government pledges to revive domestic manufacturing. What resources it will use to do so remains a question, as lower commodities prices will translate into lower tax collection from the key energy sector.


Dmitry Lvov, head of the economics department at the Russian Academy of Sciences and an advisor to First Deputy Prime Minister Yury Maslyukov, said Russia should fight off Dutch Disease by usingits oil earnings to subsidize the development of manufacturing.


Manufacturers may not be able to compete with the quality of, say, German refrigerators, but if Russia were to lower taxes on refrigerator manufacturers and raise them on the oil and gas sector, then expenses on production would be cut in half, Lvov reasoned. "And if this refrigerator is half the price, even if it is of a little worse quality than Siemens, there will be demand for it," he said.


Now is the time to try such schemes, Lvov added, as the fall in the exchange rate has given Russian manufacturers of everything from automobiles to carpets a unique opportunity to compete successfully at home and overseas.


Analysts agree with Lvov's theories on lowering taxes on industry but suggest Russia focus less on refrigerators and automobiles and more on the few manufactured items it already produces competitively, such as aircraft.


Wooing foreign manufacturers of consumer goods to open factories in Russia would also lessen dependence on imports. Boosting value-added refining of raw materials, meanwhile, would help diversify Russia's economy beyond primary commodities, as would increasing the presence of home-grown services businesses.


But the reigning fear is that the government will prop up even the most moribund of industries with subsidies, forcing the healthy sectors of the economy to support the weakest.


"They will try [to build manufacturing] but I don't think they'll be successful because they won't promote manufacture of finished goods in efficient ways," said one Russian economist who asked not to be named.


"They'll use the old way of supporting national industry with subsidies, which is artificial."


Ultimately, few think Russia can conquer its dependence on commodities anytime soon.


"There's no way out. It's very difficult to see them turning this situation around," economist Thomas said. "Russia is going to go through an extraordinarily difficult couple of years."