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. Last Updated: 07/27/2016

Petrodollars Fail to Fuel Economic Expansion

Just as crude prices stormed to new heights last September, Russian oil producers appeared to have given up. They added less and less output as the year wound down.

This seemed to defy the laws of economics: The higher the price of a product, the more incentive companies have to produce it. As it turns out, however, oil barons were responding to very real disincentives from the government.

The state had decided, in the name of diversification, to redirect investment from the oil sector to less successful parts of the economy. But since it failed to make other sectors attractive, investment cash simply fled. The blunder, say analysts, highlights the dangers of state attempts to meddle with the allocation of resources in the economy.

The Sweeping Plan

As oil proceeds reached unparalleled heights in 2003, the Kremlin began to fear that Russia was "fall[ing] asleep under the warm blanket of oil dollars," President Vladimir Putin said later that year.

Three major international credit agencies refused to grant Russia an investment grade, citing oil dependence as a major reason for their decision. If prices of crude dropped sharply, the government would see its budget surplus turn into deficit, they said.

International financial organizations, including the International Monetary Fund and the World Bank, were chirping in unison that a skewed economy was a recipe for a crisis down the road. Some of them began diagnosing Russia with the so-called "Dutch Disease" -- a situation in which high oil revenues raise the value of the national currency, hurting the competitiveness of domestic industry.

So in February 2003, in response to mounting criticism, Economic Development and Trade Minister German Gref published a 127-page plan to diversify the economy by, among other things, diverting investment from the energy sector into manufacturing.

One of the ways to achieve that, according to Gref's strategy, was to hike oil taxes while relieving tax burden on other industries -- a plan he eventually implemented in 2004. The Russian government now pockets around 80 cents in taxes and tariffs out of every dollar above $25 per barrel, Alfa Bank estimates.

The new strategy also tacitly implied that reducing the growth in oil exports by limiting export pipeline capacity could help to redirect money into other sectors. If the oligarchs could not sell every drop of their oil, they would cut investment in production, investing it elsewhere, ministers hoped. Private pipelines are banned in Russia.

"Gref has been on record many times stating that the state planned a cap on new pipelines between 2005 and 2008 so that he could take an extra tax from the oil sector to fund growth in the rest of the economy," said Chris Weafer, chief strategist at Alfa Bank.

The Fallout

If that was the plan, it backfired. Higher taxes did indeed lower the amount of capital available to firms for investment and reduced incentives to build new capacity. But other parts of the economy suffered too.

Total investment by oil companies rose by 13.5 percent in 2004 after soaring 23 percent in 2003, said Kaha Kiknavelidze, senior oil and gas analyst at Brunswick UBS. However, some companies faced 20 percent to 25 percent capital inflation, so investment not just slowed down but may have actually declined in real terms, said Alfa Bank's Weafer.

As a result, oil output has also stagnated since September 2004. After soaring by over 9 percent year on year since 1999, the volume of crude produced by the top ten oil companies and Gazprom grew by just 2.7 percent in the year to June, according to Brunswick UBS.

Meanwhile, oil companies and their owners failed to invest in other parts of the economy, wary of the risky investment climate. Capital flight in 2004 amounted to $33 billion, according to Fitch Ratings. The economy slowed down. Gref has said this month that gross domestic product could grow by as little as 5.0 percent this year, down from 7.1 percent officially recorded in 2004. Inflation rose since lower economy output meant that money was chasing fewer goods, Weafer said.

Stumbling Apart

The slowdown in the economy came as a surprise to the mandarins, who did not necessarily seek to reduce oil production.

And the government did not anticipate the repercussions of the Yukos case, which undermined the investment climate in 2004 and exacerbated investment flight.

In fact, the combination of reasons that eventually led to slower energy investments and a reduction in oil output -- tax hikes, export constraints and the uncertainty stemming from the Yukos affair -- was probably never part of a coherent plan, said Philip Vorobyov, an expert at the Cambridge Energy Research Associates, or CERA.

"I've never seen anything that makes me believe there's a cohesive or coherent government policy," he said. "There are many different government agencies with contradictory aims and goals."

Some in the Kremlin see tight control over export routes as a way to keep oil barons in check. Others in the government, like the Natural Resources and Economic Development and Trade ministries, aim to squeeze oil exports from Western Siberia so that companies would invest in harder-to-tap Eastern Siberian fields. Whatever the intentions, the policy has undermined the growth in output.

Lessons to Learn

What are the lessons the government could learn from its gaffe?

Shifting resources away from the oil sector "is not a crazy idea when you're dealing with an economy prone to Dutch disease," said William Tompson, senior economist at the Paris-based Organization for Economic Cooperation and Development. "But the only way it is going to work is if you also create the environment in which it is attractive to invest in other sectors. Otherwise, you will divert investment abroad or into consumption; people will buy yachts and football clubs."

In Russia's case, the favorable conditions are clearly not there, Tompson said. This is partly because of the Yukos case but also because reforms to stamp out red tape and corruption, launched with great fanfare in early 2004, have been all but abandoned.

"I am hearing more and more people say, 'Well, it is now too risky to invest [in oil development] because the government could take your property anytime it wants.' And that's Russians saying this," said Jonathan Stern, director of gas research at the Oxford Institute for Energy Studies.

"The bureaucrats ... should just stand back and watch production start booming again," said CERA's Vorobyov.