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. Last Updated: 07/27/2016

Putin's Record Provides Cause for Optimism

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More often than not the state's interaction with the energy sector has created the impression that investment risk is on the rise in Russia. Starting with the Economic Development and Trade Ministry's plan to raise taxes in the oil sector, unveiled in February 2003, and including the Yukos affair and the Sakhalin-2 production-sharing agreement dispute last year, the news has been about nationalization and state interference.

The concern is that greater state control is bad both for industry and ultimately for the economy. This concern is re-enforced by the fact that state companies were the laggards when industry was boosting production from 2001 to 2005, and that the state has not yet taken steps to develop several major hydrocarbon deposits that have been known of for more than a decade.

So is it the case, as the pessimists would have it, that Russia has been lucky on President Vladimir Putin's watch, benefiting from nearly three-quarters of a trillion dollars earned from oil and gas exports, but is now poised to squander this opportunity by killing the golden goose and delaying investment programs designed to broaden the economy?

Or can the case be made that the state's approach to the energy sector, albeit often clumsily implemented and poorly explained, is part of a process of using the leverage afforded by the country's most important industry to advance the consistently stated goals of achieving a better balance in the economy and more sustainable growth from a globally competitive industrial base?

In their medium- to long-term investment case for Russia, investors are banking on the second possibility.

In order to substantiate this assumption it is important to consider the state's involvement in the energy sector in the context of broader changes that have taken place since early 2000. In his inaugural address to the parliament, Putin set out key long-term objectives for Russia, including a more diversified economy and a greater international role both for the country and for industry. But he also made clear that the state would not support major reforms in the strategic industries until it was sure of its control over the process.

As a result, Putin focused on domestic issues in his first term and his government interfered little with industry, apart from the pressure put on oil companies to concentrate less on corporate restructuring and to recover lost production and exports.

In February 2003, we first heard of the state's plan effectively to slow production growth in the oil sector by raising taxes, thereby reducing the amount of cash available for new projects and delaying new development licenses and proposed export routes. This meant that production and export growth would slow sharply by 2006, as in fact happened.

This slowdown can be blamed on state interference. But far from being an accident, it fits comfortably into the state's long-term economic planning. The original plan was to use the extra tax revenue to pay for tax breaks and investment incentives for small and medium-size enterprises and industries that would contribute to economic diversification. Today the expectation is that these taxes will be channeled into projects in strategic industries.

Given the state's reluctance to pursue major industrial reforms before its control was secure, the emergence of state-owned national champions in the energy sector was an inevitable prerequisite to the next phase -- the leveraging off of the state's key asset to pursue the goals of economic diversification and industrial internationalization.

When the current government came to power, barter was still widely used in the economy. Today, while it is all but extinct as an important economic factor, the Kremlin is using "energy barter" to pursue its goals. The European Union wants an energy deal with Russia and this means securing the Kremlin's commitment to allocate known hydrocarbon deposits for development. It also means involving European energy companies in joint-venture deals and exporting the products to Europe.

The evidence suggests that the Kremlin has no fundamental objection to this prospect, but only if it secures a new trade deal in return that would end trade barriers that cost Russian exporters billions every year and that would clear the way for increased cross-border investment.

The issue of energy for trade was highlighted by the EU's negative reaction to VTB's acquisition of an equity stake in the European Aeronautic Defense and Space Co., which led to the suspension of talks on developing the Shtokman gas field. The fact that major energy projects like Shtokman remain in limbo has less to do with the government's indecisiveness than with the attempt to swap foreign participation in these projects for a less restrictive trade and investment relationship.

The Economic Development and Trade Ministry's vision of the energy sector as a source of tax revenue to sustain investment spending elsewhere has clearly changed. Today, far from capping growth in the oil and gas sector and concentrating on developing other areas, these industries remain at the core of the state's plan for the economy. The state is bartering new projects in the energy sector to get better trade deals and to clear the way for Russian companies to become more international. "The Russians Are Coming," declared a headline in the Financial Times recently. Yes they are, and the passage west, in particular, will be paid for with reciprocal deals in energy.

In addition to promoting international ambitions, the energy sector also has a role to play in diversifying the economy's growth drivers and, strange as it may sound, in lessening the vulnerability to oil price volatility.

Despite the Yukos affair and Sakhalin-2, the state's approach to the energy sector has been reasonably consistent. First it pushed the oil companies to build up production and exports; then it raised taxes to build up a substantial financial reserve; then it established a dominant role for itself via Rosneft and Gazprom; now it is bartering both the timing of new developments and foreign access in exchange for international trade and investment deals.

If this trend continues, we can expect to see several major new gas and oil deposits allocated for development from later this year with up to a 49 percent equity interest in each made available to foreign oil companies -- similar to the end result in Sakhalin-2.

At the same time we know that the government plans to promote greater investment into downstream projects, such as liquefied natural gas, refineries and petrochemicals generally, as a means to improve the balance between the export of price-volatile raw materials and less volatile, but higher value-added products.

It is tempting to point to confusing cases such as Sakhalin-2 and to conclude that the state's approach to the energy industry, and the economy as a whole, is simply a reaction to events. The state's short-term strategies appear poorly thought out, but the evidence over the past seven years suggests that it would be wrong to assume that this applies to the macro-management level as well.

The Kremlin has clearly stated long-term goals. The means by which it implements these goals may cast doubt on this assertion, but a sober analysis of the events of the last seven years supports this more optimistic conclusion.

Christopher Weafer is chief strategist at Alfa Bank.