The call of history: Copenhagen Climate Change Conference

The Copenhagen Climate Change Conference opens today in the Danish capital, with expectations raised after progress from the US and China in announcing hard targets and the revelation that US President Obama will now attend the final days of the summit, a sign the White House believes a real political framework is achievable. We will do our best to cover the developments over the next two weeks and start by highlighting a remarkable editorial run by 56 of the world's leading newspapers this morning in support of real reform, of inspired collective action, of 'the better angels of our nature.'

You can find it in The Guardian here.

I can only speak for myself, but I endorse their message.

Quick hits and pink picks: questions and answers

-Is the localization of supply chains history repeating (see: early 20th century)?

-The 'democratization' of the human genome?

-Is the US really more dependent on China?

-Who loves nuclear energy?

-Is Berlusconi the world's biggest party crasher (you might remember his G20 performance)?

-Will Arsenal win the Prem?

The Great Supply Crunch

Take no false comfort, The Economist warns of the coming oil price spike.

I have been arguing since the fall that we are experiencing but a lull; the long term trends and short term pressures contributing to oil's remarkable rise in 2008 remain firmly in place. The Economist lays out the argument in a succinct and comprehensive manner:

The explanation is simple. Oilmen are worried because they believe that many of the factors behind the record-breaking ascent last year remain in place. Much of the world’s “easy” oil has already been extracted, or is in the hands of nationalist governments that will not allow foreigners to exploit it. That leaves firms to hunt for new reserves in ever more inhospitable and inaccessible places, such as the deep waters off Africa or the frozen oceans of the Arctic. Such fields take a long time and a lot of expensive technology to develop. Worse, new discoveries tend to be smaller than in the past and to run dry faster.

So oil firms must work doubly hard to replace declining fields and to increase output. As Francisco Blanch of Merrill Lynch puts it, they must find another Saudi Arabia’s worth of oil every two years just to maintain their production at today’s levels. Yet the oil industry is short of equipment and manpower, thanks to decades of underinvestment in the 1980s and 1990s, when prices were low. That left it struggling to expand despite the strong price signal of recent years, and thus poorly positioned to cater to vast new markets in the developing world, including China and India, where oil consumption has been growing fast. At the height of the boom, with the price repeatedly setting records, production outside OPEC even fell.

As soon as the world economy starts growing again, the theory runs, demand for oil will once again outstrip the industry’s ability to supply it. The seemingly ample cushion of inventories and spare capacity will quickly be exhausted, sending prices soaring. In other words, the global recession has only interrupted the “supercycle” of which many analysts used to speak, during which the normal boom-and-bust cycle of oil and other commodities would give way to a protracted period of high prices, as ever-growing demand from emerging markets swallowed everything the extractive industries could produce. “The commodity supercycle is not over, just resting,” says Mr Blanch.

It is important to note that a number of factors can help mitigate this super-cycle: technological innovation, cap and trade and fuel efficiency standards in the world's largest and emerging economies, a prolonged demand slump in the developed world, the conversion of vehicles and mass transportation systems to natural gas, to name but a few. But the underlying demand, reserve and production trends will sustain oil's steady rise.

The Great Supply Crunch is coming.

Quick hits and pink picks: Dowdy, gloomy, dire no more

-Last week, Michael Skapinker wrote a piece in the FT entitled 'Britain's years of progress were no illusion.' It remembers 1970s Britain and asks us to retain a little perspective on the tremendous progress of the past three decades (in Britain and beyond).

-The NYT looks at the likely response of the US credit card industry to regulatory reform.

-Brazil and China will begin using their own currencies in official trade transactions, accelerating an intended shift away from the dollar by two of the world's (emerging) economic powers.

-How the Russian military (and pop stars?) sees the country's energy diplomacy with Europe, set to song and dance. Funny, and frighteningly true.

-Say it aint so, Arsene.

China: the ultimate value investor?

The US has been called the world's largest venture capitalist. Should China now be considered its largest value investor?

For a look at the implications of Chinalco's proposed investment in Rio Tinto, check out my recent piece at zzzeitgeist.

Vladimir Putin: "Don't do as we do...we do it best!"

Russian Prime Minister Vladimir Putin used his podium at the World Economic Forum to attack the dollar's supremacy, skewer Wall Street bankers, and call for a new global energy paradigm. He also layed the smack down on Michael Dell.

But it was his warning against excessive state intervention in response to the global economic crisis that really caught my attention. His statement was, um, interesting:

"Excessive intervention in economic activity and blind faith in the state’s omnipotence is another possible mistake."

Huh. Putin, excessive intervention, blind faith in state's omnipotence. I feel like these things are related.

Is the EU finally serious about its energy future?

Find out here...

IEA Report, Russia/China pipeline agreement, and the European Energy Security Plan

A number of important developments in the global energy markets over the past few weeks:

-an IEA report finds that the world's oil output is declining at a rapid pace. The annual rate of decline is projected at 9.1% without a substantial increase in upstream investment. Even after recent investment, output from the world's largest oil fields is falling by over 6%. As my analysis of Russian energy production highlighted, an increase in upstream investment is neither easy nor probable. Falling global demand will only lessen the incentive to invest more in production. With little excess capacity, and OPEC voluntarily cutting production (potentially by millions of barrels of day more in the coming months), the global oil markets risk renewed volatility when demand recovers.

-Russia and China signed a landmark oil pipeline agreement on October 28th. The addition to the East Siberia-Pacific ocean trunk pipeline could ultimately carry up to 15 million tons of Russian oil to China per year. The agreement is significant on two levels: it signals Russia's desire to pursue the "China alternative", and it could portend a greater financial role for China in Russia's energy sector.

-finally, we might look back on October 13th as the beginning of a new era in European energy. The Times of London is reporting that the bloc will announce a European Energy Security Plan. The plan calls for: 1) the construction of a European supergrid, connecting power grids from North Sea wind farms to the Baltics, 2) the construction of two new gas pipelines, connecting Caspian and African gas to the bloc, and 3) a "Community Gas Ring", which would essentially allow for the pooling of European gas supplies in the event of supply disruptions. These measures will directly address import diversification (particularly in natural gas, and specifically away from Russia), security of supply issues, and fragmented national power grids.

This is a highly ambitious plan, and in my opinion, one that has absolutely no chance of being carried out in its entirety. The pipelines just aren't commercially viable yet. Furthermore, the national regulatory and interest-group challenges to EU-wide liberalization in the energy sector are formidable, and to date have blocked any substantive effort towards a single European energy market. The political will simply isn't there in France/Germany/Italy, and national interests always trump regional considerations in European energy. Despite my pessimism, the Plan is an important development, if for only one reason: it coincides with the resumption of talks between the EU and Russia over their economic and energy relationship. It looks like the EU may have finally come around to playing hard ball with Russia, and utilizing its leverage over Russian security of demand. Stay tuned for updates on these discussions over the coming weeks.

On Russia, Part III: US-Russian relations

US-Russian relations are at their lowest point in decades, arguably since the 1960's. While the threat of direct military/nuclear confrontation is remote, the two countries have stopped talking to one another. This is troubling when US-Russian cooperation is critical to solving many of the world's most pressing challenges. Some background:

Vladimir Putin spent his presidency's first term consolidating political power, stabilizing the Russian economy, and seizing control of the country's energy sector. The US took little note. 9/11 and the "war on terror" occupied America domestically and abroad, and Russia was by all accounts a helpful ally. Putin was the first foreign leader to speak with George W. Bush after the terrorist attacks, Russia quietly helped the US prepare for Afghanistan, and it seemed as if the two countries would be natural allies in the post-9/11 world (Russia, after all, has its own terrorism problem).

But a funny little quagmire happened on the way to the party: Iraq. Russia was decidedly against US military expansion in the middle east, and aligned itself with European powers France and Germany against US hegemony. Iraq was the opening Putin needed to shift Russia's foreign policy in contrast to the US, which in retrospect appears to have been his intention all along. In 2005, Putin told the Federal Assembly that the collapse of the Soviet Union was "the greatest geopolitical catastrophe of the twentieth century". Russian rhetoric had turned sharply against the US, and Putin began to present the world an alternative vision to US hegemony.

Iraq, Syria, Iran. On each of these issues, Russia used its voice, influence, and Security Council veto in opposition to US interests. Russia re-asserted its influence over Eastern Europe and the Caucasus through energy leverage and the undermining of democratic movements. This fundamentally clashed with US (and European) policy in the region. Putin's 2007 "Munich speech", in which he lashed out at the US and its "unipolar" project, was years in the making, sharpened by US missile defense plans and prospective NATO expansion, and fed by a punch-drunk confidence derived from petro-dollars and energy leverage in Europe. It marked a new, more hostile, era in US-Russian relations.

Russia's incursion into Georgia was a watershed, with both sides lashing out at the other over those circumstances and, opportunistically, more. The war also convinced the White House that Russia was now a direct threat to US interests. This has resulted in a suspension of almost all communication between the two sides, and a decidedly icy outlook on future relations.

Three angles are important to understanding why this relationship deteriorated, and how it will develop over the coming years:

-one must look at the domestic landscape to understand Russia's foreign policy. Putin's project (political consolidation, economic nationalization, etc.) has relied on/fostered a strong nationalist sentiment within Russia. The creation of external threats is often necessary to build public support in favor of authoritarian consolidation. This works particularly well in Russia, feeding anti-immigrant sentiment, conjuring the emotion over Chechnya, and speaking to a general sense of having been "humiliated" following the collapse of the Soviet Union. Nashi, Kremlin sponsored youth summer camps, and anti-immigrant violence are all expressions of this nationalism. The Kremlin and its surrogates have fostered an image of the US as a country bent on humiliating (post-Soviet collapse), surrounding (NATO), and infiltrating Russian society (opposition groups, critical press, etc.). The perception of an imperial US is shared by Putin, the silvoki, and extreme (well connected) elements of the Russian population. The nationalism the Kremlin has fostered is dangerous, it will prove difficult to put the genie back in the bottle.

-The US appears to have been seriously blind to Russia's methodical build-up since 2001. The war in Georgia seemed to catch US officials completely off-guard. It took weeks for a clear, consistent message to come out of the US government. For an administration populated by so many creatures of the Cold War (not least, Secretary of State Rice, a renowned scholar on the USSR/Russia before joining the Bush administration), it is stunning the US was not better positioned for such events. Sure, missile defense plans have been developed with an eye towards Russia, and US policy in Central Asia is as much about securing Western energy supplies as it is the "war on terror". But the lack of insight into Russian motives and sensitivities demonstrated by the Bush administration is surprising. A final point: for all of the cowboy diplomacy and reckless unilateralism of the first Bush administration, the second term has been defined by genuine multilaterism and pragmatic, realist diplomacy. Whatever the impetus, the Bush administration does not get enough credit for this shift. It is this context that makes the suspension of almost all communication with on America's most important partners so stunning.

-the way forward is unclear. Without dialogue, the two countries risk a dangerous game of chicken, where each side positions itself against the other on critical issues. I strongly disagree with all the talk over a new cold war. It is in neither country's ultimate interest, and circumstances will bind them to a minimum level of cooperation (Russia's financial and economic problems in the current environment, the US need for Russian assistance on Iran). But on significant issues (energy, Afghanistan/Pakistan, financial crisis), they do fundamentally disagree, and a lack of dialogue will undoubtedly lead to confrontation. The importance of regimes in this context cannot be understated.

A working relationship between the US and Russia is critical to solving the energy, financial, political, arms control, and terrorism-related challenges of our time. They should start talking now.

On Russia, Part II: European Energy

The EU-Russian energy relationship has been well publicized, much commented upon, but poorly understood over the past few years. There is a broad misconception (or ignorance) in the media that Russia possesses dominant leverage over the EU in the form of natural gas supplies. However, the true story is far more complicated. The EU-Russian energy relationship is one of mutual-dependence, and neither side can afford a breakdown in cooperation.

Europe is undoubtedly dependent on Russian natural gas imports. Demand for natural gas has grown substantially in recent years (it is cheap, clean, and relatively abundant). As North Sea production has rapidly declined over the past decade, Europe’s reliance on imported natural gas has skyrocketed. The EU only produces approximately 46% of its current natural gas consumption, a figure projected to plummet over the next 20 years.

The growing supply/demand imbalance exposes the EU to greater external supply risks, particularly as it becomes dependent a single supplier. As of 2005, twelve member states imported at least 60% of their gas supplies from one source, of which eight relied exclusively on Russia.

Reliance on Russian natural gas is in many ways due to a lack of viable alternatives in pipeline gas. Russian pipelines dominate natural gas transit from within its borders and the Caspian region. With the construction of the Nord Stream pipeline (a Russo-German joint-venture) Gazprom will be able to deliver supplies directly into the heart of Western Europe, increasing its market share and the supply of affordable natural gas to EU markets. The Russian-led South Stream pipeline will dominate the supply of Caspian gas, thereby undercutting the commercial viability of the European-led Nabucco pipeline through Turkey. Russia will soon have a stranglehold on nearly all the natural gas flowing into the EU. The 2005 "gas war" with Ukraine, supply interruptions to Poland, the Czech Republic, Belarus, and Georgia have all been efforts towards this end.

Fears of Russian dominance have been further stoked by Gazprom’s strategic acquisition of downstream European network assets. The company currently owns shares in nine of the bloc’s transmission system operators (37.2% of Estonia’s Estigas, 48% of Poland’s Europolgaz, 50%-minus-one share of Germany’s Wingas, and smaller shares in French and Finnish operators). Further acquisitions would position Gazprom as the dominant energy company in Europe (foreign or domestic). The backlash to Gazprom’s expansion has challenged the European Commission’s energy liberalization agenda, and divided (partly by design it must be noted) European consensus on Russian relations.

European anxiety has also been heightened by aggressive foreign policy rhetoric out of Moscow. Gazprom has threatened to diversify away from the European market if its downstream ambitions are not realized. Additionally, hardliners in Russia’s State Duma have called on the Kremlin to exercise its energy leverage more widely, an implicit reference to Europe. To many, Gazprom’s commercial strategy is now inseparable from the Kremlin’s imperial ambitions.

In this challenging and dynamic context, it is understandable that Europe feels vulnerable to Russian political objectives. However, it is essential that practitioners and observers understand that there is a degree of both perceived and actual political risk in Russian supplies. The key points:

-Russia has demonstrated a willingness (an intention) to use the "energy weapon", and one can reasonably expect that former Soviet states will continue to be targeted with supply disruptions. However, Russia’s actions have never actually threatened deliveries to Europe. In the 2005 "gas war" with Ukraine, Russia was never close to breaking its contractual obligations to Europe. In spite of Ukraine’s refusal to settle the financial aspects of the dispute, the Kremlin quickly pumped extra gas into the system and the shortfall was narrowed. While some European states experienced 1-2 days of supply disruption, this was never actually felt by consumers. Russia has demonstrated an acute sensitivity to the impact of its actions on European deliveries (going back 20 years), and has always ensured the integrity of EU contracts.

-Europeans worry that Russian supplies will be withheld for political reasons. But the real risk lies in the potential inability of Russia to meet its obligations. As detailed in Part I of this discussion, the Russian investment climate is quite poor, particularly in the energy sector. Russian oil production declined 10% last year, and a number of analysts have warned of an impending decline in both supply and capacity. Strikingly, Gazprom currently has to purchase Caspian gas just to fulfill its contractual obligations, an indictment on the chronic underinvestment and notoriously poor management of Gazprom. Wood Mackenzie, the energy consultancy, estimates that Gazprom will have to invest around $240bn and borrow a further $65bn just to meet European demand up to 2020. As long-term foreign finance has nearly evaporated in the aftermath of the dispute in Georgia, this will be difficult to achieve. Therefore, the real risk is that Russia will not be able to meet its supply obligations. This increases the importance of Caspian gas, and ensures that the pipeline battle in the region will take on immense geopolitical implications.

-Finally, Russia is far more dependent on European demand than vice-versa. While European import dependence on Russian natural gas is forecasted to reach 40% over the coming decades, Russia is already totally dependent on European demand. The "China alternative" is distant and expensive to facilitate. Also, Gazprom relies on European revenues to finance their cheap energy provision at home, while the Russian government is dependent on tax receipts from the energy giant. Petro/Gas-roubles are critical to social stability, and any prolonged drop in prices will lead to severe pressure on an already strained pension system.

The EU-Russian energy relationship is complicated, but potentially very stable. The energy dialogue initiated in 2000 is critical to ensuring this stability is realized. Regimes facilitate long-term credible commitments to cooperation. Both the EU and Russia have a strong interest in energy cooperation, and the energy dialogue provides the mechanism for both sides to credibly commit to a mutually-beneficial course. European security of supply must be balanced with Russian security of demand. The risk is that the current climate will lead both sides to disengage (which is, unfortunately, happening already).

(Lead image via The Economist)

On Russia, Part I: investment climate

As readers of IPE Journal will know, I am fascinated by Russia (see here). The geopolitical and economic implications of Russia’s rise are immense, and its actions are both bold and confusing. This is the first in a series of pieces on the implications of Russia’s resurgence. Part I: Russia’s investment climate.

The Russian investment climate has been shaped by a number of startling developments over the past five years. The Yukos affair, re-nationalization of strategic industries such as energy, questionable legal proceedings against foreign energy companies operating Russian oil and gas fields, and most recently the deterioration of the TNK-BP joint-venture have all increased uncertainty over the integrity of Russian contracts and vulnerability of assets to expropriation. The 2005 “gas war” between Russia and Ukraine signalled to many the political levers behind the commercial actions of state-run companies like Gazprom. Prime Minister Vladimir Putin’s verbal assault on Mechel Co. (the Russian steel maker) last month knocked $6bn off of its market cap in mere hours of trading. And just last Monday, Russian authorities formally sanctioned the British Chief Executive of the TNK-BP joint-venture.

However, Russia has been a top destination of foreign direct and portfolio investment. FDI has grown over 800% since 2002. By 2006 it accounted for over 3% of GDP (comparable to China). From 2005-2006, net capital inflows rose sharply from $300m to $40bn.

There are a number of explanations for the increase in capital inflows in spite of rapidly rising political risk. Russia’s economic fundamentals are sound, growth large, external debt low, and foreign exchange reserves the third largest in the world ($58bn). Additionally, its capital markets (particularly corporate bond markets) are underdeveloped, and thus foreign investors provide the bulk of corporate finance to Russian companies. Finally, low real interest rates in the U.S. and Japan have driven capital into emerging markets in search of higher returns, and Russia has been among the best performing markets in recent years.

But Russian military action in Georgia appears to have finally reversed investor sentiment. Chris Palmer, head of emerging markets at UK fund manager Gartmore, says, “Absolutely the worst thing that can happen to a political economy is that it is involved in any kind of military activity”. Since the beginning of August, the RTS index (Russian benchmark equity index) has fallen 18.2%, including a 6.6% drop on the day President Medvedev recognized the breakaway provinces. Russia’s central bank reports that the country lost $16bn in foreign capital following the incursion into Georgia, the largest and most rapid withdrawal since the 1998 crisis. August also brought the largest monthly decline in the ruble in almost a decade. Perhaps most important to the real economy, Fitch said last week that rising tensions between Russia and the West could significantly undermine corporate borrowing conditions.

This dramatic reversal signals that foreign investor perceptions have finally converged with the actual level of political risk in the Russian economy. According to Keynes, investor confidence is largely based on the assumption that present circumstances will continue unchanged into the future. In other words, perception (not probability) drives the risk tolerance of foreign investors. For years investors have been willing to swallow a higher risk premium because Russian performance was high. But Russia’s military actions have altered this risk calculation, and the potential for political isolation has injected even greater uncertainty into capital allocation.

The negative impact of declining investor sentiment on Russian growth is likely significant. Deteriorating corporate borrowing conditions will hit Russian companies hard. As Patrick at Zeitgeist noted yesterday, the financial interests of the Russian elite are not served by poor corporate performance. However, the Kremiln has yet to demonstrate a willingness to adjust policy in reponse to declining investor sentiment. Even in the energy sector, where foreign capital and expertise is critical to upstream production, the Kremlin has pushed ahead with its aggressive expropriation and nationalization agenda.

Therefore, with the stand-off between Russia and the West unlikely to diminish any time soon (more on this to come), the Russian investment climate will be among the more immediate casualties of the escalating tensions. It will be interesting to see if Russia turns East for long-term corporate finance (to SWF’s and Chinese banks), and whether the economic policy divisions between the liberals around Medvedev and the Silvoki under Putin will burst into the public. Russia’s vast foreign exchange reserves will undoubtedly cushion it from any short-term risks. But the lack of a developed corporate finance market and banking sector will heighten the long-term impact of capital outflows. While the West has struggled to respond to Russia’s resurgence, foreign investors have cast their judgment.