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“The  Past, Present and Future of Russian Energy Strategy is republished with  permission of Stratfor.”

Read more:  The Past, Present and Future of Russian Energy Strategy | Stratfor

By Lauren Goodrich and Marc Lanthemann

The future of Russia’s ability to remain a global energy supplier and the  strength the Russian energy sector gives the Kremlin are increasingly in  question. After a decade of robust energy exports and revenues, Russia is  cutting natural gas prices to Europe while revenue projections for its energy  behemoth, Gazprom, are declining starting this year.

Russia holds the world’s largest proven reserves of natural gas and  continually alternates with Saudi Arabia as the top oil producer. The country  supplies a third of Europe’s oil and natural gas and is starting to export more  to the energy-hungry  East Asian markets. The energy sector is far more than a commercial asset  for Moscow; it has been one  of the pillars of Russia’s stabilization and increasing strength for more  than a century. The Kremlin has designated energy security as the primary issue  for Russia’s national security, especially since recent changes in global and  domestic trends have cast doubts on the energy sector’s continuing strength.

Throughout Russian history, the country’s energy sector periodically has  strengthened and weakened. Managing this cycle has been a centerpiece of  Russia’s domestic and foreign policy since czarist times. This historical burden  now rests on Vladimir Putin’s regime.

Russia’s Imperatives and the Energy Factor

Russia is an  inherently vulnerable country, surrounded by other great powers and  possessing no easily defensible borders. In addition, Russia is a massive,  mostly inhospitable territory populated by diverse ethnic groups that  historically have been at odds with Moscow’s centralized authority. This leaves  Russia with a clear set of imperatives to hold together as a country and  establish itself as a regional power. First, Russia must consolidate its society  under one authority. Second, it must expand its power across its immediate  neighborhood to create buffers against other powers. (The creation of the Soviet  Union is the clearest example of this imperative in action.) Finally, it must  leverage its natural resources to achieve a balance with the great powers beyond  its periphery.

Russia has used a variety of tools throughout history to achieve these  imperatives, ranging from agricultural exports to pure military  conquest and intimidation. Starting in the late 1800s, Russia added energy to  the list of vital commodities it could use to achieve its central strategic  goals. By the 1950s, Russia’s energy sector had become one of the major pillars  of its economic and political strength.

The revenues from oil and natural gas exports show how the energy sector  empowered the Kremlin to consolidate the country. Energy export  revenues for the Russian Empire began flowing into government coffers  in the late 1800s, with oil export revenues making up 7 percent of the export  earnings. These revenues rose to 14 percent in the late 1920s during the early  stages of the Soviet Union, and by the 1950s accounted for half of Soviet export  earnings. Currently, energy revenues make up half of the  government’s budget. This capital influx was and continues to be  instrumental in helping Russia build the military and industrial basis needed to  maintain its status as a regional — if not global — power. However, as the  Russian governments became dependent on energy, the revenues also became a large  vulnerability.

Beyond export revenues, the energy sector has contributed to the creation of  a domestically stable and industrialized state. Russia’s  domestic energy consumption is very high due to extremely cold weather for  most of the year, but despite inefficiencies within the energy sector  and the cost of producing energy, the country’s domestic reserves have  enabled Moscow to provide its citizens and the industries that employ them with  low energy prices.

The energy sector also contributes to Russia’s ability to expand its  influence to its immediate neighbors. Moscow’s use of energy as leverage in the  buffer states differs from country to country and ranges from controlling  regional energy production (as it previously did in the Azerbaijani and Kazakh  oil fields) to subsidizing cheap energy supplies to the countries and  controlling the energy transport infrastructure. Russia has used similar  strategies to shape relationships beyond the former Soviet states. For instance,  Russia is one of Europe’s two main energy suppliers and is the only European  supplier with large reserves of oil and natural gas and historically cheap  prices. Russia’s physical connectivity with Europe and ability to undercut any  competitor have served as the basis of many of Moscow’s relationships in  Europe.

Evolution of Russian Energy Strategies

Energy’s usefulness as a means of achieving Russia’s three main imperatives  has altered over time because Russia has had to change its strategies depending  on shifts in domestic or international circumstances. Moscow’s strength lies in  its flexibility in managing its energy sector.

The importance of Russian energy was established in the late 1800s, when the  monarchy saw great potential for the Russian Empire if it could develop this  sector on a large scale. However, the empire had neither the technology nor the  capital to start up an indigenous energy industry. As a solution, the monarchy  eased its foreign investment restrictions, inviting European and U.S. firms to  develop the Baku and Volga oil fields. This brought about a brief period of  warmer relations between the Russian Empire and many Western partners,  particularly the United Kingdom, France and the United States. All parties soon  realized that the only way to make the Russian oil business profitable despite  the high costs associated with the country’s harsh and vast geography was to  transform Russia into a massive producer. By the turn of the century, the  Russian Empire was producing 31 percent of global oil exports.

As the importance of the Russian Empire’s energy sector grew, it became clear  that Russia’s internal stability greatly affected the sector. The Bolsheviks  used the energy sector in their attempts to overthrow the monarchy in the early  1900s. The oil-producing regions were one of the primary hubs in which the  Bolsheviks operated because energy was one of the few sectors with organized  workers. In addition, the Bolsheviks used the oil rail networks to distribute  propaganda across the country and abroad. In 1904, when the Russian Empire  cracked down on an uprising in St.  Petersburg, mostly Bolshevik protesters set the Baku oil fields  on fire. This cut Russia’s oil exports by two-thirds, forcing Moscow and the  foreign markets to realize oil exports’ great vulnerability to Russian domestic  stability.

Russia’s modern energy strategies began forming after World War II.  With the Soviet Union left standing as one of two global hegemons towering over  a divided Europe, Moscow saw no barriers to achieving dominance in the global  energy field. Between the 1950s and 1960s, Soviet oil output had doubled, making  the Soviet Union once again the second-largest oil producer in the world and  primary supplier to both Eastern and Western Europe. Revenues from oil  exports started to make up nearly half of Soviet export income.

Because the Soviet Union was producing oil en masse and the Soviet  system kept labor costs low, Russia was able to sell its oil at prices  almost 50 percent lower than oil from the Middle East. The subsidization of  oil to the Soviet bloc and then to Western European countries helped Moscow  undercut Western regimes and strengthen its position in its own periphery  — a strategy that the CIA dubbed the Soviet Economic Offensive. For the  Soviets, this was not about making money (although they were making money) as  much as it was about shaping a sphere of influence and undermining the West.  This strategy came at a cost, since Moscow was not bringing in as much revenue  as it could and was producing oil inefficiently, rapidly depleting its  fields.

In the 1970s, the price of oil skyrocketed due to a series of crises mostly  in the Middle East. At the same time, Russia was already feeling the strain of  sustaining the massive Soviet Union. Soviet leader Leonid Brezhnev’s regime was  left with a choice: use the high global prices as a reason to raise prices in  Eastern Europe and benefit the Soviet economy, or continue subsidizing the  Eastern bloc in order to keep it beholden to Moscow and not push it to start  thinking about other energy sources. It was a choice between two  imperatives: Soviet national stability and holding the buffer zone. In the end,  Moscow chose to protect its own interests and in 1975 raised the price of  oil for its customers, allowing for further increases based on global  market prices. By 1976, oil prices in the Eastern bloc had nearly doubled,  remaining below global prices but rising high enough to force some countries in  the bloc to take out loans.

The Soviet focus on maintaining high energy revenues continued through the  mid-1980s, when these revenues accounted for nearly all of the Soviet Union’s  hard currency inflows. But the Soviets were dealt a double blow in the mid-1980s  when the price of oil collapsed and the West imposed an embargo on Soviet oil,  prompting Saudi Arabia to flood the oil markets. Moreover, the Soviet Union was  falling far behind the West in technology, particularly in energy and  agriculture. In response, starting in 1985, the Soviet Union moved closer to a  market-based energy economy, raising prices for the Eastern bloc, requiring hard  currencies for payment and allowing foreign firms to re-enter the energy  sector.

But Russian strategy shifts were not deep and timely enough to prevent the  collapse of the Soviet Union. In the decade following the fall of the Soviet  bloc, the Russian energy industry was in disarray. The energy liberalization  that started under Mikhail Gorbachev in the 1980s was taken to an extreme under  Boris Yeltsin in the 1990s. As a result, production fell by half and the Russian  energy sector was divided between foreign groups and the emerging Russian  oligarch class.

This changed under Vladimir Putin in 2000. One of the first items on Putin’s  agenda to help stabilize the country was to consolidate the energy sector under  state control. This meant radically reversing the liberal policies from the two  decades before. The government effectively nationalized the majority of the  energy sector under three state behemoths: Gazprom,  Rosneft and Transneft. The Kremlin became more aggressive in negotiating supply  contracts with the former Soviet states and Europe, locking them into large  volumes at extraordinarily high prices because these customers had no  alternative energy supplies. The Kremlin also began cutting energy supplies to  certain markets — blaming troublesome transit states such as Ukraine — in  order to shape other political negotiations.

Though Moscow’s energy strategy became fairly aggressive, it helped bring  about a stronger and more stable Russia. Russian energy revenues soared due to  high global oil prices and the high natural gas prices it charged in Europe.  Russia had excess funds to pump into its political, social, economic and  military sectors. Energy politics also helped Russia leverage its influence in  its former backyard and forced Europe to step back from countering Russia’s  resurgence. Of course, the financial crises that swept Europe and Russia in  2008 reminded Russia of its need for its biggest energy clients when oil prices  dropped and demand began declining.

Challenges to Maintaining Russian Energy

Russia’s top concern is its vulnerability to fluctuations in the price of  energy. With half of the Russian budget coming from energy revenues (of that, 80  percent is from oil and 20 percent comes from natural gas), the government could  be crippled should energy prices fall. The Kremlin has already decreased its  budget projections for oil prices to $93 per barrel instead of $119 — though  even at that price, the government is playing a game of chance. Stratfor is not  in the business of forecasting oil prices, but historical patterns show that  major international crises and fluctuations in global consumption and production  patterns repeatedly have had sufficient impact on oil prices and on Moscow’s  revenues to destabilize the country.

Natural gas export revenues are also currently in question. With alternative  natural gas supplies coming online for Russia’s  largest consumer, Europe, the Kremlin has been forced to lower its prices in  recent months. This year, Gazprom expects to give European consumers  $4.7 billion — approximately 10 percent of Gazprom’s net revenues — in rebates  due to price cuts.

In its current configuration, Russia’s energy sector is under strain. The  consolidation of the sector mostly under two large state firms had many benefits  for the Kremlin, but after a decade of consolidation the disadvantages are  piling up. With little competition for Russia’s natural gas giant, Gazprom, the  firm is lagging in technology and is considered unfriendly to outside  investment. Russia’s oil giant, Rosneft, recently began evolving into a  larger monopoly like Gazprom, which could lead it to fall into a similar trap.  With future energy projects in Russia requiring more advanced technology (due to  their location and environment) and more capital, both Gazprom and Rosneft need  modernization and foreign investment.

Corruption is also a major factor, with varying estimates of 20 to 40 percent  of Gazprom’s revenues lost to either corrupt or inefficient practices. Rosneft  has similar problems. This loss would be sustainable with Moscow’s previous high  energy revenues, but it will not be sustainable in the future should energy  prices fall or the maintenance and expansion of the energy sector become more  expensive. The Kremlin is probing Gazprom, although with a culture of corruption  rampant throughout Russian history there is little the Kremlin will be able to  do to eliminate wrongdoing within the natural gas firm.

Moreover, Europe’s dependence on Russian energy is decreasing. The natural  gas shortages experienced throughout Europe during the Russian-Ukrainian  crises of 2006 and 2009 were a stark reminder of how vulnerable  European nations were because of their dependence on Russian natural gas  exports. Both unilaterally and through the European Union, European countries  began developing strategies that would allow them to mitigate not only Europe’s  vulnerability to disputes between Moscow and intermediary transit states, but  also its general dependence on energy from Russia.

The accelerated development of new and updated liquefied  natural gas import facilities is one such effort. This will give certain  countries — Lithuania and Poland, most notably — the ability to import natural  gas from suppliers around the globe and bypass Russia’s traditional lever:  physical connectivity. This is particularly significant in light of the  accelerated development of several unconventional natural gas plays in the  world, particularly the shale reserves in the United States. The development of  a pipeline project that would bring non-Russian Caspian natural gas to the  European market is another attempt — albeit less successful so far — to  decrease European dependence on Russian natural gas.

Additionally, a set of EU-wide policies, including the Third  Energy Package, has begun giving EU member nations the political and legal  tools to mitigate Gazprom’s dominance in their respective natural gas supply  chains. This common framework also allows European nations to present a more  unified front in challenging certain business practices they believe are  monopolistic — the latest example being the EU Commission probe into Gazprom’s  pricing strategy in Central Europe. This, coupled with the EU-funded efforts to  physically interconnect the natural gas grids of EU members in Central Europe,  has made it increasingly difficult for Russia to use natural gas pricing as a  foreign policy tool. This is a major change in the way Moscow has dealt with the  region for the past decade, when it rewarded closer ties with Russia with low  gas prices (as with Belarus) and increased rates for those who defied it (the  Baltics).

Finally, Russia faces the simple yet grave possibility that the escalating  financial and political crisis in Europe will continue to reduce the Continent’s  energy consumption, or at least preclude any growth in consumption in the next  decade.

Russia’s Next Move

The Putin administration is well aware of the challenges facing the Russian  energy sector. Russia’s attempts in the past decade to shift away from  dependence on energy exports by focusing on industrial development have not been  particularly successful and keep the country tied to the fate of its energy  sector. Russia’s strategy of using its energy exports as both a foreign  policy tool and a revenue generator is contradictory at times: To use energy in  foreign policy, Moscow must be able to lower or raise prices and threaten to cut  off supplies, which is anathema to the revenue-generating aspect.

Global and regional circumstances have changed to the point that Moscow has  had to prioritize one of the two uses of its energy industry — and it has  unequivocally decided to maintain its revenue-generating capability. The Kremlin  has begun crafting a set of policies designed to adjust the country to the  changes that will come in the next two decades.

First, Russia is addressing the very damaging uncertainty surrounding its  relationship with key transit states that traditionally allowed it to export  energy to Europe. The construction of the Ust-Luga oil terminal on the Baltic  Sea allows Russia to largely bypass the Belarus pipeline system and ship  crude and oil products directly to its consumers. Similarly, the construction of  the Nord Stream natural gas pipeline under the Baltic Sea — and eventually its  southern counterpart, South  Stream, through the Black Sea — will allow Russian natural gas to bypass  the Ukrainian and Belarusian transit systems if necessary. These two  pipelines primarily will ensure natural gas deliveries to the major European  consumer markets in Germany and Italy, with which Russia seeks to maintain  long-term strategic partnerships.

By allowing Russia to guarantee deliveries to its major European customers,  the bypass systems ensure Moscow’s vital energy revenues. This strategy of  future energy export flexibility will also progressively reduce the leverage  Minsk and Kiev can exert in warding off Moscow’s attempts at consolidating  Belarus and Kiev as vassal buffer states — one of the few foreign policy goals  Moscow is still intent on pursuing through energy strategy.

Moreover, Moscow has adapted its energy strategy with European customers amid  growing diversification and liberalization efforts. Gazprom has begun expanding  the natural gas discounts formerly reserved for strategic partners such as  Germany or Italy. The Kremlin knows that its only hope of maintaining natural  gas revenues in the face of a potential global shale boom is to lock its  customers into price-competitive, long-term contracts. Moscow will continue  showing that it can offer European consumers guaranteed high volumes and  low-cost deliveries that producers relying on liquefied natural gas shipping for  transport can seldom afford.

Finally, Russia is focusing significant attention and funds on developing  connections to the growing East Asian energy markets, diversifying its export  portfolio should challenges in the European market continue intensifying. One  aspect common to all the strategies Russia is set to pursue for the next decade  is the high capital needed to complete them; the Eastern  Siberia-Pacific Ocean oil pipeline alone is set to cost nearly $15  billion. Despite the effects of the financial crisis in 2009, Russia still has  vast capital reserves earmarked for these large-scale projects, but these funds  are not infinite.

The Kremlin appears keenly aware of the challenges that Russia will face in  the next two decades as another energy cycle draws to an end. Unlike  Brezhnev and Gorbachev, Putin has proven capable of enacting effective  policy and strategy changes in the Russian energy sphere. While Russia’s  dependence on high oil prices continues to worry Moscow, Putin has so far  managed to respond proactively to the other external shifts in energy  consumption and production patterns — particularly those affecting the European  natural gas market. However, the long-term sustainability of the model  Russia is moving toward remains doubtful.

Read more:  The Past, Present and Future of Russian Energy Strategy | Stratfor