After Sochi 2014: costs and impacts of Russia s Olympic Games
Russia Watch 210114 - final - ABN AMRO · • Russia’s re-emergence backed by energy wealth. Next...
Transcript of Russia Watch 210114 - final - ABN AMRO · • Russia’s re-emergence backed by energy wealth. Next...
Russia WatchAn energy-driven Olympic giant
Group EconomicsEmerging Markets and Commodities
Arjen van Dijkhuizen / Hans van Cleef
Tel: +31 20 628 8052 / +31 20 343 4679
21 January 2014
• Russia’s re-emergence backed by energy wealth. Next month, Russia will host the 2014 Winter Olympics in
Sochi. That will bring the Winter Games home to one of the giants in Olympic history. If we add up all the gold
medals that Russia won at the Winter Olympics, including those during the Soviet era, it takes first place in the
ranking table. The fact that Russia is hosting events such as the Olympics and the World football
championships in 2018 is illustrative of its ambition to return as a key global player. Russia’s re-emergence is
bolstered by its abundance of energy; in fact, the surge in energy prices has been the key growth driver in the
first part of this century.
• Some recovery expected after lacklustre 2013. After recovering from the global financial crisis in 2010 and
2011, Russian economic growth has fallen gradually to a disappointingly low 1.5% yoy in 2013, the lowest level
since the crisis. We expect growth to accelerate to 2.5% in 2014, on the back of the global economic recovery
and some recovery of investment, which also reflects the low base and some positive effects of the Sochi
Olympics. Growth should gain further momentum in 2015, reaching 3%.
• More investment needed to safeguard long-term growth. Looking forward, however, Russia needs to tackle
a number of structural weaknesses and diversify and modernise the economy to sustain or even improve long-
term growth prospects, although pre-crisis growth levels will remain out of reach. Key here are raising the
investment ratio, improving the investment and business climate, enhance competitiveness, promoting
diversification and innovation and developing the energy sector. However, we assume that economic reforms
will likely remain unspectacular without more political reforms.
• Rising costs and new investment challenge for Russian energy sector. As a producer of oil and gas,
Russia is facing higher costs as easy oil and gas are diminishing. Alongside the fact that new investments are
needed to reach new supplies, the existing infrastructure is facing the effects of a lack of competition. As a
result, the energy infrastructure is out-dated while national energy companies are lagging in technology and
deficient in investment funding. Russia needs to secure its existing demand from traditional European markets.
Furthermore, it needs to invest in new supply and new infrastructure to service new, mainly Asian, buyers.
• Lower gas prices and potentially lower market share form threat to future income. Buyers of Russian gas
are pushing the country in the direction of loosening the oil link for gas prices. With global gas prices trading
significantly lower, especially in the US, demand for Russian gas could come under pressure as buyers are
searching for other alternatives. In order to maintain its market share, and thereby keep its exports at current
levels, Russia needs to adapt a more flexible pricing policy. Meanwhile, Russia is also struggling to deal with the
rise in domestic energy demand.
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I. INTRODUCTION
Next month, Russia will host the 2014 Winter Olympics in the
Black Sea city of Sochi for the first time (the 1980 Summer
Olympics were held in Moscow, Soviet Union). This means the
Winter Games will be held on the home turf of a giant in
Olympic history. If we add up all of Russia’s gold medals,
including those earned during the Soviet era, it takes first place
in the ranking table. Meanwhile, Russia will also host the world
football championships in 2018. The fact that Russia is hosting
such events highlights its ambition to return as a key global
player, more than twenty years after the collapse of the Soviet
Union.
Russia’s economic and political re-emergence is bolstered by
the country’s large economic potential. The abundance of
energy and the surge in energy prices have been majors
factors in its growth model in the first part of this century.
However, its energy dependence makes Russia vulnerable to
swings in global energy demand and prices. In our view,
Russia needs to invest in diversification and modernisation to
tackle a number of structural weaknesses to sustain or even
improve long-term growth and creditworthiness. The lack of
reforms aimed at tackling these weaknesses is reflected in
subdued investment, which has been an important factor
behind the economic slowdown in 2012 and 2013.
Russia must also invest in the energy sector, which will remain
the key driver of the economy, in order to remain competitive
and attuned to changing demands. In this report, we will look
at key challenges and opportunities for the Russian economy
in the coming years, with a special focus on the energy sector.
Economic growth and oil prices
Real GDP, % yoy Brent, $ per barrel
Sources: Thomson Reuters Datastream, ABN AMRO Group Economics
II. THE STATE OF THE ECONOMY
Oil bonanza in the early 2000s ….
After the fall of communism, Russia gradually transformed into
a more market-oriented and globally-integrated economy.
During the 1990s, this transition process went hand-in-hand
with a strong economic contraction. In the late 1990s, Russia
was hit by contagion from the Asian crisis, culminating in a
currency and debt crisis. It was only in 1999, eight years after
the fall of communism, that Russia entered a long period of
high growth rates. The main driver of this success was the
unprecedented rise in oil prices, which increased six-fold
between 2000 and mid-2008. Thanks to this oil bonanza, the
economy grew by an average of 7% between 1999 and 2008,
well above the global average, and GDP/capita increased
almost tenfold between 1999 and 2008.
… not sustained in recent years
This period of high growth was rudely interrupted in 2008-09,
when Russia was hit hard by the global credit crisis. With oil
prices and global demand for commodities tumbling, the
economy contracted by almost 8% in 2009. In 2010 and 2011,
the economy recovered from the crisis, growing around 4.5%,
partly thanks to a sharp recovery of oil prices. Economic
growth has fallen steadily in the past years; from almost 5%
yoy in early 2012 to a disappointingly low level of 1.2% yoy in
the second and third quarters of 2013. This has been driven by
the global slowdown and the crisis in the eurozone, but this
has coincided with a slowdown in domestic demand
(investment, in particular). We estimate that growth has fallen
to 1.5% yoy in 2013, the lowest level since the global financial
crisis. We expect growth to accelerate to 2.5% in 2014, on the
back of the global economic recovery and some recovery of
investment, which also reflects the low base and some positive
effects of the Sochi Olympics. Growth should gain further
momentum in 2015, reaching 3%.
Growth drivers
Contribution to real GDP growth, % points
Source: EIU
Consumption solid, investment fragile
The positive terms of trade shock in the early 2000s
contributed to a rapid growth in real wages, an increasing
availability of consumer credit and a decline in unemployment.
This has fed into a fast and longstanding growth in private
consumption, a trend that was only briefly interrupted during
the global credit crisis. Not surprisingly, private consumption
has been the single most important driver of Russian growth
since the start of this century from a demand-side perspective.
0
40
80
120
160
-15
-10
-5
0
5
10
15
96 98 00 02 04 06 08 10 12 14
Economic growth (lhs) Oil price (rhs)
-4
-2
0
2
4
6
8
02 04 06 08 10 12 14
Private consumption Investment Public consumption External balance
3 Russia Watch - An energy-driven Olympic giant - 21 January 2014
Gross fixed investment has trailed at quite some distance, and
its contribution to growth has fallen sharply in the past few
years. Meanwhile, the growth contribution of net exports has
remained negative in recent years, with the exception of 2009.
Domestic expenditure
USD bn, rebased (2005 constant prices and exchange rates)
Source: EIU
More recently, private consumption has been holding up rather
well, despite measures to contain rapid credit growth, while
investment is clearly lagging behind. This is also reflected in
weak industrial production, which contracted by an average
0.2% yoy in the first 11 months of 2013. Industrial production in
the manufacturing sector shrank by an average -0.6% yoy in
the period January-October 2013. Moreover, the
Manufacturing PMI fell below the neutral 50 mark again in late
2013, reaching 48.8 in December (the lowest level since July
2009).
Russia: output gap
%
Source: Thomson Reuters Datastream
Investment weakness is to a large extent explained by
structural, supply side issues. With the unemployment rate at
historically low levels (around 5%), inflation sticky above the
central bank’s 5-6% target band and capacity utilisation near to
pre-crisis levels, there is no evidence of an output gap, i.e. the
economy is running near full potential. This explains why the
central bank has refrained from aggressive monetary easing
so far, despite political pressures to lower policy rates. The
CBR wants to show its commitment to fight inflation in the run-
up to introducing inflation targeting, which will coincide with
greater exchange rate flexibility as well.
III. STRUCTURAL WEAKNESSES
As mentioned above, we expect Russian growth to recover
somewhat in 2014 (2.5%) and 2015 (3%). Longer term, we do
not foresee a return to the growth rates of around 7% reached
in 1999-2008, given that another sixfold increase in oil prices is
unlikely and a number of catch-up effects that occurred in the
past cannot be repeated. Moreover, structural weaknesses
(the most important ones are mentioned below) hinder Russia
to fully exploit its growth potential. In our view, a material
structural adjustment aimed at economic diversification and
modernisation is crucial in order to safeguard or even improve
long-term growth prospects. Key here are raising the
investment ratio, improving the investment climate and
competitiveness, promoting diversification and innovation and
developing the energy sector. However, given Russia’s
governance issues and with all kinds of vested interests
prevailing, we assume that economic reforms will likely be not
spectacular without more political reforms (see for more
background our report Russia needs Perestrojka 2.0,
published in May 2013). Weak demographics also play a role
in the Russian context, but this issue goes beyond the scope
of this report.
1. Low investment ratio
Russia’s investment-to-GDP ratio remains below the ratios
seen in emerging Asia, although more investment is needed to
maintain and expand production capacity, to modernise
industry and infrastructure and to diversify the economy.
Specific investments in the energy sector are needed as well.
Investment ratios compared
Gross fixed investment to GDP (%), 2013
Source: EIU
2. Weak investment and business climate
The low investment ratio is partly explained by Russia’s difficult
investment and business climate. Russia scores rather low
(92/189) on the World Bank’s Doing Business ranking,
0
200
400
600
800
1000
1200
1995 2000 2005 2010
Gross fixed investment Total domestic expenditure
-15
-10
-5
0
5
10
94 96 98 00 02 04 06 08 10 12 14
0 10 20 30 40 50
US
Germany
Poland
Brazil
Turkey
South Africa
Japan
Russia
Mexico
Korea
India
Indonesia
China
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although it has climbed almost 30 places in the past years and
scores better than China (96), Brazil (116) and India (134). The
government is aiming for a spot in the top 20 by 2018. Russia
scores even worse on Transparency International’s Corruption
Perceptions index (127/177). Hence, a lot needs to be done to
strengthen institutions and governance (improving the legal
and regulatory framework including property rights, reducing
corruption and red tape and strengthening the banking sector).
3. Weak competitiveness hinders optimal WTO exploitment
Russia ranks 64/148 on the World Economic Forum’s Global
Competitiveness Index, clearly below China (29) but also
somewhat worse than Brazil (56) and India (60). Its WTO entry
in 2012 can prove beneficial over time, if necessary reforms
are implemented and Russian industry becomes more
competitive. However, WTO entry also brings challenges,
particularly for the least competitive parts of industry. We do
not think that WTO entry will be a major game changer for
Russia, at least not to the extent it was for China in the early
2000s. China was much better placed to reap the benefits of
WTO entry given its strong (low-cost) manufacturing base. By
contrast, Russia has suffered from Dutch disease, with the oil
bonanza triggering a real effective appreciation of the rouble.
This has made the manufacturing sector less competitive.
4. Limited progress with privatization
Privatisation in Russia has inherited a bad name (sometimes
referred to as Catastroika), as the way it was done in the
1990s resulted in the shift of a large part of the nation’s wealth
into the hands of a small elite of oligarchs. In the aftermath of
the global crisis, privatisation went in reverse, as the state
regained control of around 60% of the economy after bailing-
out banks and corporates. New plans have since been
announced, but while some privatisations have indeed taken
place – for instance in the financial sector – implementation
has often been hindered by a lack of full political backing.
Moreover, foreign investors’ willingness to participate has
suffered from the weak investment climate and governance
issues.
5. High dependence on energy
The Russian economy remains highly dependent on energy,
which accounts for 25% of GDP, 70% of export revenues and
half of fiscal revenues. This makes the economy and public
finances vulnerable to swings in global energy demand and
energy prices. The IMF projects the total non-oil deficit at 10%
of GDP in 2013, while the ‘break-even’ oil price consistent with
a balanced budget has risen steadily, reaching USD 115 in
2012. The government has taken measures to make the
economy more resilient to oil price shocks, such as creating oil
windfall reserve funds and basing the budget on long-term oil
price averages to reduce volatility in government spending. We
believe that oil prices will continue its declining trend in the
years to come as a result of oversupply. This ample supply
should easily balance the rise in demand as a result of global
economic growth. Due to the revised methodology, Russia’s
budget calculation price has been cut back to around USD
95/bbl. Hence, Russia has taken precautionary measures,
although the country remains vulnerable to a significant decline
in energy prices.
IV. RUSSIAN ENERGY: FACING THE FUTURE
As explained above, energy is crucial to the Russian economy.
Specific investments in the energy sector are needed too, as
Russia faces serious challenges which must be dealt with.
These challenges not only relate to the production of energy,
but to changes in how it relates to customers and energy
dependency. We will explain this in the following paragraphs.
From a production perspective, overdue maintenance and the
lack of technological developments resulting from low
competition have led to inefficient and old-fashioned energy
production methods. In the past, these were sufficient, but now
large investments are needed to keep production high and
customers satisfied. Russia tries hard to increase these foreign
investments, but it will be tough.
Domestic consumption is high
One of the problems Russia is facing is rising domestic
demand while production is stagnating. To tackle these kind of
issues, the Russian government unveiled a new Energy
Strategy in 2009, which included three phases to 2030/2035.
The first phase (2009-2015) is simply about overcoming the
crisis. Some measures have been taken to keep production
going at current levels. However, we believe that the second
phase is much more important. This second phase (2015-
2022) mainly focuses on boosting domestic production of oil
and gas in the most efficient and economical way. The third
phase (2022-2030) sees a shift towards the use of alternative,
or renewable, energy (mainly hydro, wind, solar and nuclear).
This renewable energy can be used for domestic consumption
and should take some pressure off the traditional energy
resources. But up to 2022, domestic consumption is likely to
rise further.
Russian oil production
x 1.000 Mb/d
Sources: Thomson Reuters Eikon, ABN AMRO Group Economics
5.000
6.000
7.000
8.000
9.000
10.000
11.000
1999 2001 2003 2005 2007 2009 2011 2013
Russia oil production
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Buyers are searching for alternatives
In the wake of the natural gas shortages experienced
throughout Europe as a result of the Russia-Ukraine pricing
conflicts in 2006 and 2009, Europe realised it may be overly
dependent on Russian gas exports. Many new strategies were
implemented to lower this dependency in order to achieve a
stronger negotiation position and to secure energy stability for
the years to come. Europe therefore switched, or will switch, a
significant part of its energy mix • especially for the production
of electricity • to renewables (mainly (offshore-) wind energy)
and the use of coal. Coal proved to be a good alternative, not
only to meet electricity demand but also the demand for
heating. This is mainly because it is cheap compared to other
fossil fuels, as a result of increased US exports combined with
the low carbon emission prices.
Alternative approaches are also emerging in infrastructure,
signalling a lower dependency on Russia. The construction of
the Trans-Adriatic Pipeline – running from Greece to Italy via
Albania and the Adriatic Sea – will open up Caspian gas (10-
20 billion cubic metres) to Europe from 2018, representing the
first step in Europe’s long-held strategy to access gas directly
from that region. Further supply could come from
Turkmenistan and Iraq, although these are very long-term
prospects. Shale gas production could potentially be an
alternative, but even if this development takes flight, it will still
be many years before it becomes operational, and even longer
before it is potentially profitable. Some ports in Europe have
already invested in LNG terminals, and many others will follow.
The availability of (North American) liquefied natural gas (LNG)
could become a particularly interesting alternative if European
gas prices continue to rise. And even if it is somewhat more
expensive at first, LNG will become a part of the European
energy mix as other countries, like Qatar and Australia, come
online to increase their LNG exports. As a result, LNG prices
will become increasingly competitive and thus Europe become
less depending on Russia.
Buyers force Russia to lower gas prices
Russia is the world’s largest oil producer, with a daily
production of more than 10 million barrels per day (mb/d),
followed by Saudi Arabia with slightly less than 10 mb/d. On
top of that, Russia is one of the largest gas producers. With
gas prices largely linked to oil prices, significant profits were
realised in recent years on gas production. However, gas
consuming countries are forcing Russian energy companies to
either loosen the traditional oil-linkage or set significantly lower
prices when negotiating expired long-term contracts.
The main reason behind asking for lower gas prices is the
impact of US shale gas developments, resulting in lower global
market prices. Russia’s high export prices to other parts of
Europe affected its competitiveness against the US. And in
some other cases, existing contracts were reopened and
renegotiated in order to lower the gas prices for the end-
consumer. Another reason to lower prices is that sales have
come under pressure now that European electricity consumers
are switching to other (mainly renewable) energy sources. We
believe that this trend of easing European gas prices will
continue. Russia needs to adapt to avoid ultimately losing even
much more of its exports to Europe. After all, the rise in Asian
demand will not be able to fully compensate for the potential
loss of exports to Europe due to, for instance, a lack of
infrastructure and other alternatives to meet the Asian
demand.
Oil and gas price development
Gas in USD/mmBtu, Oil in USD/bbl
Sources: Thomson Reuters Eikon, ABN AMRO Group Economics
As easy oil is diminishing, costs are rising
In 2014, Russian oil production is expected to increase
marginally by 90 kb/d, bringing the total production to 10.7
mb/d. This increase is very similar to 2013. Over the next four
years, state-owned oil company Rosneft forecasts an increase
in production of a total of only 50 kb/d, despite rising
investments. With production at traditional wells easing, other
more expensive techniques were introduced to curtail declines.
Nevertheless, as wells dry up, production will have to shift
towards the so called ‘less easy’ wells. These are generally
further away and harder to bring online (as they may be
offshore, for instance) which means costs are higher. To
manage these higher costs, the government is introducing tax
breaks and incentives to stimulate investments in the sector in
order to increase and thus secure its long-term output.
Monopolies lead to a lack of investment and maintenance
Alongside the potential stagnation in oil and gas production,
Russia is facing the fallout from a lack of competition. After all,
national companies like Gazprom (gas) and Rosneft (oil) are
lagging behind in technology advances and deficient in
investment funding. One reason behind the lack of investments
is that the energy infrastructure is outdated. While markets are
increasingly shifting from Europe to Asia, the adjustments in
the Russian energy infrastructure have been delayed. As a
result, the needed pipelines connecting Russia with its
important Asian consumers are missing or still under
construction. An issue Russia has already started to tackle is
securing energy exports to Europe as part of its ambition to
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win back the trust of its European clients. The recent deal with
the Ukraine is a good example. The construction of the Nord
Stream natural gas pipeline (under the Baltic Sea) and the
South Stream (under the Black Sea) will allow Russian gas to
bypass Ukraine and Belarus, if necessary.
However, one of the country’s top priorities for the coming
years will be to improve its knowledge of technology, now that
the focus is shifting towards more difficult oil and gas
production. Meanwhile, foreign investment is needed to secure
the necessary capital. As part of its strategy to improve
knowledge and raise funds, the major Russian energy
companies have increased their stakes in foreign projects (in
partnership with Lukoil and Rosneft for oil; Gazprom for gas)
while foreign companies are being attracted to participate in
Russian-based projects.
To conclude
We expect some recovery of Russian growth, but pre-crisis
levels will remain out of reach given that oil prices will not rise
six-fold again and some catch-up effects will not be repeated.
Moreover, a number of structural weaknesses hinder Russia to
fully exploit its growth potential. In our view, Russia needs to
diversify and modernise the economy to sustain or even
improve long-term growth prospects. Key here are raising the
investment ratio, improving the investment and business
climate, enhance competitiveness and promoting
diversification and innovation. Specific investments in the
energy sector are needed as well, to be able to serve new,
mainly Asian buyers. Russia also needs more flexible pricing
policies to maintain its market share in natural gas.
Russian oil is exported all over the world
Source: ABN AMRO
Key forecasts for the economy of Russia
2011 2012 2013e 2014e 2015e
GDP (% yoy) 4.3 3.4 1.5 2.5 3.0
CPI inflation (% yoy) 8.4 5.1 6.8 5.9 5.0
Unemployment rate (%) 6.6 5.5 4.8 4.5 4.3
Budget balance (% GDP) 0.8 -0.1 -0.5 -0.5 -0.5
Government debt (% GDP) 8 8 8 8 8
Current account (% GDP) 5.1 3.5 2.5 2.0 1.0
USD/RUB (eop) 32.20 30.4 32.9 33.0 33.0
EUR/RUB (eop) 41.80 40.0 44.4 39.6 38.0
Budget balance, current acc. for 2013 and 2014 are rounded figures
Source: EIU, ABN AMRO Group Economics
7 Russia Watch - An energy-driven Olympic giant - 21 January 2014
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