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.

2 Russia Watch - An energy-driven Olympic giant - 21 January 2014

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

4 Russia Watch - An energy-driven Olympic giant - 21 January 2014

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

5 Russia Watch - An energy-driven Olympic giant - 21 January 2014

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

6 Russia Watch - An energy-driven Olympic giant - 21 January 2014

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

DisclaimerLast editing of this publication on 17 January 2014

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