A bimonthly magazine on international affairs, edited in Germany's capital

Putin’s Art of the Deal

Russia’s big energy projects make no economic sense, but they serve a political purpose.

Russia’s energy investments may seem like a holdover from Soviet times – like Moscow’s avenues and office buildings, they are often inefficient and grandiose beyond practicality. But this misses their true purpose: funneling state money into the pockets of allies and keeping foreign governments friendly.

© picture-alliance/epa

Russia’s large and excessively costly hydrocarbon and pipeline projects have often been portrayed in the media as commercially unviable, cumbersome, and driven by state-controlled national companies for their own narrow private gain. However, these projects serve a purpose beyond mere economic gain: they are primarily driven by the Kremlin for political expediency, with Russian leadership sacrificing efficiency and commercial viability for the sake of international political partnerships and the economic security of President Vladimir Putin’s inner circle. This approach gives the Russian regime a political and economic tool which is powerful and unavailable to its Western counterparts.

For anyone familiar with the reality of Russian oil and gas production, it is a well-known fact that the bulk of legacy fields developed in Soviet times are situated in Western Siberia. There are hundreds of existing fields, both old and depleted and many that are still potentially commercially viable, though the latter mostly possess small or medium-sized deposits. Western Siberia, often referred to as the Nadym-Pur-Taz (NPT) region, is one of the most industrially concentrated energy regions in the world. The necessary infrastructure already exists, from pipelines to processing facilities, and a trained and qualified labor force is already available.

Although the region no longer possesses large (or “strategic”, in Russian bureaucratic language) deposits, there is still a lot of scope to utilize the remaining resources as other components of energy development, from infrastructure to people. To make a comparison, although Texas has been a developed US energy region for more than a century, it remains a vibrant economic environment where hundreds of small- and medium-sized enterprises (SMEs), sometimes consisting of literally one or two geologists and a few managers, operate on all sorts of deposits. These SMEs are flexible enough to run even dying fields and the small satellite deposits that are of little interest to big companies.

One of the first signs that the Kremlin intended to neglect the economic development of the NPT region and instead move towards giant projects elsewhere with costly, hard-to-recover hydrocarbons was the Prirazlomnoye field. It is an Arctic offshore oilfield located in the Pechora Sea, south of Novaya Zemlya, in an area that requires costly ice-resistant oil platforms. The project, which ended up costing around $1.5 billion, was plagued with constant delays for over a decade – but shipyards operated by Sevmash and Sovcomflot and other firms controlled by Putin’s friends received lavish contracts.

Meanwhile, gas giant Gazprom has also paid little mind to costs when it has come to new production. Despite having economically viable options in Russia, it has continued to pursue costlier projects that benefited insiders even as energy prices dropped in the aftermath of the financial crisis.

Privatizing Profits, Nationalizing Losses

In fact, as far as Putin’s elite are concerned, the slogan seems to be “privatize profits and nationalize losses.” Instead of developing the NPT region or other easy and cheap options in mainland Russia, Gazprom started to develop the large Bovanenkovo field in the remote Yamal peninsula, launching it in 2012 after years of delays and costs overruns. In practice, in order to bring this project to life, unprecedented amounts of money from the Russian budget were invested into road building, rail connections, and other infrastructure, while Gazprom received various tax breaks.

In the early- to mid-2000s, Putin also asked Gazprom to work on another large offshore project in the Russian Arctic – the Shtokman field in the Barents Sea. This distant field has such tough and costly conditions for development that the monopoly could not do without Western expertise and technology for both the production and transportation of hydrocarbons. In fact, this was precisely why the Kremlin wanted this project to proceed despite its barely viable anticipated costs: Putin was seeking large and politically well-connected International Oil Companies (IOCs) in order to get them entangled in a massive production and infrastructure project and tie companies like Statoil, Norsk Hydro, Total, Chevron, and ConocoPhillips into long-term political partnerships. These companies are national champions in their home countries in the West, and Putin saw them as lobbying avenues to their respective governments. Gazprom held several rounds of negotiations with large IOCs until 2010, when the project was shelved as excessively unviable, even by Russian standards, given international oil and gas prices.

Shtokman was, however, a herald of similar extraordinary Arctic projects to come. Yamal LNG, essentially run by two of Putin’s insiders – Novatek’s Leonid Mikhelson and Gennadiy Timchenko – combined features of all three projects described above. Based around another big field in the Yamal Peninsula, South Tambey, Yamal LNG seeks to bring Arctic gas via tankers to Asia and Europe, despite an abundance of Russian gas production, spare export pipeline capacity, and the availability of many other, less remote places for LNG plants in non-Arctic areas of Russia.

However, this project proved to be a politico El Dorado for the Kremlin’s inner circle. Shipyards received contracts to construct or upgrade ice-breaking ships, while politically connected intermediaries got lucrative contracts to order special tankers abroad that Russia could not produce itself. The state budget paid for an air field and road construction connecting the field with mainland Russia, and even the warming of water in the bay area near the field. Meanwhile, Novatek received a 12-year tax break worth $4 billion. Yamal LNG also became a highly important, capital-intense, and politically important project with key foreign partners – notably France and China, which both invested in it. Despite sanctions over its military campaign in Ukraine, this has provided Putin with a channel to not only access global capital and demonstrate defiance of the US, but also lobby policymakers in Europe and Asia.

Divide and Conquer

The international political gains are even more striking with Russia’s expensive gas pipeline projects – the Nord Stream, Turkish Stream, and Power of Siberia. The latter, intended to go from East Siberia to the Western parts of China, has been delayed for several years now due to its unprecedented price tag of $55 billion. The costs of the new gas that Gazprom would have to develop in East Siberia to feed this pipeline and the costs for the pipeline and processing facilities associated make it unprofitable to export to China. However, Gazprom’s subcontractors are already building the project without a binding price agreement with their Chinese counterparts. This has now become one of the ways for Putin to create lucrative possibilities for his inner circle, while at the same time serving as an attractive resource option for President Xi, with whom Putin wants to build closer relations.Turkish Stream is equally unnecessary from an economic point of view, as there is already excess export capacity to Turkey via the Blue Stream and Trans-Balkan pipelines. However, construction of the expansion of UGSS in the south of Russia – Gazprom’s so-called “South Corridor” – has already benefited Putin’s insiders enormously. Meanwhile, Turkish Stream is an expensive but politically expedient way for the Kremlin to further exclude Ukraine from Gazprom’s gas transit to Europe and Turkey, and a great avenue to build even more ties with the corrupt and authoritarian regime in Ankara.

As for Nord Stream 1 and 2, they are the epitome of the Kremlin’s relaxed attitude to the costs of political influence. Nord Stream 1 has proved disastrous for Russian taxpayers and the Russian budget. The costs of transporting gas through Nord Stream 1 are identical or higher to those incurred by traditional transit across Ukraine. There have been no cost savings, and very little increase in capacity. The gas that is being transported through Nord Stream 1 is simply diverted from the pipelines that used to lead across Ukraine. There is no value added or economic efficiency; Gazprom has to treat the new pipeline as “a stranded investment which never makes the promised return on capital,” as one leading US industry expert told the author.

However, the Kremlin achieved a very important political goal from the project. In hiring Gerhard Schroeder to advance its plans to bypass Ukraine and lay the ground for making Germany a principal Russian gas hub in Europe, it has essentially executed a “divide and conquer” policy vis-à-vis the European Union, which supposedly wanted to increase competition and reduce dependence on Russia.

This year the Kremlin is pushing forward with Nord Stream 2, despite the fact that all of its international partners formally dropped the project after the Polish antitrust agency issued a formal objection, arguing that the project will negatively affect Poland’s purchasing power vis-à-vis Russia. Gazprom is already working on plans to bring major IOCs back on board in one way or another, and is fine financing the pipeline on its own for the time being as the political prize is higher in Putin’s eyes than any financial burdens.

If Nord Stream 2 and Turkish Stream are built, Russia will be able to fully exclude Ukraine from its gas transit, while Germany’s industrial sector and leading European IOCs will be even further tied up politically with the Kremlin than before.The Russian regime has worked out a consistent system with massive energy upstream and transit projects that excludes small- and medium-sized enterprises and private players, opens financial avenues for Kremlin insiders at the expense of the national budget, builds politically expedient relations with foreign governments and their leading energy companies – if necessary, to Russia’s economic detriment – and pushes forward projects that effectively circumvent Western financial sanctions over the conflict in Ukraine, in the process defying the US. This is how the Kremlin weighs its strengths and weaknesses in global energy politics.