Trump's "Full Throttle" Energy Policy Could Devastate Putin's Petrostate (Tillerson to Deliver the Message?)

Putin’s regime is based on Russia’s oil and gas resources, which, despite his pledge to diversify, account for a quarter of the economy and half of state revenues (two thirds if other minerals are included). Putin can live with a stagnant economy and popular unrest, but he cannot survive a large and irreversible loss of Russia’s oil and gas earnings.

Basic economics explains how a Trump “high resource case” would undermine Putin’s petrostate: The first US fracking revolution made the US energy industry the “swing” or “marginal producer” on the world market. No matter what OPEC or Russia produces, the long-run price of oil will be set by the break-even cost of US unconventional oil and gas. The break-even is currently between $50 and $60 a barrel, but it is headed to lows of $40 or below.  We should not underestimate the technological ingenuity of the fracking industry.

But wait! Will not President Trump, known admirer of Putin, and Secretary of State, Rex Tillerson, Order of Friendship recipient, use their immense political clout to cash in on lucrative Russian deals. Will not Trump and Tillerson throw money at their “bromance” partners, Putin and his Rosneft sidekick Igor Sechin, and save Russia’s failing petrostate?

What deals are we talking about? Over the near term, oil prices rule out large international investments in Russia, even if sanctions were lifted. At best, the Shells and BPs will try to salvage what they can from past mega-investments at $100 oil. No one is standing in line to throw their money away on loss-making Russian mega-deals, least among them an ExxonMobil headed by Tillerson’s successor.

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Two Major Events in International Oil: Argentina's Nationalization of YPF and Exxon's "Hostage" Deal With Russia

One of the greatest Latin American success stories was the privatization of Argentina's YPF in July of 1993 against enormous political and labor opposition. The Kirchner government reversed  this hard-won success yesterday with its nationalization of YPF. The nationalized YPF will again become a bloated political rent-seeking machine to pay off Kirchner's supporters. YPF's expropriated partners (mainly Repsol of Spain) will get little.

At about the same time, ExxonMobil signed the only possible deal with Russia's national oil company Rosneft to jointly develop Siberia's energy reserves. The key section of the deal gives Rosneft properties of equivalent value in the United States. This time when Putin decides to expropriate ExxonMobil's investment in Russia, they can take back Rosneft's U.S. holdings. Putin has forced Western energy companies into such "hostage" deals. Let's see if they work.

Tax Breaks for Big Oil or for Big Hollywood?

Congress rejected the Obama administration’s proposal to “end tax breaks for big oil.” The White House will prominently feature the Republicans as the lackeys of Big Oil in the 2012 election.

The Obama administration tells us that “tax breaks for big oil” deprive our treasury of billions.  Besides that, the energy giants are making giant profits. They are greedy and don’t want to pay their fair share. Also we hear that tax subsidies are driving up the price of gas at the pump. (I guess no one in the Obama administration took an economics exam. Subsidies increase supply and drive down the price).

If we dig deeper into the tax code, we learn that “Big Oil” tax breaks apply, in most cases, to other industries, not just to “Big Oil” as we are led to think. These other beneficiaries are not under attack. I guess they are either less successful, less greedy, or give more to the White House.

If the Obama administration wants to be honest, it should propose to Congress to continue tax subsidies that other industries routinely receive with the exception of oil and gas, for which the tax breaks will be cancelled on a discriminatory basis.

For example: 1) Depletion allowances apply generally to industries with finite supplies of natural resources above and below ground. They even apply to timber, which I thought was a renewable resource; 2) Intangible drilling costs allow oil companies to write off in one year costs associated with drilling, such as building roads and transporting supplies. Many other companies and industries have similar provisions (see Hollywood below); 3) The sheltering of taxes on profits earned abroad applies to all companies with international operations, not just to “Big Oil.” Microsoft may save as much from this provision as “Big Oil,” but Microsoft is not a target at this moment. Maybe later.

After reading Sec. 181 of the IRS code on “Treatment of Certain Qualified Film and Television Productions,” I became more concerned about “Big Hollywood” than about “Big Oil.” It turns out the filmmakers can write off the entire costs of film or television productions up to $15 million. In a deft touch of social engineering, I further learn that filmmakers can write off more if the costs are incurred in a low-income community (under section 4-D) or an isolated area of distress (designated by the Delta Regional Authority under section 20009aa-1 of Title 7). The latter must be a pay off to New Orleans. I can also imagine an IRS agent tacking film crews through treacherous slums to make sure they are spending their money in the hood.

I favor the elimination of all tax subsidies – to oil, timber, Hollywood, renewable energy and so on (The list is without end).  All tax preferences, even beloved ones such as the home interest deduction, distort economic decision making. So let’s get rid of all of them and place all economic activity on a level playing field. In return, we can all enjoy lower tax rates, not just “Big Hollywood.”

Russia Needs Our Money Now, But For How Long? Medvedev in Davos

Dimity Medvedev’s Davos charm offensive was cut short by the suicide bombing at Domodedova airport. He could not afford to be seen mingling with “Davos Men” as victims of the tragedy lay dying. Vladimir Putin learned this PR lesson when he continued his vacation as the Kursk submarine sailors suffocated under water. Medvedev returned today to Davos, his agenda reduced to two events: meeting with world business leaders and delivering a keynote address. In both events, he will deliver the same message: Russia is open for business. His listeners will be told that state companies are being spruced up for sale. Only a few will remain off limit to foreigners. Goldman Sachs has been gearing up, beefing up its presence in Moscow. Goldman and other venerable investment houses will lend an air of credibility to the undertaking.

There is no mystery why Russia is again open to foreign investment. The state budget receives half its revenues from oil and gas, whose prices are no longer soaring and whose outputs are stagnant. The Russian economy has been in a funk for a few years, and tax revenues are down. The vaunted rainy-day fund from the halcyon days of the energy boom is almost exhausted. In a word, the Russian state badly needs money.

Putin and company will be actually interested in selling state companies at high prices this time around. Previous “privatizations” have brought precious little into state coffers. The most lucrative state companies have already been sold (or resold) to the Kremlin’s friends at bargain basement prices. None remain under the control of unreliable oligarchs to be confiscated as was Khodorkovsky’s Yukos. Not that much remains to be sold. Rossneft, now owned ten percent by BP, is the big prize, so to speak. Other companies on the auction bloc are less appealing, such as RusHydro and Sovcomflot.

Medvedev’s invitation is not the first, nor will it be the last. Mikhail Gorbachev counted on a huge influx of foreign investment when he liberalized rules in 1986, but no one came. The Yeltsin administration courted foreign investment, but few ventured in. There were still no laws and rules. Willing foreign investors were subjected to endless waits for finalized versions of production sharing agreements and the underlying “normative acts.” Putin came to power on a platform of offering stability and a rule of law. BP, Exxon, and Shell took the bait to be bloodied by arbitrary tax police, environmental agencies, and local oligarchs. The passive foreign investors in Russia’s best-run oil company, Yukos, saw their investments fall to zero as Putin’s tax police and courts dismembered Yukos on phony charges.

We are now assured by Medvedev that this time it will be different. Russia is truly open for business as a reliable partner. It is said that Putin himself stands behind such deals. Medvedev’s economic team is spreading further good news at Davos, such as the government’s intent to streamline rules and lower taxes. Are such siren songs to be believed?

Recent history warns that foreign buyers should be wary for a number of reasons:

First, it matters little whether Putin and Medvedev both stand behind these deals. Putin, or whoever else is in charge in the future, can always change their minds, as BP, ExxonMobil and Shell can attest. In the absence of a rule of law, whatever those in power say is the law is the law. And there are number of ways to break agreements without violating the words written in the contract.

Second, the state will likely remain the major shareholder; minority shareholders would have to search the world for a worse partner. The Russian state will continue to use companies in which it has controlling shares as instruments of state power without much real interest in creating shareholder value.

Third, potential foreign investors should be aware that, despite the participation of the world’s leading investment bankers and accounting firms, they will have to buy a “pig in a poke.” As far as I know, there has been no real audit of any substantial Russian company, despite the respected accounting firms whose names are listed in the prospectuses. A real audit cannot be conducted because it would reveal the web of corruption and related party transaction that lie buried beneath the surface of each of these companies.

The most likely outcome is that foreign money will indeed flood in (the unknown is the price, of course). Putin, Medvedev and the Russian state will behave as long as they need access to world capital markets. With the money safe in its coffers (either in Russia or Switzerland), Russia will again at some point put the screws to hapless foreign partners when the price of oil soars or some other serendipitous event occurs.

Any foreign investor considering investing in Russia for the long run must consider two metrics: Russia currently ranks 154 out of 178 countries in corruption, equal to Tajikistan, Cambodia, and Laos, lower than Pakistan. In terms of political risk, it ranks 186 out of 196. These miserable numbers are not made up. They reflect the reality of what it has been like to do business in Russia.

How Western investors accept the Medvedev-Putin invitation is yet another test for world capital markets. If bids are low enough to reflect the reality of Russian risks and corruption, it will have done its job, and Russian public finances will not be bailed out by naïve foreign investors. If foreign investors pay prices that ignore this reality, they are again like Charlie Brown rushing forward to kick the football that Lucy will snatch away at the last moment.