On September 3, 2022, Russia took perhaps its greatest gamble since it invaded Ukraine
the previous February.
It all centered on the Nord Stream 1 pipeline, the main delivery system for Russian natural
gas into Germany.
A decade earlier, as seen here, Vladimir Putin hailed it as a major economic accomplishment
for German-Russian relations.
But back in 2022, after weeks of on and off alleged “maintenance” cycle, Gazprom announced
that the pipeline would be shutdown entirely.
The company claimed that a gas compressor station outside of Saint Petersburg had gone
down and that repairs were impossible because western sanctions prohibited delivery of the
necessary parts.
Siemens Energy, the company that maintains the system, denied this.
Instead, the West has interpreted the proclamation as an ultimatum: no gas for Germany until
the sanctions regime ends.
If that was the true intent, it raises a number of questions about Moscow’s strategy.
With that in mind, here are four ways Russia’s gamble could backfire.
Number one: lost war funding.
Let’s start with the obvious point.
Russia needs hard currency to finance—never mind win—its war with Ukraine.
Energy exports are king here, to the point that Russia is closer to an oil business that
runs a government, rather than government that runs an oil business.
As we have discussed before,
Russian success in exporting energy has gutted the country’s manufacturing sector.
Consequently, if you kill the energy exports,
you kill the service economy with it, and Russia has nothing left.
With Nord Stream shut down, Russia is no longer receiving a steady supply of German Euros.
Looking at Russia’s financing of the war—
another recurring topic on this channel—
Moscow started with 643.2 billion dollars in reserves in February 2022.
Western governments immediately froze $300 billion of it.
And Russia burned through $75 billion more over the first four months of the war.
The only thing reducing the bleeding was the steady stream of money coming in from the
energy exports, which supplemented the reserve spending.
In that light, Germany was doing Russia a favor by continuing to purchase Russian gas
at all.
And indeed, concerned about implicitly funding the Ukraine war, Germany had long-term plans
to wean itself off of Russian gas.
It then seems strange that Russia would want to cut off its own economic lifeline.
But that is what happened on September 3.
This raises the question of what is going on inside of Vladimir Putin’s head.
It appears that this is a gamble to try to accelerate a potential demise of the united
Western front against Russia’s invasion.
Russia had hoped that the start of the war would shatter NATO,
with Baltic countries looking for a stronger response,
Russian energy-reliant countries like Germany pushing for non-interference,
and those further west looking to strike a middle ground.
Instead, NATO stood together over the first seven months.
And before the Nord Stream pipeline got cut off, winter appeared to be the first potential
breaking point.
German politicians took a strong line against Russia during the spring and summer.
But the question remained whether the German voting public would continue to support that
policy when winter finally struck.
At that point, some people would struggle to pay the soaring energy prices necessary
to heat their homes.
German businesses that rely on cheap natural gas may go bankrupt, leading to higher unemployment
and compounding the problem with domestic heating.
Russia is basically forcing the question of NATO unity to be answered not in the beginning
of 2023 but rather in the fall of 2022.
It’s hard to gauge exactly what this signals from Moscow.
It might mean that Russia has found solutions to its economic woes that are not obvious
to outside observers.
That would make the German money nice
but superfluous.
Put differently, Russia can afford to put the squeeze on Germany and continue its operations
in Ukraine.
That said, this would contradict an internal Russian report that leaked on September 5.
The memo projected a 3.5% retraction of the Russian economy in 2022, worsening to 8.3%
in 2023, and growth not restarting until late 2027.
The more dire possibility in the report has the economy bottoming out in 2024 at -11.9%,
with no recovery in sight this decade.
Even the rosy “target” numbers still push the recovery to 2025.
If that is the case—and keep in mind it’s just one internal report—Russia might be
in a worse position than it seems from the outside.
Perhaps Russia has burned through more money than what is currently estimated.
Likewise, perhaps its war industry is struggling so bad that Russia needs to purchase artillery
from North Korea, as a U.S. intelligence report indicates.
Putin might know that the German gas cash is not enough to sustain operations much longer
and needs bigger financial relief.
So he ended the gas deliveries to gamble on a broader change.
Alternatively, it may not be a financial problem at all but a political one.
Perhaps Putin is feeling pressure from domestic constituencies impacted by the sanctions.
The Russian government may be sacrificing its gas revenues to change Western policy
and thereby reduce the underlying threat of a coup or popular uprising.
Whatever the case, the upshot here is that deeper answers are likely forthcoming.
If Putin is indeed in trouble, he will be facing the music sooner than later.
But no matter what is happening, the countersanctions will reduce the money Putin has available
for the war, and that brings with it additional risks.
Moving on, the second way Russia’s gamble might backfire is due to German political
backlash.
For my money—dollars that is,
which is now on par with the Euro thanks to the energy crisis—
I think this is the most perplexing part of Russia’s decision.
Imagine it was winter 2023.
The German government had voluntarily shut off the pipeline to put additional pressure
on Russia.
The average German family sees its heating bill soar,
from 160 Euros a month in 2021 up to a projected 600 in 2023.
They do not like Putin or his policies in Ukraine, but they also do not want to freeze
to death or see their jobs disappear.
So some of them begin to lobby the government to reopen the pipeline.
Yes, it will give Russia more cash to finance the war.
And that’s not good.
But other sanctions are still in place and will continue to disrupt Russian manufacturing.
Ukraine therefore still has a clear path to victory.
However, Russia’s ultimatum to halt pipeline deliveries until Western sanctions end creates
a different dichotomy for that average German family to consider.
They can still give in to the sanctions, get the oil, heat their homes, and avoid the winter
cold.
Or they can deny Russia a flourishing economy and allow Ukraine to have a good chance to
defeat Russia and in the war.
Undoubtedly,
some of those German voters will still prefer the free-flowing gas.
But the heat now comes at a substantially higher price.
More will become willing to see the sanctions through and deny Russia a chance at victory.
How many of those people feel that way depends on the rest of the West’s willingness to
aid Germany in standing up to Russia.
Against a united front, Russia’s true play here may be slightly different than the rhetoric:
remove some—not all—of the sanctions, and they will turn back on the gas.
The hope for Moscow is that enough German voters would still be okay with that, allowing
Russia to be in a better position than if it just exchanged gas for cash.
The third reason the pipeline strategy could backfire is German reserves.
Regardless of what Russia’s goal is, the timing of the shutdown is questionable.
Germany knew for seven months prior that winter 2023 was going to be a challenge.
Taking some initiative, the German government mandated the stockpiling natural gas soon
after the war began.
By the time Nord Stream shut down, Germany had filled 77% of its storage units.
That was despite Nord Stream deliveries dropping by more than 50% by June, briefly stopping
entirely in July, and another reduction shortly after it restarted.
Put differently, September 2022 was not the optimal time for Russia to execute this strategy.
It was way back in March.
As a result, this is not the Berlin Airlift 2.0.
Germany has plans to fill its storage units to capacity and still has the time to get
closer to that goal.
But even under the status quo, it is going to be awhile before Germany runs out in any
meaningful way.
In the meantime, Germany is doing everything it can to reduce its dependence on Russia,
something that its NATO allies had long lobbied for.
France, Italy, and Spain
are the European gas consumers that are comparable to Germany.
All three invested in liquid natural gas terminals.
Liquifying natural gas makes transporting it without a pipeline economically viable.
Until recently, Germany viewed such receiving stations as superfluous when Russia could
deliver the gas via Nord Stream.
The war changed that calculation, with Germany rushing at breakneck speed to have some operational
before 2023.
That would give Germany access to the broader LNG market, helping to replenish the supplies
during winter.
Germany has also worked to reduce demand,
installing electric heating systems, switching kitchen appliances to electric,
enhancing home insulation, and lowering recommended heating temperatures.
However, Germany is already running into supply issues.
Germans want the new appliances and want better insulation installed, but finding the equipment
and materials is a significant challenge.
And electric appliances still need electricity.
Natural gas made up 10.4% of Germany’s energy production in 2021.
Germany will need to cut that and make up the difference with new power plants.
As another step, Germany announced on September 5 that two of its nuclear power plants, originally
scheduled for 2022 shutdowns, will keep producing electricity until at least April 2023.
Another strategy has been to subsize public transit with the
nine Euro ticket, which provides economic relief and reduces oil consumption.
But funding for that ended in August, and German officials have not yet adopted a replacement
program.
Figuring out solutions to these problems will be critical to preempt protests in Berlin
like the estimated 70,000 Czech citizens who flooded Prague on September 3.
Finally, number four: permanent changes to German energy consumption.
There is no speculation here: Russia is going to be paying a long-term price for this and
the war as a whole.
The sanctions regime began as a way to punish Putin for starting the war—end the fighting,
and Russia could return to the international economy.
That remained true to some extent a half year into the war.
But some parts of Russia’s economic de-integration have reached a point of no return.
One way or another, those liquid natural gas terminals are going to come online.
Nord Stream may remain the more efficient method of delivering gas to Germany, but Russia
will still have to compete on price once a plausible alternative exists.
That means less profits coming in for Russia.
There still be less demand for gas overall, with the shift to electric options and improved
home efficiency.
Longer term, the investments in green energy will hasten the abandonment of gas altogether.
Thus, Russia will be receiving a lower price on a lower quantity.
The switch from temporary to de facto permanent sanctions has an interesting effect on the
resolution of the war with Ukraine.
When we think about negotiating a solution, the starting point is the expectation of what
would occur if the war were to be fought to a military end.
The costs of the war give some leeway in what can be negotiated.
Keep in mind that these are opportunity costs—what is sacrificed in war that could be kept in
peace.
At the start of the war, the consequences of the sanctions could be understood as an
opportunity cost.
But now the West is in agreement that Russia is never going to recover a good part of it.
It is no longer an opportunity cost.
It’s just forever lost.
In bilateral negotiations with Ukraine, that paradoxically puts Russia in a better position.
To be clear, Russia is not in a better position overall.
The gain here is exactly offset by the long-term loss away from Ukraine.
Also, remember that sanctions inhibit Russia’s ability to fight the war, which more generally
shifts the expected outcome and bargaining range in a way favorable to Ukraine.
As a final thought, the crazy part about all of this is that if Russia is actually telling
the truth.
it’s basically an admission
that the sanctions are working.
Russia has no ability to repair its own industry and will soon lose the ability to continue
the war.
In any case, those are four ways Russia’s Nord Pipeline strategy could backfire.
What do you think Putin’s endgame is here?
Let me know in the comments.
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