It is well known that Russia has paid for its invasion of Ukraine
with money from the oil and gas industry. This is the “fortress economy” that Russia created,
having put away $643 billion before the war
and continuing to pull in revenue from energy sector
despite the sanctions levied against Moscow.
What is not as well understood is that Russia built its fortress economy
on a house of cards that could easily cave in, thanks to something known as Dutch disease.
Despite that, the west has not yet fully exploited the
vulnerability that Russia has created for itself.
But whether that changes in the upcoming months may very well
determine whether Ukraine can expel the Russian invaders from along the Black Sea
and perhaps resolve the long-running War in Donbas as well.
To understand what’s happening, let’s head to the Netherlands
and jump back to 1959.
After turbulent times following World War
II, things were going great in post-reconstruction Western Europe.
And it was about to get even better for the Dutch.
The Netherlands was on the verge of discovering the Groningen gas field
and becoming a major player in the European energy market.
Great for the Netherlands, right? Well, yes. But a rising tide does not lift all Dutch ships.
Economists quickly observed that Dutch manufacturing was suffering,
and political discontent began to set in.
This became known as Dutch disease:
when a natural resource boom causes a decline in domestic manufacturing.
Russia has the same problem today, so let’s explain how this happens from their perspective.
Think of the Russian economy as having three major sectors: energy,
manufacturing, like cars as an example,
and service, like the entertainment and restaurant industry.
The discovery of oil and the post-millennium bull
run on oil prices has been fantastic for the Russian energy sector, causing it to grow.
But Dutch disease sets in for the manufacturers because of two problems: labor and exchange rates.
With energy booming, the sector needs to hire a little more. This effect is small in oil and gas
because they are not especially labor intensive.
However, the newly wealthy people in the energy industry will want to start having
more fun with their money, so demand for labor will increase in the service sector.
The end result is higher labor prices for the manufacturing sector,
which makes those companies less competitive on the international market.
Some of them will have no choice but to close.
Meanwhile, the energy exports cause the Russian ruble to rise,
either because foreign buyers pay for the gas directly in rubles or because the beneficiaries
need to trade their foreign currency for rubles to enjoy the services in Russia.
But the higher value of the ruble makes it cheaper to buy imported manufactured
goods. Thus, even more of the domestic industry is going to close up shop.
The end result may be a strengthened economy, but at the cost of a gutting the manufacturing sector.
On net, this is great under normal circumstances,
but it can leave your country vulnerable in the long run.
Imagine that energy prices were to suddenly fall off a cliff,
perhaps because Saudi Arabia pumps more oil
or a pandemic starts suppressing worldwide demand.
Obviously, Russia’s energy sector is trouble.
But so is the service sector—it relies on customers coming in from the energy sector.
Meanwhile, the manufacturing sector cannot pick up the slack in the short term
because it has already been gutted.
Basically, your entire country’s economy will collapse.
More important for right now, it also means that your country is vulnerable to economic sanctions.
If foreign powers shut off that one industry,
there goes the lynchpin to destroy the rest of the financial system.
In 2021, Russian exports were worth 492 billion dollars.
212 billion of that was from the energy industry.
And yet the west has thus far not fully exploited
this serious vulnerability in the Russian war machine.
Once the invasion of Ukraine started, industrial and service industry partners
worldwide rapidly fled Russia, and trade in those areas was heavily restricted.
That’s helped the west and hurt Russia, but it is not where Russia’s weakness is.
Russian manufacturing was already shot, and the service industry supports the energy industry.
The real target of value is the energy sector.
Along those lines, once the war started, the United States quickly banned oil,
gas, and coal imports.
Europe has a much higher dependency for Russian gas, however, and their response was far weaker.
On June 3, 2022, the EU passed a sanctions package
that banned Russian crude oil imported by sea … beginning December 5.
Meanwhile, such petroleum imports would be banned as well … beginning February 5, 2023.
Pipeline imports are unaffected.
Putting all this together, so far the EU has lowered Russian imports to its member states
by almost 2.2 million barrels per day—a tidy sum but not as much as they could be doing.
And yet overall Russian oil exports have only fallen by 580,000 barrels,
with India and Turkey picking up some of the slack.
The result is that the Russian oil industry has taken damage but mostly survived … so far.
The International Energy Agency anticipates that
the February 2023 sanctions will reduce Russian oil output by 20%.
Russian oil is being sold at a hefty discount to those countries,
marked down by $20-$30 per barrel. They have hit a satiation point,
where the international market simply cannot absorb much more.
India, for example, just can’t do all that much with so much oil.
As a result, oil production in Russia has fallen by about 3% so far—a notable amount
but not enough to trigger a complete Russian economic meltdown.
Still, despite how sanctions have not truly hit Russia’s weak point,
Moscow is seeing some worrying economic signs.
Russia’s GDP dropped 4% in the second quarter of 2022.
This figure understates the impact of the war. Russia observed a GDP growth of 5% in the fourth
quarter of 2021, the last full quarter before the war. By that metric, the difference is 9%,
which is a substantial amount of damage that could be attributable to the sanctions regime.
As we have discussed before,
Russia is running a budget deficit of 2% of GDP without any lenders to make up the difference,
It has also seen its $643 billion dollar rainy day fund shrink to $268 billion,
having spent $75 billion of it on the war and watched western banks freeze $300 billion.
In short, Russia is wobbling despite the sanctions not truly hitting its most vulnerable point.
It is easy to imagine that these figures will tumble further and faster if the west
fully took advantage of the Dutch disease that Russia suffers from.
How can they do that? The obvious answer is to fully lock down the Russian energy industry.
India and maybe China will step in to buy a little more
once the prices crater. If the west wanted to counteract that,
they could establish harsh secondary sanctions on China and
India to punish them for giving Putin an outlet.
though that kind of action would be a massive escalation
against otherwise neutral-ish third parties
and might not even be necessary to ensure the Russian energy sector falls apart.
Again, that causes a spillover to its service sector,
and its manufacturing sector will take years to recover from Dutch disease—
and that’s assuming any entrepreneur is going to
want to start new manufacturing businesses while the country is on economic lockdown.
Of course, this is easier said than done.
Europe needs Russian gas to heat their homes during the winter.
European politicians understand that this will hurt Ukraine’s chances to take back its territory,
but pointing that out is a hard sell when some of their constituents may literally be freezing.
The short-term solutions are not great.
Germany has prepared to fire up coal plants that were previously on reserve.
Meeting green energy goals might take a backseat to removing Russia from Ukraine.
After all, the negative effects of burning coal on climate change
are borne out by everyone—including Russia—
while the benefit of Russia losing the war is more concentrated for those in Europe.
Germany has also halted plans to close its three remaining nuclear power plants.
In contrast, adding more infrastructure to Europe will take a lot longer.
This is a winter 2024 fix at best.
New nuclear power plants will take even longer,
requiring five years to get online, and that’s under an optimistic timeline.
There is a more immediate solution, though it will come at a different cost to western countries.
Iran is sitting on a ton of oil and gas.
Prior to the invasion of Ukraine,
it was the world’s most sanctioned country. That included—and
still includes—its oil and gas exports.
Ending those sanctions—by perhaps coming to a broader agreement on its nuclear program—would
instantly lower oil prices around the world.
Indeed, Iran has claimed that it could double its exports once sanctions are lifted.
Obviously, getting Iranian supplies to Europe would be far
more inconvenient than simply piping it in from Russia, but that’s not the point here.
Even without Russian sanctions, forcing Russia to compete with Iranian oil and the lower global
prices that come with it means that Moscow brings in less money for its war chests.
The lingering question is whether Iran will take the reciprocal steps necessary
to get the United States and Europe to a point where the sanctions can come down.
Iran has benefited from the higher overall oil prices due to the invasion of Ukraine,
even with the sanctions narrowing the outlets it can go to.
But that is why negotiators from the United States,
European Union, and Iran have been in Vienna: to sort all of this out.
In sum, the west can exploit Russia’s Dutch disease,
but the countries still need to sort out how to weigh the tradeoffs.
If you thought this topic was interesting, you’ll love my book on the causes of the
war between Russia and Ukraine. You can find details about it below.
And if you enjoyed this video, please like, share, and subscribe,
and I will see you next time. Take care.