Russia’s Oily Future
Overcoming geology, not ideology, will become Moscow’s greatest challenge.

Moisйs Naнm, editor of FOREIGN POLICY

Russia's future will be defined as much by the geology of its subsoil as by the ideology of its leaders. Unfortunately, whereas policymakers can choose their ideology, they don't have much leeway when it comes to geology. Russia has a lot of oil, and this inescapable geological fact will determine many of the policy choices available to its leaders. Oil and gas now account for roughly 20 percent of Russia's economy, 55 percent of its export earnings, and 40 percent of its total tax revenues. Russia is the world's second largest oil exporter after Saudi Arabia, and its subsoil contains 33 percent of the world's gas reserves. It already supplies 30 percent of Europe's gas needs. In the future, Russia's oil and gas industry will become even more important, as no other sector can be as internationally competitive, grow as rapidly, or be as profitable. Thus, Russia risks becoming, and in many respects may already be, a “petro-state.” The arrest of oil magnate Mikhail Khodorkovsky sparked a debate over what kind of country Russia will be. In this discussion, Russia's characteristics as a petro-state deserve as much attention as its factional struggles.

Petro-states are oil-rich countries plagued by weak institutions, a poorly functioning public sector, and a high concentration of power and wealth. Their population is chronically frustrated by the lack of proportion between their nation's oil wealth and their widespread poverty. Nigeria and Venezuela are good examples.

That Russia has lots of oil is old news. What's new is the dramatically enhanced role that changes in Russian politics, oil technology, and energy markets have given to its petroleum sector. Throughout the 1990s, privatization in Russia and innovations in exploration and drilling technologies brought into production oil fields that had hitherto been underperforming or completely off-limits. To energy companies worried about growing domestic instability among the major oil exporters of the Middle East, Russia became an even more attractive hedge. Regardless of its political turmoil, Russia will continue to appeal to oil companies, which know how to operate profitably in countries with weak property rights and unstable politics. Thus, while the Khodorkovsky affair may temporarily scare away some investors, Russia's beguiling geology will eventually attract energy companies that cannot afford to be left out of some of the world's richest oil reservoirs.

But when oil revenues flood a nation with a fragile system of democratic checks and balances, dysfunctional politics and economics ensue, and a petro-state emerges. A strong democracy and an effective public sector explain why oil has not distorted the United States or Norway as it has Nigeria and Venezuela. A lot of oil combined with weak public institutions produces poverty, inequality, and corruption. It also undermines democracy. No petro-state has succeeded in converting oil into prosperity for the majority of the population.

An economy that relies mostly on oil exports inevitably ends up with an exchange rate that makes imported goods less expensive and exports more costly. This overvalued exchange rate makes other sectors—agriculture, manufacturing, tourism—less internationally competitive and hinders their growth. Petro-states also have jobless, volatile economic growth. Oil generates export revenues and taxes for the state, but it creates few jobs. Despite its economic heft, Russia's oil and gas industry employs only around 2 million workers out of a total workforce of 67 million. Also, because the international price of oil is volatile, petro-states suffer constant and debilitating economic boom-bust cycles. The busts lead to banking crises and public budget cuts that hurt the poor who critically depend on government programs. Russia already experienced this effect in 1998 when the drop in oil prices sparked a financial crash. If oil prices fall below $20 a barrel, Russia will surely face another bout of painful economic instability.

Petro-states also suffer from a narrow tax base, with the bulk of government revenues coming from just a few large taxpayers. In Russia, the 10 largest companies account for more than half of total tax revenues. Weak governmental accountability is a typical side effect of this dependency, as the link between the electorate and government spending is indirect and tenuous.

The political consequences are also corrosive. Thanks to the inevitable concentration of the oil industry into a few large firms, owners and managers acquire enormous political clout. In turn, corruption often thrives, as a handful of politicians and government regulators make decisions that are worth millions to these companies. Nationalizing the oil industry fails to solve these problems: State-owned oil companies quickly become relatively independent political actors that are rife with corruption, inefficiency, and politicization, and can dominate other weak public institutions. Privatizing the industry without strong and independent regulatory and tax agencies is also not a solution, as unbridled private monopolists can be as predatory as public ones.

In petro-states, bitter fights over the control and distribution of the nation's oil rents become the gravitational center of political life. It is no accident that the current crisis in Russia hinges on control of the country's largest oil company and the political uses of its profits.

But Russia is not Nigeria and has yet to become a full-fledged petro-state. It is a large, complex country with a highly educated population, a relatively strong technological base, and a still somewhat diversified economy. A strong democracy could help Russia compensate for the economic and political weaknesses that plague all countries dominated by oil. Russia is still struggling to overcome the crippling effects of its ideological past. Let's hope it will also be able to avoid the crippling effects of its geological present.

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