Following the referendum in Crimea it is time to face reality. It is now obvious regardless whether one thinks the referendum was fair, legitimate, legal or not that the majority of the population of Crimea no longer wants to be subject to Kiev's influence, just as in Kiev and elsewhere in Ukraine mass protests and violent clashes showed that Ukrainians do not want to be under Russian influence. Regardless whether one thinks that Crimea's population has the right to have this opinion heard and taken into consideration, the fact is that Russia is committed to supporting their aspirations, not only because they are a majority of ethnic Russians, but also because it is convenient. Crimea is perceived to be of vital strategic significance to Russia, therefore it cannot take a chance on possibly losing control of it. It is therefore now obvious that there is no turning back.
Time for a reality check: Military & economic confrontation are not good options
There are currently plenty of people who believe that Russia can be forced to turn back if pressure is applied. I am aware therefore that what I am proposing will rub a few people the wrong way. The reality is that only military or economic confrontation could reverse the situation, and neither of these are viable options.
There is no point even discussing the military option. Russia's nuclear arsenal makes sure of that. Its conventional military force may not be as formidable as that of US and NATO, but it is not by any means to be under-estimated either. If there is to be an armed conflict, at the most it would involve Ukraine and Russia, with perhaps significant material support given to Ukraine by Western powers. Even this scenario is not very likely to happen given the great disparity between Russia and Ukraine in terms of military resources.
An economic war has far more potential to develop, especially given that the United States, unlike Europe, has limited economic ties to Russia, therefore feels less vulnerable to retaliation. Nevertheless, even the United States can only take things so far before Russia decides to share the pain with the rest of the world.
There is one way for Russia to hurt the global economy, therefore that of the recovering US economy as well. It exports over 7 mb/d of crude oil per day, which is almost 10% of global crude supplies. It has often been pointed out lately that there is no way that Russia would ever consider retaliating through using the energy weapon, because after all Russia depends on revenues from those exports for its well-being. In other words, it seems people believe that Russia needs that money more than we need the energy.
People are forgetting that Russia does have about $500 billion in FX reserves. It is enough to cover the country's full budget needs for a full year. For 2014, Russia's budget is about $450 billion (link). By a more relevant measure, it is enough to cover Russia's hypothetical loss of about $260 billion it would lose per year if it was to stop exporting oil for almost two years. If Russia was to chose to only stop gas shipments to Europe, which at a cost of roughly $400 per 1000 cubic meters brings in about $60 billion per year, it would have the funds to make up for the loss of revenue for roughly eight years.
To be perfectly clear, Russia does not want this economic confrontation to unfold. Even with the reserve funds to rely on, life in Russia would become far less bearable than it is in the present. It might resemble the harsh conditions experienced in the 1990s right after the collapse of Communism. Recovery would also take a long time. It seems to me, however, that in the Western world, especially in the United States, there is a lack of understanding of the fact that we also should not want to push the Russians to the point where they feel that they have no choice but to take us down with them, because they can. I want therefore to point out some of the consequences if current tough rhetoric will translate into a tit for tat game, which will eventually lead to economic disaster.
In the event that Russian oil would not reach the export markets anymore, we would be looking at global economic disaster. There is no spare capacity available to deal with the loss of as much as 7 mb/d in lost global exports. Saudi Arabia is already pumping oil that many mistakenly believe to be production capacity in reserve, due to the need to make up for lost supplies due to Libya's internal conflict and Iran situations. Strategic reserve releases would dampen the blow for the first two or three months, but after that most countries would panic and stop releasing more oil due to the fear of depleting their reserves and being left without in the context of an uncertain situation.
It is impossible to predict with certainty what effect this would have on the world's economy, but in a worst-case scenario a process of demand destruction equivalent to 7 mb/d would probably wipe out as much as 15-20% of the global economy as an initial effect. I base this estimate on historical data, which shows that a 1% increase in oil supplies is needed in order to achieve about 2-2.5% global economic growth. Working it in reverse we can assume that in order to create demand destruction, a similar ratio of GDP would be lost per percentage of oil supplies lost.
Such a deep shock to the global economy would ensure that Russia's economic pain would be shared by everyone. Within months, we would have consumer, corporate and sovereign debt defaults on a massive scale, after which it will no longer matter whether Russia will resume oil exports or not. In fact, I expect that global oil demand would sink well below global capacity calculated without Russia and Russian oil coming back on the market would depress oil prices for many years, rendering many current oil extraction projects which rely on current prices un-viable for the rest of the decade.
I hope policymakers as well as the people they represent will not under-estimate the possibility of this scenario playing out when discussing and contemplating sanctions against Russia. I don't believe anyone really wants to go down this road; at the same time, given the lack of public acknowledgement of this situation, it makes me a little bit nervous. We should all follow the reaction coming from the West very carefully this week, because it could set the direction of the final outcome. I am hoping for wisdom.
The natural gas option
While I believe that shutting down oil exports would be a last resort option for the Russians, which would only happen in case our policymakers badly misjudge and miscalculate the situation, therefore they will resort to measures against Russia which will give them no choice but to decide to take the rest of the world down with them, I believe that aside from some European policymakers, most people are badly under-estimating the likelihood of Russia retaliating by shutting down gas exports. As I pointed out, the roughly 150 billion cubic meters (4.8 trillion cubic feet) of gas being shipped to the EU generates Russia about $60 billion per year. While Russia would be very hard hit by losing the EU market, it would be a temporary setback. Russia can survive the economic shock and replace the EU as a customer with China and other Asian countries within a few years. The effect on Europe, however, would be very severe and most likely fatal to the Union.
Russia supplies over one third of total EU gas consumption. If Russia will turn off the taps, some of the loss will be compensated with coal and nuclear capacity in the electricity generation sector, but still, it would be a very hard blow to the EU economy. This is where many believe that US LNG exports to Europe could help. It is a very misguided belief, yet it is spreading. A week ago the Central European countries of Poland Czech Republic, Slovakia and Hungary issued a joint request to the United States, urging it to start exporting LNG to the EU (link). This was in response to increasing calls especially from Republicans to do so, by arguing that it would loosen Russia's grip on the EU gas market. The poor Central Europeans did not understand that this bait was not meant for them but for the US public, and it was generally directed towards those who are not very familiar with the details of the US gas industry. It is a drive to take advantage of the situation in order to support the struggling shale gas companies which desperately need to see some increase in prices if they are to recover. LNG exports would definitely help bolster prices.
One of the details that most people are unaware of is the fact that the United States is still a net natural gas importer. Another fact that most people do not know is that last year, natural gas production in the United States only increased by less than one percent. If we were to subtract the effect of the increase in natural gas production from the Marcellus shale gas field, US gas production would be in decline. Many of the major shale gas fields which only started significant production half a decade ago such as the Barnett and Haynesville are already in decline. Taking all these factors into consideration, we realize that the United States cannot be a solution to replacing a significant portion of current Russian natural gas exports to the EU. The EIA projects that the United States will continue to import gas at least for the next two to three years, therefore, any LNG exports would only amount to a small fraction of current Russian exports to the EU.
Losing Russian gas supplies would most likely mean an end to the European Union. The resulting economic downturn is not easy to predict, but we know that the old continent has been in the grips of economic hardship since 2008 already and it has already taken a toll. In many countries such as Spain, youth unemployment is in the 50% range and the overall unemployment rate is over 20%. Most countries increased their debt burdens significantly while cutting into the social safety net. This year's EU parliamentary elections are rumored to catapult the Euro-skeptic far-right parties towards a position that challenges the traditional moderate parties at the top (link).
This shows just how disillusioned Europeans already are. Going into another economic crisis which would be far more destructive than the last financial crisis from which the EU is only expected to start recovering very moderately this year, would push EU society beyond the breaking point. The collapse of the EU would be a shock to the global economy which would be perhaps even more devastating than Russia's other option of halting oil exports. At the same time, it is the retaliatory option which would cost Russia less. It is therefore the one that we should expect to be the most likely to happen if Western policy turns out to be not as wise as we expect.
Danger remains even in the absence of economic war:
A very thoughtful, realistic and sensible Oxford report on the current situation points out the fact that a major economic confrontation is unlikely to develop between Russia and the West over the Ukraine issue, but the European Union is still in great danger of losing the gas that transits through Ukraine, because of Ukraine's desperate economic situation, which will likely lead to another Ukraine-Russia gas dispute. The dispute will be triggered by Ukraine's inability to pay for its gas bills just as it happened in 2004 and 2009. As it happened then, Russia will once again respond by cutting off supplies to Ukraine. Ukraine will then do as it did in the last two disputes and siphon off the gas transiting its territory towards the EU, leaving Russia with no choice but to shut off supplies completely.
The Oxford report does not mention this, but I have a suspicion that this time around, the shutoff could become permanent. There are a few factors which might lead Russia to make this move. The first factor is the fact that this time around, Ukraine will find it harder than ever to pay off the bill, which would leave Russia with no choice but to support losses on its gas exports due to non-payment of a portion of it.
The second factor is lack of foresight on the part of EU policymakers as evidenced by the recent decision by the EC to delay the South Stream pipeline which would bypass Ukraine and take gas supplies to the same EU customers from Russia as the current Ukrainian pipelines do (link). The Oxford report which I largely agree with points out the importance of South Stream being completed as soon as possible in order to maintain EU energy security. EU mishandling of this issue, together with Ukraine's inability to pay for its gas is likely to force Russia into taking a major decision on its natural gas policy, which will not be positive for Europe.
The Russians would definitely not be happy to have their gas taken by Ukraine without full payment, which as of April this year will have to be taken at market prices, which is about a third more expensive than the subsidized gas Ukraine has been getting up to now. The EU decision to delay South Stream basically forces Russia to accept the situation for a prolonged period of time. It has been reported that Vladimir Putin is headed to China in May and that pricing of natural gas exports to China from Russia will be the main topic. I suspect a decision could be made perhaps this year on Russia diversifying its gas exports away from Europe. It means that Russia may in fact choose not to accept the situation much longer. Besides, South Stream is also important to EU energy security for the simple reason that Ukraine's pipeline network is in urgent need of repairs estimated to cost billions of dollars. Ukraine is not able to fund those repairs while no one else is willing to invest in those repairs (link). In light of these facts, another dispute with Ukraine over gas payments will most likely leave Europe without a large portion of its current gas supplies as it gives Russia no choice but to look for other customers.
US LNG to the rescue
There is a way to avoid another major dispute between Russia and Ukraine over natural gas deliveries and payments and it would also serve as a way to inflict a bit of pain on Russia. As I pointed out, US LNG cannot make a significant difference in terms of lessening European Union dependence on Russian natural gas. Anyone who says otherwise is simply promoting distortions. US LNG exports to Ukraine could, however, avoid a dispute with Russia which would turn supplies off to the EU once again, this time with more severe consequences.
The volume needed to replace Russian exports to Ukraine is equivalent to roughly 3% of total US natural gas production, which compares favorably with 20% which is what would be needed to replace Russian exports to the EU. It is important to remember, however, that Ukraine will not be able to afford to pay for US LNG anymore than it can afford to pay for Russian gas, therefore the LNG would have to be sold at a very deep discount. I believe the United States and the EU could work out a joint program of subsidizing this gas. After all, now that Kiev turned its back on the Russian agreement, it falls to the West to prop up Ukraine's economy. This subsidy could be phased out gradually as Ukraine goes through the tough IMF led painful reforms which are expected to be implemented in return for much-needed loans meant to keep Ukraine from going into default. We can think of this subsidized natural gas as a perfusion meant to keep the patient alive while being operated on. It is important to remember that in the absence of some measures meant to soften the blow to the Ukrainian population resulting from painful IMF reforms, which will be demanded of them, Ukrainians could take to the streets again, this time against the IMF, further destabilizing the country and perhaps leading to a complete economic and social collapse.
In time, Ukraine's economy could recover and start performing, leading to increased ability of the population to cope with higher gas prices. It is also possible that domestic shale gas supplies could be tapped, leading to a lessening of reliance on subsidized LNG. It should be noted, however, that the nationalist Svoboda political party in Ukraine, which has been at the forefront of the protests that ended the presidency of Yanukovic, opposes shale gas development in Ukraine.
At the very least, it would give the EU a chance to avoid painful disruptions of its gas supplies, leading to better global economic security. It will also give Ukraine a chance to survive the much-needed reforms and austerity that is awaiting. It would also hit at Russian interests, because an important natural gas customer would be lost. It would also allow for an orderly shutdown of the Ukrainian natural gas transit pipelines towards the EU as normal relations would allow the EU and Russia to resume collaboration on building the South Stream pipeline. This would be the wisest policy the West could adopt in response to this crisis. Let us hope this will be the direction we choose.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.