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Summary

  • Russia's energy contract with China was the bare minimum needed, replacing about a fifth of EU demand, but no infrastructure investment.
  • After the Ukraine election, some stabilization is likely as the country is Finlandized.
  • There are many sources of pressure coming to bear on Russia.

Russia's Putin has been negotiating an energy deal with China for over a decade. The relationship with Europe, its largest customer, has soured, so Putin was desperate. The deal struck is significant at something on the magnitude of $400 bln over a 30-year period. Although the price of natural gas was not revealed, it appears to be somewhat lower than other Gazprom deals.

Moreover, Putin was unable to secure an investment from China to develop resource deposits and infrastructure. Instead, Gazprom (OTCPK:OGZPY) will be responsible for developing natural gas supplies in eastern Siberia while China National Petroleum Corp. will construct transportation and storage facilities within China.

When all is said and done, Putin managed to replace about 20% of Russia's energy exports to Europe. The intimidation of Ukraine, but especially the annexation of Crimea, puts risk on a medium term, with much more than a fifth of its exports to the EU. Leaving aside efforts to create an energy union, which will be a laborious process, Europe's response is a three-fold response. First, build more storage capacity and increase pipeline investment. Second, make greater efforts to diversify away from Russia toward countries such as Norway, Algeria and Qatar and in 2-3 years, possibly the US.

The third element is the most controversial. It entails deterring greater penetration into Europe by Gazprom. Even before the recent events in Ukraine and Crimea, the EU had hardened its negotiating position with Gazprom over two new pipelines, South Stream and OPAL. The former is a 500-mile pipeline under the Black Sea to Bulgaria and was projected to carry 15% of Russia's natural gas exports to Europe by 2018. The latter is a 290-mile pipeline project that would transport natural gas to the Czech Republic through Germany.

The European Parliament approved a non-binding resolution to cancel the South Stream project. European officials are expected to make a formal decision next month. They are concerned about Gazprom's concentration and possible anti-competitive practices. Environment issues have become more salient, and the EU is insisting that other companies be allowed to distribute the gas through Gazprom's pipelines.

Gazprom officials argue that these rules were not enforced in the construction of the OPAL pipeline. They expected regulatory forbearance for the South Stream project, a joint venture between Gazprom and a number of European companies, including Italy's state-owned ENI. By partnering with different European companies seems to ensure asymmetrical threat perceptions, Gazprom/Russia can create a wedge issue. Note that even after Russia annexed Crimea, Austria's OMV signed a contract with Gazprom to build a hub for South Stream on the Austria-Hungary border.

The fear of undermining the broader relationship with Russia has clearly slackened on the EC level. Europe has formally requested discussions with Russia over tariffs it has imposed on vans from Italy and Germany. This is a step toward a WTO case.

There is some evidence that there has been a larger cooling off of commercial relations between many US and European companies and Russia. Some of this was happening prior to the events in Ukraine and Crimea. For example, European trade with Russia fell about 10% in the first two months of the year. Coca-Cola (NYSE:KO) announced it would be closing two plants in Russia due to the weakness of domestic demand. Many US and European companies will not attend (boycott) next month's business expo in St. Petersburg.

Visa (NYSE:V) and MasterCard (NYSE:MA) will face a difficult decision in July. In response to the credit card companies' decision to stop processing payments from four banks due to US sanctions, Russia passed laws that require them to make a deposit (that is a function of the volume of their business). The deposit will be forfeited if the companies cease to provide services again. The credit card companies will try to negotiate (forbearance?), but if they fail, they may choose to exit Russia, which appears to account for about 2-3% of their revenues.

Putin secured the bare minimum agreement from China that can be called a victory. It looks likely that the Ukraine government that will be elected on May 25 will pursue a more political realistic course: One that recognizes the geopolitical realities and Russia's strategic interest. It is in its interest to sustain a delicate balance between European and Russian interest and influences, in a condition somewhat similar to Schrodinger's Cat. It may also pursue a more federalist system. In effect, if as Martin Wolf argues, "India's election remakes our world," then this weekend election may confirm the end of the post-Cold War era in Europe with the effective Finlandization of Ukraine.

When a great power needs to use military force to hold on to a client state, it manifests a failure. Democracies may be somewhat slow out of the blocks, but it can ultimately bring more force to bear. The political economist Charles Linbloom talked about democracies being all fingers and authoritarian regimes being all thumbs. The integration of Russia into the world economy for nearly a quarter of a century has created numerous channels of potential leverage. Working the system takes time.

At the same time, we suspect investors have under-estimated the impact of the sanctions on Russia and the larger cooling off effect it is having on the commercial relationship. The Russian government acknowledges it has been locked out of the capital markets. Reports indicate that the US, European and Japanese banks have reduced services they provide for Russian businesses, including credit provisions and pre-export financing.

The challenge for the US and Europe is less about Russia and China's historic energy pact, or even side agreements between one of Russia and China's largest banks to promote and settle trading in each other's currencies, and more about preserving the cohesiveness of the alliance. Material interests threaten to create fissures.

A quarter of the EU members rely exclusively on Russia for their energy imports. Many companies and countries are reluctant to turn down commercial activity offered by Russia. In resisting pressure regarding military sales to Russia, French officials claim to be unfairly singled out and point to the Russian money being transacted or managed in London. Russia can take advantage of such differences to keep Europe off-balanced, which tends to temper reactions.

At the same time, the seeming downgrade of the military threat and ideas that the successful completion of the Ukraine elections will lessen tensions have seen Russian assets perform well in recent days. The rouble is rivaling the Indian rupee as the strongest currency over the past five sessions. The 3% rise in the MICEX is among the best in the world and Russian bonds have rallied with the 10-year rouble yield easing 13 bp and the dollar bond yields falling almost 30 bp. Opportunistic investors need to remain nimble as we see the risk of further Russian isolation.

Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.

Source: Expect Short Honeymoon For Putin