Putin Should Worry About Oil, Not 'Blackmail'

Vladimir Putin has far more important things to handle.

This week, as falling oil prices have hammered the Russian economy, President Vladimir Putin has warned repeatedly that his country, a nuclear superpower, must not be "blackmailed." He was talking about economic sanctions, but there is a different lesson he should be drawing right now and it has nothing to do with the U.S. or the European Union.

Putin's response to the sanctions, imposed to dissuade him from further aggression in Ukraine, has been to shore up the big state companies and banks most affected. To compensate these businesses for their losses, as sanctions have squeezed them out of international credit markets, the government has raided the state budget, the pension fund and privately held companies. Smaller businesses are being crushed, accelerating a long-term trend under Putin in which Russia's economy has become ever more concentrated in state hands and reliant on natural resources -- especially oil and natural gas.

When times are good, these resources are a source of immense power and wealth. They were the engine that drove Russia's extraordinary 7 percent average annual growth from 2000 to 2008, cementing Putin's popularity. An abundance of natural gas, in particular, has also allowed Russia to punish or reward other countries by imposing high or low prices, or by simply cutting them off.

That pipelines game continues unabated. On his way to today's talks on the Ukraine crisis in Milan, Putin attended a military parade in Serbia celebrating Belgrade's liberation from German occupation in World War II. He used the occasion to discuss building the South Stream gas pipeline, which the EU has blocked since the Ukraine crisis developed but is popular in Serbia and other countries that would gain by hosting it. He also warned that the European Union may lose its gas supply this winter.

The flipside to all this energy wealth, however, is that Russia's economy has remained too dependent on energy prices: The sector accounts for about half of government revenues and a quarter of gross domestic product.

Russia's annual budget loses about $2 billion for every dollar fall in the price of oil -- a hit that couldn't come at a worse time. Sanctions, a falling ruble, rising inflation and rapid capital flight are already helping to push the economy toward recession. Although Putin himself will survive -- he has $450 billion in reserves and a population thrilled by his annexation of Crimea -- Russia is not getting any stronger. No wonder Finance Minister Anton Siluanov recently said Russia "simply cannot afford" its ambitious $500 billion rearmament program.

Putin should be well aware of the danger in relying too much on energy wealth. In the 1980s, the former Soviet Union's militarized economy crashed with the price of oil, leading to the union's ultimate collapse. And in 2008, with the global financial crisis, the price of Urals crude tumbled to $31 per barrel, from $139, in the space of six months, forcing Russia to run through $200 billion of its reserves. Although that turned out to be a relatively brief price dip (it was back up over $80 eight months later), the question that should keep Putin up at night is: What if prices don't rise so soon this time? Or next time, for that matter? Sanctions will be lifted at some point, but oil price volatility will last.

There is little reason to hope Putin will create the kind of economic environment in Russia that's needed to nurture a more balanced economy; that would threaten the system he has built around himself and his close allies. Yet there are many Russian leaders, now sidelined or quiet, who understand that until Russia diversifies, it will remain vulnerable to inevitable fluctuations in the price of oil.

--Editors: Marc Champion, Mary Duenwald.

To contact the editor on this story:
David Shipley at davidshipley@bloomberg.net