VENEZUELANS DESERVE THE WORLD BUT GET MADURO

By Kristopher Klein
Staff Writer

The collapse of OPEC may have been averted, but look out for political turmoil across its struggling member states.

Venezuelan President Nicolas Maduro recently toured OPEC member states as well as Russia to urge a cut in output. His tenacity has waned, however, as Saudi Arabia remains staunchly in favor of maintaining production. With the cut in production off the table, Maduro has shifted focus to political repression and shying away from economic reforms.

A few weeks have gone by since I published an article on how the sudden decline in oil prices was making oil export-dependent governments nervous about their annual budgets. When governments of oil-dependent nations write their budgets for the year, they typically base these off of a predicted price for their oil exports. The decline in prices has shredded the budget of Venezuela specifically, which assumed a $60 per barrel price for the year.

It was expected that the national governments of OPEC member states might react to budgetary woes by demanding that OPEC cut output or threaten to leave the cartel. However, that was not to be and the politicians of Venezuela would now rather resort to temporary fixes and political distractions than real economic reform.

Political Turmoil

Last week I watched with both dismay and amazement at the sheer audacity of Venezuelan President Nicolas Maduro as he had a chief opposition politician, the mayor of Venezuela’s capital city Caracas, hauled away to prison under allegations of supporting an American plot to take over the government.

Venezuela’s socialist elite has accepted that they will most likely fail to convince OPEC to act in order to change the price of oil, and has instead opted to short-change the people of Venezuela. The regime’s strategy is to make do with what OPEC hands them and maintain power by limiting the political alternatives of Venezuelans in an attempt to distract them from the reality of Venezuela’s damaged economy.

The tactic of drumming up foreign policy woes to take attention away from a flailing domestic economy is alive and well in politics. Maduro suppresses social unrest by portraying himself as a fearless protector of the Bolivarian legacy against the evil North American machine, like his predecessor Hugo Chavez. By accusing an opposition politician of plotting to help Americans overthrow the regime, Maduro gets rid of a prominent political opponent and keeps the Venezuelan people checking over their shoulders for the gringo conspiracy.

Prospect of Needed Economic Reforms Fading

The real problem this political turmoil presents is the death of any possibility of real economic reform. The introduction of economic reforms requires the government to feel secure enough in its political and financial position to implement reforms. Also, some social willingness to sacrifice for the reforms in the short term is necessary. Furthermore, reforms take time so a country needs an opposition willing to sit on its hands for at least a short while rather than charging incompetency if reforms do not immediately produce noticeably positive results. Venezuela seems to meet none of these requirements.

Late last year Maduro removed Rafael Ramirez from office, president of Venezuela’s state-owned petroleum company PDVSA and vice president for the economy. Before his removal Ramirez advocated for unifying Venezuela’s multiple exchange rates into one.

In Venezuela, importers of essentials like food and medicine can buy U.S. dollars from the government at a rate of 6.3 bolivares fuertes (Bf.) per dollar. Importers of other goods can buy dollars at a rate of 11 Bf. per dollar. Private exchanges used to sell dollars for around 50 Bf. per dollar, but have now been replaced by a free-floating exchange rate that trades at around 175 Bf. per dollar. There is also a substantial black market for dollars that sells at around 79 Bf. per dollar.

Ramirez wanted to unify these multiple exchange rates into one exchange rate that would be free-floating and make some goods more expensive for Venezuelans to buy in the short term. This of course would have cost Maduro some political support with the Venezuelan people, so naturally Ramirez had to be removed from his politically powerful positions involving oil and the economy.

Maduro’s government seems to be quite anxious about its current situation, something that does not bode well for the prospect of endorsing bold economic reforms. Venezuela’s Parliamentary elections in December 2015 make the likelihood of the government producing reforms even less likely. In the meantime they will try to implement some moderate reforms like introducing one free-floating currency but leaving the others as is. As Venezuela runs out of foreign currency reserve, they will also have to seek money to keep the entire system running until after elections.

Cap-in-Hand to the Richest Strongman of Them All

Nicolas Maduro recently made a trip to Beijing to secure investment from who has become the world’s most magnanimous dictator, Xi Jinping. The investments made by China, in effect, prevent reform from occurring in Venezuela.

The Maduro government stands in the way of reforms that many economists see as necessary for Venezuela to unlock sustained economic growth. Perhaps it would be the universe’s way of demanding reforms if the Venezuelan government were to run out of cash. They would be forced to accept conditions of economic reform placed on loans from the IMF or World Bank or risk being replaced at the polls by a government willing to reform.

However this near-inevitability has been avoided by China’s political involvements in the region. In January, China agreed to invest $20 billion in Venezuela to help counteract the effects of the collapse in oil prices. The $20 billion in investment is a lifeline for the Maduro regime and possibly all it needed to avoid having to make politically painful reforms. By providing the Venezuelan government with investments without first stipulating conditions of reform, China has essentially nixed an opportunity to push the Venezuelan government toward economic reform. This is not, however, the first time China has prevented reform in Venezuela.

Since 2007, China has extended credit to the Venezuelan regime to the tune of $50 billion. The tactic of offering loans and investment to a Latin American regime struggling with Western countries over loan conditions seems to work for China politically. Loans and investments will help China cement its relationship with a nation strategically placed in the Western hemisphere. However, in the end, China’s strategy loses money that it could have made if those investments were enhanced by a better market climate, one that would also bring the Venezuelan people faster economic growth.

It is unlikely that the current regime will seriously tackle economic reform or begin to improve the tense political situation in the country. More moderate politics could help underpin global confidence in Venezuela’s legal system, a must for sustained economic growth in a country with a relatively small economic market. For now all the rest of the world, and the people of Venezuela, can do is to hope for a change of heart from the Maduro regime after this year’s parliamentary elections in December.

Image by Alex Lanz

OIL PRICE WAR STIRS FEUD WITHIN OPEC

By Kristopher Klein
Staff Writer

What happens to a cartel when there is substantial competition from outside? The answer depends on patience.

The Organization of Petroleum Exporting Countries (OPEC) has been the most influential component of setting oil prices since their founding in 1960. As an organization OPEC has helped raise the price of oil above $100 per barrel for the past near-decade. Large importers of oil, such as the United States, have put up with rising prices, unable to stop OPEC from colluding in their own interest. However with the recent rise in competition from North American shale oil producers, that era has come to a swift and decisive end.

Any college-level economics course will review the concept of collusion among cartel members and the decision each cartel member makes about whether to remain in the cartel or to go out on their own.

The difference between these strategies is a matter of weighing short-term profit versus long-term profit. If the cartel remains intact, producers will be able to collude to raise prices to artificially high levels and thereby make more profits. However, if a producer leaves the cartel they can lower their price and temporarily receive a larger share of the market (i.e. more customers) and thereby make a lot of profit in the immediate future.

But the betrayal of the second strategy has consequences. If the integrity of the cartel is undermined, greater competition between all members will force producers to charge a fairer price and lose the profits they could have made through continuing to collude to raise prices.

Thus, it is a matter of patience and how soon a cartel member needs to receive their profits that determines strategy. A member who is very eager to receive short-term profits is a greater risk of leaving than a member who can afford to wait for higher profits in the long-term.

Competition from outside this cartel lowers prices and raises the risk of a cartel member, in a pinch from lower profits, making a quick dash for more revenue (either per unit or overall) by either cutting production in order to raise the price or increasing production to gain market share.

The United States has been increasing its production of shale oil since a jump in production in late 2014. Greater supply of oil, combined with slower growth in the economies of Europe and East Asia, has created a global supply glut and falling prices.

In late December the United States decided to lift its ban on the export of oil. But the United States imports more oil than it exports, so what effect could that really have? As it turns out, the United States is one of the only countries capable of refining the crudest oil into a product for the global market, so a lot. John Auers, executive vice president at Dallas-based Turner Mason & Co was quoted as saying that, “U.S. refineries built out their capacity to run heavy barrels. Refineries in the rest of world aren’t built to run heavy barrels.” That means lifting the ban on exporting oil has allowed the United States to begin refining very crude oil from around the world before then exporting refined gasoline back around the world at a price that can compete with the OPEC cartel.

The result of competition from the United States has led to a collapse in the price of oil from above the $100 per barrel level that OPEC loves so much, to around $45 per barrel today. Some OPEC members are seriously hurting. If the pain does not end soon, political turmoil could arise from within OPEC.

OPEC member Venezuela calculated its 2015 budget on the idea that oil prices would remain at about $60 per barrel and that any excess revenue would be used to help run social programs. With the price of oil now just above $45 per barrel, Venezuela looks to run a deficit this year, which will force them to limit funding to social programs.

On January 10, Venezuelan President Nicolas Maduro and Iranian President Hassan Rouhani vowed to cooperate to stabilize falling oil prices. Five days later, Maduro and Russian President Vladimir Putin, whose country is not a member of OPEC, held a “detailed discussion” about the global oil market, without releasing any details.

Saudi Arabia has repeatedly rejected calls from OPEC members for the cartel to cut production in order to defend the price of oil. Saudi Arabia has saved much of the revenue it earned from higher oil prices and now has a reserve large enough to wait a while before cutting production, a move they hope will lead to a cut in production from North American shale oil producers.

However, not every member of OPEC has the reserves that Saudi Arabia and its neighbors on the Arabian Peninsula have built up over time. Without a rise in the price of oil very soon those countries, such as Venezuela and Algeria, will come under significant pressure to find a means of changing their fortunes.

Could this fall in the price of oil and Saudi Arabia’s refusal to cut production endanger the cohesiveness of OPEC as a price-influencing entity, or perhaps even mean a collapse of the cartel altogether? It very well may. In fact, OPEC seems already to be losing its control of prices that at one time were to the penny. According to Kuwaiti Oil Minister Ali Saleh al-Omair, “OPEC would have to accept any market price for oil, whether it were $100, $80 or $60 per barrel.”

North American competition has, at least for a time, defanged OPEC and clipped the wings of global oil prices. If the American market can sustain production and OPEC is forced to proceed as a price-taker rather than price-maker, OPEC members will begin to wonder why they participate in the cartel at all.

Image by Iguanasan

BEAR MARKET FOR RUBLE REVEALS STRUCTURAL PROBLEMS FOR RUSSIAN ECONOMY

By Evan Carlo
Staff Writer

What was considered a major economic and geopolitical threat to the United States just a few months ago is now on the verge of a financial crisis. Russia is facing severe economic repercussions due to the sudden decline in the value of its currency, the ruble.

The ruble rapidly collapsed in value from November 24 to December 16, as it soared from an exchange rate of 44.83 rubles for one U.S. dollar, to 67.91. The collapse in currency caused inflation to increase swiftly. Prices are up 10 percent at the time of this article. Russian citizens, unsure of the future value of their currency, are rushing to buy consumer goods now before inflation erases their purchasing power. The rapid changes in currency led foreign businesses, like Apple, to shut down operations completely in Russia.

Dealing with the crisis will require evaluating whether the depreciation in the ruble is caused simply by temporary factors that will dissipate soon, or if the currency crisis is a result of more structural flaws in the Russian economy.

In an attempt to reverse the fall in the ruble’s value, the Russian central bank hiked interest rates to 17 percent on December 16. Central banks raise higher interest rates in order to attract foreign capital, hoping to gain a higher return on investment in the country. More foreign capital raises demand for the domestic currency causing its value to rise. Raising interest rates is a common move by central banks facing a depreciating currency. It is only a temporary solution, as maintaining high interest rates indefinitely will hurt economic growth. Eventually interest rates must come down when enough capital has been accumulated to prevent a further fall in value for the currency.

However, raising interest rates was only temporarily successful as the ruble collapsed in value again from an exchange rate of 52.08 on December 25 to 63.14 on January 12. Forecasts by Goldman Sachs predict the ruble will continue to fall to an exchange rate of 70 in the next three months and remain at 60 in 12 months.

Raising interest rates is only a temporary and ineffective solution that does not address deeper economic problems in the Russian economy. While the falling value of the ruble can be partly blamed on economic sanctions placed on Russia by western countries, deeper economic issues are also responsible. These problems are structural and cannot be fixed through monetary policy. They must be addressed with political and economic reforms.

Russia’s Natural Resource Dependence Problem

One of the structural economic problems most responsible for the ruble depreciation is Russia’s over reliance on oil and natural resources for economic growth. Ever since Vladimir Putin strengthened state control over the energy sector, it has been a vital sector of both the overall economy and government. The state now controls a large share of the energy market and directly benefits from oil and gas production. Over half of Russia’s federal budget is funded by oil and gas rents.  Approximately 13.9 and 2.3 percent of Russia’s GDP consists of oil and natural gas rents respectively. This makes Russia more vulnerable to swings in commodity prices as falling oil prices will cause Russian businesses, and the Russian government, to lose money.

This is a big problem for Russia’s 2015 economic prospects since global oil prices have plummeted over the past year. Increased production in the United States combined with Saudi Arabia’s refusal to cut back on production has created a supply glut, forcing global oil prices to fall rapidly. The fall in oil prices has simultaneously caused the value of the ruble to fall.

The rapid fall in oil prices severely jeopardized an already flailing economy facing sanctions from western governments. It is estimated that Russia needs oil to stay at $105 a barrel in order for its government budget to break even. With prices at the time of this article at around $50, state-run Russian oil companies are facing tremendous losses that are impacting the government. Since the economy is highly dependent on oil, the price drops will affect the whole economy and will most likely send the country into recession.

As a result of the loss in revenue  and a lower valued ruble, Russia will have to cut back on its government expenditures, putting social and military programs in jeopardy. As oil prices go down, Russia receives fewer rents in the oil industry and therefore has less to spend on accomplishing its domestic and foreign political goals. This makes it less likely Russia will attempt an invasion of Eastern Europe if it cannot even fulfill its budget expectations. Russia is too dependent on oil to be a serious long-term geopolitical threat.

The Russian economy has long been oriented towards extracting and exporting natural resources, rather than developing a diversified modern economy. Without other developed economic sectors, Russia is vulnerable to price swings in the commodity market and to eventual natural resources depletion. If Russia wants to prepare for the day it will run out of natural resources, it must diversify its economy.

Without a diversified economy, Russia will also be unable to attract foreign investors. The loss in oil prices and sanctions are causing investors to pull money out of the economy at an alarming rate. With less capital in the country, the Russian ruble fell rapidly as demand for the currency fell. Therefore, the currency crises cannot be blamed solely on temporary western sanctions, but on deeper structural problems that will need to be addressed.

Russian State Capitalist Structure

To address structural problems in the Russian economy, economic and political reforms will be necessary. Unfortunately the state capitalist system of Russia stands in the way of reform. The political institutions of Russia ensure Putin and the Russian elite capture the main benefits of oil profits for their respective agendas. The profits are used by the government for a variety of programs such as the oil stabilization fund, fuel subsidies and building the military.

Since the business elite and government benefit from this arrangement, this system creates incentives to develop an extractive economic system that focuses more on utilizing natural resources than developing the whole economy. The oil profits have not been used to try to diversify the economy and prevent Russia from being exposed to price swings. [1]

The oligarchic nature of Russia’s political system also directly affects investor confidence in the economy. Given the close nature of the state and private business, many investors are fearful that the state will favor selected businesses at the expense of the rest of the economy. Russia has already directly bailed out Gazprombank by injecting more than $700 million into the bank. The government further showed its commitment to helping out select businesses by allowing companies looking for loans to use the bonds of state-owned energy giant Rosneft, as collateral.

This move essentially  finances Rosneft with an influx of rubles. Such a move made investors worry that Russia will continue to bail out favored businesses during economic troubles,  jeopardizing the whole country. Such crony capitalism poses a huge threat to Russia,  as it not only guarantees Russia will remain an extraction economy, but it also makes investors fearful of competing against favored state businesses.

Future Energy Prospects

If oil prices rebound quickly, such as they did in 1998 and 2008, then Russia will recover. Russia will still be open to price swings in the future but, for the moment, will be able to continue to grow its economy.

However, it is unlikely that prices will be able to rebound enough. Since oil wells are difficult and costly to shut off, even with price decreases it is unlikely that production will stop and bring up prices. Crude Oil Brent Futures trades currently indicate that prices will not reach $60 a barrel until October 2016 and will not even reach $70 until as far out as 2023.

These prices are well below what the Russian government needs to break even on its budget. This will prompt budget cuts and reevaluations of what Russia hopes to accomplish in foreign relations. While this situation could change, the market predicts Russia is facing a bleak future. Without structural changes to the economy, the Russian bear will be vulnerable to future oil bear markets.

Image by World Bank Photo Collection

Notes

[1] Ebel, Robert E. The Geopolitics of Russian Energy: Looking Back, Looking Forward A Report of the CSIS Energy and National Security Program. Center for Strategic and International Studies. July 2009.