Russia’s Struggles: Geopolitics; Oil Prices; Return Of Alexei Kudrin by Bill O’Grady of Confluence Investment Management

(Due to the Presidents’ Day holiday, our next issue will be published Feb. 22, 2016.)

Over the past year, Russia has faced a growing number of challenges that have the potential to weaken President Putin’s hold on the reins of power. In this report, we will discuss recent trends in the country, including the economic problems caused by falling oil prices and the military operations occurring in Ukraine and Syria. We will examine the Putin government’s responses to these issues. As always, we will conclude with market ramifications.

The Russian Problem

Let’s begin with the geopolitics of Russia. Russia is essentially a landlocked country with few natural defenses.

Russia's Struggles: Geopolitics; Oil Prices; Return Of Alexei Kudrin

This map shows the physical characteristics of Europe and Russia. Note the northern European plain runs from southwestern France to the Ural Mountains. This plain has been key to European wars for centuries. Germany’s war plans for WWI were designed to fight a one-front war on this plain (the plans failed); Hitler signed a non-aggression pact with Stalin to secure a single-front war against France and later turned his sights on the Soviet Union. Napoleon also marched along this plain to Moscow in 1812.

There are three red arrows on the map, denoting Russia’s primary outlets to seas. Two of the outlets, the Baltic Sea and the Black Sea, can either be blocked by European powers or Turkey, respectively. The Russian port of Murmansk is ice-free but, during the Cold War, NATO air bases in Norway and Scotland, along with carrier groups, were capable of bottling up the Soviet navy and blockading sea traffic. Despite the multiple outlets, Russia lacks reliable access to seas, rendering it essentially landlocked.

As the Greek historian Thucydides noted, nations with access to the ocean tend to be cosmopolitan and have stronger economies due to trade, whereas landlocked nations tend to be more insular and poor. Athens, a maritime power, and Sparta, a land-based power, are examples of these differences. Athens was richer but less unified compared to Sparta.

Due to climate conditions, most of Russia’s agriculture is centered in its western region near its borders with Europe. This region is also where its population is most dense.

This Soviet-era map shows population density. Note that most of the population was in the west; in fact, what is now Ukraine had relatively high density.

This map shows land use; only about 10% of the former Soviet Union was arable, with most agricultural activity occurring in the western regions.

Russia’s geography has created conditions for an insular society. Russia has been destined to be relatively poor due to its restrained foreign trade, and due to its lack of arable land it has mostly been a supplier of natural resources, which it has in abundance. Like Sparta, Russia puts a high value on unity; its society has been inherently suspicious of outside ideas.

s noted above, Russia has few natural barriers from invaders. Throughout its history, it has tried to expand westward to force invaders to march long distances to reach the core of Russia around Moscow. Both Hitler and Napoleon found that the combination of Russian infantry and winter were deadly to invading forces.

wever, there is an internal contradiction to Russia’s desire to expand its influence westward. Invading and pacifying regions is expensive and Russia isn’t a rich nation. To maintain control, Russia has historically sold natural resources to provide economic support to annexed regions. In addition, Russia has traditionally deployed extensive internal security agencies to maintain order. Subsidizing the economies of captured areas and paying for security is expensive. Over time, when it becomes too expensive, annexed areas rebel and Russia loses its buffer.

Thus, to survive, Russia has three imperatives. First, it must have strong and loyal security services; these are necessary to quell internal dissent and to maintain order in buffer areas. Second, Russia must keep its elites satisfied. In general, this has been accomplished by giving them a share of natural resource revenue. These elites often include senior members of the security forces, so their loyalty is important. Third, the state must provide a modicum of economic support to the population. Russians are used to having less than their European or American counterparts but the population cannot be taken completely for granted.

If these three imperatives are met, Russia will have reasonable economic growth, internal security, satisfied elites, a pacified population and buffer regions to protect the country from outside powers. If these imperatives are not met, whomever is in charge of Russia is in trouble.

Russia’s Economy – Recent Trends

The drop in oil prices is putting pressure on the Russian economy.


This chart shows annual GDP for Russia with two years of forecasts from the IMF. In our experience, it is rare for international organizations to predict recessions but the IMF is projecting a second year of negative growth for Russia.

As oil prices have fallen, the Russian central bank has allowed the ruble to depreciate.


The previous chart shows the normalized value for oil prices and the ruble, beginning in 2010. A rising ruble line shows a weaker currency, in that it takes more of the local currency to buy a dollar. Since mid-2014, as oil prices began to fall, the Russian central bank has allowed the ruble to decline. Allowing the currency to depreciate protects the oil companies, who earn dollars on sales but pay their local expenses in rubles. Unfortunately, a weaker currency boosts import prices and reduces the purchasing power of Russian households.


This chart shows Russia’s yearly change in CPI with the effective exchange rate. Note that inflation jumped as the currency declined.


Real incomes fell sharply with the decline in oil prices. In fact, the last time real incomes fell this hard was in 1998, another period of low oil prices that coincided with the Russian debt default.

Russians tend to be stoic. However, as real incomes decline and inflation rises, there are signs of growing disenchantment with the regime. Recent polls suggest that Russians are worried that another 2008 is in the offing. There have been protests by Russian truck drivers against the implementation of tolls on Russian highways. Polls indicate that 63% of Russians support the truckers and see the tolls as further gouging by the nation’s elites. It is worth noting that during the last major series of protests in 2011-12, the highest level of support for Moscow protestors was around 40%.

Other protests have been steadily rising. Social commentators note that an average of 250 protests occur each year in Russia. Last year, that number was exceeded by summer. Actions against unpaid salaries are increasing. Interestingly, protests have also shifted out of the industrial sector and to the service sector, which hasn’t traditionally seen job actions. In the past, service workers tended to move to other work

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