COMMENT: AFTER THE DUST SETTLES IN THE CAUCASUS
Chris Weafer of Uralsib Capital
business new europe
Aug 22 2008
Germany
Although there is still plenty of scope for an escalation of events
in the Caucasus, the most recent news does hold promise. Russia
is starting to withdraw forces from Georgia and, although slowly,
has promised to accelerate the process from this weekend. The tone
of the rhetoric between Moscow, Nato and Western countries is tough
and is likely to remain so, at least for the next several weeks,
until Russia’s military withdraw to the pre-war positions. This
will foster a very nervous backdrop for investment sentiment towards
Russia. Beyond this, the legacy of recent events is likely to lead
to a more confrontational relationship with the US and EU through to
the end of 2008 and maybe into 2009. This will keep the perception
of investment risk in Russian assets high and, therefore, form a
negative backdrop for asset valuations.
After the dust settles. Looking beyond the current headlines, when
the dust settles the possible longer lasting effects can be viewed
under a number of categories:
Geo-Politics. The heated exchange between Russia and the US was not
unexpected, nor is it expected to result in any material change in
Russia’s status in important structures such as the G8. The fact
that WTO entry and Russia’s removal from the Jackson-Vanik list will
likely be delayed is of no great consequence at the moment. The new
Administration in the US from January 2009 will be important in terms
of the tone of its relationship, but in reality the main action will
be confined to rhetoric. It is, for example, not in Russia’s interest
to be seen to cause problems in the UN and its efforts to reach a deal
with Iran over the nuclear issue, as developing a better political and
trade relationship with countries in the Middle East is an important
priority for Russia.
Opportunities delayed with the EU. The most important relationship,
in terms of the investment case, is that with the EU. Currently, that
relationship still remains pragmatically based. So long as Russia
does withdraw its forces from Georgia, even if the process drags on,
there should be no major negative impact. The core governments within
the EU, especially the French as they now have the EU presidency, are
expected to prevent any repeat of the friction caused by the smaller
Eastern European countries in early 2007. But the main consequence
might be the lost opportunity of advancing the trade and investment
relationship during the French presidency. Now this period is likely
to be taken up with diplomatic "fire-fighting" leaving the hoped for
trade and investment deals on the table during the Czech Republic’s
tenure as head of the EU from next January. Given the controversial
missile-shield issue and the history between Russia and the Czech
Republic, the six-month presidency may well be very problematic and
lead to even lengthier delays in concluding new trade and investment
deals.
Central Asia. Despite the strong show of support for Georgia offered
by western politicians, the fact is that Russia has sent a very
strong message to the rest of the world that it regards Central Asia,
covering both sides of the Caspian Sea, as its backyard and nobody
else is welcome. Moscow has been rebuilding its relationships and
influence in the region over the past few years via building political
relationships, investment spending and energy deals, and its strong
military action in the conflict with Georgia will help reinforce
rather than hinder the process.
Energy. It is by no means clear how effective Ukraine’s decision to
order a reversal of the Odessa-Brody pipeline will by, as big questions
remain over cost and availability of oil to fill the pipe. Moscow has
been much more effective in securing energy deals in Central Asia and
in agreeing pipeline routes. While the EU is again talking about the
need to by-pass Russia the reality is that there are few alternative
options available and recent events will not change that.
Arctic. Russia will likely to pursue its goals in the Arctic region and
to establish territorial rights even more aggressively than previously.
Gas-Opec. Moscow is scheduled to host the inaugural formal meeting
of the so-called Gas-Opec group this autumn. One of the consequences
of the current stand-off with the West is that Russia will try to
strengthen its position in the global energy market, by more actively
promoting Gas-Opec, especially as Russia is central player in the
emerging LNG market
Ukraine. The next major potential conflict facing Russia is a potential
conflict with Ukraine, especially if the Kiev government attempts to
block the return of the Russian navy to Sevastopol at the end of the
month. However, Ukraine is unlikely to pursue any conflict with Russia
in the face of objections from the EU. The issue of Transdniester may
also emerge as a contentious issue with Ukraine and the EU. Sharing
a border with Ukraine, Transdniester is formally part of Moldova,
although it has declared independence and also hosts Russian peace
keepers.
Investment. The main negative aspect of recent events for the
investment case in Russia is likely to be a backdrop of tougher talking
between Moscow and Western governments and frequent threats that may
arise. This will likely result in a more volatile market and generally
lower asset valuations as the perception of investment risk will remain
higher than it was during 1H08. The Georgia conflict is of course only
part of the reason for that. Prime Minister Vladimir Putin’s Mechel
comments, the ongoing TNK-BP dispute and the deterioration in some
macro indicators are also contributing to the negative sentiment. There
will likely be an increase in budgetary resources towards the defense
industries, as Russia will want to modernize some parts of its land
forces, previously a lower priority than the export market.
Bank of Georgia – not under our coverage – has been hammered as a
result of the conflict. But we can expect to see increased financial
aid to Georgia from both the US and the EU, partly to compensate for
the lack of military or real political assistance in this conflict.
Geopolitics: Heated exchanges
Rhetoric is likely to remain tough. Right now Moscow is engaged in
a war of words with several western countries and with NATO. Even
as we expect that the tone of comments from each side will start to
calm after the Russian military withdrawal, it will be a long time
before we return to the previous more cordial relations. Russia is
now stronger and more determined to push ahead with its political and
regional priorities, old Cold War rhetoric is likely to be an issue
in the US Presidential election campaign and the missile shields
in the Czech Rep. and Poland will be a bone of contention with the
E.U. Abkhazia, South Ossetia and perhaps Transdniester might push for
formal recognition of independence or greater autonomy, and undoubtedly
Russia will cite the example of Kosovo to support these claims.
Negative backdrop. All of this suggests that normal relations are
unlikely until well into 2009 and will provide a negative backdrop
to the investment case in the meantime.
Russia and the US. The more important issues, such as Iran and
cooperation on terrorism, are too important for both sides to
be derailed by this event. Trade between the US and Russia is
relatively small for both countries – less than 5% – but, again,
it is important for both sides. For example, Russia’s VSMPO-Avisma
is the key supplier of titanium for Boeing and that cannot be easily
sourced from elsewhere. Russia is the biggest buyer of US poultry and,
again, this cannot be easily sourced in such volumes elsewhere. So,
very little trade of this trade, while small, can be easily stopped.
Cold War rhetoric is more familiar. The conflict with Georgia, and the
return to some of the old Cold War rhetoric, is now part of the US
presidential campaign and that will prevent the issue from drifting
away. If Senator John McCain wins then we can expect to have much
cooler public relations than if Senator Barrack Obama wins. Either
way, it is unlikely that the US Administration will be in any hurry
to push for Russia’s accession to the WTO or to remove it from the
provisions of the Jackson-Vanik legislation. There will be threats
to remove Russia from the G8 but, given Russia’s energy importance,
that is not expected to amount to anything other than the content of
election speeches. The opportunity to focus on the familiar theme of
Russia and the Cold War is no doubt a relief for the candidates in the
forthcoming US election, as neither side can come up with any effective
solution to Iraq or the issue of terrorism in general. However,
Russia and the Cold War is relatively straightforward by comparison.
The EU. The Russia-EU relationship is important for both sides. Russia
supplies 40% of the EU’s imported gas (25% of the total usage) and
a significant amount of other important materials. Russian coal,
for example, fuels 15% of the UK’s electricity generation. Over 50%
of Russia’s external trade is with the EU and over 50% of consumer
and manufactured goods are bought from EU countries.
EU has not been able to secure energy elsewhere. The EU has so far
tried in vain to secure energy supplies that circumvent Russia. The
reality is that the EU will become even more reliant on Russian
sourced, or controlled, energy in the future before any significant
alternative sources can be found. The most likely alternative for
the EU would be to tap into Iran’s reserves. Meantime, Moscow has
tied up supply deals with Turkmenistan and is the process of creating
JV’s with Algeria and Libya to channel their gas into Europe (see the
Energy section below). The reality is that they need each other. The
EU needs Russian energy and more of it. It also wants its energy
companies to have a JV role with the likes of Gazprom and Rosneft,
as they now plan to develop new hydrocarbon sources. For Moscow,
access to EU markets with improved trade terms, plus the ability to
increase the two-way flow of investment, which is an important part of
the government’s plan to expand and diversify the economy. A tougher,
more belligerent relationship with the EU would slow this process
and increase dependency/vulnerability to the oil price.
Lost opportunity. It was hoped that significant progress might be
made in the process of bartering energy for trade during the French
presidency of the EU. Instead, the danger is that the six month stint
will be taken up with the aftermath of the Georgian conflict. This
would delay the previous agenda until 2009, when the Czech Republic
assumes the presidency. This would hardly be a positive backdrop given
the rhetoric we have had already over the US missile-shield and will
unlikely advance economic cooperation.
East Europe. Poland this week followed the Czech Republic and
signed a deal with the US to host a site for the so-called missile
shield. Relations between Moscow and the host countries will be
more negative as a result. Several East European leaders visited
Tbilisi to show solidarity with the Georgian government and, again,
that will not endear them to Moscow. It is expected, however, that
the core EU countries such as France and Germany, will take more of
a lead in dealing with Russia and it is unlikely that the smaller
East European countries will be allowed to have the same influence
that they had in late 2006 and the early part of 2007.
Ukraine may become a thorn in the side. The issue of Ukraine is
likely to be more problematic. The Russian navy ships are expected
back in Sevastopol by the end of the month and that could spark a row
with the Kiev government. Ukraine and Russia have to negotiate a new
gas contract this winter and that might also be problematic. There
actually is little room for dispute this time, as Gazprom will simply
look to pass on the well-publicized price deal with the Central Asian
producers. President Yushchenko’s order to reverse the Odessa-Brody
pipeline flow will be an irritant to Russia, but only a minor one
(see Energy below). For many observers, the non appearance of Prime
Minister Yulia Tymoshenko in the debate is of greater curiosity and
more of an issue for domestic Ukraine politics than the Russia-Ukraine
relationship. But, given that the she is to lead the gas negotiations
with Russia it would of course be difficult for her to be openly
critical ahead of that.
Nato. Despite the very public criticism of Russia by NATO and the
support, or indications of support, for Georgian membership, it
is unlikely that the organization will actually push forward the
timetable to admit either Georgia or Ukraine. NATO would simply not
have wanted to engage with Russia over such an issue and the Georgian
actions will make them a lot more wary of admitting either. Support for
membership will be endorsed by the McCain camp for sure, but Europe’s
member countries will be a lot more cautious for a very long time.
Middle East. While Russia’s Foreign Minister Sergey Lavrov said
that Moscow may review its stance in the UN action against Iran,
the reality is that Moscow will likely be a lot more critical of US
motives in the region but will not actually oppose any actions to
push Iran towards a peaceful outcome. Building a stronger political
and economic relationship with countries like Saudi Arabia, Qatar and
the UAE is a priority for the government. Being accused of supporting
a more belligerent Iran would not suit that purpose.
WTO. Membership of the WTO is not a high priority for Russia. It is
more a "box to be ticked" rather than a critical piece of the immediate
economic program. Yes, Russia wants to be a member of the trade body,
but it is not a priority. The schedule to join was on track for later
this year or early 2009; however, it looks likely to be delayed by
six months, which is not of any great consequence.
Central Asia
Moscow has rebuilt its position in the region. Moscow began rebuilding
its influence in Central Asia during Putin’s second presidential
term and the recent military action in Georgia will actually help the
process. Moscow has sent out a very powerful message that this is its
backyard and that it is willing to defend its interests and those of
its partner countries. Western support for Georgia, on the other hand,
has amounted to little more than verbal attacks and threats against
Moscow. In Central Asia, the military message will be by far the most
important and influential.
Political ties are better. In recent years, Moscow has improved
political ties with all Central Asian states, often, as in the case of
Uzbekistan, taking advantage of western criticism of local politics to
rebuild previously damaged ties. Governments across the region find
it more comfortable to deal with an uncritical Moscow than with very
critical western governments. Russia has also increased investment
flows to the region by a much greater extent than those from the EU
or the US.
Caspian Guard Initiative. Azerbaijan’s reaction will be the most
important over the medium term, as it is the possible source of
increased energy flows to Europe via Georgia. But while the Baku
government enjoys a good relationship with the EU, its relations
with Russia have also improved markedly and during President Dmitry
Medvedev’s visit in early July both sides talked about increasing
cooperation in energy projects. The US has been pushing Azerbaijan to
agree to its Caspian Guard Initiative, which would see some US navy
craft based near Baku to help defend the oil fields against possible
attacks. Russia is very opposed to such a move, while Iran sees it
as a direct threat.
Baku has its own priorities. In the aftermath of the Georgian War,
the US will undoubtedly increase its efforts to establish a military
presence in Azerbaijan, but the government there will likely adopt an
even more cautious stance than before. President Aliyev is standing
for re-election in October and in the past he has been criticized by
both the US and the EU for slow democratic reforms. The opposition
grouping of three parties, the Azadlig, has already said that
it plans to boycott the October elections to protest the lack of
political freedoms. Azerbaijan’s priority is to regain control of
Nagornokarabakh, the territory it lost to Armenian control in the
1990’s. To achieve that, Baku will need to retain Moscow’s support
while any support by Moscow for an independent Nagorno-Karabakh would
make the process much more difficult.
US base in Kyrgzstan. We expect Moscow to cooperate with its partners
in the Shanghai Cooperation Organization and to again press Kyrgyzstan
for a date when the US airbase at Karshi-Khanabad is to be closed.
Energy
Tied to deals in Central Asia. Moscow has been much more effective
in agreeing energy cooperation deals with countries in Central Asia
than has been the EU. Turkmenistan has agreed to increase its gas
flow to Russia via the expansion of an existing pipeline northwards
and is joining with Kazakhstan and Uzbekistan in building a new pipe
to the eastern Urals region of Russia. While these agreements are not
yet covered with signed contracts it is expected that they will go
ahead as planned. Along with agreements already in place with China,
it is most unlikely that Turkmenistan will have any significant spare
volumes of gas to sell to the EU before 2015. This year the country
plans to produce just over 80 bcm of gas from 72 bcm in 2007. But
output for the first six months was actually down year on year.
Little spare oil. Azerbaijan plans to produce 1.0 mln barrels of crude
this year and to raise that to 1.2 mln barrels next year. Most of that
oil is promised for the Baku-Ceyhan pipeline so, again, there is very
little spare oil or gas in the Caspian region to ship trough either an
increased capacity Georgian pipeline or to fill the Nabucco gas pipe.
Pipelines. The EU backed Nabucco pipeline has two main problems: the
consortium needs to agree a transit deal with Turkey and it needs
to find a source of gas. Turkey is expected to drive for improved
trade access to EU markets in return for its participation in the
Nabucco project; however, it is already known that some demands
have met with a negative response from Brussels. Turkmenistan has
a tentative agreement with the EU to supply 10 bcm of gas by 2009;
however, if it also proceeds with the deals agreed with China and
Russia, it simply will not have the gas to sell to the EU.
Odessa-Brody reversal. As regards Ukraine’s plan to reverse the
flow of oil in the Odessa-Brody pipeline later this year, it is not
at all clear how this might be done. Ukraine convened a meeting of
representatives from Poland, Lithuania, Ukraine, Georgia and Azerbaijan
in Vilnius in October 2007. The result was the formation of a group
called the Sarmartin Consortium with the aim of bringing Azerbaijani
oil via an expanded pipeline across Georgia, then to Odessa via tanker
and then up to Brody. From Brody the plan is to build a new pipeline to
Plock in Poland so that the oil can feed refineries in the region. But
the plan has made no practical headway since October because there
is no agreement on the sharing of the costs and no guarantee on the
availability of enough oil to justify the project. The political will
to proceed with the project is there (perhaps less so from Azerbaijan),
but until the more practical issues of cost, etc are sorted then the
project will not be a viable alternative. The Russian oil that will
be displaced will likely feed the BTS-2, or Eastern, pipeline so the
issue is one of inconvenience.
Arctic. Russia is expected to pursue its efforts to establish
territorial rights over a large part of the Arctic with greater vigor,
in its aim to increase the size of its energy bargaining chip with
the west.
Gas-Opec formal structure expected. Moscow is already scheduled to
host a meeting of the group of gas producing countries that have,
until now, met informally as the Gas Producers Forum. At a meeting
in early June the group agreed to create a more formal structure
with a permanent Secretariat and Secretary General. The meeting to
formalize this is expected to take place in Moscow in late September
or in October. Moscow is now very likely to pursue that initiative
much more aggressively, so as to ensure it remains at the center of
the gas industry development, particularly in the area of LNG.
From: Emil Lazarian | Ararat NewsPress