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Prepared by the
Institute for the Analysis of Global Security

March 28, 2005
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Energy Security Current Issue

Iran-Pakistan-India pipeline: the Baloch wildcard
A few days after Iran’s Oil Minister Bijan Namdar Zanganeh arrived in New Delhi to discuss the future of the pipeline, terrorists in Pakistan blew up two gas pipelines sending a message to all parties involved that the "pipeline of peace" might be anything but peaceful.

Terrorism Goes to Sea
New evidence suggests that piracy is becoming a key tactic of terrorist groups. In light of al Qaeda's professed aim of targeting weak links in the global economy, this new nexus is a serious threat: most of the world's oil and gas is shipped through pirate-infested waters. In a recent Foreign Affairs article, IAGS' Gal Luft and Anne Korin analyze the situation and recommend policies to mitigate the risk.

Radical Islam and LNG in Trinidad and Tobago
Trinidad and Tobago alone account for 80% of all U.S. LNG imports. Security analyst Candyce Kelshall warns that Islamist terrorist groups are active on the island and might find LNG shipping an attractive target.

Chinese Quest for Crude Increases Focus on Africa
Leading oil sector analysts have warned of growing conflict between Western and Asian countries as they seek to outbid each other for key hydrocarbon assets in Africa. These forecasts have been largely based on the expectation that China will become the major player in nontraditional oil and gas producing regions on the continent. IAGS Associate Fellow Cyril Widdershoven discusses.

Terror's Big Prize
Since September 11, pipelines, tankers, refineries and oil terminals have been attacked frequently. Except for a sharp increase in maritime insurance premiums in these regions these attacks had marginal strategic consequences. But in at least two cases oil terrorism could have rattled the world.

Needed: Three 1-billion-barrel oil banks
The lesson from the recent oil price jump is that the oil market has too little wiggle room to deal with supply disruptions. It's time for consuming nations to think about providing their own liquidity mechanisms.

On the technology front

Fuel Cell power plant installed at NJ College
The fuel cell will provide 250 kilowatts of electric power as well as heat, to several buildings on the campus.

Biomass-to-Ethanol Progress
The enzyme costs of converting cellulosic biomass into sugars for fuel ethanol production have been reduced approximately twenty-fold with technology developed by the National Renewable Energy Laboratory (NREL) and Denmark based Novozymes, biotech-based leader in enzymes and microorganisms.

EU study: Methanol from biomass - competitive with gasoline
A study of a new patented Swedish technology concluded that the alchohol fuel methanol can be produced from biomass via black liquor gasification at a cost competitive with that of gasoline and diesel.

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Back Issues

Russia’s Growing Dependence on Oil and Its Venture into a Stabilization Fund

Undoubtedly, Russia has emerged as one of the world’s primary energy suppliers today. Its increasing reliance on natural resources, however, raises questions essential for Russia’s future evolution, as well as its international role. On the one hand, it can capitalize on its resources and boost its economic development, eventually joining the industrialized world as a competitive partner. On the other extreme, natural resources may turn out to be a curse, rather than blessing, hindering Russia’s economic diversification, expanding the level of corruption, and raising the risks for repeated economic (and political) crises.

Which path Russia will take hinges upon a range of reforms which have already been initiated, but a successful implementation is not yet assured. In short, these reforms refer to establishing a solid ground for effective collection, management and distribution of the revenues obtained from natural resources. Some of the major reform measures include: designing a tax system, which lowers the tax burden on other sectors, but does not hinder investment in the resources sector; the ability to administer and enforce the country’s tax laws; a budgetary process based on stringent measures aimed at avoiding fiscal deficits, while securing the highest level of transparency in the meantime; and finally, establishing a stabilization fund where part of the oil revenues accrue.

The focus of this article is on the Russian government’s decision to set up a stabilization fund. After evaluating its establishment in conjunction with several broader trends pertaining Russia’s oil sector and oil revenue management, it explains how the fund works and what the major challenges and risks ahead of Russia are.

The establishment of Russia’s Stabilization Fund in 2004 is a reflection of several broader trends. First, a major shift in Russian government’s focus regarding oil revenues has occurred in the past few years. The major challenge for the Russian state during Yeltsin’s presidency centered on its ability to collect revenues from the oil sector. Most revenues were ending up in the hands of a few oligarchs, which effectively employed various schemes to alleviate their tax burden. Putin’s rise to power was followed by several successive measures that allowed the state to capture increasing shares of the oil rents in the Russian economy. The tax burden on the oil sector was not only increased, but tax collection was also improved, owing to higher priority on the development of tax enforcement agencies, intimidation of private oil companies (as has occurred through the “Yukos affair”), as well as the greater willingness of these companies to emerge as good corporate players in order to attract foreign partners. Consequently, the state’s new found ability to collect taxes from the oil sector allowed the government to focus on another aspect of Russian oil revenues, namely their management.

This shift in the government’s focus occurred amidst an expanded role for the state in the oil sector overall. This was achieved through an improved and regularized intervention of regulatory bodies determining export quotas and access tariffs to the nation’s pipeline network. The “Yukos affair” has served to enhance the state’s role in the sector, as has the merger between the state controlled Gazprom and Rosneft.

Finally, the rising trend in oil prices since 1999 also contributed to the establishment of Russia’s stabilization fund. It helped to intensify debates on how to spend the sizable oil rents captured by the state. It also raised apprehensions among a number of economists about the potential harm inherent in suddenly acquiring such rents. Within this background, the establishment of Russia’s stabilization fund reflects the government’s desire to achieve greater control over the revenues collected from the oil sector, as well as its expanded ability to do so as opposed to the preceding Yeltsin period.

Scholars are far from consensus on the benefits of setting up a stabilization fund in a resource abundant country. Some have criticized the idea of establishing such a fund on the grounds that it could hardly be effective if overall budget discipline is absent, while countries with a strict fiscal system don’t really need additional mechanisms for managing rents acquired from natural resources. Still, many scholars believe that a stabilization fund helps to establish some regularity and predictability in the management of resource revenues. Especially in developing countries lacking a disciplined budgetary process, setting up a fund could enhance accountability in regards to resource rents.

Two additional benefits are attributed to stabilization funds. First, they help reduce budgetary dependence on resource rents, as revenues accumulate in the fund when prices of the commodity in question are high, and are withdrawn into the budget in periods when prices are lower than the baseline. This was a particularly strong argument in Russia, where Finance Minister Kudrin cited statistics suggesting that a 1 dollar decrease in the price of a barrel of oil is translated into a 0.5 percent reduction in the national GDP. Second, establishment of a fund provides a safeguard against the so-called “Dutch Disease”, which entails inflationary pressures and appreciation of the national currency as a result of the inflow of sizable revenues from the export of natural resources. This was another concern among Russian economists focusing their efforts on convincing the policy-makers on the establishment of a stabilization fund. For the purpose they addressed a widespread concern among the Russian public that Russia is losing its competitiveness in manufacturing and transforming into merely a raw material provider for the rest of the world.

Following lengthy debates, the law establishing the Russian stabilization fund was approved in December 2003. Accordingly, the fund’s revenues accrue from several sources: a portion of the export duty on oil and petroleum products, part of the revenues from the severance tax on mineral resources, and a portion of the surplus of the federal budget at the beginning of the fiscal year. The law set the base price at 20 USD per barrel of Urals oil, above which revenues start accumulating in the stabilization fund, while the government has the right to withdraw money if oil prices fall below the base level. It also determined a base threshold for the overall amount accruing in the stabilization fund. Set at 500 billion rubles (18 bn USD), the government is allowed to tap fund’s revenues above this threshold for expenditures outside the official budget.

Russia’s decision to establish a stabilization fund is a major success by itself. It could potentially alleviate the country’s excessive dependence on oil prices, as well as address concerns about the “Dutch Disease”. Nevertheless, Russia faces two major challenges, which are partly an outcome of the current design of the stabilization fund.

First, the 500 billion rubles threshold appears considerably low. The law adopted in 2003 set the fund’s threshold level to be equivalent to nearly 3.8 percent of Russia’s GDP. By contrast, the Finance Ministry had proposed the threshold level to be at least 9 percent of the GDP. While establishing no limits about the size of the fund is also deemed to be inefficient for the economy overall, its size needs to be large enough to insure the budget against several years of low oil prices. This does not appear to be the case in Russia, where fiscal difficulties could reappear if oil prices remain below 20 dollars again.

Second, setting the fund threshold low immediately invited sharp political battles for using the oil windfalls. In fact, the designers of the fund believed that the threshold would provide them a breathing space for at least 3-4 years until fund money could be used. However, within just one year, the 500 billion ruble threshold was surpassed, with revenues accumulated in the fund reaching 740 billion rubles (26.7 bn USD) by February 2005. Calls for the “easy money” from the stabilization fund have intensified and will further grow in strength as the revenues in the fund reach new records.

Russia’s stabilization fund has increasingly appeared at the center of debates about sustaining high levels of economic growth. Since Putin announced the target of doubling Russia’s GDP within a decade, factors affecting the country’s potential growth have become a dominant theme in Russian politics. Two camps have formed around the issue of tapping money from the stabilization fund. Most ministries and regional governors have favored utilizing fund money for various investment projects, such as funding the construction of a major oil pipeline to the Pacific coast. Meanwhile, business lobbies, such as the Union of Russian Entrepreneurs and Industrialists, have called for distributing funds in the form of development loans. The Prime Minister, himself, has proposed relying on the stabilization fund for a projected reduction in the rate of VAT. Finally, the idea of channeling windfall revenues into acquisitions of assets in the near abroad and eastern Europe has also appeared appealing to many circles in Russia.

The other camp, led by Finance Minister Kudrin has consistently opposed spending fund money for various projects within the Russian economy. They prefer to accelerate reform and improve the investment environment over reliance on stabilization fund revenues. Gaining the support of president Putin, they have called for using the surplus revenues primarily for early repayment of Russia’s foreign debt. Supported by IMF as well, this has been projected as the most viable means for having higher government expenditures and lower taxation in the longer run, as well as for reducing risks for potential currency crises in the future.

Yet, pressures for using windfall revenues accumulated in the stabilization fund are growing. Russian authorities have recently agreed to use part of the revenues to finance a shortfall in the state pension fund. Similar pressure will only mount in the future and it could become increasingly harder for the government to resist.

If eventually the Russian government does not raise the threshold, and instead, decides to spend the fund revenues, this will have important implications. The major question will be how and where the windfall revenues are spent. Several issues will require close observation. First, what will be the role of the state vs. the private sector in investment projects financed through fund revenues? Second, what will be the attitude towards involving foreign partners in projects financed through the stabilization fund? And finally, will part of the funds be used for financing acquisitions of strategic assets (mainly in the energy sector) of neighboring countries?

Adnan Vatansever is an Associate Fellow at the Institute for the Analysis of Global Security (IAGS).