Russia ogles Europe’s oil refineries

Graham Stack for Russia Profile (October 5)

 

It’s official Russian policy to push oil companies to acquire downstream assets outside of Russia, and with a wave of M&A set to sweep European refineries, opportunities are looming. But European governments are not enthusiastic – and neither are many Russian companies.

 

Igor Sechin, chief “silovik” in former president Vladimir Putin’s Kremlin, now deputy prime minister for the energy sector in Putin’s government, revealed his dream to the Wall Street Journal earlier this year – a rather modest plan for the man who is believed to have masterminded the dismantling of Mikhail Khodorkovsky’s Yukos. “My dream is for Russian oil to be refined in Russia or by assets controlled by Russian companies,” he confided.

 

Sechin’s plan might be close to realization, as analysts agree the European oil product market is facing a wave of M&A. According to Jürgen Doetsch, co-owner of German oil trader Erich Doetsch, “the European downstream market is facing a structural shift,” as margins shrink due to falling demand and rising oil prices. “The golden decade when refineries in Europe earned big money is ending, and refineries could return to being loss-makers as they were for 25 years before the turn of the century,” says Doetsch.

 

The shift is marked by big 6 supermajors such as British-Dutch Shell, French Total S.A and U.S. ConocoPhilips divesting or mulling divesting refineries. Shell is looking to sell one UK and two north German refineries, and ConocoPhilips uncertain about the future of its Wilmershaven refinery in Germany.

 

Total S.A CEO Christophe de Margerie specified September 22 that Russian companies could be among the buyers: “they have a market to develop in Europe and may be interested to buy when we are interested to sell,” he told  Bloomberg. His statement followed hot on the heels of Total’s sale of a 45 percent stake in its Dutch Vlissingen refinery to Russia’s Lukoil in June for $725 million.

 

The selling is not just limited to the multinationals. Polish petrochemical national champion PKN Orlen, owner of Europe’s largest chain of filling stations, is said to be looking to divest a 63% stake in strategically significant Czech Unipetrol and an 87% stake in Lithuania’s Mazeikiu Nafta, in order to pay down $3.2bn worth of debt.

 

Governments are also getting in on the act. Specifically, Belarus government is mulling privatization of its strategically significant Naftan-Polymir refinery complex, the country’s largest, supplied by the Druzhba pipeline. Belarus has been in talks with Russian majors Rosneft and Lukoil over a sale, but is dragging its heels. “If you have money and willingness, then please come. I am ready to support the programme of privatizing the Belarusian oil refining association,” Alexander Lukashenko said September 16, evaluating the total complex at nearly $3bn.

 

Another dark horse is Venezuelan president Hugo Chaves and the Venezuelan national oil company PDVSA. PDVSA owns stakes in a number of German refineries as partner in a joint venture with BP, Ruhr Oel that controls around a quarter of German refinery capacity. Ever since coming to power in 1999, Chavez has said he will divest PDVSA’s overseas assets and in 2003 PDVSA was in talks to sell to Russia’s Alfa Group, co-owner of oil company TNK-BP, but these talks came to nothing.

 

September, however, also saw the signing of an upstream tie-up between a consortium of Russian oil companies and PDVSA to prospect and extract in Venezuala’s Orinoco regions. The partnership could reasonably also entail asset swaps seeing transfer of Venezuela’s downstream stakes in Europe to Russian companies.

 

Pipeline pressure

 

Russian companies however face considerable political resistance to plans to buy into European refineries, especially of strategic significance. Analysts thus expect the ongoing M&A wave to trigger a number of political spats between Russia and individual European countries, and also bring pipeline politics to the fore.

 

Leonid Fedun, vice president of Lukoil, Russia’s second biggest oil company and most active acquirer of foreign assets, complained to the Financial Times in April 2009 that, “some countries in eastern Europe have an extreme level of political antagonism towards Russian investments.” In the same month Russia’s President Dmitry Medvedev complained of “idiotic” fears in Spain of Russian investment in the energy sector.

 

Fedun’s comments come a week after privately-owned Russian oil company Surgutneftegaz Mol in a surprise move acquire 21% in strategically important Hungarian energy group MOL. Hungarian politicians reacted with fury and responded in dramatic fashion: the Hungarian courts allowed MOL to delay registering the new shareholder until poison pills had been adopted in the company’s charter that left decision-making power with the government-backed board of directors at the expense of shareholders.

 

Poland watched the MOL episode with equal consternation. Despite owning only a 27% stake in petrochemical giant Orlen, the government forced through similar poison pill changes to Orlen’s charter in July, “removing all chances of PKN becoming a takeover target in the future,” according to Wood analysts.

 

Such tactics may however cause the Kremlin to up the ante rather than back off. Russia has gained bargaining power vis-a-vis the Central European refining sector supplied by the Druzhba pipeline, following the start of construction in August 2009 of the Baltic Transport System-2. BTS-2 will reroute Russian oil from Druzhba around Belarus to Russia’s new Baltic port of Ust-Luga in Leningrad Region, and thus increase flexibility of export routes. Refiners remember that Lithuanian refinery Mazeikiu has its oil supply shut off by Russian pipeline operator Transneft after it fell to Polish hands instead of Russian in 2007.

 

The East Central European countries for their part put their hopes on the Odesa-Brody pipeline running through Ukraine from the Black Sea, planning to extend it to the Polish refinery of Plock, Orlen’s biggest plant. The pipeline would then ship Azeri oil to Central Europe. However the feasibility of the plan is not yet established, and the pipeline is continues to be used in reverse mode to ship Russian oil to the Black Sea.

 

Reluctant imperialists

 

The weak link in the Kremlin’s strategy could be the Russian oil companies themselves. With the noticeable exception of Lukoil, they have shown little interest in expensive acquisitions in Europe’s downstream sector.

 

Lukoil is open about pursuing downstream expansion, with major acquisitions in Italy in 2008 along with the Dutch acquisition from Total this year. However, Lukoil’s ambitions predate Igor Sechin’s watch over Russia’s energy sector. In fact the fully private company, in which US major ConocoPhilips holds a 20% stake, counts as one of the most free from Kremlin influence. And the company’s strategy of overseas downstream expansion was evident as early as the 1990s, when it purchased a chain of filling stations in the USA.

 

On the other hand, state-owned Rosneft, Russia’s largest oil company, has still to make a large foreign acquisition, and is focused on capital-intensive upstream expansion in the Arctic and Pacific shelf, with little resources left for acquisition abroad. At the most Rosneft might acquire the Belarus refineries. Gazpromneft, the oil division of state-controlled gas giant Gazprom “doesn’t really have the scale for European acquisitions to make much sense,” according to Ron Smith, head of research at Alfa Capital.

 

Surgutnefegaz, the transparency-challenged private oil company named by Igor Sechin “Russia’s best privately-run oil company” would seem the most likely acquirer of European assets. The company is believed to be sitting on a cash pile and potential war chest of $20bn, and in April this year bought 21% of Hungary’s energy company MOL for $1.4bn from Austria’s OMV, causing outrage in Hungary.

 

At the time, however, many commentators believed the move was requested by the Kremlin for political reasons, namely to stymie the Nabucco gas pipeline project in which MOL is a participant, rather than being part of Surgutneftegaz strategy. “They are very tight and unambitious with their massive pile of money, the MOL thing notwithstanding. It would be completely out of character,” according to Smith. In addition, Surgutneftegaz are more focused on downstream investment in Russia, with large investments in the Kirishi refinery in Leningrad Oblast

 

Finally, TNK-BP held talks with PDSVA on acquiring the Venezuelan companies refinery stakes in 2003, but the talks ended without any results. Analysts say TNK-BP is very focused on adding value, and the returns on European refining are not sufficiently compelling. TNK-BP is more focused on Russian downstream, having just overhauled its Ryazan refinery, one of the largest in Russia.

 

This means leaves Lukoil with a clear field in making acquisitions downstream in Europe, as far as governments allow, and, in conjunction with the ConocoPhilips 20% stake, well on its way to becoming a true oil multinational.

Georgia vs. South Ossetia: The Prequel

The South Ossetian conflict flaring up in late 1989 started the break up of Georgia. The conflict of 2008 might well have sealed it.

Four months after Slobodan Milosevic’s speech on the Kosovo Field June 1989 symbolised the start of the Yugloslavia conflict, Georgia’s nationalist leader Zviad Gamsakhurdia, backed by over 20,000 supporters including paramilitaries, rolled towards the South Ossetian capital Tskhinvali, to assert ethnic Georgian rule over the entire territory of the republic. Ossetian groups duly blocked Gamsakhurdia’s entry to the town, and violence broke out. Andrei Sakharov, not long before his death, commented gloomily on the creation of “minor empires” in the former Soviet republics.

The standoff escalated through 1990. In April 1990, the Supreme Soviet in Moscow ruled that the ethnic autonomous territories of any republic seceding from the Soviet Union retained the right to remain in the Soviet Union. Then it was Tbilisi’s turn to pour fuel on the fire. In August 1990, the Georgian Soviet adopted a law prohibiting regional parties from participating in Georgian elections. Excluded from the political process in Georgia, South Ossetia boycotted parliamentary elections in October 1990, instead holding elections to their parliament in December 1990.

In response to the South Ossetian elections, the newly-elected Georgian parliament abolished the autonomy status of South Ossetia, declared a state of emergency in the region and in late December, imposed an economic blockade on the region that was to last to July 1992.

The conflict finally escalated into war the following month. In the first days of 1991, the Supreme Council of Georgia passed a law on the formation of the National Guard of Georgia. Then on January 5th, at the time of the Orthodox Christmas festivities, several thousand Georgian troops, police and paramilitaries entered Tskhinvali and carried out violent reprisals and atrocities against the population, ostensibly in search of arms.

The weekend war

The initial fighting took place mainly in and around Tskhinvali, around the Georgian villages, and north along the road to North Ossetia, the lifeline of the South Ossetians in the face of the Georgian blockade.

According to Nikola Cvetkovski of Caucasus Links, who has written a history of the South Ossetia conflict, the fighting in Tskhinvali initially divided the town into an Ossetian-controlled western sections and a Georgian-controlled east. But fierce resistance from Ossetian irregulars meant that already by the end of January, 1990, Georgian forces withdrew to take up positions on the heights around the city. From there they enforced a blockade that lasted almost one and a half years, and aimed at cutting the town off from heat, electricity, water and food.

Actual fighting was low intensity, deploying mostly light arms. Fighting however peaked regularly at weekends, as the so-called ‘weekend warriors’ of paramilitary formations arrived from Georgia proper. The ‘weekend warriors’ were themselves more interested in looting than fighting. As a result, military fatalities stayed low, but of the roughly 1000 Ossetians killed in the conflict, only around 100 are regarded to have been militia members: the remaining 900 were civilians. In addition, according to Alexei Zverev, ethnic conflict expert at Vrije University of Brussels, 93 villages (mostly Ossetian) were completely burned down.

Even the newly-formed Georgian national guard, intended to become the core of a new Georgian army, was recruited and financed “almost exclusively by private individuals, especially successful black-market entrepreneurs,” according to Swiss security expert Christoph Zuercher, who has written the classic account of the Georgian crisis in “The Post-Soviet Wars”.

Georgia’s second main (para)military formation prosecuting the war, the Mkhedrioni (Georgian for medieval knights), was, according to Zuercher, “created in 1989 by Jaba Ioseliani, a former patron of the Soviet underworld, and funded its activities from criminal dealings, including extortion and racketeering,” and constituted “a private army at the service of the state when it was waging war against secessionist minorities.”

“The Georgian militias—the Mkhedrioni and the National Guard—were to a very significant extent driven by the presence of private entrepreneurs of violence, undisciplined weekend warriors, who conducted frequent attacks on the civilian population and took hostages,” Zuercher continues. “But in the case of the Ossetian and Abkhazian fighters, the use of military force was not mainly motivated by private profit, but by the perceived threat to the status quo posed by an independent and nationalistic Georgia. (…). Once the Georgian militias entered their territories, Ossetians and Abkhazians saw their fears confirmed, and organized violence ceased to be an option and became a necessity,” adds Zuercher in his seminal study.

Russia appears on the scene

Until then, the Soviet Centre, in its death throes, had remained largely on the sidelines in the conflict. The Soviet leadership had apparently latterly struck a deal with Tbilisi, allowing Gamsakhurdia a free hand in South Ossetia in return for accepting Soviet supremacy. This deal was shown up during the Moscow Putsch in August 1991, when supposedly nationalist Gamsakhurdia – in sharp contrast to events in Moscow and Leningrad – meekly accepted the authority of the Provisional Committee established by the putsch, and subordinated his armed units to the Soviet Interior Ministry.

The failure of the putsch, however, destroyed Gamsakhurdia’s authority: On December 22, 1991, in the last days of the Soviet Union, approximately 500 National Guard soldiers entered Tbilisi and drove Gamsakhurdia out, marking the start of the Georgian civil war. The new interim authorities—Ioseliani (leader of the Mkhedrioni) and Kitovani (head of the National Guard), then called Eduard Shevardnadze, former Soviet foreign minister, back from Moscow to head Georgia.

The struggle for power in Tiblisi now hugely exacerbated the ongoing ethnic conflicts, as the deposed president mounted military resistance from his home region in western Georgia against the new authorities in Tbilisi – and thus triggered the Abkhasian conflict, flaring up in spring 1992 and turning to war by the summer.

The conflict constellation now also changed due to the appearance of an entirely new actor: Boris Yeltsin’s Russia. Yeltsin’s new Russia, born of the idealism of the Perestroika liberal movement, and riding high on the wave of enthusiasm following the defeat of the Putsch, was more concerned about the rights of minorities in neighbouring states than the Soviet leadership had been. Russia was also sensitive to the concerns of the North Ossetian leadership, who were inundated with refugees from the South Ossetian conflict and feared further destabilisation.

According to Alexei Zverev, this new conflict constellation made Russian intervention on the side of the South Ossetians look increasingly probable. In mid-April 1992, Georgian artillery resumed daily missile attacks on the residential quarters of Tskhinvali. Then, in 20 May 1992, unidentified gunmen, whom the Ossetians claimed were Georgians, massacred a busload of Ossetian refugees fleeing Tskhinvali.

The massacre prompted North Ossetia to cut the gas pipeline to Georgia, and elicited furious statements from Russian politicians, including chief reformer Yegor Gaidar. By June 1992, Boris Yeltsin’s administration seemed to be on the brink of intervening to protect South Ossetia.

The situation was ironically saved only by a further escalation of Georgia’s own civil war between Shevardnadze and Gamsakhurdia in Western Georgia, which was simultaneously making conflict between Tbilisi and separatist Abkhazia look imminent. In the face of this extraordinarily dangerous situation, Shevardnadze could not possibly afford to fall out with the Russians.

On 22 June 1992, Yeltsin and Shevardnadze duly met with North and South Ossetian representatives in Sochi and signed a ceasefire agreement. The agreement envisaged the deployment of joint Russian, Georgian and Ossetian peacekeeping forces. The peacekeepers moved into the region on 14 July, 1992.

In view of the civil war raging at the time in Georgia and the start of the Abkhazian conflict, no one initially gave the South Ossetian ceasefire much chance. But it held 16 years… until August 7 2008.

Germany’s elections and Russia’s gas

Graham Stack for Russia Profile (www.russiaprofile.org)

 

Despite the rhetoric, Germany’s likely new coalition may slowdown nuclear power phase-out, but will not cut back on Russian gas.

 

If, as is likely, Germany’s September 27 national elections result in a new governing coalition between incumbent chancellor Angela Merkel’s Christian Democratic Union (CDU) and the small liberal Free Democratic Party (FDP), the planned phase-out of nuclear power in Germany will be slowed indefinitely, ostensibly to reduce dependency on Russian gas. However, analysts say the shift will make no significant longterm impact on German demand for Russian gas. Moreover, FDP head Guido Westerwelle as probable foreign minister is likely to be as Russia-friendly as his social democrat predecessor Frank-Walter Steinmeier, the loser of the election.

 

The man almost certain to be Germany’s new foreign minister did not mince his words when drawing conclusions from the Russian-Ukrainian ‘gas war’ January 2009, which saw supplies to Europe halted for a number of days.  “We Europeans have to do everything to free ourselves from dependency on a single supplier of energy,” Guido Westerwelle told Poland’s Gazeta Wyborcza in March, referring to Russia. “In Germany the government has made the mistake of phasing out nuclear power for ideological reasons. That makes us vulnerable to foreign energy suppliers. Germany should do what most of our European neighbors are already doing: achieve a reasonable energy mix, with renewable energy such as solar and wind power, fossil fuels such as oil, coal and gas, but also nuclear power.”

 

Westerwelle’s call to postpone nuclear power phase-out to reduce dependency on Russian gas found an echo in one of the minor scandals that livened up an otherwise lethargic election campaign in September: a detailed election-campaign PR strategy apparently commissioned by Germany’s large energy concern E.ON, subsequently leaked to the press, advised lobbyists to actively harp on the population’s “historically rooted fears of Russia.” “E.ON can draw on these fears for its own benefit,” read the leaked PR plan.

 

With Chancellor Angela Merkel’s CDU also in favour of slowing nuclear power phase-out, this coming shift in German energy policy might seem to be one of the immediate implications for Russia to come out of yesterday’s elections.

 

Russia currently supplies 37% of German gas imports. Germany relies on gas for 12% of electricity production and around 25% of total energy needs. Nuclear power, originally to be phased out by 2022 and replaced by renewable sources, counts for around 25% of power generation and 12% of total energy requirements. These figures give rise to fears that renewables will not be able to fill the space left by decommissioned nuclear plants, leading to even greater reliance on Russian gas.

 

However, analysts claim that much of the anti-Russian rhetoric is merely a political strategy to make slowing the phase-out more acceptable to voters, while it will in fact hardly impact on projected Russian gas deliveries to Germany.

 

“I do not think that a possible postponement of the envisaged nuclear phase-out is related to fears of increasing dependency on Russian gas,” argues Marcel Viëtor, Head of Foreign Energy Policy Program at the German Council on Foreign Relations. “Rather this fear is being developed by the atomic lobby to argue for the postponement. Fear of dependency on Russian gas imports is rhetoric but not factual since the Russian companies are mutually dependent on European gas markets,” says Viëtor.

 

Pierre Noel of the European Council on Foreign Relations also argues that the real reasons behind the coming policy shift is lobbying from German energy companies, who earn good money with nuclear power, together with growing electricity demand in Germany and carbon emissions reduction goals.

 

Furthermore, Russian analysts doubt that the move will even impact significantly on the projected volume of gas supplied to Germany from Russia.

 

According to VTB Capital’s gas analyst Lev Snykov, “such a move would not impact my long-term forecasts for Gazprom’s exports to Germany. Long-term Russian gas exports to Germany will grow at a low single-digit rate, although the market share may deteriorate due to a strong push towards LNG.” Similarly, energy analyst at Renaissance Capital, Alexander Burgansky, believes that, “German demand for gas may not now grow as fast as some people had expected, but Gazprom’s supplies are anyway protected by the minimum off-take commitments under the long-term contracts.”

 

Analysts also point out that Germany’s largest energy companies such as E.ON, although lobbying domestically for a suspension of nuclear power phase-out, are also heavily involved in Russia’s gas sector. EON’s CEO Wulf Bernotat is in fact a member of the Gazprom’s Board of Directors, as the company holds a 6.5% in the gas giant. E.ON and German chemicals giant BASF are also taking stakes in the major Siberian Yuzhnoe-Russkoe gas field.

 

Thus it was logical that Thursday September 24 EON was among a group of the world’s largest energy companies addressed by Russia’s ex-president, now prime minister, Vladimir Putin, in the town of Salekhard on Russia’s Yamal peninsula. Putin called on the international companies to invest in gas production in the region, destined to become Russia’s main production region in the long term, as older fields decline. Gazprom estimates total investment needed at $100bn.

 

Germany has particular interest in the massive Yamal development, according to UralSib energy analyst Viktor Mishnyakov. “Yamal is of strategic importance for the Russian government and for Gazprom as this gas will be the source for the Nord Stream pipeline project.”

Nordstream pipeline is a controversial Gazprom-led project to bring Russian gas directly to Germany via the Baltic Sea bypassing transit countries such as the Baltic countries and Poland.

 

There has been vociferous opposition from Poland and Baltic states to the pipeline. But, according to Marcel Viëtor, this is one energy policy that definitely won’t be changed under a CDU-FDP coalition.

 

“The CDU has shown different, more critical rhetoric on Russian domestic
issues than SPD did – but it has supported NordStream and German companies
cooperating with Russian companies, investing in Russia, just like SPD did,” says Viëtor. ”In a CDU-FDP-coalition this attitude is most likely to be continued.”

 

Russia – “Europe’s natural partner”

 

Apart from adjusting energy policy, the new German government’s Russia policy is likely to remain pragmatic and constructive, including disavowing Ukraine and Georgia’s bid to join NATO. With Westerwelle almost certain to become new foreign minister, the influence of SPD elder statesman Gerhard Schroeder in shaping Germany’s Russia policy will cede to the influence of FDP elder statesman Hans-Dieter Genscher, the Federal Republic of Germany’s legendary foreign minister from 1974 to 1992.

 

With 20 years marked since the fall of the Berlin Wall this autumn, events in which Genscher played a crucial role, an FDP-led foreign ministry will be especially minded to take a pragmatic and measured policy towards Russia, considering Moscow’s support for German reunification 1989-1990. Awareness of the Kremlin’s constructive role towards unification twenty years ago has even been heightened in recent weeks by archival revelations of how bitterly European leaders such as then British Prime Minister Margaret Thatcher and French President Francois Mitterand were initially opposed to the idea.

 

Outside of energy policy, the FDP regards Russia, in Genscher’s words, as “Europe’s natural ally, not natural enemy.” Added to this is the generational factor: 47-year old Westerwelle sees himself as one of a new generation of politicians that includes US president Barack Obama and Russian president Dmitry Medvedev. Westerwelle is thus an enthusiastic supporter of Obama’s “reset” policy of improving relations and cooperation with Russia. “If President Medvedev emphasizes he is a moderate politician and wants to reform his country and pursue disarmament, we should take him at his word,” he told Gazeta Wyborcza. “He is a young politician, and together with the US president, who is also young, he will have the chance to go down in history in a positive fashion.”

Taking stock of Russian growth prospects

Graham Stack for Russia Profile (www.russiaprofile.org)

Rumours of imminent growth may be exaggerated by sketchy inventory statistics. A chorus of analysts are attributing Russia’s 10% GDP contraction this year to companies selling down inventories rather than producing, and are gung ho about growth restarting as soon as inventories empty. But others are warn against drawing strong conclusions from Russia’s sketchy national statistics on inventory levels.

 

Alexei Moiseev, macroeconomic analyst at Renaissance Capital, speaks for a number of analysts arguing that Russia’s astonishing GDP collapse of 10.2% – in the first half of 2009 was the result of huge selling down of inventories by industrial enterprises rather than demand collapse.

 

“Very expensive money resulted in massive de-stocking in fourth quarter 2008,” he argues. “The trend intensified in the first quarter of 2009, with the negative contribution to GDP in this quarter exceeding 7 percentage points of a total decline of 9.8%.” 

 

Similarly, Anton Nikitin of UralSib argues, “the fall of GDP and slowdown in industrial production was mostly driven by the huge disposal of inventories” which started late 2008 and continued into early 2009. Citibank’s Elina Ryvbakova also estimates that at least one third of the collapse in production in the first half of this year resulted from destocking.

 

Since GDP is a pure production statistic, it plummets when enterprises en masse stall production lines to sell down inventory, even if turnover stays steady. And the harder they come, the harder they fall: overheated growth in 2008 brought about unprecedented stockpiling due to anticipated future demand. “Spiraling costs of raw materials 2007-2008 also caused companies to massively build up their inventories,” says Rybakova. Moisseev speaks of “a crisis of overproduction” starting in the first quarter of 2008, with inventories at 150% of their 2007 value.

 

If destocking rather than demand collapse was so much to blame for the economic disaster this year, then logically when inventories are empty stalled production will start up again. According to Moisseev, “some of the damage done to the economy has resulted from overheating in 1H08, and some of the damage will be easy to recover. Unfortunately, inventory statistics come with a significant delay, so we have no way of knowing what has been happening since, but historical experience suggests de-stocking cannot last for longer than two-to-three quarters”

 

Shadowy statistics

 

As Moiseev admits, the catch with betting on emptying inventories to kickstart growth is that no one knows very much about them. The problem is that Russian Federal State Statistics (Rosstat) reports inventory statistics only sketchily, on a quarterly basis and aggregated across the economy. The next figures won’t appear until October, meaning that forecasting growth on their basis is very speculative.

 

“The question of inventories has advanced to be the one of the key questions, especially because the economy ministry has focused on it,” explains Vladimir Sal’nikov of the Centre of Macroeconomic Analysis. “But the problem is that inventories are not counted directly and there is a high level of statistical error involved. It is very difficult to separate the real inventory level from the margin of error.”

 

According to VTB Capital analyst Aleksandra Evtifyeva, “Rosstat only provides quarterly aggregate inventory figures that don’t allow close analysis. The Economy Ministry has a wider base of statistics available and said in August that inventories were drying up. However we don’t know for instance if oil companies are included in their statistics or not.”

 

Business daily Kommersant has reported that Bank of Moscow analysts report that inventories have remained stable over the last three quarters, and that as a proportion of turnover inventory has grown by a third compared to 2006-2008. If true, this would point to demand collapse that Sal’nikov also feels has been underestimated. “It seems to us to be the case that markets have contracted more strongly than is reflected in statistics,” he says.

 

Citi’s Rybakova admits that the quality of inventory statistics provided by Rosstat is very poor. However, she says  “the magnitude of the production collapse in the first quartern 2009 is hard to explain by any other factor. It was more severe than in 1998.”

 

“Restocking however won’t be a panacea to cure the economy,” she adds. “Instead, we are seeing an adjustment down to a new production level, meaning inventory will never return to pre-crisis levels.” Rybakova believes restocking could add 1-3% to annual GDP growth, but not before 2010. Instead, she believes that consumer demand will pull Russia back up, if it strengthens. Sal’nikov also prefers demand as a growth factor – but tips deferred demand for investment goods instead of consumers.

 

With the government still holding out for growth driven by an end to destocking, skeptical voices are growing stronger. The Finance Ministry forecast for August was for 1.5% growth, but the result disappointed at 0%. Electricity consumption statistics, a proxy for industry, show demand still contracting.

 

Timothy Ash of Royal Bank of Scotland is consequently dismissive about the talk of growth. “Brokers seems to be jumping over themselves at the moment to talk up the Russia story, that recovery has begun, and that Russia will bounce back quickly. While favourable base period effects should come into play in the final few months of the year, the data flow is far from convincing,” he says.

Ships, chips and automobiles: “Reset” German-style begins

Graham Stack for Russia Profile (www.russiaprofile.org)

 

Germany is opening its doors to Kremlin –linked companies looking for technologies in automotive manufacture, ship-building and microchip production. While the current German election campaign means any investors promising to save jobs are welcomed, the new openness could also point to an economic, European dimension to “reset”.

 

When US President Barack Obama came to power ten months ago and promised a “reset” to relations between the West and Russia, the talk was of missile shields, NATO expansion, Iran and Afghanistan. No one thought that reset could ripple out to include the ownership of embattled German car plant Opel. But precisely this seems to be the case, according to Arkady Dvorkovich, econmomic adviser to Prime Minister Vladimir Putin.

 

“It is a very good political signal,” Dvorkovich said on Tuesday, September 16, referring to the deal that will see Russia’s state-owned Sberbank and Canadian car components producer Magna take a majority stake in Opel, European subsidiary of bankrupt US car giant General Motors. “It means the U.S. administration is ready for maximum economic cooperation with us,” Dvorkovich said at the Reuters Russia Investment Summit. Following bankruptcy, GM is owned by the US Treasury.

 

According to Dvorkovich, powerful anti-Russia interest groups were out to scupper the deal, accounting for General Motors’ down-to-the-wire hesitancy over the deal. But President Barack Obama’s support for the Russian bid tipped the scales, according to Dvorkovich.

 

As a result, Sberbank, Russia’s largest bank, and Magna, the world’s largest car components producers, will each receive 27.5% of the car maker. Sberbank will inject $0.5m and the German government $1.7m. Magna will oversee the restructuring of the company, with an eye to the Russia market.

 

Coming in the same week that Obama implemented a key reset policy by tearing up plans for an anti-missile shield stationed in Poland and Czech republic that Russia opposed, the presidential nod for Russia’s Opel bid raises the question whether there is an economic – and European – dimension to reset.

 

Certainly the German government under Chancellor Angela Merkel has been warming to Russia ever since Obama came to power in January 2009. Merkel had previously positioned herself as a skeptic on Russia, compared to her predecessor in office Gerhard Schroeder, and sought closer ties with the US. But Germany now seems to be moving in the wake of Obama’s reset to reembrace Russia.

 

In 2007, a wave of acquisitions by Russian oligarchs in sectors ranging from airlines to tourism caused jitters in German.  But last week, visiting the prestigious International Automotive Fair in Frankfurt last week, Merkel talked down the risks associated with Russian investors. calling Russia a “market of the future, not something to be kept at arm’s length.”

 

Merkel backed the Sberbank-Magna-Opel deal strongly and publicly all the way, despite criticism from her own economy minister and officials involved in administrating the crippled car maker.

 

This also despite the fact that the real strategic investor in the Opel case, as well as in similar deals in the pipeline for Germany’s Infineon chipmaker and Wadan shipyards, is evidently the Kremlin, through proxies such as state-owned Sberbank or other state-linked companies. This both politicizes the deals and makes them quite opaque, since it is unclear what economic entity will end up with the stake. “Our medium-term view is that Sberbank may well be a conduit for the transaction and a more logical Russian state or industrial entity will eventually be passed the stake,” says banking analyst David Nangle from Renaissance Capital, referring to the Opel case.

 

On the other hand, it is very clear what the Kremlin wants from the deals: “If the import of technologies does not take place, it will mean that (the deal) was just a waste of time,” Sberbank CEO German Gref was quoted saying to journalists on Friday.

 

The German government’s willingness to support such deals – with the nod from Obama – may point to a European dimension to reset, looking to integrate Russia economically despite the risks, rather than keep it at arm’s length.

 

Ships and chips

 

Two other deals similar to the Opel rescued have been broached by the Russians during the summer. Both involve opaque, Kremlin-linked structures bailing out struggling German companies that despite their losses have technologies the Russians want.

 

On Friday, September 18, media reported that Russia’s largest telecommunications holding AFK Sistema is negotiating to purchase a share in Infineon, the largest German microchip producer. According to Kommersant business daily, the deal currently under discussion is for Sistema to acquire 15-20% of the company for EUR 1bn, with the purchase funded by Russian state corporation Bank for Development (VEB). Sistema is a private company (although historically linked to Moscow city government).  However, following a succession of deals where the Kremlin has helped Sistema, “this [deal] could be an anticipated reciprocal ‘favour’”, says telecoms analyst Ivan Kim of investment bank UralSib. Sistema owns Russia’s largest chip producer, Sinterra.

 

And in a smaller, but similar deal, former Russian energy minister, Igor Yussufov, current member of the Gazprom board of governors, is set to acquire Germany’s bankrupt Wadan shipyards, based in Wismar and Rostock.

 

It is widely believed Yussufov is acting on behalf of Russian state-linked strategic investors, including state-owned gas giant Gazprom, and the state-owned United Ship-building Corporation. The financially stricken Wadan shipyards possess unique ice-breaking technologies that Russia needs to retool its naval shipyards to build transport vessels for energy projects in the Arctic. Again this deal has been welcomed by Merkel and the German government, despite the opaqueness about who is actually buying these asets.

 

Thus the German government seems to look positively on the Kremlin’s shopping around for technologies to modernize the Russian economy. For Vladimir Putin, and his colleague as head of state engineering and defence corporation Russian Technologies Sergei Chemezov, who according to Putin biographer Alexander Rahr were both involved in industrial espionage on Germany during Soviet times, Russian access to German technologies is a dream come true.

 

Do these deals mark an economic, European dimension to reset? On Friday, September 18, Putin called on Obama to follow up on cancellation of missile shield plans by supporting Russia’s bid to join the WTO – the longest bid in the history of the organization, with Russia the largest economy to remain outside the WTO. Former German chancellor Gerhard Schroeder has stated openly that the US has been blocking Russia’s WTO accession for political reasons. Obama’s position on Russia’s WTO bid might show whether reset can develop an economic dimension. US reset on Russia’s WTO bid will also have knock-on effects for Russian-Europe ties, since the signing of a new Russian-EU partnership agreement is largely dependent on Russia’s achieving WTO membership.

Russia: Saved by the oil, Medvedev asks what next?

Graham Stack for Russia Profile (www.russiaprofile.org)

As the ongoing crisis descended on Russia in the last quarter of 2008, its most blatant manifestation, twinned with the stock market collapse, was the plummeting oil price, falling from a record-breaking $145 to a low point of $35 a barrel. Back then it seemed that collapsing oil prices would trip Russia up as catastrophically as they did in 1998. But they soon recovered, leaving Russia ever more dependent on the black gold, and causing the country’s president to appeal to the public for help in kicking the addiction. But is Russian society able and willing to respond to his pleas for modernization?

One year on since the collapse of the Lehman Brothers ushered in the crisis, the oil price has more than doubled from that low point, to reach $72 per barrel last Thursday, with the stock market following eagerly in its footsteps. Each day, economists are proclaiming the sighting of more green shoots in the economy, and it now seems that the price of oil will be the factor that lifts Russia out of collapse, rather than ditching it.

The oil price hike looks set to continue in the short term. Last week, the International Energy Authority (IEA) raised demand forecasts for this year and next by 500,000 barrels. OPEC, also meeting last week, retained its current quotas to support the price. As a result, Goldman Sachs, Wall Street’s biggest commodities dealer, declared that oil prices could hit $85 a barrel by the end of 2009. Gazprom’s boss Alexei Miller predicted that oil could even break the $100 per barrel mark.

So despite the global crisis, oil prices have fallen only to their 2007 level – a level that at the time was hailed as unprecedentedly high. Compare this to 1998, when in the wake of a regional (Asian) economic crisis, oil prices collapsed as far down as $8 a barrel.

And there was more oil-related “good news” for Russia last week. Russia’s crude output in August hit an 18-year high. State-owned Rosneft notched a 5.5 percent year-on-year increase thanks to launching its Vankor field, and the sector as a whole is slated for a 0.3 percent increase on the year instead of the originally estimated 1.1 percent drop. Consequently, the Russian Trading System (RTS) index is likely to reach a new high for 2009 this week. Analysts and economists forecast the resumption of growth this quarter.

No credit revival

But coming out of the immediate crisis, the Kremlin is confronting the fact that Russia is now more dependent than ever on the price of oil – the very dependency that Kremlin policies over the last eight years have been trying to reduce. This is not just because the stabilization fund, intended to act as an air bag in the case of a commodity price crash, will have been used up by 2010 on funding a massive budget deficit. And not just because the current oil price still seems detached from the fundamentals and another sharp drop could still be around the corner next year.

The problem is that the flow of cheap financing from global markets to Russia that drove a lot of economic growth during Vladimir Putin’s presidency has now dried up for good. It was the dramatic expansion of credit during Putin’s second term that created the first signs of diversification – through consumer demand and the funding of new industrial projects.

The continued availability of such funds was crucial to the “Putin plan” of diversifying the economy. According to Chris Weafer of UralSib, “the evidence is that, even from the early days of Vladimir Putin’s presidency, there existed at least a broad outline of a long-term development plan to transform the economy from its dependency on natural resources to one with a better range of drivers, where the risk of the sort of boom-to-bust cycle experienced recently is substantially reduced.” The mechanism for achieving this was the classic plan to “move up the value-added chain.” Weafer claims that “the main message of last week is ‘don’t worry so much about the oil price.’ By far the bigger problem is the near-absence of credit and lending in the economy.”

Cheap credit and open Kremlin encouragement for Russian companies to borrow abroad caused an influx of international funding into the Russian private sector that now has left the county’s companies with nearly $500 billion in foreign debt to pay back. And no new credit is on the horizon. This means that growth, when it resumes, will be one-legged, based on and limited to commodity sector revenues, bereft of the prospect of industrial diversification as envisaged by Putin – and all the more vulnerable to another downturn in commodity prices.

Medvedev turns from economy to society for modernisation

With the credit-starved economy unable to deliver the modernization the Kremlin wants, there is no alternative now but to turn to society and campaign against the litany of social ills that throttle Russia’s prospects just as much as the drying up of credit markets has. This is the significance of Dmitry Medvedev’s cri de coeur article “Forward Russia!” published Thursday, September 10, almost exactly one year since the start of the crisis.

“First, let’s answer a simple but very serious question,” begins Medvedev. “Should a primitive economy based on raw materials and endemic corruption accompany us into the future? And should the inveterate habit of relying on the government, foreign countries, on some kind of comprehensive doctrine, on anything or anyone – as long as it’s not ourselves – to solve our problems do so as well? And if Russia cannot relieve itself from these burdens, can it really find its own path for the future?”

“Twenty years of tumultuous change has not spared our country from its humiliating dependence on raw materials,” he continued. “With a few exceptions, domestic business does not invent nor create the necessary things and technology that people need. We sell things that we have not produced, raw materials or imported goods.”

Alongside calling for heightened rule of law, Medvedev has recently called attention to crucial social problems: road deaths that have robbed Russia of an incredible 300,000 citizens over the last ten years, and alcoholism and smoking accounting for many times that number. Economists put the cumulative effect of these evils at two to three percent of GDP per year.

Thus, with Putin’s plan to tap industry for a modernization drive left on the rocks by the outgoing credit tide, Medvedev’s plan is to tap society’s modernization potential. The day following the publication of the article, a raft of proposals to regulate the alcohol market was published.

There should be some easy gains here, analysts say. It surely can’t be that hard to persuade Russians to wear a seatbelt or to drink and smoke less, especially given the extent of media control. All Western governments have wrestled with these same problems over the last 30 to 40 years with considerable success.

But huge hazards await anyone trying to change Russian society from the top, as Mikhail Gorbachev found out to his cost during his Perestroika-era anti-alcohol campaign – a campaign that positively impacted life expectancy, but reflected negatively on Gorbachev’s popularity. Basically, Russians do not like being preached to by their leaders.

This is the risk Medvedev will run if he tries to mobilize a distrustful society for modernization. It is a dilemma that a colleague of Medvedev’s, the Governor of the Kirov region Nikita Belykh, documented very accurately on the exact same day when Medvedev’s article was published.

Thirty-five year old Belykh, the former head of opposition liberal party the Union of Right Forces (SPS) and a sharp critic of Vladimir Putin’s policies, was appointed to head the Kirov region by Medvedev in December of 2008. “When I was in opposition,” Belykh said at a roundtable discussion on “Society and Reforms,” “I despised the authorities. Now that I am in office myself, I still don’t like them, perhaps even less so, but to be honest, I am starting to dislike society as well. A more destructive, obdurate, inadequate and stupid institution than society does not exist. We sit down together at one table, talk, discuss problems, reach an agreement and sign, and the next day they are out demonstrating against you under your window.”

“People refuse to recognize that the authorities can achieve anything,” Belykh was quoted by polit.ru as saying. “There’s an assumption of guilt. Any actions are regarded either as a provocation, or simply go unnoticed. It’s difficult not to act as a dictator, to break with the liberal idea.”

Medvedev calls for democracy po-russki

“Russian democracy will not merely copy foreign models. Civil society cannot be bought with foreign grants,” Russian President Dmitry Medvedev has said in an article published today September 10 by Internet newssite Gazeta.ru, expressing a conservative evolutionary vision of democraticisation.

Crucially, however, Medvedev said that parties would play a central role in Russian democracy, competing for power at all levels, and even nominating candidates for the post of president.

“As in most democratic states, parliamentary parties will be leaders in the political struggle, regularly replacing each other in power. Parties and their coalitions will form federal and regional governments, not vice versa, and nominate candidacies for president, and regional and local government leaders,” Medvedev said, according to Interfax.

But this won’t happen overnight. Medvedev said genuine democracy has to develop through experience and practice, and cannot simply be imported. “Only our own experience of democratic development will give us the right to say that we are free, we are responsible, we are successful,” Medvedev wrote. “Political culture cannot be changed merely by imitating political events of progressive societies, (…) freedom cannot be copied from a book, even if it is a very good book. (…) But no one will live our life for us. No one will become free, successful, and responsible for us,” Medvedev said.

Medvedev argued in favour of gradualism rather than the attempts at radical democraticisation Russia saw in the 1990s.

“We have no right to put social stability at risk and threaten life even for the sake of the loftiest of the goals. (…) Reforms are intended for people, not people for reforms. (…) Change will come. Yes, it will be gradual and well thought out, and go step-by-step. But it will be steady and consistent,” Medvedev said, according to Interfax.

Medvedev significantly failed to mention the role of the mass media and freedom of the press in his article. Instead, he highlighted an effective judiciary as the missing link in Russia’s attempts at democraticisation to date.

“Democracy is in need of protection as much as the fundamental rights and liberties of our citizens are. First of all, protection from corruption, which breeds lawlessness, lack of freedom and injustice. We are just beginning to build such a protection mechanism. The judiciary must be its nucleus,” he wrote.

Although insisting Russia had to take its fate in its own hands, Medvedev also said Russia needed more international integration to be successful. “Our internal financial and technological capabilities are insufficient today to give a real boost to the quality of life. We need money and technologies from countries of Europe, America and Asia,” he wrote, according to Interfax.

Medvedev also highlighted the roots of the demographic crisis. “The population is shrinking with every passing year. Alcoholism, smoking, traffic accidents, poor access to many of the modern medical technologies and environmental problems cut the life span of many people. An increase in birthrate that has made itself felt, does not compensate for the number of deaths,” he said.

Medvedev has made a series of strong statements about the impact of alcoholism on Russia’s development, and spoken positively about Mikhail Gorbachev’s ill-fated anti-alcohol campaign. However, specific measures have yet to be formulated.

Unistream money transfer network expands despite crisis

Graham Stack in Hamburg for Business New Europe (bne)

 

Unistream, the biggest player on the money transfer market in the CIS, tells bne the crisis has not impacted on operations, and the network is set to expand into Germany.

 

One year ago, as the economic crisis struck, it seemed the Central Asian countries would soon plunge into crisis as the remittances from Russia they depend upon dried up.  However, Suren Ayriyan, president of Unistream bank, the biggest operator of money transfers in the CIS region, tells bne that the money transfer volume has remained stable on the year. “After a short blip, transfer volumes are back to their level of one year ago,” says Ayriyan.

 

Unistream is the Western Union of the East, with a share of 27% of  the money transfer market for the CIS corridor at the end of 2008, according to the Russian Central Bank. With remittances from Russia accounting for 20-45% of GDP for the countries of the Caucasus and Central Asia, the severity of the crisis descending on Russia at the end of 2008 seemed to bode ill for Eurasia. Alarmist scenarios predicted even state collapse in Tadzhikistan as workers returned home empty handed.

 

“Nothing like this has happened,” says Suren Ayriyan, president of Unistream. “Money transfers did fall at the start of 2008, but recovered by the spring. People simply did not return home even if they lost their jobs,” Ayriyan explains. “They stayed in the country, and found other work, even if only in the informal economy. No one went anywhere.”

 

Another factor supporting money transfer volumes during the crisis: with fuel prices staying high, the cost of transport home has become unaffordable for many migrant worker. “That’s why, although the average amount of a single transfer has fallen, the number of transfers has risen,” explains Ayriyan.

 

This means that despite the 30% dip in the market in the first quarter, money was quickly flowing again as things stabilised. With Russian companies looking to cut costs, cheap immigrant workers outcompete Russians on the Russian labour market. Tadzhikistan, Uzbekistan and Kyrgyzstan are among the few CIS countries to have experienced growth this year, not least due to the stable level of remittances facilitated by Unistream.

 

Unistream’s total volume of transfers in 2008 was $4bn (at current dollar rates) and in 2009 is looking to reach $4.5bn, despite the crisis.

 

The Unistream network has snowballed. With a turnover of $760m in 2005, the company reached $1.85bn volume in 2006, and $3.7bn in 2007, with the number of customers soaring from 870,000 in 2005 to 3.7m in 2007,

 

In 2008, the company took 57% of the market in Armenia , 45% in Kyrgyzstan , 41% in Moldavia , 25% in Tajikistan , and 22% in Uzbekistan.

 

Unistream is not just about remittances: Russia being the size it is, and the banking system still underdeveloped, Unistream’s Russian in-house network adds up to more than 40% of the system’s total turnover.

 

The particularly strong showing in Armenia is not coincidental. Both Ayriyan and co-owner of the bank Gagik Zakarian are of Armenian origin, one of the historic diaspora nations. “$4bn flow to Armenia from Russia annually,” Zakarian tells bne, “and about another  $500m from the US.”

 

Going German

 

The awareness of the West as a source of remittances is now prompting Unistream to roll out its system in the EU countries, including Britain and Greece, but first and foremost Germany.

 

“Today more than three million of the country’s residents are economic migrants from the CIS, which, given the decidedly high standard of living in Germany , is inevitably a dynamic growth driver for the money transfer market,” says Ayriyan.

 

Analysts at Unistream estimate that Germany’s money transfer market in all directions will be annually worth more than $12bn even in the immediate post-crisis period, which is absolutely colossal, bearing in mind that the Russia-CIS corridor added up to a total $15bn in 2008. The Germany-CIS corridor’s value is around $4bn. Unistream is looking to take 10% of this corridor’s volume in the mid term, according to Ayriyan.

 

A particular challenge to setting up in Germany is the toughness of the money laundering laws and general supervisory requirements of financial sector, that make obtaining a license a time-consuming and exhausting process. Despite strictness of personal identification rules for money wires, the extent of Internet coverage here means Unistream is developing an online service. “At the same time, taking into account that many migrants in Germany from the CIS are of the older generation, it is important to have a physical presence including Russian speaking staff,” says Ayriyan.

 

Powerful backing

 

Unistream is owned by its founders Georgii Piskov and Gagik Zakarian, with a 26% stake spun off to Aurora private equity group in 2006. Piskov and Zakarian were the founders and owners of Russia’s Uniastrum Bank, until selling 80% of the bank to the Bank of Cyprus in 2008 for 447m euros, months before the financial crash. This means the Unistream owners have deep pockets with which to finance the further expansion of the system, which was not included in the deal.

 

“Unistream is a highly solvent, highly liquid system,” Piskov tells bne, “which does not need any extra financial support presently. However, any funds it requires for business purposes will be forthcoming.”

 

Piskov makes no bones of his ambitions in the money transfer business. “We want to go global, and expand beyond the CIS corridor. When you have created such a system, it’s simply logical to roll it out in country after country,” he says.

Afghan heroin could kill US-Russian reset

Graham Stack for Russia Profile (www.russiprofile.org)

In context of the “reset” in U.S.-Russian relations, the two countries’ cooperation over Afghanistan has been hailed as a model for working together in other areas, ranging from Europe to Iran and North Korea. But with the reset hardly underway, opinion differences are already emerging between Moscow and Washington over anti-narcotics policy in Afghanistan.

Russia’s security policy hawks tend to react negatively to the United States acting unilaterally, deploying interventionist military power and tweaking UN mandates to expand missions. But when in 2008 U.S. hardliners pushed for the American military and allies to widen the fight against the Afghan Taliban to include military engagement of the country’s billion-dollar narco-industry, including a shoot-to-kill policy against heroin producers and a blanket aerial crop-eradication campaign, Russia’s siloviki stood up and applauded.

U.S. hardliners regarded Afghanistan’s opium production as a crucial source of financing for the strengthening Taliban insurgency, and drew inspiration from the America’s experience of having fought and largely won a war with drug producers in Columbia. In 2007, the U.S. ambassador to Columbia William Wood, an ardent supporter of aerial crop eradication, was reassigned to Afghanistan to step up the war on drugs. “If there is no poppy, there is nothing to traffic,” Wood told reporters on arrival. In 2007, military operations supporting manual eradication got underway, and in January 2009, a leaked letter by NATO’s Supreme Commander General John Craddock to European counterparts declared an effective shoot-to-kill policy for the drug war, saying it was “no longer necessary to produce intelligence or other evidence that each particular drug trafficker or narcotics facility in Afghanistan meets the criteria of being a military objective.”

Iraq, Iran and North Korea are all examples where Russia has vehemently opposed the use of American military force against weapons of mass destruction. But without any sense of irony, Viktor Ivanov, the head of Russia’s Federal Anti-Narcotics Service (FSKN) speaking in February called Afghanistan’s heroin “a weapon of mass destruction of a special kind,” and expressly demanded that the United States and its allies in Afghanistan engage and destroy it.

Ivanov’s reasoning is clear: Russia is the country worst affected by Afghanistan’s heroin exports. According to FSKN statistics, Russia has up to 2.5 million drug addicts, mostly in the critical reproductive age group of 18 to 39, with the number surging by 80,000 a year. Ninety percent of drug addicts in the country use Afghan heroin. These alarming figures do not take into account the enormous number of HIV infections transmitted via dirty needle sharing. “Today it is self-evident for everyone that the state should take decisive emergency measures to prevent an approaching national catastrophe,” Reuters reported Ivanov as saying in May, adding that “it is time the world community got serious about the Afghan drug problem.”

Although Ivanov has no official foreign policy remit, he is not simply a law-enforcement officer lobbying for a larger budget. A former KGB officer, he is a longstanding associate of the current Prime Minister Vladimir Putin, and a key member of the influential “silovik” network of former KGB officers from St. Petersburg responsible for Russian security policy. He was a top Kremlin aide throughout Putin’s presidency before moving to the FSNK in 2008. And there is also a special personal background to Ivanov’s interest in Afghanistan: he served there with the Soviet forces in the 1980s during the Soviet Union’s disastrous occupation. His move to the FSNK duly shifted the organization’s attention from the domestic to the international dimension of Russia’s heroin problem.

It is testimony to Ivanov’s influence that the joint declaration given by U.S. President Barack Obama and Russian President Dmitry Medvedev at June’s Moscow summit listed combating illegal drug trafficking alongside the fight against terrorism and armed extremism as shared goals in Afghanistan, with Obama acknowledging that “Russia has deep concerns about the [Afghan] drug trade and its infiltration into Russia.”

New man on the job

The Obama-Medvedev summit was the birth of the U.S.-Russian “reset,” and the new spirit of cooperation was marked by Russia’s agreement to allow the transit of U.S. weapon cargo to Afghanistan. But ironically, as part of Obama’s global adjustment of foreign policy, the U.S. policy in Afghanistan is also being reset – and the results are not looking like anything Russia would want them to be.

Obama’s shift away from George Bush’s hardline policies has seen both general Craddock and ambassador Wood lose their posts this year. Instead, a veteran Democrat diplomat Richard Holbrooke has taken over the U.S. policy in the area as the American special envoy to Afghanistan and Pakistan. Holbrooke is a longstanding opponent of any form of crop eradication, whether on ground or by air, and indeed largely denies that Afghanistan’s opium trade is the main source of funding for the Taliban insurgency.

“If the drugs ended tomorrow, it would not have a major effect on the Taliban source of funding,” Holbrooke declared in June at a ceremony to mark General Stanley McChrystal’s assumption of command of American and NATO forces in Afghanistan.

Holbrooke pointed out that the ground-based crop eradication program has been costly in terms of money and lives, and has failed to make any impact. These are points the Russians agree with – but instead of ending crop eradication, Ivanov is demanding a step-up to aerial eradication, and lamented general Craddock’s departure in an interview he gave to the Kommersant daily in June.

In response to Holbrooke, Ivanov claims it would be possible to end the Afghan opium production swiftly, and adduces two examples: firstly, he says, following the UN’s condemnation of Afghanistan’s heroin exports in 1999, in 2000 and 2001 the Taliban reduced the opium harvest practically to zero. Secondly, the U.S. crop eradication campaign in Columbia has been largely successful. According to Ivanov, 74 percent of the coca crop was destroyed in 2008, with no increase in armed resistance.

Ivanov says the UN should force the United States and its allies to take decisive action against opium production in Afghanistan, firstly by declaring Afghan’s narcotics trade an international threat, as it has done with terrorism and piracy. Following this, Russia should make the next annual renewal of the UN mandate for international troops in Afghanistan conditional on action against heroin production and trafficking. “The further presence of coalition forces in Afghanistan should be made conditional on an undertaking to destroy drug fields,” Ivanov told a conference in April. Russia’s UN Security Council veto means that theoretically, Russia has the leverage to do this.

Ivanov has gone as far as to propose tying U.S. transit of weaponry to Afghanistan via Russia to a more active pursuit of crop eradication on behalf of the Americans. “The granting of transport corridors to NATO forces in Afghanistan should be conditioned on a commitment to destroy sown areas, laboratories, stocks and other infrastructure of the Afghan drug business,” he told Russia’s Duma in late June.

With Russian demands for crop eradication becoming more strident while U.S. strategy moves decisively away from the approach, the signs do not bode well for U.S.-Russian cooperation in the one policy area where it has been strongest to date.

At the same time, however, U.S. strategy is shifting away from unconditional support for the Afghan President Hamid Karzai, an opponent of crop eradication who has been frequently accused of protecting major figures involved in opium and heroin production. Indeed, on August 28 reports appeared in the media that Holbrooke had had a major row with Karzai over allegations of ballot-stuffing in the August 20 presidential elections.

A more distanced approach toward the Karzai administration could make Holbrooke’s plan to go after the big fish of heroin production and trafficking, instead of the small fry opium farmers, seem more plausible to the Russians. This is something that Ivanov, who has called for a UN blacklist of Afghan drug barons to be compiled, could go along with. On the other hand, Russia’s drugs tsar is skeptical that the big fish can be found in Afghanistan. “All these people live a long way from Afghanistan, for instance in United Arab Emirates and Saudi Arabia,” he told Kommersant in June