The Oil Price Crash Could Be Good for Russia in the Long Run

By Markets Fool.com

Russia is in big trouble. In just six months, the price of oilhas been cut in half -- a nightmare scenario for the Kremlin that has only occurred once beforein the post-Soviet era.

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Russians have a long history with oil.
Artist: Niko Pirosmani.

Oil and gas account for two-thirdsof all Russian exports and roughly half of Russia's federal government revenue. In late October, as the oil crash accelerated, Morgan Stanley energy analysts estimated that each $10 shaved off the price of oil would shave 1.6% off of Russian GDP. The price of a barrel of Brent crude oil topped out at $115 per barrel this past summer, and with prices just below $50 per barrel today, Russia is looking at a potential loss of roughly 10% of its GDP. The American economy never fell so far during the Great Recession. In fact, the only comparable crashin any living American's memory would be the one that began in 1929.

But this might be a good thing in the long run.

A story of oil
The story of Russia's economy is, and has been for decades, a story of oil. Soviet posturing during the 1960s gave Americans a collective national fear, but by then, Soviet leaders were already finding it increasingly difficultto feed their people. Salvation eventually came in the form of black gold drilled in the Siberian tundra, and Soviet oil production boomed throughout the 1970s, driven by a 12-fold increase in oil pumped from Siberia between 1970 and 1982.

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The Soviets were also extremely fortunate to strike oil a few years before OPEC instigated the worst oil price shock in history in 1974, which was followed by another huge oil price spike in 1979. The price of oil, which had been less than $3 per barrel in nominal terms in 1970, peaked at more than $37 per barrel in 1981. This price would not be surpassed again until 2005, to Russia's lasting detriment:


Sources: U.S. Energy Information Administrationand United Nations National Accounts.

The USSR's doom was sealed not by any American president, but by Sheikh Ahmed Zaki Yamani, the Saudi Arabian oil minister who opened the floodgates on Saudi production in 1985. In an effort to prop up oil prices after the price spikes of the 1970s, the Saudis had reduced production by 4.8 million barrels of oil from 1980 to 1985. This loss of output accounted for three-quarters of a worldwide decline in oil production during that time. But from 1985 to 1990, the Saudis boosted their daily oil production by 3.2 million barrels per day as worldwide production shot to new records.

The 48% decline in domestic oil prices from 1985 to 1986 in response to this strategic shift remains the worst year-over-year drop in history, at least up to 2013. Instead of adapting to this new reality, Soviet leaders tried to paper over their fiscal problems with international loans, but by 1989, no one would lend the Soviets the money they needed to make up the oil revenue shortfalls. Within two years, the Soviet Union had ended.

Russia's financial problems went so deep by the end that it could no longer even afford to sustain the oil output of its aging wells. From 1988 to its final year in 1991, the Soviet Union's oil production fell by 17%, and Russia's production fell by a further 22% from 1992 through 1998, when it suffered through a second crash in which oil prices declined by a third. By the end of 1999, Russia's per-capita GDP was a stunning 65% weaker than it had been when the Soviet Union ended in 1991. This collapse had an unexpected consequence: the ascent of Vladimir Putinto the Russian presidency.

Putin has a firm grip on power.Source: Presidential Press Office (kremlin.ru).

The Putin economic "miracle"
Russia's economic health was bound closely to the price of oil in the years preceding the Soviet Union's collapse, but Russian prosperity and oil prices now move in virtual lockstep, as its economy has become a virtual petro-state. Under Putin, per-capita GDP grew roughly tenfold from its 1998 low to 2012, but this growth was greatly aided by a fivefold increase in oil prices and a 4.3 million-barrel-per-day increase in Russian oil production over the same time frame.

This decade-plus economic expansion has created for Putin -- deservedly or not -- a cult of personality that has actually strengthened as Russia's economy has weakened. Putin's approval rating has never dipped below 60% since the start of the 21st century, and it stood at 85% just last month, despite the ongoing slide in both oil prices and the Russian ruble.

Putin's approval rating is far stronger than former President Boris Yeltsin'sever was, but it's important to note that Putin has yet to face the sort of economic withering over which Yeltsin presided. Putin had also not presided over a ruble crash before this past year, and the effect of that crash may eventually remind Russians of the 1998 collapse, according to AvaTrade International Chief Market Analyst and currency exchange expert Naeem Aslam:

Russia is once again under economic threat and its current government is not ameliorating the economic meltdown, which will feel like deja vu to Russians who experienced the same thing in 1998. Falling oil prices have taken the biggest toll on Russia's economy and once again the government has failed to hedge. The primary foundation of the Russian market is still built on the energy sector, and they have not made any fundamental changes to their economy since the last major crash.

Putin has held onto power for more than a decade, but even popular leaders must adapt or fall amid a drawn-out economic crisis. If Russia can learn from this crash to finally reduce its reliance on oil and diversify its economy, it would be a tremendous boon to both the Russian people and the world at large. Of all oil-dependentcountries, only Nigeriahas more people than Russia, and most Nigerians (medianage: 18.2 years) are still too young to fully participate in a modern skills-driven economy. To do this, Russia and its people must develop more companies and industries with little to no dependence on the price of oil.

Only six of the 28 Russian companies on Forbes' most recent Global 2000 list (not including three banks) rake in their rubles without handling oil, gas, metals, or other substances drawn from the earth. Only three of those six companies -- retailers Magnitand X5and national Internet giant Mail.ru-- are truly post-Soviet entities, as the others were refashioned out of Soviet-era telecom and hydroelectric assets.

The country's public markets are so reliant on extractive industries that the past year's oil price crash has made all Russian stocks combined worth less than the largest American public company, Apple . Russia's 10 largest pure-play Internet companiesearned less combined revenue in 2013 than Facebook earned in the second half of that year, and the 20 largest Russian e-commerce sites combined for less total revenue than what Amazon.com earned during the holiday season.

What comes next?
Yet this is still a much stronger foundation than what Russia stood on in 1998, during the last crash. In fact, these Russian Internet companies offer a glimmer of hope for the country's beleaguered economy; all but one of these 30 companies were formed after the 1998 crash, and many of them are so new that they have ample room to grow in an eventual recovery.

And while extractive industries are currently vital to the Russian economy, they're hardly the only thing Russia has going for it. Russia's manufacturing, retail/wholesale, and real estate sectors all contributed more to Russian GDPthan its extractive industries, even at the higher oil prices of two years ago. Russia also has in its favor a sizable amount of financial reserves -- more than three times as much as those held by the United States. These assets, built up by years of oil-revenue surplus, could be used to seed a more diverse and resilient Russian economy.

Today, Russia needs $100 oil, but over the long run, it needs to modernize its economy. So long as its policymakers cling to the myth of permanently high oil prices, Russia will never move forward. The longer oil prices remain low, the worse the situation gets for Putin and his inner circle -- and the better things might get for Russia in the end.

The article The Oil Price Crash Could Be Good for Russia in the Long Run originally appeared on Fool.com.

Alex Planes holds no financial position in any company mentioned here. Follow him on Twitter @TMFBiggles or connect with him on LinkedIn for more insight into investing, markets, economic history, and cutting-edge technology.The Motley Fool recommends Amazon.com, Apple, and Facebook. The Motley Fool owns shares of Amazon.com, Apple, and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.